Global Economics

  

Set up a Ricardo-type comparative advantage numerical example with two countries and two goods. Distinguish “absolute advantage” from “comparative advantage” in the context of your example. Then select an international terms-or-trade ratio and explain in some detail how trade between the two countries benefits each of them in comparison with autarky. When would either of your countries NOT benefit from engaging in trade? Explain.

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write a 2-3 page paper in response to a case study or similar assignment provided by your professor. Student answers are to be clear, well-organized, and specific. Provide a concise, cogent argument and include details to support your response.    

CLO2: Assess comparative advantage and all related concepts such as opportunity costs, cost conditions, and the impact of trade on jobs. Explain how the sources of comparative advantage and related concepts such as economies of scale, theories and effects, and the product life cycle theory. (5-9)

  

The paper uses at least 8 quality peer reviewed and scholarly resources (nonwebsite based ) and 1 textbook-based resource to support his/her argument.

Professional Assignment 1 – CLO 2

CLO2: Assess comparative advantage and all related concepts such as opportunity costs, cost conditions, and the impact of trade on jobs. Explain how the sources of comparative advantage and related concepts such as economies of scale, theories and effects, and the product life cycle theory. (5-9)

Set up a Ricardo-type comparative advantage numerical example with two countries and two goods. Distinguish “absolute advantage” from “comparative advantage” in the context of your example. Then select an international terms-or-trade ratio and explain in some detail how trade between the two countries benefits each of them in comparison with autarky. When would either of your countries NOT benefit from engaging in trade? Explain.

In Weeks 2 and 6 students will write a 2-3 page paper in response to a case study or similar assignment provided by your professor. Student answers are to be clear, well-organized, and specific. Provide a concise, cogent argument and include details to support your response. Please refer to Expectations of Student Assignments and the Formatting Requirements for Written Assignments on page 10 of the University Policies for a detailing of specific expectations for how to format and write your paper. Additionally, you may refer to the PA and CLA Grading Rubric found on page 12 of the syllabus.

The paper uses at least 8 quality peer reviewed and scholarly resources (nonwebsite based ) and 1 textbook-based resource to support his/her argument.

The paper is content rich, all questions and their parts have been answered demonstrating: *critical analysis *application of learned concepts to real world *research-based evidence

The paper: *demonstrates effective, well supported argument *provides supporting evidence for argument *demonstrates a strong relationship between argument and assignment requirements

The paper is well organized and includes: *logical flow *correct use of APA headings *introduction and conclusion

The paper contains correct grammar, spelling, and sentence structure.

The paper follows all formatting guidelines, including page-length, APA formatting requirements, correctly formatted in text citations, and correctly formatted references and reference page

*draw logical and valid conclusions *provide supporting researchedbased evidence including peer reviewed articles *utilize the textbook, online databases and the internet to locate supporting literature

app9062x_fm_i-xxiv.indd i 06/23/16 07:11 AM
INTERNATIONAL
ECONOMICS
NINTH EDITION
DENNIS R. APPLEYARD
DAVIDSON COLLEGE
ALFRED J. FIELD, JR.
UNIVERSITY OF NORTH CAROLINA
AT CHAPEL HILL
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app9062x_fm_i-xxiv.indd ii 06/27/16 12:48 PM
INTERNATIONAL ECONOMICS, NINTH EDITION
Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2017 by McGraw-
Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2014, 2010,
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not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.
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Library of Congress Cataloging-in-Publication Data
Names: Appleyard, Dennis R., author. | Field, Alfred J., author.
Title: International economics / Dennis R. Appleyard, Davidson College,
Alfred J. Field, Jr., University of North Carolina at Chapel Hill.
Description: Ninth edition. | New York, NY : McGraw-Hill Education, [2017]
Identifiers: LCCN 2016016254 | ISBN 9781259290626 (alk. paper)
Subjects: LCSH: International economic relations. | International trade. |
International finance.
Classification: LCC HF1359 .A77 2017 | DDC 337—dc23 LC record available at
https://lccn.loc.gov/2016016254
The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website
does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does
not guarantee the accuracy of the information presented at these sites.
mheducation.com/highered
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app9062x_fm_i-xxiv.indd iii 06/23/16 07:11 AM
The McGraw-Hill Series Economics
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iv
app9062x_fm_i-xxiv.indd iv 06/23/16 07:11 AM
Dennis R. Appleyard
Dennis R. Appleyard is James B. Duke Professor of International Studies and Professor of Economics,
Emeritus, Davidson College, Davidson, North Carolina, and Professor of Economics, Emeritus, Univer-
sity of North Carolina at Chapel Hill. He attended Ohio Wesleyan University for his undergraduate work
and the University of Michigan for his Master’s and Ph.D. work. He joined the economics faculty at the
University of North Carolina at Chapel Hill in 1966 and received the universitywide Tanner Award for
“Excellence in Inspirational Teaching of Undergraduate Students” in 1983. He moved to his position at
Davidson College in 1990 and retired in 2010. At Davidson, he was Chair of the Department of Economics
for seven years and was Director of the college’s Semester-in-India Program in fall 1996 and fall 2008, and
the Semester-in-India and Nepal Program in fall 2000. In 2004 he received Davidson’s Thomas Jefferson
Award for teaching and service.
Professor Appleyard has taught economic principles, intermediate microeconomics, intermediate
macro economics, money and banking, international economics, and economic development. His research
interests lie in international trade theory and policy and in the Indian economy. Published work, much of
it done in conjunction with Professor Field, has appeared in the American Economic Review, Economic
Development and Cultural Change, History of Political Economy, Indian Economic Journal, International
Economic Review, Journal of Economic Education, and Journal of International Economics, among others.
He has also done consulting work for the World Bank, the U.S. Department of the Treasury, and the Food
and Agriculture Organization of the United Nations (in Islamabad, Pakistan). Professor Appleyard always
derived genuine pleasure from working with students, and he thinks that teaching kept him young in spirit,
since his students were always the same age! He is also firmly convinced that having the opportunity to
teach others about international economics in this age of growing globalization is a rare privilege and an
enviable challenge.
Alfred J. Field, Jr.
Alfred J. Field is a Professor of Economics, Emeritus, at the University of North Carolina at Chapel Hill.
He received his undergraduate and graduate training at Iowa State University and joined the faculty at
Carolina in 1967. Field taught courses in international economics and economic development at both the
graduate and undergraduate level and directed numerous Senior Honors theses and Master’s theses. He
served as principal member or director of more than 100 Ph.D. dissertations, duties that he continued to
perform after retirement in 2010. In addition, he has served as Director of Graduate Studies, Associate
Chair/Director of the Undergraduate Program in Economics, and Acting Department Chair. In 1996, he
received the Department’s Jae Yeong Song and Chunuk Park Award for Excellence in Graduate Teaching,
and in 2006 he received the University of North Carolina at Chapel Hill John L. Sanders Award for Excel-
lence in Undergraduate Teaching and Service. He also served on the Advisory Boards of several university
organizations, including the Institute for Latin American Studies.
Professor Field’s research encompasses the areas of international trade and economic development.
He has worked in Latin America and China, as well as with a number of international agencies in the
United States and Europe, primarily on trade and development policy issues. His research interests lie
in the areas of trade policy and adjustment and development policy, particularly as they relate to trade,
agriculture, and household decision making in developing countries. Another of Field’s lines of research
addressed trade and structural adjustment issues in the United States, focusing on the textile and apparel
industries and the experience of unemployed textile and apparel workers in North Carolina during the
1980s and 1990s. He maintains an active interest in theoretical trade and economic integration issues, as
well as the use of econometric and computable general equilibrium models in analyzing the effects of trade
policy, particularly in developing countries.
ABOUT THE AUTHORS
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v
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It is our view that in a time of dramatic increase in globalization and high interrelatedness among coun-
tries, every student should have a conscious awareness of “things international.” Whether one is studying,
for example, political science, sociology, chemistry, art, history, or economics, developments worldwide
impinge upon the subject matter of the chosen discipline. Such developments may take the form of the dis-
covery of a new compound in Germany, an election result in Greece, a new oil find in Mexico, formation
of a new country in Africa, startling new political/terrorist/military events in Pakistan, Syria, France, or
the United States, or a change in consumer tastes in China. And, because information now gets transmit-
ted instantaneously across continents and oceans, scientists, governments, firms, and households all react
quickly to new information by altering behavior in laboratories, clinics, legislative processes, production
and marketing strategies, consumption and travel decisions, and research projects. Without keeping track
of international developments, today’s student will be unable to understand the changing nature of the
world and the material that he or she is studying.
In addition to perceiving the need for international awareness on the part of students in general, we
think it is absolutely mandatory that students with an interest in economics recognize that international
economic events and the international dimensions of the subject surround us every day. As we prepared
to launch this ninth edition of International Economics, we could not help noting how much had changed
since the initial writing for our first edition. The world has economically internationalized even faster than
we anticipated more than 20 years ago, and the awareness of the role of international issues in our lives
has increased substantially. Almost daily, headlines focus on developments such as the increased problems
facing monetary union in Europe and the euro; proposed policies of erecting additional trade barriers as a
protective response to worldwide economic weakness; increased integration efforts such as the emerging
Trans-Pacific Partnership; and growing vocal opposition and hostility in many countries to the presence of
large and increasing numbers of immigrants at home and abroad. Beyond these broad issues, headlines also
trumpet news of the U.S. trade deficit, rising (or falling) gasoline prices, the value of the Chinese renminbi
yuan, and the shifting of the headquarters of U.S. firms to foreign locations. In addition, as we write this
edition, the world has become painfully aware that increased globalization links countries together strongly
in times both of recession and prosperity.
The growing awareness of the importance of international issues is also in evidence in increased stu-
dent interest in such issues, particularly those related to employment, international working conditions,
and equity. It is thus increasingly important that individuals have a practical working knowledge of the
economic fundamentals underlying international actions to find their way through the myriad arguments,
emotions, and statistics that bombard them almost daily. Young, budding economists need to be equipped
with the framework, the tools, and the basic institutional knowledge that will permit them to make sense of
the increasingly interdependent economic environment. Further, there will be few jobs that they will later
pursue that will not have an international dimension, whether it be ordering components from a Brazilian
firm, traveling to a trade show in Malaysia, making a loan for the transport of Caspian Sea oil, or working
in an embassy in Quito or in a medical mission in Burundi.
The motive for writing this edition is much the same as in earlier editions: to provide a clear and com-
prehensive text that will help students move beyond simple recognition and interest in international issues
and toward a level of understanding of current and future international developments that will be of use
to them in analyzing the problem at hand and selecting a policy position. We seek to help these scholars
acquire the necessary human capital for dealing with important questions, for satisfying their intellectual
curiosity, and for providing a foundation for future on-the-job decisions.
We have been very flattered by the favorable response to the previous eight editions of our book. In
this ninth edition, we continue to build upon the well-received features to develop a text that is current and
attuned to our objectives. We have also continued to attempt to clarify our presentation of some of the more
difficult concepts and models in order to be more student-friendly.
IMPROVEMENTS AND SPECIFIC CHAPTER CHANGES
In this edition, as usual, we have attempted to provide current and timely information on the wide variety
of international economic phenomena. New boxes have been added and previous ones modified to provide
up-to-date coverage of emerging issues in the global economy. The text includes such matters as recent
developments in U.S. trade policy, major changes in the European Union and developments since the
PREFACE
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vi PREFACE
app9062x_fm_i-xxiv.indd vi 06/23/16 07:11 AM
Chapter 1
∙ Updated all tables and their accompanying
descriptions.
Chapter 2
∙ Introduced additional material to the “In the
Real World” box on current thinking with Mer-
cantilist underpinnings and slightly amended
existing material in the box.
Chapter 3
∙ Updated material in the “In the Real World”
box on export concentration of selected
countries.
Chapter 4
∙ Extended the table on freight and insurance fac-
tors in the “In the Real World” box on transpor-
tation costs to include 2013 as well as different
countries; introduced new replacement table
showing relative transportation costs by major
geographical trading area; updated table on con-
tainership charter rates.
∙ Replaced existing Golub study on unit labor
costs and trade patterns with newer and more
comprehensive examination of the empirical
validity of the Ricardian model.
∙ Introduced recent research on relative produc-
tivities and country specialization in output.
∙ Updated graphs showing U.S. steel industry
labor productivity and U.S. import penetration
ratios in steel in the existing “In the Real World”
box.
∙ Introduced material on the spread of the ben-
efits of productivity growth in China to other
countries.
Chapter 5
∙ Updated the “In the Real World” box on con-
sumer expenditure patterns since 1960 to
include 2014 data.
Chapter 6
∙ Revised the “In the Real World” box on income
distribution and trade to include recent material
on changes in welfare due to trade.
Chapter 7
∙ Updated information contained in “In the Real
World” boxes showing the commodity terms of
trade and income terms of trade of major groups
of countries since 1973.
Chapter 8
∙ Introduced additional 2014 material on Cana-
dian capital/labor ratios in selected industries.
∙ Updated estimates of tariff equivalence of trans-
port costs in international trade.
∙ Restructured and updated the “In the Real
World” box on cartels and monopolistic behav-
ior in international trade.
Chapter 9
∙ Condensed the discussion of the Leontief
paradox.
∙ Added new material on factor-intensity
reversals.
∙ Added new material on the testing of the
Heckscher-Ohlin theorem.
∙ Updated the data on the increasing income
inequality in the United States.
∙ Provided new information on the impact of edu-
cation on relative wages.
2007–2009 worldwide financial crisis/recession. We should note that, in the monetary material, we con-
tinue to maintain our reliance on the IS/LM/BP framework for analyzing macroeconomic policy options,
such as during the recent period, because we believe that the framework is effective in facilitating student
understanding. We also continue to incorporate key aspects of the asset approach into the IS/LM/BP model.
Particular mention should be made of the fact that, in this edition, we have continued to employ Learn-
ing Objectives at the beginning of each chapter to orient the reader to the central issues. This text is com-
prehensive in its coverage of international concepts, and the Learning Objectives are designed to assist the
instructor with the choice of chapters to cover in designing the course and to assist the students in focusing
on the critical concepts as they begin to read each chapter. The Learning Objectives are now coordinated
with the major sections of the chapter in that each objective is tied to a particular section. Further, because
of the positive response to the opening vignettes in recent editions, we have retained and updated them in
this edition to focus on the real-world applicability of the material.
We have continued to use the pedagogical structure employed in the eighth edition. As in that edition,
the “In the Real World” boxes are designed to provide examples of current international issues and
developments drawn straight from the news that illustrate the concepts developed in the chapter. We have
added, updated, or deleted boxes where appropriate. In situations where particularly critical concepts would
benefit from further elaboration or graphical representation, we have continued to utilize “Concept” boxes.
Generally speaking, in each chapter we edited and updated textual material, in addition to the specific
changes listed below. Also, where appropriate, we have deleted outdated or overly technical material, and
these deletions are not included in this list.
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PREFACE vii
app9062x_fm_i-xxiv.indd vii 06/23/16 07:11 AM
∙ Added material on the effects of Danish
outsourcing.
Chapter 10
∙ Reorganized the chapter to separate early post–
Heckscher-Ohlin theories from more recent
post–Heckscher-Ohlin theories.
∙ Added material on the Melitz model of trade as
well as material on multiproduct exporting.
Chapter 11
∙ Updated table showing the factor endowments
of the United States, Japan, Canada, Australia,
France, and Mexico to include 2014.
∙ Revised the “In the Real World” box discuss-
ing the recent terms-of-trade movements of four
developing countries (Brazil, Jordan, Pakistan,
and Thailand).
Chapter 12
∙ Updated the tables on foreign direct investment
abroad by U.S. firms and foreign direct invest-
ment in the United States, as well as the tables
on the world’s largest corporations and the
world’s largest banks.
∙ Updated the “In the Real World Box” on migra-
tion into the United States and the country ori-
gins of that migration.
Chapter 13
∙ Updated the “In the Real World” box on impor-
tant features of the commercial policy schedules
of Australia, Pakistan, and El Salvador.
Chapter 14
∙ Added material on the U.S. ban on the export of
crude oil.
∙ Introduced a new “In the Real World” box on
the welfare impacts of Japanese import restric-
tions on rice.
∙ Introduced material regarding the potential
impact of relaxing import restrictions in the con-
text of the Melitz model.
∙ Added material to the “In the Real World” box
on U.S. import restrictions on sugar.
Chapter 15
∙ Updated the “In the Real World” box on trade
taxes as a source of government revenue.
∙ Updated the “In the Real World” boxes on U.S.
antidumping actions and U.S. countervailing
duties.
∙ Added recent developments to the “In the
Real World” boxes on Harley-Davidson and
Airbus-Boeing.
Chapter 16
∙ Introduced new Gallup opinion polls on Ameri-
cans’ attitudes toward trade.
∙ Updated the “In the Real World” box on
Trade Adjustment Assistance to include 2015
legislation.
∙ Updated the discussion of the Doha Develop-
ment Agenda.
∙ Did a general re-working of the text’s recount-
ing of significant U.S. trade policy actions.
Chapter 17
∙ Updated the “In the Real World” box on eco-
nomic integration groups and added the Com-
monwealth of Independent States.
∙ Updated material on economic developments in
the European Union; in particular, added mate-
rial on the Greece debt crisis.
∙ Updated the discussion of NAFTA.
∙ Added material to the “In the Real World” box
on ASEAN.
∙ Introduced material on the Trans-Pacific
Partnership.
Chapter 18
∙ Changed designation of middle- and low-
income countries from “less developed coun-
tries” (LDCs) to “emerging and developing
countries” (EDCs).
∙ Updated the table on economic and noneco-
nomic characteristics of countries at different
income levels.
∙ Updated the table on external debt and debt
ratios of emerging and developing countries.
∙ Re-worked the “In the Real World” box on the
Multilateral Debt Relief Initiative (MDRI) to
focus on the Heavily Indebted Poor Countries
(HIPC) Initiative as well as on the MDRI.
Chapter 19
∙ Re-worked the material on sample entries in
balance-of-payments accounting and on the
U.S. balance of payments in light of the IMF’s
and U.S. Department of Commerce’s new for-
mat for presenting information on international
transactions.
∙ Updated the table and the discussion of U.S.
international transactions.
∙ Updated the “In the Real World” box on U.S.
trade deficits with Japan, China, and Canada;
replaced OPEC with Mexico as the 4th economic
unit examined.
∙ Updated the table and discussion of the U.S.
international investment position in view of the
recent U.S. Department of Commerce change
to have direct investment included at its market
value rather than at its current cost.
∙ Updated the “In the Real World” box on the
U.S. net international investment position and
the U.S. net direct investment position.
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viii PREFACE
app9062x_fm_i-xxiv.indd viii 06/23/16 07:11 AM
Chapter 20
∙ Updated the “In the Real World” box on the
nominal and real Canadian dollar/U.S. dollar
exchange rate and the U.S. dollar’s nominal and
real effective exchange rates.
∙ Updated the “In the Real World” box on the spot
and PPP dollar/euro exchange rates and the spot
and PPP dollar/pound exchange rates.
∙ Updated the Concept Box on currency futures
quotations.
Chapter 21
∙ Updated the table on gross and net international
bank lending and the table on the stock of inter-
national debt securities.
∙ Changed the “In the Real World” box on interest
rates across countries to a discussion and presen-
tation of (2014) nominal and real lending rates
across countries rather than the previous focus
on government bond yields across countries.
∙ Updated the “In the Real World” box on U.S.
and eurodollar deposit and lending rates.
∙ Updated the table and graph on the size of global
derivative instruments.
Chapter 22
∙ Introduced a new opening vignette (on the flow
of funds out of the eurozone).
∙ Updated the discussion and table in the “In the
Real World” box dealing with U.S. monetary
concepts and the Federal Reserve’s balance
sheet.
∙ Introduced recent empirical tests of the mon-
etary approach to the balance of payments and
the exchange rate and a test of uncovered inter-
est parity.
Chapter 23
∙ Added several recent studies to the “In the Real
World” box on exchange rate pass-through.
∙ Expanded the “In the Real World” box on U.S.
agricultural exports and the exchange rate to
include recent export experience.
Chapter 24
∙ Updated the “In the Real World” box on average
propensities to import of five major countries.
∙ Introduced a new “In the Real World” box on
estimates of the government spending multiplier
in developed and developing countries.
Chapter 25
∙ Updated the “In the Real World” box on foreign
exchange restrictions in IMF countries.
Chapter 26
∙ Updated the “In the Real World” box on the
variability of commodity prices and U.S. real
GDP.
∙ Added a brief review of the euro’s recent move-
ments to the “In the Real World” box on policy
frictions between the European Union and the
United States.
∙ Placed additional emphasis on the G-20 in
the “In the Real World” box on macro policy
coordination.
Chapter 27
∙ Updated the “In the Real World” box on actual
and natural U.S. levels of GDP and rates of
unemployment; replaced previous Robert Gor-
don estimates with Congressional Budget Office
estimates.
∙ Updated data and discussion in the “In the Real
World” box on Sub-Saharan Africa.
∙ Updated data and discussion in the “In the
Real World” box on U.S. inflation and
unemployment.
Chapter 28
∙ Introduced new vignette on problems with both
a flexible exchange rate and a fixed exchange
rate.
∙ Updated and included revised information in
the “In the Real World” box on reserve holdings
under fixed and flexible exchange rates.
∙ Added brief recent information to the “In the
Real World” box on currency boards in Estonia
and Lithuania.
Chapter 29
∙ Introduced new opening vignette pertaining to
recent exchange rate movements and the post-
Bretton Woods system.
∙ Introduced a new “In the Real World” box
on currency risk and confidence in exchange
rates under the 1880–1914 international gold
standard.
∙ Updated the table on country quotas at the IMF.
∙ Updated the table on the current exchange rate
arrangements of countries.
∙ Updated the table on central bank international
reserves, including recognition of the fact that
the IMF now values gold at the current London
market price rather than at the previous 35 SDRs
= 1 ounce of gold price.
∙ Introduced a new “In the Real World” box on
bitcoin.
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PREFACE ix
app9062x_fm_i-xxiv.indd ix 06/23/16 07:11 AM
It is our hope that the changes in the ninth edition will prove beneficial to students as well as to instruc-
tors. The improvements are designed to help readers both understand and appreciate more fully the grow-
ing importance of the global economy in their lives.
DESCRIPTION OF TEXT
Our book follows the traditional division of international economics into the trade and monetary sides of the
subject. Although the primary audience for the book will be students in upper-level economics courses, we
think that the material can effectively reach a broad, diversified group of students—including those in political
science, international studies, history, and business who may have fewer economics courses in their back-
ground. Having taught international economics ourselves in specific nonmajors’ sections and Master’s of Busi-
ness Administration sections as well as in the traditional economics department setting, we are confident that
the material is accessible to both noneconomics and economics students. This broad audience will be assisted
in its learning through the fact that we have included separate, extensive review chapters of microeconomic
(Chapter 5) and macroeconomic (Chapter 24) tools.
International Economics presents international trade theory and policy first. Introductory material and
data are found in Chapter 1, and Chapters 2 through 4 present the Classical model of trade, including a
treatment of pre-Classical Mercantilism. A unique feature is the devotion of an entire chapter to extensions
of the Classical model to include more than two countries, more than two goods, money wages and prices,
exchange rates, and transportation costs. The analysis is brought forward through the modern Dornbusch-
Fischer-Samuelson model including a treatment of the impact of productivity improvements in one country
on the trading partner. Chapter 5 provides an extensive review of microeconomic tools used in interna-
tional trade at this level and can be thought of as a “short course” in intermediate micro. Chapters 6 through
9 present the workhorse neoclassical and Heckscher-Ohlin trade theory, including an examination of the
assumptions of the model. Chapter 6 focuses on the traditional production possibilities—indifference curve
exposition. We are unabashed fans of the offer curve because of the nice general equilibrium properties of
the device and because of its usefulness in analyzing trade policy and in interpreting economic events, and
Chapter 7 extensively develops this concept. Chapter 8 explores Heckscher-Ohlin in a theoretical context,
and Chapter 9 is unique in its focus on testing the factor endowments approach, including empirical work
on the trade-income inequality debate in the context of Heckscher-Ohlin.
Continuing with theory, Chapters 10 through 12 treat extensions of the traditional material. Chapter 10
discusses various post–Heckscher-Ohlin trade theories that relax standard assumptions such as international
factor immobility, homogeneous products, constant returns to scale, and perfect competition. An important
focus here is upon imperfect competition and intra-industry trade, and new material has been added regard-
ing the multiproduct exporting firm. Chapter 11 explores the comparative statics of economic growth and
the relative importance of trade, and it includes material on endogenous growth models and on the effects of
growth on the offer curve. Chapter 12 examines causes and consequences of international factor movements,
including both capital movements and labor flows.
Chapters 13 through 17 are devoted to trade policy. Chapter 13 is exclusively devoted to presentation
of the various instruments of trade policy. Chapter 14 then explores the welfare effects of the instruments,
including discussion of such effects in a “small-country” as well as a “large-country” setting. Chapter 15
examines various arguments for protection, including strategic trade policy approaches. Chapter 16 begins
with a discussion of the political economy of trade policy, followed by a review of various trade policy ac-
tions involving the United States as well as issues currently confronting the WTO. Chapter 17 is a separate
chapter on economic integration. We have updated the discussion of the European Union (including recent
problems) and the North American Free Trade Agreement. In addition, there is new material on the U.S.
free-trade agreements with Colombia, South Korea, and Panama and on the Trans-Pacific Partnership.
The trade part of the book concludes with Chapter 18, which provides an overview of how international
trade influences growth and change in the emerging/developing countries as well as a discussion of the
external debt problem.
The international monetary material begins with Chapter 19, which introduces balance-of-payments
accounting. This is followed by discussion of the foreign exchange market in Chapter 20. We think this sequence
makes more sense than the reverse, since the demand and supply curves of foreign exchange reflect the debit
and credit items, respectively, in the balance of payments. A differentiating feature of the presentation of
the foreign exchange market is the extensive development of various exchange rate measures, for example,
nominal, real, and effective exchange rates. Chapter 21 then describes characteristics of “real-world” inter-
national financial markets in detail, and discusses a (we hope not-too-bewildering) variety of international
financial derivative instruments. Chapter 22 presents in considerable detail the monetary and portfolio balance
(or asset market) approaches to the balance of payments and to exchange rate determination. The more technical
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discussion of testing of these approaches is in an appendix, which has been updated to include recent empiri-
cal research. The chapter concludes with an examination of the phenomenon of exchange rate overshooting.
In Chapters 23 and 24, our attention turns to the more traditional price and income adjustment mechanisms.
Chapter 24 is in effect a review of basic Keynesian macroeconomic analysis.
Chapters 25 through 27 are concerned with macroeconomic policy under different exchange rate re-
gimes. As noted earlier, we continue to utilize the IS/LM/BP Mundell-Fleming approach rather than em-
ploy exclusively the asset market approach. The value of the IS/LM/BP model is that it can embrace both
the current and the capital/financial accounts in an understandable and perhaps familiar framework for
many undergraduates. This model is presented in Chapter 25 in a manner that does not require previous
acquaintance with it, but does constitute review material for most students who have previously taken an
intermediate macroeconomic theory course. The chapter concludes with an analysis of monetary and fis-
cal policy in a fixed exchange rate environment. These policies are then examined in a flexible exchange
rate environment in Chapter 26. We have included in the appendixes to Chapters 25 and 26 material that
develops a more formal graphical link between national income and the exchange rate. The analysis is then
broadened to the aggregate demand–aggregate supply framework in Chapter 27. The concluding chapters,
Chapters 28 and 29, focus on particular topics of global concern. Chapter 28 considers various issues
related to the choice between fixed and flexible exchange rates, including material on currency boards.
Chapter 29 then traces the historical development of the international monetary system from Bretton
Woods onward, examines proposals for reform such as target zone proposals, and addresses some implica-
tions of the 2007–2009 world recession and recent issues with the euro.
Because of the length and comprehensiveness of the International Economics text, it is not wise to at-
tempt to cover all of it in a one-semester course. For such a course, we recommend that material be selected
from Chapters 1 to 3, 5 to 8, 10, 13 to 15, 19 and 20, 22 to 26, and 29. If more emphasis on international trade
is desired, additional material from Chapters 17 and 18 can be included. For more emphasis on international
monetary economics, we suggest the addition of selected material from Chapters 21, 27, and 28. For a two-
semester course, the entire International Economics book can be covered. Whatever the course, occasional
outside reading assignments from academic journals, current popular periodicals, a readings book, and Web
sources can further help to bring the material to life. The “References for Further Reading” section at the
end of the book, which is organized by chapter, can hopefully give some guidance. If library resources are
limited, the text contains, both in the main body and in boxes, summaries of some noteworthy contributions.
PEDAGOGICAL DEVICES
To assist the student in learning the material, we have included a variety of pedagogical devices. We like
to think of course that the major device in this edition is again clear exposition. Although all authors stress
clarity of exposition as a strong point, we continue to be pleased that many reviewers praised this feature.
Beyond this general feature, more specific devices are described herein.
Except for Chapter 1, every chapter begins with a set of explicit learning objectives to help students focus
on key concepts. The learning objectives can also be useful to instructors in selecting material to cover in
their respective classes.
These opening vignettes or cases were mentioned earlier. The intent of each case is to motivate the student
toward pursuing the material in the forthcoming chapter as well as to enable the student to see how the
chapter’s topics fit with actual applied situations in the world economy.
There are three types of material that appear in boxes (more than 100 of them) in International Economics.
Some are analytical in nature (Concept Boxes), and they explain further some difficult concepts or relation-
ships. We have also included several biographical boxes (Titans of International Economics). These short
sketches of well-known economists add a personal dimension to the work being studied, and they discuss
not only the professional interests and concerns of the individuals but also some of their less well-known
“human” characteristics. Finally, the majority of the boxes are case studies (In the Real World), appearing
throughout chapters and supplemental to the opening vignettes. These boxes serve to illuminate concepts
and analyses under discussion. As with the opening vignettes, they give students an opportunity to see the
relevance of the material to current events. They also provide a break from the sometimes heavy dose of
theory that permeates international economics texts.
These are short “stopping points” at various intervals within chapters (about two per chapter). The con-
cept checks pose questions that are designed to see if basic points made in the text have been grasped by
the student.
Learning Objectives
Opening Vignettes
Boxes
Concept Checks
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These are standard fare in all texts. The questions and problems are broader and more comprehensive than
the questions contained in the concept checks.
The major terms in each chapter are boldfaced in the chapters themselves and then are brought together at
the end of the chapter in list form. A review of each list can serve as a quick review of the chapter.
These lists occur at the end of the book, organized by chapter. We have provided bibliographic sources
that we have found useful in our own work as well as entries that are relatively accessible and offer further
theoretical and empirical exploration opportunities for interested students.
This companion work offers instructors assistance in preparing for and teaching the course. We have
included suggestions for presenting the material as well as answers to the end-of-chapter questions and
problems. In addition, sample examination questions are provided, including some of the hundreds of
multiple-choice questions and problems that we have used for examining our own students. Access this
ancillary, as well as the Test Bank, through the text’s Online Learning Center.
The ninth edition of International Economics is accompanied by a comprehensive website, www.mhhe
.com/appleyard/9e. The Instructor’s Manual and Test Bank exist in Word format on the password-protected
portion. Additionally, the password-protected site includes answers to the Graphing Exercises. Students
also benefit from visiting the Online Learning Center. Chapter-specific graphing exercises and interactive
quizzes serve as helpful study materials. A Digital Image Library contains all of the images from the text.
The ninth edition also contains PowerPoint presentations, one to accompany every chapter, available on
the Online Learning Center.
End-of-Chapter Ques-
tions and Problems
Lists of Key Terms
References for
Further Reading
Instructor’s Manual
and Test Bank
Online Learning
Center
CourseSmart is a new way for faculty to find and review eTextbooks. It’s also a great option for students
who are interested in accessing their course materials digitally. CourseSmart offers thousands of the
most commonly adopted textbooks across hundreds of courses from a wide variety of higher educa-
tion publishers. It is the only place for faculty to review and compare the full text of a textbook online.
At CourseSmart, students can save up to 50 percent off the cost of a print book, reduce their impact on
the environment, and gain access to powerful Web tools for learning including full text search, notes
and highlighting, and e-mail tools for sharing notes between classmates. Complete tech support is also
included for each title.
Finding your eBook is easy. Visit www.CourseSmart.com and search by title, author, or ISBN.
ACKNOWLEDGMENTS
Our major intellectual debts are to the many professors who taught us economics, but particularly to
Robert Stern of the University of Michigan and Erik Thorbecke of Cornell University. We also have found
conversations and seminars over the years with faculty colleagues at the University of North Carolina at
Chapel Hill to have been extremely helpful. We particularly wish to thank Stanley Black, Patrick Conway,
William A. Darity, Jr., Richard Froyen, and James Ingram. Thanks also to colleagues at Davidson College,
especially Peter Hess, Vikram Kumar, David Martin, Lou Ortmayer, and Clark Ross; and to the many
students at Chapel Hill and Davidson who were guinea pigs for the material and provided helpful insights
and suggestions. In addition, we express special appreciation to Steven L. Cobb of the University of North
Texas for his contributions to several previous editions of this book. As a coauthor, Steve provided numer-
ous creative ideas and valuable content, much of which continues to be used in this ninth edition.
We are also indebted to the entire staff at McGraw-Hill, especially Jane Mohr, Sarah Otterness, Ka-
tie Hoenicke, and James Heine, as well as freelancer Beth Baugh. We thank them for their cooperation,
patience, encouragement, and guidance in the development of this ninth edition.
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xii PREFACE
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In addition, we are grateful to the following reviewers; their thoughtful, prescriptive comments have
helped guide the development of these nine editions:
Deergha Raj Adhikari
University of Louisiana at Lafayette
Francis Ahking
University of Connecticut–Storrs
Mohsen Bahmani-Oskooee
University of Wisconsin–Milwaukee
Scott Baier
Clemson University
Michael Barry
Mount St. Mary’s University
Amitrajeet A. Batabyal
Rochester Institute of Technology
Tibor Besedes
Georgia Institute of Technology
Bruce Blonigen
University of Oregon
Eric Bond
Pennsylvania State University
Harry Bowen
University of California–Irvine
Josef Brada
Arizona State University
Victor Brajer
California State University–Fullerton
Charles H. Brayman
Kansas State University
Drusilla Brown
Tufts University
Geoffrey Carliner
Babson College
Roman Cech
Longwood University
Winston W. Chang
State University of New York at Buffalo
Charles Chittle
Bowling Green State University
Patrick Conway
University of North Carolina at Chapel Hill
Bienvenido Cortes
Pittsburg State University
Kamran Dadkhah
Northeastern University
Joseph Daniels
Marquette University
William L. Davis
University of Tennessee at Martin
Alan Deardorff
University of Michigan
Khosrow Doroodian
Ohio University–Athens
Mary Epps
University of Virginia
Jim Gerber
San Diego State University
Norman Gharrity
Ohio Wesleyan University
Animesh Ghoshal
DePaul University
William Hallagan
Washington State University
James Hartigan
University of Oklahoma
Stephen Haynes
University of Oregon
Pershing Hill
University of Alaska
William Hutchinson
Vanderbilt University
Robert Jerome
James Madison University
William Kaempfer
University of Colorado
Mitsuhiro Kaneda
Georgetown University
Baybars Karacaovali
Fordham University
Theodore Kariotis
Towson University
Patrick Kehoe
University of Pennsylvania
Frank Kelly
Indiana University–Purdue University Indianapolis
Randall G. Kesselring
Arkansas State University
David Kemme
Wichita State University
Madhu Khanna
University of Illinois–Champaign
Yih-Wu Liu
Youngstown State University
Thomas Love
North Central College
Svitlana Maksymenko
University of Pittsburgh
Judith McDonald
Lehigh University
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We also wish to thank David Ball (North Carolina State University), David Collie (Cardiff University),
David Cushman (University of Saskatchewan), Guzin Erlat (Middle East Technical University–Ankara),
J. Michael Finger (World Bank, retired), Dan Friel (Bank of America), Art Goldsmith (Washington and
Lee University), the late Monty Graham (The Peterson Institute of International Economics), Michael
Jones (Bowdoin College), Joseph Joyce (Wellesley College), Jay Bryson and Nick Bennenbroek (Wells
Fargo), and Joe Ross (Goldman Sachs) for their helpful comments on this and earlier editions. Apprecia-
tion is also extended to the many other individuals who have contacted us over the years regarding our
book. Of course, any remaining shortcomings or errors are the responsibility of the authors (who each
blame the other). A special note of thanks goes to our families for their understanding, support, and for-
bearance throughout the time-absorbing processes required to complete all nine editions.
Finally, we welcome any suggestions or comments that you may have regarding this text. Please
feel free to contact us at our e-mail addresses. And thank you for giving attention to our book!
Dennis R. Appleyard
deappleyard@davidson.edu
Alfred J. Field, Jr.
afield@email.unc.edu
Thomas McGahagan
University of Pittsburgh at Johnstown
Joseph McKinney
Baylor University
Thomas McKinnon
University of Arkansas
Michael McPherson
University of North Texas
William G. Mertens
University of Colorado at Boulder
Thomas Mondschean
DePaul University
Michael Moore
The George Washington University
Sudesh Mujumdar
University of Southern Indiana
Vange Mariet Ocasio
University of Denver
John Pomery
Purdue University
Michael Quinn
Bentley College
James Rakowski
University of Notre Dame
James Rauch
University of California–San Diego
Monica Robayo
University of North Florida
Simran Sahi
University of Minnesota
Jeff Sarbaum
University of North Carolina–Greensboro
W. Charles Sawyer
University of Southern Mississippi
Don Schilling
University of Missouri
James H. Schindler
Columbia Southern University
Modiful Shumon Islam
Columbia Southern University
Richard Sicotte
University of Vermont
Karen J. Smith
Columbia Southern University
John N. Smithin
York University
Richard G. Stahl
Louisiana State University
Jeffrey Steagall
University of North Florida
Grigor Sukiassyan
California State University–Fullerton
Kishor Thanawala
Villanova University
Edward Tower
Duke University
John Wilson
Michigan State University
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xiv
PART 3
ADDITIONAL THEORIES AND EXTENSIONS 173
CHAPTER 10
Post–Heckscher-Ohlin Theories of Trade and
Intra-Industry Trade, 173
CHAPTER 11
Economic Growth and International Trade, 203
CHAPTER 12
International Factor Movements, 226
PART 4
TRADE POLICY 257
CHAPTER 13
The Instruments of Trade Policy, 257
CHAPTER 14
The Impact of Trade Policies, 280
CHAPTER 15
Arguments for Interventionist Trade Policies, 320
CHAPTER 16
Political Economy and U.S. Trade Policy, 359
CHAPTER 17
Economic Integration, 387
CHAPTER 18
International Trade and the Developing
Countries, 416
BRIEF CONTENTS
CHAPTER 1
The World of International Economics, 1
PART 1
THE CLASSICAL THEORY OF TRADE 15
CHAPTER 2
Early Trade Theories: Mercantilism and the
Transition to the Classical World of David Ricardo, 15
CHAPTER 3
The Classical World of David Ricardo and
Comparative Advantage, 26
CHAPTER 4
Extensions and Tests of the Classical Model
of Trade, 40
PART 2
NEOCLASSICAL TRADE THEORY 62
CHAPTER 5
Introduction to Neoclassical Trade Theory: Tools to
Be Employed, 62
CHAPTER 6
Gains from Trade in Neoclassical Theory, 84
CHAPTER 7
Offer Curves and the Terms of Trade, 100
CHAPTER 8
The Basis for Trade: Factor Endowments and the
Heckscher-Ohlin Model, 122
CHAPTER 9
Empirical Tests of the Factor Endowments
Approach, 150
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BRIEF CONTENTS xv
PART 5
FUNDAMENTALS OF INTERNATIONAL
MONETARY ECONOMICS 448
CHAPTER 19
The Balance-of-Payments Accounts, 448
CHAPTER 20
The Foreign Exchange Market, 468
CHAPTER 21
International Financial Markets and Instruments:
An Introduction, 498
CHAPTER 22
The Monetary and Portfolio Balance Approaches
to External Balance, 531
CHAPTER 23
Price Adjustments and Balance-of-Payments
Disequilibrium, 562
CHAPTER 24
National Income and the Current Account, 590
PART 6
MACROECONOMIC POLICY IN THE OPEN
ECONOMY 619
CHAPTER 25
Economic Policy in the Open Economy under Fixed
Exchange Rates, 619
CHAPTER 26
Economic Policy in the Open Economy under
Flexible Exchange Rates, 651
CHAPTER 27
Prices and Output in the Open Economy: Aggregate
Supply and Demand, 673
PART 7
ISSUES IN WORLD MONETARY
ARRANGEMENTS 701
CHAPTER 28
Fixed or Flexible Exchange Rates? 701
CHAPTER 29
The International Monetary System: Past, Present,
and Future, 728
References for Further Reading, 765
Index, 784
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xvi
CONTENTS
CHAPTER 1
The World of International Economics, 1
INTRODUCTION, 1
THE NATURE OF MERCHANDISE TRADE, 3
The Geographical Composition of Trade, 3
The Commodity Composition of Trade, 6
U.S. International Trade, 7
WORLD TRADE IN SERVICES, 9
THE CHANGING DEGREE OF ECONOMIC INTERDEPENDENCE, 11
SUMMARY, 12
Appendix, A General Reference List in International
Economics, 12
PART 1
THE CLASSICAL THEORY OF TRADE 15
CHAPTER 2
Early Trade Theories: Mercantilism and the Transition to the
Classical World of David Ricardo, 15
INTRODUCTION, 16
The Oracle in the 21st Century, 16
MERCANTILISM, 16
The Mercantilist Economic System, 16
The Role of Government, 17
Mercantilism and Domestic Economic Policy, 18
IN THE REAL WORLD: MERCANTILISM IS STILL ALIVE 19
THE CHALLENGE TO MERCANTILISM BY EARLY
CLASSICAL WRITERS, 20
David Hume—The Price-Specie-Flow Mechanism, 20
CONCEPT BOX 1: CAPSULE SUMMARY OF THE PRICE-
SPECIE-FLOW MECHANISM, 20
CONCEPT BOX 2: CONCEPT REVIEW—PRICE ELASTICITY AND
TOTAL EXPENDITURES, 21
Adam Smith and the Invisible Hand, 22
TITANS OF INTERNATIONAL ECONOMICS:
ADAM SMITH (1723–1790), 23
SUMMARY, 24
CHAPTER 3
The Classical World of David Ricardo and
Comparative Advantage, 26
INTRODUCTION, 27
Some Common Myths, 27
ASSUMPTIONS OF THE BASIC RICARDIAN MODEL, 27
TITANS OF INTERNATIONAL ECONOMICS: DAVID RICARDO
(1772–1823), 28
RICARDIAN COMPARATIVE ADVANTAGE, 28
IN THE REAL WORLD: EXPORT CONCENTRATION OF SELECTED
COUNTRIES, 31
COMPARATIVE ADVANTAGE AND THE TOTAL GAINS
FROM TRADE, 32
Resource Constraints, 32
Complete Specialization, 33
REPRESENTING THE RICARDIAN MODEL WITH
PRODUCTION-POSSIBILITIES FRONTIERS, 34
Production Possibilities—An Example, 34
Maximum Gains from Trade, 36
COMPARATIVE ADVANTAGE—SOME CONCLUDING
OBSERVATIONS, 37
SUMMARY, 38
CHAPTER 4
Extensions and Tests of the Classical Model
of Trade, 40
INTRODUCTION, 41
Trade Complexities in the Real World, 41
THE CLASSICAL MODEL IN MONEY TERMS, 41
WAGE RATE LIMITS AND EXCHANGE RATE LIMITS, 42
CONCEPT BOX 1: WAGE RATE LIMITS AND EXCHANGE RATE
LIMITS IN THE MONETIZED RICARDIAN FRAMEWORK, 44
MULTIPLE COMMODITIES, 45
The Effect of Wage Rate Changes, 46
The Effect of Exchange Rate Changes, 47
TRANSPORTATION COSTS, 48
IN THE REAL WORLD: THE SIZE OF
TRANSPORTATION COSTS, 49
MULTIPLE COUNTRIES, 50
EVALUATING THE CLASSICAL MODEL, 51
IN THE REAL WORLD: LABOR PRODUCTIVITY AND IMPORT
PENETRATION IN THE U.S. STEEL INDUSTRY, 54
IN THE REAL WORLD: EXPORTING AND PRODUCTIVITY, 56
SUMMARY, 56
Appendix, The Dornbusch, Fischer, and Samuelson
Model, 58
PART 2
NEOCLASSICAL TRADE THEORY 62
CHAPTER 5
Introduction to Neoclassical Trade Theory: Tools to Be
Employed, 62
INTRODUCTION, 63
THE THEORY OF CONSUMER BEHAVIOR, 63
Consumer Indifference Curves, 63
TITANS OF INTERNATIONAL ECONOMICS: FRANCIS YSIDRO
EDGEWORTH (1845–1926), 64
The Budget Constraint, 68
Consumer Equilibrium, 69
PRODUCTION THEORY, 70
Isoquants, 70
IN THE REAL WORLD: CONSUMER EXPENDITURE PATTERNS IN
THE UNITED STATES, 71
Isocost Lines, 73
Producer Equilibrium, 75
THE EDGEWORTH BOX DIAGRAM AND THE PRODUCTION-
POSSIBILITIES FRONTIER, 75
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CONTENTS xvii
The Edgeworth Box Diagram, 75
The Production-Possibilities Frontier, 78
SUMMARY, 82
CHAPTER 6
Gains from Trade in Neoclassical Theory, 84
INTRODUCTION, 85
The Effects of Restrictions on U.S. Trade, 85
AUTARKY EQUILIBRIUM, 85
INTRODUCTION OF INTERNATIONAL TRADE, 87
The Consumption and Production Gains
from Trade, 89
Trade in the Partner Country, 91
MINIMUM CONDITIONS FOR TRADE, 92
Trade between Countries with Identical PPFs, 92
Trade between Countries with Identical Demand
Conditions, 93
Conclusions, 95
SOME IMPORTANT ASSUMPTIONS IN THE ANALYSIS, 95
Costless Factor Mobility, 95
Full Employment of Factors of Production, 95
The Indifference Curve Map Can Show
Welfare Changes, 96
IN THE REAL WORLD: CHANGES IN INCOME DISTRIBUTION AND
WELFARE WITH INCREASED TRADE, 97
SUMMARY, 98
Appendix, “Actual” versus “Potential” Gains
from Trade, 99
CHAPTER 7
Offer Curves and the Terms of Trade, 100
INTRODUCTION, 101
Terms-of-Trade Shocks, 101
A COUNTRY’S OFFER CURVE, 101
CONCEPT BOX 1: THE TABULAR APPROACH TO DERIVING
AN OFFER CURVE, 104
TRADING EQUILIBRIUM, 105
SHIFTS OF OFFER CURVES, 107
CONCEPT BOX 2: MEASUREMENT OF THE TERMS OF TRADE, 110
ELASTICITY AND THE OFFER CURVE, 111
IN THE REAL WORLD: TERMS OF TRADE FOR MAJOR GROUPS
OF COUNTRIES, 1973–2013, 112
OTHER CONCEPTS OF THE TERMS OF TRADE, 116
Income Terms of Trade, 116
Single Factoral Terms of Trade, 116
IN THE REAL WORLD: INCOME TERMS OF
TRADE OF MAJOR GROUPS OF COUNTRIES, 1973–2013, 117
Double Factoral Terms of Trade, 118
SUMMARY, 118
Appendix A, Derivation of Import-Demand Elasticity on an
Offer Curve, 119
Appendix B, Elasticity and Instability of Offer Curve
Equilibria, 120
CHAPTER 8
The Basis for Trade: Factor Endowments and the
Heckscher-Ohlin Model, 122
INTRODUCTION, 123
Do Labor Standards Affect Comparative Advantage? 123
FACTOR ENDOWMENTS AND THE HECKSCHER-
OHLIN THEOREM, 124
Factor Abundance and Heckscher-Ohlin, 124
Commodity Factor Intensity and Heckscher-
Ohlin, 125
IN THE REAL WORLD: RELATIVE FACTOR ENDOWMENTS IN
SELECTED COUNTRIES, 126
The Heckscher-Ohlin Theorem, 128
IN THE REAL WORLD: RELATIVE FACTOR
INTENSITIES IN CANADA, 128
TITANS OF INTERNATIONAL ECONOMICS: PAUL ANTHONY
SAMUELSON (1915–2009), 132
TRADE, FACTOR PRICES, AND INCOME DISTRIBUTION 132
The Factor Price Equalization Theorem, 132
The Stolper-Samuelson Theorem and Income
Distribution Effects of Trade in the Heckscher-
Ohlin Model, 135
Conclusions, 137
THEORETICAL QUALIFICATIONS TO HECKSCHER-
OHLIN, 137
Demand Reversal, 137
Factor-Intensity Reversal, 138
Transportation Costs, 139
Imperfect Competition, 141
Immobile or Commodity-Specific Factors, 142
IN THE REAL WORLD: MONOPOLY BEHAVIOR IN INTERNATIONAL
TRADE, 144
Other Considerations, 147
CONCEPT BOX 1: THE SPECIFIC-FACTORS MODEL AND THE
REAL WAGE OF WORKERS, 147
SUMMARY, 149
CHAPTER 9
Empirical Tests of the Factor Endowments Approach, 150
INTRODUCTION, 151
Theories, Assumptions, and the Role of
Empirical Work, 151
THE LEONTIEF PARADOX, 151
INITIAL EXPLANATIONS FOR THE LEONTIEF PARADOX, 152
Demand Reversal, 152
Factor-Intensity Reversal, 153
IN THE REAL WORLD: TESTING FOR FACTOR-INTENSITY
REVERSALS, 154
U.S. Tariff Structure, 155
Different Skill Levels of Labor, 155
The Role of Natural Resources, 156
MORE RECENT TESTS OF THE HECKSCHER-OHLIN
THEOREM, 157
Factor Content Approach with Many Factors, 158
Technology, Productivity, and “Home Bias”, 161
IN THE REAL WORLD: HECKSCHER-OHLIN AND COMPARATIVE
ADVANTAGE, 163
HECKSCHER-OHLIN AND INCOME INEQUALITY, 164
IN THE REAL WORLD: TRADE AND INCOME INEQUALITY
IN A LESS DEVELOPED COUNTRY: THE CASE OF
MOZAMBIQUE, 168
IN THE REAL WORLD: OUTSOURCING AND WAGE
INEQUALITY, 170
SUMMARY, 172
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CONCEPT BOX 1: LABOR FORCE GROWTH AND PER CAPITA
INCOME, 217
CONCEPT BOX 2: ECONOMIC GROWTH AND THE OFFER
CURVE, 219
GROWTH AND THE TERMS OF TRADE: A DEVELOPING-COUNTRY
PERSPECTIVE, 221
IN THE REAL WORLD: TERMS OF TRADE OF BRAZIL, JORDAN,
PAKISTAN, AND THAILAND, 1980–2014, 222
SUMMARY, 224
CHAPTER 12
International Factor Movements, 226
INTRODUCTION, 227
INTERNATIONAL CAPITAL MOVEMENTS THROUGH
FOREIGN DIRECT INVESTMENT AND MULTINATIONAL
CORPORATIONS, 227
Foreign Investors in China: “Good” or “Bad” from the
Chinese Perspective? 227
Definitions, 229
Some Data on Foreign Direct Investment and Multinational
Corporations, 229
Reasons for International Movement of Capital, 232
IN THE REAL WORLD: DETERMINANTS OF FOREIGN DIRECT
INVESTMENT, 234
THE EFFECTS OF INTERNATIONAL CAPITAL MOVEMENTS 236
A Theoretical Framework for Analyzing International
Capital Movements, 236
IN THE REAL WORLD: HOST-COUNTRY DETERMINANTS OF
FOREIGN DIRECT INVESTMENT INFLOWS, 237
Potential Benefits and Costs of Foreign Direct Investment
to a Host Country, 239
LABOR MOVEMENTS BETWEEN COUNTRIES, 242
Seasonal Workers in Germany, 242
Permanent Migration: A Greek in Germany, 243
IN THE REAL WORLD: MIGRATION FLOWS INTO THE UNITED
STATES, 1986 AND 2013, 244
Economic Effects of Labor Movements, 245
Additional Considerations Pertaining to International
Migration, 248
IN THE REAL WORLD: IMMIGRANT REMITTANCES, 249
Immigration and the United States—Recent
Perspectives, 252
IN THE REAL WORLD: IMMIGRATION AND TRADE, 253
IN THE REAL WORLD: IMMIGRATION INTO THE UNITED STATES
AND THE BRAIN DRAIN FROM DEVELOPING COUNTRIES, 255
SUMMARY, 256
PART 4
TRADE POLICY 257
CHAPTER 13
The Instruments of Trade Policy, 257
INTRODUCTION, 258
In What Ways Can Governments Interfere with Trade?, 258
IMPORT TARIFFS, 259
PART 3
ADDITIONAL THEORIES AND
EXTENSIONS 173
CHAPTER 10
Post–Heckscher-Ohlin Theories of Trade and
Intra-Industry Trade, 173
INTRODUCTION, 174
A Trade Myth, 174
EARLY POST–HECKSCHER-OHLIN THEORIES OF TRADE, 174
The Imitation Lag Hypothesis, 174
The Product Cycle Theory, 175
The Linder Theory, 178
Economies of Scale, 181
MORE RECENT ALTERNATIVE TRADE THEORIES, 182
The Krugman Model, 182
The Reciprocal Dumping Model, 185
Vertical Specialization-Based Trade, 186
IN THE REAL WORLD: NEW VENTURE
INTERNATIONALIZATION, 187
Firm-Focused Theories, 188
The Gravity Model, 188
The Melitz Model and Multiproduct Exporting, 189
Concluding Comments on Post–Heckscher-Ohlin
Trade Theories, 191
IN THE REAL WORLD: GEOGRAPHY AND TRADE, 192
INTRA-INDUSTRY TRADE, 193
Reasons for Intra-Industry Trade in a Product
Category, 194
The Level of a Country’s Intra-Industry Trade, 196
SUMMARY, 197
Appendix A, Economies of Scale, 198
Appendix B, Monopolistic Competition and Price
Elasticity of Demand in the Krugman Model, 200
Appendix C, Measurement of Intra-Industry Trade, 202
CHAPTER 11
Economic Growth and International Trade, 203
INTRODUCTION, 204
China—A Regional Growth Pole, 204
CLASSIFYING THE TRADE EFFECTS OF ECONOMIC GROWTH, 204
Trade Effects of Production Growth, 204
Trade Effects of Consumption Growth, 206
SOURCES OF GROWTH AND THE PRODUCTION-POSSIBILITIES
FRONTIER, 208
The Effects of Technological Change, 208
IN THE REAL WORLD: LABOR AND CAPITAL REQUIREMENTS PER
UNIT OF OUTPUT, 209
IN THE REAL WORLD: “SPILLOVERS” AS A CONTRIBUTOR TO
ECONOMIC GROWTH, 212
The Effects of Factor Growth, 212
FACTOR GROWTH, TRADE, AND WELFARE IN THE SMALL-
COUNTRY CASE, 215
GROWTH, TRADE, AND WELFARE: THE LARGE-COUNTRY
CASE, 216
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IN THE REAL WORLD: DOMESTIC EFFECTS OF THE SUGAR
QUOTA SYSTEM, 310
SUMMARY, 312
Appendix A, The Impact of Protection in a Market with
Nonhomogeneous Goods, 313
Appendix B, The Impact of Trade Policy in the Large-Country
Setting Using Export Supply and Import Demand Curves, 314
CHAPTER 15
Arguments for Interventionist Trade Policies, 320
INTRODUCTION, 321
Calls for Protection, 321
TRADE POLICY AS A PART OF BROADER SOCIAL POLICY
OBJECTIVES FOR A NATION, 321
Trade Taxes as a Source of Government Revenue, 322
National Defense Argument for a Tariff, 322
IN THE REAL WORLD: THE RELATIVE IMPORTANCE OF TRADE
TAXES AS A SOURCE OF GOVERNMENT REVENUE, 323
Tariff to Improve the Balance of Trade, 324
The Terms-of-Trade Argument for Protection, 325
Tariff to Reduce Aggregate Unemployment, 327
Tariff to Increase Employment in a Particular Industry, 328
IN THE REAL WORLD: INDUSTRY EMPLOYMENT EFFECTS OF
TRADE LIBERALIZATION, 328
IN THE REAL WORLD: COSTS OF PROTECTING INDUSTRY
EMPLOYMENT, 329
Tariff to Benefit a Scarce Factor of Production, 329
Fostering “National Pride” in Key Industries, 330
Differential Protection as a Component of a Foreign Policy/
Aid Package, 330
PROTECTION TO OFFSET MARKET IMPERFECTIONS, 331
The Presence of Externalities as an Argument for
Protection, 331
Tariff to Extract Foreign Monopoly Profit, 333
The Use of an Export Tax to Redistribute Profit from a
Domestic Monopolist, 334
PROTECTION AS A RESPONSE TO INTERNATIONAL POLICY
DISTORTIONS, 335
Tariff to Offset Foreign Dumping, 335
Tariff to Offset a Foreign Subsidy, 336
IN THE REAL WORLD: ANTIDUMPING ACTIONS IN THE UNITED
STATES, 337
IN THE REAL WORLD: COUNTERVAILING DUTIES IN THE UNITED
STATES, 339
MISCELLANEOUS, INVALID ARGUMENTS, 341
STRATEGIC TRADE POLICY: FOSTERING COMPARATIVE
ADVANTAGE, 341
The Infant Industry Argument for Protection, 342
IN THE REAL WORLD: U.S. MOTORCYCLES—A SUCCESSFUL
INFANT INDUSTRY? 343
Economies of Scale in a Duopoly Framework, 344
Research and Development and Sales of a Home Firm, 347
Export Subsidy in Duopoly, 349
Strategic Government Interaction and World Welfare, 352
IN THE REAL WORLD: AIRBUS AND BOEING, 353
Concluding Observations on Strategic Trade Policy, 355
SUMMARY, 356
Specific Tariffs, 259
Ad Valorem Tariffs, 259
Other Features of Tariff Schedules, 259
IN THE REAL WORLD: U.S. TARIFF RATES, 261
IN THE REAL WORLD: THE U.S. GENERALIZED SYSTEM OF
PREFERENCES, 263
Measurement of Tariffs, 265
IN THE REAL WORLD: NOMINAL AND EFFECTIVE
TARIFFS IN THE EUROPEAN UNION, 267
IN THE REAL WORLD: NOMINAL AND EFFECTIVE TARIFF
RATES IN VIETNAM AND EGYPT, 268
EXPORT TAXES AND SUBSIDIES, 270
NONTARIFF BARRIERS TO FREE TRADE, 271
Import Quotas, 271
“Voluntary” Export Restraints (VERs), 271
Government Procurement Provisions, 271
Domestic Content Provisions, 272
European Border Taxes, 272
Administrative Classification, 273
Restrictions on Services Trade, 273
Trade-Related Investment Measures, 273
Additional Restrictions, 273
Additional Domestic Policies That Affect Trade, 274
IN THE REAL WORLD: IS IT A CAR? IS IT A TRUCK? 274
IN THE REAL WORLD: EXAMPLES OF CONTROL OVER
TRADE, 275
IN THE REAL WORLD: THE EFFECT OF PROTECTION
INSTRUMENTS ON DOMESTIC PRICES, 276
SUMMARY, 278
CHAPTER 14
The Impact of Trade Policies, 280
INTRODUCTION, 281
Gainers and Losers from Steel Tariffs, 281
TRADE RESTRICTIONS IN A PARTIAL EQUILIBRIUM SETTING: THE
SMALL-COUNTRY CASE, 282
The Impact of an Import Tariff, 282
The Impact of an Import Quota and a Subsidy to
Import-Competing Production, 285
The Impact of Export Policies, 288
IN THE REAL WORLD: REAL INCOME GAINS FROM TRADE
LIBERALIZATION IN AGRICULTURE, 289
TRADE RESTRICTIONS IN A PARTIAL EQUILIBRIUM SETTING: THE
LARGE-COUNTRY CASE, 291
Framework for Analysis, 291
The Impact of an Import Tariff, 294
The Impact of an Import Quota, 297
The Impact of an Export Tax, 299
IN THE REAL WORLD: WELFARE COSTS OF U.S. IMPORT
QUOTAS AND VERS, 301
The Impact of an Export Subsidy, 302
TRADE RESTRICTIONS IN A GENERAL EQUILIBRIUM SETTING, 303
Protection in the Small-Country Case, 303
IN THE REAL WORLD: WELFARE EFFECTS OF RESTRICTIVE RICE
POLICIES IN JAPAN, 304
Protection in the Large-Country Case, 306
OTHER EFFECTS OF PROTECTION, 309
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Early Growth and Disappointments, 401
Completing the Internal Market, 401
U.S. ECONOMIC INTEGRATION AGREEMENTS, 403
NAFTA, 403
Effects of NAFTA, 405
IN THE REAL WORLD: NAFTA—MYTHS VS. FACTS, 408
Recent U.S. Integration Agreements, 409
OTHER MAJOR ECONOMIC INTEGRATION EFFORTS, 411
MERCOSUR, 411
FTAA, 411
Chilean Trade Agreements, 412
APEC, 412
Trans-Pacific Partnership, 412
IN THE REAL WORLD: ASIAN ECONOMIC INTERDEPENDENCE
LEADS TO GREATER INTEGRATION, 413
Transatlantic Trade and Investment Partnership, 414
SUMMARY, 414
CHAPTER 18
International Trade and the Developing Countries, 416
INTRODUCTION, 417
Recovery in East Asia after Financial Crisis, 417
AN OVERVIEW OF THE DEVELOPING COUNTRIES, 417
THE ROLE OF TRADE IN FOSTERING ECONOMIC
DEVELOPMENT, 418
The Static Effects of Trade on Economic
Development, 419
The Dynamic Effects of Trade on Development, 420
Export Instability, 421
Potential Causes of Export Instability, 422
Long-Run Terms-of-Trade Deterioration, 423
TITANS OF INTERNATIONAL ECONOMICS: RAUL
PREBISCH (1901–1986) AND HANS WOLFGANG SINGER
(1910–2006), 425
Empirical Evidence on Trade and Development, 427
TRADE POLICY AND THE DEVELOPING COUNTRIES, 429
Policies to Stabilize Export Prices or Earnings, 429
Problems with International Commodity
Agreements, 430
Suggested Policies to Combat a Long-Run
Deterioration in the Terms of Trade, 430
IN THE REAL WORLD: MANAGING PRICE INSTABILITY, 431
IN THE REAL WORLD: THE LENGTH OF COMMODITY PRICE
SHOCKS, 431
Inward-Looking versus Outward-Looking
Trade Strategies, 434
IN THE REAL WORLD: EMERGING CONNECTIONS BETWEEN
ASIA AND AFRICA, 437
THE EXTERNAL DEBT PROBLEM OF THE DEVELOPING
COUNTRIES, 438
Causes of the Developing Countries’ Debt
Problem, 439
Possible Solutions to the Debt Problem, 440
IN THE REAL WORLD: THE HIPC AND MDRI DEBT RELIEF
INITIATIVES, 443
SUMMARY, 446
CHAPTER 16
Political Economy and U.S. Trade Policy, 359
INTRODUCTION, 360
Contrasting Vignettes on Trade Policy, 360
THE POLITICAL ECONOMY OF TRADE POLICY, 360
The Self-Interest Approach to Trade Policy, 361
IN THE REAL WORLD: WORLD ATTITUDES TOWARD FOREIGN
TRADE, 362
IN THE REAL WORLD: U.S. ATTITUDES TOWARD INTERNATIONAL
TRADE, 363
The Social Objectives Approach, 364
IN THE REAL WORLD: POLITICS PUTS THE SQUEEZE ON
TOMATO IMPORTS, 365
A REVIEW OF U.S. TRADE POLICY AND MULTILATERAL
NEGOTIATIONS, 366
Reciprocal Trade Agreements and Early
GATT Rounds, 367
The Kennedy Round of Trade Negotiations, 367
The Tokyo Round of Trade Negotiations, 368
IN THE REAL WORLD: TRADE ADJUSTMENT ASSISTANCE AND ITS
IMPLEMENTATION, 370
The Uruguay Round of Trade Negotiations, 371
Trade Policy Issues after the Uruguay Round, 373
IN THE REAL WORLD: TARIFF REDUCTIONS RESULTING FROM
THE URUGUAY ROUND, 374
IN THE REAL WORLD: NATIONAL SOVEREIGNTY AND THE
WORLD TRADE ORGANIZATION, 377
The Doha Development Agenda, 377
Recent U.S. Actions, 380
CONCLUDING OBSERVATIONS ON TRADE POLICY, 384
The Conduct of Trade Policy, 384
SUMMARY, 385
CHAPTER 17
Economic Integration, 387
INTRODUCTION, 388
Promise and Problems of Integration, 388
TYPES OF ECONOMIC INTEGRATION, 388
Free-Trade Area, 388
Customs Union, 389
Common Market, 389
Economic Union, 389
THE STATIC AND DYNAMIC EFFECTS OF ECONOMIC
INTEGRATION, 389
Static Effects of Economic Integration, 389
IN THE REAL WORLD: ECONOMIC INTEGRATION UNITS, 391
IN THE REAL WORLD: TRADE CREATION AND TRADE
DIVERSION IN THE EARLY STAGES OF EUROPEAN ECONOMIC
INTEGRATION, 392
General Conclusions on Trade Creation/Diversion, 396
CONCEPT BOX 1: TRADE DIVERSION IN GENERAL
EQUILIBRIUM, 396
Dynamic Effects of Economic Integration, 398
Summary of Economic Integration, 398
THE EUROPEAN UNION, 399
History and Structure, 399
IN THE REAL WORLD: THE EAST AFRICAN COMMUNITY, 400
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PART 5
FUNDAMENTALS OF INTERNATIONAL
MONETARY ECONOMICS 448
CHAPTER 19
The Balance-of-Payments Accounts, 448
INTRODUCTION, 449
China’s Trade Surpluses and Deficits, 449
CREDITS, DEBITS, AND SAMPLE ENTRIES IN BALANCE-OF-
PAYMENTS ACCOUNTING, 450
ASSEMBLING A BALANCE-OF-PAYMENTS SUMMARY
STATEMENT, 453
IN THE REAL WORLD: CURRENT ACCOUNT DEFICITS, 457
BALANCE-OF-PAYMENTS SUMMARY STATEMENT FOR THE UNITED
STATES, 459
IN THE REAL WORLD: U.S. TRADE DEFICITS WITH CANADA,
CHINA, JAPAN, AND MEXICO, 460
INTERNATIONAL INVESTMENT POSITION OF THE
UNITED STATES, 463
IN THE REAL WORLD: TRENDS IN THE U.S. INTERNATIONAL
INVESTMENT POSITION, 465
SUMMARY, 466
CHAPTER 20
The Foreign Exchange Market, 468
INTRODUCTION, 469
The Yen Also Rises (and Falls), 469
THE FOREIGN EXCHANGE RATE AND THE MARKET FOR
FOREIGN EXCHANGE, 469
Demand Side, 469
Supply Side, 470
The Market, 470
THE SPOT MARKET, 472
Principal Actors, 473
The Role of Arbitrage, 473
Different Measures of the Spot Rate, 474
IN THE REAL WORLD: NOMINAL AND REAL EXCHANGE RATES
OF THE U.S. DOLLAR, 477
THE FORWARD MARKET, 480
IN THE REAL WORLD: SPOT AND PPP EXCHANGE RATES, 482
CONCEPT BOX 1: CURRENCY FUTURES
QUOTATIONS, 486
THE LINK BETWEEN THE FOREIGN EXCHANGE MARKETS AND THE
FINANCIAL MARKETS, 487
The Basis for International Financial Flows, 487
Covered Interest Parity and Financial Market Equilibrium, 490
Simultaneous Adjustment of the Foreign Exchange Markets
and the Financial Markets, 493
SUMMARY, 496
CHAPTER 21
International Financial Markets and Instruments: An
Introduction, 498
INTRODUCTION, 499
Financial Globalization: A Recent Phenomenon? 499
INTERNATIONAL BANK LENDING, 499
THE INTERNATIONAL FINANCIAL MARKETS, 505
International Bond Market (Debt Securities) 505
IN THE REAL WORLD: INTEREST RATES ACROSS
COUNTRIES, 508
International Stock Markets, 510
FINANCIAL LINKAGES AND EUROCURRENCY
DERIVATIVES, 512
Basic International Financial Linkages: A Review, 513
International Financial Linkages and the Eurodollar
Market, 514
IN THE REAL WORLD: U.S. DOMESTIC AND EURODOLLAR
DEPOSIT AND LENDING RATES, 1989–2014, 516
Hedging Eurodollar Interest Rate Risk, 518
CONCEPT BOX 1: EURODOLLAR INTEREST RATE FUTURES
MARKET QUOTATIONS, 523
THE CURRENT GLOBAL DERIVATIVES MARKET, 527
SUMMARY, 529
CHAPTER 22
The Monetary and Portfolio Balance Approaches to
External Balance, 531
INTRODUCTION, 532
International Interdependence of Money, 532
THE MONETARY APPROACH TO THE BALANCE
OF PAYMENTS, 532
The Supply of Money, 533
The Demand for Money, 534
IN THE REAL WORLD: RELATIONSHIPS BETWEEN MONETARY
CONCEPTS IN THE UNITED STATES, 535
Monetary Equilibrium and the Balance of
Payments, 537
THE MONETARY APPROACH TO THE EXCHANGE RATE, 539
A Two-Country Framework, 540
THE PORTFOLIO BALANCE APPROACH TO THE BALANCE OF
PAYMENTS AND THE EXCHANGE RATE, 542
Asset Demands, 542
Portfolio Balance, 544
Portfolio Adjustments, 545
EXCHANGE RATE OVERSHOOTING, 548
TITANS OF INTERNATIONAL ECONOMICS: RUDIGER
DORNBUSCH (1942–2002), 549
SUMMARY, 555
Appendix, Examples of Empirical Work on the Monetary and
Portfolio Balance Approaches, 556
CHAPTER 23
Price Adjustments and Balance-of-Payments
Disequilibrium, 562
INTRODUCTION, 563
Price Adjustment: The Exchange Rate Question, 563
THE PRICE ADJUSTMENT PROCESS AND THE CURRENT ACCOUNT
UNDER A FLEXIBLE-RATE SYSTEM, 563
The Demand for Foreign Goods and Services and the
Foreign Exchange Market, 564
Market Stability and the Price Adjustment Mechanism, 567
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CONCEPT BOX 1: ELASTICITY OF IMPORT DEMAND AND THE
SUPPLY CURVE OF FOREIGN EXCHANGE WHEN DEMAND IS
LINEAR, 571
The Price Adjustment Process: Short Run versus Long
Run, 574
IN THE REAL WORLD: ESTIMATES OF IMPORT AND EXPORT
DEMAND ELASTICITIES, 575
IN THE REAL WORLD: ESTIMATES OF EXCHANGE RATE PASS-
THROUGH, 577
IN THE REAL WORLD: JAPANESE EXPORT PRICING AND
PASS-THROUGH IN THE 1990s, 578
IN THE REAL WORLD: U.S. AGRICULTURAL EXPORTS AND
EXCHANGE RATE CHANGES, 582
THE PRICE ADJUSTMENT MECHANISM IN A FIXED
EXCHANGE RATE SYSTEM, 583
Gold Standard, 583
The Price Adjustment Mechanism and the Pegged Rate
System, 585
SUMMARY, 586
Appendix, Derivation of the Marshall-Lerner
Condition, 588
CHAPTER 24
National Income and the Current Account, 590
INTRODUCTION, 591
Does GDP Growth Cause Trade Deficits? 591
THE CURRENT ACCOUNT AND NATIONAL INCOME, 591
The Keynesian Income Model, 591
TITANS OF INTERNATIONAL ECONOMICS: JOHN MAYNARD
KEYNES (1883–1946), 592
Determining the Equilibrium Level of National
Income, 597
IN THE REAL WORLD: AVERAGE PROPENSITIES TO IMPORT,
SELECTED COUNTRIES, 598
THE MULTIPLIER PROCESS, 603
The Autonomous Spending Multiplier, 603
IN THE REAL WORLD: MULTIPLIER ESTIMATES
FOR INDIA, 605
The Current Account and the Multiplier, 606
IN THE REAL WORLD: THE GOVERNMENT SPENDING
MULTIPLIER IN DEVELOPED AND DEVELOPING
COUNTRIES, 607
Foreign Repercussions and the Multiplier
Process, 608
IN THE REAL WORLD: HISTORICAL CORRELATION OVER
TIME OF COUNTRIES’ GDP, 610
AN OVERVIEW OF PRICE AND INCOME ADJUSTMENTS AND
SIMULTANEOUS EXTERNAL AND INTERNAL
BALANCE, 610
IN THE REAL WORLD: RECENT SYNCHRONIZATION
OF GDP MOVEMENTS OF COUNTRIES, 611
SUMMARY, 613
Appendix A, The Multiplier When Taxes Depend
on Income, 614
Appendix B, Derivation of the Multiplier with Foreign
Repercussions, 616
PART 6
MACROECONOMIC POLICY IN THE
OPEN ECONOMY 619
CHAPTER 25
Economic Policy in the Open Economy under Fixed Exchange
Rates, 619
INTRODUCTION, 620
The Case of the Chinese Renminbi Yuan, 620
TITANS OF INTERNATIONAL ECONOMICS: ROBERT
A. MUNDELL (BORN 1932), 621
TARGETS, INSTRUMENTS, AND ECONOMIC POLICY IN A
TWO-INSTRUMENT, TWO-TARGET MODEL, 621
GENERAL EQUILIBRIUM IN THE OPEN ECONOMY:
THE IS/LM/BP MODEL, 624
General Equilibrium in the Money Market: The
LM Curve, 624
General Equilibrium in the Real Sector: The IS
Curve, 628
Simultaneous Equilibrium in the Monetary and Real
Sectors, 630
Equilibrium in the Balance of Payments: The BP
Curve, 630
IN THE REAL WORLD: THE PRESENCE OF EXCHANGE CONTROLS
IN THE CURRENT FINANCIAL SYSTEM, 635
Equilibrium in the Open Economy: The Simultaneous Use
of the LM, IS, and BP Curves, 636
THE EFFECTS OF FISCAL POLICY UNDER FIXED EXCHANGE
RATES, 639
THE EFFECTS OF MONETARY POLICY UNDER FIXED EXCHANGE
RATES, 642
THE EFFECTS OF OFFICIAL CHANGES IN THE EXCHANGE
RATE, 644
IN THE REAL WORLD: THE HISTORICAL RISE AND
FALL OF A CURRENCY BOARD—THE CASE OF
ARGENTINA, 646
SUMMARY, 648
Appendix, The Relationship between the Exchange Rate and
Income in Equilibrium, 649
CHAPTER 26
Economic Policy in the Open Economy under
Flexible Exchange Rates, 651
INTRODUCTION, 652
Movements to Flexible Rates, 652
THE EFFECTS OF FISCAL POLICY UNDER FLEXIBLE
EXCHANGE RATES WITH DIFFERENT CAPITAL
MOBILITY ASSUMPTIONS, 652
CONCEPT BOX 1: REAL AND FINANCIAL FACTORS THAT
INFLUENCE THE BP CURVE, 654
THE EFFECTS OF MONETARY POLICY UNDER FLEXIBLE
EXCHANGE RATES WITH DIFFERENT CAPITAL MOBILITY
ASSUMPTIONS, 657
Policy Coordination under Flexible Exchange
Rates, 659
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THE EFFECTS OF EXOGENOUS SHOCKS IN THE IS/LM/BP MODEL
WITH IMPERFECT MOBILITY OF CAPITAL, 661
IN THE REAL WORLD: COMMODITY PRICES AND U.S. REAL
GDP, 1972–2014, 662
IN THE REAL WORLD: EUROPEAN INSTABILITY AND
U.S. GDP, 666
IN THE REAL WORLD: POLICY FRICTIONS IN AN
INTERDEPENDENT WORLD, 667
IN THE REAL WORLD: MACROECONOMIC POLICY
COORDINATION: THE IMF, THE G-7/G-8, AND
THE G-20, 669
SUMMARY, 670
Appendix, Policy Effects, Open-Economy Equilibrium, and the
Exchange Rate under Flexible Rates, 671
CHAPTER 27
Prices and Output in the Open Economy: Aggregate Supply
and Demand, 673
INTRODUCTION, 674
Crisis in Argentina, 674
AGGREGATE DEMAND AND SUPPLY IN THE CLOSED
ECONOMY, 675
Aggregate Demand in the Closed
Economy, 675
Aggregate Supply in the Closed
Economy, 676
Equilibrium in the Closed Economy, 680
IN THE REAL WORLD: U.S. ACTUAL AND NATURAL INCOME
AND UNEMPLOYMENT, 681
AGGREGATE DEMAND AND SUPPLY IN THE OPEN
ECONOMY, 682
Aggregate Demand in the Open Economy under Fixed
Rates, 683
Aggregate Demand in the Open Economy under Flexible
Rates, 684
THE NATURE OF ECONOMIC ADJUSTMENT AND MACRO ECONOMIC
POLICY IN THE OPEN-ECONOMY AGGREGATE SUPPLY AND
DEMAND FRAMEWORK, 685
Shifts in the Aggregate Demand Curve under Fixed and
Flexible Rates, 685
The Effect of Monetary and Fiscal Policy on the
Aggregate Demand Curve under Fixed and
Flexible Rates, 686
Summary, 687
Monetary Policy in the Open Economy with Flexible
Prices, 688
Currency Adjustments under Fixed Rates, 692
Fiscal Policy in the Open Economy with
Flexible Prices, 692
Economic Policy and Supply Considerations, 693
IN THE REAL WORLD: ECONOMIC PROGRESS IN
SUB-SAHARAN AFRICA, 695
EXTERNAL SHOCKS AND THE OPEN ECONOMY, 696
IN THE REAL WORLD: INFLATION AND UNEMPLOYMENT IN THE
UNITED STATES, 1970–2014, 697
SUMMARY, 700
PART 7
ISSUES IN WORLD MONETARY
ARRANGEMENTS 701
CHAPTER 28
Fixed or Flexible Exchange Rates? 701
INTRODUCTION, 702
Exchange Rate Experiences, 702
CENTRAL ISSUES IN THE FIXED–FLEXIBLE EXCHANGE
RATE DEBATE, 702
Do Fixed or Flexible Exchange Rates Provide for Greater
“Discipline” on the Part of Policymakers? 702
Would Fixed or Flexible Exchange Rates Provide
for Greater Growth in International Trade and
Investment? 704
IN THE REAL WORLD: EXCHANGE RISK AND INTERNATIONAL
TRADE, 705
Would Fixed or Flexible Exchange Rates Provide for Greater
Efficiency in Resource Allocation? 706
Is Macroeconomic Policy More Effective in Influencing
National Income under Fixed or Flexible Exchange
Rates? 707
Will Destabilizing Speculation in Exchange Markets Be
Greater under Fixed or Flexible Exchange Rates? 709
IN THE REAL WORLD: RESERVE HOLDINGS UNDER FIXED AND
FLEXIBLE EXCHANGE RATES, 709
TITANS OF INTERNATIONAL ECONOMICS: MILTON
FRIEDMAN (1912–2006), 713
Will Countries Be Better Protected from External
Shocks under a Fixed or a Flexible Exchange Rate
System? 714
IN THE REAL WORLD: “INSULATION” WITH FLEXIBLE
RATES—THE CASE OF JAPAN, 715
CURRENCY BOARDS, 716
Advantages of a Currency Board, 716
IN THE REAL WORLD: CURRENCY BOARDS IN ESTONIA AND
LITHUANIA, 717
Disadvantages of a Currency Board, 718
OPTIMUM CURRENCY AREAS, 719
IN THE REAL WORLD: THE EASTERN CARIBBEAN CURRENCY
UNION AND OTHER MONETARY UNIONS, 721
HYBRID SYSTEMS COMBINING FIXED AND FLEXIBLE EXCHANGE
RATES, 722
Wider Bands, 722
Crawling Pegs, 723
Managed Floating, 724
IN THE REAL WORLD: COLOMBIA’S EXPERIENCE WITH A
CRAWLING PEG, 725
SUMMARY, 726
CHAPTER 29
The International Monetary System: Past, Present,
and Future, 728
INTRODUCTION, 729
Monetary System Uncertainties, 729
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IN THE REAL WORLD: CONFIDENCE IN EXCHANGE RATES
UNDER THE GOLD STANDARD, 730
IN THE REAL WORLD: FLEXIBLE EXCHANGE RATES IN POST–
WORLD WAR I EUROPE: THE UNITED KINGDOM, FRANCE, AND
NORWAY, 731
THE BRETTON WOODS SYSTEM, 732
The Goals of the IMF, 733
The Bretton Woods System in Retrospect, 736
GRADUAL EVOLUTION OF A NEW INTERNATIONAL MONETARY
SYSTEM, 737
Early Disruptions, 737
Special Drawing Rights, 737
The Breaking of the Gold–Dollar Link and the Smithsonian
Agreement, 738
The Jamaica Accords, 739
The European Monetary System, 740
Exchange Rate Fluctuations in Other Currencies in the
1990s and 2000s, 743
CURRENT EXCHANGE RATE ARRANGEMENTS, 745
EXPERIENCE UNDER THE CURRENT INTERNATIONAL MONETARY
SYSTEM, 746
The Global Financial Crisis and the 2007–2009 Recession,
751
SUGGESTIONS FOR REFORM OF THE INTERNATIONAL MONETARY
SYSTEM, 753
A Return to the Gold Standard, 753
A World Central Bank, 754
CONCEPT BOX 1: A WORLD CENTRAL BANK WITHIN
A THREE-CURRENCY MONETARY UNION, 755
The Target Zone Proposal, 756
Controls on Capital Flows, 758
Greater Stability and Coordination of Macroeconomic
Policies across Countries, 759
IN THE REAL WORLD: THE EMERGENCE OF A NEW CURRENCY:
BITCOIN, 760
International Monetary Arrangements and the
Emerging/Developing Countries, 762
SUMMARY, 763
References for Further Reading, 765
Index, 784
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CHAPTER
INTRODUCTION
Welcome to the study of international economics. No doubt you have
become increasingly aware of the importance of international transactions
in daily economic life. When people say that “the world is getting smaller
every day,” they are referring not only to the increased speed and ease of
transportation and communications but also to the increased use of interna-
tional markets to buy and sell goods, services, and financial assets. This is
not a new phenomenon, of course: in ancient times international trade was
important for the Egyptians, the Greeks, the Romans, the Phoenicians, and
later for Spain, Portugal, Holland, and Britain. It can be said that all the
great nations of the past that were influential world leaders were also impor-
tant world traders. Nevertheless, the importance of international trade and
finance to the economic health and overall standard of living of a country
has never been as clear as it is today.
Signs of these international transactions are all around us. The clothes we
wear come from production sources all over the world: the United States to
the Pacific Rim to Europe to Central and South America. The automobiles
THE WORLD OF
INTERNATIONAL
ECONOMICS 1
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we drive are produced not only in the United States but also in Canada, Mexico, Japan,
Germany, France, Italy, England, Sweden, and other countries. The same can be said for
the food we eat, the shoes we wear, the appliances we use, and the many different services
we consume. In addition, in the United States, when you call an 800 number about a prod-
uct or service, you may be talking to someone in India. Further, products manufactured in
the United States often use important parts produced in other countries. At the same time,
many U.S. imports are manufactured with important U.S.-made components.
This increased internationalization of economic life is made even more complicated
by foreign-owned assets. More and more companies in many countries are owned par-
tially or totally by foreigners. In the 1990s, foreigners began to purchase U.S. govern-
ment bonds and corporate stocks in record numbers, partly fueling the stock market
boom of those years. The overall heightened presence of foreign goods, foreign produc-
ers, and foreign-owned assets causes many to question the impact and desirability of
international transactions. This questioning became more intense with the onset of the
2007–2008 global financial crisis and accompanying recession.
These recent events draw attention to the changes in the world economic structure that
have been taking place in the years following World War II (WWII) when the United States
was the dominant world economic power. The nature of that dominance has, however, been
undergoing considerable change in terms of world production structure and importance in
global GDP and trade. The emergence of Japan, the European Union (EU), and, notably,
China on the world scene has been significant. Indeed, in terms of relative importance in
global GDP and trade, the United States and China are roughly equivalent. The nature of
economic activity both in terms of location and structure has also been changing as world
production has become more integrated through global supply chains and the evolution of
the world international monetary system. Even though the United States has diminished in
relative importance in goods production and trade, it remains the dominant player in terms
of global finance and global services and in areas such as technology development, and
electronic development/processing. In addition, every country is affected by actions of the
U.S. Federal Reserve as the U.S. dollar remains the world’s key currency.
You will be studying one of the oldest branches of economics. People have been con-
cerned about the goods and services crossing their borders for as long as nation-states or
city-states have existed. Some of the earliest economic data relate to international trade,
and early economic thinking often centered on the implications of international trade for
the well-being of a politically defined area. Although similar to regional economics in
many respects, international economics has traditionally been treated as a special branch
of the discipline. This is not terribly surprising when one considers that economic trans-
actions between politically distinct areas are often associated with many differences that
influence the nature of exchanges between them rather than transactions within them. For
example, the degree of factor mobility between countries often differs from that within
countries. Countries can have different forms of government, different currencies, differ-
ent types of economic systems, different resource endowments, different cultures, differ-
ent institutions, and different arrays of products.
The study of international economics, like all branches of economics, concerns decision
making with respect to the use of scarce resources to meet desired economic objectives.
It examines how international transactions influence such things as social welfare, income
distribution, employment, growth, and price stability, and the possible ways public policy
can affect the outcomes. In the study of international trade, we ask, for example: What deter-
mines the basis for trade? What are the effects of trade? What determines the value and the
volume of trade? What factors impede trade flows? What is the impact of public policy that
attempts to alter the pattern of trade? In the study of international monetary economics we
address questions such as: What is meant by a country’s balance of payments? How are
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exchange rates determined? How does trade affect the economy at the macro level? Why
does financial capital flow rapidly and sizably across country borders? Should several coun-
tries adopt a common currency? How do international transactions affect the use of mon-
etary and fiscal policy to pursue domestic targets? How do economic developments in a
country get transmitted to other countries? This chapter provides an overview of the subjects
and issues of international economics that will be discussed throughout the rest of this text.
THE NATURE OF MERCHANDISE TRADE
Before delving further into the subject matter of international economics, however, it is
useful to take a brief look at some of the characteristics of world trade today. The value
of world merchandise exports was $18.9 trillion in 2014, a figure that is dramatic when
one realizes that the value of goods exported worldwide was less than $2 trillion in 1985.
Throughout the past four decades, international trade volume has, on average, outgrown
production (see Table 1), illustrating how countries are becoming more interdependent.
With the worldwide recession, slow recovery, and uncertainties of recent years, trade
growth has been variable: It grew 2.5 percent in 2014, 3.0 percent in 2013, 2.5 percent in
2012, 5.0 percent in 2011, 13.8 percent in 2010, and a negative 12.0 percent in 2009.1
In terms of major economic areas, the industrialized countries dominate world trade. Details
of trade on a regional basis are provided in Table 2. The relative importance of Europe,
North America, and Asia is evident, as they account for more than 83 percent of trade. Asia
has become increasingly important in developing countries’ imports and exports.
To obtain an idea of the geographical structure of trade, look at Table 3, which provides
information on the destination of merchandise exports from several regions for 2014. The
first row, for example, indicates that 50.2 percent of the exports of countries of North
America went to other North American countries, 8.6 percent of North American exports
The Geographical
Composition of Trade
1963–1973 1970–1979 1980–1985 1985–1990 1990–1998 1995–2000 2000–2006 2005–2010 2010–2014 2014
Production
All commodities 6.0% 4.0% 1.7% 3.0% 2.0% 4.0% 2.5% 2.0% 2.5% 2.0%
Agriculture 2.5 2.0 2.9 1.9 2.0 2.5 2.0 2.0 2.5 1.5
Mining 5.5 2.5 −2.7 3.0 2.0 2.0 1.5 0.5 1.5 2.5
Manufacturing 7.5 4.5 2.3 3.2 2.0 4.0 3.0 2.5 2.5 2.5
Exports
All commodities 9.0% 5.0% 2.1% 5.8% 6.5% 7.0% 5.5% 3.5% 3.5% 2.5%
Agriculture 14.0 4.5 1.0 2.2 4.0 3.5 4.0 3.5 3.5 2.5
Mining 7.5 1.5 −2.7 4.8 5.5 4.0 3.0 1.5 1.5 1.0
Manufacturing 11.5 7.0 4.5 7.0 7.0 8.0 6.0 4.0 4.0 4.0
Sources: General Agreement on Tariffs and Trade, International Trade 1985–86 (Geneva: GATT, 1986), p. 13; GATT, International Trade 1988–89, I (Geneva:
GATT, 1989), p. 8; GATT, International Trade 1993: Statistics (Geneva: GATT, 1993), p. 2; GATT, International Trade 1994: Trends and Statistics (Geneva:
GATT, 1994), p. 2; World Trade Organization, Annual Report 1999: International Trade Statistics (Geneva: WTO, 1999), p. 1; WTO, International Trade Statistics
2003 (Geneva: WTO, 2003), p. 19; WTO, International Trade Statistics 2007 (Geneva: WTO, 2007), p. 7; WTO, International Trade Statistics 2011 (Geneva: WTO,
2011), p. 19; and WTO, World Trade Report 2015, p. 39, all obtained from www.wto.org.
TABLE 1 Growth in Volume of World Goods Production and Trade, 1963–2014 (average annual
percentage change in volume)
1World Trade Organization, International Trade Statistics 2015, Table 1.1, and World Trade Organization, Press
Release 658, April 12, 2012, “Trade Growth to Slow in 2012 after Strong Deceleration in 2011,” both obtained
from www.wto.org.
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Exports Imports
(billions of dollars,
f.o.b.*) Share (%)
(billions of dollars,
c.i.f. *) Share (%)
North America† $ 2,493 13.2% $ 3,300 17.4%
South and Central America 695 3.7 739 3.9
Europe 6,739 35.6 6,722 35.3
(European Union)‡ (6,162) (32.6) (6,133) (32.2)
Commonwealth of
Independent States (CIS)§ 735 3.9 506 2.7
Africa 555 2.9 642 3.4
Middle East 1,288 6.8 784 4.1
Asia 6,426 33.9 6,325 33.3
World $18,930 100.0% $19,018 100.0%
Note: Components may not sum to totals because of rounding.
*Exports are recorded f.o.b. (free on board) and imports are recorded c.i.f. (cost, insurance, and freight).
†Including Mexico.
‡Austria, Belgium, Bulgaria, Croatia, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary,
Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovak Republic, Slovenia,
Spain, Sweden, and United Kingdom.
§Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyz Republic, Moldova, Russian Federation, Tajikistan,
Turkmenistan, Ukraine, and Uzbekistan.
Source: World Trade Organization, World Trade Report 2015, pp. 24, 26, obtained from www.wto.org.
TABLE 2 Merchandise Exports and Imports by Region, 2014 (billions of dollars and
percentage of world totals)
Destination
Origin
North
America
South and
Central America Europe CIS Africa Middle East Asia World
North America 50.2% 8.6% 15.2% 0.7% 1.7% 3.2% 20.2% 100.0%
South and Central America 24.8 25.8 16.4 1.4 2.5 2.4 24.5 100.0
Europe 7.9 1.7 68.5 3.2 3.3 3.4 10.8 100.0
CIS 3.9 0.9 52.4 17.8 2.1 3.1 18.2 100.0
Africa 7.0 5.1 36.2 0.4 17.7 3.3 27.3 100.0
Middle East 7.7 0.8 11.5 0.5 2.8 8.8 53.9 100.0
Asia 18.0 3.1 15.2 2.1 3.5 5.1 52.3 100.0
World 17.3 4.0 36.7 2.8 3.5 4.2 29.7 100.0
Note: Destination percentages for any given origin area do not sum to 100.0% because of rounding and/or incomplete specification.
Source: World Trade Organization, International Trade Statistics 2015, p. 41, obtained from www.wto.org.
TABLE 3 Regional Structure of World Merchandise Exports, 2014 (percentage of each origin area’s exports going
to each destination area)
went to South and Central America, and so forth. From this table it is clear that the major
markets for all regions’ exports are in North America, Europe, and Asia. This is true for
these three areas themselves, especially for Europe, which sends 68.5 percent of its exports
to itself. In addition, the table makes it evident that the countries in Africa and the Middle
East do not trade heavily among themselves.
At the individual country level (see Table 4), the relative importance of Europe, North
America, and Asia in 2014 is again quite evident. The largest country exporter is China
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Exports Imports
Country Value Share Country Value Share
1. China $ 2,342 12.4% United States $ 2,413 12.7%
2. United States 1,621 8.6 China 1,959 10.3
3. Germany 1,508 8.0 Germany 1,216 6.4
4. Japan 684 3.6 Japan 822 4.3
5. Netherlands 672 3.6 United Kingdom 684 3.6
6. France 583 3.1 France 678 3.6
7. Republic of Korea 573 3.0 Hong Kong (China) 601 3.2
8. Italy 529 2.8 Netherlands 588 3.1
9. Hong Kong (China) 524 2.8 Republic of Korea 526 2.8
10. United Kingdom 506 2.7 Canada* 475 2.5
11. Russian Federation 498 2.6 Italy 472 2.5
12. Canada 475 2.5 India 463 2.4
13. Belgium 471 2.5 Belgium 452 2.4
14. Singapore 410 2.2 Mexico 412 2.2
15. Mexico 398 2.1 Singapore 366 1.9
16. United Arab Emirates 360 1.9 Spain 358 1.9
17. Saudi Arabia 354 1.9 Russian Federation* 308 1.6
18. Spain 325 1.7 Taiwan 274 1.4
19. India 322 1.7 United Arab Emirates 262 1.4
20. Taiwan 314 1.7 Turkey 242 1.3
21. Australia 241 1.3 Brazil 239 1.3
22. Switzerland 239 1.3 Australia 237 1.2
23. Malaysia 234 1.2 Thailand 228 1.2
24. Thailand 228 1.2 Poland 220 1.2
25. Brazil 225 1.2 Malaysia 209 1.1
26. Poland 217 1.1 Switzerland 203 1.1
27. Austria 178 0.9 Austria 182 1.0
28. Indonesia 176 0.9 Indonesia 178 0.9
29. Czech Republic 174 0.9 Saudi Arabia 163 0.9
30. Sweden 164 0.9 Sweden 163 0.9
30 countries $15,542 82.1% $15,592 82.0%
World $18,930 100.0% $19,018 100.0%
Note: Components do not sum to totals because of rounding.
*Imports valued f.o.b.
Source: World Trade Organization, World Trade Report 2015, p. 26, obtained from www.wto.org.
TABLE 4 Leading Merchandise Exporters and Importers, 2014 (billions of dollars and percentage share of world totals)
(which displaced Germany in 2009, which in turn had displaced the United States in 2003).
The six largest traders (exports plus imports) are China, the United States, Germany, Japan,
France, and the Netherlands, and they account for nearly 40 percent of world trade. Also
noteworthy has been the spectacular growth in the trade of Hong Kong, the Republic of
Korea (South Korea), Taiwan, and Singapore. Finally, the 10 largest trading countries
account for over 50 percent of world trade. World trade thus tends to be concentrated among
relatively few major traders, with the remaining approximately 200 countries accounting for
slightly less than 50 percent.
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Turning to the 2014 commodity composition of world trade (Table  5), manufactures
account for 66.5 percent of trade, with the remaining amount consisting of primary prod-
ucts. Among primary goods, trade in fuels is the largest (16.7 percent), followed by food
products (8.1 percent). Trade in raw materials, ores and other minerals, and nonferrous
metals accounts for 5.4 percent. In the manufacturing category, machinery and transport
equipment account for 33.2 percent of world trade. Office and telecom equipment and
automotive/transport products are major subcategories, accounting for 9.7 percent and
11.4 percent of exports, respectively. Other important categories of manufactures include
trade in chemicals (11.1 percent) and in textiles and clothing (4.3 percent).
What is especially notable is the current importance of trade in manufactures and the
declining importance of primary products. Comparison of the last column of Table 5 with
the next-to-last column illustrates the relatively sluggish growth of primary products in
world trade compared with the growth in manufactured goods. For example, food products
accounted for 11.0 percent of world exports in 1980 but only 8.1 percent in 2014; fuels,
which constituted 23.0 percent in 1980, fell in importance to 16.7 percent in 2014; and
the share of primary products in total dropped from 42.4 percent in 1980 to slightly over
30 percent in 2014. These developments are of particular relevance to many developing
countries, whose trade has traditionally been concentrated in primary goods. Specializa-
tion in commodity groups that are growing relatively more slowly makes it difficult for
them to obtain the gains from growth in world trade accruing to countries exporting manu-
factured products. The demand for primary products not only tends to be less responsive to
income growth but also is more likely to demonstrate greater price fluctuations.
The Commodity
Composition of Trade
Product Category Value in 2014 ($ billion) Share in 2014 Share in 1980
Agricultural products $ 1,765 9.6% 14.7%
Food 1,486 8.1 11.0
Raw materials 279 1.5 3.7
Fuels and mining products 3,789 20.6 27.7
Ores and other minerals 366 2.0 2.1
Fuels 3,068 16.7 23.0
Nonferrous metals 354 1.9 2.5
Manufactures 12,243 66.5 53.9
Iron and steel 472 2.6 3.8
Chemicals 2,054 11.1 7.0
Other semimanufactures 1,185 6.4 6.7
Machinery and transport equipment 6,112 33.2 25.8
Office and telecom equipment 1,794 (9.7) (4.2)
Automotive products and other
transport equipment 2,107 (11.4) (6.5)
Other machinery 2,211 (12.0) (15.2)
Textiles 314 1.7 2.7
Clothing 483 2.6 2.0
Other manufactures 1,623 8.8 5.8
Total $18,422 100.0% 100.0%
Note: Components may not sum to category totals because of rounding. The three aggregate categories do not sum to $18,422
and 100.0% because of incomplete specification of products.
Sources: World Trade Organization, International Trade 1995: Trends and Statistics (Geneva: WTO, 1995), p. 77; WTO, World
Trade Report 2015, p. 24, and Appendix Table A12, obtained from www.wto.org.
TABLE 5 Commodity Composition of World Exports, 2014 and 1980
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To complete our discussion of the current nature of merchandise trade, we take a closer
look at the geographic and commodity characteristics of the 2014 U.S. international trade
(see Tables 6 and 7). Geographically, Canada is the most important trading partner for the
United States, both in exports and imports. The North American Free Trade Agreement
(NAFTA) partners (Canada and Mexico) are the largest multicountry unit, followed by
the EU. The second-largest individual trading partner country of the United States, behind
Canada, is China, followed by Mexico, Japan, Germany, Republic of Korea, the United
Kingdom, France, Brazil, and Taiwan. Of note is the fact that a major portion (63.7 percent)
of the trade deficit of the United States in 2014 could be traced to China, Japan, and Mexico.
U.S. International
Trade
Exports to Imports from
Region or Country Value Share Value Share
Europe $ 337,024 20.6% $ 495,893 20.9%
European Union 279,127 17.1 422,580 15.7
Belgium 34,752 2.1 21,160 0.9
France 31,684 1.9 47,606 2.0
Germany 49,637 3.0 124,174 5.2
Ireland 7,907 0.5 34,088 1.4
Italy 17,123 1.0 42,451 1.8
Netherlands 43,195 2.6 21,363 0.9
Switzerland 22,552 1.4 31,370 1.3
United Kingdom 54,547 3.3 55,439 2.3
Non-European Union 57,897 3.5 73,313 3.1
Canada 313,510 19.2 354,354 14.9
Latin America and Other
Western Hemisphere 425,401 26.1 452,876 19.1
Brazil 42,412 2.6 30,102 1.3
Mexico 240,721 14.7 301,403 12.7
Venezuela 11,129 0.7 30,339 1.3
Asia and Pacific 445,305 27.3 931,750 39.2
China 124,747 7.6 467,940 19.7
Hong Kong (China) 41,997 2.6 6,345 2.6
India 22,523 1.4 45,412 1.9
Japan 68,014 4.2 136,680 5.8
Republic of Korea 46,114 2.8 69,846 2.9
Singapore 30,063 1.8 16,456 0.7
Taiwan 27,135 1.7 40,700 1.7
Middle East 73,434 4.5 104,350 4.4
Israel 15,094 0.9 23,199 0.9
Saudi Arabia 17,866 1.1 47,125 1.8
Africa 37,670 2.3 34,879 1.5
Nigeria 5,982 0.4 3,896 0.2
(Members of OPEC) (81,372) (4.9) (133,198) (5.6)
Total $1,632,639 100.0% $2,374,101 100.0%
Notes: (a) Components may not sum to totals because of rounding; and (b) data are preliminary.
Source: U.S. Department of Commerce, Bureau of Economic Analysis, Table 2.3 of Press Release, September 17, 2015,
obtained from www.bea.gov.
TABLE 6 U.S. Merchandise Trade by Area and Country, 2014 (millions of dollars
and percentage shares)
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Value of Exports Share (%) Value of Imports Share (%)
Foods, feeds, and beverages 143.8 8.8 126.7 5.4
Coffee, cocoa, and sugar — — 8.2 0.3
Fish and shellfish 6.0 0.4 20.2 0.9
Grains and preparations 32.8 2.0 — —
Meat products and poultry 20.1 1.2 12.1 0.5
Soybeans 25.1 1.5 — —
Vegetables, fruits, nuts, and preparations 25.2 1.5 28.2 1.2
Industrial supplies and materials 500.0 30.6 672.6 28.5
Building materials, except metals 15.5 0.9 28.2 1.2
Chemicals, excluding medicinals 119.3 7.3 80.7 3.4
Energy products 182.5 11.2 375.0 15.9
Metals and nonmetallic products 89.7 5.5 114.6 1.8
Iron and steel products 19.0 1.2 46.2 2.0
Nonferrous metals 33.3 2.0 37.6 1.6
Paper and paper base stocks 22.5 1.4 12.6 0.5
Textile supplies and related materials 15.2 0.9 14.8 0.6
Capital goods, except automotive 551.3 33.0 595.7 25.3
Civilian aircraft, engines, and parts 113.1 6.9 53.2 2.3
Machinery and equipment, except consumer-type 431.5 26.4 535.5 22.7
Computers, peripherals, and parts 31.9 2.0 121.7 5.2
Electric generating machinery, electric apparatus, and parts 57.3 3.5 71.3 3.0
Industrial engines, pumps, and compressors 29.7 1.8 24.8 1.0
Machine tools and metalworking machinery 7.7 0.5 11.4 0.5
Measuring, testing, and control instruments 25.2 1.5 20.0 0.8
Oil drilling, mining, and construction machinery 29.6 1.8 24.1 1.0
Scientific, hospital, and medical equipment and parts 46.2 2.8 40.2 1.7
Semiconductors 43.7 2.7 44.0 1.9
Telecommunications equipment 40.7 2.5 58.7 2.5
Automotive vehicles, parts, and engines 159.7 9.8 328.5 13.9
(to/from Canada) (60.0) (3.7) (63.2) (2.7)
Passenger cars, new and used 60.6 3.8 153.6 6.5
Trucks, buses, and special purpose vehicles 19.9 1.2 32.5 1.4
Engines and engine parts 18.4 1.1 29.4 1.2
Other parts and accessories 60.9 3.8 113.1 4.8
Consumer goods (nonfood), except automotive 198.3 12.1 559.4 23.7
Durable goods 110.8 6.8 301.3 12.8
Household and kitchen appliances and other household goods 40.2 2.5 164.8 7.0
Radio and stereo equipment, including records, tapes, and disks 4.8 0.3 9.8 0.4
Televisions, video receivers, and other video equipment 4.6 0.3 28.2 1.2
Toys and sporting goods, including bicycles 10.4 0.6 36.9 1.6
Nondurable goods 87.5 5.4 258.1 10.9
Apparel, footwear, and household goods 11.3 0.7 135.9 5.8
Medical, dental, and pharmaceutical preparations 51.0 3.1 91.9 3.9
Goods, not elsewhere classified (including U.S. import goods returned) 56.6 3.5 75.7 3.2
Total $1,609.7 100.0% $2,358.7 100.0%
Notes: (a) Major category figures may not sum to totals because of rounding; (b) — = not available or negligible; and (c) data are preliminary.
Source: U.S. Department of Commerce, Bureau of Economic Analysis, Table 2.1 of Press Release, September 17, 2015, obtained from www.bea.gov.
TABLE 7 Composition of U.S. Trade, 2014 (billions of dollars and percentage shares)
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Turning to the commodity composition of U.S. trade (Table  7), agricultural products
(foods, feeds, and beverages) are an important source of exports. The capital goods category
is the largest single export category and is dominated by nonelectric machinery. Industrial
supplies, importantly consisting of chemicals and metal/nonmetallic products, is also an
important export category for the United States. If energy products are excluded, this category
would show a small trade surplus. Sizeable net imports occur in consumer goods, autos, and
energy products. The largest import category is industrial supplies and materials, followed by
capital goods (except automotive) and consumer goods imports.
WORLD TRADE IN SERVICES
The discussion of world trade has to this point focused on merchandise trade and has
ignored the rapidly growing exports of services, estimated to be almost $5 trillion in 2014
(one-fifth of total exports in goods and services). The rising importance of services in trade
should not be unexpected since the service category now accounts for the largest share of
income and employment in many industrial countries including the United States. More
specifically, in recent years services accounted for 79 percent of gross domestic product
(GDP) in France, 69 percent in Germany, 78 percent in the United States, 78 percent in
the United Kingdom, and 73 percent in Japan.2 In this context, services generally include
the following categories in the International Standard Industrial Classification (ISIC) sys-
tem: wholesale and retail trade, restaurants and hotels, transport, storage, communications,
financial services, insurance, real estate, business services, personal services, community
services, social services, and government services.
International trade in services broadly consists of commercial services, investment income,
and government services, with the first two categories accounting for the bulk of services.
Discussions of trade in “services” generally refer to trade in commercial services. During the
1970s this category grew more slowly in value than did merchandise trade. However, since
that time, exports of commercial services have outgrown merchandise exports, and the rela-
tive importance of commercial services is roughly the same today as it was in the early 1970s.
A word of caution is in order, however: the nature of trade in “services” is such that it is
extremely difficult to obtain accurate estimates of the value of these transactions. This results
from the fact that there is no agreed definition of what constitutes a traded service, and the
ways in which these transactions are measured are less precise than is the case for merchan-
dise trade. Estimates are obtained by examining foreign exchange records and/or through sur-
veys of establishments. Because many service transactions are not observable (hence, they are
sometimes referred to as the “invisibles” in international trade), the usual customs records or
data are not available for valuing these transactions. Thus, it is likely that the value of trade in
commercial services is underestimated. However, there may also be instances when firms may
choose to overvalue trade in services, and reported figures must be viewed with some caution.
In terms of the geographical nature of trade in services, this trade is also concentrated
among the industrial countries (see Table 8). The principal world traders in merchandise are
generally also the principal traders in services. It is notable that both exports and imports of
services are important for industrializing economies such as Thailand, Taiwan, and India.
The nature of trade in services is such that until the 1980s they were virtually ignored
in trade negotiations and trade agreements. However, because of their increasing impor-
tance, there has been a growing concern for the need to establish some general guidelines
for international transactions in services. Consequently, discussions regarding the nature of
the service trade and various country restrictions that may influence it were included in the
2World Bank, World Development Indicators 2015, Table 4.2, obtained from http://wdi.worldbank.org/table/4.2.
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last completed round of trade negotiations (the Uruguay Round) conducted under the aus-
pices of the General Agreement on Tariffs and Trade (GATT), which became the World
Trade Organization in 1995. In the WTO years, services have continued to play an important
role in trade negotiations, as in the ongoing Doha Development Agenda discussions and
the recently expanded Information Technology Agreement. Services are also central to
the Trans-Pacific Partnership agreement that was signed in 2015. Clearly, with the rapid
advances that have already been made in communications, it is likely that trade in services
will continue to grow. It is important that guidelines for trade in services be established
so that country restrictions on trade in services and information flows do not impede their
movement and the benefits that occur because of them.
Exports Imports
Country Value Share Country Value Share
1. United States $ 686 14.1% United States $ 454 9.6%
2. United Kingdom 329 6.8 China 382 8.1
3. Germany 267 5.5 Germany 327 6.9
4. France 263 5.4 France 244 5.1
5. China 222 4.6 Japan 190 4.0
6. Japan 158 3.3 United Kingdom 189 4.0
7. Netherlands 156 3.2 Netherlands 165 3.5
8. India 154 3.2 Ireland 142 3.0
9. Spain 135 2.8 Singapore 130 2.7
10. Ireland 133 2.7 India 124 2.6
11. Singapore 133 2.7 Russian Federation 119 2.5
12. Belgium 117 2.4 Republic of Korea 114 2.4
13. Switzerland 114 2.3 Italy 112 2.4
14. Italy 114 2.3 Belgium 108 2.3
15. Hong Kong (China) 107 2.2 Canada 106 2.2
16. Republic of Korea 106 2.2 Switzerland 93 2.0
17. Luxembourg 98 2.0 Brazil 87 1.8
18. Canada 85 1.7 Hong Kong (China) 78 1.6
19. Sweden 75 1.5 United Arab Emirates 72 1.5
20. Denmark 72 1.5 Spain 72 1.5
21. Russian Federation 66 1.4 Luxembourg 67 1.4
22. Austria 65 1.3 Sweden 65 1.4
23. Taiwan 57 1.2 Denmark 64 1.3
24. Thailand 55 1.1 Australia 62 1.3
25. Macao (China) 53 1.1 Saudi Arabia 60 1.3
26. Australia 52 1.1 Thailand 53 1.1
27. Turkey 50 1.0 Norway 53 1.1
28. Norway 49 1.0 Austria 51 1.1
29. Poland 46 0.9 Taiwan 46 1.0
30. Greece 42 0.9 Malaysia 44 0.9
30 countries $4,058 83.5% $3,871 81.7%
World $4,860 100.0% $4,740 100.0%
Note: Components do not sum to totals because of rounding.
Source: World Trade Organization, World Trade Report 2015, p. 28, obtained from www.wto.org.
TABLE 8 Leading Exporters and Importers of Commercial Services, 2014 (billions of dollars and percentage share
of world totals)
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THE CHANGING DEGREE OF ECONOMIC INTERDEPENDENCE
It is important to recognize not only the large absolute level of international trade but also
that the relative importance of trade has been growing for nearly every country and for all
countries as a group. The relative size of trade is often measured by comparing the size of
a country’s exports with its GDP. Increases in the export/GDP ratio indicate that a higher
percentage of the output of final goods and services produced within a country’s borders is
being sold abroad. Such increases indicate a greater international interdependence and a more
complex international trade network encompassing not only final consumption goods but also
capital goods, intermediate goods, primary goods, and commercial services. The increase
in international interdependence is evident by comparing the various export/GDP ratios for
selected countries for 1970, 2010, and 2014, as shown in Table 9. Note, however, that while
1970 2010 2014
Industrialized countries:
Australia 14% 20% 21%
Belgium 52 80 84
Canada 23 29 32
France 16 25 29
Germany NA 47 46
Italy 16 27 29
Japan 11 15 16
Republic of Korea 14 52 51
Netherlands 42 78 83
United Kingdom 23 30 28
United States 6 13 13
Emerging/developing countries:
Argentina 9 22 15
Chile 15 39 34
China 3 30 23
Czech Republic NA 79 84
Egypt 14 21 15
India 4 22 24
Kenya 30 26 16
Mexico 6 30 33
Nigeria 8 39 16
Russian Federation NA 30 29
Singapore 102 211 188
Low- and middle-income countries:
Sub-Saharan Africa 21 30 29
East Asia and Pacific 7 37 30
South Asia 5 20 22
Europe and Central Asia NA 31 35
Middle East and North Africa 29 NA NA
Latin America and Caribbean 13 22 23
Notes: (a) NA = not available; and (b) some of the figures are for a slightly different year.
Sources: World Bank, World Development Report 1993 (Oxford: Oxford University Press, 1993), pp. 254–55; World Bank,
World Development Indicators 2012 (Washington, DC: The International Bank for Reconstruction and Development/The World
Bank, 2012), pp. 242–44, obtained from www.worldbank.org; World Bank, World Development Indicators 2015, Table 4.8,
obtained from http://wdi.worldbank.org/table/4.8.
TABLE 9 International Interdependence for Selected Countries and Groups of Countries,
1970, 2010, and 2014 (exports of goods and nonfactor services as a percentage
of GDP)
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12 CHAPTER 1 THE WORLD OF INTERNATIONAL ECONOMICS
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SUMMARY
International trade has played a critical role in the ability of
countries to grow, develop, and be economically powerful
throughout history. International transactions have been becom-
ing increasingly important in recent decades as countries seek
to obtain the many benefits that accompany increased exchange
of goods, services, and factors. The relative increase in the
importance of international trade makes it increasingly impera-
tive that we all understand the basic factors that underlie the
successful exchange of goods and services and the economic
impact of various policy measures that may be proposed to
influence the nature of international trade. This is true at both
the micro level of trade in individual goods and services and the
macro level of government budget deficits/surpluses, money,
exchange rates, interest rates, and possible controls on for-
eign investment. It is our hope that you will find the economic
analysis of international transactions helpful in improving your
understanding of this increasingly important type of economic
activity.
the exports/GDP ratio continued to increase for most of the industrialized countries from
2010 to 2014, there were sharp declines in that ratio for several of the emerging/developing
countries during that time period. Some of these declines might be explained by falling oil
and commodity prices and local political instability.
Although the degree of dependence on exports varies considerably among countries,
the relative importance of exports has increased over the last 40–50 years in almost all
individual cases and for every country grouping where data are available. This means not
only that individual countries are experiencing the economic benefits that accompany the
international exchange of goods and services but also that their own economic prosperity is
dependent upon economic prosperity in the world as a whole. It also means that competition
for markets is greater and that countries must be able to facilitate changes in their structure
of production consistent with changes in relative production costs throughout the world.
Thus, while increased interdependence has many inherent benefits, it also brings with it
greater adjustment requirements and greater needs for policy coordination among trading
partners. Both of these are often more difficult to achieve in practice than one might imag-
ine, because even though a country as a whole may benefit from relative increases in inter-
national trade, individual parties or sectors may end up facing significant adjustment costs.
Even though the United States is less dependent on exports than most of the industrial-
ized countries, the relative importance of exports has increased substantially since 1960,
when the export/GDP ratio was about 4 percent. Thus, the United States, like most of
the countries of the world, is increasingly and inexorably linked to the world economy.
This link will, in all likelihood, grow stronger as countries seek the economic benefits
that accompany increased economic and political integration. Such movements have been
evident in recent decades as Europe has pursued greater economic and monetary union and
the NAFTAwas implemented by Canada, Mexico, and the United States. Such increases
in interdependence can also enhance tensions between countries, as revealed in the recent
stresses related to maintaining the monetary union in Europe. In addition, stresses are cur-
rently being generated by sizeable movements of people between countries.
Appendix A GENERAL REFERENCE LIST IN INTERNATIONAL ECONOMICS
The various books, articles, and data sources cited throughout this text will be useful for those of
you who wish to examine specific issues in greater depth. Students who are interested in pursuing
international economic problems on their own, however, will find it useful to consult the following
general references:
Specialized Journals
European Economic Review
Finance and Development (World Bank/IMF)
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CHAPTER 1 THE WORLD OF INTERNATIONAL ECONOMICS 13
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Foreign Affairs
International Economic Journal
The International Economic Review
The International Trade Journal
Journal of Common Market Studies
Journal of Development Economics
Journal of Economic Integration
Journal of International Economics
Journal of International Money and Finance
Review of International Economics
The World Economy
World Trade Review
General Journals
American Economic Journal: Applied Economics
American Economic Journal: Economic Policy
American Economic Review
American Journal of Agricultural Economics
Brookings Papers on Economic Activity
Canadian Journal of Economics
Challenge: The Magazine of Economic Affairs
The Economic Journal
Journal of Economic Literature
Journal of Economic Perspectives
Journal of Finance
Journal of Political Economy
Kyklos
Quarterly Journal of Economics
Review of Economics and Statistics
Sources of International Data
Balance of Payments Statistics Yearbook (IMF)
Bank for International Settlements Annual Report
Direction of Trade Statistics (IMF, quarterly and annual yearbook)
Federal Reserve Bulletin
International Financial Statistics (IMF, monthly and annual yearbook)
OECD Main Economic Indicators
Survey of Current Business (Bureau of Economic Analysis, U.S. Department of Commerce)
UN International Trade Statistics Yearbook
UN Monthly Bulletin of Statistics
US Economic Report of the President
World Development Report and World Development Indicators (World Bank)
World Economic Outlook (IMF)
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General Current Information
The Economist
Financial Times
The International Herald Tribune
The International Economy
The Los Angeles Times
The New York Times
The Wall Street Journal
The Washington Post
Internet Sources
https://research.stlouisfed.org [for Federal Reserve Economic Data (FRED)]
www.bea.gov (Bureau of Economic Analysis, U.S. Department of Commerce)
www.bis.org (Bank for International Settlements)
www.imf.org (International Monetary Fund)
www.cia.gov/cia/publications/factbook (Central Intelligence Agency’s World Factbook)
www.unctad.org (United Nations Conference on Trade and Development)
www.usitc.gov (U.S. International Trade Commission)
www.ustr.gov (U.S. Trade Representative)
www.worldbank.org (World Bank)
www.wto.org (World Trade Organization)
www.intracen.org (International Trade Centre)
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15
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CHAPTER
LEARNING OBJECTIVES
LO1 Explain the basic concepts and policies associated with Mercantilism.
LO2 Distinguish the analyses of David Hume and Adam Smith from
Mercantilist views.
EARLY TRADE THEORIES
Mercantilism and the Transition to the
Classical World of David Ricardo 2
PART 1: The Classical Theory of Trade
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16 PART 1 THE CLASSICAL THEORY OF TRADE
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INTRODUCTION
When the ancient Greeks faced a dilemma, they consulted the Oracle at Delphi. If we were to
ask the Oracle the secret to wealth, what would she say? Work hard? Get an education? Probably
not. Diligence and intelligence are strategies for improving one’s lot in life, but plenty of smart,
hardworking people remain poor.
No, the Oracle’s advice would consist of just a few words: Do what you do best. Trade for the
rest. In other words, specialize and then trade.1
When did the idea of gains from trade first emerge? How did the views on trade change in
the 18th century? It has long been perceived that nations benefit in some way by trading
with other nations. Although the underlying basis for this belief has changed considerably
over time, it is surprising how often we encounter ideas about the gains from trade and the
role of trade policy that stem from some of the earliest views of the role of international
trade in the pursuit of domestic economic goals. Some of these early ideas are found in the
writings of the Mercantilist school of thought. Later, these ideas were challenged both by
time and by writers who subsequently were identified as early Classical economic think-
ers. This challenge to Mercantilism culminated in the work of David Ricardo, which to
this day lies at the heart of international trade theory. To render a sense of the historical
development of international trade theory and to provide a basis for evaluating current
trade policy arguments that are clearly Mercantilist in nature, this chapter briefly examines
several of the more important ideas of these Mercantilist writers, the problems associated
with Mercantilist thinking, and the emergence of a different view of trade offered by Adam
Smith. It is useful to note that Mercantilist notions still exist even though their shortcom-
ings were ascertained long ago.
MERCANTILISM
Mercantilism refers to the collection of economic thought that came into existence in
Europe during the period 1500–1750. It cannot be classified as a formal school of thought,
but rather as a collection of similar attitudes toward domestic economic activity and the
role of international trade that tended to dominate economic thinking and policy during
this period. Many of these ideas not only were spawned by events of the time but also
influenced history through their impact on government policies. Geographical explora-
tions that provided new opportunities for trade and broadened the scope of international
relations, the upsurge in population, the impact of the Renaissance on culture, the rise of
the merchant class, the discovery of precious metals in the New World, changing religious
views on profits and accumulation, and the rise of nation-states contributed to the devel-
opment of Mercantilist thought. Indeed, Mercantilism is often referred to as the political
economy of state building.
Central to Mercantilist thinking was the view that national wealth was reflected in a coun-
try’s holdings of precious metals. In addition, one of the most important pillars of Mercan-
tilist thought was the static view of world resources. Economic activity in this setting can
be viewed as a zero-sum game in which one country’s economic gain was at the expense
of another. (A zero-sum game is a game such as poker where one person’s winnings are
The Oracle in the 21st
Century
The Mercantilist
Economic System
1“The Fruits of Free Trade,” 2002 Annual Report, reprint, Federal Reserve Bank of Dallas, p. 6 (italics in original
article).
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CHAPTER 2 EARLY TRADE THEORIES 17
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matched by the losses of the other players.) Acquisition of precious metals thus became
the means for increasing wealth and well-being and the focus of the emerging European
nation-states. In a hostile world, the enhancement of state power was critical to the growth
process, and this was another important Mercantilist doctrine. A strong army, strong navy
and merchant marine, and productive economy were critical to maintaining and increasing
the power of a nation-state.
Mercantilists saw the economic system as consisting of three components: a manu-
facturing sector, a rural sector (domestic hinterland), and the foreign colonies (foreign
hinterland). They viewed the merchant class as the group most critical to the successful
functioning of the economic system, and labor as the most critical among the basic factors
of production. The Mercantilists, as did the Classical writers who followed, employed a
labor theory of value; that is, commodities were valued relatively in terms of their relative
labor content. Not surprisingly, most writers and policymakers during this period subscribed
to the doctrine that economic activity should be regulated and not left to individual prerog-
ative. Uncontrolled individual decision making was viewed as inconsistent with the goals
of the nation-state, in particular, the acquisition of precious metals. Finally, the Mercantil-
ists stressed the need to maintain an excess of exports over imports, that is, a favorable
balance of trade or positive trade balance. This doctrine resulted from viewing wealth
as synonymous with the accumulation of precious metals (specie) and the need to main-
tain a sizeable war chest to finance the military presence required of a wealthy country.
The  inflow of specie came from foreigners who paid for the excess purchases from the
home country with gold and silver. This inflow was an important source of money to
countries constrained by a shortage in coinage. Crucial to this view was the implicit Mer-
cantilist belief that the economy was operating at less than full employment; therefore, the
increase in the money supply stimulated the economy, resulting in the growth of output and
employment and not simply in inflation. Hence, the attainment of a positive trade balance
could be economically beneficial to the country. Obviously, an excess of imports over
exports—an unfavorable balance of trade or a negative trade balance—would have the
opposite implications.
The economic policies pursued by the Mercantilists followed from these basic doctrines.
Governments controlled the use and exchange of precious metals, what is often referred
to as bullionism. In particular, countries attempted to prohibit the export of gold, silver,
and other precious metals by individuals, and rulers let specie leave the country only out
of necessity. Individuals caught smuggling specie were subject to swift punishment, often
death. Governments also gave exclusive trading rights for certain routes or areas to spe-
cific companies. Trade monopolies fostered the generation of higher profits through the
exercise of both monopoly and monopsony market power. Profits contributed both directly
and indirectly to a positive trade balance and to the wealth of the rulers who shared the
profits of this activity. The Hudson Bay Company and the Dutch East India Trading Com-
pany are familiar examples of trade monopolies, some of which continued well into the
19th century.
Governments attempted to control international trade with specific policies to maximize
the likelihood of a positive trade balance and the resulting inflow of specie. Exports were
subsidized and quotas and high tariffs were placed on imports of consumption goods. Tariffs
on imports of raw materials that could be transformed by domestic labor into exportables
were, however, low or nonexistent, because the raw material imports could be “worked up”
domestically and exported as high-value manufactured goods. Trade was fostered with the
colonies, which were seen as low-cost sources of raw materials and agricultural products
The Role of
Government
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18 PART 1 THE CLASSICAL THEORY OF TRADE
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and as potential markets for exports of manufactures from the parent country. Navigation
policies aimed to control international trade and to maximize the inflow (minimize the out-
flow) of specie for shipping services. The British Navigation Acts, for example, excluded
foreign ships from engaging in coastal trade and from carrying merchandise to Britain or
its colonies. Trade policy was consistently directed toward controlling the flow of com-
modities between countries and toward maximizing the inflow of specie that resulted from
international trade.
The regulation of economic activity also was pursued within the country through the con-
trol of industry and labor. Comprehensive systems of regulations were put into effect uti-
lizing exclusive product charters such as those granted to the royal manufacturers in France
and England, tax exemptions, subsidies, and the granting of special privileges. In addition
to the close regulation of production, labor was subject to various controls through craft
guilds. Mercantilists argued that these regulations contributed to the quality of both skilled
labor and the manufactures such labor helped produce—quality that enhanced the ability
to export and increased the wealth of the country.
Finally, the Mercantilists pursued policies that kept wages low. Because labor was the
critical factor of production, low wages meant that production costs would be low and a
country’s products would be more competitive in world markets. It was widely held that
the lower classes must be kept poor in order to be industrious and that increased wages
would lead to reduced productivity. Note that, in this period, wages were not market deter-
mined but were set institutionally to provide workers with incomes consistent with their
traditional position in the social order. However, because labor was viewed as vital to the
state, a growing population was crucial to growth in production. Thus, governments stimu-
lated population growth by encouraging large families, giving subsidies for children, and
providing financial incentives for marriage.
Mercantilist economic policies resulted from the view of the world prominent at that
time. The identification of wealth with holdings of precious metals instead of a nation’s
productive capacity and the static view of world resources were crucial to the policies that
were pursued. While these doctrines seem naive today, they undoubtedly seemed logical in
the period from 1500 to 1750. Frequent warfare lent credibility to maintaining a powerful
army and merchant marine. The legitimization of and growing importance of saving by the
merchant class could easily be extended to behavior by the state, making the accumulation
of precious metals seem equally reasonable. However, the pursuit of power by the state at
the expense of other goals and the supreme importance assigned to the accumulation of
precious metals led to an obvious paradox: rich nations in the Mercantilist sense would
comprise large numbers of very poor people. Specie was accumulated at the expense of
current consumption. At the same time, the rich nations found themselves expending large
amounts of their holdings of precious metals to protect themselves against other nations
attempting to acquire wealth by force.
Mercantilism and
Domestic Economic
Policy
1. Why were Mercantilist thinkers concerned
with the acquisition of specie as opposed to
overall productive capacity?
2. Why was regulation of economic activity
critical to this line of thinking?
3. If one is referred to as a Mercantilist, what
types of trade policy does one favor? Why?
CONCEPT CHECK
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IN THE REAL WORLD:
MERCANTILISM IS STILL ALIVE
On April 30, 1987, the U.S. House of Representatives
passed the Trade and International Economic Policy Reform
Act, which became known as the Omnibus Trade Bill. Prior
to its passing, Rep. Richard A. Gephardt (D–MO) offered an
amendment “to require the U.S. trade representative to enter
into negotiations with countries running excessive unwar-
ranted trade surpluses with the United States and mandate
retaliatory action against such countries if negotiations fail.”
Under the proposed amendment, countries with “exces-
sive” trade surpluses with the United States were to be
placed on a list, and a six-month negotiation period would
begin with those countries. Successful negotiations would
lead to no action by the United States, but the trading prac-
tices of the country in question were to be reexamined at
yearly intervals. In the case of unsuccessful negotiations,
the United States was to retaliate on a dollar-for-dollar basis
against the value of the unfair trading practices that the coun-
try in question maintained. If the country failed to eliminate
its unfair trading practices, it would be faced with a bilateral
surplus reduction requirement. The amendment passed by a
narrow vote and was later enacted into law in a relaxed form
(as the “Super 301” provision) in the Omnibus Trade and
Competitiveness Act of 1988. Thankfully (for economists),
Super 301 is no longer a part of U.S. trade policy.
Other comments and examples abound with respect to the
initiation of policy measures to restrict trade so as seemingly
to benefit the trade-restricting nation. For example, Canada
and the United States have “cabotage” laws. The Canadian law
states that ships carrying merchandise between Canadian ports
must be owned and crewed by Canadians; the United States
law adds to the ownership and crew provisions that the ship
must have been built in the United States. Such laws are “justi-
fied” as providing for national defense because they give rise
to a strong merchant marine. Of course, they also add to export
receipts because of this legislated use of domestic shipping
services. One 1995 estimate indicated that the U.S. law costs
U.S. consumers and firms $2.8 billion annually ($4.3 billion in
2014 dollars). Also, in the United States (as well as in Canada),
foreign airlines cannot pick up passengers for transport solely
between domestic cities. However, an exception in the United
States has been made for Canadian National Hockey League
teams flying on chartered flights between consecutive U.S.
venues. (A similar provision is made for U.S. teams flying on
chartered flights in Canada.) Further, a dispute arose in 2009
when the U.S. Department of Transportation gave approval for
Air Canada to fly U.S. teams between U.S. cities.
The balance-of-trade doctrine was verbalized beautifully
by a member of presidential candidate Ross Perot’s United
We Stand organization in 1993. In reference to the U.S.
trade deficit of the time, he said, “If we just stopped trading
with the rest of the world, we’d be $100 billion ahead.”
Another example of thinking that has a Mercantilist
flavor consists of the statements and literature associated
with a prominent Washington, DC-based organization, the
Coalition for a Prosperous America. This organization does
not generally push for a U.S. trade surplus per se but rather
for the elimination of U.S. trade deficits and for balanced
trade. However, in a press release after President Obama’s
January 2015 State of the Union address, the Coalition indi-
cated that “Just like any business, America needs to sell
more than it buys to grow. Businesses live on net profit
while America lives on net exports.” This statement would
certainly meet the approval of a committed Mercantilist!
Finally, considerable debate occurred over “Buy American”
provisions with respect to iron and steel that were contained
in the 2009 stimulus package passed early in the Obama
administration (although President Obama himself was
not in favor of those provisions). Overall, The Economist
summarized the attitudes of many people when it stated, in
2004, that “Mercantilism has been defunct as an economic
theory for at least 200 years, but many practical men in
authority remain slaves to the notion that exports must be
promoted and imports deterred.”
Sources: Congressional Digest, June–July 1987, pp. 169, 184, 186,
192; Bob Davis, “In Debate over Nafta, Many See Global Trade as
Symbol of Hardship,” The Wall Street Journal, October 20, 1993,
p. A9; “Jones Act,” obtained from www.mctf.com/jones_act.shtml;
“The Jones Act,” obtained from www.geocities.com/The Trop-
ics/1965/jones.htm; “Liberating Trade,” The Economist, May 13,
2004, obtained from www.Economist.com; United States Trade
Representative, 1999 Trade Policy Agenda and 1998 Annual Report
of the President of the United States on the Trade Agreements
Program, p. 254, obtained from www.ustr.gov/reports/tpa/1999/
viii ; Anthony Faiola,“‘Buy American’ Rider Sparks Trade
Debate,” The Washington Post, January 29, 2009, p. A01, obtained
from www. washingtonpost.com; Sallie James, “A Service to the
Economy: Removing Barriers to ‘Invisible Trade,’” Center for
Trade Policy, Cato Institute, February 4, 2009, p. 13; Neil King,
Jr., and John W. Miller, “Obama Risks Flap on ‘Buy American,’”
The Wall Street Journal, February 4, 2009, p. A4; and Susan Carey,
“NHL Teams in Air Brawl,” The Wall Street Journal, Septem-
ber 15, 2009, p. A3; Coalition for a Prosperous America, “Press
Release: CPA Analysis of Obama’s SOTU Request for Fast Track,”
January 21, 2015. ●
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THE CHALLENGE TO MERCANTILISM BY EARLY CLASSICAL WRITERS
In the early 18th century, ideas regarding the nature of economic activity began to change.
Bullionism and bullionists began to be thought of as naive. National political units had
already emerged under the pressure of peasant wars and kingly conquest, and feudalism
began to give way to centralized monarchies. Technological developments coupled with
the strengthening of the profit motive supported the development of market systems, and
state monopolies began to disappear. New ideas and new philosophies (particularly the
skeptical inquiry of the humanist viewpoint), fostered in part by the Italian Renaissance,
contributed to the continuing spirit of change. By the late 18th century, ideas concerning
international trade began to change when early Classical writers such as David Hume and
Adam Smith challenged the basic tenets of Mercantilism.
One of the first attacks on Mercantilist thought was raised by David Hume (in his Political
Discourses, 1752) with his development of the price-specie-flow mechanism. Hume chal-
lenged the Mercantilist view that a nation could continue to accumulate specie without any
repercussions to its international competitive position. He argued that the accumulation of
gold by means of a trade surplus would lead to an increase in the money supply and there-
fore to an increase in prices and wages. The increases would reduce the competitiveness of
the country with a surplus. Note that Hume is assuming that changes in the money supply
would have an impact on prices rather than on output and employment. At the same time,
the loss of gold in the deficit country would reduce its money supply, prices, and wages,
and increase its competitiveness (see Concept Box 1). Thus, it is not possible for a nation
to continue to maintain a positive balance of trade indefinitely. A trade surplus (or deficit)
automatically produces internal repercussions that work to remove that surplus (or deficit).
The movement of specie between countries serves as an automatic adjustment mechanism
that always seeks to equalize the value of exports and imports (i.e., to produce a zero trade
balance).
Today the Classical price-specie-flow mechanism is seen as resting on several assumptions.
David Hume—The
Price-Specie-Flow
Mechanism
CONCEPT BOX 1
CAPSULE SUMMARY OF THE PRICE-SPECIE-FLOW MECHANISM
Given sufficient time, an automatic trade balance adjustment would take place between a trade surplus country and a trade
deficit country by means of the following steps:
Italy (Trade Deficit) vis-à-vis Spain (Trade Surplus)
Step 1 Exports < Imports Exports > Imports
Step 2 Net outflow of specie Net inflow of specie
Step 3 Decrease in the money supply Increase in the money supply
Step 4 Decrease in prices and wages Increase in prices and wages
Decrease in imports and increase in exports Increase in imports and decrease in exports
UNTIL UNTIL
Exports = Imports Exports = Imports ●
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CONCEPT BOX 2
CONCEPT REVIEW—PRICE ELASTICITY AND TOTAL EXPENDITURES
Price elasticity of demand refers to the ratio between the
percentage change in quantity demanded of a given product
and the percentage change in its price, that is, η = (ΔQ/Q)/
(ΔP/P). (Because quantity demanded varies inversely with
price, price elasticity of demand will have a negative sign.
Economic convention often ignores the negative sign, but it
is understood that η’s value will be less than 0, that is, nega-
tive.) When this ratio (ignoring the negative sign) is greater
than 1.0, indicating that the percentage change in quantity
demanded for a given price change is greater than the per-
centage change in price, demand is said to be elastic. When
the ratio has a value of 1.0, demand is said to be unit-elastic,
and when the ratio is less than 1.0, demand is said to be
inelastic. Because the relative change in quantity is greater
than the relative change in price when demand is elastic, total
expenditures on the product will increase when the price falls
(quantity demanded increases) and will fall when the price
increases (quantity demanded falls). When demand is inelas-
tic, the exact opposite happens: Total expenditures rise with a
price increase and decline with a price decrease. In the case of
unit elasticity, total expenditures are invariant with changes
in price. Thus, for trade balances to change in the appropriate
manner in the price-specie-flow mechanism, it is sufficient to
assume that demand for traded goods is price elastic. ●
1. There must be some formal link between money and prices, such as that provided in
the quantity theory of money when full employment is assumed:
MSV = PY
where: MS = the supply of money
V = the velocity of money, or the rate at which money changes hands
P = the price level
Y = the level of real output
If one assumes that the velocity of money is fixed by tradition and institutional arrange-
ments and that Y is fixed at the level of full employment, then any change in the supply of
money is accompanied by a proportional change in the level of prices.
2. Demand for traded goods is price elastic (see Concept Box 2). This is necessary to
ensure that an increase in price will lead to a decrease in total expenditures for the traded
goods in question and that a price decrease will have the opposite effect. If demand is
price inelastic, the price-specie-flow mechanism will tend to worsen the disequilibrium in
the trade balance. However, demand elasticities tend to be greater in the long run than in
the short run as consumers gradually adjust their behavior in response to price changes.
Hence, even though the price-specie-flow mechanism may be “perverse” in the short run,
Hume’s result is likely to occur as time passes.
3. Perfect competition in both product and factor markets is assumed in order to estab-
lish the necessary link between price behavior and wage behavior, as well as to guarantee
that prices and wages are flexible in both an upward and a downward direction.
4. Finally, it is assumed that a gold standard exists. Under such a system, all curren-
cies are pegged to gold and hence to each other, all currencies are freely convertible into
gold, gold can be bought and sold at will, and governments do not offset the impact of the
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gold flows by other activities to influence the money supply. This is sufficient to establish
the link between movements of specie and changes in a nation’s money supply.
If all of these assumptions are satisfied, the automatic adjustment mechanism will, allow-
ing time for responses to occur, restore balanced trade anytime it is disrupted. Balance-of-
payments adjustment mechanisms and the gold standard are still prominent in discussions
of international monetary economics.
A second assault on Mercantilist ideas came in the writing of Adam Smith. Smith per-
ceived that a nation’s wealth was reflected in its productive capacity (i.e., its ability to pro-
duce final goods and services), not in its holdings of precious metals. Attention thus turned
from acquiring specie to enlarging the production of goods and services. Smith believed
that growth in productive capacity was fostered best in an environment where people were
free to pursue their own interests. Self-interest would lead individuals to specialize in and
exchange goods and services based on their own special abilities. The natural tendency “to
truck, barter, and exchange” goods and services would generate productivity gains through
the increased division and specialization of labor. Self-interest was the catalyst and com-
petition was the automatic regulation mechanism. Smith saw little need for government
control of the economy. He stressed that a government policy of laissez-faire (allowing
individuals to pursue their own activities within the bounds of law and order and respect
for property rights) would best provide the environment for increasing a nation’s wealth.
The proper role of government was to see that the market was free to function in an uncon-
strained manner by removing the barriers to effective operation of the “invisible hand” of
the market. In The Wealth of Nations, Smith explained not only the critical role the market
played in the accumulation of a nation’s wealth but also the nature of the social order that
it achieved and helped to maintain.
Smith applied his ideas about economic activity within a country to specialization and
exchange between countries. He concluded that countries should specialize in and export
those commodities in which they had an absolute advantage and should import those
commodities in which the trading partner had an absolute advantage. Each country should
export those commodities it produced more efficiently because the absolute labor required
per unit was less than that of the prospective trading partner.
Consider the two-country, two-commodity framework shown in Table 1. Assume that
a labor theory of value is employed (meaning that goods exchange for each other at home
in proportion to the relative labor time embodied in them). In this situation, with a labor
theory of value, 1 barrel of wine will exchange for 4 yards of cloth in England (or 1C for
1/4 W); on the other hand, 1 barrel of wine will exchange for 1 1/2 yards of cloth in Portugal
(or 1C for 2/3 W). These exchange ratios reflect the relative quantities of labor required to
produce the goods in the countries and can be viewed as opportunity costs. These opportu-
nity costs are commonly referred to as the price ratios in autarky. England has an absolute
advantage in the production of cloth and Portugal has an absolute advantage in the produc-
tion of wine because less labor time is required to produce cloth in England and wine in
Adam Smith and the
Invisible Hand
Cloth Wine
Price Ratios in
Autarky
England 1 hr/yd 4 hr/bbl 1W:4C
Portugal 2 hr/yd 3 hr/bbl 1W:1.5C
TABLE 1 Labor Requirements and Absolute Advantage
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Portugal. According to Smith, there is a basis for trade because both nations are clearly
better off specializing in their low-cost commodity and importing the commodity that can
be produced more cheaply abroad.
For purposes of illustrating the gains from trade, assume that the two countries, rather
than producing each good for themselves, exchange goods at a rate of 1 barrel of wine for 3
yards of cloth. For England this means obtaining wine in Portugal for only 3 yards of cloth
per barrel instead of 4 yards at home. Similarly, Portugal benefits from acquiring cloth for
a cost of only 1/3 barrel of wine instead of 2/3 barrel of wine at home. It is important to note
(as will be discussed in Chapter 3) that gains from trade can occur over a wide range of
barter prices. Smith’s argument was especially significant at the time because it indicated
that both countries could benefit from trade and that trade was not a zero-sum game as
the Mercantilists had believed. The fact that trade was mutually beneficial and was
a positive-sum game (i.e., all players can receive a positive payoff in the game) was a
TITANS OF INTERNATIONAL ECONOMICS:
ADAM SMITH (1723–1790)
It is more than 200 years since the death of this Scottish
social philosopher, yet his ideas on economic organization
and economic systems continue to be fashionable world-
wide, especially with the late-Twentieth-Century spread of
the market system in Central and Eastern Europe, the for-
mer Soviet Union, and several Asian economies. Smith was
born in 1723 in Kirkcaldy, County Fife, Scotland, a town
of 1,500, where nails were still used for money by some
residents. Smith demonstrated intellectual ability early in
life, and he received a sound Scottish education. At 17 he
went to Oxford University where he studied for six years. He
returned to Edinburgh and gave lectures on political econ-
omy that contained many of the principles he later developed
in The Wealth of Nations. (The actual full title is An Inquiry
into the Nature and Causes of the Wealth of Nations, which
is commonly shortened to The Wealth of Nations.) In 1751
he accepted the Chair of Logic at the University of Glasgow,
and two years later, the Chair of Moral Philosophy, which he
held until 1764. During those years he wrote his first book,
The Theory of Moral Sentiments (1759), an inquiry into the
origin of moral approbation and disapproval, which attracted
immediate attention in England and on the Continent.
Work on The Wealth of Nations began in the late 1760s in
France, where he was serving as a tutor to the young duke of
Buccleuch. Although an initial draft of the masterpiece was
apparently completed by 1770, he continued to work on it
for six more years, finally publishing it in 1776. Little did he
know the impact that his work, often referred to as the most
influential book on economics ever written, would have for
years to come.
It is remarkable that this writer of moral philosophy was
able to envision some sort of order and purpose in the world
of contrasts with which he was confronted daily. There
hardly seemed a moral purpose to the contrast between the
opulence of the leisured classes and the poverty, cruelty,
and danger that existed among the masses and which Smith
deplored. Production occurred in diverse situations such as
the Lombe textile factory (consisting of 26,586 water-driven
wheels and 97,746 movements working 221,178 yards of
silk thread each minute—and staffed by children working
12- to 14-hour days), mines with degrading human condi-
tions, simple cottage industries, and bands of roaming agri-
cultural laborers from the Welsh highlands. The brilliant
man who saw some central purpose to this hostile world was
the epitome of the “ivory tower” professor. He not only was
notoriously absentminded but also suffered from a nervous
disorder throughout his life, which often caused his head
to shake and contributed to his odd manner of speech and
walking gait. A true intellectual, his life was his writing and
discourse with students and thinkers such as David Hume,
Benjamin Franklin, François Quesnay, and Dr. Samuel
Johnson. A confirmed bachelor, Smith lived out the rest of
his life in Edinburgh, where he served as commissioner of
customs and took care of his mother. Smith died at the age
of 67 on July 17, 1790.
Sources: Robert L. Heilbroner, The Worldly Philosophers: The
Lives, Times, and Ideas of the Great Economic Thinkers, rev. ed.
(New York: Simon and Schuster, 1961), chap. 3; and “The Modern
Adam Smith,” The Economist, July 14, 1990, pp. 11–12. ●
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24 PART 1 THE CLASSICAL THEORY OF TRADE
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powerful argument for expanding trade and reducing the many trade controls that char-
acterized the Mercantilist period. Smith saw the source of these absolute advantages as
the unique set of natural resources (including climate) and abilities that characterized a
particular nation. He also recognized that certain advantages could be acquired through the
accumulation, transfer, and adaptation of skills and technology.
Smith’s ideas were crucial for the early development of Classical thought and for alter-
ing the view of the potential gains from international trade. David Ricardo expanded upon
Smith’s concepts and demonstrated that the potential gains from trade were far greater
than Adam Smith had envisioned in his concept of absolute advantage.
CONCEPT CHECK 1. Is there a basis for trade in the following case,
according to Smith’s view? Why or why not?
If there is, which commodity should each
country export?
Cutlery Wheat
Germany 50 hr/unit 30 hr/bu
Sweden 40 hr/unit 35 hr/bu
2. Suppose that Germany has a trade surplus
with Sweden. Explain how the price-specie-
flow mechanism would work to bring about
balanced trade between the two countries,
given sufficient adjustment time.
SUMMARY
Immediately prior to Adam Smith, the Mercantilists’ views
on the role and importance of international trade were domi-
nant. They emphasized the desirability of an export surplus
in international trade as a means of acquiring specie to add to
the wealth of a country. Over time, this concept of wealth, the
role of trade, and the whole Mercantilist system of economic
thought were challenged by writers such as David Hume and
Adam Smith. Smith’s concept of absolute advantage was
instrumental in altering views on the nature of and potential
gains from trade. The realization that all countries could benefit
simultaneously from trade had great influence on later Classical
thought and trade policy.
KEY TERMS
absolute advantage
bullionism
favorable balance of trade
(or positive trade balance)
gold standard
labor theory of value
laissez-faire
Mercantilism
positive-sum game
price-specie-flow mechanism
quantity theory of money
unfavorable balance of trade
(or negative trade balance)
zero-sum game
QUESTIONS AND PROBLEMS
1. Why did the Mercantilists consider holdings of precious
metals so important to nation-state building?
2. What were the pillars of Mercantilist thought? Why was
regulation of the economy so important?
3. What is meant by the “paradox of Mercantilism”? How was
this reflected in Mercantilist wage and population policies?
4. What are the critical assumptions of the price-specie-flow
mechanism? What happens to the trade balance in a sur-
plus country if the demand for traded goods is price inelas-
tic? Why?
5. Briefly explain why the ideas of Smith and Hume were so
devastating to Mercantilist thinking and policy.
6. The following table shows the hours of labor required to
produce 1 unit of each commodity in each country:

Wheat Clothing
United States 3 hr 9 hr
United Kingdom 4 hr 4 hr
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Which country has an absolute advantage in wheat? In cloth-
ing? Why? If trade takes place between the United States
and the United Kingdom at a barter price of 1 unit of cloth-
ing for 2 units of wheat (or 1 unit of wheat for 1/2 unit of
clothing), why does each country gain from trade? Explain.
7. (a) Suppose that, in the situation in Question 6, the United
Kingdom has 500 hours of labor available to it. Prior to
trade, the country is using 300 of those labor hours
to produce clothing and the remaining 200 labor hours to
produce wheat. How much wheat and how much cloth-
ing will the United Kingdom be producing in this pre-
trade situation? (Because there is no trade, your answers
will also indicate the amounts of wheat and clothing
consumed in the United Kingdom prior to trade.)
(b) Now suppose that the United Kingdom enters into trade
with the United States at the previously indicated barter
price of 1 unit of clothing for 2 units of wheat (or 1 unit
of wheat for 1/2 unit of clothing). The United Kingdom
now devotes all of its labor hours to clothing production
and hence produces 125 units of clothing and 0 units of
wheat. Why is this so? Suppose that the country exports
40C (and therefore receives 80W in exchange) and keeps
the remaining 85C for its own consumption. What will
be the United  Kingdom consumption of wheat and cloth-
ing in the trading situation? By how much has the United
Kingdom, because of trade, been able to increase its
consumption of wheat and its consumption of clothing?
8. (a) Continuing with the numerical example in Question 6,
now assume that the United States has 600 hours of labor
available to it and that, prior to trade, it is using 330 of
those hours for producing wheat and the remaining 270
hours for producing clothing. How much wheat and how
much clothing will the United States be producing (and
therefore consuming) in this pretrade situation?
(b) Assume that trade between the United Kingdom and the
United States takes place as in Question 7(b). With trade
the United States devotes all of its labor hours to wheat
production and obtains 200 units of wheat. Consistent
with the United Kingdom’s trade in Question 7(b),
the United States then exports 80W and imports 40C.
What will be the United States consumption of wheat
and clothing in the trading situation? By how much has
the United States, because of trade, been able to increase
its consumption of wheat and its consumption of cloth-
ing? Looking at your answers to this question and to
Question 7(b), can you conclude that trade is indeed a
positive-sum game? Why or why not?
9. China has had an overall trade surplus in recent years.
Economists suggest that this continuing phenomenon is
due to several things, including an inappropriate exchange
rate. How would a Mercantilist view this surplus? Why
might David Hume argue that the surplus will disappear on
its own?
10. Suppose that, in the context of the price-specie-flow mech-
anism, Switzerland currently exports 5,000 units of goods
to Spain, with each export unit having a price of 100 Swiss
francs. Hence, Switzerland’s total value of exports to Spain
is 500,000 Swiss francs. At the same time, Switzerland
imports 410,000 francs’ worth of goods from Spain, and
thus has a trade surplus with Spain of 90,000 Swiss francs
(= 500,000 francs − 410,000 francs). Because of this trade
surplus, suppose that all prices in Switzerland now rise uni-
formly by 10 percent, and assume that this rise in price of
Swiss goods causes its imports from Spain to rise from
their initial level of 410,000 francs to a level of 440,000
francs. (For purposes of simplicity, assume that the price
level in Spain does not change.)
Suppose now that the elasticity of demand of Spanish
consumers for Swiss exports is (ignoring the negative sign)
equal to 2.0. With the 10 percent rise in the price level in
Switzerland, the Swiss export price for each unit of its
exports thus rises to 110 francs. With this information, cal-
culate the resulting change in quantity and the new total
value of Swiss exports. Has the price rise in Switzerland
been sufficient to eliminate its trade surplus with Spain?
Why or why not? Alternatively, suppose that the elastic-
ity of demand of Spanish consumers for Swiss exports
(again ignoring the negative sign) is equal to 0.2. With the
10 percent rise in Swiss export prices, what happens to
Switzerland’s trade surplus with Spain in this case?
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CHAPTER
3 THE CLASSICAL WORLD OF DAVID RICARDO AND COMPARATIVE ADVANTAGE
LEARNING OBJECTIVES
LO1 Identify the basic assumptions of the Ricardian model.
LO2 Explain comparative advantage as a basis for trade between nations.
LO3 Illustrate comparative advantage and the potential gains from trade using
production-possibilities frontiers.
LO4 Articulate the broader implications of the Classical model.
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INTRODUCTION
We hear that trade makes us poorer. It’s just not so. Trade is the great generator of economic
well-being. It enriches nations because it allows companies and workers to specialize in doing
what they do best. Competition forces them to become more productive. In the end, consumers
reap the bounty of cheaper and better goods and services. . . .
We hear that exports are good because they support U.S. industry, but imports are bad
because they steal business from domestic producers. Actually, imports are the real fruits of
trade because the end goal of economic activity is consumption. Exports represent resources
we don’t consume at home. They are how we pay for what we buy abroad, and we’re better off
when we pay as little as possible. Mercantilism, with its mania for exporting, lost favor for good
reason. . . .
We need to understand what’s at stake. Being wrongheaded on trade increases the risk of
making bad choices that will sap our economy and sour our relations with other nations.1
The underlying basis for these words is comparative advantage. Unfortunately, it remains
a widely misunderstood concept, even today—some 200 years since it was introduced by
David Ricardo in The Principles of Political Economy and Taxation (1817), who stressed
that the potential gains from international trade were not confined to Adam Smith’s abso-
lute advantage. We begin this chapter by focusing on the basic assumptions that underlie
the modern expositions of the Ricardian model. Several of these assumptions are very
restrictive and unrealistic, but they will be relaxed later and do not invalidate the basic con-
clusions of the analysis. The chapter then provides a rigorous demonstration of the gains
from trade according to the Classical model. The overriding purpose of the chapter is to
show that, contrary to Mercantilist thinking, trade is a positive-sum game (i.e., all trading
partners benefit from it).
ASSUMPTIONS OF THE BASIC RICARDIAN MODEL
1. Each country has a fixed endowment of resources, and all units of each particular
resource are identical.
2. The factors of production are completely mobile between alternative uses within a
country. This assumption implies that the prices of factors of production also are the
same among these alternative uses.
3. The factors of production are completely immobile externally; that is, they do not
move between countries. Therefore, factor prices may be different between coun-
tries prior to trade.
4. A labor theory of value is employed in the model. Thus, the relative value of a com-
modity is based solely on its relative labor content. From a production standpoint,
this implies that (a) no other inputs are used in the production process, or (b) any
other inputs are measured in terms of the labor embodied in their production, or
(c) the other inputs/labor ratio is the same in all industries. In simple terms, this
assumption means that a good embodying two hours of labor is twice as expensive
as a good using only one hour.
5. The level of technology is fixed for both countries, although the technology can dif-
fer between them.
Some Common Myths
1“The Fruits of Free Trade,” 2002 Annual Report, reprint, Federal Reserve Bank of Dallas, p. 5. (Emphasis
added.)
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6. Unit costs of production are constant. Thus, the hours of labor per unit of produc-
tion of a good do not change, regardless of the quantity produced. This means that
the supply curve of any good is horizontal.
7. There is full employment.
8. The economy is characterized by perfect competition. No single consumer or pro-
ducer is large enough to influence the market; hence, all are price takers. All par-
ticipants have full access to market information, there is free entry to and exit from
an industry, and all prices equal the marginal cost of production.
9. There are no government-imposed obstacles to economic activity.
10. Internal and external transportation costs are zero.
11. The analysis is confined to a two-country, two-commodity “world” to simplify
the presentation. This simplification will be dropped later to make the model more
realistic.
RICARDIAN COMPARATIVE ADVANTAGE
Ricardo began by noting that Smith’s idea of absolute advantage determined the pattern
of trade and production internal to a country when factors were perfectly mobile. Using
the example of Yorkshire and London, he noted that industry locates where the greatest
TITANS OF INTERNATIONAL ECONOMICS:
DAVID RICARDO (1772–1823)
David Ricardo was born in London on April 18, 1772, the
son of wealthy Jewish immigrants. He received private
instruction as a child and was exceedingly bright. At age 14
he started work in his father’s stockbroker’s office, but this
association with his family ended seven years later when
he became a Unitarian and married a Quaker. Ricardo then
began his own immensely successful career in securities and
real estate. A most important factor in his financial success
was his purchase of British government securities only four
days before the Duke of Wellington defeated Napoleon at
Waterloo in 1815. The subsequent boom in British securi-
ties alone made him a wealthy man.
While on vacation in 1799, Ricardo read Adam
Smith’s The Wealth of Nations. (Don’t we all read
economics books while on vacation?) Fascinated, he
gradually made economics his avocation and wrote pam-
phlets and newspaper articles on the subject. Ricardo’s
opposition to the government’s gold policies and to
the Corn Laws (the restrictive laws on the importa-
tion of grain into England) attracted widespread atten-
tion, and he soon broadened his inquiries to questions
of profits and income distribution. In 1817, Ricardo’s
landmark book, The Principles of Political Economy
and Taxation, was published, bringing him fame even
though he himself thought that few people would under-
stand it. He became a member of Parliament in 1819.
An excellent debater, despite a voice once described as
“harsh and squeaky,” he was influential in educating the
House of Commons on economic questions, although the
Corn Laws were not repealed until long after his death.
Ricardo is usually credited with originating the concept
of comparative advantage. In addition, Ricardo built an
entire model of the economic system in which growth rests
on capital accumulation and profits and the law of dimin-
ishing returns eventually leads to a stationary state with
zero profits and affluent landlords. Ricardo was a paradox
through his condemnation of the landlord class, even though
he himself was a member of that class. After a remarkable
career as a businessman, scholar, and politician, Ricardo
died unexpectedly at age 51 on September 11, 1823. He was
survived by his wife and seven children.
Sources: Robert B. Ekelund, Jr., and Robert F. Hebert, A History
of Economic Theory and Method, 3rd ed. (New York: McGraw-
Hill, 1990), chap. 7; Robert L. Heilbroner, The Worldly Philoso-
phers: The Lives, Times, and Ideas of the Great Economic Thinkers,
3rd ed. (New York: Simon and Schuster, 1967), chap. 4; G. de Vivo,
“David  Ricardo,” in John Eatwell, Murray Milgate, and Peter
Newman, eds., The New Palgrave: A Dictionary of Economics,
Vol. 4 (London: Macmillan, 1987), pp. 183–86. ●
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absolute advantage exists and that labor and capital move to the area where productiv-
ity and returns are the greatest. This movement would continue until factor returns were
equalized. Internationally, however, the story is different. While international trade can
take place on the basis of absolute advantage (e.g., trade between tropical and temperate
zones), given the international immobility of the factors of production, gains from trade
on the basis of comparative advantage can occur as well. To make his point, Ricardo
presented a case describing the production of two commodities, wine and cloth, in England
and Portugal. The labor requirements per unit of production, given in Table 1, reflect the
technologies in each country and imply the relative value of each commodity.
In this example, Portugal has an absolute advantage in the production of both commod-
ities. From Adam Smith’s perspective, there is no basis for trade between these countries
because Portugal is more efficient in the production of both goods. England has an absolute
disadvantage in both goods. Ricardo, however, pointed out that Portugal is relatively more
efficient in the production of wine than of cloth and that England’s relative disadvantage
is smaller in cloth. The figures show that the relative number of hours needed to produce
wine (80 in Portugal, 120 in England) is less than the relative number of hours needed to
produce cloth (90 in Portugal, 100 in England). Because of these relative cost differences,
both countries have an incentive to trade. To see this, consider the autarky (pretrade) price
ratios (i.e., the price ratios when the country has no international trade). Within England,
1 barrel of wine would exchange for 6/5 yards of cloth (because the same labor time is
embodied in each quantity), while in Portugal, 1 barrel would exchange for only 8/9 yard
of cloth. Thus, Portugal stands to gain if it can specialize in wine and acquire cloth from
England at a ratio of 1 barrel:6/5 yards, or 1W:6/5 C. Similarly, England would benefit by
specializing in cloth production and exporting cloth to Portugal, where it could receive
9/8 barrels of wine per yard of cloth instead of 5/6 barrel per yard at home. Even though
trade is unrealistically restricted to two goods in this basic analysis, similar potential
gains also occur in more comprehensive analyses, as developed in Chapter 4. The main
point is that the basis for and the gains from trade rest on comparative, not absolute,
advantage.
To examine the gains from trade, let us explore the price ratios further. With England
in autarky, 1 barrel of wine exchanges by the labor theory of value for 1.2 (6/5) yards
of cloth, so any price ratio in which less than 1.2C have to be given up for 1W is desir-
able for England. Similarly, the autarkic price ratio in Portugal is 1W:8/9C, or 0.89C.
Thus, Portugal will gain if its wine can command in trade more than 0.89 unit of cloth.
With an international price ratio between these two autarkic price ratios, both coun-
tries will gain.
Ricardo did not examine the precise determination of the international price ratio or
the terms of trade. But the important point is that, after trade, there will be a common
price of wine in terms of cloth in the two countries. To see this point, consider what is
happening in the two countries with trade. Because wine is coming into England (new
supply from Portugal) and Portugal is now demanding English cloth (new demand), the
relative price of English cloth in terms of wine will rise. This means that less cloth will
exchange for a unit of wine than the previous 1.2C. In Portugal, the relative price of
TABLE 1 Ricardian Production Conditions in England and Portugal
Wine Cloth Price Ratios in Autarky
Portugal 80 hr/bbl 90 hr/yd 1W:8/9C (or 1C:9/8W)
England 120 hr/bbl 100 hr/yd 1W:6/5C (or 1C:5/6W)
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wine will rise because cloth is arriving from England and the English are demanding
Portuguese wine. Thus the price will rise above 1W:0.89C toward more cloth being given
up to obtain a unit of wine. The pretrade ratios of 1W:1.2C in England and 1W:0.89C
in Portugal thus converge toward each other through trade. This is simply the economic
phenomenon of two separate markets (autarky) unifying into a single market (trade). A
single price will then prevail rather than two different prices. With trade, prices are no
longer determined solely by the labor theory of value but also by relative demands in the
two trading countries.
To illustrate the gains from trade, Ricardo arbitrarily assumed that the terms-of-trade
ratio was 1W:1C. At these terms, consider the gain for England. With trade, England
could devote 100 hours of labor to producing cloth, its comparative-advantage good, and
get 1C. This 1C could then be exchanged with Portugal for 1W. Thus, 100 hours of labor
in England have indirectly produced 1 unit of wine. If England had chosen to produce
1W at home directly, the cost involved would have been 120 hours of labor. However,
trade saves England 20 hours (120 − 100) of labor for each unit of its imported good.
Ricardo expressed the gains in terms of labor time saved because he viewed trade essen-
tially as a mechanism for reducing the outlay of labor necessary for obtaining goods, for
such labor implied work effort and “real costs.” Another way to state the same result is
that with trade more goods can be obtained for the same amount of labor time than is
possible in autarky.
There is also a gain for Portugal in terms of labor time saved. Portugal can take
80 hours of labor and produce 1 unit of wine. With this 1W, Portugal can obtain 1 unit
of cloth through trade. Direct production of 1C in Portugal would have required 90 hours
of labor; trade has enabled the country to gain or save 10 hours of labor per unit of its
imported good. Thus, unlike the zero-sum game of the Mercantilists, international trade is
a positive-sum game.
The precise terms of trade reflect relative demand and will be considered in later chap-
ters. However, the terms of trade are important for the distribution of the gains between the
two countries. Suppose that we specify the terms of trade as 1W:1.1C instead of 1W:1C.
Intuitively, we expect Portugal to gain more in this case because its export good is now
commanding a greater volume of the English good. In this case, Portugal could take
80 hours of labor, get 1W, and then exchange that 1W for 1.1C; in effect, Portugal is
obtaining 1.1C for 80 hours of labor. To produce 1.1C at home would have required
99 hours (90 hours × 1.1), so Portugal gains 19 hours (99 − 80) per each 1.1C, or 17.3 hours
per each 1C (19/1.1 = 17.3).
England experiences smaller gains in the second case. If England devotes 110 hours
to cloth production, it will get 1.1C, which can then be exchanged for 1W. Because 1W
produced directly at home would have required 120 hours of labor, England saves 10 hours
rather than 20 hours per unit of wine. Clearly, the closer the terms of trade are to a coun-
try’s internal autarky price ratio, the smaller the gain for that country from international
trade. At the limits (1W:1.2C for England and 1W:0.89C for Portugal), the country whose
prices in autarky equaled the terms of trade would get no gain and would be indifferent to
trade. The other country would obtain all the gains from trade.
The equilibrium terms of trade are those that bring about balanced trade (exports =
imports in total value) for each country. If the Ricardian 1W:1C ratio left Portugal with a
balance-of-trade surplus, the terms of trade would shift toward relatively more expensive
wine, say, 1W:1.1C. This shift occurs because the price-specie-flow mechanism raises
prices and wages in the surplus country, Portugal, and depresses them in the deficit coun-
try, England.
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IN THE REAL WORLD:
EXPORT CONCENTRATION OF SELECTED COUNTRIES
In the Classical model presented in this chapter, a country
exports only one good. This is an unrealistic situation, so mul-
tiple exports are incorporated into the model in Chapter 4. Nev-
ertheless, some countries broadly resemble the single export
situation, and there is no doubt that trade moves production
in all countries toward a more specialized production pattern
than would be the case in autarky. Table 2 presents data on the
degree of commodity export concentration for several coun-
tries based on the most aggregated categories in the Standard
International Trade Classification (SITC) system of the United
Nations. The types of goods exported differ, reflecting the
underlying comparative advantage of each country.
Country Export Categories (SITC No.)
Percentage of
Total Export Value
Algeria (2013) Mineral fuels, lubricants (3) 98.3%
Chemicals (5) 0.7
Azerbaijan (2013) Mineral fuels, lubricants (3) 93.0
Food, animals (0) + beverages, tobacco (1) 2.9
Bangladesh (2011) Miscellaneous manufactured articles (8) 81.1
Goods classified chiefly by material (6) 9.8
Cabo Verde (2013) Food, animals (0) + beverages, tobacco (1) 86.1
Miscellaneous manufactured articles (8) 13.5
Central African Republic (2011) Crude materials (2) + animal and vegetable oils (4) 91.4
Machinery and transport equipment (7) 4.0
Japan (2013) Machinery and transport equipment (7) 57.9
Goods classified chiefly by material (6) 13.2
Republic of Korea (2013) Machinery and transport equipment (7) 54.6
Goods classified chiefly by material (6) 12.8
Kuwait (2011) Mineral fuels, lubricants (3) 94.8
Chemicals (5) 3.1
Malawi (2013) Food, animals (0) + beverages, tobacco (1) 69.4
Crude materials (2) + animal and vegetable oils (4) 22.4
Maldives (2012) Food, animals (0) + beverages, tobacco (1) 98.2
Crude materials (2) + animal and vegetable oils (4) 1.7
Russian Federation (2013) Mineral fuels, lubricants (3) 70.6
Goods classified chiefly by material (6) 10.2
Zambia (2013) Goods classified chiefly by material (6) 71.0
Food, animals (0) + beverages, tobacco (1) 9.8
Note: “Goods classified chiefly by material” refers to products such as rubber, wood, and textile yarn and fabrics; “Miscellaneous manufac-
tured articles” refers to a wide variety of consumer products such as clothing, furniture, and footwear.
Source: United Nations, 2013 International Trade Statistics Yearbook, Vol. I (New York: United Nations, 2014), various pages, obtained
from http://comtrade.un.org.
TABLE 2 Extent of Export Concentration, Selected Countries

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COMPARATIVE ADVANTAGE AND THE TOTAL GAINS FROM TRADE
The essence of Ricardo’s argument is that international trade does not require different
absolute advantages and that it is possible and desirable to trade when comparative advan-
tages exist. A comparative advantage exists whenever the relative labor requirements differ
between the two commodities. This means simply that, when the relative labor require-
ments are different, the internal opportunity cost of the two commodities is different in
the two countries; that is, the internal price ratios are different between the two countries
prior to trade. The gain from different relative prices was demonstrated for England and
Portugal in terms of labor time saved per unit of the imported good acquired.
We now turn from the gain per unit of the imported good to the total gains from trade
for the country. Table 3 provides information that can be used to increase familiarity with
the type of numerical examples used in Ricardian analysis.
Country A has a comparative advantage in the production of cloth, and country B has
a comparative advantage in the production of wine. Country A’s comparative advantage
clearly lies in cloth, inasmuch as the relative labor cost (½) is less than that in wine (¾).
The basis for trade is also evident in the fact that the autarky price ratios in each country
are different.
When trade is initiated between the two countries, it will take place at international
terms of trade that lie within the limits set by the price ratios for each country in autarky.
If trade takes place at one of the limiting autarky price ratios, one country reaps all the
benefits. For example, if trade commences at international terms of trade of 1W:3C, then
country B gains 1 yard of cloth per each 1 barrel of wine exchanged, while country A gains
nothing because it pays the same relative price that it faces in autarky. Thus, for both coun-
tries to gain, the international terms of trade must lie somewhere between the autarky price
ratios. The actual location of the equilibrium terms of trade between the two countries is
determined by the comparative strength and elasticity of demand of each country for the
other’s product. This is often referred to as reciprocal demand, a concept developed by
John Stuart Mill in 1848 (see Chapter 7).
To demonstrate the total gains from trade between these two countries, it is necessary to
first establish the amount of the constraining resource—labor—available to each country.
Suppose that country A has 9,000 labor hours available and country B has 16,000 labor
hours available. These constraints, coupled with the production information in Table  3,
permit us to establish the production possibilities open to these two countries in autarky.
Country A can produce 9,000 yards of cloth and no wine, or 3,000 barrels of wine and no
cloth, or any combination of these two goods that absorbs 9,000 hours of labor. Country B,
on the other hand, can produce 8,000 yards of cloth and no wine, 4,000 barrels of wine and
no cloth, or any combination of these two goods that exactly absorbs 16,000 hours of labor.
Assume that country A produces 6,000 yards of cloth and 1,000 barrels of wine prior to
trade and that country B produces 3,000 yards of cloth and 2,500 barrels of wine. Suppose
Resource Constraints
TABLE 3 Ricardian Production Characteristics
Cloth Wine
Price Ratios in
Autarky
Country A 1 hr/yd 3 hr/bbl 1W:3C
Country B 2 hr/yd 4 hr/bbl 1W:2C
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CHAPTER 3 THE CLASSICAL WORLD OF DAVID RICARDO AND COMPARATIVE ADVANTAGE 33
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that the two countries exchange goods at the terms of trade of 1W:2.5C. Suppose also that
country A exchanges 2,500 yards of cloth for 1,000 barrels of wine from country B, but the
two countries do not alter their production. How will the posttrade and pretrade scenarios
compare?
In keeping with Ricardo’s emphasis on labor time, we examine the equivalent quantity
of domestic labor services consumed before and after trade for each country. We will
use the common yardstick of labor hours because wine and cloth cannot be added mean-
ingfully without weighting for relative importance (the old “apples and oranges” prob-
lem). Prior to trade, country A produced and consumed 6,000C and 1,000W, reflecting
the 9,000 labor hours available to it. After trade, country A consumes 3,500C (6,000 yards
produced − 2,500 yards exported to country B) and 2,000W (1,000 barrels produced at
home + 1,000 barrels imported from country B), a combination that would have required
9,500 labor hours if produced at home (3,500 hours for cloth, because each cloth unit
would require 1 hour, and 6,000 hours for wine, because each of the 2,000 wine units
would require 3 hours). Country A has thus gained the equivalent of 500 labor hours
(9,500  −  9,000) through trade. What about country B? Prior to trade, it produced and
consumed 3,000 yards of cloth and 2,500 barrels of wine, reflecting the 16,000 labor
hours available to it. After trade, country B consumes 5,500 yards of cloth (3,000 yards of
domestic production + 2,500 yards of imports) and 1,500 barrels of wine (2,500 barrels
of domestic production − 1,000 barrels of exports to country A), a combination that would
have required 17,000 labor hours if produced at home (11,000 hours for cloth, because
each of the 5,500 cloth units would require 2 hours, and 6,000 hours for wine, because
each of the 1,500 wine units would require 4 hours). Country B has gained the equivalent
of 1,000 labor hours (17,000 − 16,000) through trade.
In the previous example, both countries gained from trade even though neither altered
its production of cloth or wine. But this is an incomplete picture. With the new prices
determined by trade, producers will necessarily increase the production of the good that
has a comparative advantage because this good gets a relatively higher price on the
world market than it did in autarky. Complete specialization means that all resources
are devoted to the production of one good, with no production of the other good. Both
countries now alter their production patterns and engage in complete specialization in
the commodities in which they have a comparative advantage. Each experiences even
greater gains from trade.
Assume that with country A producing only cloth and country B producing only wine,
they exchange 2,000 barrels of wine for 5,000 yards of cloth. In this instance, country A
would consume 4,000C (9,000 yards produced − 5,000 yards exported) and 2,000W (all
imported). This combination has a labor value in country A of 10,000 hours (4,000 hours
for cloth, because each cloth unit would require 1 hour, and 6,000 hours for wine, because
each of the 2,000 wine units would require 3 hours), which is greater than the labor value
of consumption in either autarky or in the case of trade with no production change. Country
B is also better off because it now consumes 5,000 yards of cloth (all imported) and 2,000
barrels of wine (4,000 barrels produced − 2,000 barrels exported) with a labor value of
18,000 hours (10,000 hours for cloth, because each of the 5,000 cloth units would require
2 hours, and 8,000 hours for wine, because each of the 2,000 wine units would require
4 hours). This contrasts with a labor value of 16,000 in autarky and 17,000 in trade with
incomplete specialization of production. The Classical writers concluded that if there is
a basis for trade, it automatically leads a country toward complete specialization in the
commodity in which it has the comparative advantage. Consumption remains diversified
across goods as dictated by consumer preferences.
Complete
Specialization
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CONCEPT CHECK 1. In a Ricardian model, suppose that the United
States can produce 1 unit of wheat in 3 days
of labor time and 1 unit of clothing in 4 days
of labor time. What is the autarky price ratio
in the United States? If the world price ratio
(terms of trade) is 1 wheat:1 clothing, which
good will the United States export and which
will it import? Why? Suppose that the world
price ratio is 1 wheat:0.5 clothing. Which good
will the United States export and which will
it import? Why?
2. When a country has a comparative advan-
tage in a good, must it also have an absolute
advantage in that good? Why or why not?
3. If a country has an absolute advantage in a
good, must it also have a comparative advan-
tage in that good? Why or why not?
REPRESENTING THE RICARDIAN MODEL WITH
PRODUCTION-POSSIBILITIES FRONTIERS
The basis for trade and the gains from trade can also be demonstrated with the production-
possibilities frontier (PPF) concept. The production-possibilities frontier reflects all
combinations of two products that a country can produce at a given point in time given
its resource base, level of technology, full utilization of resources, and economically
efficient production. Because all of these conditions are met in the list of assumptions
presented early in this chapter, it is clear that the Classical model assumes the participat-
ing countries to be producing and consuming on their production-possibilities frontiers in
autarky. Furthermore, the constant-cost assumption implies that the opportunity cost of
production is the same at the various levels of production. The production-possibilities
frontier is thus a straight line whose slope represents the opportunity cost of economy-
wide production.
The shift into this framework presents not only a graphical picture of the Ricardian
model. It also provides a means for escaping from the limitations of the labor theory of
value while retaining the comparative-advantage conclusions about the basis for trade.
Because the slope (ignoring the negative sign) of the production-possibilities frontier indi-
cates the amount of production of one commodity that must be given up to obtain one
additional unit of the other commodity, the values that lie at the basis of this calculation
can reflect the cost of all inputs, not only labor, that go into the production of the commod-
ities. This realization not only makes the concept of comparative advantage more realistic
and interesting but also implies that the basic idea is sufficiently general to cover a wide
range of production scenarios, among which a labor theory of value is only one possibility.
The figures on labor hours and production for countries A and B (see Table 3) make it
possible to display the production-possibilities frontiers for each country. A production-
possibilities schedule can be calculated and the respective production-possibilities curves
can be inferred from those schedules (see Figure 1). Because constant costs are assumed,
we need merely to locate the intercepts on each product axis and connect these points with
a straight line. The result is a constant-cost production-possibilities frontier whose slope
reflects the opportunity cost in autarky—what we have called the autarky price ratio. Coun-
try A had a pretrade combination of 6,000 yards of cloth and 1,000 barrels of wine. With the
initiation of trade, country A was able to obtain 1 barrel of wine for only 2½ yards of cloth
compared with 3 yards at home. This produces for country A a new, flatter consumption-
possibilities frontier (CPF) with trade, which begins at the initial production point and
lies outside the production-possibilities frontier. This new consumption-possibilities fron-
tier is indicated by CPFA1. (Note that the consumption-possibilities frontier under autarky
Production
Possibilities—An
Example
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CHAPTER 3 THE CLASSICAL WORLD OF DAVID RICARDO AND COMPARATIVE ADVANTAGE 35
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is the same as the production-possibilities frontier.) By participating in trade with country B,
country A can now choose to consume a combination of goods that clearly lies outside
its own production possibilities in autarky, thus demonstrating the potential gains from
trade. In other words, trade permits consumption combinations that are unattainable with-
out trade. The farther the new consumption-possibilities curve lies outside the PPF, the
larger the potential gains. The CPF moves out when country A begins to specialize in the
production of cloth—in which it has a comparative advantage—and reduces its production
of wine. The largest set of consumption possibilities for given terms of trade occurs when
country A produces only cloth and no wine. To consume on this consumption-possibilities
frontier (CPFA2) means that country A must export cloth to country B in exchange for
wine if it wishes to consume any wine at all. [For example, at the maximum, if country A
exports all 9,000 yards of cloth it could obtain 3,600 barrels of wine (9,000/2.5 = 3,600).]
More favorable terms of trade for country A would yield a flatter consumption- possibilities
frontier, further enlarging the potential gains from trade.
FIGURE 1 Ricardian Production-Possibilities Schedules and Frontiers
9,000
6,000
3,000
0
1,000 2,000 3,000 3,600
CPFA2 (slope = 1 W:2.5C)
CPFA1 (slope = 1 W:2.5C)

PPF (slope = 1 W:3C)
Wine
Cloth
Country A
Cloth
(yards)
Wine
(barrels)
9,000
7,500
6,000
4,500
3,000
1,500
0
0
500
1,000
1,500
2,000
2,500
3,000
G
F
1,000 2,500 4,000 Wine
6,000
3,000
0
8,000
10,000
Cloth
Country B
Cloth
(yards)
Wine
(barrels)
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
H
J
CPFB1 (slope = 1 W:2.5C)

PPF (slope = 1 W:2C)
CPFB2 (slope = 1 W:2.5C)
Country A produces and consumes 6,000 yards of cloth and 1,000 barrels of wine in autarky (point F) at its
opportunity cost ratio of 1W:3C. When exposed to international terms of trade of 1W:2.5C, country A can, even
without a change in production, consume along consumption-possibilities frontier CPFA1, which enables it to
consume combinations impossible in autarky. If country A completely specializes in cloth (its comparative-
advantage good), it produces at point G and can consume even greater quantities of the two goods (on CPFA2).
For country B, initial production at point H can yield consumption combinations along CPFB1, and complete
specialization (with production at point J) permits consumption with trade to be on CPFB2, which indicates
that, for any level of wine consumption below 4,000 barrels, more cloth can be obtained.
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36 PART 1 THE CLASSICAL THEORY OF TRADE
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The situation is similar for country B. Production and consumption in autarky was
initially 3,000 yards of cloth and 2,500 barrels of wine. With trade, country B can now
obtain 2.5C for 1W, instead of obtaining only 2C at home. Country B faces a consumption-
possibilities frontier through trade (CPFB1) that is steeper and, with no production changes,
begins at the initial level of production. This trading possibility allows country B to con-
sume outside its consumption-possibilities frontier in autarky, reflecting again the potential
gains from trade with country A. The set of consumption possibilities can be made even
larger the more country B specializes in the production of wine, its comparative-advantage
good. The largest potential consumption combinations for given terms of trade occur when
country B produces only wine and imports all of its cloth. [For example, at the maximum,
if country B exports all 4,000 barrels of wine, it could conceptually obtain 10,000 yards of
cloth (4,000 × 2.5 = 10,000).]
In the Classical model, production generally takes place at an endpoint of the production-
possibilities frontier of each country. We first indicated the potential gain from trade with-
out changing the production point purely as an expositional device. Our procedure showed
that trade could benefit a country even if all of its resources were “frozen” into its existing
production patterns. However, economic incentives cause production to tend to move to
an endpoint of the frontier, where the maximum gain for the given terms of trade will
be realized. For example, the new international price ratio of 1W:2.5C, compared with
the price ratio of 1W:2C in autarky, indicates that country B has an incentive to expand
the production of wine because 2.5 units of cloth can be obtained for 1 unit of wine even
though the opportunity cost of 1W is only 2C. This opportunity cost stays the same even
with additional wine production because of the constant-cost technology. Thus, there is
no reason to stop at any point on the production-possibilities frontier until the maximum
amount of 4,000 barrels is reached. In simple terms, the “cost” of producing 1 barrel of
wine is 2 yards of cloth, but the “return” from producing 1 barrel of wine is 2.5 yards of
cloth. A similar conclusion applies to any price ratio where more than 2C are obtained
in the world market for 1W. In country A, the incentive is to expand cloth production by
exactly the same cost versus benefit reasoning.
An exception to this complete specialization can occur. Suppose that in the previous
example (see Figure 1), total demand of both countries A and B for cloth is larger than
the maximum 9,000 yards of available supply from country A. In this case, country B
will continue to produce both cloth and wine on its PPF at country B’s opportunity cost
of 1W:2C, somewhere between point H and point J. Trade will take place at country
B’s autarkic price ratio, and country A will therefore attain maximum gains from trade.
Country B, however, will continue to consume at the autarkic consumption point H on
its own PPF because prices are the same in both international trade and in autarky. All
benefits from trade will accrue to country A as it trades at the opportunity cost prevail-
ing in country B. In the Classical world, a country whose production capacity of its
comparative-advantage good is incapable of meeting total world demand for that good
will experience substantial gains from trade. The price of wool blankets exported from
Nepal to the United States, for example, is likely to be dominated by U.S. rather than
Nepali market conditions.
Maximum Gains
from Trade
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COMPARATIVE ADVANTAGE—SOME CONCLUDING OBSERVATIONS
Up to this point, nothing has been said about the basis for the comparative advantage that
a country might have in trade. Indeed, the Classical theory does not offer a satisfactory
explanation of why production conditions differ between countries. This is perhaps not
surprising given the nature of production at that time. Resource and cost differences were
taken as given and as part of the environment in which the economic system functioned.
The underlying cost differences were viewed as being determined outside the economic
system for the most part, governed by the natural endowment of a country’s resources. For
Smith and his successors, this endowment included the quantity of usable land, the quality
of the soil, the presence of natural resources, and the climate, as well as cultural character-
istics influencing such things as entrepreneurship, labor skills, and organizational capacity.
Thus, for any or all of these reasons, production conditions were assumed to vary across
countries. The theory does, however, make it clear that even if a country is absolutely more
or less efficient in the production of all commodities, a basis for trade still exists if there is
a difference in the degree of relative efficiency across commodities.
The Classical economists thought that participation in foreign trade could be a strong
positive force for development. Adam Smith argued that export markets could enable a
country to use resources that otherwise would remain idle. The resulting movement to
full employment would increase the level of economic activity and allow the country to
acquire foreign goods to enhance consumption and/or investment and growth. Ricardo and
subsequent Classical economists argued that the benefits from trade resulted not from the
employment of underused resources but from the more efficient use of domestic resources
which came about through the specialization in production according to comparative
advantage. Besides the static gains resulting from the reallocation of resources, econo-
mists such as John Stuart Mill pointed out the dynamic effects of trade that were of critical
importance to a country’s economic development. These included the ability to acquire
foreign capital and foreign technology and the impact of trade and resource reallocation
on the accumulation of savings. In addition, the benefits associated with increased contact
with other countries and cultures could help break the binding chains of tradition, alter
wants, and stimulate entrepreneurship, inventions, and innovations.
Economic growth and development propelled by trade can of course generate some unde-
sirable consequences. Specialization in the production of goods that have few links to the rest
of the economy can lead to a lopsided pattern of growth and do little more than produce an
export enclave, a result that often negates the dynamic effects of trade. These more complex
trade issues are examined in Chapter 18.
Thus, the Classical writers have made us aware that trade not only produces static gains
but also can be a positive vehicle for economic growth and development and that it should
be encouraged. Any country can benefit from trade in which some foreign goods can be
purchased at prices that are relatively lower than those at home, even if it is absolutely less
efficient in the production of all goods compared to a more developed trading partner.
CONCEPT CHECK 1. In the Ricardian analysis, why does each trad-
ing partner have an incentive to produce at an
endpoint of its production-possibilities frontier?
2. Use a diagram to defend this statement: The
greater the difference between the terms of
trade and prices under autarky, the greater the
gains from trade.
3. When might the consumption-possibilities fron-
tier with trade not be outside the consumption-
possibilities frontier under autarky? Why?
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SUMMARY
This chapter has developed the basic Ricardian comparative
advantage model. This model demonstrates that gains from
trade occur even if a country is absolutely more or absolutely
less efficient in the production of all of its goods than other
countries. The source of these gains lies in the fact that rela-
tive prices with trade differ from relative prices in autarky. The
gains were shown through numerical examples and through the
use of production-possibilities frontiers. While the principle of
comparative advantage as it applies to countries is the focus of
international trade, the basic principle also applies to individu-
als and to regions within a country. Specialization according to
comparative advantage enhances the efficiency of resource use
and increases the well-being of the participating countries.
In the next chapter, some of the assumptions of the Ricardian
model are relaxed, and the analysis will take into account more
real-world characteristics, including the introduction of more
than two countries, more than two goods, transportation costs,
prices in monetary terms, and exchange rates.
KEY TERMS
autarky (pretrade) price ratios
comparative advantage
complete specialization
consumption-possibilities frontier
(CPF)
equilibrium terms of trade
production-possibilities frontier
(PPF)
terms of trade
1. The following table shows the number of days of labor
required to produce 1 unit of output of computers and wheat
in France and Germany:
Computers Wheat
France 100 days 4 days
Germany 60 days 3 days
(a) Calculate the autarky price ratios.
(b) Which country has a comparative advantage in comput-
ers? Explain why. Which has a comparative advantage
in wheat? Explain why.
(c) If the terms of trade are 1 computer:22 units of wheat,
how many days of labor does France save per unit of its
import good by engaging in trade? How many days does
Germany save per unit of its import good?
(d) If the terms of trade are 1 computer:24 units of wheat,
how many days of labor do France and Germany each
save per unit of their respective import good?
(e) What can be said about the comparative distribution of
the gains from trade between France and Germany in
part (d) and part (c)? Why?
2. The following table shows the number of days of labor
required to produce a unit of textiles and autos in the United
Kingdom and the United States:
Textiles Autos
United Kingdom 3 days 6 days
United States 2 days 5 days
(a) Calculate the number of units of textiles and autos that
can be produced from 1 day of labor in each country.
(b) Suppose that the United States has 1,000 days of labor
available. Construct the production-possibilities frontier
for the United States.
(c) Construct the U.S. consumption-possibilities frontier with
trade if the terms of trade are 1 auto:2 units of textiles.
(d) Select a pretrade consumption point for the United
States, and indicate how trade can yield a consumption
point that gives the United States greater consumption
of both goods.
3. In the example in Question 2, suppose that the United States
always wishes to consume autos and textiles at the ratio of
1 auto to 10 units of textiles. What quantity of each good
would the United States consume in autarky? What combi-
nation would the United States consume with trade and com-
plete specialization? What would be the gains from trade?
4. In the light of the Ricardian model, how might you evaluate
the claim by developing countries that they are at a disad-
vantage in trade with powerful industrialized countries?
5. Suppose that Portugal requires 4 days of labor to produce
1 unit of wine and 6 days of labor to produce 1 unit of cloth-
ing, while England requires 8 days of labor to produce 1 unit
of wine and 12 days of labor to produce 1 unit of clothing.
Which country has absolute advantages and why? What is
the situation with respect to comparative advantages?
6. How can a country gain from trade if it is unable to change
its production pattern?
7. During the debate prior to the passage of the North American
Free Trade Agreement (NAFTA), opponents argued that
given the relative size of the two economies, the income
QUESTIONS AND PROBLEMS
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gains resulting from the agreement would likely be smaller
for the United States than for Mexico. Comment on this
position in view of what you have learned about the distri-
bution of the benefits of trade in the Classical model.
8. “If U.S. productivity growth does not keep up with that
of its trading partners, the United States will quickly lose
its international competitiveness and not be able to export
any products, and its standard of living will fall.” Critically
evaluate this statement in light of what you have learned in
this chapter.
9. Suppose that country A and country B both have the same
amount of resources and that country A has an absolute advan-
tage in both steel and wheat and a comparative advantage in
steel production. Draw production-possibilities frontiers for
countries A and B (on the same graph) that reflect these charac-
teristics, and explain why you drew them in the manner you did.
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40
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LEARNING OBJECTIVES
LO1 Explain how money and prices affect the Classical model.
LO2 Demonstrate how wages and exchange rates conceptually affect
comparative advantage and international trade patterns.
LO3 Examine the implications of extending the basic model of comparative
advantage to more than two commodities.
LO4 Show how the introduction of transportation costs can influence the
comparative advantage trade pattern.
LO5 Examine the implications of extending the basic model of comparative
advantage to more than two countries.
LO6 Show that real-world trade patterns are consistent with underlying
comparative advantages.
EXTENSIONS AND TESTS
OF THE CLASSICAL MODEL
OF TRADE4
CHAPTER
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INTRODUCTION
North Carolina textile manufacturers complain about the “undervalued” Chinese renminbi yuan
and the adverse impact it has on their industry. At the same time, steel producers continue to
complain about foreign producers selling internationally at unfairly low prices, while yet other
producers continue to worry about the impact of cheap foreign labor on their competitiveness and
their ability to stay in business. In addition, changes in transportation costs related to delivery
time, new shipping technologies, and fluctuations in fuel costs certainly influenced the nature and
structure of trade. Further, analysts ponder whether exchange rate adjustments would, in fact,
remove some of the trade imbalances that seem to grow with the years. With the onset of the
2007–2008 financial and economic crises and subsequent slow growth and unemployment con-
cerns in high-income countries (more so in Europe and Japan than in the United States), relative
wage shifts, and changes in economic structure and demand have stimulated calls for protection
in the political arena.
Our discussion of Classical comparative advantage and the basis for gains from trade
presented in the previous chapter did not incorporate information on variables such as
those mentioned in the vignette above and the possible effect they could have on the basis
for trade and the commodity composition between countries. It is important to note that
the usefulness of the simple labor-based Ricardian model is not restricted to the basic
barter framework that was the focus of Chapter 3. Indeed, incorporating several of these
important monetary/cost/price considerations into the analysis can provide helpful insights
into the underlying basis for trade across a range of goods. Thus, in this chapter we show
how the basic Ricardian model can be made more realistic by incorporating wage rates and
an exchange rate. This exercise then permits us to analyze trade in terms of money and
prices and to examine rigorously the role of wages, productivity, and the exchange rate
in influencing trade patterns. The realism of the model is further extended by including a
larger number of commodities, transportation costs, and more than two countries. Relax-
ing the restrictive assumptions used in the discussion of the Classical model provides help-
ful insights into the forces that influence international trade.
THE CLASSICAL MODEL IN MONEY TERMS
The first extension of the Classical model changes the example from one of labor require-
ments per commodity to a monetary value of the commodity. This is a logical extension
because most economic transactions, even in Ricardo’s time, were based on money prices
and not barter. This monetization will be accomplished by assigning a wage rate to each
country. The domestic value of each good is then found by multiplying the labor require-
ment per unit by the appropriate wage rate. This valuation procedure does not change
the internal prices under autarky because the relative labor content—the underlying basis
for relative value—is still the same. It does, however, provide a set of money prices in
each country that can be used to determine the attractiveness of buying or selling abroad.
Because each country’s price is now stated in its own currency, however, money prices
cannot be used until a link between the two currencies is established. The link is pro-
vided by specifying an exchange rate, which is the number of units of one currency that
exchange for one unit of a second currency. Once the exchange rate is established, the
value of all goods can be stated in terms of one currency.
To demonstrate comparative advantage in a monetized Ricardian model, let us examine
the production of cloth and wine in Ricardo’s original example countries of England and
Portugal. In this example, England has the absolute advantage in both goods. Table 1 con-
tains data on wages per hour and the money price of each commodity based on the labor
Trade Complexities in
the Real World
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needed to produce 1 unit of each good in each country. Assume that the fixed exchange
rate is 1 escudo (esc) = £1. (The escudo was the long-time Portuguese currency unit prior
to Portugal’s adoption of the euro in 1999.) The pattern of trade now responds to money-
price differences. Cloth will be purchased in England because the price of cloth in either
currency is less in England than in Portugal. Wine, however, is cheaper in Portugal, so
consumers will buy Portuguese wine. This result is the same as that reached in the exami-
nation of relative labor efficiency between the two countries (i.e., England should export
cloth and import wine because ½ < ¾). The monetizing of the model produces an additional piece of information: Once prices and an exchange rate are specified, the international commodity terms of trade are uniquely specified. Table 1 shows that the low price of cloth (in England) is £1/yd or 1 esc/yd, while the low price of wine (in Portugal) is £2.4/bbl or 2.4 esc/bbl. As trade takes place, England will export cloth and import wine at a rate of 2.4 yards of cloth per each barrel of wine. The price ratio, Pwine /Pcloth (2.4/1), yields the quantity of cloth that exchanges for 1 barrel of wine. These are clearly viable international terms of trade because they lie within the limits imposed by the prices under autarky (opportunity costs) in the two countries. As under barter, both countries will benefit from trade on these terms. If for some reason the terms of trade do not produce balanced trade, then gold will move to the country with an export surplus and away from the country with a trade deficit. When this occurs, the price- specie- flow mechanism will cause prices (and wages) in the surplus country to rise and prices (and wages) in the deficit country to fall, as discussed in Chapter 2. These adjustments will take place until the international terms of trade bring about balanced trade. WAGE RATE LIMITS AND EXCHANGE RATE LIMITS In the monetized version of the Classical model, a country exports a product when it can produce it the most inexpensively, given wage rates and the exchange rate. The export condition—the cost conditions necessary for a country to export a good—can be stated in the following manner for any country 1 (England in our example): a1jW1e < a2jW2 where: a1j = the labor requirement/unit in country 1 for commodity j W1 = the wage rate in country 1 in country 1’s currency e =  the country 2 currency/country 1 currency exchange rate, or the number of units of country 2’s currency required to purchase 1 unit of country 1’s currency a2j = the labor requirement/unit in country 2 for commodity j W2 = the wage rate in country 2 in country 2’s currency It is clear that England (country 1) should export cloth since (1 hr) × (£1/hr) × (1 esc/£1)  <  (2  hr)  ×  (0.6  esc/hr). This condition does not, however, hold for wine, because Cloth Wine Wage/Hour Labor/Unit Price Labor/Unit Price (1) England £1/hr 1 hr/yd £1 3 hr/bbl £3 (2) Portugal 0.6 esc/hr 2 hr/yd 1.2 esc 4 hr/bbl 2.4 esc TABLE 1 Labor Requirements and Money Prices in a Ricardian Framework Final PDF to printer CHAPTER 4 EXTENSIONS AND TESTS OF THE CLASSICAL MODEL OF TRADE 43 app9062x_ch04_040-061.indd 43 06/17/16 06:12 PM (3 hr) × (£1/hr) × (1 esc/£1) > (4 hr) × (0.6 esc/hr). Thus, England should export cloth and
import wine. In a two-country, two-commodity framework, once the export and import
goods are known for one country, the import and export pattern for the trading partner is
also determined: England’s exports are Portugal’s (country 2’s) imports, and England’s
imports are Portugal’s exports.
The export condition is a useful way to examine potential trade flows; it makes it clear
that, in a monetized world, the ability to export depends not only on relative labor effi-
ciency but also on relative wage rates and the exchange rate. Shifts in wage rates and/or
the exchange rate can affect trade. This possibility is apparent if one rewrites the export
condition in the following manner:
a1j/a2j < W2/(W1 × e) A fall in W2 reduces the relative cost competitiveness of country 1, whereas a fall in W1 enhances its cost competitiveness. Similarly, if the pound rises in value relative to the escudo (a rise in e), English goods cost more in Portugal, thus offsetting some of England’s initial relative labor efficiency. If the escudo rises in value relative to the pound (a fall in e), England’s cost advantage in cloth increases or its cost disadvantage in wine decreases. Because changes in the wage rate can alter the degree of cost advantage to a country, changes that are too severe could eliminate a country’s ability to export or its willingness to import a good. A country would lose the ability to export if wages rose sufficiently to cause the domestic price to exceed the foreign price. The same country would have no desire to import a good if its wage rate fell to the point that the price of the import good was now cheaper at home than abroad. Thus, given a fixed exchange rate and a fixed wage in the second country, the wage rate must lie within a certain range if trade is to take place by comparative advantage. If we adopt the Portuguese wage rate and the exchange rate from the example, and if the English wage rises to £1.2/hr, then prices for cloth are equalized between England and Portugal, and England loses its guaranteed export market. If wages in England fall to £0.8/hr, then the cost of wine is equalized between both countries, and England has no incentive to import wine from Portugal. Given the English wage and the exchange rate, the wage rate limits—the endpoints of the range within which the wage can vary without eliminating the basis for trade—for Portugal are 0.5 esc/hr and 0.75 esc/hr. At 0.5 esc/hr, the prices of cloth are equal, and at a wage rate of 0.75 esc/hr, the prices of wine are equal. However, if the Portuguese wage rate were 0.4 esc/hr, then cloth in Portugal would cost 0.8 esc (£0.8) and wine in Portugal would cost 1.6 esc (£1.6). Portugal would then be able to export both goods to England, but the price-specie-flow mechanism would subsequently restore two-way trade by increasing the Portuguese wage rate (and reducing the English wage rate). Similarly, there are exchange rate limits. Using the wage levels in the England– Portugal example (see Table 1), it is obvious that an exchange rate of 1.2 esc/£1 will cause the price of cloth to be the same in both countries. On the other hand, an exchange rate of 0.8 esc/£1 will cause wine prices to be the same in both countries. For trade to take place, the exchange rate must lie within these limits. The closer it lies to 1.2 esc/£1, the more the terms of trade benefit England. The closer the exchange rate lies to 0.8 esc/£1, the more the terms of trade benefit Portugal. For a summary, see Concept Box 1. The limits to wages and the exchange rate can also be determined by using the export condition explained earlier. Because the export condition indicates when a country has a cost advantage in a particular product, that condition can be used to determine the wage that will cause prices to be the same in the two countries. Replace the < sign with an = sign; then solve for the single unknown wage, given the wage rate in the other country, labor requirements, and the exchange rate. For example, suppose that you want to know what Final PDF to printer CONCEPT BOX 1 WAGE RATE LIMITS AND EXCHANGE RATE LIMITS IN THE MONETIZED RICARDIAN FRAMEWORK The wage rate and exchange rate limits related to Table 1 can be summarized in the following manner. In England, with a Portuguese wage rate of 0.6 esc/hr and an exchange rate of 1 esc/£1, the following wage limits hold: (Price of wine equalized) (Price of cloth equalized) 0 0.8 1.2 WEng. £/hr No imports of wine Import wine, export cloth No exports of cloth (Price of cloth equalized) (Price of wine equalized) 0 0.5 0.75 WPort. esc/hr No imports of cloth Import cloth, export wine No exports of wine In Portugal, with an English wage rate of £1/hr and an exchange rate of 1 esc/£1, the following wage limits hold: (Price of wine equalized) (Price of cloth equalized) 0 0.8 1.2 Exchange rate esc/£ No wine exports from Portugal Portugal exports wine, England exports cloth No cloth exports from England ● Finally, with WPort. = 0.6 esc/hr and WEng. = £1/hr, the following exchange rate limits hold: 44 PART 1 THE CLASSICAL THEORY OF TRADE app9062x_ch04_040-061.indd 44 06/17/16 06:12 PM wage would cause Portugal to lose its price advantage over England for wine. You would set the wine labor requirements ratio equal to the wage ratio, or a1j/a2j = W2/(W1 × e) 3/4 = W2/(1 × 1/1) W2 = 3/4 = 0.75 esc/hr To find the other wage limit, you proceed in the same manner, except that you use the rela- tive labor requirements for cloth instead of wine: 1/2 = W2/(1 × 1) W2 = 1/2 = 0.5 esc/hr Final PDF to printer CHAPTER 4 EXTENSIONS AND TESTS OF THE CLASSICAL MODEL OF TRADE 45 app9062x_ch04_040-061.indd 45 06/17/16 06:12 PM To locate the limits to England’s wages, you solve for W1, given wages in Portugal and the exchange rate. For example, for the upper limit to England’s wages, 1/2 = 0.6/W1(1) W1 = £1.2/hr whereas for the lower limit, 3/4 = 0.6/W1(1) W1 = £0.8/hr The limits to the exchange rate are found by setting up the same relationships and then solving for e, given the wage levels in the two countries. Work this out by yourself to dem- onstrate that the limits are indeed 0.8 esc/£1 and 1.2 esc/£1. You may have noticed that the range of English wages is above the range of Portuguese wages. This is no accident: the higher-productivity country will have more highly paid workers. Portuguese workers could, at most, be paid three-quarters (which is the relative productivity to England in wine, Portugal’s comparative-advantage good) of the English wage. If Portuguese workers sought wages equal to those in England, Portugal would be unable to export either good and would want to import both goods. The price-specie-flow mechanism would then operate to reduce Portuguese wages and raise English wages until relative wages fell within the specified range. CONCEPT CHECK 1. Once prices are brought into the Ricardian framework, what is the export condition that determines the basis for trade? 2. Suppose that the exchange rate in the exam- ple in Table  1 had been 0.9 esc/£1. What would the English wage limits be? 3. Is there a basis for trade in the following case if the exchange rate (using the historical cur- rencies) is 1 franc/1.25 marks? If so, what commodity will each country export? What are the terms of trade? What are the wage limits in each country? What are the limits to the exchange rate? Wage Rates Cutlery Wheat Germany 2 marks/hr 60 hr/unit 30 hr/bu France 3 francs/hr 30 hr/unit 20 hr/bu MULTIPLE COMMODITIES Up to this point, it has been assumed that trade was taking place within a two-country, two-commodity world, but in the real world countries produce and trade more than two products. What, if anything, can Ricardian comparative advantage say about the nature of trade in a multicommodity world? As it turns out, the concept of comparative advan- tage can be extended into a larger group of products using the export condition discussed in the previous section. Suppose that two countries have labor requirements per unit of production and wages as described in Table 2 and that the exchange rate is 0.8 pound/1 euro or £0.8/€1. In this situation, the relative labor requirements, a1j/a2j must be less than W2/(W1e) in order for Spain (country 1) to export the good. If Spain’s relative labor require- ments are greater than the relative wage cost (expressed in a common currency), then Spain should import the good from the United Kingdom. With only two countries, once imports and exports are determined for one country, they are automatically determined for the other. The way to solve this problem is to place the commodities in ascending order Final PDF to printer 46 PART 1 THE CLASSICAL THEORY OF TRADE app9062x_ch04_040-061.indd 46 06/17/16 06:12 PM The pattern of trade is thus clear: Spain should specialize in and export cloth, wine, and wheat while importing cheese, hardware, and cutlery from the United Kingdom. (In this example, each country exports three goods, but there is no a priori reason for two trading partners to import and export the same number of goods, as we shall see later.) To verify that indeed each country’s exports are in fact the lowest price goods, the array of goods prices is as follows: Cloth Wine Wheat W2/(W1 × e) Cheese Hardware Cutlery 6/5 < 4/3 < 5/2.8 < 3.2/[(2)(0.8/1)]  < 7/3 < 15/6 < 12/4 { Spain exports } { U.K. imports } =  2.0 { Spain imports } { U.K. exports } Wine Cutlery Cloth Hardware Wheat Cheese Spain (in euros) €8 €24 €12 €30 €10 €14 United Kingdom (in pounds) £9.6 £12.8 £16 £19.2 £8.96 £9.6 Spain (in pounds) £6.4 £19.2 £9.6 £24 £8 £11.2 according to their relative labor requirements (a1j /a2j) and then position the relative wage cost in the appropriate place in the goods spectrum. The following array of goods will then appear: Wage Rate Wine Cutlery Cloth Hardware Wheat Cheese Spain €2/hr 4 hr 12 hr 6 hr 15 hr 5 hr 7 hr United Kingdom £3.2/hr 3 hr 4 hr 5 hr 6 hr 2.8 hr 3 hr TABLE 2 Unit Production Conditions in a Two-Country, Multicommodity Ricardian Framework When the prices are all stated in one currency (e.g., pounds) using the exchange rate, it is clear that the array of exports (imports) based on price alone is the same as previously demonstrated. That is, Spain exports cloth, wine, and wheat, and the United Kingdom exports cutlery, hardware, and cheese. A final observation is important: should the ratio of relative labor requirements equal exactly the ratio of relative wages, the good in question will cost the same in both coun- tries. Hence, it may or may not be traded because consumers would pay the same price regardless of the source of the good (and no transportation costs are assumed). Expanding the number of commodities is a useful extension of the basic Classical model because it permits an analysis of the effects of exogenous changes in relative wages or the exchange rate on the pattern of trade. (In the two-country, two-commodity model, sufficiently large wage or exchange rate movements can remove the basis for trade, but if trade takes The Effect of Wage Rate Changes Final PDF to printer CHAPTER 4 EXTENSIONS AND TESTS OF THE CLASSICAL MODEL OF TRADE 47 app9062x_ch04_040-061.indd 47 06/17/16 06:12 PM This shift in relative wages means that Spain will now export cheese and hardware, instead of importing them from the United Kingdom. The pattern of trade has shifted mark- edly because the United Kingdom’s cost advantage has been eroded by the increase in its wage rate, which has eliminated its ability to export two products. If trade takes place, however, cloth will always be exported by Spain and cutlery by the United Kingdom. Changes in the exchange rate also can alter a country’s trade pattern. A shift in tastes and preferences toward foreign goods, which leads to an increase in the domestic price of foreign currency, will make domestic products cheaper when measured in that foreign cur- rency, thereby increasing the competitiveness of a country in terms of exports. A decrease in the domestic price of foreign currency will make foreign goods cheaper and act as a stimulus to imports. In the Classical model, this means that changes in the exchange rate can cause goods not at the endpoints of the spectrum to change from exports to imports. In the example with the original wage rates, an increase in the pound/euro exchange rate to £1/€1 from £0.8/€1 will cause the relative wage ratio to become 1.6 [= 3.2/(2 × 1/1)], down from the original 2.0. Wheat becomes an import instead of an export for Spain. A decrease in the pound/euro rate would have the opposite effect, potentially increasing Spain’s exports and reducing its imports. What determines the equilibrium relative wage ratio in this two-country, multiple- commodity analysis? In this single-factor approach, the relative size of the labor force will clearly be critical from the supply perspective. Holding other considerations constant, the larger the labor force in one country, the smaller is its relative wage rate and, other things being equal, the larger the number of goods it will export. Reciprocal demand will also play a role in determining the ultimate relative wage rate in equilibrium. As John Stuart Mill (1848) pointed out, the equilibrium terms of trade will reflect the size and elasticity of demand of each country for each other’s products, given the initial production condi- tions determined by the resource endowments and technology. Appropriate adjustment to demand conditions is provided in the Classical model by the price-specie-flow mechanism if trade is not balanced between the two trading partners. The equilibrium terms of trade are thus realized by adjustments in the relative wage rates because of the movement of gold between the two countries. A country with a trade surplus will find gold flowing in, resulting in an increase in prices and wages. This will continue until wages have risen sufficiently to reduce its exports and increase its imports and trade is balanced between the two countries. The reverse will occur in the deficit country. The mechanism ensures that each country will export at least one good. The Effect of Exchange Rate Changes place, it is always the same trade pattern.) To drive this point home, suppose that an increased preference for leisure causes the U.K. wage rate to increase from £3.2/hr to £4.2/hr. With the new, higher wage rate, the relative labor wage ratio is now 2.6 (i.e., 4.2/[(2)(0.8/1)] = 2.6) instead of 2.0. This means that the dividing point between exports and imports has now shifted to the right and lies to the right of both cheese and hardware, as shown here: Cloth Wine Wheat Cheese Hardware W2/(W1 × e) Cutlery 6/5 < 4/3 < 5/2.8 < 7/3 < 15/6 < 4.2/[(2)(0.8/1)] < 12/4 { Spain exports } { United Kingdom imports } {Spain imports} {United Kingdom exports} Final PDF to printer 48 PART 1 THE CLASSICAL THEORY OF TRADE app9062x_ch04_040-061.indd 48 06/17/16 06:12 PM The general equilibrium nature of the Classical approach is formally presented in a well-known model by Rudiger Dornbusch, Stanley Fischer, and Paul Samuelson (1977). They construct a multicommodity model between two countries that captures the relative supply conditions between the two countries and incorporates total (both countries) rela- tive demand for the commodities under consideration. This enables them to demonstrate the simultaneously determined links between relative wage rates, prices, and exchange rates and to show clearly that wages and prices are jointly determined with trade when bal- anced trade between the two countries is achieved. The original model also incorporated transportation costs, tariffs, and nontraded goods.1 Using this model, Dornbusch, Fischer, and Samuelson explain how exogenous changes in productivity and relative demand can affect the structure of trade, wages, and prices in the trading partners. For a more complete description of this model, see the appendix at the end of this chapter. TRANSPORTATION COSTS Our discussion of the Classical explanation of international trade has so far assumed no transportation costs. The incorporation of transport costs alters the results covered to this point, because the cost of moving a product from one country’s location to another affects relative prices. To examine the effect of transportation costs, it is assumed that (1) all transportation costs are paid by the importer and (2) transportation costs are measured in terms of their labor content, in keeping with the labor theory of value. Transportation costs are perceived as increasing the amount of relative labor required per unit of out- put in the exporting country. The labor cost of transportation is added to the production labor requirement in that country. In the first Spain–United Kingdom multiple- commodity example, the transportation costs to export cloth, wine, and wheat would be added to Spain’s labor requirements in production, while the transportation costs for cheese, hard- ware, and cutlery would be added to those of the United Kingdom. With transportation costs, Spain’s (country 1’s) export condition becomes (a1j + trj)/a2j < W2 /(W1 × e) and the import condition becomes W2/(W1 × e) < a1j /(a2j + trj). The symbol trj reflects the trans- portation cost per unit for commodity j measured in labor hours. Taking account of trans- portation costs in this manner allows for the possibility that certain commodities might not be imported by either country because the transportation cost makes them more expensive than the domestically produced alternative. This will be true anytime (a1j + trj)/a2j > W2/
(W1 × e) and W2/(W1 × e) > a1j /(a2j + trj).
To illustrate this point numerically, consider again the Spain–United Kingdom example
in Table 2 (page 46). In addition, assume that the transportation cost per unit of each of the
products is 1 labor hour. The relative labor cost of each product delivered in the importing
country is now:
1Appleyard, Conway, and Field (1989) extended this model to a three-country framework.
Cloth Wine Wheat W2/(W1 × e) Cheese Hardware Cutlery
(6 + 1)/5 (4 + 1)/3 (5 + 1)/2.8 3.2/[(2)(0.8)] 7/(3 + 1) 15/(6 + 1) 12/(4 + 1)
When these additional costs are taken into consideration, wheat becomes a nontraded good
for Spain because (5 + 1)/2.8 = 2.1 > 3.2/(2)(0.8) = 2, while the United Kingdom is no
longer cost competitive in cheese because 7/(3 + 1) = 1.75 < 2. Each of these goods is pro- duced for domestic use in both countries. Both are tradeable goods, but they are not traded Final PDF to printer CHAPTER 4 EXTENSIONS AND TESTS OF THE CLASSICAL MODEL OF TRADE 49 app9062x_ch04_040-061.indd 49 06/17/16 06:12 PM because the comparative advantage in each case is overcome by the cost of transportation. The incorporation of transportation costs is important because it produces a third category of goods, nontraded goods, that will not enter into international trade, even though one of the countries may have a comparative advantage in production. Given relative labor requirements, goods that lie close to the wage ratio are thus likely to be nontraded. Consid- eration of transportation costs also illustrates that products subject to high transportation costs must have a relatively large production cost advantage if a country is to sell them to another country. It is not surprising that many bulky, heavy products are not traded. IN THE REAL WORLD: THE SIZE OF TRANSPORTATION COSTS The cost of shipping a product from one point to another is determined by a number of factors, including distance, size, weight, value, and the overall volume of trade between the two points in question. To get an idea of the average impact of shipping costs on trade in general, a freight and insurance factor (FIF) has in the past been estimated by the Interna- tional Monetary Fund. This factor is calculated by dividing the value of a country’s imports, including freight and insur- ance costs (the c.i.f. value) by the value of its imports exclud- ing shipping expenses, the f.o.b. (free-on-board) value (i.e., FIF = importsCIF/importsFOB). If, for example, the FIF has a value of 1.08, it indicates that shipping and insurance costs added an additional 8 percent to the cost of imports. The value of this ratio thus reflects not only the composition of a country’s imports but also the shipping distances involved as well as the other factors. Some examples of this measure are given in part (a) of Table 3 for several countries for 1975, 1985, 1995, 2005, and 2013. (The 2005 and 2013 figures were calculated by the authors.) To get some idea of the relative importance of transpor- tation costs for specific goods, some freight rates as a per- centage of price for selected groups of countries are given in Table 3(b). Table 4 then provides another set of data per- taining to freight rates. These figures show the charter rates, in dollars per 14-ton slot per day, for selected years in the 2002–2013 period for various geared and gearless container ships. The various categories indicate size of ship in TEUs, or 20-foot equivalent units (20-foot-long containers). The UN Conference on Trade and Development has estimated that freight costs as a percentage of world import value declined from 6.64 percent in 1980 to 5.25 percent in 1995/1996. Shipping rates fluctuated in the late 1990s and early years of the new century because of such factors as changes in petroleum prices, surges in demand for container shipping, and overcapacity. The decline in rates at the end of the 2000–2010 years will be augmented in the future by the introduction of jumbo shipping vessels that will ratchet upward the average size of vessels and provide significant economies of scale. In addition, if the large drop in oil prices in 2014 continues for several years, that will also bring down transportation costs. (See Robert Guy Matthews, “A Surge in Ocean-Shipping Rates Could Increase Consumer Prices,” The Wall Street Journal, November 4, 2003, pp. A1, A13; John W. Miller, “The Mega Containers Invade,” The Wall Street Journal, January 26, 2009, p. B1. For a useful discussion of long-term shipping costs, see “Schools Brief: Delivering the Goods,” The Economist, November 15, 1997, p. 85.) 1975 1985 1995 2005 2013 Industrialized countries 1.065 1.048 1.044 NA NA Australia 1.070 1.118 1.067 1.055 1.042 Czech Republic NA NA 1.050 1.014 1.033 France 1.049 1.039 1.034 1.025 1.021* Germany 1.041 1.028 1.028 1.030 1.030 New Zealand 1.095 1.082 1.078 1.068 1.053 United States 1.066 1.047 1.037 1.037 1.027 Developing countries 1.128 1.118 1.114 NA NA Argentina 1.124 1.085 1.119 1.051 1.044 Colombia 1.111 1.110 1.072 1.071 1.049 Maldives 1.100 1.100 1.137 1.087 1.082 Mexico 1.050 1.041 1.047 1.047 1.026 Philippines 1.092 1.087 1.074 NA 1.053 South Africa 1.097 1.112 1.130 1.135 1.056 *2012 figure NA = not available or not applicable TABLE 3(a) Freight and Insurance Factors 1975, 1985, 1995, 2005, 2013 (continued) Final PDF to printer 50 PART 1 THE CLASSICAL THEORY OF TRADE app9062x_ch04_040-061.indd 50 06/17/16 06:12 PM MULTIPLE COUNTRIES In a two-country framework, the pattern of trade has always been unambiguous. With two commodities, the pattern of trade was determined by comparative advantage based on relative unit labor requirements. In the monetized, multicommodity model, the trade pattern was uniquely determined by relative labor costs and relative wages. When several countries are taken into account, however, the specification of the trade pattern is less straightforward. Returning to our two-good world to simplify the analysis, let us examine the case for trade between three countries in order to make generalizations about the pattern of trade. Table 5 shows a clear basis for trade because the autarky prices are different among the potential trading partners. The incentive for trade will be greatest between the two countries with the greatest difference in autarky prices. The potential gains from trade initially are the greatest between Sweden and France; that is, the autarky price ratios are the most dif- ferent. The equilibrium terms of trade will settle somewhere between 1C:2.5F and 1C:4F. Sweden has the comparative advantage in the production of cutlery (10/20 < 4/5), France has the comparative advantage in fish, and the trade pattern between the two countries is determined as in the two-country model. But what of Germany? Will there be a reason for Germany to trade? If so, in which commodity will it have a comparative advantage? Country Fish Cutlery Autarky Price Ratio Sweden 4 hr/lb 10 hr/unit 1 cut:2½ lb fish Germany 5 hr/lb 15 hr/unit 1 cut:3 lb fish France 5 hr/lb 20 hr/unit 1 cut:4 lb fish TABLE 5 Labor Requirements in a Two-Good, Three-Country Ricardian Framework IN THE REAL WORLD: (continued) Country Group 1984 1994 2000 2004 2010 Developing Africa 12.30% 12.78% 11.55% 10.78% 10.93% Developing Oceania 11.52 11.74 11.61 9.89 8.56 Developing America 8.12 8.53 8.8 8.74 7.34 Developing Asia 8.87 9.61 8.29 8.05 7.89 Developed economies 7.48 7.52 6.26 6.39 6.52 TABLE 3(b) Freight Costs as a Percentage of Value of Imports (five-year moving averages) 2002 2005 2008 2011 2013 300–500 TEUs $15.1 $28.3 $20.0 $12.8 $10.9 1,000–1,299 TEUs 6.9 22.6 12.2 8.7 6.6 1,600–1,999 TEUs 5.7 15.8 10.8 6.8 4.1 Sources: International Monetary Fund (IMF), 1996 International Financial Statistics Yearbook (Washington, DC: IMF, 1996), pp. 122–25; International Financial Statistics data available at www.elibrary.data.imf .org; United Nations Conference on Trade and Development (UNCTAD), Review of Maritime Transport 1998 (New York: UNCTAD, 1999), p. 70; UNCTAD, Review of Maritime Transport 2012 (New York and Geneva: UNCTAD, 2012), p. 74; UNCTAD, Review of Maritime Transport 2014 (New York and Geneva: UNCTAD, 2014), p. 54. TABLE 4 Container Ship TEU Charter Rates ($ per 14-ton slot/day) ● Final PDF to printer CHAPTER 4 EXTENSIONS AND TESTS OF THE CLASSICAL MODEL OF TRADE 51 app9062x_ch04_040-061.indd 51 06/17/16 06:12 PM EVALUATING THE CLASSICAL MODEL Although the Classical model seems limited in today’s complex production world, econo- mists have been interested in the extent to which its general conclusions are realized in international trade. In particular, economists have focused on the link between relative labor productivity, relative wages, and the structure of exports. One of the earliest empiri- cal studies was conducted by G. D. A. MacDougall in 1951. In this classic study, the relative export performance of the United States and the United Kingdom was examined, using the export condition utilized throughout this chapter. MacDougall wanted to see if export performance was consistent with relative labor productivities and wage rates in the two countries. He argued that, relative to the United Kingdom, the United States should be more competitive in world markets whenever its labor was more productive than that Like “middle goods” in the example of multiple commodities, there is no single answer about the middle country’s (Germany’s) trade role. Germany’s participation will be depen- dent on the international terms of trade. Three possibilities exist within the 1C:2.5F–1C:4F range. The terms of trade may be 1C:3F, 1C > 3F, or 1C < 3F. In the first instance (1C:3F), where the terms of trade are exactly equal to Germany’s own domestic price ratio in autarky, Germany would have no potential gains from trade. In the second category, for example, 1C:3.5F, Germany stands to gain from trade because the terms of trade are dif- ferent from its own autarky prices. This gain will come about if Germany exports cutlery and imports fish, receiving 3.5 pounds for each unit of cutlery instead of only 3 pounds at home. The world pattern of trade in this case would consist of Germany and Sweden exporting cutlery and importing fish from France. If, on the other hand, the terms of trade settled in the third category, for example, 1C:2.8F, Germany would again find it profit- able to trade since the terms of trade again differ from its own autarkic price ratio. The pattern of trade would not, however, be the same as in the second case. At these terms of trade, Germany would find it advantageous to produce and export fish and import cutlery, because 1 unit of cutlery can be obtained for only 2.8 pounds of fish with trade as opposed to 3 pounds of fish at home. The world pattern of trade would consist of France and Germany exporting fish and importing cutlery from Sweden. Introducing multiple countries into the analysis results in an ambiguity in the trade pat- tern for all but the end-of-spectrum countries until the ultimate equilibrium terms of trade are specified. Once an international terms-of-trade ratio is specified, then the trading status of the “middle” countries can be determined. Little can be said about the trade pattern of a middle country beyond noting the international terms of trade at which it would not gain from trade and the pattern of trade that would emerge if the world price ratio is less than or greater than its own autarkic price ratio. More advanced analysis exploring many countries and many goods is beyond the scope of this text. CONCEPT CHECK 1. What determines the basis for trade in a two- country, multicommodity Ricardian framework? 2. What happens to the pattern of trade if the level of wages in one country increases, other things being equal? If the price of foreign currency rises for the same country (i.e., its home currency depreciates in value)? 3. Briefly explain under what conditions the “middle countries” will trade in a two-good, multicountry Ricardian framework. Why can you not say, a priori, which commodity these countries will export? Final PDF to printer 52 PART 1 THE CLASSICAL THEORY OF TRADE app9062x_ch04_040-061.indd 52 06/17/16 06:12 PM Some Commodity Examples Represented in the Above Graph (Pre–World War II) U.S. Output/Worker (1938) U.S. Weekly Wages ($) (1937) U.S. Export Quantity U.K. Output/Worker U.K. Weekly Wages ($) U.K. Export Quantity Pig iron 3.6 1.5 5.1 Motor cars 3.1 2.0 4.3 Machinery 2.7 1.9 1.5 Glass containers 2.4 2.0 3.5 Paper 2.2 2.0 1.0 Beer 2.0 2.6 0.056 Hosiery 1.8 1.9 0.30 Cigarettes 1.7 1.5 0.47 Woolens and worsteds 1.35 2.0 0.004 Source: G. D. A. MacDougall, “British and American Exports: A Study Suggested by the Theory of Comparative Costs, Part I,” The Economic Journal 61, no. 244 (December 1951), pp. 703, 707. FIGURE 1 Labor Productivity, Relative Wages, and Trade Patterns in the MacDougall Study U.S. export volume U.K . export volume 4.0 3.0 2.0 1.0 0 1.0 WUS WUK Labor productivity, U.S. Labor productivity, U.K . of the United Kingdom, after taking into account wage rate differences. Another way to state this is that the value of U.S. commodity exports should be greater than that of U.K. commodity exports whenever the ratio of labor productivity in the United States to that in the United Kingdom in that industry is greater than the ratio of wages between the United States and the United Kingdom (i.e., the ratio of labor input/unit in the United States to that in the United Kingdom is less than WUK/WUS). Whenever the ratio of U.S. to U.K. produc- tivity in a given industry is less than the ratio of U.S. to U.K. wages, the United Kingdom should dominate in exports of the good. The early results of MacDougall and later studies by Stern (1962) and Balassa (1963) confirmed the initial hypothesis. Some of MacDougall’s early findings are conceptually represented in Figure 1. The relative productivity of more than 20 exporting industries in each of the two countries is plotted on the vertical axis; the relative volume of individual industry exports is plotted on the horizontal axis. In 1937, U.S. wages were on average twice those of the United Kingdom. A horizontal line is drawn intersecting the vertical axis at the value of 2. If a vertical line is now drawn intersecting the horizontal axis at a value of 1 Final PDF to printer CHAPTER 4 EXTENSIONS AND TESTS OF THE CLASSICAL MODEL OF TRADE 53 app9062x_ch04_040-061.indd 53 06/17/16 06:12 PM (as a dividing line between U.S. dominance of exports and U.K. dominance of exports), four quadrants are formed. If the basic thrust of the Classical model holds, U.K. dominant exports should lie in the lower left-hand quadrant and U.S. dominant exports should lie in the upper right-hand quadrant. You can see that the empirical results tend to confirm the Classical prediction. The MacDougall general framework has been applied to more recent years by Stephen Golub and Chang-Tai Hsieh (2000). They focused on U.S. trade with various countries over the period 1970–1992. One set of estimates compared unit labor costs in 39 man- ufacturing sectors in the United States relative, individually, to such costs in Australia, Canada, France, Germany, Italy, Japan, and the United Kingdom. In general, unit labor cost for an industry is defined as the labor cost per unit of output, and it can be calculated by dividing the total wage bill (including fringe benefits) by the industry’s output. In the Golub-Hsieh paper, comparative trade performance between the United States and any given other country was measured in two ways: (a) the ratio of total exports of the United States from the given sector to total exports of the other country from that sector, and (b) the ratio of the U.S. exports from the given sector to the particular other country to U.S. imports in that sector from that other particular country. The expectation from Ricardo’s analysis would be that higher unit labor costs in the other country relative to U.S. unit labor costs would be associated with better U.S export performance relative to the other country’s performance. This expected result was almost universally found and in a statisti- cally significant manner. A second set of tests added South Korea and Mexico to the previous seven coun- tries being examined. The testing of comparative trade performance used (instead of unit labor costs) the ratio of the amount of labor required per unit of output in any given manufacturing sector in the United States relative to the labor required per unit of out- put in that sector in each other country. There were 21 manufacturing sectors included. It would be expected that greater labor required per unit of output in the United States compared to the labor required in the other country would result in poorer export perfor- mance by the United States. Again, there was almost complete support for the hypoth- esis. Overall, Golub and Hsieh concluded that they provided fairly solid support for the Ricardian model. In another paper, Carlin, Glyn, and Van Reenen (2001) utilized data pertaining to the export patterns in 12 aggregate manufacturing categories of 14 developed countries from 1970 to the early 1990s. They calculated unit labor costs in similar fashion to Golub-Hsieh, but then calculated the relative unit labor costs of the 14 countries in any given indus- try category. Thus, for example, in “transport equipment,” they ranked countries in unit labor costs for each of the various years. Each industry’s unit labor cost was divided by the 14-country industry average and then ranked from lowest to highest. This set of data was then paired with export market share data—that is, the percentage that each country’s industry had of the 14 countries’ total exports in the product category (again, from lowest to highest) in each of the given years. With these series in hand, statistical tests were run to see if changes in the export market shares were correlated with changes in the relative unit labor costs by industry across the countries across the years. If labor costs were important in determining market shares, a negative relationship would be expected—higher relative unit labor costs would be associ- ated with lower shares of exports of the 14-country total. Carlin, Glyn, and Van Reenen then estimated determinants of market shares and indeed found a statistically significant negative relationship. When they disaggregated the 12 industries into 26 categories, they obtained a virtually identical result. Thus, Classical comparative advantage theory does seem to be supported by this comprehensive study. Final PDF to printer 54 PART 1 THE CLASSICAL THEORY OF TRADE app9062x_ch04_040-061.indd 54 06/17/16 06:12 PM Recent research by Arnaud Costinot and Dave Donaldson (2012) tested the key idea of Ricardian comparative advantage that different factors of production tend to specialize in those activities where their relative productivities are the greatest. Using an extensive set of agricultural sector data (17 sectors and 55 countries) from the Food and Agricul- ture Organization of the United Nations (FAO), Costinot and Donaldson estimated sector output levels using a Ricardian-based model and then compared them to actual levels of output. The empirical results indicated that the estimated outputs compared favorably with the actual levels, despite the abstractions by the theory from the many factors affecting actual production, and that there is a useful link between relative factor productivity and relative specialization in production. IN THE REAL WORLD: LABOR PRODUCTIVITY AND IMPORT PENETRATION IN THE U.S. STEEL INDUSTRY Although the Classical model is deficient in many respects, there is a clear relationship in practice between relative improvements in labor productivity and import competi- tiveness. This is demonstrated in the experience of the U.S. steel industry in recent decades. As U.S. productivity and wage changes led to a relative increase in the unit cost of steel compared with other world producers in the 1970s and early 1980s, the penetration of imports in the U.S. mar- ket generally increased. Parts (a) and (b) of Figure 2 show absolute U.S. productivity (1973–2011) and the import penetration ratio (i.e., the share of imports in U.S. consump- tion, 1970–2013), respectively. Labor productivity rose in the late 1980s and continued to do so through the 1990s. In the 2000s, productivity increased rapidly early in the decade before a sharp rise in 2008, a sharp fall in 2009, and a rebound in 2010. The import penetration ratio declined in the late 1980s and then leveled off, but it climbed again in the mid- to late 1990s. It then moved erratically with no clear trend through 2012. FIGURE 2(a) Trends in U.S. Steel Industry Labor Productivity (1973–2011) 0.0 20.0 40.0 60.0 80.0 100.0 120.0 140.0 160.0 19 73 19 77 19 8 1 19 8 5 19 8 9 19 9 3 19 9 7 2 0 0 1 2 0 0 5 2 0 0 9 2 0 13 Labor Productivity (2002 = 100) Labor Productivity (continued) Final PDF to printer CHAPTER 4 EXTENSIONS AND TESTS OF THE CLASSICAL MODEL OF TRADE 55 app9062x_ch04_040-061.indd 55 06/17/16 06:12 PM IN THE REAL WORLD: (continued) LABOR PRODUCTIVITY AND IMPORT PENETRATION IN THE U.S. STEEL INDUSTRY FIGURE 2(b) U.S. Steel Industry Import Penetration Ratios, 1970–2013 (imports as percentage of U.S. market) 0 5 10 15 20 25 30 35 19 70 19 74 19 78 19 8 2 19 8 6 19 9 0 19 9 4 19 9 8 2 0 0 2 2 0 0 6 2 0 10 2 0 14 Import/Use Import/Use Sources: B. Eichengreen, “International Competition in the Products of U.S. Basic Industries,” in M. Feldstein, ed., The United States in the World Economy (Chicago: University of Chicago Press for the National Bureau of Economic Research, 1988), p. 311; American Metal Market, Metal Statistics 1995 (New York: Chilton Publications, 1995), p. 39; American Metal Market, Metal Statistics 1999 (New York: Cathers Business Information, 1999), p. 267; Gary Clyde Hufbauer and Ben Goodrich, “Time for a Grand Bargain in Steel?” Policy Brief 02-1, obtained from the Institute for International Economics website, www.usii.net/iie; International Iron and Steel Institute, Steel Statisti­ cal Yearbook 2006, pp. 75, 84, Steel Statistical Yearbook 2010, pp. 66, 89, and Steel Statistical Yearbook 2014, pp. 56, 79, obtained from www.worldsteel.org. The index of labor productivity for all years was obtained from www.bls.gov. ● While these various findings suggest that the Classical model may be generally consistent with observed trading patterns, they in no way suggest that this model is suffi- cient for understanding the basis for trade. In today’s complex trading world, the Classical model has several severe limitations that restrict its usefulness. Among the most limiting assumptions are the labor theory of value and constant costs, which are at odds with what can be observed in the present-day world. In addition, as countries grow and develop, rela- tive resource endowments, including labor, change. Consequently, a richer paradigm is needed to better grasp the underlying basis for international trade. This richer paradigm is presented in Part 2, “Neoclassical Trade Theory.” The Classical model examined in this part, however, gives some suggestions for the direction of policy. Free trade is a means for a country and the world to enhance well-being. Further, in order to realize the full benefits of specialization and exchange through increased labor efficiency, resources need to be mobile within countries. Finally, government restraints and taxes on industry reduce economic competitiveness and the gains from trade. Final PDF to printer 56 PART 1 THE CLASSICAL THEORY OF TRADE app9062x_ch04_040-061.indd 56 06/17/16 06:12 PM IN THE REAL WORLD: EXPORTING AND PRODUCTIVITY The Ricardian model, both in its simplified form as given in Chapter 3 and in its various extended forms as given in this current chapter, indicates that any particular country will export the goods in which it has the greatest relative productivity. As a result of engaging in trade in this fash- ion, where the country exports goods from its relatively high-productivity industries, the country (as well as each of its trading partners) gains from trade. Not included in the Ricardian model per se, but a phenomenon to which Ricardo’s fellow Classical writers Adam Smith and John Stuart Mill gave broad reference, is the fact that exporting by an industry can increase productivity. Hence, we have a virtuous circle where high productivity leads to exports and exporting subsequently leads to even higher productivity. The higher productivity that results from exporting can be a result of learning-by-doing, economies of scale, or other factors. Two studies that have lent support to this view that exporting leads to higher productivity are of interest. In one study, Johannes Van Biesebroeck (2005) examined approxi- mately 200 manufacturing firms in nine African countries (Burundi, Cameroon, Côte d’Ivoire, Ethiopia, Ghana, Kenya, Tanzania, Zambia, Zimbabwe) over the 1992–1996 period. He first discovered that, in comparison with non-exporting firms, the exporting firms on average produced more than 50 percent greater output per worker and paid on average 34 percent higher wages. Economic theory would of course suggest that higher productivity would be reflected in higher wages. In the second part of the study, Van Biesebroeck determined that being an exporter in effect shifted the pro- duction function upward by 25–28 percent—that is, it increased the exporting firms’ productivity. In a second study, Jan De Loecker (2007) analyzed whether firms that start to export become more produc- tive after doing so. He employed data for the manufactur- ing sector of Slovenia for the period 1994–2000. Over the period, on average per year, there were 4,258 firms in the study, of which 1,953 already were exporters and 312 firms began exporting. As in the Van Biesebroeck study, exporters were found to be more productive than non-exporters (by 29.59 percent) and to pay higher wages (by 16.14 percent). With respect to exporting and resulting increases in pro- ductivity, De Loecker found that, relative to the situation of their domestic counterparts, the firms that started export- ing had 17.7 percent greater productivity gains after two years and 46 percent greater gains after four years. Hence, again, we see that high-productivity firms tend to export and that the process of exporting leads to higher productivity for the firms engaged in it. Sources: Johannes Van Biesebroeck, “Exporting Raises Productiv- ity in Sub-Saharan African Manufacturing Firms,” Journal of Inter­ national Economics 67, no. 2 (December 2005), pp. 373–91; Jan De Loecker, “Do Exports Generate Higher Productivity?,” Journal of International Economics 73, no. 1 (September 2007), pp. 69–98. ● SUMMARY This chapter has focused on several of the more common extensions of the Classical Ricardian model of trade that con- tribute to a fuller understanding of the forces influencing the pattern of trade in the world. By monetizing the model, the criti- cal roles of relative wages and the exchange rate were observed. The inclusion of these variables not only led to a specific esti- mate of the international commodity terms of trade but also provided a vehicle by which the price-specie-flow adjustment mechanism would work if trade is unbalanced. This analysis also indicated that wages and/or the exchange rate could change only within certain limits without removing the basis for trade and setting the adjustment mechanism into operation. Extend- ing the analysis to include multiple commodities and transpor- tation costs not only made the model more realistic but also provided an explanation for the presence of nontraded goods. The multicommodity framework allowed us to see that changes in relative wages or the exchange rate can cause a country to change from being an exporter to an importer (or vice versa) of certain, but not all, commodities. These extensions also permitted the examination of the link between relative wages and the exchange of goods and services. The consideration of multiple countries indicated that, while comparative advantage would  permit the determination of the trade pattern for the end- of -spectrum countries, the trade pattern of “middle coun- tries” was dependent on the world terms of trade that emerged. Finally, empirical tests have given support to the relationships between relative productivities, unit labor costs, and trade pat- terns suggested by the Classical economists. Final PDF to printer CHAPTER 4 EXTENSIONS AND TESTS OF THE CLASSICAL MODEL OF TRADE 57 app9062x_ch04_040-061.indd 57 06/17/16 06:12 PM KEY TERMS exchange rate exchange rate limits export condition nontraded goods unit labor costs wage rate limits Bread VCRs Lamps Rugs Books United Kingdom 2 days 8 days 4 days 3 days 2 days United States 2 days 6 days 2 days 2 days 3 days QUESTIONS AND PROBLEMS 1. Suppose that France has a trade surplus with the United Kingdom. What would you expect to happen to prices, wages, and commodity prices in France? Why? What would happen to the terms of trade between the two countries? 2. Consider the following Classical labor requirements: noted that average wages and fringe benefits in Mexican manufacturing industries were about one-fifth those in U.S. manufacturing and that U.S. output per worker was about five times that of Mexican manufacturing. Based on your under- standing of this chapter and of the Classical model, is there any causal relationship between these two facts? Explain. 7. You are given the following Classical-type table showing the number of days of labor input required to obtain 1 unit of output of each of the five commodities in each of the two countries: Clothing Fish Cutlery Italy 9 hr/unit 3 hr/unit 16 hr/unit Switzerland 10 hr/unit 2.5 hr/unit 15 hr/unit Fish Potatoes Poland 3 hr/lb 5 hr/bu Denmark 1 hr/lb 4 hr/bu Sweden 2 hr/lb 2 hr/bu Shoes Wine Italy 6 hr/pr 4 hr/gal Switzerland 8 hr/pr 4 hr/gal (a) Why is there a basis for trade? (b) With trade, Italy should export _____ and Switzerland should export _____ because _____. (c) The international terms of trade must lie between _____ and _____. (d ) If the wage rate in Italy is €4/hr, the wage rate in Switzerland is 3.5 francs/hr, and the exchange rate is 1 franc/€1, what are the commodity terms of trade? 3. In the example in Question 2, what are the limits to the wage rate in each country, other things being equal? What are the exchange rate limits? 4. If the following three commodities are included in the exam- ple in Question 2, what will the export and import pattern be? Will your answer change if a transportation charge of 1 hour/ commodity is taken into consideration? Why or why not? 5. In the following two-good, multicountry example of labor requirements, do all the countries stand to gain from trade if the international terms of trade are 1 lb fish:0.5 bu potatoes? If so, what commodities will each country export and import? If these commodities are not exported or imported, why not? 6. During the debate on the North American Free Trade Agree- ment (NAFTA), The Economist (September 11, 1993, p. 22) (a) Assume that the wage rate in the United Kingdom (WUK) is £8/day, the wage rate in the United States (WUS) is $20/day, and the exchange rate (e) is $2/£1. With this information, determine the goods that will be U.K. exports and the goods that will be U.S. exports. (b) Keeping WUS at $20/day and keeping the exchange rate at $2/£1, calculate the upper and lower limits (in pounds per day) to the U.K. wage rate that are consis- tent with two-way trade between the countries. (c) With WUK at £8/day and WUS at $20/day, calculate the upper and lower limits (in $/£) to the exchange rate that are consistent with two-way trade between the countries. 8. Suppose that, starting from your initial WUK, WUS, e, and the resulting trading pattern in part (a) of Question 7, there is now a uniform 20 percent improvement in productivity in all of the U.K. industries (i.e., the labor coefficients for the five industries in the United Kingdom all fall by 20 percent). (a) In this new situation, determine the goods that will be U.K. exports and the goods that will be U.S. exports. (b) In this new situation, and keeping WUS at $20/day and e at $2/£1, calculate the upper and lower limits (in pounds per day) to the U.K. wage rate. 9. What do you regard as the main weaknesses of the Ricardian/Classical model as an explanation of trade patterns? Why do you regard them as weaknesses? 10. (Requires appendix material) Explain what would hap- pen in the DFS model to relative wages and the pattern of trade if there is a uniform increase in productivity in all industries in the foreign country. What will happen to real income in each of the two countries? Why? Final PDF to printer 58 PART 1 THE CLASSICAL THEORY OF TRADE app9062x_ch04_040-061.indd 58 06/17/16 06:12 PM Appendix THE DORNBUSCH, FISCHER, AND SAMUELSON MODEL The interaction of supply and demand in the Classical model and the determination of relative wages and the trade pattern between two countries, given their initial endowments of labor, has been dem- onstrated by Rudiger Dornbusch, Stanley Fischer, and Paul Samuelson (1977), hereafter called the DFS model. Assuming a large number of goods, they rank the goods from the one with the smallest relative labor requirement to the one with the largest from the home country perspective (country 1). All commodities are indexed by A = a2/a1, where a2 is the labor requirement for a unit of output in country 2 and a1 the unit labor requirement in country 1 for any particular good in the continuum. The good with the lowest relative labor requirement for country 1 (lowest a1/a2 or highest a2/a1) is ranked first and the good with the highest relative labor requirement for country 1 (highest a1/a2 or lowest a2/a1) is ranked last. This is equivalent to ranking goods starting with those in which country 1’s relative productivity is the greatest (i.e., relative labor time is the smallest). The question of which goods will be produced in which country is approached by using the general export condition in this chapter. The location of production (country 1 or country 2) for any good will depend on rela- tive wages and the exchange rate. The home country will export those commodities where a1 a2 < W2 W1e , or a2/a1 > W1e/W2, and import those products where
a1
a2
>
W2
W1e
, or a2/a1 < W1e/W2. With this framework in mind, one can graph the home production and export goods at various relative wage rates and a fixed exchange rate. If the array of commodities is plotted on the horizon- tal axis and relative wages on the vertical axis, the two will have a downward-sloping relationship because the number of goods exported from country 1 will rise as W1e/W2 falls. For a large number of commodities, this downward-sloping relationship can be drawn as the continuous A curve in Figure 3. The commodities supplied by the home country reflect those goods whose relative labor time (a2/a1) is greater than the ratio of relative wages, W1e/W2 [or a1/a2  <  W2/W1e]. The condi- tion a2/a1 = W1e/W2 separates the goods produced and exported by the home country from those imported, given the relative wages. The A curve reflects supply conditions. On the demand side, national income (which equals the wage rate times the amount of labor) and the wage rate in the home country will depend, other things being equal, on the number of commodities that it produces based on world demand. The greater the number of goods demanded from the home country (i.e., moving to the right on the horizontal axis), the higher will be its wage rate relative to the other country, since the greater demand for the goods of country 1 will lead to a greater demand for country 1’s labor and therefore drive up country 1’s wage. This relationship is shown in Figure 3 as the upward-sloping curve C, which plots relative wages against the array of goods. A more thorough explanation of the upward-sloping C curve involves interpreting that curve as reflecting alternative balanced-trade positions between the two countries. For any good on the horizontal axis, designate the cumulative fraction of income spent on country 1’s goods up through that particular good (by the world as well as by each country, since tastes are assumed to be identi- cal everywhere) as θ1. Also, let the cumulative fraction of income spent on country 2’s goods at that particular good (which are all goods other than country 1’s goods) be represented by θ2. Because the fraction of income spent on country 1’s goods plus the fraction of income spent on country 2’s goods must add up to 100 percent of income (or 1), the term θ2 is therefore equal to (1 − θ1). Consider a situation of balanced trade between the two countries. The income spent on imports by country 1 from country 2 is equal to country 1’s income multiplied by the fraction of income spent on country 2’s goods; that is, it is (when expressed in terms of country 2’s currency) θ2 × W1L1 × e where W1 = wage rate in country 1 and L1 = labor force in country 1. Likewise, the income spent on imports by country 2 from country 1 is country 2’s income multiplied by the fraction of income spent on country 1’s goods; that is, Final PDF to printer CHAPTER 4 EXTENSIONS AND TESTS OF THE CLASSICAL MODEL OF TRADE 59 app9062x_ch04_040-061.indd 59 06/17/16 06:12 PM θ1 × W2L2 where W2 = wage rate in country 2 and L2 = labor force in country 2. With balanced trade, the amount spent on imports by country 1 equals the amount spent on its exports by country 2 (i.e., the amount spent on imports by country 2). Hence, in a balanced-trade situation, θ2W1L1e = θ1W2L2 or (1 − θ1)W1L1e = θ1W2L2 or W1e W2 = θ1L2 (1 − θ1)L1 From this expression note that, as we move to the right on the horizontal axis in Figure 3, more goods are being exported from country 1, and therefore the cumulative fraction of income spent on country 1’s goods increases. With this increase, other things being equal, the fraction θ1L2/(1 − θ1)L1 rises, since the numerator gets larger and the denominator gets smaller. With balanced trade, this means that W1e/W2 rises and thus a movement to the right on the horizontal axis is associated with a movement upward on the vertical axis in Figure 3. The C curve is therefore upward sloping. FIGURE 3 Determination of Equilibrium in the Dornbusch-Fischer-Samuelson Model W1 e/W2 (W 1 e/W2)* C (W 1 e/W2) A = a2 a1 Goodsj k The A curve describes the pattern of trade between country 1 and country 2 that exists for different sets of rela- tive wages, given the exchange rate e. For example, if relative wages were equal to (W1e/W2)′, country 1 would export all commodities whose relative labor requirements, a2/a1, are greater than (W1e/W2)′ (i.e., goods to the left of good j) and would import all commodities lying to the right of j. The demand side of the DFS model, represented by the upward-sloping C curve, demonstrates that, as a greater number of home country (country 1) goods are demanded and therefore produced (i.e., a movement to the right on the horizontal axis), the home country wage rate will be bid up relative to the foreign country wage rate (i.e., a movement upward on the vertical axis). The intersection of the C curve and the A curve yields the equilibrium set of relative wages and the accompanying actual pattern of trade. Final PDF to printer 60 PART 1 THE CLASSICAL THEORY OF TRADE app9062x_ch04_040-061.indd 60 06/17/16 06:12 PM When the A curve and the C curve are in place, observe in Figure 3 how the patterns of trade and relative wages are determined simultaneously, given the size of the labor force in each country, pref- erences for commodities, the exchange rate, and the level of technology. This equilibrium reflects the joint influence of the trade pattern and wages on each other. The equilibrium relative wage and the trade pattern are indicated by the intersection of the two curves at relative country wage (W1e/W2)* and good k. All goods to the left of good k are produced and exported by the home country because country 1’s relatively low labor time compared with country 2 more than offsets the wage rate in country 1 relative to country 2’s wage rate. That is, country 1 has lower unit labor costs in all goods to the left of good k. All goods to the right are produced and exported by the foreign country because country 1’s unit labor costs are higher than unit labor costs in country 2 in all goods to the right of good k. This Classical-like framework can also be used to demonstrate the effects of changes in tech- nology, the relative size of labor forces, and changes in preferences. For example, suppose that preferences in both countries shift toward the goods lying nearest the origin. Because these goods are exported by the home country, this change in preferences will lead to an increase in demand for country 1’s goods, causing an increase in its relative wages. Each of the goods is therefore associ- ated with a higher W1e/W2, meaning that the C curve has shifted to C′ in Figure 4(a). Consequently, the range of goods produced and exported by country 1 is reduced because labor is shifted to the production of those goods for which demand is growing. Basically, the greater demand for country 1’s products has increased country 1’s relative wage and thereby reduced the number of different W 1 e/W2 (W1 e/W2)* (W 1 e/W2)* A C ' C (a) k ' k Goods (b) W1 e/W2 (W 1 e/W2)* (W1 e/W2)* A C A k 'k Goods FIGURE 4 Demand and Productivity Shifts in the DFS Model Final PDF to printer CHAPTER 4 EXTENSIONS AND TESTS OF THE CLASSICAL MODEL OF TRADE 61 app9062x_ch04_040-061.indd 61 06/17/16 06:12 PM goods that country 1 can export. An increase in the size of the foreign country relative to the home country would have a similar effect on equilibrium because of the impact on demand for country 1’s products. On the other hand, suppose that there is an improvement in technology in country 1 that uni- formly reduces the labor requirements (a1) for producing every good there. This means that a2/a1 rises for each good, so the A curve shifts to A′ as shown in Figure 4(b). Compared with the initial equilibrium level, there will be an increase in country 1’s export goods. The result is that both the range of goods exported and the relative wage of the home country will rise. A very important result of this technological improvement that is often overlooked should be stressed here. The result is that, even though country 1, because of its increase in productivity, is exporting more goods and therefore country 2 is exporting fewer goods, country 2 still benefits from country 1’s technological advance because country 2’s real income rises due to that advance. To elaborate, consider real income in country 2. Real income is nominal income (W2L2) divided by goods prices, and it can be expressed in terms of any particular set of goods chosen. For example, real income in country 2 can be measured in terms of any of its own goods as W2L2/(a2 × W2), where the denominator a2 × W2 is the price of a good (because it is labor time multiplied by the wage rate per unit of that labor time). Real income in country 2 can also be measured in terms of country 1’s goods as W2L2/(a1 × W1e). If productivity uniformly increases in country 1’s industries (i.e., a1 falls), then the real income of country 2 measured in terms of any of country 2’s goods does not change. This is so because W2L2 a2W2 = L2 a2 and L2 and a2 are unaffected by country 1’s productivity improvement. However, when the real income of country 2 is measured in terms of any of country 1’s goods, that is, W2L2 a1eW1 = L2 a1 × (W1e/W2) there is an improvement in country 2’s real income. How do we know this? L2 is constant, so the right-hand numerator does not change. In the denominator, a1 falls because of the productivity improvement in country 1, but W1e/W2 rises. However, W1e/W2 does not rise by as much as a1 falls since, in Figure 4(b), a1 falls by the vertical distance between curve A and curve A′ but W1e/W2 rises by the vertical distance from (W1e/W2)* to (W1e/W2)*′, which is a smaller amount than the vertical distance between A and A′. Thus the denominator of L2/[a1 × (W1e/W2)] falls, and the whole expres- sion rises. This indicates that, because some of country 2’s consumption bundle consists of imported goods from country 1, there is an increase in real income in country 2. In other words, the benefits of technological progress get transmitted across country borders, and country 2’s real income goes up as a result of an improvement in productivity in country 1’s industries. The fact that productivity growth in one country that can benefit trading partner countries has also been investigated empirically. Julian di Giovanni, Andrei A. Levchenko, and Jing Zhang (2014) built a quantitative model that focused on China and included 19 manufacturing sectors and 75 trad- ing partners. While the specific transmission mechanism employed was not that of the DFS model, trading partners on average received enhancements in welfare because of increases in productivity in Chinese manufacturing industries. By using the same general technique, you should be able to demonstrate that country 1’s real income rises from its own productivity increase. This result occurs both when real income is mea- sured in terms of country 1’s own goods and when country 1’s real income is measured in terms of country 2’s goods. Final PDF to printer 62 app9062x_ch05_062-083.indd 62 06/17/16 06:13 PM CHAPTER 5 INTRODUCTION TO NEOCLASSICAL TRADE THEORY Tools to Be Employed LEARNING OBJECTIVES LO1 Describe the principles of consumer behavior. LO2 Articulate the manner in which producers seek to attain productive efficiency. LO3 Outline how an economy’s production-possibilities frontier is obtained. PART 2: Neoclassical Trade Theory Final PDF to printer CHAPTER 5 INTRODUCTION TO NEOCLASSICAL TRADE THEORY 63 app9062x_ch05_062-083.indd 63 06/17/16 06:13 PM INTRODUCTION The principal changes in trade theory since Ricardo’s time have centered on a fuller devel- opment of the demand side of the analysis and on the development of the production side of the economy in a manner that does not rely on the labor theory of value. To set the stage for this analysis, this chapter presents basic microeconomic concepts and relationships employed in analyzing trade patterns and the gains from trade. This chapter should prepare the reader for the way the tools are employed in trade theory. We first present the theoreti- cal analysis of decision making by consumers as they seek to maximize their satisfaction by proper allocation of their spending among final goods and services. Next, we describe a similar kind of process that occurs when producers allocate expenditures among factors of production in order to maximize efficiency. Finally, the meaning of efficient production in the entire economy is developed. The systematic application of the concepts and relation- ships in the context of international trade begins in the next chapter. THE THEORY OF CONSUMER BEHAVIOR Traditional microeconomic theory begins the analysis of individual consumer decisions through the use of the consumer indifference curve. The originator of the concept of the consumer indifference curve was F. Y. Edgeworth. This curve shows, in an assumed two- commodity world, the various consumption combinations of the two goods that provide the same level of satisfaction to the consumer. A typical indifference curve diagram is shown in Figure 1. Adopting the basic postulate that more of any good is preferred to less, the S1, S2, and S3 curves illustrate different levels of satisfaction, with level S3 being greater than level S2, which in turn is greater than level S1. Economists recognize that it is impossible to measure an individual’s levels of satisfaction precisely; for example, we cannot say that S1 represents 20 units of welfare while S2 represents 35 units of welfare. Such a numbering of the indifference curves would indicate cardinal utility; that is, actual numerical values Consumer Indifference Curves FIGURE 1 Consumer Indifference Curves Good Y y2 y1 x3 x1 S3 x4 Good X S2 S 1 x2 G H F K J y3 0 Indifference curve S1 shows the various combinations of good X and good Y that bring equivalent welfare to the consumer. Curves S2 and S3 represent successively higher levels of welfare. If, from point F, the consumer gives up FK of good Y, he or she must receive amount KG of good X in order to be restored to the welfare level S1. The (negative of the) slope at any point on an indifference curve is called the marginal rate of substitution (MRS). Final PDF to printer 64 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch05_062-083.indd 64 06/17/16 06:13 PM can be attached to levels and changes of welfare. Instead, micro theory uses the concept of ordinal utility, which means that we can say only that welfare or utility on curve S2 is greater than welfare on curve S1. How much greater cannot be determined, but the con- cept of ordinal utility reflects the assumption that a consumer can rank different levels of welfare, even if he or she cannot specify precisely the degree to which welfare is different. It is also important to note that consumers are assumed to have transitivity in their prefer- ences. Transitivity means that if a bundle of goods B2 is preferred (or equal) to a bundle of goods B1 and if a bundle of goods B3 is preferred (or equal) to B2, then bundle B3 must be preferred (or equal) to bundle B1. Given this indifference curve map, it is instructive to focus next on a given curve, S1 (see Figure 1). The definition of the curve indicates that this consumer is indifferent among all points on the curve. Thus, possession of quantity 0x1 of good X and quantity 0y1 of good Y (at point G) brings the same level of satisfaction as does possession of quantity 0x2 of good X and quantity 0y2 of good Y (at point F). Note that point J (on curve S2) is preferred TITANS OF INTERNATIONAL ECONOMICS: FRANCIS YSIDRO EDGEWORTH (1845–1926) F. Y. Edgeworth was born in Edgeworthstown, County Longford, Ireland, on February 8, 1845. He was educated at home by tutors and then entered Trinity College, Dublin, in 1862, where he specialized in the classics. He then went on to Oxford University where he earned the highest distinction in his field. Possessed of a prodigious memory, he supposedly could recite complete books of Homer, Milton, and Virgil. At his final oral examination at Oxford, he is said to have responded to a particularly difficult question by asking, “Shall I answer briefly, or at length?” Subsequently, Edgeworth studied mathematics and law, and he was admitted to the bar. Edgeworth lectured for a number of years on English language and literature at London’s Bedford College. The scholarly Edgeworth used vocabulary seldom heard in con- versational English. The poet Robert Graves (quoted in Creedy, 1986, p. 11) tells the story that when Edgeworth met T. E. Lawrence (Lawrence of Arabia) upon Lawrence’s return from a visit to London, he asked, “Was it very caliginous in the metropolis?” Lawrence replied, “Somewhat caliginous, but not altogether inspissated.” (To save you a trip to the dic- tionary, caliginous means “misty or dim; dark,” and inspis- sated means “thickened; dense.”) In 1891, Edgeworth became professor of political economy at Oxford University. There he remained for the rest of his career. In addition, he served as editor of the prestigious Economic Journal from 1890 to 1911, when he was succeeded by John Maynard Keynes. Edgeworth died at the age of 81 on February 13, 1926. Today students are familiar with Edgeworth through his box diagram (see pages 75–78), sometimes called the Edgeworth-Bowley box diagram, in joint recognition of the contribution of Professor A. L. Bowley. Edgeworth first formulated the concept of the consumer indiffer- ence curve in Mathematical Psychics (1881). His work in microeconomic theory and mathematical economics has been widely recognized, particularly his forceful demon- stration of the application of mathematics to economics. He argued that mathematics can assist “unaided” reason, as is reflected in the following quotation (Mathematical Psychics, p. 3): He that will not verify his conclusions as far as possible by mathematics, as it were bringing the ingots of com- mon sense to be assayed and coined at the mint of the sovereign science, will hardly realise the full value of what he holds, will want a measure of what it will be worth in however slightly altered circumstances, a means of conveying and making it current. Sources: John Creedy, Edgeworth and the Development of Neoclassical Economics (Oxford: Basil Blackwell, 1986), chap. 1; F. Y. Edgeworth, Mathematical Psychics (London: C. Kegan Paul, 1881); John Maynard Keynes, Essays in Biography (London: Macmillan, 1933), part II, chap. 3; Peter Newman, “Francis Ysidro Edgeworth,” in John Eatwell, Murray Milgate, and Peter Newman, eds., The New Palgrave: A Dictionary of Economics, Vol. 2 (London: Macmillan, 1987), pp. 84–98. ● Final PDF to printer CHAPTER 5 INTRODUCTION TO NEOCLASSICAL TRADE THEORY 65 app9062x_ch05_062-083.indd 65 06/17/16 06:13 PM to point F because the consumer has the same amount of good Y at the two points but more of good X (0x4 > 0x2). The consumer is better off at point J than at point F in terms of well-
being. By applying the concept of transitivity, it is also clear that J is preferred to G and H,
because the latter two points provide the same welfare as F.
Another feature of the indifference curve is its shape. First, we know that the curve must
be downward sloping because, since goods are substitutes, less of one good must be compen-
sated with more of the other good to maintain the same satisfaction level. But we can make an
even stronger statement. The indifference curve is not only downward sloping but also convex
to the origin, as are the curves in Figure 1. The reason for this convexity lies in the economic
principle of the diminishing marginal rate of substitution, reflecting the law of diminishing
marginal utility. The marginal rate of substitution (MRS) is the name given to reflect the slope
of the indifference curve. (It is actually the slope, which is negative, multiplied by a minus
sign, which gives a positive number.) In economic theory, the MRS is defined as the quantity
of good Y that must be taken away from a consumer to keep that individual at the same level
of welfare when a specified additional amount of good X is given to the consumer. Along any
indifference curve in Figure 1, successive additional units of X are associated with succes-
sively smaller reductions in Y. This is because each additional unit of X brings less utility than
did the previous unit; likewise, a reduction in the number of units of Y brings a higher utility
for the last unit consumed. Hence, the MRS is diminishing as we move toward consumption
of a greater number of units of good X along any given indifference curve.
The MRS can be expressed in useful economic terms. If we reduce the amount of good
Y consumed, the change in utility (ΔU, where Δ indicates a small change) is equal to the
change in Y (ΔY) multiplied by the marginal utility associated with the amount of Y lost
(MUY), or ΔU = (ΔY) × (MUY). If we offset this loss by giving additional X to the con-
sumer, the change in utility from this additional X is equal to the amount of new X (ΔX)
times the marginal utility associated with that X (MUX). Hence,
(ΔY) × (MUY) + (ΔX) × (MUX) = 0
(ΔY ) × (MUY) = −(ΔX) × (MUX)
−ΔY/ΔX = MUX/MUY
This expression indicates that the (negative of the) slope of the indifference curve equals
the ratio of the marginal utilities of the two goods. Note that we do not need the actual mar-
ginal utilities—for example, 5 units of satisfaction for MUY and 4 units of satisfaction for
MUX—in order to measure the MRS. All that is required is a knowledge of the ratio—for
example, 5/4—of the marginal utilities.
One final property associated with an indifference curve is the obvious one that indiffer-
ence curves cannot intersect for the individual consumer. If they did, then one combination
of X and Y (at the intersection) would yield two different levels of satisfaction, and this
makes no economic sense.
The nonintersecting indifference curves are important to the study of international eco-
nomics, because in Chapter 6, indifference curves will be used to represent welfare not for
an individual consumer but for a country. The community indifference curve (or country
indifference curve) drawn in Figure 2 shows the combinations of goods X and Y that
yield the same level of well-being for the community (or country) as a whole. To obtain
this curve, we do not add together individual consumer indifference curves; economists
do not believe that utilities of different consumers can be compared. Rather, the following
question is answered as we plot the community indifference curve: if a given quantity of
good Y is taken away from the community so that each person’s consumption of good Y is
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FIGURE 2 A Community Indifference Curve
B
Good Y
Good X
A
CI 1
Y
X
A community indifference curve shows the various consumption combinations of good X and good Y that yield
equivalent satisfaction for the “community” or country. Removal of amount ΔY of good Y requires that amount
ΔX of good X be provided to the community in order to yield the original welfare for each person in the com-
munity (at point B) as at starting point A.
reduced in proportion to that person’s share of the country’s total consumption of good Y,
how much of good X must be given to consumers so that each consumer is brought back
to his or her original level of utility? When the total amount of good Y removed from all
consumers (ΔY immediately below point A) is replaced by the total of good X necessary
to bring all consumers back to each consumer’s original utility level (ΔX), we have traced
out the movement from point A to point B. The entire curve CI1 can be plotted when this
exercise is done for each point on the curve.
If consumers differ in their tastes, a crucial point is that a community indifference curve
for one distribution of income in the country can intersect a community indifference curve
for another possible income distribution in the country. In Figure 3, curve CI1 represents
the community indifference curve for a given income distribution, and curve CI′1 is a more
preferred curve for the same income distribution. Community indifference curve CI2 rep-
resents a curve for another income distribution, one in which consumers with less relative
preference for good X have a greater weight in the income distribution. (Curve CI′2 is a less
preferred curve for this second income distribution.) If we start at point A, the removal of
ΔY would require that ΔX be given to consumers in the first income distribution (moving
to A′ on curve CI1) to keep community welfare the same as at point A. However, with the
second income distribution, more of good X (amount ΔX′) must be given to consumers to
compensate for the loss of ΔY (moving consumers to point A″). More of good X must be
provided because it does not bring as much marginal utility as in the first income distribu-
tion; thus, more units of X are needed to offset the loss of Y. In other words, because con-
sumers who have a greater preference for good Y at the margin and a smaller preference for
good X at the margin have a greater proportion of the income in this second distribution,
they require more X to be compensated for a loss of good Y.
What is the point of this discussion? Very simply, suppose that some economic event
moves the country from point A to point B. This event can change the income distribution
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so that curve CI1, for example, is relevant before the event but curve CI′2 is relevant after
the event. What can be said about welfare change for the community? On the basis of the
first income distribution, the community is better off since point B on curve CI′1 is pre-
ferred to point A on curve CI1. However, on the basis of the second income distribution,
the community is worse off, because B on curve CI′2 is inferior to A on curve CI2. Thus,
the possibility that changes in income distribution may alter the community indifference
map must be kept in mind when employing this concept. Although this presents a potential
problem when the community indifference map is employed in the analysis of the impact
of international trade, community indifference curves will be employed in subsequent
chapters assuming that the community indifference map, like those for individuals, does
not change within the period of analysis. Further discussion of the intersecting indifference
curve problem will be presented in subsequent chapters but the point should be clear: the
use of indifference curves to represent community welfare is a more complex phenomenon
than the use of indifference curves to represent welfare for an individual consumer.
FIGURE 3 Intersecting Community Indifference Curves
B
Good Y
Good X
A
Y
X
X
A
A
CI1
CI2 CI 1
CI 2
CI2
CI 2
CI 1CI 1
Curves CI1 and CI′1 are community indifference curves for one distribution of income in the country. If ΔY is
removed from the total of all consumption bundles, then amount ΔX must be provided in order to keep each
consumer at his or her original level of welfare. Curves CI2 and CI′2 represent a second income distribution,
one in which income is distributed more heavily toward consumers who have a higher preference at the margin
for good Y and a lower preference at the margin for good X than in the first income distribution. Hence, when
aggregate amount ΔY is proportionately removed from total consumption, aggregate amount ΔX′ must be
provided to keep all consumers at their initial levels of welfare. In the graph as drawn, point B is preferred to
point A on the basis of the first income distribution, but point A is preferred to point B on the basis of the second
income distribution.
CONCEPT CHECK 1. What is the distinction between cardinal util-
ity and ordinal utility?
2. Why is the marginal rate of substitution along
an indifference curve “diminishing” as more
of the good on the horizontal axis is con-
sumed and less of the good on the vertical
axis is consumed?
3. If consumers differ in their tastes, why
does a change in the income distribution
within a country lead potentially to a differ-
ently shaped community indifference curve,
one that can intersect a community indif-
ference curve reflecting the “old” income
distribution?
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To determine actual consumption on the individual consumer’s indifference curve, we
need to examine the income level of the consumer. The income level is represented by
the budget constraint (or budget line) as shown in Figure 4. This line shows the vari-
ous combinations of goods X and Y that can be purchased with a given level of income
at fixed commodity prices. Income level I1 gives this constraint for one level of income
(say, $500 per week), and income level I2 (say, $600 per week) shows the constraint
for a higher level of income. Consider income level I1. If all income is spent on good
X, then quantity 0x1 (at point B) can be purchased, but none of good Y. Alternatively,
quantity 0y1 (at point A) can be purchased, but there is no income remaining with which
to purchase any X. It is assumed that an infinite number of such combinations could
be selected, and thus a straight line can be drawn connecting all feasible consumption
combinations, given income level I1. Hence, an intermediate position such as point C can
also be attained.
The slope of the budget line can be determined in the following way: If all income were
spent on good X (at point B), then the quantity purchased of X is simply the income I1
divided by the price of good X, that is, 0x1 = I1/PX. Similarly, if all income were spent on
good Y (at point A), the quantity purchased is the income divided by the price of Y, that
is, 0y1 = I1/PY. The slope of the curve as movement occurs from point B to point A is the
change in Y divided by the change in X, or
Slope (or ΔY/ΔX) = (0y1) (−0x1)
= (I1/PY)/(−I1/PX)
= −PX/PY
The (negative of the) slope of the budget line is thus simply the price of X divided by the
price of Y. An increase in the price of X (or a decrease in the price of Y) would yield a
The Budget
Constraint
FIGURE 4 Consumer Budget Constraints
B
Good Y
Good X
A
I1
y2
C
y1
x1x2
I2
0
With income level I1 and fixed commodity prices, the consumer can spend all income on good X (at point B) or
on good Y (at point A) or some income on Y and some on X (such as at point C). Higher income level I2 permits
higher consumption levels. The (negative of the) slope of the budget line is PX/PY.
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steeper budget line, and a decrease in the price of X (or an increase in the price of Y) would
yield a flatter budget line.1
With the concepts of the consumer indifference curve and the budget constraint in mind,
it is a straightforward matter to indicate consumer equilibrium. The objective of the con-
sumer is to maximize satisfaction, subject to the income constraint. Because the individual
indifference curves show (ordinal) levels of satisfaction, and the budget line indicates the
income constraint, the consumer maximizes satisfaction when the budget line just touches
the highest indifference curve attainable. The point of maximum satisfaction with budget
line FG is shown as point E on indifference curve S2 in Figure 5. Clearly, the consumer
would not settle at point B because B is on a lower indifference curve (curve S1), or welfare
level, than point E. Also, although the consumer would like to be at point A (on higher
indifference curve S3), this point is not possible given the income level of the consumer.
If income rises so that the consumer faces budget constraint F′G′, then point A could be
1The slope of the budget line can also be determined through algebraic examination of the consumer’s budget
constraint. If the consumer spends all income on the two goods (no saving takes place), then the expenditures on
good X (the price of X times the quantity of X purchased) plus expenditures on good Y (the price of Y times the
quantity of Y purchased) must equal the consumer’s entire income. Thus,
(PX) (X) + (PY) (Y) = I1
Y = (I1)/(PY) − (PX/PY) (X)
This expression gives the equation of the budget line, with I1/PY as the intercept (point A in Figure  4)
and –(PX/PY) as the slope.
Consumer
Equilibrium
FIGURE 5 Consumer Equilibrium
A
E
B
F
yE
0
F S1
S2 S3
S1
S2
S3
G G Good XxE
Good Y
The consumer maximizes satisfaction for budget constraint FG by settling at point E, at which quantity 0xE of
good X and quantity 0yE of good Y are consumed. Point A on indifference curve S3 is unattainable unless higher
income reflected in budget constraint F′G′ becomes available. Point B would not be chosen with budget con-
straint FG because MUX/MUY is greater than PX/PY at that point and welfare level S1 is lower than welfare level
S2, which can be attained by consuming less of good Y and more of good X.
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PRODUCTION THEORY
Having examined consumer behavior, we now turn to producers. Our focus is not on every
aspect of production—for example, we do not examine the producer’s decision of what
price to charge for a product—but on input choice and production efficiency within the firm.
In considering producer choice of inputs, assume that there are two factors of production,
capital (K) and labor (L), employed in generating output. An isoquant is the concept that
relates output to the factor inputs. An isoquant shows the various combinations of the two
inputs that produce the same level of output; a typical production isoquant is illustrated in
Figure 6. For example, output Q0 (say, 75 units) could be produced with the quantity 0k1 of
capital and the quantity 0l1 of labor (point A). Alternatively, that level of output could be
produced by using 0k2 of capital and 0l2 of labor (point B).
Isoquants
attained and more of both goods could be consumed. (For a look at consumer allocation of
expenditures among various categories of goods in the United States, see page 71.)
It is important to grasp the economic meaning of consumer equilibrium point E in
Figure 5. Because budget line FG is tangent to indifference curve S2 in equilibrium, the
slope of S2 at point E is therefore equal to the slope of budget line FG at point E. Thus, in
consumer equilibrium,
MUX/MUY = PX/PY
or
MUX/PX = MUY/PY
This last expression indicates that, at the margin, the utility obtained from spending $1 on
good X is equal to the utility obtained from spending $1 on good Y. If this were not the
case, the consumer could increase welfare by reallocating purchases from one good to the
other.
For example, consider a position such as point B. The consumer will not wish to remain
at B because
MUX/MUY > PX/PY
or
MUX/PX > MUY/PY
In this situation, the marginal utility obtained from spending the last dollar on good
X exceeds the marginal utility obtained from spending the last dollar on good Y. The
consumer can increase total utility by switching a dollar spent on good Y to good X. The
consumer will continue to reallocate expenditures until this difference in marginal utility
per dollar of the two goods disappears, at point E.
CONCEPT CHECK 1. Suppose that, in Figure 5, the consumer is situ-
ated at the point where indifference curve S1
crosses budget constraint FG just above point G.
Use economic reasoning to explain why the
consumer will move from this point to point E.
2. Students often ask why the (negative of the)
slope of the budget line is PX/PY and not
PY/PX. How would you answer these students?
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IN THE REAL WORLD:
CONSUMER EXPENDITURE PATTERNS IN THE UNITED STATES
The tangencies of consumer indifference curves (reflecting
tastes) with budget lines (reflecting incomes and relative
prices) determine household expenditure patterns. Table  1
indicates the percentages of personal consumption expen-
ditures in the United States devoted to broad categories of
goods and services in 1960, 1980, 2000, and 2014.
These figures show that, as incomes have grown over
time, U.S. families have chosen to devote a somewhat
smaller percentage of their consumption expenditures to
durable goods and a much smaller percentage to nondurable
goods. Particularly important declines in spending shares
occurred in food, clothing and footwear, while recreational
goods and vehicles rose in relative importance. A dramatic
rise in expenditure share has occurred in services, with
66.7  percent of consumer expenditures being devoted to
this category in 2014. Within services, considerable growth
occurred in purchases of health care, where the share rose
from 4.8 percent in 1960 to 16.7 percent in 2014, and the
share spent on financial services and insurance almost
doubled.
Item 1960 1980 2000 2014
Durable goods 13.8% 12.9% 13.4% 10.9%
Motor vehicles and parts 5.9 4.8 5.3 3.8
Furnishings and durable household equipment 4.6 3.9 3.1 2.4
Recreational goods and vehicles 1.9 2.7 3.4 3.0
Nondurable goods 39.6 32.7 22.7 22.3
Food and beverages for off-premises consumption 18.9 13.6 8.0 7.4
Clothing and footwear 7.8 5.9 4.1 3.1
Gasoline and other energy goods 4.8 5.8 2.7 3.3
Services 46.6 54.4 63.9 66.7
Housing and utilities 17.1 17.8 17.6 18.2
Health care 4.8 9.8 13.5 16.7
Transportation services 2.8 3.2 3.9 2.9
Recreation services 2.0 2.3 3.7 3.7
Food services and accommodations 6.2 6.9 6.0 6.3
Financial services and insurance 4.1 5.4 8.3 7.4
Note: Major category totals may not sum to 100 percent because of rounding.
Sources: Economic Report of the President, February 2008 (Washington, DC: U.S.Government Printing Office, 2008), p. 246;
U.S. Department of Commerce, Bureau of Economic Analysis, Survey of Current Business 95, no. 3 (March 2015), National
Income and Product Accounts Table 2.3.5, obtained at www.bea.gov. ●
TABLE 1 U.S. Consumer Expenditure Patterns, 1960–2014
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The exact shape of an isoquant reflects the substitution possibilities between capital and
labor in the production process. Curves Q0, Q1, and Q2 in Figure 6 illustrate how capital
and labor can be relatively easily substituted for each other. If substitution were difficult,
the curve would be drawn more like a right angle. If substitution were easier, the isoquant
would have less curvature. A precise measure of the curvature, and thus of the substitution
possibilities, is the elasticity of substitution (see Chapter 8).
A major feature of isoquants is that they, unlike consumer indifference curves, have car-
dinal properties rather than simply ordinal properties. Thus, in Figure 6, the three isoquants
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represent different absolute levels of output, with isoquants farther from the origin repre-
senting higher levels of output. Clearly, isoquants are downward sloping, but not verti-
cal or horizontal or upward sloping, because reducing usage of one input requires greater
usage of the other to maintain the same level of output. In addition, isoquants cannot inter-
sect. If they could intersect, doing so would mean that, at the intersection point, the same
quantity of capital and labor would be producing two different levels of output. Because
an assumption behind isoquants is that maximum technical or engineering efficiency is
achieved along each curve, an intersection makes no sense.
Finally, consider the slope of the isoquant. Suppose that the producer reduces the
amount of capital used in production and offsets the effect on output by adding labor.
The loss in output from the removal of capital is the change in the amount of capital
employed (ΔK) multiplied by the marginal physical product of that capital (MPPK), or
ΔQ = (ΔK) × (MPPK). The addition to output (ΔQ) from the extra labor is equal to the
amount of that additional labor (ΔL) multiplied by the marginal physical product of that
labor (MPPL), or ΔQ = (ΔL) × (MPPL). Hence, since output remains unchanged after the
substitution of labor for capital:
(ΔK) × (MPPK) + (ΔL) × (MPPL) = 0
(ΔK) × (MPPK) = −(ΔL) × (MPPL)
−ΔK/ΔL = MPPL/MPPK
FIGURE 6 Production Isoquants
B
0
Labor
Capital
A
Q2 = 125 units of output
k1
k2
l1 l2
Q1 = 100 units of output
Q0 = 75 units of output
Q0
Q1
Q2
C
An isoquant shows the various combinations of the two factor inputs that produce the same output. Isoquant Q1
represents a greater amount of output than does isoquant Q0 since, for a given amount of any input, a greater
amount of the other input is being used. Thus, isoquants that are “farther out” from the origin represent greater
quantities of output. By definition, isoquants cannot intersect, since the intersection point would imply that one
combination of inputs is producing two different levels of output. In addition, starting at point A on isoquant
Q0 and moving to point C, the removal of k2k1 of capital will decrease output by the amount of capital removed
(ΔK = k1k2) multiplied by the marginal physical product of capital (MPPK). The subsequent addition of l1l2 of
labor to move to point B will increase output by the amount of labor added (ΔL = l1l2) multiplied by the mar-
ginal physical product of labor (MPPL). Because the output level at B is the same as at A, the (negative of the)
slope of an isoquant (ΔK/ΔL) can be expressed as MPPL /MPPK.
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Because the slope at any point on the isoquant is ΔK/ΔL, this last expression states that
the (negative of the) slope of the isoquant at any point is equal to the ratio of the marginal
productivities of the factors of production (MPPL/MPPK). The ratio of marginal produc-
tivities is often referred to as the marginal rate of technical substitution (MRTS). The
MRTS is defined economically as the amount of capital that must be removed to keep
output constant when one unit of labor is added. Clearly, the MRTS declines as more
labor and less capital are used. This decline reflects the fall of MPPL as we use more labor
and the rise of MPPK as we use less capital (because of the law of diminishing marginal
productivity).
A final point needs to be made about isoquants as they relate to international trade
theory. The assumption usually employed in trade theory is that the production function is
characterized by constant returns to scale. This means that if all the inputs are changed by
a given percentage, then output will change in the same direction by the same percentage.
Thus, in Figure 7, a doubling of the inputs (labor from 20 to 40 units and capital from 10 to
20 units) will double the output (from 100 to 200 units). If increasing returns to scale
existed, then isoquant Q2 would have an output value greater than 200, as the doubling of
the inputs would more than double the output. Analogously, decreasing returns to scale
means that output Q2 would be less than 200 units.
In making the decision of how many units of each factor of production to employ, the firm
must know not only the technical relationship between inputs and output but also the rela-
tive cost of those inputs. The costs of the factors of production are illustrated by isocost
lines. An isocost line shows the various combinations of the factors of production that can
be purchased by the firm for a given total cost at given input prices. Thus, if the given wage
Isocost Lines
FIGURE 7 Isoquants with Constant Returns to Scale
P
P
0
Labor
Capital
Q2 = 200 units of output
Q1 = 100 units of output
20
10
20 40
The term constant returns to scale means that a given percentage increase in all inputs will lead to the same
percentage increase in output. Thus, the doubling of the quantity of inputs used at point P (from 10 to 20 units
of capital and from 20 to 40 units of labor) will mean that, at point P′, twice as much output (200 units) is
obtained as at point P (100 units).
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rate is $10 per hour and the rental rate on machinery is $50 per hour, then a “budget” or
“cost” of $500 per hour means that the firm could hire 25 workers and 5 pieces of machin-
ery. (If machinery is owned rather than rented, there is still an “opportunity cost” equal to
the rental rate on machinery.) Alternatively, the firm could use 8 machines and 10 workers.
Clearly, there are many such possibilities; these possibilities are reflected in an isocost or
budget line, such as line B1 in Figure 8.
Before indicating the optimal choice of how much of each factor to employ, consider the
slope of an isocost line. In Figure 8, if all of budget B1 were spent on capital, then 0k1 units
could be purchased but no labor could be employed (point A). Or 0l1 of labor could be hired
but no capital could be used (point C). If we imagine a movement from point C to point A,
the slope is simply ΔK/ΔL or (0k1)/(–0l1). The distance 0k1 can be restated as the size of
the budget (B1) divided by the rental rate on capital or price of capital (r); the distance 0l1
can be restated as the size of the budget divided by the wage rate (w):
(ΔK)/(ΔL) = (0k1)/(−0l1)
= −(0k1)/(0l1)
= −(B1/r)/(B1/w)
−(ΔK)/(ΔL) = w/r
Thus, the (negative of the) slope of the isocost is equal to the ratio of the wage rate to the
rental rate on capital; and, for this reason, the isocost line is often referred to as the factor
FIGURE 8 Producer Equilibrium
Capital
G
E
H
B1
B2
Q1
Q0
Ak1
C
l1 Labor
0
An isocost line such as B1 shows the combinations of the two inputs that can be purchased by the firm for the
same cost. At point C, quantity 0l1 of labor can be hired but no capital can be employed; at point A, 0k1 of
capital can be used but no labor can be employed. For the budget B1, the firm obtains the most output (Q1)
by producing at point E, where the (negative of the) slope of the isoquant (MPPL /MPPK) is equal to the
(negative of the) slope of the isocost line (w/r). Production at point G obtains less output (Q0) for budget B1
than production at point E. Production at point H provides the same output as production at point E, but at a
higher cost.
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CHAPTER 5 INTRODUCTION TO NEOCLASSICAL TRADE THEORY 75
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price line. A steeper isocost line reflects a rise in the wage rate relative to the rental rate on
capital, while a flatter factor price line indicates the opposite.2
The choice of the combination of factors of production to employ involves consideration of
factor prices and technical factor requirements. Point E in Figure 8 indicates the producer
equilibrium position for a given cost B1. At this point the isoquant is tangent to the iso-
cost, and the firm is obtaining the maximum output for the given cost (i.e., production
efficiency). The firm would not settle at a point like G because this point yields less output
for the given cost than does point E. Alternatively, the producer equilibrium can be viewed
as the point where the given output (Q1) is obtained for the lowest cost. Isocost line B2
(e.g., at point H) also could be used to get Q1 of output, but B2 involves greater cost than B1.
In straightforward economic terms, it is clear why point E would be chosen but point
G would not. Because the isoquant is tangent to the isocost at point E, this means that
MPPL/MPPK = w/r, or that MPPL/w = MPPK/r. In other words, producer equilibrium is
obtained when the marginal productivity of $1 spent on labor is equal to the marginal
productivity of $1 spent on capital. It is clear that point G is not an efficient production
point since MPPL/MPPK is greater than w/r (or MPPL/w is greater than MPPK/r). Thus, the
entrepreneur has an incentive to employ more labor services and fewer capital services—
which decreases MPPL and increases MPPK —and the firm moves down the isocost line
from point G to point E.
2Another way to look at the isocost line is to obtain the equation of the line. The producer’s budget, or amount
spent for the factors of production, is simply the rental rate on capital times the amount of capital used plus the
wage rate times the amount of labor used:
B = rK + wL
rK = B − wL
K = (B/r) − (w/r)L
This equation indicates that the isocost line has a vertical intercept of B/r and a slope of –(w/r).
Producer Equilibrium
CONCEPT CHECK 1. Why are isoquants drawn as convex to the
origin?
2. Briefly explain what happens to the intercepts
and the slope of an isocost line for a given
budget size if the rental rate on capital (r) falls
at the same time that the wage rate (w) rises.
3. If MPPL/MPPK in production of a good is
less than w/r, why is the firm not in producer
equilibrium? Explain how, with a given bud-
get for the firm, output can be increased by
changing input combinations.
THE EDGEWORTH BOX DIAGRAM AND THE PRODUCTION-POSSIBILITIES FRONTIER
From the standpoint of understanding international trade theory, two other concepts need
to be introduced in this chapter. Both concepts look at the entire economy, not simply indi-
vidual consumers and producers.
This diagram is useful for discussion of a number of economic concepts and relationships.
It will be used in this book to study efficient economywide production. (It can also be
used to discuss economywide consumption.) Construction of a typical Edgeworth box
diagram begins by considering firms in two separate industries, industry X and industry Y
The Edgeworth Box
Diagram
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(see Figure 9). Part (a) shows the isoquants for firms in industry X, and part (b) shows the
isoquants for firms in industry Y. Because ray 0X A is flatter than ray 0Y B, the X industry
is the more labor-intensive industry and the Y industry is the more capital-intensive indus-
try.3 It should be remembered that, in a competitive economy with factor mobility between
industries, the relative factor prices (w/r)1 facing the two industries will be identical.
The Edgeworth box diagram takes the isoquants of these two industries (assumed to be
the only two industries in the economy) and puts them into one diagram as in Figure 10.
The isoquants of industry X are positioned as in part (a) of Figure  9. However, the Y
isoquants of part (b) of Figure 9 are positioned differently in Figure 10. The origin for
the Y industry, 0Y, is positioned so that increased use of capital is indicated by downward
movements from 0Y and increased use of labor is indicated by leftward movements from
0Y. Hence, from 0Y, increased output of the Y industry is indicated by moving to isoquants
that are further downward and to the left of 0Y. An important feature of the Edgeworth
box diagram is that its dimensions measure the total labor and total capital available in
the economy as a whole. Thus, horizontal distance 0XF and horizontal distance 0YG each
indicate the total labor available, while vertical distance 0XG and vertical distance 0YF each
measure the total capital available. The total labor and the total capital in the economy will
be divided between the two industries.
The economy can produce at any point within the confines of the Edgeworth box.
However, some points of production are better (i.e., yield more total output) than other
points. The points of “best” production are those where isoquants of the two industries are
3The slope of a ray from the origin to the production point for any industry gives the ratio of capital to labor (K/L)
used in the industry. A steeper ray implies a greater K/L and thus greater capital intensity. Fuller discussion of
relative factor intensity is provided in Chapter 8.
FIGURE 9 Isoquants for Two Industries with Different Factor Intensities
Labor
Capital Capital
Labor
0X 0Y
B1
B2
X2
X1
B
A
Y2
Y1
b1
b2Factor
prices
(w/r ) 1
(a) (b)
Factor
prices
(w/r ) 1
The X industry in panel (a) and the Y industry in panel (b) both face factor prices (w/r)1, as indicated by the (negative of the) slope of the isocost
lines. In producer equilibrium the X industry employs, for the given factor prices, a ratio of capital to labor (reflected by the slope of the ray 0XA)
that is lower than the ratio of capital to labor employed in the Y industry (reflected by the slope of the ray 0YB). The X industry is designated as
the relatively labor-intensive industry and the Y industry is designated as the relatively capital-intensive industry.
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CHAPTER 5 INTRODUCTION TO NEOCLASSICAL TRADE THEORY 77
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tangent, such as point Q (isoquants x1 and y5) or point R (isoquants x2 and y4). The line con-
necting these points of tangency is called the production efficiency locus, or the “contract
curve.” It is evident that this efficiency locus runs from 0X through Q, R, S, T, W to 0Y. At
any given point on the locus, MPPL/MPPK is identical in both industries (and equal to w/r
if the economy chooses to produce at that particular point).
Why do efficiency locus points represent the points of best production? To illustrate,
consider point V off the locus. At V, the X industry is producing quantity x3 of output and
is using quantity 0Xl1 of labor and 0Xk1 of capital. The Y industry is producing y1 of output
and is using 0Yl2 (= l1F) of labor and 0Yk2 (= k1G) of capital. Note also that the labor used in
the two industries adds up to the total labor available in the economy because 0Xl1 + 0Yl2 =
0Xl1 + l1F = 0XF (or = l2G + 0Yl2 = 0YG). By similar analysis, the sum of the capital used
in the two industries is the total capital available in the economy.
But consider point S, which is on the efficiency locus. This production point yields x3 of
X output, the same as point V because the two points are on the same isoquant. However,
point S yields y3 of Y output, which is greater than the Y output at point V because S is on
a Y isoquant with greater production. Hence, point S is a superior point to V because S has
the same amount of X output but a larger amount of Y output. From point V, point S could
be reached by shifting l4l2 (= l1l3) of labor from Y production to X production and shifting
k3k1 (= k2k4) of capital from X production to Y production. These shifts move labor out of
the capital-intensive industry into the labor-intensive industry, and they move capital out
of the labor-intensive industry into the capital-intensive industry. By a similar argument,
point W is superior to point M because W has the same Y output as M but more X output.
FIGURE 10 The Edgeworth Box Diagram and Economywide Production Efficiency
G Labor I2 I4 0Y
k2
k4
Capital
Production
efficiency
locus
FI1 I30X
k1
k3
y1
x3
V
Q
R
S
T
W
y5
x1
y4
x2
y3
y2
M
x4
x5
Labor
Capital
The production efficiency locus 0X QRSTW 0Y shows points where more of one good can be produced only by
producing less of the other good. If the economy is off the efficiency locus (such as at point V), more output
can be obtained of at least one good with no less output of the other good by moving to the efficiency locus (as
to point S). Alternatively, more output can be obtained of both goods (as in moving from point V to point T) by
producing on the efficiency locus.
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Finally, a point such as T has greater X output and greater Y output than either points V
or M. The important conclusion is that, for each point not on the efficiency locus, some
point on the efficiency locus involves greater production of at least one good and no less
production of the other good.
What comparisons can be made of points along the production efficiency locus itself?
From the production standpoint alone, no judgments can be made about the relative desir-
ability of these points because movement from one point to another leads to greater output
of one good and less output of the other. Thus, for example, point S has more Y output but
less X output than point W. Only when demand in the economy is brought into the analy-
sis (see Chapter 6) can we indicate the relative desirability of points along the locus and
the output combination that will actually be chosen. Nevertheless, we can conclude that
points off the locus are inefficient for the economy as a whole because any such point can
be improved upon by moving to the production efficiency locus. Points on the locus are
efficient, because moving along the locus requires giving up output of one good in order
to get more output of the other good. The economist’s term for this trade-off characterizing
the efficiency locus is called Pareto efficiency, after Vilfredo Pareto (1848–1923).
A typical production-possibilities frontier (PPF) is drawn in Figure  11. Unlike the PPF
used by the Classical economists, however, this PPF demonstrates increasing opportunity
costs. If the economy is located at point A, it is producing 0x1 of the X good and 0y4 of
the Y good. If movement takes place to point B, then x1x2 of the X good is being added,
but y3y4 of Y is being given up. If we add an additional amount of X, x2x3, which is equal
to x1x2, the amount y2y3 of the Y good must be forgone. Increasing amounts of Y must be
The Production-
Possibilities Frontier
FIGURE 11 Increasing Opportunity Costs on the PPF
x3x1 x2 x4 Good X
Good Y
y1
y2
y3
y4
B
A
C
D
0
As production is shifted from point A to point B, the additional x1x2 of output of good X requires that output of
good Y be reduced by amount y3y4. For a subsequent move from point B to point C, additional good X output of
x2x3 (which is equal to x1x2) requires that amount y2y3 of good Y, which is greater than y3y4, be given up. Thus,
the opportunity cost of getting more X rises as more X is produced. This conclusion holds for any movement
along the PPF. Similarly, moving in the direction of greater output of good Y requires that increasing amounts
of good X be given up for each additional unit of Y output.
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given up in order to get the same additional amount of X because y1y2 > y2y3 > y3y4, and so
on. Similarly, if the economy moves in the other direction (say, from point D), increasing
opportunity costs occur because giving up equal amounts of good X (e.g., x3x4, then x2x3,
then x1x2) yields smaller increments of good Y (y1y2, then y2y3, then y3y4). With increasing
opportunity costs, the shape of the PPF is thus concave to the origin or bowed out, as shown
in Figure 11.
The formal name for the (negative of the) slope of the PPF is the marginal rate of
transformation (MRT), which reflects the change in Y (ΔY) associated with a change
in X (ΔX). Because the slope itself (ΔY/ΔX) is negative, the negative of the slope or
–ΔY/ΔX is a positive number (the MRT). It can be shown mathematically [which we will
not do here, thankfully for you (?)] that MRT = MCX/MCY, or the ratio of the marginal
costs in the two industries. Because firms incur rising marginal costs when they expand
output, movement toward more X production means that MCX will rise; similarly, as less
Y production is undertaken, MCY will fall. As more X and less Y production is undertaken,
the ratio MCX/MCY will rise. In other words, the PPF gets steeper as we produce relatively
more X.
There are several other ways to explain the concave shape of the PPF. One of the early
explanations (given by Gottfried Haberler in 1936) involved “specific factors” of produc-
tion. Suppose we move from point D to point C in Figure  11. In Haberler’s view, the
factors of production in the X industry that will move into Y production are the more
mobile and adaptable factors. Their adaptability enables them to contribute a good deal
to Y output. As we continue to shift resources from X to Y (e.g., from C to B), however,
the factors being shifted are less adaptable. They contribute less to Y production than the
previous factors. It is evident that the additional output of Y attained for given reductions
in X output is declining. Thus, increasing opportunity costs are occurring.
Another way to explain the shape of the PPF has been offered by Paul Samuelson (1949,
pp. 183–87). Suppose that each industry is characterized by constant returns to scale; sup-
pose, too, that the industries have different factor intensities: the X industry is relatively
labor intensive and the Y industry is relatively capital intensive. Then, in Figure 12, assume
that all factors (only capital and labor in this discussion) are devoted to Y production, so
that the economy is located at point R and is producing 0y1 of good Y and none of good
X. Now assume that one-half of the economy’s labor and capital are removed from Y pro-
duction and devoted to X production. Where would the economy then be situated? With
constant returns to scale, Y production will be cut in half because one-half the factors have
been removed, and X production will reach one-half of its maximum amount. Thus, the
economy will be located at point M, where 0x1/2 and 0y1/2 are being produced. If various
proportions of the factors were switched in this fashion, the straight line RMQ would be
traced. However, as Samuelson has indicated, this switching of factors in proportionate
fashion from one industry to the other does not make economic sense (the technical term
for this is “dumb”). Because X is the labor-intensive industry and Y is the capital-intensive
industry, it makes more sense to switch relatively more labor from Y to X and relatively
less capital. The industries will then be using factors in greater correspondence with their
optimum requirements than in the equiproportional switching strategy, and the economy
can do better than straight line RMQ. Thus, the PPF will be outside RMQ except at end-
points R and Q, and the concave line connecting R and Q is the PPF, which clearly has
increasing opportunity costs.
Finally, a useful way to look at the PPF and its slope is to examine the relationship
between the PPF and the Edgeworth box diagram, because the Edgeworth box dia-
gram is the analytical source of the PPF. To demonstrate this point, consider Figure 13.
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The  Edgeworth box in panel (a) has the properties discussed earlier, while panel (b) shows
an increasing-cost PPF.
In the Edgeworth box, suppose that production is taking place at the X industry origin,
also labeled as point R′. At this point, maximum Y production and zero X production are
occurring. We can thus transfer this point R′ onto Figure 13(b) as point R, with 0y7 of good
Y and none of good X being produced. Similarly, point Q′ in the box (with maximum X
production and zero Y production) translates in Figure 13(b) as point Q, with 0x4 of good
X and none of good Y being produced. To facilitate the discussion, we have placed illustra-
tive output numbers on the axes of the PPF diagram in Figure 13(b).
What about points where some production of both goods occurs? Keeping in mind
the assumption of constant returns to scale, move along the diagonal of the box. If M′ is
midway along the diagonal between R′ and Q′, then one-half of the economy’s capital and
one-half of the economy’s labor is devoted to each industry. Thus, isoquant x2 is one-half
the output level of isoquant x4, and isoquant y3 is one-half the output level of isoquant y7.
Point M′ in the Edgeworth box is then plotted as point M in Figure 13(b). Further, suppose
that point T′ in the box involves one-quarter of the economy’s labor and capital being used
in the X industry and three-quarters in the Y industry. Point T′ will then be plotted as point
T in panel (b), where 0x1 is one-quarter of 0x4 and 0y5 is three-quarters of 0y7. A similar
analysis yields point W in panel (b) if point W′ in the box in panel (a) represents employ-
ment of three-quarters of the economy’s labor and capital in the X industry and one- quarter
of the economy’s labor and capital in the Y industry. Hence, the dashed line RTMWQ in
panel (b) represents the plotting of the diagonal R′T′M′W′Q′ in panel (a). Clearly, any
FIGURE 12 An Increasing-Opportunity-Cost PPF with Constant Returns to Scale
x1
2
x1
Labor-intensive good X
Capital-intensive
good Y
y1
0
R
M
Q
y1
2
If all capital and all labor are devoted to the production of capital-intensive good Y, production in the economy
occurs at point R. With constant returns to scale, allocation of one-half of each factor to X production and one-
half of each factor to Y production yields production point M, where one-half the maximum output of each
good is produced. Other proportionate allocations of the factors would trace the straight line RMQ. However, if
relatively more of the labor supply is allocated to production of labor-intensive good X and relatively more of
the capital stock is allocated to capital-intensive good Y, the economy can produce on the concave line connect-
ing R and Q. That is, it can produce combinations of output that are superior to those on straight line RMQ.
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point in the Edgeworth box—not only those on the diagonal—has a corresponding point
in panel (b).
However, the PPF indicates the best that the economy can do in terms of production
of the two goods. Does RTMWQ in panel (b) represent maximum production points?
Certainly not. As you recall, maximum production points in the Edgeworth box are located
FIGURE 13 The Edgeworth Box and the Production-Possibilities Frontier
As discussed in the text, any point in the Edgeworth box diagram of panel (a) translates to a particular point in
the production-possibilities diagram in panel (b). If production moves along the diagonal R′T′M′W′Q′ in panel
(a), these output combinations follow straight line RTMWQ in panel (b). Points on the production efficiency
locus R′S′V′N′Q′ in panel (a) translate to the production-possibilities frontier RSVNQ in panel (b).
y 7 R
Labor
Labor
Capital
0X
Capital
T’
M’
W’
N
V
S
y 6
y 5
x1
y 4
y 3
x2
y 2
y 1
x3
x4
(a)
Q
0Y
x3x1 x2 x4 Good X
Good Y
y4
y5
y6
y7
S
R
V
N
0
y1
y2
y3
Q
(50) (1 00) (1 50) (200)
(400)
(330)
(300)
(240)
(200)
(1 30)
(1 00)
T
M
W
(b)
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on the production efficiency locus. Hence, plotting these production efficiency points in
panel (b) will generate the PPF; any point on the efficiency locus will be on the PPF, and
any point on the PPF must necessarily have been derived from a point on the production
efficiency locus.
To demonstrate that points on the efficiency locus are maximum production points,
consider points T′, M′, and W′ on the Edgeworth diagonal in Figure 13(a) and their analogs
T, M, and W in Figure 13(b). Point T′ is associated with 0x1 of good X (50X) and 0y5 of
good Y (300Y). However, the isoquants indicate that we can get more Y output by moving
to isoquant y6 and still maintain the same amount of X output. Thus, we can move to point
S′ in the box to get the most Y output compatible with 0x1 of X output. Point S′ translates
into point S on the PPF (50X, 330Y). An identical procedure can be done with points M′
and V′ in the box, as well as with points W′ and N′. Hence, the maximum production points
on the efficiency locus in Figure 13(a) are all represented in Figure 13(b) as points on the
PPF, which shows maximum production combinations for the economy.4
Finally, remember that on the production efficiency locus, increases in output of one
good require that output of the other good be decreased. This same property is also appli-
cable to the PPF due to its construction from the efficiency locus. On the PPF, increases in
the output of one good must involve decreases in the output of the other. This is not true,
however, for points inside the PPF (i.e., off the production efficiency locus). On the PPF,
all resources are fully employed and are utilized in their most efficient manner given the
technology reflected in the isoquants. In addition, the shape and position of the PPF will
also reflect the endowments of labor and capital in the economy.
4Note that if the production efficiency locus is the diagonal, then the accompanying production-possibilities
frontier will exhibit constant opportunity costs; that is, it will be a straight line. When this happens, both goods
have the same capital/labor ratio throughout the production range, meaning that the two industries cannot be
distinguished by relative factor intensity.
SUMMARY
This chapter has reviewed and developed basic tools of micro-
economic analysis that will be used in international trade theory
in later chapters. In micro theory, individual consumers are
interested in maximizing satisfaction subject to their budget
constraints, and the indifference curve–budget line analysis sets
forth the principles involved in this maximization. Individual
firms are interested in the most efficient use of production
inputs (i.e., in obtaining the maximum output for a given cost),
and the isoquant-isocost analysis provides basic principles
for realizing this efficient production. Finally, examination of
economic efficiency from the standpoint of the economy as a
whole was undertaken through development of the Edgeworth
box diagram and the production-possibilities frontier. All the
analytical material of this chapter will be employed in our pre-
sentation of international trade theory. The next chapter begins
this application of the tools.
CONCEPT CHECK 1. Why do points on the production efficiency
locus in the Edgeworth box diagram show
“production efficiency” in the economy?
2. If a production combination in a country’s
production-possibilities diagram is inside the
production-possibilities frontier, can the coun-
try be producing on its production efficiency
locus in the Edgeworth box diagram? Why or
why not?
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QUESTIONS AND PROBLEMS
1. Suppose that, from an initial consumer equilibrium posi-
tion, the price of one good falls while the price of the other
good remains the same. Using indifference curve analysis,
explain how and why the consumer’s relative consumption
of the two goods will change.
2. Explain why a change in the distribution of income in a
country can change the shapes of the community indiffer-
ence curves for the country.
3. If the MPPL/MPPK in the production of a good is less than
w/r, why is the producer not in producer equilibrium? Explain
how, with no change in budget size for the firm and with the
given factor price ratio, output of the firm can be increased.
4. Suppose that, from an initial producer equilibrium posi-
tion, the rental rate of capital rises and the wage rate of
labor falls. Can it be determined unambiguously whether
the quantity of output of the firm will rise or fall as a result
of this change in relative factor prices? Why or why not?
5. Suppose that a firm has a budget of $30,000, that the wage
rate is $10 per hour, and that the rental rate of capital is
$100 per hour. If the wage rate increases to $15 per hour
and the rental rate of capital rises to $120 per hour, what
happens to the producer budget or isocost line? What will
happen to the equilibrium level of output because of this
change in factor prices? What will happen to the relative
usage of labor and capital because of the change in factor
prices? Explain.
6. If the production efficiency locus in the Edgeworth box
diagram were the diagonal of the box, what would be the
shape of the production-possibilities frontier, assuming
constant returns to scale in both industries?
7. Evaluate the statement: If a country’s production- possibilities
frontier demonstrates increasing opportunity costs, this
means that each of the industries within the country must be
operating in a context of decreasing returns to scale.
8. In Figure 13, as one moves from S′ to V′, is the country
producing more or less of the capital-intensive good and
less or more of the labor-intensive good? What should hap-
pen to the demand for labor and the demand for capital as
this movement takes place? What will happen to relative
factor prices? Will the slope of the isoquants at the point of
tangency on the contract curve be the same at V′ as it was
at S′? Why or why not?
9. Suppose that the country experiences an increase in its
capital stock. How would the Edgeworth box change? How
would the production-possibilities frontier change as a
result? Could the country now obtain more of both goods
than before the increase in capital stock or more of only the
capital-intensive good? Explain.
10. Suppose that the price or rental rate of capital rises. Explain
how producers would respond, using the isocost/isoquant
framework. What would happen to the capital/labor ratio in
production?
KEY TERMS
budget constraint
(or budget line)
cardinal utility
community indifference curve (or
country indifference curve)
constant returns to scale
consumer equilibrium
consumer indifference curve
decreasing returns to scale
diminishing marginal rate of
substitution
Edgeworth box diagram
increasing opportunity costs
increasing returns to scale
isocost line
isoquant
marginal rate of technical
substitution (MRTS)
marginal rate of transformation
(MRT)
ordinal utility
Pareto efficiency
producer equilibrium
production efficiency locus
transitivity
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CHAPTER
6 GAINS FROM TRADE IN NEOCLASSICAL THEORY
LEARNING OBJECTIVES
LO1 Describe economic equilibrium in a country that has no trade.
LO2 Discover the welfare-enhancing impact of opening a country to
international trade.
LO3 Demonstrate that either supply differences or demand differences
between countries are sufficient to generate a basis for trade.
LO4 Discuss the implications of key assumptions in the neoclassical trade
model.
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INTRODUCTION
In 1999, economist Howard J. Wall of the Federal Reserve Bank of St. Louis investigated the extent
to which trade barriers restricted U.S. trade and the size of the welfare costs of U.S. interferences
with free trade.1 He focused his attention on U.S. trade with countries other than Mexico and
Canada since the United States had been removing barriers to trade with those countries due to the
start of the North American Free Trade Agreement (NAFTA) in 1994. Wall indicated that the
United States imported $723.2 billion of goods from non-NAFTA countries in 1996, but it would
have had imports that were $111.6 billion greater than that if there had been no U.S. import
restrictions. Hence, U.S. imports would have been 15.4 percent larger ($111.6  billion  ÷
$723.2  billion = 15.4%) but for the restrictions. He also calculated that U.S. exports to non-NAFTA
countries, which were $498.8 billion in 1996, would have been $130.4 billion or more than
26 percent larger ($130.4  billion ÷ $498.8 billion = 26.1%) if foreign countries had not had barriers
to U.S. exports. Hence, interferences with free trade substantially reduced the amount of U.S. trade.
Wall then calculated that the reduction in U.S. imports imposed a welfare cost on the United States
of $97.3 billion in 1996 (equivalent to $146.8 billion in 2014), which was 1.4 percent of U.S. gross
domestic product at the time. Although he was unable to estimate the welfare cost of the restrictions
on U.S. exports, it is nevertheless clear that sizeable welfare losses in general can occur because of
interferences with free trade.
In this chapter we use the microeconomic tools developed in Chapter 5 to present the basic
case for participating in trade and thus for avoiding these welfare costs of trade restric-
tions. This case is essentially an updating of the Ricardian analysis to include increasing
opportunity costs, factors of production besides labor, and explicit demand considerations.
We first describe the autarky position of any given country in the neoclassical theoretical
framework, then explain why it is advantageous for the country to move from autarky to
trade, and finally discuss qualifications that can be made to the analysis. Comprehending
the nature of the gains from trade in this more general framework should provide an intui-
tive understanding of the welfare costs that result from the imposition of trade restrictions.
AUTARKY EQUILIBRIUM
To the economist, autarky means total absence of participation in international trade.
In this situation, as well as one with trade, the economy is assumed to be seeking to
maximize its well-being through the behavior of its economic agents. Crucial assumptions
made throughout this chapter include the following: (1) Consumers seek to maximize
satisfaction, (2) suppliers of factor services and firms seek to maximize their return from
productive activity, (3) there is mobility of factors within the country but not interna-
tionally, (4) there are no transportation costs or policy barriers to trade, and (5) perfect
competition exists.
In autarky, as in trade, production takes place on the production-possibilities frontier
(PPF). The particular point at which producers operate on the PPF is chosen by considering
their costs of inputs relative to the prices of goods they could produce. Producer equilib-
rium on the PPF is illustrated in Figure 1. The equilibrium is at point E, where the PPF is
tangent to the price line for the two goods.
Why is point E the equilibrium point? You will remember from Chapter 5 that the
(negative of the) slope of the budget line or relative price line for goods X and Y is PX /PY.
The Effects of
Restrictions on U.S.
Trade
1Howard J. Wall, “Using the Gravity Model to Estimate the Costs of Protection,” Federal Reserve Bank of
St. Louis Review, January/February 1999, pp. 33–40.
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It was also pointed out that the (negative of the) slope of the PPF is the marginal rate of
transformation (MRT) of the goods, which in turn is equal to the ratio of the marginal costs
of production in the two industries, MCX/MCY. Thus, in production equilibrium on the PPF,
PX/PY = MRT = MCX /MCY. Alternatively, PX /MCX = PY/MCY, which indicates that, at
point E, producers have no incentive to change production because the price received in the
market for each good relative to the marginal cost of producing that good is the same. Only
if these price/cost ratios were different would there be an incentive to switch production.
(Remember also that with perfect competition, price equals marginal cost in equilibrium.)
Suppose that the economy is not at point E, but at point A (again, see Figure 1). Would
this be an equilibrium point for the economy? Clearly not. At point A, because the given
price line is steeper than the PPF, PX /PY > MCX /MCY or, restating, PX /MCX > PY /MCY.
Hence, point A cannot be an equilibrium production position for the economy because the
price of good X relative to its marginal cost exceeds the price of good Y relative to its mar-
ginal cost. Producers have an incentive to produce more X and less Y because X production
is relatively more profitable at the margin than Y production. As resources consequently
move from Y to X, the economy slides down the PPF toward point E, and it will continue
to move toward more X production and less Y production until point E is attained. As
the movement from A to E takes place, the expanded X production raises MCX and the
reduced Y production lowers MCY. Therefore, the ratio PX/MCX is falling and the ratio
PY/MCY is rising; because PX /MCX was originally greater than PY /MCY—at point A—this
means that the two ratios are converging toward each other. They will continue to converge
until point E is reached, where PX/MCX = PY/MCY. Movement to E would also occur from
point B, where PX/PY < MCX/MCY. Next, consumers are brought into the picture and the economy is portrayed in autarky equilibrium at point E in Figure 2. The attainment of this point is the result of the country attempting to reach its highest possible level of well-being, given the production constraint FIGURE 1 Producer Equilibrium in Autarky E B A Good Y Good X (PX /PY) Production equilibrium in autarky is at point E, where the domestic price line is tangent to the PPF. At point E, PX/PY = MCX/MCY and there is thus no incentive for producers to alter production. At point A, however, PX/PY > MCX/MCY, and at point B, PX/PY < MCX/MCY, indicating that greater profits can be obtained in both instances by moving to point E. Final PDF to printer CHAPTER 6 GAINS FROM TRADE IN NEOCLASSICAL THEORY 87 app9062x_ch06_084-099.indd 87 05/06/16 01:34 PM of the PPF. Note that the resulting price line is tangent not only to the PPF but also to the (community) indifference curve CI1. The tangency between an indifference curve and the price line reflects the fact that the relative price ratio PX/PY is equal to the ratio of marginal utilities MUX/MUY, which in turn is defined as the marginal rate of substitution (MRS). Thus, in autarky equilibrium for the economy as a whole, MRT = MCX/MCY = PX/PY = MUX/MUY = MRS With equilibrium at point E and given prices PX/PY, production of good X is 0x1 and production of good Y is 0y1. Note that equilibrium consumption under autarky is also 0x1 of good X and 0y1 of good Y. Without trade, production of each good in a country must equal the consumption of that good because none of the good is exported or imported. If the good were exported, then home production of the good would exceed home consumption because some of the production is being sent out of the country. If the good were imported, then home consumption would exceed home production because some of the consumption demand is met from production in other countries. INTRODUCTION OF INTERNATIONAL TRADE Suppose international trade opportunities are introduced into this autarkic situation. The most important feature to keep in mind is that the opening of a country to international trade means exposing the country to a new set of relative prices. When these different prices are available, the home country’s producers and consumers will adjust to them by reallocating their production and consumption patterns. This reallocation leads to gains from trade. The ultimate source of gain from international trade is the difference in relative prices in autarky between countries. FIGURE 2 General Equilibrium in Autarky E Good Y Good X y1 CI0 CI1 x1 0 PX/PY The autarky equilibrium for a country, taking account of both supply and demand, is at point E. At that point, the country is on the highest community indifference curve possible, given production constraints described by the PPF. Neither producers nor consumers can improve their situation, because, at point E, MUX/MUY =  PX/PY = MCX/MCY. Final PDF to printer 88 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch06_084-099.indd 88 05/06/16 01:34 PM The reallocation of production and consumption and the gains from trade are illus- trated in Figure 3. (This figure will be used extensively in this book, so it is important to understand it now.) Under autarky the optimal point for the economy is at E, producing and consuming 0x1 of the X good and 0y1 of the Y good. The welfare level is indicated by indifference curve CI1, and prices in autarky are (PX/PY)1. Suppose that the country now faces international prices of (PX/PY)2. This new set of prices is steeper than the prices in autarky, reflecting the assumption that relative prices in the home market are lower for X and higher for Y than in the international market. Thus, the home country has a com- parative advantage in good X and a comparative disadvantage in good Y. The difference between relative prices in the home country and the set of international prices indicates that the home country is relatively more efficient in producing X and relatively less effi- cient in producing Y. With producers now facing a relatively higher price of X in the world market than in autarky, they will want to shift production toward X and away from Y because they anticipate greater profitability in X production. Thus, production will move from point E to point E′. The stimulus for increasing X production and decreasing Y production is that the new relative price ratio (PX/PY)2 exceeds the ratio MCX/MCY at E and will continue to exceed MCX/MCY until equality between relative prices and relative marginal costs is restored at point E′. At E′, production of good X has risen from 0x1 to 0x2, and production of good Y has fallen from 0y1 to 0y2. FIGURE 3 Single (Home) Country Gains from Trade CI2 E F C Good Y Good X y3 x1 0 E y1 y2 x3 x2 CI1 (PX /PY )2 (PX /PY ) 1 In autarky, the home country is in equilibrium at point E. With the opening of trade, it now faces the interna- tional terms of trade, (PX/PY)2. Given the relatively higher international price of the X good, production moves to E′, the point of tangency between the international terms of trade and the PPF. At the same time, the Y good is relatively less expensive at international prices, so consumers increase their relative consumption of it and begin consuming at point C′, where the terms of trade are tangent to the highest community indifference curve attainable. C′ lies outside the PPF and is obtained by exporting the amount x3x2 of the X good and exchanging it for y2y3 imports of the Y good. The country is clearly better off because trade permits it to consume on the higher indifference curve CI2. Final PDF to printer CHAPTER 6 GAINS FROM TRADE IN NEOCLASSICAL THEORY 89 app9062x_ch06_084-099.indd 89 05/06/16 01:34 PM Thus, production in the home country will move to point E′. What about the country’s consumption? In tracing consumption geometrically, the key point is that the relative price line tangent at E′ is also the country’s trading line, or consumption-possibilities frontier (CPF). With production at E′, the country can exchange units of good X for units of good Y at the new prevailing prices, (PX /PY)2. Thus, the country can settle anywhere on this line by exchanging some of its X production for good Y in the world market. Consumer theory tells us that consumers will choose a consumption point where an indifference curve is tangent to the relevant price line. With trade, this point is C′ in Figure 3. The well-being of the country’s consumers is maximized at C′, and the consumption quantities are 0x3 of good X and 0y3 of good Y. Thus, with trade and the new relative prices, production and consumption adjust until MRT = MCX /MCY = (PX /PY)2 = MUX /MUY = MRS. Note that point C′ is beyond the PPF. Like the Classical model discussed in Chapter 3, international trade permits consumers to consume a bundle that lies beyond the production capabilities of their own country. Without trade, consumption possibilities were confined to the PPF, and the PPF was also the CPF. With trade, the CPF differs from the PPF and permits consumption combinations that simply cannot be reached by domestic production alone. The CPF is represented by the given international price line, since the home country could choose to settle at any point along this line. Access to the new CPF can benefit the country because consumption possibilities can be attained that previously were not pos- sible. The gains from trade in Figure 3 are reflected in the fact that the new CPF allows the country to reach a higher community indifference curve, CI2. Trade has thus enabled the country to attain a higher level of welfare than was possible under autarky. The trade itself also is evident in Figure 3. Because production of good X is 0x2 and consumption of good X is 0x3, the difference between these two quantities, x3x2, represents the exports of good X by this country. Similarly, because 0y2 is production of good Y and 0y3 is consumption of good Y, the difference between these two quantities, y2y3, measures the imports of good Y by the country. Further, the trade pattern is sum- marized conveniently in the trade triangle FC′E′. This triangle for the home country has the following economic interpretation: (a) The base of this right triangle (distance FE′) represents the exports of the country, because FE′ = x3x2; (b) the height or vertical side of the triangle (distance FC′) represents the imports of the country, because FC′ = y2y3; and (c) the hypotenuse C′E′ of the triangle represents the trading line, and (the negative of) its slope indicates the world price ratio or terms of trade. As discussed, the home country has gained from trade. Economists sometimes divide the total gains from trade into two conceptually distinct parts—the consumption gain (or gains from exchange) and the production gain (or gains from specialization). The consumption gain from trade refers to the fact that the exposure to new relative prices, even without changes in production, enhances the welfare of the country. This gain can be seen in Figure  4, where points E, E′, and C′ are analogous to E, E′, and C′ in Figure  3, as are the autarky prices (PX/PY)1 and the trading prices (PX /PY)2. When the country has no international trade, it is located at point E. Now suppose that the country is introduced to the trading prices (PX /PY)2 but that, for the moment, production does not change from point E. A line representing the new price ratio is then drawn through point E; production remains at E, and the new, steep price line with slope (PX/PY)2 is the trading line. With this trading line, consumers can do better than at point E, so they move to a tangency between the new prices and an indifference curve. If consumers remained at E, the price of good X divided by the price of good Y would be greater than the marginal utility of good X divided by the marginal utility of good Y. In other words, the marginal utility of good Y The Consumption and Production Gains from Trade Final PDF to printer 90 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch06_084-099.indd 90 05/06/16 01:34 PM per dollar spent on Y would exceed the marginal utility of good X per dollar spent on X. The consumers would hence change their consumption bundle toward consuming more of good Y and less of good X. Maximizing welfare with this production constraint thus places consumers at point C. Because point C is on a community indifference curve (CI′1) that is higher than the community indifference curve (CI1) in autarky, the country has gained from trade even though production has not changed. The gain reflects the fact that, with new prices, consumers are switching to greater consumption of import good Y, now priced lower, and away from export good X, now priced higher. Thus, even if a country has an absolutely rigid production structure where no factors of production could move between industries, there are still gains from trade. A further welfare gain occurs because production changes rather than remains fixed at E in Figure 4. With the new relative prices, there is an incentive to produce more of good X and less of good Y since X is now relatively more profitable to produce than is Y, and the production switch from E to E′ is in accordance with comparative advantage. Moving production toward the comparative-advantage good thus increases welfare, permitting con- sumers to move from point C to point C′. In sum, the total gains from trade attained by moving from point E to point C′ (and correspondingly from CI1 to CI2) can be divided conceptually into two parts: (1) the consumption gain, involving movement from point E to point C (and correspondingly from CI1 to CI′1), and (2) the production gain, involving movement from point C to point C′ (and correspondingly from CI′1 to CI2). FIGURE 4 Gains from Exchange and Specialization with Trade CI1 CI2 E E C Good Y Good X C CI 1 A B (PX/PY )2 (PX /PY ) 1 In autarky, domestic consumption and production take place at point E. With the opening of trade but without any change in domestic production, consumers can consume along the international terms-of-trade line, (PX/PY)2, passing through point E. Because the relative price of good Y is lower internationally, consumers will begin to consume more Y and less X, choosing point C. The increase in well-being represented by the differ- ence between CI1 and CI′1 is referred to as the consumption gain or “gains from exchange.” Given enough time to adjust production, domestic producers will begin producing more of the relatively more valuable good X and less of good Y, maximizing profits at point E′. The increase in welfare brought about through the specialization in good X allows consumers to reach CI2 and C′. The increase in well-being represented by the movement from C to C′ (CI′1 to CI2) is referred to as the production gain or “gains from specialization.” Final PDF to printer CHAPTER 6 GAINS FROM TRADE IN NEOCLASSICAL THEORY 91 app9062x_ch06_084-099.indd 91 05/06/16 01:34 PM If we assume a two-country world, the analysis for the trading partner is analogous to that employed for the home country, although the trade pattern is reversed. Figure 5(a) is the basic graph. The discussion of it can be brief because no new principles are involved. For purposes of contrast, panel (b) illustrates the home country situation discussed earlier. In Figure 5(a), the trading partner’s equilibrium in autarky is at point e, where the coun- try faces autarky prices (PX /PY)3. The partner is producing quantity 0x4 of good X and quantity 0y4 of good Y, and the welfare level for the country is indicated by indifference curve W1. With international trade, international relative prices (PX/PY)2 will be less than autarky prices (PX /PY)3. (The exact determination of trading prices will be explored in con- siderably more detail in Chapter 7.) Thus, this partner country has a comparative advantage in good Y and a comparative disadvantage in good X. Because of the new relative prices available through international trade, producers in the partner country have an incentive to produce more of good Y and less of good X. The production point moves from e to e′, where there is a tangency of the PPF with (PX/PY)2 and where production of good X is 0x5 and production of good Y is 0y5. From point e′, the country can move along the trading line until consumers are in equilibrium, represented by a point of tangency of the price line (PX /PY)2 to an indifference curve. The consumption equilibrium is point c′ with trade, and consumption is 0x6 of good X and 0y6 of good Y. As in the case of the home country, the difference between production and consumption of any good reflects the volume and pattern of trade. Because production of good X is 0x5 and consumption of good X is 0x6, the country imports x5x6 of good X. Because production of good Y is 0y5 and consumption of good Y is 0y6, the country thus exports y6y5 of good Y. Trade triangle fe′c′ represents the same phenomenon as earlier, but in this case horizontal side fc′ indicates imports and vertical side fe′ represents exports. Note that in a two-country Trade in the Partner Country FIGURE 5 Partner-Country Gains from Trade y5 Good Y Good X Good Y Good X y4 y6 x5 x4 x6 e e c W2 W1 y3 y1 y2 x3x1 x2 F C S2 S 1 Partner country Home country E (a) (b) f E 0 0 (PX /PY )2 (PX /PY )3 (PX /PY )2 (PX /PY ) 1 As indicated in panel (a), in autarky the partner country produces and consumes at point e. With trade it now faces the international price ratio (PX/PY)2, which is flatter than its internal relative prices in autarky. Consequently, production of the relatively more expensive good Y expands and production of good X contracts, until further adjustment is no longer profitable at point e′. Consumers now find good X relatively less expensive and adjust their consumption expenditures by moving from point e to point c′. The opening of trade allows the country to consume outside the PPF on the higher indifference curve W2, thus demonstrating the gains from trade (the difference between W1 and W2). Note that, with trade, both countries face the same set of relative product prices, (PX/PY)2. Final PDF to printer 92 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch06_084-099.indd 92 05/06/16 01:34 PM world, the partner-country trade triangle fe′c′ is congruent to home country trade triangle FC′E′. This must be so because, by definition, the exports of the home country are the imports of the partner country, and the imports of the home country are the exports of the partner country. In addition, the trading prices (PX /PY)2 are the same for each country. It is obvious that the partner country also gains from trade. With trade, the country’s consumers are able to reach indifference curve W2, whereas in autarky the consumers could reach only lower indifference curve W1. The “gains from trade” for this country could also be split into the “production gain” and the “consumption gain” as was done for the home country, but this is an exercise left for the reader. CONCEPT CHECK 1. What is necessary for a country to gain from trade in neoclassical theory? How does one know if a country has gained from trade? 2. Explain the difference between the “gains from exchange” (consumption gain), the “gains from specialization” (production gain), and the “total gains from trade.” 3. What is meant by the trade triangle? Why must the trade triangles of the partner and the home country be congruent in a two-country analysis? 4. Within what range must the international terms of trade lie? MINIMUM CONDITIONS FOR TRADE The discussion in the previous section demonstrated that there is a basis for trade whenever the relative prices of goods in autarky of the two potential trading partners are different. It is important to address briefly conditions under which this could come about. If the genera- tion of relative price differences in autarky seems highly unlikely, then the total potential gains from trade would be limited and trade theory largely irrelevant. On the other hand, if there seems to be a considerably broad set of circumstances that could generate relative price differences, there would be a strong underlying basis for believing that potential gains from trade are present. Theoretically, there are two principal sources of relative price variation between two countries: differences in supply conditions and differences in demand conditions. To estab- lish minimum conditions for generating relative price differences in autarky, we look first at the role of demand, assuming identical production conditions. Second, we address the role of supply under identical demand conditions. This case could not possibly have been handled in the Classical analysis. In Ricardian anal- ysis, if the production conditions were the same for the trading partners in all commodities (i.e., identical PPFs), then the pretrade price ratios in the two countries would be the same; there would be no incentive for trade and of course no gains from trade. According to neoclassical theory, two countries with identical production conditions can benefit from trade. Different demand conditions in the two countries in the presence of increasing opportunity costs characterize this situation. Increasing opportunity costs are critical for the result, but the recognition of how different demand conditions influence trade is also necessary to update the Classical analysis. Figure 6 illustrates this special case. The two countries have identical production condi- tions, so we need to draw only one PPF because it can represent either country. The different tastes in the two countries are shown by different indifference maps. Suppose that country I has a relatively strong preference for good Y; this preference is indicated by curves S1 and S2, which are positioned close to the Y axis. On the other hand, country II has a relative Trade between Countries with Identical PPFs Final PDF to printer CHAPTER 6 GAINS FROM TRADE IN NEOCLASSICAL THEORY 93 app9062x_ch06_084-099.indd 93 05/06/16 01:34 PM preference for the X good, so its curves W1 and W2 are positioned close to the X axis. The autarky equilibrium points are point E for country I and point e for country II. Given these autarky positions, it is evident that the autarky price ratio in country I is (PX /PY)1 and that the autarky price ratio in country II is (PX/PY)2. Because (PX/PY)1 is less than (PX /PY)2, country I has the comparative advantage in good X, and country II has the comparative advantage in good Y. The price ratios show that the preference for good Y in country I has bid up PY relative to PX and that the preference for good X in country II has bid up PX relative to PY. With the opening of trade between the two countries, country I will export X and expand the production of X in order to do so and it will decrease production of good Y as good Y is now imported. Similarly, country II will have an incentive to expand production of and to export good Y and an incentive to contract production of and to import good X. The countries will trade at a price ratio (not shown) somewhere between the autarky price ratios, a price ratio that is tangent to the identical PPFs at a point between E and e. Both countries will be able to attain higher indifference curves. The common sense of the mutual gain from trade is that each country is now able to consume more of the good for which it has the greater relative preference. Thus, trade between identical economies with different demand patterns can be a source of gain and can be interpreted easily by neoclassical trade theory, while the Classical model cannot explain why trade would take place because, with identical constant-opportunity- cost PPFs, relative prices in the two countries would not differ. We now turn to the situation in which two countries have the same demand conditions but different production conditions. Production conditions may differ because different technologies are employed in two countries with the same relative amounts of the two fac- tors, capital and labor, because similar technologies exist in both countries but the relative Trade between Countries with Identical Demand Conditions FIGURE 6 The Basis for Trade between Two Countries with Identical PPFs and Different Demand Conditions Good X Good Y E e PPF I, II S2 S1 W2 W1 (PX /PY ) 1 (PX /PY )2 With identical production conditions in country I and country II, the same PPF (PPF I, II) exists for both. If demand conditions differ between the two countries, then their respective community indifference maps are different. If this is the case, points of tangency between the two different community indifference curves and the common PPF will occur at different points on the PPF (i.e., E and e) and hence reflect different sets of relative prices in autarky. There is thus a basis for trade. Final PDF to printer 94 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch06_084-099.indd 94 05/06/16 01:34 PM availability of factors differs, or because the two countries have a combination of different technologies and different relative factor availabilities. Let us assume for the present discussion that production conditions differ between the two countries because the technologies are different. Each country is employing a differ- ent technology, so there will be different production possibilities and different PPFs (see Figure 7). Assuming that the relative amounts of factors are similar between the two coun- tries, PPFI demonstrates a technology that is relatively more efficient in the production of good X, and PPFII a technology that is relatively more efficient in the production of good Y. With demand conditions assumed to be identical in both countries, an identical com- munity indifference map can be used to represent tastes and preferences. The existence of different production conditions is sufficient to produce different domestic price ratios in autarky, even in the presence of identical demand conditions. Country I, which is relatively more efficient in producing good X, will find itself producing and consuming relatively more of this product in autarky, for example, at point E. Similarly, country II, which has the technological advantage in good Y, will find itself producing and consuming more of FIGURE 7 The Basis for Trade between Two Countries with Identical Demands and Different Production Structures Good Y e E PPF II PPF I S0 S0 S1 S1 Good X (PX /PY )2 (PX /PY ) 1 Different production structures based on the existence of different country technologies (but with similar resource availabilities) are demonstrated in the two differently shaped PPFs. Country I has a technical advantage in the production of good X and country II has a technical advantage in production of good Y. Given identical demand structures (i.e., a common community indifference map), the tangencies between the PPFs and the highest indifference curve will occur at different points E and e. Because the slopes at those points are different, the relative prices in autarky are different. With international terms of trade somewhere between the two sets of autarky prices, both countries can gain by trading. Final PDF to printer CHAPTER 6 GAINS FROM TRADE IN NEOCLASSICAL THEORY 95 app9062x_ch06_084-099.indd 95 05/06/16 01:34 PM good Y in equilibrium (point e). As relative prices are different in autarky, there is a basis for trade because (PX /PY)I < (PX /PY)II. Country I will export good X and import good Y at terms of trade (not shown) that are between the two autarky price ratios, and it will increase production of good X and decrease production of good Y. Country II will do the reverse—it will expand production of and export good Y and will contract production of and import good X. Each country can then attain a higher indifference curve. We conclude that a second possible minimal condition for gains from international trade is a difference in supply conditions, even with identical demand in the two countries. We have seen that relative prices in autarky reflect underlying supply and demand conditions, thus depending jointly on the relative amounts and quality of available resources, the char- acteristics of the production technologies employed, and the nature of demand in a country. Different relative prices can therefore exist between countries as long as one or more of these factors are different. Such a minimal condition suggests that the likelihood of a basis for trade between the many countries of the world is great. It also makes it clear that the underlying basis for trade can change as technology changes, as factors grow within countries, as fac- tors move between countries, and as individual country demand patterns change in response to economic development and/or the increased exposure to different products and cultures. SOME IMPORTANT ASSUMPTIONS IN THE ANALYSIS This section briefly discusses three important assumptions used in the previous analysis that may need to be taken into account when examining the “real world.” The intent is to introduce an element of caution rather than doubt concerning neoclassical theory. Indeed, few principles are so universally accepted by economists as comparative advantage and the gains from international trade. One important assumption is that factors of production can shift readily and without cost along the PPF as relative prices change and trade opportunities present themselves. In practice, however, it may not be possible to adjust immediately to the changed relative prices. Movement from the autarky production point to the trade production point may first involve a movement inside the PPF as workers and equipment are no longer used in the import-competing industry but have yet to be fully absorbed in the export industry. Perhaps labor must be retrained, factors must be moved from one section of the country to another, or depreciation allowances for plant and equipment must accumulate before capital can be reinvested elsewhere. Only after time passes will the export industry be able to employ the unused factors and move the economy to the PPF. These kinds of mobility problems are assumed away in the theory presented earlier. When factor movement does occur slowly or experiences an adjustment cost so that the production point does not slide easily along the PPF but moves inside it, many economists argue that some type of government assistance is required. Many countries have set up such assistance programs. For example, beginning in 1962 and continuing to the present, the United States has had a recently controversial program of trade adjustment assistance in place (although the nature and funding of the program have varied over the years) to help in the transition following tariff reductions through trade negotiations. (The program of such assistance in the United States is discussed further in Chapter 16.) This assumption is related to the problem of adjustment, but it merits separate treatment because of its application to a more general context. The assumption that all of a country’s factors of production are fully employed (or experience a given level of unemployment Conclusions Costless Factor Mobility Full Employment of Factors of Production Final PDF to printer 96 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch06_084-099.indd 96 05/06/16 01:34 PM owing to institutional characteristics, e.g., a “natural level of unemployment”), combined with their efficient use in the competitive market, means that the country is operating on the PPF. Thus, because of this assumption, we have not previously analyzed situations where trade moved the country from somewhere inside the PPF to a point on the PPF. The “full-employment” assumption is a general one in microeconomic theory as well as in trade theory. In micro, it is assumed that the macroeconomic question of unemployment has been solved. The solution to the problem of unemployment might lie, for example, with effective monetary and fiscal policies. Given this solution, the subject of microeconomics looks at questions of efficiency and welfare. Of course, realistically, countries do not always attain full employment, as has been evident in recent years. The full-employment assumption allows the analyst to focus on efficiency and welfare, as distinct from the problems of unemployment and idle capacity. Clearly, a country can have unemployment whether it is in autarky or is engaged in trade. However, it should be emphasized that even if a country has unemployment in autarky and is operating inside its PPF, trade permits it to move to a higher indifference curve. The opening of the country to trade will lead to different prices facing consumers and producers than was the case with autarky. Gains from exchange and specialization still occur. In Chapter 5, the possibility that community indifference curves might intersect was raised. If intersections occur, there might be a problem in interpreting welfare changes when a country moves from autarky to trade. In this chapter, however, no intersecting community indifference curves have so far been drawn. It is useful to comment on this disparity. A number of somewhat restrictive assumptions can be used to construct nonintersecting community indifference curves. These assumptions can guarantee that welfare changes can be interpreted as they have been in this chapter (see Tower, 1979). The explanation of the conditions necessary for concluding that welfare will improve when autarky gives way to trade is straightforward. Two general conditions are pertinent: (1) individuals within the economy have reasonably similar tastes, and (2) the opening of the economy to trade does not radically alter the distribution of income. The underlying rationale for these condi- tions is that, without them, our earlier analysis would suggest that community indifference curves could intersect. By assuming that redistribution is not large and that people have similar tastes, we thus minimize the possibility of not being able to tell whether actual welfare has changed. However, even with these general conditions, we cannot be sure that the direction of the actual welfare change can be meaningfully ascertained, as the phrases “have reasonably similar tastes” and “radically alter the distribution of income” do not lend themselves to precise interpretation. Because of this uncertainty, advanced trade theory has gone well beyond the use of indifference curves to other modes of demonstrating the gains from trade. The compensation principle summarizes the general conclusion of these exten- sions. The advanced literature demonstrates that potential gains from trade exist in the sense that, within the country, the people who gain from trade can compensate the losers and still be better off. This must mean, therefore, that there is a larger “pie” to split up after trade has been introduced. If the compensation is paid, then society is better off because the gainers have benefited even after compensating the losers. Everyone is at least as well off as in autarky, and some people are better off. Thus, trade can yield higher welfare than autarky, but the reverse is never true. If the compensation is not actually paid, then society is described as being only “potentially” better off. It is potential because some people could be made better off and everyone else no worse off, but this would not happen without the transfer. Further consideration of this principle using our familiar community indifference curves is given in the appendix to this chapter. The Indifference Curve Map Can Show Welfare Changes Final PDF to printer CHAPTER 6 GAINS FROM TRADE IN NEOCLASSICAL THEORY 97 app9062x_ch06_084-099.indd 97 05/06/16 01:34 PM IN THE REAL WORLD: CHANGES IN INCOME DISTRIBUTION AND WELFARE WITH INCREASED TRADE With the opening of trade, the relative price of export goods increases and the relative price of import substitute goods decreases. On the supply side, this will lead to an expansion of production of export goods and a contraction of produc- tion of import-substitute goods. Consequently, there will be an increase in the demand for inputs used in export produc- tion and a reduction in demand for inputs used in the domes- tic production of the import good. In the adjustment process, the price of certain factors or inputs will likely increase and the price of others will likely decline, leading to a change in income distribution. Estimates of such supply-side impacts will be discussed in Chapters 8 and 9. However, a study by Spilimbergo, Londoño, and Székely (1999) exam- ined 34  countries from 1965 to 1992 and concluded that reductions in trade barriers decreased income inequality in capital-abundant countries but increased income inequality in skill-abundant countries. In another study, Andrew Berg and Anne Krueger (2002) hypothesized that trade liberalization can benefit the poorer segments of a country’s population at least as much as lib- eralization benefits the average person. This hypothesized result occurs because, among other phenomena, greater openness of a country can reduce the power of domestic monopolies. Nevertheless, after surveying existing literature examining the relationship of openness and income distribu- tion across many countries at a point in time, they concluded that no systematic relationship between the liberalization and the poor can be made. Studies of any given country over time might lead to more definite results, however. In addition, distribution effects occur in consumption. Because the price of export goods is rising with trade and that of import goods is falling, individuals who spend rela- tively more of their income on export goods will find their real income relatively smaller compared to that of individu- als who spend relatively more on import goods, other things being equal. To give an example of the magnitude of pos- sible consumption-related income distribution effects, Susan Hickok (1985) estimated the impact of the higher domes- tic prices caused by U.S. import restrictions on automo- biles, sugar, and clothing in 1984. The protection-induced increases in expenditure on these products were equivalent to an income tax surcharge of 66 percent for low-income earners ($7,000−$9,350  annually), 33 percent for those in the $14,050−$16,400  range, 20 percent for those earning $23,400−$28,050, and only 5 percent for individuals earning $58,500 and above. Because these products absorb a higher percentage of individual expenditures of low-income earners than of high-income earners, increasing international trade by removing those tariff and quota barriers would clearly have had the effect that low-income groups would benefit rela- tively more than high-income groups. Some recent work has tried to measure the welfare gains from trade using aggregate data on the relative size of trade to a country’s economy and the responsiveness of trade to changing costs. Marc J. Melitz and Stephen J. Redding (2014) note that calculated welfare gains in these studies are relatively small and cite a study (Eaton and Kortum, 2002) of 19 devel- oped countries that indicated that the loss in welfare of going from trade to autarky varied from 0.2 to 10.3 percent. Melitz and Redding suggest, however, that trade in intermediate inputs can increase productivity in domestic industries and hence increase country well-being, and this channel and its associated gains are not incorporated into welfare studies. Work by Ariel Burstein and Javier Cravino (2015) in a similar vein supports the notion that estimates of gains from trade must include the productivity-enhancing impacts of that trade. ● CONCEPT CHECK 1. Briefly describe the minimum conditions for trade to take place between two countries, that is, for there to be a difference in their respective price ratios in autarky. 2. Why do different demand conditions influ- ence the basis for trade in neoclassical theory but not in Classical theory? 3. How can opening a country to trade influence income distribution? How does this affect our ability to demonstrate the gains from trade? Final PDF to printer 98 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch06_084-099.indd 98 05/06/16 01:34 PM SUMMARY Neoclassical trade theory’s demonstration of the gains from international trade uses the analytical tools of the production- possibilities frontier and the community indifference curve. In autarky, a country reaches its highest indifference curve when the marginal rate of transformation (MRT) in production equals the price ratio of goods, which in turn equals the marginal rate of substitution (MRS) in consumption. When the country is opened to international trade, it faces a new set of relative prices. The adjustment by producers and consumers to this new set of prices and the resulting trade enables the country to attain a higher indifference curve. Consideration of the minimal con- ditions necessary to produce different autarky prices showed that autarky price ratios can differ as long as there is a differ- ence in either demand or supply conditions. For example, two countries with identical (increasing-opportunity-cost) PPFs can both gain from trade if tastes differ between the countries. Or a basis for trade can exist if different technologies are employed by countries that are otherwise identical. The important role played by the relative availability of factors in influencing rela- tive prices in autarky will be discussed in Chapter 8. The neoclassical theory of trade makes use of some special assumptions involving adjustment to change, full employment, and indifference curves. The implications of these assumptions were discussed briefly in this chapter. In addition, we frequently utilized an assumption that, when a country is opened to trade, the country takes the new set of world prices as given. Forces influencing the determination of the new price ratio will be covered in more detail in the next chapter. KEY TERMS autarky equilibrium compensation principle consumption gain (or gains from exchange) production gain (or gains from specialization) total gains from trade trade adjustment assistance trade triangle trading line QUESTIONS AND PROBLEMS 1. Indicate the equilibrium production and consumption point in autarky, using a PPF and a community indifference curve under increasing-opportunity-cost conditions. Why is this an equilibrium? What must occur for this country to gain from trade? 2. Assume that a country produces and consumes two goods, cloth and machines, and is in equilibrium in autarky. It now finds that it can trade at international prices where (Pcloth/Pmachines) on the world market is greater than (Pcloth/Pmachines) in the domestic market. Should it trade? If so, what commodity should it export? Why? Will it gain from trade? How do you know? 3. Explain the difference between the “gains from exchange” (consumption gain) and the “gains from specialization” (production gain). 4. Suppose a country that is producing within its production- possibilities frontier in autarky experiences an 8 percent rate of unemployment. Is it possible for it to gain from trade if the rate of unemployment remains approximately the same? 5. “The inability of factors to move from one use to another in production will completely take away any possible gains from trade.” Agree? Disagree? Explain. 6. What general conditions must hold for one to be able to use community indifference curves to represent consumer well-being in a country and demonstrate gains from inter- national trade? 7. Suppose that the United States removes its long-standing embargo on trade with Cuba. Opponents of ending the embargo argue that opening trade between the United States and Cuba would benefit Cuba and hurt the United States by injuring U.S. producers of goods that compete with potential Cuban exports. Evaluate this position utiliz- ing what you have learned in this chapter. 8. If the production conditions in the United States and Japan were to become essentially the same, would the neoclas- sical model suggest that trade between the two countries would cease? Why or why not? 9. Ms. Jones, one of your neighbors, spends the majority of her income on food. She complains to you that, after your country became more open to trade and began exporting a variety of food products, her real income was reduced. She therefore maintains that the country has obviously been hurt by the new, expanded trade and that trade restrictions should be imposed. How would you respond to Ms. Jones? 10. (Requires appendix material) “If trade should cause income distribution to change such that there was a shift in the indiffer- ence map, it would be impossible to reach a conclusion regar- ding any possible gains from international trade.” Discuss. Final PDF to printer CHAPTER 6 GAINS FROM TRADE IN NEOCLASSICAL THEORY 99 app9062x_ch06_084-099.indd 99 05/06/16 01:34 PM Appendix “ACTUAL” VERSUS “POTENTIAL” GAINS FROM TRADE You have seen in Chapter 5 an illustration in which a change in income distribution yielded new community indifference curves that intersected previous community indifference curves. Figure 8 shows this situation in the context of trade (see Samuelson, 1962, pp. 826–27). In autarky, the coun- try is at point E on indifference curve CI1. Suppose that the introduction of trade moves production to point P and consumption to point C, a tangency point to community indifference curve CI2 associated with the new income distribution that has resulted from trade. Clearly, point C is preferred to point E on the basis of the new income distribution (CI2 represents a higher level of welfare than does CI′2), but C is inferior to E on the basis of the autarky income distribution (CI′1 represents a lower level of welfare than does CI1). Do we conclude that trade has not improved the welfare of the country? No! With trading line (PX/PY)T, the amount of trade could be altered to move to consumption at point F, which has larger quantities of both goods X and Y than does point E. This is the essence of the compensation princi- ple: Trade provides the means to make at least some people better off and no one worse off, enabling society to gain. With consumption at point F, the quantities of X and Y are sufficient to compensate fully any losers (i.e., to reproduce the consumption bundle at autarky position E) and still have some of both goods left over. If the country remains at point C and no compensation is paid, it still has gained welfare in the “potential” sense that trade has made it possible to have gainers and no losers. Furthermore, even at C, the country is consuming at a point that was impossible under autarky, and trade has thus opened up possibilities that were previously unattainable. FIGURE 8 Gains from Trade with Intersecting Community Indifference Curves CI 1 CI 2 F E CI2 P C Good Y Good X CI1 (PX /PY )T Trade moves the country from production (and consumption) point E to production point P and consumption point C. On the basis of the income distribution under autarky, C is “worse” than E (CI′1 represents a lower level of welfare than does CI1); on the basis of the income distribution with trade, C is “better” than E (CI2 represents a higher level of welfare than does CI′2). However, trade makes possible a movement to a point such as F, where the consumption bundle in autarky at point E can be reproduced (i.e., there would be no losers from trade) and some additional quantities of goods X and Y would still remain available for consumption by the “gainers” from trade. Final PDF to printer 100 app9062x_ch07_100-121.indd 100 06/01/16 07:35 AM CHAPTER 7 OFFER CURVES AND THE TERMS OF TRADE LEARNING OBJECTIVES LO1 Describe a country’s offer curve and show how it is obtained. LO2 Identify how the equilibrium international terms of trade are attained. LO3 Explain how changes in both supply and demand conditions influence a country’s international terms of trade and volume of trade. LO4 Illustrate how different elasticities on the offer curve affect the impact of economic changes. LO5 Demonstrate the usefulness of different concepts of the terms of trade. Final PDF to printer CHAPTER 7 OFFER CURVES AND THE TERMS OF TRADE 101 app9062x_ch07_100-121.indd 101 06/01/16 07:35 AM INTRODUCTION Changes in the terms of trade of a country—the price of the country’s exports divided by the price of its imports—can be sizeable, and they can have major economic effects on the country. For example, economists Paul Cashin and Catherine Pattillo1 of the International Monetary Fund (IMF) calculated that, in 1986–1987, a drop in the price of coffee, a main export from Ethiopia, caused a 40 percent drop in Ethiopia’s terms of trade and a decline of about 6 percent in Ethiopia’s real income. And such shocks may last for some time, too: in their study of sub-Saharan coun- tries, Cashin and Pattillo estimated that a typical shock’s duration for Mozambique is from six months to three years, while the duration for a typical shock for The Gambia could be up to 12.2 years. Estimates were also made of the size of the shocks. For example, in Côte d’Ivoire in any given year, there is a one-in-three chance that the country’s terms of trade will change by more than 9 percent; for Nigeria, there is a one-in-three chance that the movement in its terms of trade in any given year will be more than 20 percent. A second IMF study2 looked at movements of the terms of trade during 1998, 1999, and January–June 2000 for countries exporting mainly primary products. These movements were then compared with the terms-of-trade average level for the base period 1995–1997. For almost 30 countries, their terms of trade fell during the January 1998–June 2000 period by more than 10 percent in comparison with the base period, and in 11 countries the fall exceeded 20 percent. For three countries (Burundi, Ethiopia, and Uganda), the decline was greater than 30 percent. The losses due to the terms-of-trade movements were estimated to be equivalent to more than 8  percent of total domestic spending for some countries and, on average for the countries exam- ined in the study, about 4 percent of total domestic spending. Clearly terms-of-trade movements can occur, can last for a long time, and can have impor- tant economic effects. This chapter introduces and explains the factors that determine the terms of trade or posttrade prices. In the discussion in previous chapters, an important sim- plification was made: world prices with trade were assumed to be at a certain level. Thus, for example, in the Ricardo model we assumed that one barrel of wine would exchange for one yard of cloth in international trade and did not investigate the factors that deter- mined this relative price ratio. Similarly, in Chapter 6, a given PX /PY was drawn in the production-possibilities frontier (PPF)– indifference curve diagram, and no attention was paid to the reason for this price ratio. An important analytical concept employed to explain the determination of the terms of trade is known as the offer curve. We first present this basic analytical tool and then use it to demonstrate how equilibrium prices are attained in international trade. Then the offer curve framework is used to explain the price and trade volume effects of phenomena such as economic growth and changes in consumer tastes. This concept is helpful in the interpretation and understanding of ongoing, complex eco- nomic events in the international arena. A COUNTRY’S OFFER CURVE The offer curve (or reciprocal demand curve) of a country indicates the quantity of imports and exports the country is willing to buy and sell on world markets at all possible relative prices. In short, the curve shows the country’s willingness to trade at various pos- sible terms of trade. The offer curve is a combination of a demand curve (the demand for imports) and a supply curve (the supply of exports). The two-pronged nature of the curve Terms-of-Trade Shocks 1Paul Cashin and Catherine Pattillo, “The Duration of Terms of Trade Shocks in Sub-Saharan Africa,” Finance and Development 37, no. 2 (June 2000), pp. 26–29. 2International Monetary Fund, World Economic Outlook, October 2000 (Washington, DC: International Monetary Fund, 2000), pp. 78–79. Final PDF to printer 102 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch07_100-121.indd 102 06/01/16 07:35 AM distinguishes it from most graphic devices in economics. An offer curve is easy to under- stand, and we are great fans of the concept because it usefully portrays the net result of a wide variety of reactions and activities by consumers and producers. There are several methods of deriving an offer curve, but we will concentrate on the method that builds directly upon the PPF–indifference curve diagram. This method is called the trade triangle approach. Consider Figure 1(a), which shows the equilibrium trading position for a country at world prices (PX /PY)1. Free trade is occurring, and the country is producing 0x2 of good X and 0y2 of good Y (at point P). Consumption is 0x1 of good X and 0y1 of good Y (at point C). With these amounts of production and consumption, x1x2 of good X is exported and y2y1 of good Y is imported. This trade pattern is reflected in trade triangle RCP, with line RP representing the exports and line RC representing the imports the country is willing to undertake at the terms of trade (PX /PY)1. Consider Figure 1(b). The country now faces a steeper world price line than it did in panel (a), and its production and consumption have correspondingly adjusted. Because (PX/PY)2 in panel (b) is greater than (PX /PY)1 in panel (a), producers have responded to the relatively higher price of X (and to the relatively lower price of Y) by increasing their pro- duction of X and decreasing their production of Y. Production now takes place at P′, with 0x4 of good X and 0y4 of good Y being produced. At prices (PX /PY)2 consumption takes place at point C′ with 0x3 of good X and 0y3 of good Y consumed. Exports of this country are now x3x4 of good X, and imports are y4y3 of good Y. This volume of trade is represented by trade triangle R′C′P′. It is clear from Figure 1 that different trade volumes exist at the two different sets of relative commodity prices. The offer curve diagram takes the information from panels (a) and (b) of Figure 1 and plots it onto a new curve (see Figure 2). This figure does not show production or consumption but presents only the quantities of exports and imports at the two sets of prices. The key geometrical difference between the two figures is that the FIGURE 1 Trade Triangles at Two Possible Terms of Trade Good Y Good X y1 y2 x2x1 Good Y Good X y3 y4 x4x3 C P V S1R S2 V P R C PX PY( ) 2( )PXPY 1 (a) (b) 0 0 In panel (a) with free trade and terms of trade (PX/PY)1, the country exports x1x2 of good X and imports y2y1 of good Y. This trade situation is summarized by trade triangle RCP, with length RP representing exports of good X and length RC representing imports of good Y. In panel (b), a higher relative price for good X (and therefore a lower relative price for good Y) is indicated by terms-of-trade line (PX /PY)2, which is steeper than (PX /PY)1 in panel (a). With the terms of trade of panel (b), the country exports x3x4 of good X and imports y4y3 of good Y. This trade pattern is summarized by trade triangle R′C′P′, with exports equal to length R′P′ and imports equal to length R′C′. Final PDF to printer CHAPTER 7 OFFER CURVES AND THE TERMS OF TRADE 103 app9062x_ch07_100-121.indd 103 06/01/16 07:35 AM PX /PY price ratios are plotted as upward sloping in Figure 2 rather than downward sloping. Thus, (PX /PY)1 in Figure 2 is the same price ratio as (PX /PY)1 in Figure 1(a). Angle 0VC in Figure 1(a), where the price line hits the x-axis, is the same size as the angle formed at the origin in Figure 2 between the (PX /PY)1 line and the x-axis. At this set of prices, the country exports quantity 0x5, which is equal to distance x1x2 in Figure 1(a). Similarly, the country imports quantity 0y5, which is equal to distance y2y1 in Figure 1(a). With the exports and imports thus plotted, point T represents the volume of trade associated with the (PX /PY)1 price ratio. Point T is a point that corresponds to the volume of trade indicated by the hori- zontal and vertical sides of trade triangle RCP in Figure 1(a). The higher relative price ratio (PX /PY)2 of Figure 1(b) is represented by a steeper price line in Figure 2, as it was in panel (b) of Figure 1. A higher price for X on the world market means that greater quantities of it are exported. Quantity of exports 0x6 in Figure 2 corresponds to quantity of exports x3x4 in Figure 1(b). At this new, higher relative price for good X, good Y is relatively lower priced. Therefore, quantity of imports 0y6 in Figure 2, which equals quantity y4y3 in Figure 1(b), is greater than quantity of imports 0y5. The vol- ume of trade at prices (PX/PY)2 is thus represented by point T′. We have now obtained two points on this country’s offer curve. You can conceptualize the remainder of the curve by mentally constructing trade triangles in Figure 1 for every set of possible prices. The sides of these trade triangles would be plotted in Figure 2 as indicated by illustrative points T″ and T′″. The construction of the offer curve is completed FIGURE 2 Alternative Terms of Trade and Export-Import Combinations on the Offer Curve Imports of good Y T Exports of good X T T T OC I 0 y5 y6 x5 x6 (Px /Py ) 4 (Px /Py ) 3 (Px /Py )2 (Px /Py ) 1 Relative prices (PX /PY)1 are the same as in Figure 1(a). At these terms of trade, the country exports quantity 0x5 of good X [equal to x1x2 in Figure 1(a)] and imports quantity 0y5 of good Y [equal to y2y1 in Figure 1(a)], yielding point T. At the higher relative price ratio (PX /PY)2, which is equal to (PX/PY)2 in Figure 1(b), the country exports 0x6 of good X and imports 0y6 of good Y [equal to x3x4 and y4y3 in Figure 1(b), respectively], yielding point T′. Additional possible trade points (such as T″ and T′″) are then joined with T and T′ to form the offer curve for country I, OCI. At its pretrade prices in autarky (prices not shown), country I would be situated at the origin with zero exports and zero imports. Final PDF to printer 104 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch07_100-121.indd 104 06/01/16 07:35 AM CONCEPT BOX 1 THE TABULAR APPROACH TO DERIVING AN OFFER CURVE An alternative approach to the use of trade triangles for deriv- ing an offer curve is the tabular approach, which simply uses a numerical example. This approach (see Haberler, 1936, pp. 145–48) is demonstrated by development of a hypotheti- cal country A’s offer curve from the information contained in Table 1. Column (1) lists possible terms of trade on the world market. Column (2) illustrates the demand side of an offer curve by listing country A’s assumed quantity demanded of imports of good Y at the various prices indicated by the terms of trade in column (1). Moving down column (1), good Y gets relatively cheaper because more of it exchanges for one unit of good X. Corresponding to the law of demand, greater quanti- ties of good Y are demanded as we move down column (2). Column (3) indicates the supply side of the offer curve and illustrates the link between exports and imports. Exports are supplied to the world market so that the country can purchase imports. In the first row of the table, 10 units of good Y are being demanded on the world market and the price of 1Y is 1X; therefore, 10 units of X must be supplied to the world market. Similarly, in row 2, 44Y are demanded at a price that requires one unit of X be given up for every two units of Y and 22X must thus be “given up” or exported. The figures in column (3) are obtained by dividing the numbers in column (2) by the relative prices in column (1). From the information in this table, the offer curve is obtained by plotting the quantities exported and imported at each relative price on the familiar set of axes, as in Figure 3. If you imagine an infinite number of such combinations, then you have plotted the offer curve of country A. (1) Terms of Trade (assumed) (2) Quantity Demanded of Imports of Y (assumed) (3) Quantity Supplied of Exports of X =  (2) /[PX/PY in (1)] 1X:1Y or PX/PY = 1 10 units 10 units 1X:2Y or PX/PY = 2 44 units 22 units 1X:3Y or PX/PY = 3 81 units 27 units 1X:4Y or PX/PY = 4 120 units 30 units TABLE 1 Country A’s Exports and Imports at Various Terms of Trade (continued) by connecting all possible points at which a country is willing to trade, with the resulting curve labeled OCI, designating our country as country I. The exact shape of this offer curve will be discussed later. Concept Box 1 provides another method of deriving an offer curve. The most useful feature of the offer curve diagram is that it can bring two trading coun- tries together in one diagram. To accomplish this, the offer curve of country I’s trading partner, country II, needs also to be developed. There is nothing new analytically about country II’s offer curve. The trade triangles for that country are plotted in the same manner as those for country I. The only difference is that country II exports good Y and imports good X. Thus, country II’s offer curve appears as curve OCII in Figure 4. This curve reflects country II’s willingness to trade at alternative relative prices. Of course, a lower PX /PY means that country II has a greater willingness to trade, because a lower relative price for good X means a greater incentive for country II’s consumers to import it. Similarly, a lower PX /PY means a relatively higher price for good Y, leading to a greater willingness by country II to export it. Final PDF to printer CHAPTER 7 OFFER CURVES AND THE TERMS OF TRADE 105 app9062x_ch07_100-121.indd 105 06/01/16 07:35 AM CONCEPT BOX 1 (continued) THE TABULAR APPROACH TO DERIVING AN OFFER CURVE FIGURE 3 Country A’s Offer Curve 0 Imports of good Y Exports of good X 120 2210 81 44 10 3027 OCA PX PY( ) = 11 X:1 Y or PX PY( ) = 21 X:2Y or PX PY( ) = 31 X:3Y or PX PY( ) = 41 X:4Y or Row 1 of Table 1 indicates that, at a PX/PY ratio of 1, country A wants to import 10 units of good Y. Therefore, 10 units of good X would be exported to obtain that quantity of imports. At PX/PY = 2, the country wants 44 units of imports of good Y and therefore would export 22 units of good X to obtain them. The plotting of the other two import-export combinations, plus a tracing of other possible combinations of imports, exports, and terms of trade, yields offer curve OCA. ● TRADING EQUILIBRIUM With the two countries’ offer curves brought together in one figure (see Figure  4), we can indicate the trading equilibrium and show the equilibrium terms of trade (TOTE). The horizontal axis indicates exports of good X for country I and imports of good X for country II. Similarly, the vertical axis indicates country I’s imports of good Y and country II’s exports of good Y. Trading equilibrium occurs at point E, and the equilibrium terms of trade, TOTE, are indicated by the slope of the ray from the origin passing through E. Why is point E the trading equilibrium? At point E, the quantity of exports that country I wishes to sell (0xE, on OCI) exactly equals the quantity of imports that country II wishes to buy (also 0xE, on OCII). In addition, the quantity of imports that country I wishes to buy (0yE, on OCI) equals exactly the quantity of exports that country II wishes to sell (also 0yE, on OCII). Thus, relative prices (PX/PY)E are market-clearing prices because the demand for and supply of good X on the world market are equal, as are the demand for and supply of good Y. Let us explore economically why TOTE is the market-clearing (equilibrium) price ratio. Suppose in Figure 4 that world prices are not at TOTE but at some lower relative price for good X of TOT1. At this set of prices, country I would like to trade at point A; that is, it would like to sell 0x1 of good X and buy 0y1 of good Y. However, at this lower relative Final PDF to printer 106 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch07_100-121.indd 106 06/01/16 07:35 AM price for good X, country II would like to trade at point B. It would like to buy 0x2 of good X and sell 0y2 of good Y. Therefore, at TOT1, there is excess demand for good X of the amount x1x2 and excess supply of good Y of the amount y1y2. The excess demand for good X will bid up its price on the world market, while the excess supply of good Y will bid down its price. With these changes in price, the relative price ratio (PX /PY)1 will rise, which means that the price line becomes steeper. As it does, both the excess demand for good X and the excess supply of good Y will be reduced. The price line will continue to rise until the excess demand and the excess supply are eliminated at equilibrium point E. It should be noted that in this two-commodity model an excess demand for one good means that there must be an excess supply of the other; equilibrium in one good’s market means that equilibrium exists in the other good’s market also. FIGURE 4 Trading Equilibrium y2 I’s exports of good X, Equilibrium terms of trade II’s imports of good X I’s imports of good Y, II’s exports of good Y B 0 or TOTE or TOT1 OCI E A y1 yE x2x1 xE OCII (PX /PY )E (PX/PY ) 1 Relative prices (PX /PY)E (or terms of trade TOTE) are market-clearing prices since the quantity of good X (0xE) that country I wishes to export equals the quantity of good X that country II wishes to import and the quantity of good Y that country I wishes to import (0yE) equals the quantity of good Y that country II wishes to export. Thus, point E is the trading equilibrium position, and the equilibrium terms of trade are equal to the slope of the ray from the origin through point E. If relative prices (PX/PY)1 or TOT1 prevailed in the market instead of (PX/PY)E or TOTE, there would be excess demand for good X of amount x1x2 and excess supply of good Y of amount y1y2. Therefore, (PX /PY)1 or TOT1 would rise until the excess demand and excess supply were eliminated at (PX /PY)E or TOTE. CONCEPT CHECK 1. Why does a point on a country’s offer curve represent the country’s willingness to trade at those particular terms of trade? In other words, what motivates the country to export and import those particular quantities at that  relative price ratio? (Hint: Remember what a “trade triangle” implies about the level of well-being of the country.) 2. Why would a country exporting good X be willing to import greater quantities of good Y as PX /PY rises? 3. Suppose that in Figure 4 a terms-of-trade line TOT2 appears that is steeper than TOTE. In terms of excess supply and excess demand, explain why the terms of trade will fall from TOT2 to TOTE. Final PDF to printer CHAPTER 7 OFFER CURVES AND THE TERMS OF TRADE 107 app9062x_ch07_100-121.indd 107 06/01/16 07:35 AM SHIFTS OF OFFER CURVES The determination of the equilibrium relative prices in the last section was carried out under the assumption that offer curves are fixed for each country. What we have done is develop a “snapshot” of the trading situation at a particular point in time. In practice, how- ever, offer curves do not stay fixed. Over time, changes in the two countries lead to changes in the offer curves—and a new “snapshot” will emerge. Suppose that, after reaching equilibrium as shown in Figure 4, the consumers in country I change their tastes and decide that they would like to purchase more of good Y. Because Y is the import, this means an increase in demand for imports. Country I now has greater willingness to trade and its offer curve will shift or pivot to indicate this change. The shift is analogous to an “increase in demand” in the ordinary demand-supply diagram. An increased willingness to trade in the offer curve analysis means that, at each possible terms of trade, the country is willing to supply more exports and demand more imports. (Back in Figure 1, this change in tastes toward good Y would shift the indifference curves toward the y-axis. Hence, the trade triangle for each relative price line would be larger.) In Figure 5, the offer curve shifts or pivots to the right from OCI to OC′I. Note that the shift is accomplished by plotting a point “farther out” on each potential price line than was origi- nally plotted (such as point F′ instead of point F, point G′ instead of point G, and so on). The shift could occur of course for reasons other than a change in tastes for the imported good. Other reasons could include a rise in income that led to an increased demand for imports or an improvement in productivity in country I’s export industries that caused an increased supply of exports. Similarly, a decrease in willingness to trade or a decrease in reciprocal demand is indicated by offer curve OC″I, where the curve has shifted or pivoted FIGURE 5 Shifts in Country I’s Offer Curve H F G G I’s exports of good X I’s imports of good Y 0 F TOT1 TOT2 TOT3 OC OC IOC H Decreased willingness to trade Increased willingness to trade I I If country I changes its tastes toward relatively greater preference for the (imported) Y good, or for any other reason wants to increase its international trade, offer curve OCI shifts diagonally or pivots to the right to become offer curve OC′I. This new curve indicates a greater willingness to trade at all possible terms of trade. A decreased willingness to trade (such as would result, for example, from the imposition of a tariff by country I) would shift OCI diagonally leftward to OC″I. Final PDF to printer 108 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch07_100-121.indd 108 06/01/16 07:35 AM inward to the left. This decrease could reflect a change in tastes away from the imported good, a decline in national income, or, of particular importance, the imposition of a tariff by country I. An analogous procedure applies to country II. Because an increased willingness to trade represents a desire to export and import greater quantities at all terms of trade, the original OCII in Figure 6 shifts or pivots upward to OC′II. Note again that, on each price line, the willingness-to-trade points are plotted farther out than they were originally. Country II’s decreased willingness to trade is reflected in offer curve OC″II. When offer curves shift, the TOTE and volume of trade change. These changes reflect the alteration of underlying market conditions. Suppose that country I and country II are in initial equilibrium in Figure 7 at TOTE and at trading volumes 0xE of good X and 0yE of good Y. Now suppose that there is a shift in tastes by country I toward its import good Y. As noted earlier, this change in tastes will cause offer curve OCI to shift to OC′I. With the increase in country I’s willingness to trade, the previous terms of trade, TOTE, are no longer sustainable. TOTE results in excess demand for good Y and, correspondingly, excess supply of good X. Country I is willing to buy 0y2 of good Y and offer 0x2 of good X in exchange. However, country II has experienced no change in its offer curve, and it is still willing to supply only 0yE of good Y and to demand 0xE of good X at TOTE. With excess demand of yEy2 for good Y and excess supply of xEx2 for good X, the price of Y will rise on the world market and the price of X will fall. This change in relative prices will continue until the excess demand for Y and the excess supply of X are eliminated at new equilibrium point E′ with terms of trade TOT1. The change in the terms of trade means that the price of the good that country I sells (good X) has fallen relative to the price of the good that it buys (good Y); alternatively, the price of the good that country I buys has risen relative to the price of the good that it FIGURE 6 Shifts in Country II’s Offer Curve II’s imports of good X II’s exports of good Y 0 OC II Decreased willingness to trade Increased willingness to tradeS R R S OC II T OC II TOT3 TOT2 TOT1 If country II increases its willingness to trade, its offer curve OCII shifts diagonally or pivots to OC′II, indicating a greater desire to trade at each possible terms of trade. For example, point R with TOT3 becomes point R′, point S with TOT2 becomes point S′, etc. Similarly, a decreased will- ingness to trade on the part of country II shifts OCII diagonally downward to OC″II. Final PDF to printer CHAPTER 7 OFFER CURVES AND THE TERMS OF TRADE 109 app9062x_ch07_100-121.indd 109 06/01/16 07:35 AM sells. (See Concept Box 2 on the measurement of changes in a country’s terms of trade in practice.) The economic explanation for this rise in the relative price of the import good is that the increased demand for the good by country I’s consumers indicates that they value good Y more highly than before and are willing to give up more of good X to get each unit of good Y. Thus, with an unchanged supply schedule of exports from country II, the price of the good has been bid up. The increased desire for imports has raised the volume of imports from the original 0yE to 0y1, and the quantity of exports exchanged for the new import quantity is 0x1, a larger amount than the original 0xE. We have illustrated the effect of an increased willingness to trade by country I. Obviously, other shifts could take place. For example, a decreased willingness to trade by country I would shift or pivot its offer curve to the left and lead to a higher PX /PY and a smaller volume of trade. Further, an increased willingness to trade by country II would shift or pivot its offer curve upward and, with no change in country I’s offer curve, also would lead to higher equilibrium PX /PY but with a greater volume of trade than prior to the shift. A decreased willingness to trade by country II would shift its offer curve downward and produce a fall in PX /PY and a reduction in the volume of trade. (A discussion of recent movements in the terms of trade of major trading areas—movements that reflect the con- tinuing shifts of offer curves in the real world—can be found on pages 112–13.) The conclusion that shifts in a country’s offer curve can affect its terms of trade has an important exception in a country that is a small country. A small country is defined in international economics as a country that is unable to influence its terms of trade by its own actions. On the other hand, a large country can influence its terms of trade by its own actions, and most of the offer curve diagrams in this book portray this case. The inability FIGURE 7 An Increased Demand for Imports by Country I y2 0 E y1 yE x2x1xE I’s exports of good X, II’s imports of good X I’s imports of good Y, II’s exports of good Y TOTE TOT1 OCII I OCI If country I’s tastes shift toward its import good Y, OCI shifts to OC′I. At original equilibrium point E with TOTE, there is now an excess demand of yEy2 for good Y and an excess supply of xEx2 of good X. The resulting movement in the terms of trade from TOTE to TOT1 eliminates the excess demand and supply. The new equilib- rium position is point E′, with quantities 0x1 of good X and 0y1 of good Y being traded. Final PDF to printer 110 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch07_100-121.indd 110 06/01/16 07:35 AM CONCEPT BOX 2 MEASUREMENT OF THE TERMS OF TRADE The relative price ratio PX/PY in the offer curve diagram is called the commodity terms of trade, or net barter terms of trade, but usually, and most simply, the terms of trade (TOT). (Other concepts of the terms of trade are discussed later in this chapter.) The commodity terms of trade for any particular country are defined as the price of that country’s exports divided by the price of its imports. Thus, in our previous examples, the TOT for country I would be PX /PY, while the TOT for country II would be PY /PX. The economic interpretation of the terms of trade is that, as the price of exports rises relative to the price of imports, each unit of a country’s exports is able to purchase a larger quantity of imports. Thus, more imports, which like any other goods bring utility to consumers, can be obtained with a given vol- ume of exports, and the country’s welfare on the basis of these price relations alone has improved. In calculating the terms of trade for any given country, because a country trades many goods, a price index must be calculated for exports and for imports. A price index is a weighted average of the prices of many goods, calculated for comparison with a base year. A base year for the export price (PX) and import price (PM) indexes must be chosen. The base-year price indexes are then set at values of 100, and other years can be compared with them. For example, the International Monetary Fund (IMF), in its International Financial Statistics database, uses 2010 as its base year in calculating the export and import price indexes for Japan (and other countries); thus PXJPN2010 and PMJPN2010 = 100. Suppose we then consider 2014. According to the IMF, the price index for Japanese exports (using dollar values to construct the index) in 2014 was 91.609 (i.e., export prices were about 8.4 percent below the 2010 base-year prices), and the price index for Japanese imports was 106.069 (i.e., import prices were about 6 percent above the 2010 base-year values). The index of the terms of trade for Japan in 2014 would be calculated as follows: TOTJPN2014 = PXJPN 2014 PMJPN 2014 = (91.609/106.069) × 100 = 86.367 or 86.4 The multiplication by 100 is carried out to put the result into the usual index number form. The number 86.4 means that each unit of Japanese exports in 2014 exchanged for 13.6 percent (13.6 = 100 − 86.4) fewer units of imports than in the base year. Calculations of the commodity terms of trade have been carried out extensively in empirical work in econom- ics. Indeed, an ongoing controversy concerns the claim by spokespersons for developing countries that, over the long run, developing countries have been damaged by a decline in their commodity terms of trade. If the world is divided into only two groups—developing countries and the developed countries—then a decline in the terms of trade for developing countries must be associated with a rise in the terms of trade of the developed countries. (This rise would occur because, with only two trading groups, one group’s exports must be the other group’s imports and vice versa.) Such behavior of the terms of trade would imply that real income is being transferred from developing countries to developed countries! This controversy is covered more fully in Chapter 18. ● of a small country to influence the terms of trade means that, no matter how many units of its import good the country buys or how many units of its export good the country sells on the world market, the country will have no effect on world prices. The small country is a “price taker” in the same sense as is the individual consumer as a buyer and the individual firm as a seller in perfect competition in microeconomic theory. In the offer curve context, the offer curve facing the small country is a straight line from the origin. Thus, in Figure 7 on page 109, if the offer curve of (small) country I (OCI) shifted outward to OC′I, the terms of trade would remain at TOTE. (The TOTE line in effect would be the offer curve of the rest of the world that is facing country I.) Country I, if small, would be unable to influ- ence its terms of trade no matter where its offer curve were located (although the location of the offer curve would affect the volume of trade). Final PDF to printer CHAPTER 7 OFFER CURVES AND THE TERMS OF TRADE 111 app9062x_ch07_100-121.indd 111 06/01/16 07:35 AM Whether a country is large or small is an empirical question. Increased demand by Chad for machinery imports or increased export supply by Grenada of textiles is unlikely to affect either world prices or the terms of trade of those countries. However, some countries whose land area or gross domestic product (GDP) is small may be large in the economic sense because they export large quantities of goods that are in strong demand and they therefore have significant impact on world prices (e.g., Ghana in cocoa, Thailand in rice, Colombia in coffee). ELASTICITY AND THE OFFER CURVE A feature previously neglected in this chapter is the precise shape of the offer curve, and the shape is important because it influences the impacts of shifts in offer curves. The shape can be discussed in terms of the general concept of elasticity. The elasticity of an offer curve at various points can be defined in several ways, but we shall present the most com- mon definition. It deals with the elasticity of demand for imports along the curve, which is the percentage change in the quantity of imports demanded divided by the percentage change in the relative price of imports. This definition is analogous to the usual definition of price elasticity of demand, except that it refers to the relative price of the good instead of to an absolute price.3 Geometrically, the import-demand elasticity can be measured as follows. (The proof involves mathematical manipulation shown in Appendix A at the end of this chapter.) On the offer curves OCI in Figure 8, consider any point P. From this point, drop a perpendicular 3Two other definitions of elasticity used in offer curve analysis are (a) the elasticity of supply of exports, which is the percentage change in the quantity of exports supplied divided by the percentage change in the relative price of exports (which recognizes the “dual” nature of an offer curve as showing a supply of exports as well as a demand for imports), and (b) the elasticity of the offer curve itself, which is the percentage change in imports divided by the percentage change in exports as movement occurs along the offer curve. To avoid the confusion of multiple definitions and to conform to standard practice, we employ only the elasticity of demand for imports in this text. We also refer to the elasticity of demand for imports along the offer curve as “elasticity of the offer curve,” although this usage is not strictly correct. FIGURE 8 The Elasticity of Demand for Imports along an Offer Curve P 0 OCI 0 0 RS Imports of Y Exports of X Exports of X P R S Exports of X OCI Imports of Y Imports of Y P R,S OCI W (a) (b) (c) The import-demand elasticity of the offer curve at any point is measured by the distance 0R divided by the distance 0S. In panel (a) the curve is “elastic” at point P because 0R > 0S and therefore 0R/0S > 1. In panel (b) the offer curve is “inelastic” at point P because 0R < 0S and therefore 0R/0S < 1. In panel (c) the offer curve is “unit-elastic” at point P since 0R = 0S and therefore 0R/0S = 1. Final PDF to printer 112 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch07_100-121.indd 112 06/01/16 07:35 AM line to the horizontal axis and draw a tangent to P that also hits the horizontal axis. The elasticity is measured as the horizontal distance from origin 0 to the intersection of the perpendicular line, divided by the horizontal distance from the origin to the intersection of the tangent line. In Figure 8, the import-demand elasticity is thus 0R/0S. (Technically, a negative sign is in front of this measure, which we will disregard in our discussion.) The three parts of Figure 8 illustrate the three classifications associated with elasticity. In panel (a), 0R/0S > 1 because 0R is a longer distance than 0S, and the offer curve is referred to
as “elastic” at points on this upward-sloping range. In panel (b), distance 0R is shorter
than distance 0S; thus the fraction 0R/0S < 1. The offer curve in this downward-sloping or backward-bending portion is “inelastic.” In panel (c), 0R = 0S (the perpendicular and the tangent are the same line), so the offer curve is “unit-elastic” at point P. The total offer curve as usually drawn has three ranges like those in panels (a), (b), and (c) in Figure 8. In panel (c), the offer curve is “elastic” at all points from the origin to point P. This is the way offer curves have been drawn heretofore in this chapter. From point P to point W (in the limiting case, W could be on the vertical axis), the offer curve is “inelastic.” The offer curve at point P itself is “unit-elastic.” The use of elastic-inelastic-unit-elastic IN THE REAL WORLD: TERMS OF TRADE FOR MAJOR GROUPS OF COUNTRIES, 1973–2013 A country’s terms-of-trade movements over time reflect shifts in underlying demand and supply conditions (“will- ingness to trade” in the offer curve context). In Table 2 IMF export and import price data have been used to construct terms-of-trade indexes for particular groups of countries over the period 1973–2013. The indexes have been con- structed with a base year of 2010 = 100. The industrial or advanced countries experienced a terms-of-trade decline of 18 percent (from an index value of 115 to 94) during the 1973–1980 period—when imported oil prices were increasing rapidly—and a rise of 17 percent from 1980 to 1995, when oil and other imported primary- product prices were generally falling. Sufficient data for the oil-exporting countries are not available for calculat- ing their terms of trade for the 1973–1985 period, but the terms of trade for the Middle East and North Africa can be used as rough proxies. The Middle East and North Africa terms of trade rose by 155 percent (from an index of 33 to an index of 84) from 1973 to 1974. A substantial decline then occurred as the index fell to 41 in 1995. The dra- matic rise reflected the oil embargo of 1973–1974, when the Organization of Petroleum Exporting Countries (OPEC) restricted oil exports. This development can be thought of as a large leftward shift in the OPEC offer curve on the offer curve diagram, when OPEC exports are placed on the horizontal axis. The subsequent decline in the terms of trade from 1980 to 1995 can be interpreted as reflecting a downward shift in the collective OPEC trading partners’ offer curve as demand for OPEC oil was reduced through events such as increased energy conservation, the emer- gence of substitute energy sources (e.g., solar energy), and the rise of alternative oil sources (the North Slope in Alaska, the North Sea). The indexes in the table for emerging and developing countries as a whole mix together oil-exporting countries and non–oil-exporting countries and are less meaningful than separate indexes would be. In fact, the terms of trade for emerging and developing countries showed no marked trend during the 1973–2013 period. Note that performance differs by geographical grouping—the terms of trade of the Asian developing countries, after an initial decline, showed remarkable stability after 1990. The Western Hemisphere countries showed little trend in the early years but a substan- tial decline after 1990. (continued) Final PDF to printer CHAPTER 7 OFFER CURVES AND THE TERMS OF TRADE 113 app9062x_ch07_100-121.indd 113 06/01/16 07:35 AM in this offer curve context parallels its use in ordinary demand curve analysis. When a country is located in the “elastic” range of its offer curve, a given percentage change in the relative price of that country’s import good will induce a greater percentage change in the quantity of imports purchased. When the country is located in the “inelastic” range, a given percentage change in the relative price of imports will induce a smaller percentage change in the quantity of imports purchased. Finally, in the “unit-elastic” range, a given percent- age change in the relative price of imports will induce an equal percentage change in the quantity of imports. These elasticity ranges give a clue to the reason for the shape of the offer curve. Recall that an “elastic” demand means that if the price of a good falls, total spending (or total rev- enue, price times quantity) will rise because the percentage increase in quantity is greater than the percentage decrease in price. In the “inelastic” demand situation, a fall in price IN THE REAL WORLD: (continued) TERMS OF TRADE FOR MAJOR GROUPS OF COUNTRIES, 1973–2013 Country Group 1973 1974 1980 1985 1990 Advanced countries 115 103 94 95 106 Emerging and developing countries 93 132 97 92 86 Africa NA NA NA NA NA Asia 139 149 113 113 89 Europe NA NA 69 62 66 Middle East and North Africa 33 84 71 71 51 Western Hemisphere 154 117 146 122 145 Country Group 1995 2000 2005 2010 2013 Advanced countries 107 102 102 100 97 Emerging and developing countries 88 90 97 100 92 Africa NA NA 104* 100 122** Asia 102 97 99 100 78 Europe 110 102 103 100 97 Middle East and North Africa 41 71 105 100 146** Western Hemisphere 104 98 106 100 105 NA = not available. *2008 figure. **2012 figure. Source: Calculations from data obtained from the IMF website elibrary-data.imf.org. ● TABLE 2 Terms-of-Trade Indexes, Selected Years, 1973–2013 (2010 = 100) Final PDF to printer 114 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch07_100-121.indd 114 06/01/16 07:35 AM is associated with a fall in total spending on the good (total revenue) because the percent- age increase in quantity is less than the percentage decrease in price. Finally, if demand is “unit-elastic,” then a fall in price will produce no change in total revenue because the percentage increase in quantity matches the percentage decrease in price. The relationship of total spending or revenue change to elasticity is relevant to the shape of the offer curve. The important point is that a country gives up its export good to be able to purchase its import good. In the offer curve diagram, the quantity of exports is analo- gous to total spending or total revenue in the ordinary demand curve analysis. The export quantity plays this role because it shows what a country is willing to part with to obtain imports, just as in ordinary demand analysis the total amount spent on the good is what consumers are willing to part with to obtain the good. Because exports are analogous to total spending, the shape of the offer curve can be related to elasticity in a straightforward manner. Consider Figure 9. In range 0V, a change in the terms of trade from (PX /PY)1 to (PX /PY)2 indicates a relative decline in the price of good Y. Consequently, country I is willing to spend more on good Y because demand for Y is elastic, so country I’s willingness to export rises from 0x1 to 0x2. The upward-sloping portion of the offer curve is the elastic portion because declines in the price of the import good are associated with giving up more exports (0x2 rather than 0x1) in order to purchase more imports; that is, the country moves from a point like A to a point like B. It is clear why the inelastic portion of the offer curve is downward sloping. Suppose that prices are (PX/PY)4 at point F but then rise to (PX /PY)5. Country I’s willingness to trade—as FIGURE 9 Elasticity Ranges and Export Quantities Given Up to Acquire Imports y2 0 y1 y3 x2x1x5 I’s exports of good X I’s imports of good Y F G W V B A x4 x3 y4 y5 (PX/PY )5 (PX /PY )4 (PX /PY )3 (PX /PY )2 (PX /PY ) 1 In the elastic range of the offer curve, when the relative export price rises (relative import price falls) from (PX /PY)1 to (PX /PY)2, the quantity of exports increases from 0x1 to 0x2 as more imports (y1y2) are demanded; in the inelastic range of the curve, when the relative export price rises (relative import price falls) from (PX /PY)4 to (PX /PY)5, the quantity of exports decreases from 0x4 to 0x5 as more imports (y4y5) are demanded; and at uni- tary point V on the offer curve, an infinitesimal rise in the relative export price (fall in relative import price) from (PX /PY)3 would yield no change in the quantity of exports supplied by the country. These export quantity responses are analogous to the total spending (revenue) responses of consumers to a fall in the price of a good when demand is elastic, inelastic, and unit-elastic. Final PDF to printer CHAPTER 7 OFFER CURVES AND THE TERMS OF TRADE 115 app9062x_ch07_100-121.indd 115 06/01/16 07:35 AM shown by its offer curve—indicates that because the relative price of the import has fallen, country I is willing to purchase more imports of good Y (an increase from quantity 0y4 to quantity 0y5). However, because demand is inelastic, country I is willing to spend less on Y or, in this offer curve context, to give up fewer exports. Thus, exports fall from 0x4 to 0x5. Finally, the unit-elastic case at point V is the borderline case between elastic and inelas- tic. For an infinitesimal price change at V, or a larger price change if a vertical offer curve segment had been drawn for some distance above V, there would be some increase in the quantity of imports but no change in the quantity of exports 0x3 if prices rose above (PX/PY)3. Thus, no change in spending on imports is associated with a relative price change at this point, a characteristic of unit-elastic demand. This discussion has used the concept of elasticity to identify and explain the shape of the offer curve. The unusual feature that emerges in the offer curve is the downward- sloping or backward-bending portion of the curve. Several explanations can be given for the economic behavior behind these various sizes of elasticity, and we briefly present one explanation to provide a better impression of what takes place as the terms of trade change and the country moves along its offer curve. When the price of good X rises relative to the price of good Y—that is, PX /PY rises and the terms-of-trade line gets steeper—let’s consider what will happen to the quantity of exports supplied. (We know from Figure 9 that the quantity of imports demanded will increase as PX /PY rises.) First, country I’s consumers will tend to shift their purchases away from good X and toward good Y. Thus, out of any given production of good X by country I, more of X will be available for export because home consumers do not wish to consume as much of it. This substitution effect makes the offer curve upward sloping because, other things equal, the higher price of X results in a rise in the quantity of desired exports of X. When the price of good X rises relative to the price of good Y, country I’s producers will also have an incentive to produce more X and less Y because the higher price of good X indicates potentially higher profitability in X production relative to Y production. This production effect will reinforce the substitution effect because the greater production of X means that a greater quantity of X is available for export. Thus, the production effect, other things being equal, tends to yield an upward-sloping offer curve since the relatively higher price of X is inducing a greater quantity of exports of X. Finally, when the price of good X rises relative to the price of good Y, it is clear that country I’s real income has risen because the good it is selling abroad (good X) is com- manding a relatively higher price while the good being purchased from abroad (good Y) is now relatively cheaper. With the rise in real income because of the relative price change, country I purchases more of both X and Y.4 Other things being equal, the greater domestic purchases of good X because of higher real income reduce the amount of good X available for export. This income effect or terms-of-trade effect on exports works in the opposite direction from the substitution and production effects. When the combined substitution and production effects on exports are stronger than the income effect on exports, the offer curve will be upward sloping or “normal” in shape, such as in range OV of Figure 9. However, if the income effect dominates the other two effects, the offer curve will have a downward-sloping or backward-bending portion like range VW. Obviously, if the income effect just matches the other two effects, the offer curve would be 4We are assuming the absence of inferior goods. An “inferior good” is a good purchased in smaller quantities as real income rises. For example, as your real income rises, you may buy less hamburger because you are switch- ing to higher-quality meats. This assumption of “no inferior goods” seems reasonable if we think of good X as country I’s entire bundle of export goods and of good Y as country I’s entire bundle of import goods. Final PDF to printer 116 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch07_100-121.indd 116 06/01/16 07:35 AM vertical and would be unit-elastic. Ultimately, the shape of the offer curve is an empirical question. For a discussion of how offer curve elasticities can influence the stability of an equilibrium position, see Appendix B at the end of this chapter. CONCEPT CHECK 1. From an initial trading equilibrium position in the offer curve diagram, suppose that a coun- try’s consumers change their tastes so that they have a relatively stronger preference for the good their country exports. What will hap- pen to the willingness to trade and the terms of trade of this country? Illustrate and explain. 2. Assume that a single offer curve represents the willingness to trade of a group of oil- exporting countries (such as OPEC). What effect would the group’s collusive agreement to demand a higher price for oil exports have on this collective offer curve and on the terms of trade of the oil-exporting countries, other things equal? Explain. 3. In what respect is the shape of a country’s offer curve analogous to the relationship between price changes and total revenue changes along an ordinary straight-line demand curve for a commodity? OTHER CONCEPTS OF THE TERMS OF TRADE We conclude this chapter with a brief discussion of three other meanings of the phrase terms of trade that exist in the literature. These meanings differ from the price of exports/ price of imports (PX /PM) or commodity terms-of-trade concept (the PX /PY of country I) that is most frequently used in this chapter. It is important to keep the various concepts distinct because they are not interchangeable in their implications. A country’s income terms of trade (TOTY)—sometimes judged to be more useful than the commodity terms of trade from an economic development perspective—are the commod- ity terms of trade multiplied by a quantity index of exports, that is, TOTY = (PX/PM) × QX or (PX × QX)/PM. They are thus an index of total export earnings or value (PX × QX) divided by the price index of imports (PM). This measure attempts to quantify the trend of a coun- try’s export-based capacity to import goods, as opposed to only the price relations between exports and imports. A rise in TOTY indicates that the country’s export earnings now permit the country to purchase a greater quantity of imports. For developing countries, capital- and technology-intensive imports yield a stream of output in the future and can be critical for the development effort. A rise in TOTY can be very beneficial. The commodity terms of trade and the TOTY do not have to move in the same direction over time, because a decline in PX /PM, for example, could be more than offset by a rise in the quantity of exports (QX). It is also true that a decline in the commodity terms of trade for a country can be reinforced by a decline in the quantity of exports, so that the TOTY fall to a greater extent than the commodity terms of trade. The single factoral terms of trade (TOTSF) relate import price trends to productivity growth of the factors of production. The TOTSF concept is the commodity terms of trade multi- plied by an index of productivity in the export industries, that is, TOTSF = (PX/PM) × OX, where OX is the productivity index. If the TOTSF rise, the economic interpretation is that a greater quantity of imports can be obtained for a given unit of work effort in produc- ing exports. In other words, a rise means that more imports can be purchased for a given amount of employment time of the factors of production in the export industries. There have been some calculations of TOTSF, but a major difficulty involves generating accurate Income Terms of Trade Single Factoral Terms of Trade Final PDF to printer CHAPTER 7 OFFER CURVES AND THE TERMS OF TRADE 117 app9062x_ch07_100-121.indd 117 06/01/16 07:35 AM IN THE REAL WORLD: INCOME TERMS OF TRADE OF MAJOR GROUPS OF COUNTRIES, 1973–2013 Table 3 portrays income terms-of-trade indexes for 1973– 2013, calculated by dividing the index of export value in each year (PX × QX, with 2010 = 100) by the index of import prices. Compare this table with the commodity terms of trade in Table 2, noting that movements in the income terms of trade do not necessarily mirror movements of the commod- ity terms of trade. Furthermore, all groups of countries have shown improvement in their income terms of trade over time (although the Middle East had marked deterioration in the early 1980s), a result that is conceptually impossible with the commodity terms of trade because an improvement in the commodity terms of trade of some groups must mean a deterioration for at least one other group. By region, the most dramatic improvement in income terms of trade over the entire period occurred for the developing economies in Asia, which importantly reflects the strong demand in world markets for the products of China, Hong Kong, South Korea, Singapore, and Taiwan. Country Group 1973 1974 1980 1985 1990 Advanced countries 17 16 21 25 38 Emerging and developing countries 9 11 13 12 17 Africa NA NA NA NA NA Asia 3 3 4 6 9 Europe NA NA 6 10 11 Middle East and North Africa 12 24 36 20 28 Western Hemisphere 14 16 25 27 35 Country Group 1995 2000 2005 2010 2013 Advanced countries 50 72 88 100 105 Emerging and developing countries 27 44 73 100 106 Africa NA NA 144* 100 166** Asia 20 32 60 100 93 Europe 23 38 71 100 119 Middle East and North Africa 27 57 101 100 156** Western Hemisphere 46 75 97 100 115 NA = not available. *2008 figure. **2012 figure. Source: Calculated from data obtained from the IMF website elibrary-data.imf.org. ● TABLE 3 Income Terms-of-Trade Indexes, Selected Years, 1973–2013 (2010 = 100) productivity indexes. The TOTSF will usually show a more favorable (or less unfavorable) trend for any given country than will the commodity terms of trade because productivity usually increases over time. Final PDF to printer 118 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch07_100-121.indd 118 06/01/16 07:35 AM The final terms of trade concept adjusts the TOTSF for productivity trends in a country’s trading partners. Thus, the double factoral terms-of-trade ratio (TOTDF) is the TOTSF divided by the index of productivity in the export industries of the trading partners, that is, TOTDF = (PX/PM) × (OX/OM), where OM represents the foreign productivity index for the home country’s imports. A rise in TOTDF indicates that given quantities of the services of the home country’s factors of production in its export industries are being exchanged for a greater quantity of the services of the factors of production in export industries in trading partner countries. In this sense, the “exchange of factors” between the partners has become more favorable for the home country. The TOTDF have been occasionally calculated in practice, but the empirical difficulty of obtaining data on the productivity of foreign factors of production must be added to the difficulty of obtaining data on the productivity of home factors of production. In overview, the selection of the appropriate terms-of-trade concept to emphasize depends upon the purpose the analyst has in mind. Each concept is designed to interpret a different aspect of relative price changes. In the remainder of this text, terms of trade will refer to the commodity or net barter terms of trade unless otherwise indicated. However, keep in mind that this concept is not necessarily appropriate for examination of many trade issues. Double Factoral Terms of Trade CONCEPT CHECK 1. If demand increases for the export good of country A, how does the elasticity of country A’s offer curve influence the extent to which its terms of trade will improve? 2. If demand for a country’s export good rises, other things being equal, will both the com- modity terms of trade and the income terms of trade improve? Explain. SUMMARY This chapter has developed the concept of the offer curve. The offer curve demonstrates a country’s willingness to participate in international trade at various terms of trade and provides a vehicle for illustrating the determination of the equilibrium terms of trade in the world market. Economic growth, changes in tastes, and commercial policy actions are among the events that will shift a country’s offer curve and can influence the volume and terms of trade. Finally, the chapter discussed the elasticity of an offer curve and several concepts of the terms of trade. KEY TERMS commodity terms of trade (or net barter terms of trade) double factoral terms of trade elasticity of demand for imports equilibrium terms of trade income effect (or terms-of-trade effect) income terms of trade large country offer curve (or reciprocal demand curve) price index production effect single factoral terms of trade small country substitution effect QUESTIONS AND PROBLEMS 1. Discuss several economic events that would increase a country’s willingness to trade. 2. Assume that demand increases for a country’s export good. Will there be a different qualitative effect on the country’s terms of trade if the country is “large” rather than “small”? Why or why not? 3. Suppose that country I increases its willingness to trade at the same time that trading partner country II decreases its Final PDF to printer CHAPTER 7 OFFER CURVES AND THE TERMS OF TRADE 119 app9062x_ch07_100-121.indd 119 06/01/16 07:35 AM willingness to trade. What can be said about the resulting impact on the terms of trade and on the volume of trade? (Note: You will not be able to say anything concrete about one of these two impacts. Why not?) 4. Suppose that country I and trading partner country II decrease their willingness to trade at the same time. What will be the impact on the terms of trade and on the volume of trade? (Note: You will not be able to say anything con- crete about one of these impacts. Why not?) 5. In the offer curve analysis, why must an excess supply of one good be associated with an excess demand for the other good? 6. In August 1990, many countries decided to retaliate against Iraq for its invasion of Kuwait by refusing to trade with Iraq (except in food and humanitarian goods). With such an “embargo” in place, what conceptually would happen to Iraq’s terms of trade and volume of trade? Illustrate and explain your answer using offer curves. 7. Suppose that an offer curve diagram has developed coun- tries’ exports on one axis and developing countries’ exports on the other axis. Explain the predicted impact, other things equal, on the terms of trade of developing countries of rel- atively slow growth in demand for developing countries’ goods by developed countries combined with relatively rapid growth in demand by developing countries for devel- oped countries’ goods. 8. In the past, the members of OPEC have been able to raise the relative price of petroleum by a large amount with a relatively small decrease in export volume, thereby increas- ing substantially the revenues they received from the buy- ers of their petroleum exports. Describe the likely shapes of the offer curves of the importing countries—shapes that enabled the OPEC countries to pursue their trade strategy successfully. 9. “If countries are behaving rationally, they should always be willing to export more at a higher export price. Thus, one would not expect to see ‘backward-bending’ offer curves.” Discuss. 10. You have the following information for a country for 2015, with all price indexes utilizing 2005 as the base year: The export price index is 120, the import price index is 130, the quantity index of exports is 115, and the quantity index of imports is 100. Calculate the commodity terms of trade and the income terms of trade for this country for 2015. Interpret your results. Appendix A DERIVATION OF IMPORT-DEMAND ELASTICITY ON AN OFFER CURVE To derive the import-demand elasticity on the offer curve at any point P in the standard fashion, con- sider Figure 8(a) on page 111. The import-demand elasticity (ε) is the percentage change in the quantity demanded of the import good Y divided by the percentage change in the relative price of Y. The rela- tive price of Y is the amount of export good X given up to obtain 1 unit of good Y. Using the calculus, ε = dY/Y d(X/Y) X/Y = (dY/Y)(X/Y) d(X/Y) Hence, ε = (XdY/Y2) d(X/Y) = (XdY)/Y 2 YdX − XdY Y2 = XdY YdX − XdY = 1 YdX XdY − 1 Geometrically, at point P in Figure 8(a), Y/X = RP/0R and dX/dY = SR/RP. Therefore, ε = 1 RP 0R × SR RP − 1 = 1 SR 0R − 1 = 1 SR − 0R 0R = 1 −0S 0R = −0R 0S Ignoring the negative sign, the import-demand elasticity ε is thus 0R/0S, or the distance from the origin to the point where the perpendicular from P hits the x-axis divided by the distance from the origin to the point where the line tangent to P hits the x-axis. Final PDF to printer 120 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch07_100-121.indd 120 06/01/16 07:35 AM Appendix B ELASTICITY AND INSTABILITY OF OFFER CURVE EQUILIBRIA In this chapter and in the rest of this book, unless otherwise noted, we assume that equilibrium posi- tions are stable. This means that a deviation from an equilibrium will set forces into motion to move to the equilibrium. This kind of equilibrium is the type familiar, for example, from ordinary demand and supply diagrams. A price of a good above (below) the equilibrium price is associated with excess supply (demand), and the price therefore falls (rises) to the equilibrium price. However, in the offer curve diagram, it is possible for an equilibrium position to be an unstable one. This means that a deviation from equilibrium will push the relative price PX/PY farther away from the original equilib- rium relative price rather than toward that price. Recall that an offer curve can be drawn with an elastic range, a unit-elastic turning point, and an inelastic range. It is theoretically possible for the interaction of two countries’ curves to yield multiple equilibrium positions (see Figure 10). In this unusual-looking graph, which resembles a poorly tied bow tie, there are three equilibrium positions—E1, E2, and E3—with offer curves OCI and OCII. The existence of multiple equilibria makes it unclear where the world economy will settle, because the resting place could be a matter of historical accident rather than of any particular economic forces. Points E1 and E3 are stable equilibrium positions because small deviations from those points set forces in motion to move to those points. For example, at point E1 and TOT1, it is clear that terms of trade TOT2 are associated with excess supply of good X and excess demand for good Y. Hence, TOT2 are not sustainable and relative prices fall to TOT1. Similarly, relative prices TOT3 are associated with FIGURE 10 Multiple Equilibria in International Trade y5 0 x5 I’s exports of X, II’s imports of X I’s imports of Y, II’s exports of Y TOT1 OC II OC I y4 x4 TOT4 TOT3 TOT2 II E2 E3 E4 E1 F G With backward-bending offer curves OCI and OCII, there are three possible equilibrium positions. Point E1 is a stable equilibrium, since terms of trade TOT2 and TOT3 will be associated with excess demands and sup- plies of the goods that will move the terms of trade to TOT1. However, terms of trade at TOT4 will not move to equilibrium position E2 because, at TOT4, there is excess supply of good X (of amount x5x4) and excess demand for good Y (of amount y5y4). The terms of trade will thus move from TOT4 downward to TOT1. Analogously, a terms-of-trade line slightly above E2 would move up to stable equilibrium position E3. In addition, if the initial equilibrium position is E1, a shift in OCII to OC′II would cause equilibrium to move to position E4. Final PDF to printer CHAPTER 7 OFFER CURVES AND THE TERMS OF TRADE 121 app9062x_ch07_100-121.indd 121 06/01/16 07:35 AM excess demand for good X and excess supply of good Y, so the terms of trade move to TOT1. An identical analysis with point E3 would show that E3 is also a stable equilibrium position. However, in Figure  10, point E2 is an unstable equilibrium position. Consider terms of trade TOT4. With the trading partners in disequilibrium at TOT4, will trade move to E2? Clearly not! At TOT4, country I wishes to trade at point G, where it will be supplying quantity 0x4 of exports and demanding quantity 0y4 of imports. However, country II, at point F on its offer curve, wishes to sup- ply quantity 0y5 of exports and to demand 0x5 of imports. At TOT4, there is excess supply of good X (of x5x4) and excess demand for good Y (of y5y4). This situation will cause the PX /PY ratio to fall; thus, TOT4 will give way to a flatter price line. The trading partners under the forces of the market will not go to E2, but to E1, where the excess supply of good X and the excess demand for good Y are eliminated. A similar analysis can show why a terms-of-trade line slightly above E2 will set forces in motion to drive the trading equilibrium to point E3. Incidentally, the mathematical condition for an unstable equilibrium, such as E2, to exist is that the sum of the absolute values of the two countries’ import elasticities of demand at that point be less than 1.0. The relevant empirical question to be investigated concerns whether the sum of the absolute values of the elasticities is high enough (such as 0.4 + 1.5 = 1.9) to generate a stable equilibrium or whether it is so low (such as 0.5 + 0.3 = 0.8) that an equilibrium position is unstable. A main point is that if elasticities in international trade are such that countries are operating on the inelastic portion of their offer curves, then it is possible that countries can experience large move- ments of prices in one direction (such as from immediately below E2 to E1). Further, suppose that the two countries are initially at E1 but that the offer curve of country II (OCII) now shifts upward to OC′II. The new equilibrium position will be E4, with a considerably different set of prices and volume of trade than at E1. Such large changes could engender risk for many firms and individuals engaged in international trade. Risk-averse participants might then be less willing to expose themselves to the world economy altogether and would sacrifice gains from trade. Final PDF to printer 122 app9062x_ch08_122-149.indd 122 06/17/16 06:48 PM CHAPTER 8 THE BASIS FOR TRADEFactor Endowments and the Heckscher-Ohlin Model LEARNING OBJECTIVES LO1 Examine how relative factor endowments affect relative factor prices and generate a basis for trade. LO2 Explain how trade affects relative factor prices and income distribution. LO3 Analyze how real-world phenomena can modify Heckscher-Ohlin conclusions. Final PDF to printer CHAPTER 8 THE BASIS FOR TRADE 123 app9062x_ch08_122-149.indd 123 06/17/16 06:48 PM INTRODUCTION The role of labor standards in fostering international trade has been in the forefront of the trade policy agenda in recent years. It has attracted the interest of humanitarian organizations, govern- ments, and international organizations as production of labor-intensive goods has continued to move to developing countries with increased globalization. In a 2002 article, Matthias Busse analyzed econometrically whether different categories of labor standards do, in fact, have an effect on comparative advantage in developing countries.1 He addressed the question of whether a developing country can derive comparative advantage in unskilled-labor-intensive goods by employing low labor standards and thus increase its world exports. A number of different groups believe that this is happening and thus are urging the implementation of import barriers against countries with notably lower standards for both humanitarian reasons and to ensure a more “level playing field.” Busse distinguished between “core” labor standards (important human rights such as union rights, freedom from forced labor, abolition of child labor, equal opportunity) and labor standards often referred to as “acceptable conditions of work” (e.g., minimum wages, safety and health standards). He focused on the effect of core standards on comparative advantage and exports utilizing the Heckscher-Ohlin theoretical framework developed in this chapter to provide the underpinnings for his empirical work. Because comparative advantage is determined by rela- tive factor endowments, he hypothesized that lower core labor standards would lead to a relative increase in unskilled labor and thus increase relative exports of unskilled-labor-intensive goods. Five indicators of core labor standards [discrimination against women, presence of child labor, use of forced labor, basic union rights, and number of ratifications of the eight International Labour Office (ILO) conventions of core labor standards] were key variables used to explain the share of unskilled-labor-intensive goods in total exports in an 83-country cross-section regression analysis. Several of the more interesting conclusions were that greater discrimination against women weakened comparative advantage, whereas weaker union rights, greater child labor, and greater use of forced labor increased export share. Interestingly, the number of ratifications of the ILO conventions appeared to have no significant effect. It is, however, important to note that in all cases educational attainment and the overall relative labor endowment had relatively stronger influences on the trade patterns than did the labor standard variables. Interesting and useful policy analysis such as that contained in the Busse paper necessitates the use of a more formal structure in which the complexities of international comparative advantage can be sorted out in a consistent way. In previous chapters, we demonstrated that a country will gain from trade anytime that the terms of trade differ from its own relative prices in autarky. The country gains by expanding production of and exporting the com- modity that is relatively more valuable in the foreign market and reducing production of and importing the good that is relatively less expensive in the foreign market. These adjust- ments permit the consumption of a combination of goods that lies outside the production- possibilities frontier at a higher level of consumer well-being. It was further demonstrated that the underlying basis for the relative price differences that led to international trade could be traced to differences in supply and/or demand conditions in the two countries. This analysis assumes that there is no intervention in the markets to alter prices from these general equilibrium results. Clearly, taxes and subsidies can cause autarky prices to be more or less different prior to trade. This chapter will examine in greater detail the factors that influence relative prices prior to international trade, focusing on differences in supply conditions. We first examine how different relative quantities of the factors of production can influence product prices and Do Labor Standards Affect Comparative Advantage? 1Matthias Busse, “Do Labor Standards Affect Comparative Advantage in Developing Countries?” World Devel- opment 30, no. 11 (November 2002), pp. 1921–32. Final PDF to printer 124 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch08_122-149.indd 124 06/17/16 06:48 PM produce a basis for trade. We then discuss how the resulting trade will in turn affect factor prices and the distribution of income within the trading countries. Finally, the implications of various assumptions employed in the analysis are presented. The purpose of this chapter is to provide a deeper understanding of the critical factors underlying relative cost differ- ences and therefore comparative advantage. FACTOR ENDOWMENTS AND THE HECKSCHER-OHLIN THEOREM The effects of factor endowments on international trade were analyzed early in the twentieth century by two Swedish economists, Eli Heckscher (in 1919) and Bertil Ohlin (in 1933). As employed by modern economists, this analysis makes a number of simplify- ing assumptions, specifically that: 1. There are two countries, two homogeneous goods, and two homogeneous factors of production whose initial levels are fixed and assumed to be relatively different for each country. 2. Technology is identical in both countries; that is, production functions are the same in both countries. 3. Production is characterized by constant returns to scale for both commodities in both countries. 4. The two commodities have different relative factor intensities, and the respective commodity factor intensities are the same for all factor price ratios. 5. Tastes and preferences are the same in both countries. Further, for any given set of product prices, the two products are consumed in the same relative quantities at all levels of income; that is, there are homothetic tastes and preferences.2 6. Perfect competition exists in both countries. 7. Factors are perfectly mobile within each country and not mobile between countries. 8. There are no transportation costs. 9. There are no policies restricting the movement of goods between countries or inter- fering with the market determination of prices and output. Most of these assumptions are common to the models examined in previous chapters. However, the two that are especially critical to the Heckscher-Ohlin (H-O) explanation of the emergence and structure of trade are (assumption 1) that factor endowments are differ- ent in each country and (assumption 4) that commodities are always intensive in a given factor regardless of relative factor prices. These two assumptions need to be examined in greater detail prior to discussing the H-O theorem. It is important to understand that the phrase different factor endowments refers to different relative factor endowments, not different absolute amounts. Crucial to the H-O analysis is that factor proportions are different between the two countries. Relative factor abun- dance may be defined in two ways: the physical definition and the price definition. The physical definition explains factor abundance in terms of the physical units of two factors, for example, labor and capital, available in each of the two countries. Country I would be Factor Abundance and Heckscher-Ohlin 2It can be shown in more advanced discussions that, with identical and homothetic tastes and preferences, changes in income distribution will not cause the indifference map to change. Thus, the possibility that pretrade and posttrade community indifference curves might intersect due to trade-induced changes in income distribution is precluded. Final PDF to printer CHAPTER 8 THE BASIS FOR TRADE 125 app9062x_ch08_122-149.indd 125 06/17/16 06:48 PM the capital-abundant country if its ratio of capital to labor exceeded the ratio of capital to labor in country II [(K /L)I > (K /L)II]. It must be stressed that the relative amount of the
factors is critical, not country size. A country with fewer absolute units of physical capital
than a larger country could still be the capital-abundant country as long as the amount of
capital relative to labor was greater than the same ratio in the larger country. Finally, in the
two-country, two-factor case, if country I is the capital-abundant country, then country II
must by definition be the labor-abundant country.
The price definition relies on the relative prices of capital and labor to reveal the type
of factor abundance characterizing the two countries. According to this definition, country
I would be the capital-abundant country as long as (r/w)I < (r/w)II; that is, the ratio of the price or rental rate of capital (r) to the price or wage of labor (w) in country I is less than in country II. This definition views relative abundance in terms of the factors’ relative scarcity prices. The greater the relative abundance of a factor, the lower its relative price. One definition focuses on physical availability (supply), and the other focuses on factor price. What is the link, if any, between the two? On the surface, there does not seem to be a problem because the greater or smaller the supply of a factor, the lower or higher its price tends to be. In countries with large populations such as India and China, the price of labor is relatively low while that of capital is relatively high. The converse tends to be true in a country such as Germany or the United States. However, the problem is that the factor price reflects not only the supply of available factors but also the demand. Because factors of production are not consumed directly but are used to produce final goods and services that are consumed, demand for the factors results from the structure of demand for final goods and services. Demand for a factor of production is thus often referred to as a derived demand resulting from producers meeting final consumption preferences. Factor prices reflect not only the physical availability of the factors in question but also the structure of final demand and the production technology employed. Fortunately, because the H-O model assumes that technology and tastes and preferences are the same in both countries, the two definitions will produce the same result. With technology and demand influences neutralized between the two countries, the country with the relatively larger K/L ratio also will have the relatively smaller r/w ratio. The link between the two definitions is unambig- uous unless technology or demands differ between the two countries. When this happens, the price definition may differ from the physical definition; for example, physically abun- dant capital may be relatively high priced. We refer to this possibility later in the chapter. A commodity is said to be factor-x-intensive whenever the ratio of factor x to a second fac- tor y is larger when compared with a similar ratio of factor usage of a second commodity. For example, steel is said to be capital intensive compared with cloth if the K/L ratio in steel production is larger than the K/L ratio in cloth production. H-O assumes not only that the two commodities have different factor intensities at common factor prices but also that the difference holds for all possible factor price ratios in both countries. This means that at all possible factor prices, the isoquants reflecting the technology used in steel production are more oriented toward the capital axis, compared with the isoquants reflecting cloth production, so that the capital/labor ratio for steel will always be larger than that for cloth (see Figure 1). It is important to note that this assumption does not preclude substituting labor for capital if capital becomes relatively more expensive, or substituting capital for labor if the relative price of labor rises. While such price changes would indeed change the capital/labor ratios in both commodities, they would never cause cloth to use more capital relative to labor compared with steel. This is a strong assumption and it is critical to the H-O analysis. We will later examine some possible conditions when it would not hold and the resulting implications for international trade. Commodity Factor Intensity and Heckscher-Ohlin Final PDF to printer 126 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch08_122-149.indd 126 06/17/16 06:48 PM FIGURE 1 Factor-Intensity Relationships A F G B (w/r)1 (K/L)C1 C0 K L (K/L)C2 (K/L)S1 (K/L)S2 S0 (w/r)2 (w/r)1 A critical assumption of the H-O analysis is that commodities are intensive in a given factor regardless of rela- tive factor prices. This assumption is met in the above case for steel (isoquant S0) and cloth (isoquant C0). Given the nature of the isoquant map for each commodity, steel will always have a higher K/L ratio than cloth what- ever the relative factor prices, and thus it is the capital-intensive product. If steel is relatively capital intensive, it follows that cloth must necessarily be relatively labor intensive; that is, it will always have a smaller K/L ratio compared with steel. This is evident if one compares the K/L ratios of the two goods when labor is relatively cheap [(w/r)1] with ratios when labor is relatively expensive [(w/r)2]. The K/L ratio used in production at any point on an isoquant is given by the slope of a ray from the origin through the production point. Thus, at (w/r)1 production of steel (at A) is more K intensive than production of cloth (at B); at (w/r)2, production of steel (at F) is again more K intensive than production of cloth (at G). IN THE REAL WORLD: RELATIVE FACTOR ENDOWMENTS IN SELECTED COUNTRIES Relative factor endowments differ considerably across countries. Table 1 gives three factor ratios for a number of selected countries to provide some indication of the degree of difference in endowments in 1992. Table 2 then provides more recent estimates for a smaller number of countries for 2010. The wide variety of relative factor endowments supports the idea that underlying factor supply conditions continue to vary from country to country, as Heckscher and Ohlin posited many years ago. Country Capital/Labor ($/worker) Capital/Land ($/sq. kilometer) Labor/Land (workers/sq. kilometer) Australia $38,729 $ 40,278 1.04 Austria 36,641 1,744,478 47.61 Bolivia 5,335 24,274 4.55 Canada 44,970 62,958 1.40 TABLE 1 Relative Factor Endowments, 1992 (continued) Final PDF to printer CHAPTER 8 THE BASIS FOR TRADE 127 app9062x_ch08_122-149.indd 127 06/17/16 06:48 PM IN THE REAL WORLD: (continued) Country Capital/Labor ($/worker) Capital/Land ($/hectare) Labor/Land (workers/hectare) United States $33,782 $ 700 20.7 Japan 47,927 10,060 209.1 Canada 30,396 144 4.7 Australia 39,018 89 2.3 France 36,433 2,204 60.5 Mexico 8,204 218 26.6 Source: Based on data in Table 1, Chapter 11, page 213. TABLE 2 Relative Factor Endowments, 2010 ● Country Capital/Labor ($/worker) Capital/Land ($/sq. kilometer) Labor/Land (workers/sq. kilometer) Chile 11,306 74,733 6.61 Denmark 33,814 2,359,203 69.77 Finland 47,498 421,782 8.88 France 37,460 1,764,366 47.10 Germany 41,115 4,491,403 109.24 Greece 23,738 719,261 30.30 Hong Kong 14,039 42,117,000 3,000.00 India 1,997 204,073 102.19 Ireland 22,171 633,425 28.57 Italy 33,775 2,580,748 76.41 Japan 41,286 6,881,138 166.67 Madagascar 1,750 14,910 8.52 Mexico 13,697 223,809 16.34 Norway 47,118 290,718 6.17 Philippines 3,598 287,840 80.00 Spain 30,888 917,682 29.71 Sweden 41,017 364,641 8.89 Switzerland 76,733 5,614,554 73.17 Turkey 7,626 244,718 32.09 United Kingdom 22,509 2,572,554 114.29 United States 35,993 476,187 13.23 Venezuela 18,296 140,513 7.68 Note: Capital is valued at 1985 prices. Sources: Capital/labor: Penn World Tables, obtained from datacentre.chass.utoronto.ca; capital/land: (capital/labor) ×  (labor/land); labor/land: World Bank, World Development Report 1994 (New York: Oxford University Press, 1994), pp. 162–63, 210–11. Final PDF to printer 128 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch08_122-149.indd 128 06/17/16 06:48 PM The set of assumptions about production leads to the conclusion that the production- possibilities frontier (PPF) will differ between two countries solely as a result of their differing factor endowments. With identical technology in both countries, constant returns to scale, and a given factor-intensity relationship between final products, the country with abundant capital will be able to produce relatively more of the capital-intensive good, while the country with abundant labor will be able to produce relatively more of the labor-inten- sive good. The shape and position of the PPF is thus determined by the factor intensities of the two goods and the amount of each factor available. This is obvious if one compares the Edgeworth boxes for two countries with different factor endowments (see Figure 2). The two boxes show that country I is the capital-abundant country. This is evident since the height of the box (amount of capital) is greater for country I, whereas the length of the box (physical amount of labor) is greater for country II. In more general terms, the slope of the diagonal reflects the K/L ratio and therefore the relative endowment of the country. This slope is greater in country I, making it clearly the capital-abundant country. The analysis in Chapter 5, which discussed how the PPF was obtained from the Edgeworth box, leads us to conclude that the PPF for each country will be different. Country I’s PPF is oriented more toward steel, and country II’s PPF is oriented more toward cloth. If these two differently shaped PPFs are now combined with the same set of tastes and preferences, two different sets of relative prices will emerge in autarky, as shown in Figure 3(a). The relative price of steel will be lower in country I (the capital-abundant country) as reflected in a steeper autarky price line, while the relative price of cloth will be lower in country II (the labor-abundant country) as evidenced by a flatter autarky price line. Because relative prices in autarky are different between the two countries, a clear basis for trade results from the different factor endowments. The trade implications of this situation can be seen in Figure 3(b). The international terms of trade must lie necessarily between the two internal price ratios, being flatter than the autarky price line in country I and steeper than the autarky price line in country II. In this situation, country I will export steel to and import cloth from country II, reaching a higher community indifference curve in the process. Country II also will find itself better off by exporting cloth and importing steel. The common equilibrium international terms of trade that produce this result are drawn between the autarky prices of both of the countries. A single international terms-of-trade (TOT) line, (PC/PS)int, tangent to both PPFs, is used in panel (b) for convenience, although The Heckscher-Ohlin Theorem IN THE REAL WORLD: RELATIVE FACTOR INTENSITIES IN CANADA Heckscher-Ohlin importantly assumed that relative factor intensities were different across commodities. To provide an indication of the degree of variation within a given coun- try, we calculated in Table 3 the capital/labor ratios for a selected group of industries, mostly in manufacturing, in Canada in 2006. (The data for constructing this table are not available for years after 2006 as the relevant series were dis- continued.) As can be observed, there are huge differences in the ratios, going from a high of $2,675,267 per worker to about $9,000 per worker. Then, in Table 4, we present Canadian capital/labor ratios for a range of more broadly defined industries in 2014. The figures are the ratio of net capital stock at the end of 2013 (beginning of 2014) to the number of workers employed in 2014. Again, there is a very large degree of variation across industries. (continued) Final PDF to printer CHAPTER 8 THE BASIS FOR TRADE 129 app9062x_ch08_122-149.indd 129 06/17/16 06:48 PM IN THE REAL WORLD: (continued) Industry Capital per Worker (in 2002 Canadian dollars) Oil and gas extraction $2,675,267 Petroleum and coal products manufacturing 617,066 Rail transportation 413,434 Mining (except oil and gas) 398,287 Chemical manufacturing 144,029 Paper manufacturing 118,777 Transportation equipment manufacturing 92,315 Wood product manufacturing 70,598 Hospitals 56,559 Motion picture and sound recording industries 53,596 Forestry and logging 49,007 Food manufacturing 45,111 Computer and electronic product manufacturing 44,266 Waste management and remediation services 43,851 Plastics and rubber products manufacturing 40,912 Electrical equipment, appliance, and component manufacturing 32,240 Truck transportation 30,180 Fabricated metal products manufacturing 22,349 Leather and allied product manufacturing 12,573 Clothing manufacturing 8,954 Source: Figures are derived from data on real GDP per worker and real GDP per $1,000 of capital stock supplied by Statistics Canada, at www.csls.ca/data/ptablnAug2008/. TABLE 3 Capital/Labor Ratios in Canada, 2006, by Industry Industry Capital/Labor Ratio (in 2007 Canadian dollars) Mining, quarrying, and oil and gas extraction $2,176,732 Utilities 1,798,002 Transportation and warehousing 173,615 Information and cultural industries 154,299 Finance, insurance, real estate, rental, and leasing 138,419 Manufacturing 81,767 Arts, entertainment, and recreation 45,168 Construction 29,283 Wholesale and retail trade 28,203 Professional, scientific, and technical services 27,568 Accommodation and food services 20,395 Administrative and support, waste management, and remediation services 11,946 Health care and social assistance 6,524 Educational services 1,272 Sources: Capital stock data from Statistics Canada, Table 031-0006; labor data from Statistics Canada Table 281-0024; both available at www5.statcan.gc.ca/cansim/. TABLE 4 Capital/Labor Ratios in Canadian Industries, 2014 ● Final PDF to printer 130 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch08_122-149.indd 130 06/17/16 06:48 PM FIGURE 2 Different Relative Factor Endowments and the Nature of the Edgeworth Box C0 K L S0 Steel Cloth S1 S2 S3 C1 C2 C3 C0 K L S0 Steel Cloth S1 S2 S3 C1 C2 C3 Country I Country II The different shapes of the Edgeworth boxes reflect the relative factor endowments in the two countries. The relatively taller box for country I— the steeper diagonal reflects a higher K/L ratio—indicates that it is the capital-abundant country, whereas the relatively longer box for country II (flatter diagonal) indicates that it is the labor-abundant country. If technology is the same in both countries, the different relative factor endow- ments will lead to differently shaped PPFs. Because country I has relatively more capital than country II, it will be able to produce relatively more of the capital-intensive good. Consequently, its PPF will reflect a greater relative ability to produce steel, whereas country II’s PPF will reflect a greater relative ability to produce cloth. FIGURE 3 Gains from Trade in Two Countries with Identical Technology and Demands but Different Relative Factor Endowments S0 Steel Cloth Steel Cloth (PC/PS) I (PC/PS) II ICI,II = IC0 (PC/PS)int S1 S2 C2 C0C1 q Q C c IC1 IC0 (a) (b) Country II Country I The two graphs demonstrate the basis for trade when demand conditions and technology are assumed to be identical but relative factor endow- ments are different for countries I and II. Country I is assumed to be the capital-abundant country and has a PPF skewed toward the production of the capital-intensive good, steel. The PPF for country II, the labor-abundant country, is skewed toward the labor-intensive good, cloth. With iden- tical demand structures, indicated by the common community indifference curve, ICI,II, we see that the relative price of cloth (PC /PS)II in country II is going to be less (a flatter relative price line) than that in country I, (PC/PS)I. There is thus a basis for trade between the two countries. For both to benefit from trade, they must settle at an international terms of trade that lie between the two domestic price ratios in autarky, (PC/PS)int in panel (b). Both countries will now wish to consume at C′c′, which lies outside their respective PPFs. At the same time, production will move to Q in country I and to q in country II. Country II will therefore export C1C0 of cloth and import S2S1 of steel. Country I will export S1S0 of steel and import C2C1 of cloth. In equilibrium, C1C0 of country II exports is the same as C2C1 of country I imports, and S1S0 of country I exports is the same as S2S1 of country II imports. Final PDF to printer CHAPTER 8 THE BASIS FOR TRADE 131 app9062x_ch08_122-149.indd 131 06/17/16 06:48 PM all that is required is an equally sloped TOT line, not necessarily a common line. For equilibrium to occur, country I’s desired exports of steel (S1S0) and imports of cloth (C2C1) must equal exactly country II’s desired exports of cloth (C1C0) and imports of steel (S2S1) at the prevailing international terms of trade. When this occurs, both countries find them- selves on the higher indifference curve, IC1, indicating the mutual gain from trade. The previous discussion used the physical definition of factor abundance. A similar result would have occurred if we had used the price definition. Because country I is the capital-abundant country, (r/w)I < (r/w)II [or (w/r)I > (w/r)II]. With identical technology
and constant returns to scale, country I will be able to produce steel relatively more cheaply
than country II, and country II can produce cloth relatively more cheaply than country I.
This relationship between relative factor prices and relative product prices can be devel-
oped more formally through isoquant-isocost analysis. Consider Figure 4(a). Given isocost
line MN in country I, whose slope reflects (w/r)I, steel would be produced at point X and cloth
at point Y. Thus, the same factor cost in the two industries yields S1 units of steel and C1 units
of cloth. On the other hand, (w/r)II < (w/r)I, so a flatter isocost line is present in country II (M′N′). Given this isocost line, country II’s producers would select points Q and T. Hence, in country II, C2 units have the same cost as S1, while in country I only C1 units (a smaller quantity than C2) could be produced for the same cost as S1. Thus, cloth is relatively cheaper in country II and steel is relatively cheaper in country I [(Pcloth/Psteel)II <  (Pcloth /Psteel)I]. The conclusion is that a higher w/r leads to a higher relative price of cloth. The H-O relationship is illustrated in Figure 4(b). Note that if steel had been the relatively labor- intensive good rather than cloth, the relationship would be reflected in a downward- sloping line. It is now clear that different relative factor prices will generate different relative commod- ity prices in autarky. Consequently, there is a basis for trade, and each country will export the product it can produce less expensively: steel in country I and cloth in country II. This same conclusion was reached in the graphical PPF analysis that utilized the physical definition of FIGURE 4 Relative Factor Prices and Relative Product Prices (a) (w/r)I C1 N N' Q S1 C2 L C2 C1 X S1 (w/r)II M M K Y (b) (w/r)II (w/r)I w/r Pcloth Psteel Pc Ps( ) II Pc Ps( ) I T Relative factor prices (w/r)I are represented in panel (a) by isocost line MN. Country I will produce S1 units of steel at point X and C1 units of cloth at point Y. Because labor is relatively more abundant in country II, its relative factor prices (w/r)II < (w/r)I; that is, its isocost line M′N′ is flatter than that of country I. It will therefore produce at point Q and at point T. Because C2 represents a larger quantity of cloth for the same opportunity cost of steel, S1, the relative price of cloth must be cheaper in country II than in country I. This link between relative factor prices and relative product prices is shown more directly in panel (b). An increase in the wage rate relative to the price of capital will lead to an increase in the price of the labor-intensive good, cloth, relative to the price of the capital-intensive good, steel. If relative factor prices are placed on the hori- zontal axis and relative product prices on the vertical axis, this relationship takes the form of an upward-sloping line. Final PDF to printer 132 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch08_122-149.indd 132 06/17/16 06:48 PM factor abundance. In both cases, each country expanded production of and exported the good that made the more intensive use of its relatively abundant factor of production. With this H-O analysis in mind, one of its major conclusions, commonly referred to as the Heckscher-Ohlin theorem, can be stated: a country will export the commodity that uses relatively intensively its relatively abundant factor of production, and it will import the good that uses relatively intensively its relatively scarce factor of production. This conclusion follows logically from the initial assumptions. While the Heckscher-Ohlin theorem seems to be consistent in a general way with what we observe, violations of H-O assumptions can lead to different behavior by a nation in terms of the commodity structure of its trade. The extent to which the H-O theorem is supported by empirical tests is dis- cussed in the next chapter. TRADE, FACTOR PRICES, AND INCOME DISTRIBUTION Different relative prices in autarky are sufficient to generate a basis for trade in trade theory. Further, as trade takes place between two countries, prices adjust until both countries face the same set of relative prices. Our discussion of H-O demonstrated that this convergence of product prices takes place as the price of the product using the relatively abundant factor increases with trade and the price of the product using the country’s relatively scarce factor The Factor Price Equalization Theorem TITANS OF INTERNATIONAL ECONOMICS: PAUL ANTHONY SAMUELSON (1915–2009) Paul A. Samuelson was one of the most widely known econ- omists in the United States, due not only to his prodigious research for the last half-century but also for the success of his principles book, Economics, which introduced millions of students to the subject and which has been in print for well over 60 years. He was born in Gary, Indiana, in 1915 and later attended some 14 different secondary schools, eventually entering the University of Chicago at age 16. Upon graduation in 1935, he studied economics at Harvard University for five years. Samuelson published his first arti- cle in 1937 as a 21-year old graduate student and averaged more than five articles a year during his career. His 1941 doctoral dissertation is still regarded as the groundbreak- ing work on the mathematical foundations of theoretical economics. He accepted a position on the economics fac- ulty at the Massachusetts Institute of Technology in 1940 and remained there until his death in 2009. His contribu- tions were in the areas of microeconomic theory, consumer theory, and welfare economics; capital theory, dynamics, and general equilibrium; public finance; macroeconomics; and international trade. He received the National Medal of Science in 1996 from President Bill Clinton, and he advised Presidents Kennedy and Johnson. Samuelson once said, “Our subject puts its best foot for- ward when it speaks out on international trade,” and his own contributions in the area have had a lasting impact. In the study of trade, he is well known for his seminal work on Heckscher-Ohlin (sometimes referred to as the Heckscher- Ohlin-Samuelson model), focusing on factor price equalization and the Stolper-Samuelson theorem on the distributional effects of trade (discussed later in this chapter). He was awarded the Nobel Prize in Economics in 1970 and has received all the major honors in the economics profession. His many math- ematical and theoretical contributions have had a profound effect on the discipline and the profession. His MIT colleague Robert Solow (also a Nobel laureate) noted that Samuelson “was producing new ideas into his 94th and last year.” Sources: Stanley Fischer, “Paul Anthony Samuelson,” in John Eat- well, Murray Milgate, and Peter Newman, eds., The New Palgrave: A Dictionary of Economics, Vol. 4 (London: Macmillan, 1987), pp. 234–41; Adrian Kendry, “Paul Samuelson and the Scientific Awakening of Economics,” in J. R. Shackleton and Gareth Lock- sley, eds., Twelve Contemporary Economists (London: Macmil- lan, 1981), chap. 12; “Paul A. Samuelson, Nobel Laureate,” MIT Department of Economics website, econ-www.mit.edu; Robert M. Solow, “Paul A. Samuelson, (1915–2009),” Science, vol.  327, January 15, 2010, p. 282. ● Final PDF to printer CHAPTER 8 THE BASIS FOR TRADE 133 app9062x_ch08_122-149.indd 133 06/17/16 06:48 PM falls. This change in final product prices has implications for the prices of factors in both of the participating countries as well, as was rigorously pointed out by Paul A. Samuelson in 1949. Let’s again consider the two countries producing cloth and steel, with cloth the labor- intensive good and steel the capital-intensive good. Country I is the capital-abundant coun- try and country II the labor-abundant country. With the opening of trade, the price of cloth rises and the price of steel falls in country II, signaling producers to produce more cloth and less steel. Assuming perfect competition, production will shift along the PPF toward more output of cloth and less of steel. For this to happen, resources must be shifted from the production of steel to cloth. However, the bundle of resources released from steel pro- duction is different from the bundle required for increased cloth production because the relative factor intensities of the two goods differ. As the capital-intensive good, steel uses a bundle of resources that contains relatively more capital than the bundle of resources desired by cloth producers at the initial factor prices. Alternatively, the bundle released from steel production does not contain the required amount of labor relative to capital to satisfy the expanding cloth production. There is thus an increase in the demand for labor and a decrease in the demand for capital as this adjustment takes place. Assuming fixed factor supplies (see Figure 5), these market changes will lead to an increase in the price of labor and a decrease in the price of capital. The change of factor prices will cause the fac- tor price ratio, (w/r)II, to rise and induce producers to move to a different equilibrium point on each respective isoquant (see Figure 6). Note that these price and production adjust- ments lead to a higher K/L ratio in both industries in this labor-abundant country. In country I, a similar adjustment takes place. With the initiation of trade, the relative price of steel rises, signaling producers to produce more steel and less cloth. The expan- sion of steel production and the contraction of cloth production lead to an increase in the overall demand for capital and a decrease in the overall demand for labor. With factor sup- plies fixed, an increase in the price of capital and a decrease in the price of labor will occur. The resulting decline in the factor price ratio, (w/r)I, means that producers will substitute labor for capital in both industries until the ratio of factor prices is again equal to the slope of the production isoquants. As a result of this change in relative prices, the K/L ratio in country I will fall in both industries. FIGURE 5 Factor Price Adjustments with Trade r r0 r1 w0 w1 SK DK K K W SL L DL L Capital Labor With the shift in production in country II away from the capital-intensive good, steel, toward the labor-intensive good, cloth, a change in the demand for both capital and labor occurs. The expansion of cloth production will lead to an increase in overall demand for labor because cloth is labor-intensive relative to steel. At the same time, the reduction in steel production leads to a decline in the overall demand for capital. These shifts in demand result in a fall in the price of capital and a rise in the price of labor. Final PDF to printer 134 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch08_122-149.indd 134 06/17/16 06:48 PM Combining the general equilibrium results of country I and country II reveals an inter- esting phenomenon. Prior to trade, (w/r)I < (w/r)II. However, with trade the factor price ratio in country I falls while that of country II rises. Trade will expand until both countries face the same set of relative factor prices. The result is what is known as the factor price equalization theorem, often referred to as the second important contribution of the H-O analysis (the first being the H-O theorem): in equilibrium, with both countries facing the same relative (and absolute) product prices, with both having the same technology, and with constant returns to scale, relative (and absolute) costs will be equalized; the only way this can happen is if, in fact, factor prices are equalized. Trade in final goods essentially substitutes for movement of factors between countries, leading to an increase in the price of the abundant factor and a fall in the price of the scarce factor among participating coun- tries until relative factor prices are equal (see Figure 7). Although the implications of trade for factor prices seem logically correct, we do not observe in practice the complete factor price equalization suggested by H-O. This is not surprising because several of the assumptions of H-O are not realized, or not realized as fully as stated in the model. Transportation costs, tariffs, subsidies, or other economic poli- cies contribute to different product prices between countries. If product prices are not the same, then relative factor prices certainly cannot be expected to be the same although the tendency to equalize can still be present. In addition to the failure of goods prices to equalize, imperfect competition, nontraded goods, and unemployed resources also cause problems for factor price equalization. In addition, the factors of production are not homogeneous. If one acknowledges that the relative structure and quality of factors can vary between countries, the equalization of factor prices—in the sense that they are discussed here—is much less likely to come about. Further, technology is not everywhere identical, so that the rewards given the fac- tors of production may well vary from country to country and inhibit the equalization of factor prices. FIGURE 6 Producer Adjustment to Changing Relative Factor Prices Accompanying International Trade Steel (w/r)0 (w/r)1 L K Cloth (w/r)0 (w/r)1 (K/L)1 (K/L)1 (K/L)0 L K 0 As the production of cloth (the labor-intensive good) expands and the production of steel (the capital-intensive good) declines in country II, the price of labor increases and the price of capital declines. This change in relative prices is depicted here as the change from (w/r)0 to (w/r)1. The relative increase in the cost of labor leads producers to substitute some capital for labor, that is, to move along the relevant production isoquant in both industries. This factor substitution results in a rise in the K/L ratio from (K/L)0 to (K/L)1 in cloth production and from (K/L)′0 to (K/L)′1 in steel production. Because of the increase in cloth production, this factor-use adjustment takes place along a higher isoquant, while the reduction in steel production causes this adjustment to take place along a lower isoquant. Final PDF to printer CHAPTER 8 THE BASIS FOR TRADE 135 app9062x_ch08_122-149.indd 135 06/17/16 06:48 PM Despite these limitations, the H-O model provides some helpful insights into the likely impact of trade on relative factor prices. Trade based on comparative advantage should tend to increase the demand for the abundant factor and ultimately exert some upward pressure on its price, assuming that the presence of unemployed resources does not entirely absorb the price pressure. Thus, for the labor-abundant country, trade can offer a way to employ more fully the abundant factor and/or to increase its wages, and at the same time earn scarce foreign exchange necessary to import needed capital goods. The experiences of economies such as Taiwan support this view and demonstrate that in a general way, the factor price movements described earlier do occur. Finally, as economist Robert Mundell (1957) noted, the same result would obtain with respect to commodity prices and factor prices if factors were mobile between countries and final products were immobile internationally. In this instance, the relatively abundant factors would move from relatively low-price countries to high-price countries, causing factor price movements similar to those described. These fac- tor movements would continue until factor (and commodity) prices are equalized, assuming that such movement of factors is costless. Thus, concerning their impact on prices, goods movements and factor movements are indeed substitutes for each other. Wolfgang Stolper and Paul Samuelson developed the Stolper-Samuelson theorem in an article published in 1941. The initial article focused on the income distribution effects of tariffs, but the theorem was subsequently employed in the literature to explain the income distribution effects of international trade in general. The argument builds upon the changes in factor prices that accompany the opening of trade, which were discussed in the previous section. The argument proceeds as follows: assume that a labor-abundant country initiates trade. This will lead to an increase in the price of the abundant factor, labor, and a decrease in the price of the scarce factor, capital. Assuming that full employment takes place both The Stolper- Samuelson Theorem and Income Distribution Effects of Trade in the Heckscher-Ohlin Model FIGURE 7 Factor Price Equalization with Trade (w/r)I(w/r)II w/r Pcloth Psteel (w/r)int PC PS( ) I PC PS( ) II PC PS( ) int Country II is assumed to be labor-abundant and country I capital-abundant. Prior to trade (PC/PS)II < (PC/PS)I, and (w/r)II < (w/r)I. With the initiation of trade, (w/r)I begins to fall and (w/r)II begins to rise. These movements will continue until each country’s factor prices are consistent with the new international terms of trade, (PC/PS)int. This will occur only when (w/r)II = (w/r)I = (w/r)int, that is, when relative factor prices are equalized between the two countries. Given the assumptions of the H-O model, absolute prices for given factors are also equalized. Final PDF to printer 136 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch08_122-149.indd 136 06/17/16 06:48 PM before and after trade, it is clear that labor’s total nominal income has increased, because the wage has increased and the labor employed remains the same. Similarly, the nominal income share of capital will have fallen since the price of capital has fallen and the capital employed remains the same at full employment. To this point the argument seems very straightforward. However, it is important to remember that the ability to obtain goods and services, that is, real income, depends not only on changes in income but also on changes in product prices. Thus, workers who con- sume only the cheaper, imported capital-intensive good are clearly better off, because their nominal income has increased and the price of the capital-intensive good has fallen. Their absolute and relative command over this product has increased. But what about those workers who consume only the labor-intensive export good? This case is not so clear, since both their nominal income and the price of the good they consume have increased. If their income has increased relatively more (less) than the price of the labor-intensive good, then their real income has increased (decreased). Is it possible to reach a definitive conclu- sion about the real income of this group with trade? Using the equilibrium condition that comes about in competitive factor markets, we can demonstrate that the wage rate in the labor-abundant country will rise relatively more than the price of the export good. Remember that, in equilibrium, labor’s wage equals the mar- ginal physical product of labor (MPPL) times the price of the export good. Because both the wage and the price of the export good are increasing, the answer to the question, “Which is rising relatively more?,” rests on the nature of changes in MPPL. If labor is becoming more productive, then wages will be rising more than the price of the export good, and real income will be rising. If labor is becoming less productive, then wage increases will be outpaced by rising export-good prices. With trade, the labor-abundant country will find the price of capital falling and the wage rate increasing (as noted earlier), and its producers will respond by using relatively more capital and relatively less labor in production; that is, the capital/labor ratio in production will rise. This will increase the productivity of labor at the margin (i.e., MPPL increases), resulting in an unambiguous increase in the real income of labor. We can therefore con- clude that the real income share of the owners of the abundant factor increases with trade. Because a similar argument can be used to demonstrate that the price of capital is falling relatively more than the price of the capital-intensive import (because with an increase in the capital/labor ratio the marginal product of capital is falling, as each unit of capital has less labor to work with), it is clear that the real income of the owners of the scarce factor is decreasing with trade. This result—that the price of a factor changes relatively more than the price of the good intensive in that factor—is often referred to as the magnification effect. Thus, the third aspect of the Heckscher-Ohlin analysis regarding the income distri- bution effects of trade is explained in the following more formal way by the Stolper- Samuelson theorem: with full employment both before and after trade takes place, the increase in the price of the abundant factor and the fall in the price of the scarce factor because of trade imply that the owners of the abundant factor will find their real incomes rising and the owners of the scarce factor will find their real incomes falling. Given these conclusions, it is not surprising that owners of the relatively abundant resources tend to be “free traders” while owners of relatively scarce resources tend to favor trade restrictions. For example, within the United States, agricultural producers and owners of technology and capital-intensive industries have tended to support expanding trade and/or dismantling trade restrictions, while organized labor has tended to oppose the expansion of trade. Finally, we may not see the clear-cut income distribution effects with trade because relative factor prices in the real world do not often appear to be as responsive to trade as the H-O model implies. In addition, personal or household income distribution reflects Final PDF to printer CHAPTER 8 THE BASIS FOR TRADE 137 app9062x_ch08_122-149.indd 137 06/17/16 06:48 PM not only the distribution of income between factors of production but also the ownership of the factors of production. Because individuals or households often own several factors of production, the final impact of trade on personal income distribution is far from clear. The initial work by Heckscher and Ohlin has had a profound effect on the theory of inter- national trade. This seminal work led not only to the famous H-O theorem but also to three additional propositions. Two of these, the factor price equalization theorem and the Stol- per-Samuelson theorem, have been discussed. The final theorem, the Rybczynski theorem, which focuses on changes in factor endowments and the accompanying changes in final products produced, will be developed in Chapter 11. Conclusions CONCEPT CHECK 1. What is the basis for trade according to Heckscher-Ohlin? What products should a country export? Why? 2. Explain why the K/L ratio in each indus- try will rise with the initiation of trade in a labor-abundant country and will fall in a capital-abundant country. 3. What happens to the functional (factor- based) distribution of income with trade? THEORETICAL QUALIFICATIONS TO HECKSCHER-OHLIN Several of the assumptions in the H-O model are not always applicable to the real world. For that reason, it is useful to examine assumptions that seem especially critical to the results of the model and to determine the impact of their absence on the H-O result. A strong assumption in the H-O model is that tastes and preferences are identical in the trading countries. If this is not true, it is no longer possible to predict the pretrade autarky prices and thus the structure of trade. The reason is that each country’s tastes and prefer- ences could cause it to value the products in very different ways. An extreme example of this is often referred to as demand reversal. In Figure 8, demands in the two countries are so different that in country I the price of the good (steel) that intensively uses the relatively abundant factor is actually higher than its price in the trading partner, country II. With the opening of trade, country I would find itself exporting cloth and importing steel from coun- try II because steel is relatively cheaper at international prices. This is illustrated in Figure 8 by the international terms-of-trade line, (PC /PS)int, which is steeper than autarky prices in country I and flatter than autarky prices in country II. This pattern of trade is, of course, the opposite of that predicted by H-O. It will cause the relative price of capital to fall in country I and that of labor to fall in country II. The difference in the nature of demand between these two countries, with each tending to prefer the good intensive in its physically abundant fac- tor, has caused them to trade in a manner opposite to that anticipated by the H-O analysis. While demand patterns seem to be similar throughout the world, especially among sim- ilar socioeconomic income classes, differences in tastes and preferences certainly exist. If the differences are sufficiently strong, they can reduce the ability of the H-O model to predict trade and the movement of factor prices. Note, however, that the H-O model would still hold even in this instance if the analysis is restricted to the price definition of relative factor abundance. This occurs because home demand for the product using the abundant factor intensively leads to such a high price for that product and the factor used intensively in its production that the physically abundant factor is the scarce factor from the standpoint of the price definition. Demand Reversal Final PDF to printer 138 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch08_122-149.indd 138 06/17/16 06:48 PM A second assumption crucial to the H-O conclusions is that a commodity is always rela- tively intensive in a given factor regardless of relative factor prices (the strong-factor- intensity assumption). Critical to this exercise is drawing the curvature of the isoquants so that each possible pair intersects only once (see Figure 1, page 126). Without this assump- tion, the H-O model cannot always accurately predict the structure of trade, even if tech- nology is the same between countries. A violation of the assumption appears in Figure 9. The degree of substitution between the two factors is sufficiently different between industries (labor and capital can be sub- stituted for each other more easily in cloth production than in steel production) so that we cannot guarantee that a given product will always be relatively intensive in the same fac- tor. To see why this is so, look at panel (b). At (w/r)1, capital is relatively expensive; that is, the price of capital is high and the price of labor is low. With relatively flat isocost lines, producers will minimize costs by using KS1 amounts of capital and LS1 amounts of labor in steel production and KC1 amounts of capital and LC1 of labor in cloth production. The K/L ratio in steel production is greater than that in cloth production, suggesting that steel is the capital-intensive product. Next, suppose that labor is relatively more expensive. This results in a higher w/r ratio, (w/r)2, and a steeper isocost line. Producers attempting to minimize cost will employ KS2 amounts of capital and LS2 amounts of labor in steel production and KC2 amounts of capi- tal and LC2 amounts of labor in cloth production. With this set of relative prices, the K/L ratio for cloth is now larger than the K/L ratio for steel. The factor-intensity comparison between steel and cloth has reversed with this large change in relative factor prices. These commodities are thus not always relatively intensive in the same factor. The H-O model may no longer be able to predict the export good based on relative factor abundance. Factor-Intensity Reversal FIGURE 8 Demand Reversal E Cloth PC PS( ) I PC PS( ) II PC PS( ) int Steel Cloth Steel e PC PS( ) int Country I Country II Demand in country I is so oriented toward steel, the commodity using relatively intensively its relatively abundant factor, that the relative pretrade price of steel is greater than that in country II. Consequently, (PC /PS)I < (PC /PS)II. With trade, country I expands production of cloth, contracts production of steel, exports cloth, and imports steel. Country II does the opposite, and a pattern of trade emerges that is directly opposite to that predicted by H-O. Because this is the result of a particular set of demand conditions, it is referred to as demand reversal. Final PDF to printer CHAPTER 8 THE BASIS FOR TRADE 139 app9062x_ch08_122-149.indd 139 06/17/16 06:48 PM Suppose that (w/r)1 applies to country I and (w/r)2 to country II. From H-O, we expect country I (the labor-abundant country in this example) to export cloth (the labor-intensive good) and country II (the capital-abundant country) to export steel (the capital-intensive good). However, when capital is abundant (country II), cloth is the capital-intensive good. We would expect cloth to be country II’s export as well. Predicting trade flows in this two- country case is problematic because factor-intensity reversal (FIR) exists. FIR occurs when a commodity has a different relative factor intensity at different relative factor prices. With one country exporting cloth and the other exporting steel in actual trade, one of them will match the H-O prediction, but the other will not. Factor-intensity reversal could also interfere with factor price equalization, because one of the two countries can end up exporting the good that intensively uses its relatively scarce factor. For example, in Figure 9, country I might end up exporting steel and import- ing cloth. This will produce upward pressure on the price of capital and downward pres- sure on wages in country I, much like that occurring in country II. If this happens, relative factor prices in both countries (w/r) will move in the same direction (both will be falling) instead of converging toward each other. In the larger context, FIR helps us understand why it might be possible for a labor-abundant country such as India and a capital-abundant country such as the United States to export the same commodity, steel, for example. The question remains open as to whether FIRs actually exist to any important degree, but most economists doubt that these reversals alone are likely to explain trade patterns that appear to be inconsistent with H-O. A third assumption that is not valid in the real world is that of no transportation costs. Product prices will differ between two locations by the cost of transportation. This is demonstrated Transportation Costs FIGURE 9 Factor-Intensity Reversal L K Steel Cloth LC2LS2 LS1 LC1 L K KC2 KS1 KS2 KC1 Steel Cloth (w/r)1 (w/r)2 (a) (b) The isoquants for steel and cloth violate the H-O assumption that steel and cloth would each be intensive in a particular factor regardless of rela- tive factor prices. The pair of isoquants crossing twice indicates that the nature of factor substitution for each product is sufficiently different so that the relative factor intensities can change as factor prices change. This is demonstrated in panel (b), where we see that when labor is relatively cheap [flatter isocost lines with slope (w/r)1], cloth is the labor-intensive good (lower K/L ratio). But when labor is relatively expensive [steep isocost lines with slope (w/r)2], cloth is the capital-intensive good (higher K/L ratio). If the relative factor intensity is different at different relative factor prices, it is impossible to predict the nature of trade based on the H-O proposition without more information. Final PDF to printer 140 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch08_122-149.indd 140 06/17/16 06:48 PM by the two-country market graphs for corn in Figure 10. The market price in autarky for corn is lower in France than in Norway. Consequently, Norway has an incentive to buy corn from France. Ignoring transportation costs, these two countries should trade at a common (international) price for corn that will be lower than the price in Norway and higher than the autarky price in France. That will cause the amount of excess supply available for export in France (Q1Q2) to be exactly equal to the excess demand for imports (q1q2) in Norway. Suppose that we now include transportation costs. If France attempts to pass the entire transportation cost on to Norway, the price of corn in Norway will rise and Norway’s excess demand (and imports) will fall. This leaves France with an inventory of corn it does not want. France will lower its price and, thus, the price including transportation costs in Norway. As this happens, France will find that it now has a smaller amount of corn avail- able for export, an amount more in line with the new quantity demanded in Norway at the higher transportation-inclusive price. Ultimately, the price in Norway will rise above the original international equilibrium price, and the price in France will fall below that price until the amount of France’s desired exports is exactly equal to the amount of Norway’s desired imports. The difference between the price of corn in the two countries will equal exactly the transportation costs involved. Another point is that the participating countries will not necessarily share the transpor- tation costs equally. Ultimately, the incidence of the transportation cost will depend on the elasticities of supply and demand in each country. The more inelastic supply and demand are in the importing country and the more elastic demand and supply are in the exporting country, the larger the relative amount of transportation costs paid by the importing coun- try. Similarly, the more inelastic market conditions are in the exporting country and the more elastic in the importing country, the greater the amount of transportation costs borne by the exporting country. The costs associated with moving goods between countries have been undergo- ing change in recent years because of new transport technologies and emerging market FIGURE 10 The Impact of Transportation Costs on Trade Q P 21 Pint PN Scorn Dcorn Transport cost FranceNorway Q P PF Scorn Dcorn Pint q1 q2 1 2Q2Q1 In the absence of transportation costs, the international price will settle at Pint, where Norway’s desired imports (q1q2) are equal to France’s desired exports (Q1Q2). With the introduction of transport costs, the price in Norway rises (the quantity of imports demanded falls) and the price in France decreases (the quantity of exports falls) until the difference between the two prices is exactly equal to the amount of the transportation charge. At the new equilibrium the amount of France’s desired exports (Q′1Q′2) is exactly equal to Norway’s desired imports (q′1q′2). Final PDF to printer CHAPTER 8 THE BASIS FOR TRADE 141 app9062x_ch08_122-149.indd 141 06/17/16 06:48 PM concerns. Until recently, transportation costs had demonstrated a downward trend because of the use of larger ocean vessels, new cargo handling techniques, and an expanded use of air transport.3 However, in the new globalized world where “quick response” is replacing the holding of large inventories, increased attention is being directed to transport time as well as distance. David L. Hummels and Georg Schauer (2013), using U.S. merchandise import data, estimate that “ocean shipping costs are equivalent to a 3 percent tariff and air shipping costs are equivalent to an 8 percent tariff” (p. 2943). They also estimate that one extra day in transit would be equivalent to an additional tariff in the 0.6–2.1 percent range, depending on the product, because time is valuable to sales. Hummels and Schauer sug- gest that timely delivery is like an increase in product quality to a consumer, a feature that, in conjunction with a dramatic fall in air transport costs, is consistent with the fact that in recent decades air shipments have increased 2.6 times faster than ocean shipments. The implications of transportation costs do not alter H-O conclusions about the com- position of trade. However, the amount of trade and specialization of production will be reduced, and the relative structure of trade could be changed as a result of differences in transportation costs for different types of goods. However, because relative product prices do not equalize between countries, relative factor prices will not equalize and complete factor price equalization cannot be attained. Finally, if transportation costs are sufficiently large, they can prevent trade from taking place, even though commodity autarky prices are clearly different between countries; that is, transportation costs can lead to the presence of nontraded goods. A fourth assumption important to the H-O analysis has been the presence of perfect com- petition. This assumption was necessary to guarantee that product prices and factor prices would equalize with trade. Again, we know in the real world that imperfect information, barriers to entry (both natural and contrived), and so forth, lead to imperfect competition of many different forms. Let’s examine briefly how imperfect competition such as monopoly can alter the H-O conclusions about several of the effects of trade. A first case is a variant of the traditional domestic monopoly model. The monopo- list maintains the monopoly position at home but at some point chooses to export at world prices. In other words, the monopolist continues to act as a price setter at home but becomes a price taker on the world market. This can occur only if imports are prevented from coming into the country. Assume that the monopolist is maximizing profits at the quantity of output where marginal cost (MC) equals marginal revenue (MR), that is, at P0 and Q0 in Figure 11. If it now becomes possible to export as much as desired at the world price, Pint, what should the monopolist do to maximize profits? Profits are still maximized by equating MC with MR. However, the MR curve now consists of the domestic MR curve down to the Pint curve and the Pint curve beyond that point. Because the monopoly firm can sell all that it wishes at the international price, it has no reason ever to sell at a lower MR. Consequently, production is Q1, where MC = Pint. The quantity Q2 is sold in the domestic market at price P2, and Q1 − Q2 is exported. Because the international price puts a floor on the marginal revenue at all quantities to the right of Q2, the monopolist actually reduces the amount sold in the local market and charges a higher price. In this case, international trade leads to an increased difference between the domestic price and the world price, not a convergence to a single commodity price. The production and factor price effects tend to approach the H-O result as the monopolist acts as a price taker in the world market. However, the domestic market distortion that permits the monopolist to sell with trade at Imperfect Competition 3See the related discussion on transport costs in Chapter 4, pages 49–50. Final PDF to printer 142 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch08_122-149.indd 142 06/27/16 01:21 PM a higher price at home than in autarky inhibits product price equalization and thus factor price equalization. A second case is simply the application of pure monopolistic price discrimination to international trade. In this case, we have a single world supplier faced with how to dis- tribute output among several countries and what price to charge in each. It is assumed that the monopolist is a profit maximizer, that the markets in the various countries can be kept separate (i.e., arbitrage cannot take place between markets), and that the elasticities of demand differ between the various markets. Assume that the monopolist is faced with two markets (see Figure 12). Assume also that the marginal cost of the monopolist is constant. What is the optimal amount to sell in each market? The level of total output is equal to the sum of the optimal amount of sales in each market. To maximize profits, the monopolist locates the quantity in each market at which MC = MR. The profit maximization criterion thus indicates that at a marginal cost of MC*, the quantity QI should be sold in country I at PI, and QII in country II at PII. A higher price will be charged in the market where demand is less elastic. Pure price discrimination leads to the charging of different prices in different markets and tends to reduce the degree of factor price equalization that takes place. (Remember that this type of discrimination exists only as long as there is no arbitrage between mar- kets.) Although the presence of a single world supplier of a product is very rare, it is not uncommon for several major suppliers to band together and form a cartel. This arrangement allows them to behave economically as a single world supplier and to price- discriminate between markets. It has been assumed up to this point that factors are completely mobile between different uses in production within a country. This assumption permits production adjustments to move smoothly along the PPF in response to changes in relative product prices. Often, Immobile or Commodity-Specific Factors Q P Q2 Pint P0 MC D Pint P2 MR Q0 Q1 FIGURE 11 Domestic Monopoly and Exports The domestic monopolist maximizes profits by producing where MC = MR,(Q0), and charging P0 in the domes- tic market. However, by exporting, the monopolist’s MR beyond Q2 becomes Pint and profits are maximized by producing where MC = Pint, that is, at Q1. Because the monopolist need not accept a lower MR than Pint, the quantity sold in the domestic market is lowered to Q2 and the domestic price is raised to P2. Participating in international trade thus leads to a widening of prices between the domestic and the foreign markets, not a nar- rowing as was the case under perfect competition. Final PDF to printer CHAPTER 8 THE BASIS FOR TRADE 143 app9062x_ch08_122-149.indd 143 06/17/16 06:48 PM however, it is not easy or even possible for factors to be moved from the production of one product to another (e.g., from wheat to automobile production). With some degree of factor immobility, at least in the short run, the nature of the adjustment to international trade is altered from that suggested in the H-O framework. Adjustment to trade has been analyzed in this instance through the use of the specific-factors model. The specific-factors model (SF model) is an attempt to explore the implications of short- run factor immobility between sectors in an H-O context. In the short run, it assumes that there are three factors of production, not two. The three factors in industries X and Y are: (a) labor, which is mobile and can be used to produce either good X or good Y; (b) capital in industry X, KX, which can be employed in that industry but not in industry Y; and (c) capital in industry Y, KY, which cannot be used in industry X. The SF model acknowledges that, in practice, it takes time for capital to be depreciated in one industry and reemployed in another. The contrast between the assumptions of the SF model and those of the H-O model can be shown in an Edgeworth box diagram (see Figure 13). In panel (a) the factors are freely mobile between sectors, and the production contract curve has smooth curvature and con- nects the lower-left and upper-right origins of the box. This is the typical Edgeworth box. Panel (b) illustrates the Edgeworth box in the context of the SF model. Because capital is fixed in industry X, that amount of fixed capital is shown by the vertical distance 0xKx. No matter what amount of good X is produced, quantity 0xKx of capital is used in industry X. Similarly, the fixed capital used in industry Y is shown by the vertical distance 0yKy. Hence, in the SF model, the contract curve is the horizontal line KxAKy. This contract curve coincides with the “normal” contract curve only at point A. The different contract curves in the two situations will be associated with different PPFs, because PPFs are derived from contract curves (see Chapter 5). In Figure 14, the PPF labeled RA′S is the PPF associated with the normal contract curve of both panels of Figure 13. The PPF labeled TA′V represents the PPF associated with the specific-factors FIGURE 12 Market Price Discrimination in International Trade Q P QI PI MRI DI Country IICountry I Q P QII DII PII MRII MC* MC* The price-discriminating monopolist is faced with the question of what quantity to sell in each of the above markets and what price to charge in each. The monopolist will determine the amount to sell in each market by equating MC to MR in each respective market. To maximize profits, the monopolist will sell QI in country I and charge PI, while QII will be sold in country II at PII. As long as the markets are kept separate and the elas- ticity of demand is different in each, the product prices in the two countries will not tend to equalize. A move to perfect competition would lead to an expansion of output and a common price in both markets. Final PDF to printer 144 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch08_122-149.indd 144 06/17/16 06:48 PM IN THE REAL WORLD: MONOPOLY BEHAVIOR IN INTERNATIONAL TRADE Economists know from their understanding of market behavior that imperfect competition leads to a reduction in quantity sold and an increase in price, as well as to the possibility of price discrimination. An historical example of this latter behavior was the incandescent electric lamp cartel, where firms in different countries acted jointly as a monopoly. A 1939 U.S. Tariff Commission study indi- cated the severe price discrimination practices of this cartel, as the accompanying table shows. The cartel clearly kept prices from equalizing across countries, inhibiting any ten- dency toward factor price equalization. A current example of monopolistic behavior came to light when the European Union (EU) in 2015 levied formal charges against Russian government–controlled natural gas supplier Gazprom, accusing the firm of blocking competi- tion and charging unfair prices in its sales to countries in southern and eastern Europe. Monopolistic price discrimi- nation was alleged, because, in comparison with the $341 average price per cubic meter of natural gas charged to the EU, Gazprom charged, for example, 21.7 percent more in Estonia, Latvia, and Lithuania, 11.1 percent more in Poland, 5.3 percent less in Germany, and 9.7 percent less in the Slo- vak Republic. Such price differences clearly could not exist if free resale of natural gas between countries were possible. Until very recently, the Organization of Petroleum Exporting Countries (OPEC), mostly Middle-Eastern coun- tries, has been a relatively strong international cartel. It was successful in raising prices dramatically through produc- tion controls and the exercise of market power in the two oil shocks of 1973–1974 and 1979–1980. The average price for oil (the benchmark Brent crude oil price) was $3.61 per barrel in 1972, $4.25 in 1973, and $12.93 in 1974. By 1978 the price was $14.26 per barrel, and it rose to $32.11 in 1979 and $37.89 in 1980. Oil prices then fell because of con- sumer conservation, new sources of supply from Mexico, the North Sea, and Alaska; and switches to alternative fuels. By 1986 crude prices had fallen to $14.43; they then fell, after some increase in the early 1990s, to $12.72 in 1998. OPEC then attempted to restrict output, and the price aver- aged $28.31 in 2000. The decision by OPEC to cut output by 10 percent in early 2004, as well as growth in demand, led to an average price of $54.43 in 2005. The price rose to $97.66 by 2008 but then decreased due to the Great Reces- sion to $61.86 in 2008 and $79.63 in 2009. However, the average oil price subsequently rose to above $100 per barrel in 2011, 2012, and 2013. It reached about $115 in June 2014 but then, with the slowdown of GDP growth in many coun- tries and the emergence of huge new supplies of shale oil in the United States, a glut occurred and the price fell to about $50 per barrel in early 2015. Effective cartels clearly are not permanent in nature. Sources: U.S. Tariff Commission, “Incandescent Electric Lamps,” Report no. 133, 2nd series (Washington, DC: U.S. Government Printing Office, 1939), p. 49; Tom Fairless and Gabriele Stein- hauser, “EU Charges Gazprom with Abusing Dominance,” The Wall Street Journal, April 23, 2015, p. A14; data from IMF website http://elibrary-data.imf.org; www.nasdaq.com. ● Country 25 Watts 45 Watts 60 Watts Netherlands $0.32 $0.59 $0.70 Germany 0.30 0.36 0.48 United States 0.15 0.15 0.15 Japan — — 0.07 contract curve KxAKy. This “new” PPF is coincident with the “normal” PPF only at point A′. A movement from point A to point B on the normal contract curve in Figure  13(b) yields a movement from point A′ to point B′ on the normal PPF in Figure  14, while a movement from A to C on the specific-factors contract curve results in a movement from point A′ to point C′. But the output of good Y at B or B′ (amount y2) in the normal situa- tion will be associated with less output of good X under the specific-factors situation than under the normal or mobile-factors situation. This difference in output of X reflects the fact that isoquant y2 in Figure 13(b) is associated with isoquant x2 on the normal contract curve but only with the smaller quantity of X on isoquant x3 (at point C) on the specific- factors contract curve. Because analogous contrasts can be made with all other points on the two different contract curves in Figure 13(b), it follows that the specific-factors PPF Final PDF to printer CHAPTER 8 THE BASIS FOR TRADE 145 app9062x_ch08_122-149.indd 145 06/17/16 06:48 PM FIGURE 13 Capital Immobility in the Edgeworth Box Diagram Capital Capital CapitalCapital Labor Labor Labor Labor 0x 0y 0x 0y Kx – Ky – y2 y1 x1 x3 x1 x3 y1 y2 y3 y3 (a) (b) A A C B x2 x2 B In panel (a), the smooth contract curve reflects the fact that both factors are perfectly mobile between production of goods X and Y, with A and B both being possible efficient-production points. In panel (b), it is assumed that capital cannot move in the short run from the amounts 0xKx and 0yKy that are used to produce the two products at A. Thus, any attempt to produce more of the X good can be accomplished only by acquir- ing labor previously used in the production of Y. This will lead to a movement along the KxAKy line to, for example, point C. This production point is off the perfect-mobility contract curve, and it represents a smaller amount of production of the X good than exists on the perfect-mobility contract curve for the new quantity of Y (represented by y2) being obtained. It thus represents a production point inside the PPF that is constructed when factors are completely mobile. FIGURE 14 Production Adjustment When Capital Is Immobile Good Y y2 y1 x1 x2x3 R T V S Good X The PPF represented by the solid line RA′S is drawn under the assumption that factors are completely mobile. Thus, points A′ and B′ correspond to points A and B, respectively, in Figure 13(b). If both factors were completely immobile, the production-possibilities frontier would be represented by y1A′x1. If only capital is immobile, the production possibilities will lie somewhere between these two extremes. Such a possibility is represented by the dashed PPF TA′V. Assuming that only labor is mobile, the attempt to produce more of the X good will force the economy to use resources less efficiently, thus moving to a new point on TA′V inside the normal PPF. Point C′ represents a possible new production point consistent with point C in Figure 13(b). Final PDF to printer 146 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch08_122-149.indd 146 06/17/16 06:48 PM in Figure 14 will lie inside the normal PPF except at point A. In fact, in the United States at present, a case can be made that not only is capital a specific factor, but labor also may be immobile in the sense of possessing particular skills. In this situation there may be potential for the country to be even further “inside” its normal PPF, as evidenced by the recent reces- sion. We do not pursue this additional immobility complication in this chapter, however. The implication of the immobility of capital in an H-O context can be seen by compar- ing the impact on the rates of return to the factors of production when a country moves from autarky to trade. Suppose we have the normal situation of a country with full mobility of all factors of production. If the country is located at point A in Figure 13(b) in autarky, then an opening of the country to trade involving specialization in the labor-intensive good X will result, for example, in a movement from A to B in Figure 13(b) or from A′ to B′ in Figure 14. This movement will bid up the price of labor and reduce the price of capital as expanding industry X seeks to acquire relatively more labor and contracting industry Y is releasing relatively more capital. After the adjustment, at point B in Figure 13(b), the ratio of capital to labor in each industry has risen. With the rise in the K/L ratio in each industry, each worker in each industry has relatively more capital to work with, so the worker is more productive; thus, productivity and wages rise. The flip side of the rise in wages is the fall in the real return to capital. The important policy implication in the traditional Heckscher-Ohlin, full-factor mobil- ity situation is that the country’s abundant factor prefers free trade to autarky and that the country’s scarce factor prefers autarky to free trade. Even though the country as a whole gains from trade, some part of the economy (the scarce factor) will have an incentive to argue for protection. What is the consequence of trade for factor returns in the specific-factors model? With autarky at point A in Figure 13(b) and the opening of the country to trade, labor-intensive industry X expands because of the higher price of X and capital-intensive industry Y con- tracts because of the lower price of Y. Production tends to move to the right from point A in the direction of a point such as point C on the SF contract curve. The increased demand for labor will bid up the money wage of all labor. However, the direction of movement of the return to capital depends on which industry is being considered. Industry X has increased its demand for capital, but the supply of capital is fixed at 0xKx. Hence, the return to capital in X rises with the opening of the country to trade. However, the demand for capital in industry Y falls because some of good Y is now imported rather than produced at home. Thus, the demand for capital in industry Y decreases, while its supply of capital is fixed. The return to capital in Y therefore falls. These income distribution effects of trade are obviously different from those of the traditional H-O model. There, capital as a whole suffered a decline in its return, but in the SF model capital in X gains and capital in Y loses. The scarce factor of production will not be unanimously opposed to moving from autarky to trade. Owners of capital in industry Y will argue against free trade, while those in industry X will argue in favor of it. This situation may indeed be more realistic than the traditional H-O type of model, especially in the short run, where all of one factor was opposed to trade and all of the other factor favored it. A final note is necessary about the return to labor. Saying that the money wage for labor has risen does not mean that labor’s real wage has risen. Consider the money wage in industry X, which equals the money wage in industry Y with competition. Remember that the money wage equals the price of the product times the marginal physical product of labor, thus, w = (PX)(MPPLX). With trade, MPPLX falls, because more labor is being used with the fixed amount of capital 0xKx. In other words, each worker has less capital to work with. Because w = (PX)(MPPLX), this means that w/PX has fallen because (w/PX) = MPPLX. The fall in w/PX simply indicates that money wages have not risen as much as the price of Final PDF to printer CHAPTER 8 THE BASIS FOR TRADE 147 app9062x_ch08_122-149.indd 147 06/17/16 06:48 PM good X. Workers who consume only good X are worse off because their real wages have declined. Analogously, w/PY rises; thus, if workers consume only good Y, their real wages have risen. The direction of the real return for a worker therefore depends on the bundle of goods being consumed. The SF model yields conclusions on the winners and losers from free trade that may be more consonant than traditional H-O trade theory with what we observe in the real world. (See Concept Box 1 for a more thorough discussion of the impact of trade on labor’s real wage in the specific-factors model.) It is evident that several other assumptions, such as constant returns to scale, identical technology, and the absence of policy obstacles to trade, also are not always applicable to the real world. To the extent that they are not, the conclusions of the H-O model are com- promised. Several of these conditions will be examined further in Chapter 10 and in later chapters on trade policy. Other Considerations CONCEPT BOX 1 THE SPECIFIC-FACTORS MODEL AND THE REAL WAGE OF WORKERS As noted in the text, the direction of movement of the real return to a worker when a country is opened to trade in the specific-factors model depends on that worker’s consump- tion pattern. This conclusion is illustrated in Figure 15. The figure portrays the demand for labor by the X industry and by the Y industry. Each industry’s demand for labor reflects the fact that a firm will hire a worker as long as the worker’s contribution to the firm’s revenue (the marginal physical (continued) G E DLY W3 WE WE MPPLy × Py,MPPLx × Px, DLX L10 Labor 0'L2 F money wage money wage FIGURE 15 Labor Demand and Wages in the Specific-Factors Model Final PDF to printer 148 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch08_122-149.indd 148 06/17/16 06:48 PM CONCEPT BOX 1 (continued) THE SPECIFIC-FACTORS MODEL AND THE REAL WAGE OF WORKERS product of labor times the price of the output) exceeds the cost to the firm (the wage rate). Thus, in the figure, curve DLX is the demand curve for labor by firms in the X industry (with DLX = MPPLX × PX), and DLY is the demand curve for labor by firms in the Y industry (with DLY = MPPLY × PY). These curves are downward sloping. As the wage rate falls, industry X hires more labor (reading rightward from origin 0); alternatively, as more labor is added to the fixed amount of other inputs, the MPPLX falls and the additional labor will be hired only if the wage rate is reduced. Curve DLY indi- cates the demand curve for labor by the Y industry but, for this industry, the quantity of labor is read in the leftward direction from the origin 0′. Given the two demand curves in this two-good economy and given that labor is mobile between the two sectors, the equilibrium point in the labor market occurs at wage rate 0WE (which equals wage rate 0′WE). At this wage rate, quantity 0L1 of labor is employed in industry X and quantity of labor L10′ is employed in industry Y, thus exhausting the entire stock of labor 00′. If the wage rate were higher than WE, some labor would be unemployed and the wage would fall to WE. This WE equilibrium in the economy is posited as the situation when the country is in autarky. Suppose that this country is now opened to international trade and that good X is the export good and good Y is the import good. This means that PX/PY in the world market exceeds the autarky PX/PY. Let us assume that PX/PY is 10 percent higher in the world market than in autarky. For simplicity, we’ll say that PX is 10 percent higher in the world market than at home and that PY is the same in the world market as at home. (In actual practice, PX would be higher and PY would be lower in the world market than at home, but the ratio PX/PY would be 10 percent higher in the world market regardless of the abso- lute particular values of PX and PY. Our increase of PX by 10 percent with no change in PY is a simplification that makes the analysis less complicated but does not alter any central conclusions.) If PX increases by 10 percent, then, in Figure 15, DLX shifts vertically upward by 10 percent because DLX = MPPLX × PX and PX has gone up by 10  percent. With this upward shift in demand for labor by the X industry from DLX to D′LX, employment rises in the X industry from amount 0L1 to amount 0L2. The L1L2 of new labor working in the X industry is labor that has been released from the contracting Y industry, so that the remaining labor in Y is L20′. As is evident in the graph, the money wage has risen in both industries to 0W′E (which equals 0′W′E). Because the money wage has risen, does this mean that all workers are better off? No! Remember that, for welfare conclusions, it is the real wage that is critical, not the money wage. If the money wage had risen by 10 percent, it would have risen by a distance equal to WEW3, or by the equivalent distance EG. In fact, the money wage has risen by the smaller amount WEW′E or, equivalently, by distance EF. Hence, if a worker consumes only the X good, the price of X increased by 10 percent but the worker’s money wage increased by less than 10 percent, meaning that that worker has experienced a decline in the real wage. On the other hand, if the worker consumes only the import good, the money wage has risen by less than 10 percent but the price of Y has not changed, mean- ing that that worker has experienced a rise in the real wage. Given this analysis, it is clear that the following general statements can be made with respect to the specific-factors model. If a worker’s consumption bundle is heavily tilted toward the export good, then that worker will tend to have a reduced real wage because of the opening of the country to trade and will hence tend to be less well off. If a work- er’s consumption bundle is heavily tilted toward the import good, that worker will tend to have an increased real wage because of the opening of the country to trade and will tend to be better off. ● CONCEPT CHECK 1. Explain the difference between factor- intensity reversal and demand reversal. Do they have similar effects on the validity of the H-O theorem? 2. Can factor-intensity reversal occur if the two industry isoquants do not cross each other twice but are tangent to one another? Explain. 3. What are the conditions necessary for imper- fect competition to cause prices to be further apart after trade than before trade? 4. Explain how the opening of trade can lead to an increase in money wages in a capital- abundant country if capital is immobile between sectors. Does this mean that labor is necessarily better off with trade? Final PDF to printer CHAPTER 8 THE BASIS FOR TRADE 149 app9062x_ch08_122-149.indd 149 06/17/16 06:48 PM SUMMARY This chapter first examined the underlying basis for differences in relative prices in autarky. Country differences in demand, technology, and factor abundance contribute to possible differ- ences in relative prices in autarky. Attention then focused on the Heckscher-Ohlin explanation of trade, factor price equaliza- tion, and income distribution effects of trade. Building on a rigorous set of assumptions, Heckscher-Ohlin demonstrated that differences in relative factor endowments are sufficient to generate a basis for trade, even if there are no country differences in technology or demand conditions. Their model allowed them not only to predict the pattern of trade based on initial factor endowments but also to demonstrate that trade would lead to an equalization of factor prices between trading countries. Stolper-Samuelson pointed out that the same relative factor price movements would lead to an improvement in real income for owners of the abundant factor and a worsen- ing position for owners of the scarce factor. Several theoretical qualifications on the role of tastes and preferences, factor intensity of products, transportation costs, imperfect competition, and factor immobility were briefly dis- cussed. Reflection on the limitations imposed by these assump- tions helps one to understand why the pattern and effects of international trade are not always what we might expect from the H-O theory. These limitations do not destroy the basic link between relative factor abundance and the pattern of trade. They do, however, influence the degree to which these links hold and are observed. Chapter 9 examines the validity of the factor endowments approach in the real world. KEY TERMS demand reversal different relative factor endowments different relative factor intensities factor-intensity reversal (FIR) factor price equalization theorem Heckscher-Ohlin theorem physical definition of factor abundance price definition of factor abundance specific-factors model Stolper-Samuelson theorem QUESTIONS AND PROBLEMS 1. Explain the difference between the price and the physical definitions of factor abundance. When could they give con- flicting answers about which factor is the abundant factor? 2. If the K/land ratio for Belgium is higher than that for France, what kind of products might Belgium export to France? Why? 3. Suppose that the K/L ratio is higher in France than in Spain. What would you expect to happen to wages in France as trade took place between the two countries? Why? 4. You read in a newspaper that the owners of capital in a par- ticular country are urging their government to restrict trade through import quotas. What might you infer about the rela- tive factor abundance in that country? Why? 5. It has been argued that opening a country to international trade is a great “antitrust” policy. What impact would the threat of imports have on a monopolist who had never before been faced with foreign competition? How would the monopolist respond concerning the quantity produced and the price charged in the domestic market? 6. How does the existence of demand reversal complicate the predictions of Heckscher-Ohlin? 7. Using the specific-factors model, explain why you might expect to see certain capital owners and labor groups argu- ing against expanding trade in a capital-abundant country. 8. Given your knowledge of the basis for trade, would you be surprised or not to learn that the composition of the exports and imports of a former Soviet bloc country such as Hun- gary or Poland changed with the dissolution of the Soviet Union and the opening of trade with the West? Explain your answer. 9. In Figure  14, suppose the country is producing in equi- librium at A′. If Px then increases such that it would lead to production at B′ on the “normal” PPF, would the same change in relative prices lead to production precisely at C′ in the specific-factors case? Why or why not? 10. “Within the Heckscher-Ohlin framework, complete factor price equalization cannot be achieved in the presence of transportation costs.” Agree? Disagree? Explain. 11. Even though their relative factor abundances differ widely, both India and the United States export similar agricultural products such as rice. What might explain this apparent contradiction of the Heckscher-Ohlin model? 12. “Increasing the mobility of labor and/or capital within a country not only will reduce the internal opposition to the expansion of the country’s international trade but also will lead to greater gains in real income for the country.” Com- ment on this statement. Final PDF to printer 150 app9062x_ch09_150-172.indd 150 06/17/16 03:57 PM CHAPTER 9 EMPIRICAL TESTS OF THE FACTOR ENDOWMENTS APPROACH LEARNING OBJECTIVES LO1 Describe the Leontief paradox pertaining to the failure of the U.S. trade pattern to conform to Heckscher-Ohlin predictions. LO2 Summarize possible explanations of the U.S. trade paradox. LO3 Explain recent tests of the Heckscher-Ohlin theorem. LO4 Assess the role of trade in generating growing income inequality. Final PDF to printer CHAPTER 9 EMPIRICAL TESTS OF THE FACTOR ENDOWMENTS APPROACH 151 app9062x_ch09_150-172.indd 151 06/17/16 03:57 PM INTRODUCTION It is common to hear trade theories criticized for not being “relevant to the real world” or for having “unrealistic assumptions.” This has led researchers such as Leamer and Levinson (1995) to assert that empirical work on trade has had very little influence on trade theories and to encour- age their colleagues to “Estimate, don’t test.” They propose that researchers should attempt to learn from real-world data rather than simply accepting or rejecting an abstract hypothesis. Rather than using the lack of relevance to the real world as a reason to ignore trade theory, it should serve as a motivation for empirical testing. Davis and Weinstein (1996, p. 434) offer a more encouraging view of empirical work. “. . . look for ways of weakening the strict assumptions of the theory . . . to find a version that does in fact work . . . [W]e should learn which of the assumptions . . . are most crucial, and to which types of data sets one can sensibly apply the various versions of the theory.”1 This chapter examines the empirical tests of the Heckscher-Ohlin predictions in an attempt to find which of the often strict assumptions are crucial. You will see that there is not a consensus among economists on the degree to which relative factor endowments explain international trade flows and the consequences of trade flows. As developed in Chapter 8, the Heckscher-Ohlin theorem states that a country will export goods that use relatively intensively the country’s relatively abundant factor of pro- duction and will import goods that use relatively intensively the country’s relatively scarce factor of production. In this chapter, we review some empirical tests of this seemingly straightforward and commonsense hypothesis. The literature has produced some conflict- ing results on the real-world validity of the H-O theorem. The most surprising result of one early test was that the world’s largest trader, the United States, did not trade according to the Heckscher-Ohlin pattern. Explanations are given on why this surprising result might have occurred. We then review tests for other countries and more recent work on trade patterns. In addition, we survey the current controversy regarding the extent to which H-O- type trade has contributed to the increasing income inequality in developed countries in recent years, especially in the United States. THE LEONTIEF PARADOX The first major test of the H-O theorem was conducted by Wassily W. Leontief and pub- lished in 1953. This comprehensive test has influenced empirical research in this area ever since. Leontief made use of his own invention—an input-output table—to test the H-O prediction. An input-output table provides details, for all industries in an economy, of the flows of output of each industry to all other industries, the purchases of inputs from all other industries, and the purchases of factor services. In addition, the table can be used to indicate not only the “direct factor requirements” of any given industry—the capital and labor used with intermediate goods in the particular stage of production—but also the total factor requirements. The total requirements include the direct requirements as well as the capital and labor used in the supplying industries of all inputs to the industry Theories, Assumptions, and the Role of Empirical Work 1For a review of the relevant early literature see Edward E. Leamer and James Levinsohn, “International Trade Theory: The Evidence,” in Handbook of International Economics, vol. III, ed. Gene M. Grossman and Kenneth Rogoff (Amsterdam: Elsevier, 1995), pp. 1339–94; Donald R. Davis and David E. Weinstein, “Empirical Tests of the Factor Abundance Theory: What Do They Tell Us?” Eastern Economic Journal 22, no. 4 (Fall 1996), pp. 433–40. For a more recent overview of the literature, see Robert E. Baldwin, The Development and Testing of Heckscher-Ohlin Trade Models: A Review (Cambridge, MA: MIT Press, 2008). Final PDF to printer 152 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch09_150-172.indd 152 06/17/16 03:57 PM (the “indirect factor requirements”). The table is very useful for calculating the aggregate country requirements of capital and labor for producing a bundle of goods such as exports and import substitutes. To evaluate the H-O prediction for the United States, Leontief imagined a situation where, using 1947 data, the United States simultaneously reduced its exports and imports propor- tionately by a total of $1 million each. The input-output table made it possible to determine how much capital (K) and labor (L) would be released from producing exports and how much capital and labor would be required to produce at home the $1 million of goods no lon- ger being imported. (Leontief confined his analysis to “competitive imports,” meaning that he did not include goods that the United States did not produce at home, such as bananas.) Given the estimates of the K and L released from reducing exports and required to repro- duce imports, a comparison could be made between them. Because the United States was thought to be a relatively capital-abundant country, the expectation from the statistical anal- ysis was that the K/L ratio of the released factors from the export reduction would be greater than the K/L ratio of the factors required to produce the forgone imports. This expectation could be evaluated as to its validity through the concept of the Leontief statistic, which is defined as (K/L)M (K/L)X where (K/L)M refers to the capital/labor ratio used in a country to produce import-competing goods and (K/L)X refers to the capital/labor ratio used to produce exports. According to the H-O theorem, a relatively capital-abundant country would have a Leontief statistic with a value less than 1.0 (since the denominator would be larger than the numerator) and a rela- tively labor-abundant country would have a Leontief statistic greater than 1.0. Leontief’s results were startling. He found that the hypothesized reduction of U.S. exports would release $2.55 million worth of capital and 182.3 years of labor-time, for a (K/L)X of approximately $14,000 per labor-year. On the import side, to produce the for- gone imports would require $3.09 million worth of capital and 170.0 years of labor-time, yielding a (K/L)M of approximately $18,200 per labor-year. Thus, the Leontief statistic for the United States was 1.3 (= $18,200$14,000), totally unexpected for a relatively capital-abundant country. A disaggregated analysis of his results also supported these findings. The most important export industries tended to have lower K/L ratios and higher labor requirements and lower capital requirements per dollar of output than did the most important import- competing industries. Thus, the seemingly commonsense notion that a country abundant in capital would export capital-intensive goods and import labor-intensive goods was seri- ously called into question. The doubt cast on the widely accepted Heckscher-Ohlin theo- rem by this study became known as the Leontief paradox. INITIAL EXPLANATIONS FOR THE LEONTIEF PARADOX Leontief’s results have produced many studies seeking to explain why these unexpected findings might have occurred. In this section, we briefly discuss the more well-known “explanations.” The concept of demand reversal was introduced in Chapter 8. In demand reversal, demand patterns across trading partners differ to such an extent that trade does not follow the H-O pattern when the physical definition of relative factor abundance is used. The relative preference of a country for goods made with its physically abundant factor (called “own-intensity preference”) offers one explanation for the Leontief paradox Demand Reversal Final PDF to printer CHAPTER 9 EMPIRICAL TESTS OF THE FACTOR ENDOWMENTS APPROACH 153 app9062x_ch09_150-172.indd 153 06/17/16 03:57 PM if we hypothesize that the United States has relative preference for capital-intensive goods and that U.S. trading partners have relative preference for labor-intensive goods. The U.S. demand for capital-intensive goods bids up the price of those goods until the U.S. comparative advantage lies in labor-intensive goods. A similar process occurs in trading partners, giving them a comparative advantage in capital-intensive goods. The validity of demand reversal as an explanation of the Leontief paradox is an empiri- cal question. However, considerable dissimilarity (which seems unlikely in practice) is required for the demand reversal explanation to be of value in understanding the paradox. Further, the presence of demand reversal would imply that demand within the United States for labor-intensive goods would be relatively low and therefore U.S. wages also would be relatively low—which is not consistent with observed wage rates across countries. Thus, other reasons for the Leontief result need to be explored. As noted in Chapter 8, factor-intensity reversal (FIR) occurs when a good is produced in one country by relatively capital-intensive methods but is produced in another country by relatively labor-intensive methods. It is not possible to specify unambiguously which good is capital intensive and which is labor intensive, and the Heckscher-Ohlin theorem can  be valid for only one of the two countries. For example, consider a situation where X is the K-intensive good in country I but is the L-intensive good in country II (and hence Y is the L-intensive good in country I but is the K-intensive good in country II) and country I is the relatively K-abundant country. If country I is exporting X to II, then the Heckscher- Ohlin prediction is correct for country I but it cannot be correct for country II, because country II, the L-abundant country, must be exporting good Y to country I (because both countries cannot be exporting X in this two-country H-O model). However, good Y is the K-intensive good in country II, and therefore country II is not conforming to the H-O theo- rem. In the context of the Leontief paradox, the FIR suggests that, although U.S. import goods might have been produced labor intensively overseas, the production process of these goods in the United States was relatively capital intensive. The trading partners (being labor- abundant) were conforming to H-O when they exported the goods, but the United States was not conforming to H-O. The validity of this explanation for the occurrence of the Leontief paradox is also an empirical question. The literature is somewhat divided on the matter of whether factor intensity reversals occur with any frequency, and we cannot rule them out altogether. The most famous test was conducted by B. S. Minhas (1962) for the United States and Japan using 1947 and 1951 data for 20 industries. Suppose that we consider the same 20 industries, that we have the K/L ratio employed in each country in each of the 20 indus- tries, and that we rank the 20 industries in descending order in each country according to K/L ratios (as Minhas did). For example, in the United States (using total capital and labor requirements) petroleum products constituted the most capital-intensive industry (it had the highest K/L ratio), coal products ranked number 2, iron and steel ranked number 8, textiles ranked number 11, shipbuilding ranked number 15, leather ranked number 19, and so forth. If there are no FIRs, then the rankings for Japan would be the same as those for the United States. Statistically, this means that the rank correlation coefficient between the U.S. ranking and the Japanese ranking would be 1.0. (Note: If two rankings are identical, the correlation coefficient between them is 1.0; if they are perfectly opposite to each other, the coefficient is −1.0; and if there is no association between the two rankings whatsoever, the rank correlation coefficient is 0.) When Minhas calculated this correlation coefficient using total factor requirements, he obtained a rank correlation coefficient of only 0.328. (This reflects that in Japan iron and steel was number 3 instead of 8, shipbuilding was number 7 instead of 15, etc.) For Factor-Intensity Reversal Final PDF to printer IN THE REAL WORLD: TESTING FOR FACTOR-INTENSITY REVERSALS Another study that examined the potential likelihood of factor-intensity reversals in the real world is that of Matthias Lücke (1994). Lücke notes that empirical work on the causes of trade patterns often relies on the assumption that U.S. rel- ative factor intensities across industries are representative of relative factor intensities across industries in other countries. To test whether this assumption is valid, Lücke gathered data on 22 manufacturing industries in 37 industrialized and devel- oping countries (the same 22 industries in each country). He then calculated the dispersion across these industries in each country of what he called “total capital intensity” (value added per employee), “human capital intensity” (wages per employee), and “physical capital intensity” (non-wage value added per employee). The resulting dispersion values within each country were then correlated with the dispersion in intensity of these same industries within the United States. Lücke’s hypothesis was that a significantly positive correla- tion coefficient (a linear correlation to represent the structure of intensities in general, not a rank correlation) between the dispersion in any given country and the dispersion in the United States would suggest that relative factor intensities in manufacturing industries are broadly similar between the countries and thus relative factor-intensity reversals in gen- eral are unlikely. Using the three different measures of intensity (total capital intensity, human capital intensity, and physical cap- ital intensity) and two different time periods, Lücke was able, given data limitations, to calculate 192 different cor- relation coefficients between the factor-intensity dispersion in the 36 other countries and the factor-intensity dispersion in the United States. All but eight of the coefficients were positive in a statistically significant sense. He regarded his results as highly supportive of the notion that the structure of factor intensities in manufacturing industries in gen- eral in the 36 other countries was indeed very similar to that structure in the United States. Hence, factor-intensity reversals across countries in the manufacturing sector seemed very unlikely. A more recent investigation (2011) pertaining to factor- intensity reversal is that of Yoshinori Kurokawa (2011). Kurokawa’s work takes a different approach from most factor-intensity reversal studies in that it focuses on a pos- sible factor-intensity reversal between relatively high- skilled labor and relatively low-skilled labor rather than on a possible reversal between relative capital- and labor- intensity. He dealt with U.S.–Mexican trade in 1994 and in 2000 (as NAFTA—the North American Free Trade Agreement—was being implemented). He divided manufac- turing industries into two mutually exclusive categories— the “electronics” industry and all other industries, with the latter being very broadly classified as the “non-electronics” industry. Between 1994 and 2000, the electronics industry in the United States experienced a very large increase in its net exports to Mexico, at the same time that net imports into the United States from Mexico of non-electronic goods increased dramatically. Within this two-industry context of the electronics industry and the non-electronics industry, Kurokawa then examines the relative skill intensity in the two industries in 1994 and 2000 by calculating the ratio of the number of non-production workers in an industry to the number of pro- duction workers in the industry. Non-production workers are roughly designed to represent high-skill workers, and the production workers are roughly designed to represent low-skill workers. Non-production workers are gener- ally viewed as having greater educational attainment than production workers. Kurokawa then compares this ratio in the two broad industries in each of the two countries with the average skill intensity figure for each country as a whole. Unsurprisingly, Kurokawa finds that the skill intensity in electronics in the United States is above the U.S. average skill intensity and that the skill intensity in non-electronics is below the U.S. average. Hence, for the United States, exports to Mexico conform to Heckscher-Ohlin since the United States is generally thought to be relatively more well-endowed with high-skill labor than is Mexico and the United States is exporting the relatively high-skill intensive product to Mexico. With respect to Mexico, the results are indeed surprising. Kurokawa determines that, in both 1994 and 2000, the ratio of non-production workers to production workers in non-electronics was higher than the average for Mexico, while that ratio was lower in electron- ics than the Mexican average. Hence, by this measure, the non- electronics industry in Mexico utilized relatively high- skill labor compared to the electronics industry (and thus the electronics industry utilized relatively low-skill labor compared to the non- electronics industry). Mexico was thus exporting its relatively high-skill-intensive product to the United States whereas the country is generally viewed as low-skill abundant relative to the United States—not in conformity with Heckscher-Ohlin. How is this surprising (continued) 154 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch09_150-172.indd 154 06/17/16 03:57 PM Final PDF to printer ● result possible? Kurokawa’s explanation is that the result reflects a factor-intensity reversal—the electronics indus- try is relatively high-skill intensive in the United States compared to non-electronics, while at the same time elec- tronics is relatively low-skill intensive compared to the non- electronics industry in Mexico. This conclusion is consistent with the earlier discussion in this chapter that, with a factor- intensity reversal, only one of the two countries can conform to Heckscher-Ohlin. It is also consistent with Kurokawa’s observation that the wages of high-skill workers relative to low-skill workers increased in both the United States and Mexico during this period—a phenomenon which fits with our earlier point that, with a factor-intensity reversal, the tendency for trade to lead toward factor price equalization disappears. The Kurokawa study would suggest that further analysis is needed, especially with regard to the point that the electronics industry is less skill-intensive in Mexico than the skill-intensity level of other industries. Sources: Matthias Lücke, “A Note on Empirical Evidence on Factor Intensity Reversals in Manufacturing,” Economia Internazionale 47, no. 1 (February 1994), pp. 51–54; Yoshinori Kurokawa, “Is a Skill Intensity Reversal a Mere Theoretical Curiosum? Evidence from the US and Mexico,” Economics Letters 112, no. 2 (August 2011), pp. 151–54. IN THE REAL WORLD: (continued) TESTING FOR FACTOR-INTENSITY REVERSALS CHAPTER 9 EMPIRICAL TESTS OF THE FACTOR ENDOWMENTS APPROACH 155 app9062x_ch09_150-172.indd 155 06/17/16 03:57 PM “direct” requirements only, the coefficient was higher but still only 0.730. Thus, doubt can be cast on the “no FIRs” assumption of Heckscher-Ohlin. However, economists such as G. C. Hufbauer (1966) and D. S. Ball (1966) pointed out that if the differences in land avail- ability and agriculture in the two countries and the influence of these differences on the relative employment of K and L are allowed for, then the rank correlation coefficients are much closer to 1.0. This explanation for the Leontief paradox focuses on the factor intensity of the goods that primarily receive tariff (and other trade barrier) protection in the United States. From Heckscher-Ohlin and the accompanying Stolper-Samuelson theorem we learned that the opening of a country to trade increases the real return of the abundant factor and decreases the real return of the scarce factor. This suggests that, in the United States, labor will be more protectionist than will owners of capital (which is the case). Therefore, U.S. trade barriers tend to hit hardest the imports of relatively labor-intensive goods. With these goods restricted, the hypothesis is that the composition of the U.S. import bundle is relatively more capital intensive than would otherwise be the case because labor-intensive goods are kept out by protection. Thus, the Leontief result might have been in part a reflection of the tariff structure of the United States and not an indication of the free-trade pattern that might conform to Heckscher-Ohlin. Can this argument account for the occurrence of the Leontief paradox? In a 1971 study, Robert Baldwin recognized the possible role of tariffs and estimated that the K/L ratio in U.S. imports would be about 5 percent lower if this effect were incorporated. While allow- ance for the tariff structure works toward reducing the extent of the paradox, it seemed unable to remove it fully. In this explanation of the Leontief paradox, the basic point is that the use of “labor” as a factor of production may involve a category that is too aggregative, because there are many different kinds and qualities of labor. One early test involving this approach was con- ducted by Donald Keesing (1966). Keesing divided labor into eight different categories. U.S. Tariff Structure Different Skill Levels of Labor Final PDF to printer 156 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch09_150-172.indd 156 06/17/16 03:57 PM For example, category I (scientists and engineers) was regarded as the most skilled labor (we have unsuccessfully searched for a listing of economists in this category!), while cat- egory II (technicians and draftsmen) was regarded as the second most skilled. This list- ing continued through category VIII (unskilled and semiskilled workers). Keesing then compared U.S. labor requirements in export- and import-competing industries with those of 13 other countries for 1962. He found that U.S. exports embodied a higher proportion of category I workers and a lower proportion of category VIII workers than the exports of other countries. Similarly, on the import side, the United States used the smallest fraction of category I workers and the largest fraction of category VIII workers. This type of test suggests that the Leontief paradox may have occurred because a two- factor test was employed instead of a test with a larger number of factors (with each skill category of labor regarded as a distinct factor of production). Perhaps the United States is skilled labor abundant (as well as capital abundant) and unskilled labor scarce in its factor endowments. If so, the U.S. trade pattern conformed to Heckscher-Ohlin because the United States was exporting goods that were relatively intensive in skilled labor and importing goods that were relatively intensive in unskilled labor. Other tests have confirmed the general impressions from the Keesing analysis. For exam- ple, Robert Baldwin’s study (1971) found that, compared with import-competing industries, export industries had a higher proportion of workers with 13 or more years of schooling. On the other hand, compared with export industries, import-competing industries had a higher proportion of workers with eight years of schooling or less. Using data from the 1970s and early 1980s, Staiger, Deardorff, and Stern (1988) estimated that a move to free trade by the United States would lead to a reduction in demand for operatives and an expansion of demand for scientists, engineers, and physical capital. These results of eliminating trade restrictions are also consistent with an H-O multifactor explanation of trade that has no Leontief para- dox. Indeed, many tests of this type have suggested that it is necessary to go beyond a two- factor model to test whether the U.S. trade pattern conforms to Heckscher-Ohlin. This explanation also builds around the notion that a two-factor test is too restrictive for proper assessment of the empirical validity of the Heckscher-Ohlin theorem. In this case, the additional factor is “natural resources.” In the context of the Leontief paradox, many of the import-competing goods labeled as “capital intensive” were really “natural resource intensive.” Leontief was assessing the factor requirements for producing imports at home and found that this production required the use of capital-intensive production processes; but in industries such as petroleum products, coal products, and iron and steel, domestic production of the goods involves a great deal of natural resources as well as capital. For Leontief, production of these import-competing goods involved capital-intensive produc- tion [raising (K /L)M in the calculation of the Leontief statistic] because his was a two-factor test. However, the “true” intensity of the goods produced might not be in capital but in natural resources. If we were able to identify the true factor intensity, we might conclude that the United States was importing natural-resource-intensive products. If the United States is relatively scarce in its endowment of natural resources, then there is no paradox with Heckscher-Ohlin. The importance of natural resources has been confirmed in some empirical tests. For example, James Hartigan (1981) performed Leontief-type tests for U.S. trade for 1947 and 1951. A paradox existed in general, but not when natural-resource-intensive indus- tries were deleted from the tests. Without natural-resource industries, U.S. trade yielded a Leontief statistic of 0.917 for 1947 and 0.881 for 1951. These results are not “paradoxi- cal.” Leontief himself (1956) also discovered that adjustment for natural resources could reverse the paradox. On the other hand, Robert Baldwin (1971) found that accounting for The Role of Natural Resources Final PDF to printer CHAPTER 9 EMPIRICAL TESTS OF THE FACTOR ENDOWMENTS APPROACH 157 app9062x_ch09_150-172.indd 157 06/17/16 03:57 PM natural resources reduced the paradox but did not eliminate it. Thus, there is uncertainty about the relative importance of the “natural resources as a third factor” explanation of the Leontief paradox. MORE RECENT TESTS OF THE HECKSCHER-OHLIN THEOREM The paradox found by Leontief has spawned many, many investigations into the ques- tion of the validity of the Heckscher-Ohlin theorem in predicting trade patterns. We will mention only a few of these studies here, but even our limited discussion should suffice to indicate that the question of the empirical validity of H-O continues to be an unan- swered one. This ambiguity was established early on when some tests utilizing Leontief’s approach—Tatemoto and Ichimura (1959) for Japan, Stolper and Roskamp (1961) for East Germany, and Rosefielde (1974) for the Soviet Union—found support for the theorem, because factor intensities of trade flows matched expectations from factor endowments, while other studies—Wahl (1961) for Canada and Bharadwaj (1962) for India—yielded “surprising,” unexpected results. (For example, India’s exports to the United States were found to be relatively capital intensive and India’s imports from the United States were found to be relatively labor intensive!) With respect to the United States, Robert Baldwin (1971, p. 134) found, for 1962 trade, a Leontief statistic of 1.27; when agriculture was excluded, the figure rose to 1.41, and when natural resource industries were excluded, the Leontief statistic fell to 1.04. Thus, in all cases (although only barely so when natural resource industries were excluded), the paradox still existed. However, utilizing a different approach, Harkness and Kyle (1975) found that, if natural resource industries are excluded, a U.S. industry had a greater prob- ability of being a positive net exporter (where net exports = exports minus imports of the industry’s product) if, among other characteristics, it utilized a higher ratio of capital to labor in production. This does not suggest a paradox because the United States was thought to be relatively capital abundant and relatively labor scarce. In addition, an industry had a higher probability of being a positive net exporter if it had a higher ratio of scientists and engineers in its labor force, which lends support to a “labor skills” or “human capi- tal” explanation of the U.S. trade pattern. An important role for human capital was also uncovered by Stern and Maskus (1981). They attempted to explain the net export position of U.S. industries over the years 1958–1976, and they found the size of net exports of an industry to be positively correlated with the amount of human capital used in the industry. They also found the size of net exports to be negatively correlated with the amount of labor in the industry and sometimes, although not always, negatively correlated with the amount of physical capital used in the industry. (In affirmation of the traditional H-O prediction, positive net exports were in fact positively associated with physical capital in some years.) A recent study by Julien Gourdon of the World Bank (2009) examined relative factor endowments as predictors of whether countries would be net exporters or net importers of goods in various product categories. He examined the endowments and trade patterns of 71 countries over the period from 1960 to 2000. Factor endowments for any given country were measured relative to world factor endowments, and factors were broken into the cate- gories of arable land per inhabitant, capital stock per worker, and three types of labor based on differing levels of skill. Commodities were classified into groupings such as agricultural products, processed food products, manufactured goods intensive in capital, and manu- factured products intensive in unskilled labor. The results with respect to the predictions of the correct sign between the relevant endowments and net exports or net imports of the given products were encouraging—for example, the correct sign was obtained 56 percent of the time for unskilled labor-intensive manufactured products, 70 percent of the time for Final PDF to printer 158 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch09_150-172.indd 158 06/17/16 03:57 PM agricultural products, 71 percent of the time in capital-intensive manufactured products, 72 percent of the time in skilled labor-intensive products, and 85 percent of the time in what he called technology-intensive products. Gourdon then added variables associated with newer, post–Heckscher-Ohlin theories, such as consumer preferences and economies of scale (discussed in Chapter 10), and the results were even better for these endowments- plus-newer-variables tests. In an overview, Gourdon indicated that, over time, endowments are indeed important for determining trade and that an increasing role in trade and special- ization is being played by different types of labor skills. An interesting study that seemed to provide strong support for the Heckscher-Ohlin theo- rem was conducted by Nicholas Tsounis (2003). This study focused on whether Heckscher- Ohlin is valid empirically on a bilateral basis (i.e., in the trade of a country with individual trading partner countries rather than in the country’s total trade). Greece was the “home” country whose bilateral trade patterns were being examined, and the selected trading part- ners were the 11 other European Union countries during the trading time period being considered, 1988 and 1989. (The trading partners were Belgium, Denmark, France, West Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, and the United Kingdom.) First, utilizing capital stock/investment data and an assumed depreciation rate of capital together with information on the number of working persons, Tsounis calculated the factor endowment ratio, K/L, for each country. He then divided this K/L result for each trading partner country by the Greek K/L endowment ratio. For example, the 1988 ratio for France was 2.82, meaning that France’s endowment of capital to labor was nearly three times Greece’s endowment of capital to labor. For every trading partner European Union (EU) country except for Portugal, the ratio always exceeded 1.00 (Portugal’s ratio was 0.72 in 1988 and 0.75 in 1989). Thus, Greece was relatively labor-abundant in comparison with each of its EU trading partners except for Portugal. Using an input-output table for each country, Tsounis calculated the Leontief statistic for Greece in its trade with the partner countries. In all cases except in Greek trade with Portugal, the Leontief statistic indicated that Greek imports from the EU trading partner were more capital-intensive (less labor- intensive) than were Greek exports to that trading partner. In the case of Portugal, the opposite (by a very slim margin) was found. Hence, on a bilateral basis, Greece’s trading pattern with each of its EU partners seemed to conform to Heckscher-Ohlin. Other studies have also moved beyond calculating Leontief statistics and often beyond examining only the United States. Many factors of production in many countries have been included. Calculations are first made (using input-output tables) of the quantity of any given factor needed to produce the goods contained in any given country’s aggregate out- put bundle (i.e., the supply of the factor’s services embodied in production). This require- ment is then compared with the demand for the given factor embodied in the country’s existing aggregate consumption bundle. If the total production requirement for any given factor exceeds the total consumption requirement, then (with assumed full employment of the factor) the country must, on balance, be exporting the services of that factor; if the total consumption requirement exceeds the total production requirement, then the country must, on balance, be importing the services of the given factor. In effect, then, a country with positive net exports of the services of a given factor must be relatively abundant in that factor, and a country with negative net exports (i.e., positive net imports) of the services of a given factor must be relatively scarce in that factor.2 Factor Content Approach with Many Factors 2Technically, this relationship is known as the Heckscher-Ohlin-Vanek theorem, in recognition of the work of Jaroslav Vanek in the 1960s. The theorem basically states that a country’s relative factor abundances are revealed by the country’s trade flows. Final PDF to printer CHAPTER 9 EMPIRICAL TESTS OF THE FACTOR ENDOWMENTS APPROACH 159 app9062x_ch09_150-172.indd 159 06/17/16 03:57 PM As an example of this “factor-content” type of study, Keith Maskus (1985) attempted to ascertain the implied factor endowments in the United States by examining the net exports and net imports of the services of five broad categories of factors of production. For the year 1958, he determined that the factor-abundance rankings were (1) scientists and engineers (most abundant because largest net export), (2) nonproduction workers except scientists and engineers, (3) human capital (reflecting mainly education), (4) production labor, and (5) physical capital (least abundant because largest net import). For 1972, the rankings for the first three factors were the same, but physical capital and production labor switched positions. Along the same line, a very ambitious study of factor abundance and net export of factor services was carried out in 1987 by Harry Bowen, Edward Leamer, and Leo Sveikauskas. This study examined 12 different factors of production in 27 different countries to predict the implied factor abundances (and hence the implied Heckscher-Ohlin trade flows). Their general qualitative results for six countries are given in Table 1. A plus sign indicates that, through trade, the country was a net exporter of the services of that factor and thus was “revealed” to be abundant in that factor (because more of the factor’s services were sup- plied in production than were demanded by the country through its consumption pattern); a minus sign indicates that the country was a net importer of a factor service and therefore that the country was relatively scarce in that factor (because more of the services of the factor were demanded through the country’s consumption pattern than were supplied in domestic production). For the United States in 1967 (the test year), the Leontief paradox did not seem to exist when allowance was made for factors other than capital and labor. The United States exported the services of capital (as general intuition would expect), as well as the services of professional/technical workers, agricultural workers, and arable land. Eight other ser- vices were imported and thus scarce in the United States. With respect to other countries, Table 1 indicates that Canada exported the services of capital, agricultural workers, and various kinds of land while importing different kinds of labor services. Germany and Japan imported capital and land services while exporting the services of professional/tech- nical workers and managerial workers. (The latter two worker categories had the largest TABLE 1 Net Export (+) and Net Import (−) of Factor Services through Trade, Selected Countries, 1967 Factor of Production U.S. Canada Fed. Rep. of Germany Japan Mexico Philippines Capital stock + + − − − − Total labor force − − − + + − Professional/technical workers + − + + + − Managerial workers − − + + + − Clerical workers − − + + + − Sales workers − − − − + + Service workers − − − − + + Agricultural workers + + − − + + Production workers − − + + − − Arable land + + − − + + Forest land − + − − + − Pasture land − + − − + − Source: Derived from Harry P. Bowen, Edward E. Leamer, and Leo Sveikauskas, “Multicountry, Multifactor Tests of the Factor Abundance Theory,” American Economic Review 77, no. 5 (December 1987), p. 795. Final PDF to printer 160 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch09_150-172.indd 160 06/17/16 03:57 PM net exports for Germany and Japan in the underlying data for Table 1.) For the develop- ing countries in the table, Mexico was a net exporter of land-based factor services and various labor services while a net importer of the services of capital (these results are not surprising and thus are not paradoxical), while the Philippines imported capital and skilled-labor services and exported some “lower-skilled” labor services (again, results that are not surprising). A relatively recent addition to the list of factors that may serve as a source of compara- tive advantage is the financial sector. Svaleryd and Vlachos (2005) propose that underlying technological and organizational differences among industries cause them to differ in their need for external financing. If the assumption is made that the services provided by the financial sector are relatively immobile across national boundaries, patterns of industrial specialization should be influenced by the relative endowments of financial development. Using a broad group of developed countries for their empirical analysis, Svaleryd and Vlachos find that countries with well-functioning financial systems tend to specialize in industries highly dependent on external financing. In fact, their results show that differ- ences in financial systems are more important than differences in human capital. Their results support the Heckscher-Ohlin-Vanek model. In a more recent study of comparative advantage in Brazil based on the H-O model, Muriel and Terra (2009) estimated the sources of comparative advantage revealed by its international trade. Two time periods were used in the analysis, the first (1980–1985) just prior to trade liberalization and the second (1990–1995) following trade liberalization. The authors employed estimates of both the relative factor intensities associated with net exports, as well as direct estimates of the factor content of international trade. The results led to the conclusion that Brazilian trade revealed comparative advantages in the use of unskilled labor, capital, and land, but not in goods relatively intensive in skilled labor. Given the actual relative abundance of especially unskilled labor and land, these results tend to support the basic H-O model. However, even the seemingly more friendly results for the Heckscher-Ohlin theorem (such as the Bowen-Leamer-Sveikauskas type) have been called into question. Remember the nature of factor-content tests—they are calculating whether a factor’s services, on bal- ance, are being exported or imported by a country, and, if exported (imported), the con- clusion is drawn that the country is abundant (scarce) in that factor. Then a judgment is rendered as to whether this abundance or scarcity fits with general intuition and thus whether H-O generally seems to have been validated. But a point of attack with respect to these more recent studies is that the calculated relative abundance (scarcity) of a factor may not match the actual relative abundance (scarcity) that can be ascertained by the use of different, independent data. In other words, for example, a factor might be calculated as being “relatively abundant” in a country because there is positive net export of the factor’s services, but independent data on actual endowments of the factor in that country and other countries would show the factor to be relatively scarce in that country. The independent data in these comparisons would consist of measures such as a country’s share of the world’s actual endowments of capital and labor (such as used in the Gourdon study dis- cussed on pages 157–58). Indeed, Maskus (1985) found that, in tests comparing the United States with other countries, the actual U.S. relative abundances and scarcities matched the predicted abundances and scarcities two-thirds of the time in one test, one-third of the time in another test, and only one-sixth of the time in a third test. These results are hardly rea- ssuring. Bowen, Leamer, and Sveikauskas also examined their 12 factors in 27 countries to see if the predicted relative abundances and scarcities matched the actual data. Only in 4 of the 12 factors was there a predictive success rate of 70 percent or more across the countries, and only 7 of the 12 factors were successfully predicted for the United States. Final PDF to printer CHAPTER 9 EMPIRICAL TESTS OF THE FACTOR ENDOWMENTS APPROACH 161 app9062x_ch09_150-172.indd 161 06/17/16 03:57 PM In other work, Daniel Trefler (1995) examined, for the year 1983, data for 33 countries that accounted, at the time, for 76 percent of world exports and 79 percent of world GNP. Nine factors of production were considered: (1) capital; (2) cropland; (3) pasture land; (4) profes- sional and technical workers; (5) clerical workers; (6) sales workers; (7) service workers; (8) agricultural workers; and (9) production, transport, and unskilled workers. His first test of the data with respect to whether net factor flows through trade matched the expectation from actual endowments produced disappointing results. However, he noted that, while the Heckscher-Ohlin theorem and the usual H-O tests assume that technology/productivity in any given industry is identical across countries, this assumption is very unrealistic. In fact, he found that, across countries, there tended to be systematic differences in productiv- ity levels. For example, Panama’s industries tended to be about 28 percent as productive as U.S. industries, and Finland’s about 65 percent as productive as U.S. industries. Thus the United States had close to four times as much “effective” labor (1/0.28 = 3.6) in com- parison with Panama as standard labor force measures would indicate [or, alternatively, Panama had only about one-quarter (0.28) as much “effective” labor relative to the United States as standard labor force measures would indicate]. Hence, Trefler adjusted his data to reflect these differences. Panama’s factor endowments, when compared with those of the United States, were thus only 28 percent of the actual level, Finland’s only 65 percent of the actual level, and so on. These adjusted factor endowments were then used in the com- parison of factor endowments with the flows of factor services through trade. This type of adjustment was also accompanied by another adjustment—Trefler felt that, for whatever reason, consumers in any given country had a preference for home goods over foreign goods, and this preference needed to be incorporated into the examination of trade flows. (This adjustment was necessitated in Trefler’s view because standard Heckscher-Ohlin tests seemed to predict a much larger volume of trade than actually occurred—Trefler’s “home bias” was designed to account for this difference.) With both of these adjustments in place, Trefler more satisfactorily “explained” the existing trade patterns than he had done without the adjustments and than had been done with regard to explaining trade in the various previous studies. The thrust of his work, then, is that actual trade differs from Heckscher-Ohlin-predicted trade because technology/ productivity levels differ across countries and because consumers have a general prefer- ence for home goods. These two factors should be taken account of in considering the determination of trade flows, because H-O by itself does not do a very good job of explain- ing the flows. In 2002, Conway confirmed Trefler’s conclusion regarding these mysteries but suggested alternate explanations. Further, Feenstra and Hanson (2003) indicate that it is standard in Heckscher-Ohlin models to assume that exports are produced entirely by combining domestic factors of production with domestically produced intermediate inputs. They suggested that in a globalized world this assumption is wrong and that accounting for trade in intermediate inputs can help resolve the mystery of the missing trade. In a survey of the relevant literature, Helpman (1999) strongly questioned the home- bias assumption of Trefler. However, Helpman and others have increasingly explored the notion of productivity/technology differences across countries, and the view that such differences are important is becoming more generally accepted. Helpman (1999, p. 133) noted that recent work suggests that “allowing for differences in techniques of production can dramatically improve the fit of factor content equations. Now economists need to iden- tify the forces that induce countries to choose different techniques of production.” Further, Reeve (1998, cited in Helpman, 1999) and Davis, Weinstein, Bradford, and Shimpo (1997) have found, in different settings, that factor endowments do a decent job of predicting the location of particular types of industries, if not of predicting trade itself. That is, while a country that is relatively abundant in a particular factor may not have been found by Technology, Productivity, and “Home Bias” Final PDF to printer 162 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch09_150-172.indd 162 06/17/16 03:57 PM existing estimation techniques to be exporting the services of that factor, the country’s pro- duction structure emphasizes goods that are relatively intensive in that factor. This finding would be consistent with the Heckscher-Ohlin general notion that a country will specialize in the production of goods utilizing the country’s abundant factors, even if the next step of linking production to trade has not been empirically established. In another study of the issue of productivity/technology differences across countries, Schott (2003) looked beyond the traditional industry-based data to examine the actual sub- sets of goods produced in a country. His contention was that too many traditional attempts to find empirical support for the Heckscher-Ohlin idea that a country’s endowments deter- mine production and trade have used the overly restrictive assumption that all countries produce a given category of goods using the same technology. Schott argued that within the category of electronics, for example, the more labor-abundant Philippines may be pro- ducing portable radios while the more capital-abundant Japan is manufacturing semicon- ductors and satellites. The Schott approach permits a given sector’s output to vary with a country’s endowments, allowing countries to move in and out of sectors as they develop. The estimation focuses on finding the capital per labor cutoffs, where changes in the subset of output produced take place and using this to group countries according to the subset of goods they produce. Schott’s technique highlights the potential differences in the choices of output within industries across countries and suggests that moving beyond the standard, industry-level data is necessary to test Heckscher-Ohlin hypotheses. By designating products within the category of manufacturing by the relative capital intensity of their production, Schott found strong support for the idea that country product mix varies with relative endowments. In addition to pointing out the need to move beyond industry-level data to test international specialization, this analysis suggests that the technique can be used to explore violations of Heckscher-Ohlin assumptions assigned to home bias in trade (e.g., Trefler, 1995). A newer approach to empirical verification of the Heckscher-Ohlin hypothesis sug- gests that the quality of available data has been a problem in the testing process. Fisher and Marshall (2007) found overwhelming support for the Heckscher-Ohlin paradigm using Organization for Economic Cooperation and Development (OECD) input-output data on the technology of production across 33 countries in the year 2000. Fisher and Marshall used this rich data set to create a technology matrix for each country. By observ- ing a specific output vector for a country, they defined the country’s “virtual endow- ment” as the factor services that would be needed to produce that output in view of the implied level of technology of the country. While their innovative empirical approach is new, their results suggested that a more careful treatment of technological differences between countries can explain a substantial portion of Trefler’s missing trade. Fisher and Marshall hope that the availability of new and better data will allow economists to reexamine past studies that questioned the validity of the Heckscher-Ohlin theorem using differences in technology and restore the profession’s confidence in this important paradigm. Finally, some new work has attempted to test the relative strength of the Heckscher- Ohlin analysis and other approaches in explaining actual trade patterns. For a summary of this work, see the “In the Real World” box on pages 163–64. In overview, while the Heckscher-Ohlin theorem is logical, straightforward, and seem- ingly a commonsense hypothesis, there have been difficulties in demonstrating the validity of the theorem in practice. As empirical work continues, however, we are beginning to get a better picture of what the analysis does and does not seem to explain. Supplementary forces besides factor endowments and factor intensities increasingly need to be considered, however, and some of these factors are dealt with in the next chapter. Final PDF to printer IN THE REAL WORLD: HECKSCHER-OHLIN AND COMPARATIVE ADVANTAGE Two 2010 articles in the international economics literature focused on examining the contribution of a Heckscher-Ohlin explanation of country specialization compared to other explanations of the pattern of any given country’s trade. These recent additions to the long stream of Heckscher- Ohlin tests indeed suggest that the H-O model is relevant to the real world, but they also point out that the H-O analy- sis does not produce the sole explanation of the structure of trade and specialization. David Chor (2010) of Singapore Management University, in seeking to identify the underlying sources of comparative advantages of countries, looked at the patterns of specializa- tion in bilateral trade of any given country with its various trading partners. The dependent variable in his regressions was the value of exports of a country to a specific trading partner in a specific industry. He employed a sample of 83 countries (and thus each country had 82 potential trad- ing partners) and 20 manufacturing industries for the year 1990. Not all partners engaged in trade in all the industries, but Chor still ended up with over 45,000 data points. For explanatory variables (independent variables) of the amount of bilateral trade, he utilized distance and geographic vari- ables (such as whether there was a common border, a com- mon language, and so on), the Heckscher-Ohlin variables of human capital per worker and physical capital per worker, and institutional variables representing the level of a coun- try’s financial development, the country’s dependence on external sources of finance (foreign investment or borrow- ing), the flexibility in a country’s labor market, and various aspects of the country’s legal system. Important results that Chor obtained were that, pre- dictably, distance was significant—other things being equal, a halving of distance between partners led to more than a doubling of their bilateral trade. Pertaining directly to the focus of this chapter, there was verification of the importance of Heckscher-Ohlin, in that relatively skilled- labor- abundant countries had greater exports in the more skilled-labor- intensive industries. Also, if a country had a relatively greater endowment of physical capital per worker, it tended to have greater exports in physical-capital- intensive industries, other things being equal. For the institutional variables, one result was that countries with higher levels of financial development were more successful in exporting goods from industries that had greater amounts of external funding. Of further interest, Chor also attempted to focus on welfare and found that, as a general rule, if the human capital variables’ separate influences on specialization were taken away, country welfare on average would fall by 3.1 percent; for physical capital by itself, the fall in welfare would be 2.8 percent. These welfare declines were larger than would occur, for example, with the institutional vari- ables of the country’s financial development and its labor market flexibility. Peter Morrow (2010) of the University of Toronto stud- ied the role of the Heckscher-Ohlin theorem in explaining trade patterns in a somewhat different manner. He noted that, in theory, the Ricardian model (of Chapters 2–4 in this text) indicates that countries export goods from industries that have the greatest relative productivity (or, in modern terminology, the greatest relative total factor productivity [TFP]) compared to trading partners. The Heckscher-Ohlin analysis, on the other hand, ignores productivity differences across countries by assuming that the production function in any given industry is the same everywhere; the analy- sis then attributes comparative advantage to relative factor endowments and relative factor intensities. In the real world, (continued) CHAPTER 9 EMPIRICAL TESTS OF THE FACTOR ENDOWMENTS APPROACH 163 app9062x_ch09_150-172.indd 163 06/17/16 03:57 PM This chapter began with Leamer and Levinsohn’s call for a reorientation of empirical work in international trade. Their call was summarized in the statement “Estimate, don’t test.” In other words, draw on relevant empirical evidence to improve understanding of a phenomenon rather than trying to devise a perfect, yes-or-no test of a theorem explaining the phenomenon. A review of empirical work on the H-O-V model by Davis and Weinstein (1996) suggested that the accumulation of results is more influential than any individual study. Each study sheds new light on the circumstances under which a particular theory is useful. Davis and Weinstein suggested that researchers should both estimate and test. Their suggested criterion: Does the test narrow the range of sensible application of the theory? An affirmative reply indicates that the test is useful. Final PDF to printer IN THE REAL WORLD: (continued) HECKSCHER-OHLIN AND COMPARATIVE ADVANTAGE though, suppose that an exporting industry indeed uses the relatively abundant factor in a relatively intensive way in the production process but that the factor is also relatively more productive compared to the trading partner countries— in this mixed kind of setting, do you consider comparative advantage to be a result of the Heckscher-Ohlin model or of the Ricardian model? To get at this question of the relative importance of the Ricardian and Heckscher-Ohlin models, Morrow empiri- cally tested trade patterns and their causes with a sample of 20 countries (both developed countries and developing countries), 24 manufacturing industries, and 11 years (1985– 1995). The formulation of his theoretical model and of his precise empirical tests is beyond the scope of this text, but the essence is that the variability of the relationship between productivity (TFP) and skill intensity across industries was decomposed into the variation due to relative factor abun- dance and the variation due to Ricardian-type international relative productivity differences. Important Morrow results were that countries with a relative abundance of skilled labor specialized in the production of skilled-labor-intensive goods and that relative productivity in any given industry was uncorrelated with the relative skill intensity employed in that industry. In other words, although relative productiv- ity in an industry is certainly, in and of itself, a source of comparative advantage, that result is not being intermingled with Heckscher-Ohlin relative skill intensity when empirical tests are run. Therefore, separation of the Ricardian model from the Heckscher-Ohlin model is possible, and Morrow concluded that, empirically, both the Ricardian and the Heckscher-Ohlin models are useful in explaining special- ization patterns of countries. Finally, the H-O explanation of comparative advantage was somewhat more important than the Ricardian explanation, in that a given variation (one standard deviation) in relative factor abundance was judged by Morrow to be 1.6 to 2.3 times as powerful as a variation of one standard deviation in Ricardian TFP in explaining patterns of production in a country. Sources: David Chor, “Unpacking Sources of Comparative Advantage: A Quantitative Approach,” Journal of International Economics 82, no. 2 (November 2010), pp. 152–67; Peter M. Morrow, “Ricardian-Heckscher-Ohlin Comparative Advantage: Theory and Evidence,” Journal of International Economics 82, no. 2 (November 2010), pp. 137–51. ● 164 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch09_150-172.indd 164 06/17/16 03:57 PM HECKSCHER-OHLIN AND INCOME INEQUALITY In recent years, a debate has been taking place in the United States and in western Europe over a phenomenon that is associated with the Heckscher-Ohlin analysis. While the debate is not always couched in H-O terms (the average person on the street, unlike you, is not an expert on Heckscher-Ohlin!), it involves an important implication of that analysis and has also been the subject of empirical tests. The phenomenon is the growing income inequality that has been occurring in the developed countries.3 It is clear that income inequality in the United States has been increasing in recent years. For example, U.S. Census Bureau4 data indicate that the share of household income (in constant 2013 dollars) received by the lowest 20 percent of households fell from a high of 4.3 percent in 1976 to 3.2 percent in 2013, while the top 20 percent of households experienced an increase in their share of income from 43.7 percent in 1976 to 51.0  percent in 2013. During the same period, the middle 20 percent (40–60) of households expe- rienced a drop from 17.0 percent of income to 14.4 percent, while the second quintile 3There has also been growing inequality of the same general nature in developing countries. It should be noted that Slaughter (1999, p. 612) maintained that, among developed countries, the growing inequality had mainly occurred only in the United States and the United Kingdom. 4The income data in the next two paragraphs come from Carmen DeNavas-Walt and Bernadette D. Proctor, Income and Poverty in the United States: 2013 (Washington, DC: U.S. Census Bureau, September 2014), pp. 30, 33. Final PDF to printer CHAPTER 9 EMPIRICAL TESTS OF THE FACTOR ENDOWMENTS APPROACH 165 app9062x_ch09_150-172.indd 165 06/17/16 03:57 PM (20–40) faced a decline from 10.3 percent to 8.4 percent and the share of the fourth quintile (60–80) dropped from 24.7 percent to 23.2 percent. With respect to average real household income by household in dollar terms from 1976 to 1913, the changes were as follows: lowest 20 percent—minus 0.7 percent; second lowest 20 percent—plus 6.2  percent; mid- dle 20  percent—plus 10.7 percent; second highest 20 percent—plus 21.7 percent; and top 20 percent—plus 52.5 percent. (Above that level, the Census Bureau also gives the change for the top 5 percent of households—plus 74.2 percent.) Thus, over this long period, the second lowest quintile’s income grew faster than the first’s, the third’s faster than the second’s, and similarly on up the scale. There has been a general widening of the income distribution; it is not correct, looking at these particular data, to say that it’s only the very top income earners who have gained at the expense of everyone else; the only group that lost was the lowest group, but the distribution widened all the way up the scale. This same general broad widening of the entire income distribution also occurs if we look at the Census Bureau real household income data pertaining to the “Great Recession” of recent years and the beginnings of recovery. In those years, all quintiles experienced a decrease in household income, but the decreases were smaller as one goes up the income scale. The changes from 2007 to 2013 were as follows: lowest 20 percent of households— decrease of 10.2 percent; second lowest 20 percent—decrease of 7.8 percent; middle 20 percent—decrease of 6.8 percent; second highest 20 percent—decrease of 6.0 percent; highest 20 percent—decrease of 1.9 percent; and top 5 percent—decrease of 0.1 percent. It should be noted, however, that measurements of the amount of growth in income inequality in the United States over the last several decades depend to a considerable degree on the estimates/measurements of income. The above Census Bureau measures of income include money income received by households—including income from work, interest, dividends, and cash transfer payments of various kinds such as unemployment compensa- tion and welfare payments (although not non-cash transfers such as food stamps), but not capital gains. Another set of data by other researchers, for example, concentrates on the top 1 percent of income earners in the United States, and measures income before deduction for income taxes and prior to any transfer payments and including capital gains, and finds that the percentage of income received by the top 1 percent rose from 9 percent in 1976 to 20 percent in 2011.5 This result seems hard to reconcile with the Census Bureau figures that had the top 5 percent earning 22.2 percent in 2013 (and 22.3 percent in 2011). The treatment of taxes, transfers, and capital gains obviously makes a difference. Nevertheless, by any measure, and many studies have been conducted, there has been a clear rise in the degree of income inequality in the United States during the past several decades. Finally, figures pertaining to wealth (i.e., the net worth of households = the value of all assets minus the value of all liabilities) rather than income show increased inequality as well. For example, the Pew Research Center in 2011 indicated that in 2009 the median net worth of the typical household headed by an older individual (65 years and older) was $170,494, while the median net worth of a household headed by a younger individual (under 35 years) was $3,662. Although the older household would clearly be expected to have greater net worth because of a lifetime of accumulation and earnings, the 2009 ratio of 47 to 1 ($170,494 ÷ $3,662 = 47) of the two typical households had been a ratio of 10  to 1 in 1984. To put this difference in clearer perspective, the net worth of the median older household had risen (in real terms) by 42 percent since 1984, while the net worth of the median younger household had decreased by 68 percent from the 1984 level.6 5Facundo Alvaredo, Anthony B. Atkinson, Thomas Piketty, and Emmanuel Saez, “The Top 1 Percent in International and Historical Perspective,” Journal of Economic Perspectives 27, no. 3 (Summer 2013), p. 4. 6Pew Research Center, “The Rising Age Gap in Economic Well-Being,” obtained from http://pewresearch.org. Final PDF to printer 166 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch09_150-172.indd 166 06/17/16 03:57 PM Taking a longer view, Wojciech Kopczuk suggested that there are four different ways of measuring wealth distribution in the United States and the share held by top groups—by carrying out a sample survey weighted toward wealthy individuals, by looking at estate tax records, by estimating wealth from the flow of capital income of individuals, and by exam- ining lists of the wealthiest individuals such as provided by Forbes magazine.7 Kopczuk is able to assemble data over the long haul on capital income (1913–2012) and the estate tax (1916–2000). He concludes from this long-run information that the share of U.S. wealth held by the top 10 percent of individuals has fluctuated between 65 and 85 percent of total wealth, the share of the top 1 percent between 20 and 45 percent, and the share of the top 0.1 percent from a little below 10 percent to 25 percent. Importantly, after 1980, one series (estimating wealth from capital income) showed a dramatic increase for these top groups through 2012 while the other series (estimating wealth from estate tax collections) stayed relatively constant through 2000. Note, though, that because of estate tax changes and increases in the size of estate needed in order to be required to pay federal estate tax, that series was not really able to be calculated usefully after 2000. On the basis of this work and on other studies, however, it is fair to say that wealth as well as income inequality has increased in recent decades in the United States.8 Meanwhile, in western Europe, where wage rates are less flexible than in the United States due to institutional factors such as strong labor legislation and prominent unions, the increased inequality has registered itself not so much through widening wage differentials as through increased unemployment rates (with consequent loss of income). In 1973, the unemployment rate for developed countries in Europe was 2.9 percent, but unemployment averaged 9.3 percent from 1983 to 1991 (Freeman, 1995, p. 18) and in mid-1999 was at double-digit levels in Belgium (12.7 percent), France (14.2  percent), Germany (10.5 percent), Italy (12.0 percent), and Spain (16.1 percent) (The Economist, September 11, 1999, p. 114). For the same five countries, the mid-2015 figures were 8.6 percent, 10.3 percent, 6.4 percent, 12.4 percent, and 22.5 percent, respectively (The Economist, July 11,2015, p. 80). This phenomenon of rising inequality clearly has generated considerable tension and dissatisfaction. It was an important factor in the emergence of the Occupy Wall Street move- ment in the United States in 2011, although other matters lay behind that movement as well. To many observers, a disturbing factor about this rise in inequality is that it has been occurring at the same time that the United States and the world as a whole have been becoming more open to international trade. In 1970, the ratio of U.S. exports to U.S. gross domestic product (GDP) was 5.5 percent, while that of imports to GDP was 5.4 percent; by 1980 these ratios had reached 10.0 percent for exports and 10.6 percent for imports; and in 2014 the figures were 13.5 percent and 16.6 percent, respectively (Economic Report of the President, February 1999, pp. 326–27; U.S. Department of Commerce, Bureau of Economic Analysis, Survey of Current Business, October 2015, Table 1.1.5). And, in par- ticular, rapid growth has been occurring in imports into the United States and western Europe from developing countries. These imports into the United States were 14 percent 7Wojciech Kopczuk, “What Do We Know about the Evolution of Top Wealth Shares in the United States?” Journal of Economic Perspectives 29, no. 1 (Winter 2015), pp. 48–51. 8A widely noted 2014 book by Thomas Piketty, Capital in the Twenty-First Century (Cambridge, MA and London: Belknap Press of Harvard University Press), examines wealth and income distribution in the United States and several European countries over several centuries and puts forth the conclusion that growing inequality has indeed occurred in recent decades. A principal hypothesis that Piketty posits is that, if the annual rate of return to capital exceeds the annual rate of economic growth of a country, which has been the case in the past and will likely be the case in the future, then, other things equal, an increase in wealth and income inequality may well continue. Final PDF to printer CHAPTER 9 EMPIRICAL TESTS OF THE FACTOR ENDOWMENTS APPROACH 167 app9062x_ch09_150-172.indd 167 06/17/16 03:57 PM of all imports in 1970 but rose to 35 percent by 1990, 49 percent in 2000, and 54 percent in 2013. For the European Union countries, the figures were 5 percent of all imports in 1970, 18 percent in 1990, 24 percent in 2000, and 29 percent in 2013.9 These kinds of increases in trade in general and especially in imports from developing countries suggest that there may be a link between them and the rising inequality. Clearly, the Heckscher-Ohlin and Stolper-Samuelson theorems can provide such a link. As was developed in Chapter 8, the H-O theorem postulates that a country will export goods intensive in the country’s relatively abundant factor of production and will import goods intensive in the country’s relatively scarce factor of production. Extending this pat- tern of trade to income distribution considerations, the Stolper-Samuelson theorem indi- cates that, with trade, the real return to the abundant factor rises and the real return to the country’s scarce factor falls. In the context of an expanded H-O framework for the United States where labor is divided into relatively skilled labor and relatively unskilled labor, such as the framework utilized in empirical tests discussed earlier in this chapter, the implication is that the real incomes of highly skilled workers (who tend to be in the upper portions of the income distribution) will increase with expanded trade and the real incomes of less skilled workers (who tend to be in the lower portions) will decrease. Probing further into the matter, there is an increasing body of information that supports the idea that increased levels of education have a positive relative effect on workers’ incomes. In the United States, full-time working college graduates aged 25–32 on average annually earn about $17,500 more than peers who have only a high school diploma. The actual amount, of course, depends on the degree pursued and the charac- teristics of the individual involved.10 Other research carried out by the Organization for Economic Development suggests that, across 25 OECD countries, the net long-term returns to having a tertiary degree instead of an upper secondary degree are greater than $175,000 for men and more than $110,000 for women.11 Other studies showed that greater levels of higher education benefit the public sector as well through higher levels of productivity, tax revenues, and social contributions that exceed public investment costs. Finally, additional work has suggested that the return to higher education in developing countries is greater than in higher-income countries.12 The critical question facing trade economists concerns the extent to which the rising imports are the cause of the increased wage inequality.13 Most studies of the relationship have found trade to be a factor accounting for the increased inequality but not a major 9The 1970 and 1990 figures are from Freeman (1995, pp. 16, 19). The 2000 and 2013 figures were obtained from data in International Monetary Fund, Direction of Trade Statistics Yearbook 2007 (Washington, DC: IMF, 2007), pp. 32, 499, and Direction of Trade Statistics Quarterly, March 2015, pp. 26, 424, respectively. 10“Is College Worth It?” The Economist, April 5, 2014, obtained from www.economist.com. 11Organization for Economic Cooperation and Development, “What Are the Returns on Higher Education for Individuals and Countries?” Education Indicators in Focus, June 2012. 12“By and Large, the Return to Higher Education Is Higher in Poor Countries than in Rich Ones,” Investment Watch, April 3, 2015, obtained from www.investmentwatchblog.com. 13It should be reiterated that the increased wage inequality occurred only since the late 1970s. In a useful article, Robert E. Baldwin and Glen G. Cain note that the time period in the United States from 1968 through 1996 can be divided into four subperiods with differing characteristics regarding wages and wage equality: (1) 1968–1973, when average real wages increased and there was also a movement toward greater wage equality; (2) 1973–1979, when average real wages decreased slightly and there continued to be a movement toward greater wage equality; (3) 1979–1987, when average real wages increased slightly and there was a sizable increase in wage inequality; and (4) 1987–1996, when average real wages fell somewhat and the trend toward greater inequality generally continued. See Robert E. Baldwin and Glen G. Cain, “Shifts in Relative U.S. Wages: The Role of Trade, Technology, and Factor Endowments,” Review of Economics and Statistics 82, no. 4 (November 2000), pp. 580–95. Final PDF to printer 168 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch09_150-172.indd 168 06/17/16 03:57 PM factor. For example, Borjas, Freeman, and Katz (1992, discussed in Burtless, 1995, p. 808) calculated that from 8 to 15 percent of the 1980–1988 rise in the wage differential between college and high school graduates in the United States was attributable to the combined effects of trade and immigration into the United States, with most of this 8 to 15 percent due to the trade component. Other studies also found modest effects, and Richard Freeman (1995, p. 25) summarizes by stating that “factor content analysis studies indicate that trade can account for 10–20 percent of the overall fall in demand for unskilled labor needed to explain rising wage differentials in the United States or rising joblessness in Europe.” IN THE REAL WORLD: TRADE AND INCOME INEQUALITY IN A LESS DEVELOPED COUNTRY: THE CASE OF MOZAMBIQUE As less developed countries are influenced by the policy prescriptions of the International Monetary Fund and adopt trade strategies that favor export trade, the impact of these policies on the countries needs to be analyzed. A consider- able amount of effort has been devoted to examining the link between trade and income inequality at the national level in developed and developing countries. To this point, much less attention has been paid to regional differentiation within the countries. Julie A. Silva (2007) uses Mozambique as a test case for examining the regional differences in inequality. Mozambique is an interesting case because there is a long history of uneven development. The area to the south of the Zambezi River is relatively more developed, while the north is more isolated. The two regions are governed by the same economic development policies but differ in terms of climate, infrastructure, culture, and levels of development. Most of the population lives in rural areas, and 90 percent of rural Mozambicans are involved in agriculture. Households can produce cash (export) crops, domestically traded veg- etable crops, or both. Using data from government censuses conducted between 1996 and 2000, cross-sectional analysis was possible. There are significant differences in the trade orientation between the two regions. In the northern dis- tricts, 31 percent of agricultural households produce cash (export) crops, while only 13 percent of southern households do. Both regions are similar (18 percent in the north and 13 percent in the south) in terms of growing domestically traded vegetable crops. The primary focus of the analysis is on the impact of the trade variables on income inequality. In the south, Silva’s results suggest that only the domestic trade orientation has a significant impact, and it increases inequality. The coef- ficient of the export orientation variable is not significant, but this is not surprising because the southern households have a long tradition of resistance to growing cash crops. In addition, the local markets for domestically traded vegetable crops are well developed in the south. The indication that higher levels of trade would increase the income inequality contradicts the standard H-O predictions. In the northern districts, her cross-section analysis sug- gests that the export orientation has a negative and sta- tistically significant impact on inequality. The domestic trade orientation coefficient was positive (contributing to an increase in inequality as in the south) but was not sig- nificant. In both regions, the variables measuring physical and human capital were significant. In addition, the per- centage of households that were female-headed was also significant but also curious. In the south, a higher percent- age of female-headed households contributed to greater income inequality. In the north, the coefficient on female- headed households was negative and significant. While this result contradicts the expectation that economic margin- alization of women in sub-Saharan Africa would lead to higher inequality, the explanation may lie in the matrilin- eal social system of three of the largest tribes in northern Mozambique. In these tribes, wealth and land tenure pass through the female line. Overall, this study suggests the need to move beyond the traditional H-O framework focusing on the national level as we study income inequality in developing countries. The framework seems to be too narrow to capture the dynamics within and across regions in the less developed countries. The case of Mozambique suggests that differences in his- tory, culture, and capital across regions may be as critical as the economic forces in explaining income inequality. Source: Julie A. Silva, “Trade and Income Inequality in a Less Developed Country: The Case of Mozambique,” Economic Geography 83, no. 2 (April 2007), pp. 111–36. ● Final PDF to printer CHAPTER 9 EMPIRICAL TESTS OF THE FACTOR ENDOWMENTS APPROACH 169 app9062x_ch09_150-172.indd 169 06/17/16 03:57 PM The findings on this relatively minor role for trade have been disputed by other econo- mists.14 The most ardent advocate of the view that the increased trade with the develop- ing countries has led to the increased income inequality in developed countries has been Adrian Wood of the University of Sussex (see Wood, 1991, 1994), who contends that the usual estimates of the decrease in demand for unskilled labor in the developed countries are significant underestimates. In essence, he claims that replacing labor-intensive imports from developing countries with developed-country production would require considerably more low-skilled labor than is generally thought to be the case. As a response to these arguments, economists have usually made several major points, which we summarize here: 1. A major consideration brought out in the discussion is that if trade is operating in accordance with the Stolper-Samuelson theorem to generate the increased inequal- ity, then the prices of low-skill-intensive goods would also be falling. This follows because factor prices in the Heckscher-Ohlin analysis move in the same direction as the prices of the goods that the factors are used to produce. However, studies of rela- tive goods’ price movements in recent years do not find a pronounced decline in the prices of unskilled-labor-intensive goods relative to skilled-labor-intensive goods. Thus, the trade explanation for the increased inequality lacks a mechanism that is consistent with trade theory. 2. The rise in the demand for skilled labor relative to unskilled labor in the devel- oped countries has not been confined to the traded goods industries—indeed, it has occurred across almost all industries. If the increased inequality were purely a trade phenomenon, the fall in the relative price of unskilled labor would cause the nontraded goods industries to substitute toward the use of relatively more unskilled labor, which is the opposite of what has happened. Rather, the use of skilled labor relative to unskilled labor has risen across industries, whether the industries are pro- ducing traded goods or nontraded goods. Consequently, the general rise in demand for skilled labor in all industries is likely to have occurred because of the nature of technological change in this age of increased use of computers, robots, and so on. 3. There are other reasons for the decline in the relative earnings of unskilled labor besides trade and the above-mentioned technological change. In regard to the United States, some such reasons are the increased immigration of relatively unskilled labor, the decline in the importance and influence of organized labor, and the fall in the real minimum wage (since the nominal minimum wage has not kept pace with the price level). Indeed, in an informal survey of economists attending a confer- ence at the Federal Reserve Bank of New York, the average respondent attributed 45 percent of the rising wage inequality in the United States to technological change, 11 percent to trade, and less than 10 percent each to the decline in the real minimum wage, the decline in unionization, and the increased immigration of unskilled labor (with the remainder attributed to various other reasons). (See Burtless, 1995, p. 815, and Economic Report of the President, February 1997, p. 175.) Despite these strong points, however, the matter of the causes of the inequality is an unsettled one. For example, Wood has countered the technological-change argument by 14See, for example, Mishel, Bernstein, and Allegretto (2007, pp. 171–77). In addition, the entire January 1995 issue of the Federal Reserve Bank of New York’s Economic Policy Review was devoted to the rising wage inequality in the United States. Also, four papers (by Peter Gottschalk; George E. Johnson; Robert H. Topel; and Nicole M. Fortin and Thomas Lemieux) in the Spring 1997 issue of the Journal of Economic Perspectives address the increase in wage inequality. Final PDF to printer IN THE REAL WORLD: OUTSOURCING AND WAGE INEQUALITY Robert Feenstra and Gordon Hanson (1996) maintained that outsourcing has played an important causal role in the increasing wage inequality that has occurred in the United States in recent decades. To test this hypothesis, they con- structed a measure of outsourcing and a measure of the trend in wage inequality for the years 1972–1990 for 435 U.S. industries and ran statistical tests to see if there was a sig- nificant association between the two constructed data series. Feenstra and Hanson measured outsourcing for an indus- try as the share of imported intermediate inputs in the pur- chases of total nonenergy materials by the industry. Hence, if $30 worth of inputs were imported and the industry’s total nonenergy input purchases were $1,000, outsourcing would be calculated for this industry as 0.03 (=$30/$1,000). Energy inputs generally cannot be outsourced since the geographi- cal location of such supplies cannot be shifted, but this mea- sure in effect treats all other imported inputs as fitting into the “outsourced” category. This is a very broad measure of outsourcing. To some observers, outsourcing (often called “offshoring”) intuitively implies something more narrow, as in Hummels, Rapoport, and Yi (1998, p. 82), who defined it as “the relocation of one or more stages of the production of a good from the home country”; or, as in current discussions in the United States, the sending of particular jobs abroad, such (continued) 170 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch09_150-172.indd 170 06/17/16 03:57 PM strongly suggesting that the adoption of the unskilled-labor-saving type of new technology is occurring as a response to the threat of imports and thus that this reduction in the demand for unskilled labor should also be attributed to trade.15 Further, it could be said that the weakening of unions is also a result of new trade pressures. In addition, other potential causes for the increased inequality have been suggested. For example, Robert Feenstra and Gordon Hanson (1996) hypothesized that an important factor in reducing the demand for unskilled labor is the rise in “outsourcing” by U.S. firms. The point here is that firms are increasingly shipping abroad their component and intermediate-input production that is relatively unskilled-labor-intensive in nature, and this can also put downward pressure on the wages of U.S. low-skilled laborers. In Feenstra’s view (1998, p. 41), outsourcing and the shifting of activities abroad lead to the result that “the whole distinction between ‘trade’ versus ‘technology’ becomes suspect.” This muddling of trade and technology occurs because outsourcing can importantly be a response to technological change (e.g., improve- ments in communications, enhanced use of computers for inventory and monitoring pur- poses), and then trade responds to the outsourcing. Hence, in this view, the most important cause of increasing inequality is not to be identified as trade or technology—rather, both trade and technology are involved together in the increasing-wage-inequality process. To conclude this discussion, it is difficult in empirical analysis to sort out the specific impact on inequality of trade by itself in a complex, dynamic economy under- going continuous structural change. Economists in general tend to doubt that trade is the dominant factor in the rising wage inequality, but needed work continues on this important issue. 15Responses to this argument would be that firms in nontraded goods industries have also adopted skill-intensive technological change and that firms will adopt new technology in order to pursue profit maximization regardless of whether the threat comes from imports or from purely domestic competitors. Final PDF to printer IN THE REAL WORLD: (continued) OUTSOURCING AND WAGE INEQUALITY as staffing call centers in India rather than in the United States (for more discussion of outsourcing, see Chapter 16). In con- trast, the Feenstra-Hanson measure counts goods that have nothing to do with relocated production from a home firm. Nevertheless, using their measure (which they called SO), Feenstra and Hanson indicated increasing interdependence between the United States and other countries, since SO for the 435 industries in the aggregate doubled from 1972 (5.34 percent) to 1990 (11.61 percent). Feenstra and Hanson also examined another measure of interdependence (which they called SM), which was the share of imports in final U.S. con- sumption of the products of the various industries. This fig- ure for the 435 industries as a whole also doubled from 1972 (5.02 percent) to 1990 (10.65 percent). Feenstra and Hanson (1996, p. 242) took the fact that SO and SM moved together over the period as “consistent with the idea that outsourcing is a response to import competition.” In other words, when final goods imports as a percentage of U.S. consumption rose, U.S. firms responded by seeking lower costs through obtaining intermediate inputs from foreign locations. As a measure of wage trends, Feenstra and Hanson calcu- lated, for each of the 435 industries, the share of the indus- try’s wage bill that is paid to nonproduction workers. This is used as a proxy for the relative demand for skilled labor. As payments to nonproduction workers (e.g., executives, scientists, computer technicians) rise relative to payments to production workers, this measure (which they called SN) will rise. This rise is interpreted by Feenstra and Hanson to be a relative increase in the demand for skilled labor and hence an indication of greater wage inequality. Again, this measure is clearly a broad one, and it ignores differing skills and wage trends within the nonproduction-worker category, as well as within the production-worker category. With the SO, SM, and SN figures in hand for the 435 indus- tries, Feenstra and Hanson then conducted statistical tests for the years 1972–1990. They divided the period into two parts (1972–1979 and 1979–1990), in recognition of the fact that the increasing-inequality phenomenon had basically begun only at about the end of the 1970s. Their results were that, for 1972–1979, the annual changes in SN were not related to the annual changes in SO (after allowing for other influences on the wage share besides the annual changes in SO); for 1979–1990, however, there was a highly significant positive association between SN and SO. Changes in SN were also posi- tively related to changes in SM in a highly significant manner in the later period, whereas that had not been the case in the earlier period. In view of these statistical associations and the differing results for the later period as compared with the ear- lier period, Feenstra and Hanson (1996, p. 243) concluded that their research suggests, for the 1979–1990 period, “that outsourcing has contributed substantially to the increase in the relative demand for nonproduction labor.” Indeed, they estimated that the outsourcing could account for from 30.9 to 51.3 percent of the increase that had occurred in the share of the wage bill going to nonproduction workers. In a followup study, Feenstra and Hanson (2003) pre- sented evidence of a direct link between trade and wage inequality. By using data on changes in industry behavior over time, they showed that foreign outsourcing or offshor- ing is associated with increases in the share of wages paid to skilled workers in the United States, Japan, Hong Kong, and Mexico. In several cases, outsourcing can account for half or more of the observed skill upgrading. In the case of the United States, Feenstra and Hanson present evidence that during the 1980s and 1990s outsourcing contributed to changes in industry productivity and product prices that, in turn, mandated increases in the relative wage of skilled labor. Building upon the Feenstra-Hanson work, David Hummels, Rasmus Jorgensen, Jakob Munch, and Chong Xiang (2014) examined the effects of offshoring by firms in Denmark on Danish workers’ wages. They note that the purchase of an input from a foreign supplier can clearly replace work previously done by a domestic laborer, hence potentially costing the domestic worker a job or resulting in a lower wage. On the other hand, the domestic firm, by buy- ing cheaper inputs from abroad, can reduce the firm’s costs, increase the firm’s productivity, and perhaps thus lead to increased domestic output and employment and to a higher domestic wage. Hummels, Jorgensen, Munch, and Xiang investigated this research question by looking at the period 1995–2006 and at the individual firm, product, and worker level. A central conclusion was that offshoring increased the wages of Danish skilled labor and lowered the wages of Danish unskilled labor. Interesting other conclusions were that workers doing routine jobs lost wages, while workers in occupations that utilized knowledge in math, social sci- ence, and languages gained. Natural science and engineering workers were neither more nor less likely to be protected from the effects of offshoring on wages than was an average manufacturing worker. ● CHAPTER 9 EMPIRICAL TESTS OF THE FACTOR ENDOWMENTS APPROACH 171 app9062x_ch09_150-172.indd 171 06/17/16 03:57 PM Final PDF to printer 172 PART 2 NEOCLASSICAL TRADE THEORY app9062x_ch09_150-172.indd 172 06/17/16 03:57 PM SUMMARY The seemingly straightforward and intuitively appealing Heckscher-Ohlin theorem has been subjected to a large num- ber of empirical tests. However, the theorem has not had a particularly high success rate. An early and extensive test for the United States resulted in the famous Leontief paradox. Various explanations for the occurrence of this paradox have been offered, but none of them has been judged to be entirely convincing. The most promising avenues for further testing of Heckscher-Ohlin seem to lie in the incorporation of a larger number of factors of production by disaggregating labor into different skill categories and by adding natural resources, as well as incorporation of technology differences across coun- tries. Nevertheless, tests for other countries besides the United States have sometimes shown success in the standard two- factor framework. In addition, tests of a significant implication of the Heckscher-Ohlin analysis—that a country’s scarce fac- tor loses from trade—have been conducted in the context of examining the importance of trade as a cause of rising income inequality (especially in the United States); these tests have also yielded mixed results. Particularly given the frustrations that have emerged with respect to successful verification of the Heckscher-Ohlin pre- dictions on trade patterns, two questions pose themselves to economists: (1) Should we look for better ways of testing Heckscher-Ohlin? or (2) Should we search for other theoreti- cal explanations of trade patterns and the composition of trade, as H-O has not been particularly successful? The literature has moved in both directions in response to these questions. The “better-testing” approach has focused importantly on extend- ing the analysis to a greater number of factors than the origi- nal two, capital and labor. This approach runs the risk that, in disaggregating into more factors, we lose generality and meaningful understanding of the forces influencing a coun- try’s trade pattern. As Paul Samuelson has suggested, we may end up concluding that Switzerland exports Swiss watches because Switzerland is well endowed with Swiss watchmak- ers! The second approach of searching for alternative trade theories to Heckscher-Ohlin has generated a great deal of activity in recent years. These newer theories are the subject of the next chapter. KEY TERMS input-output table Leontief paradox Leontief statistic total factor requirements QUESTIONS AND PROBLEMS 1. What was the “Leontief paradox,” and why was it a paradox? 2. What do you think is the major defect in the Leontief test that might have caused the paradox to occur? Why? 3. How might the existence of factor-intensity reversals be a reason for the Leontief paradox? How might the existence of demand reversal? 4. If you have traveled in a foreign country, would your obser- vations confirm the view that the country’s demand pat- terns reflect consumer preferences in that country for goods produced with the country’s relatively abundant factor of production? 5. If U.S. tariffs and other trade barriers are placed more heav- ily on labor-intensive goods than on capital-intensive goods because of the H-O suggestion that the scarce factor of production gains from protection, how do you explain why many developing countries also have relatively high import barriers on labor-intensive goods? 6. Should economists discard the Heckscher-Ohlin theorem as a practical explanation of trade patterns and search for other theories of trade? Or should they seek better ways of testing Heckscher-Ohlin? Explain. 7. Build a case for the view that increasing openness of the U.S. economy has been the primary factor causing increased income inequality in recent decades. 8. Build a case against the view that increasing openness of the U.S. economy has been the primary factor causing increased income inequality in recent decades. Final PDF to printer 173 app9062x_ch10_173-202.indd 173 06/01/16 09:38 AM CHAPTER LEARNING OBJECTIVES LO1 Present early explanations for trade beyond relative factor endowments and intensities. LO2 Discuss recent theories of trade, with particular focus on imperfect competition. LO3 Describe the phenomenon known as intra-industry trade. POST–HECKSCHER- OHLIN THEORIES OF TRADE AND INTRA-INDUSTRY TRADE 10 PART 3: Additional Theories and Extensions Final PDF to printer 174 PART 3 ADDITIONAL THEORIES AND EXTENSIONS app9062x_ch10_173-202.indd 174 06/01/16 09:38 AM INTRODUCTION As early as 1999, Roy J. Ruffin of the University of Houston and Federal Reserve Bank of Dallas pointed out that, contrary to popular belief, the top U.S. imports from Mexico were not cloth- ing, fruits, and vegetables. These represented only 10 percent of the U.S. imports. Electrical machinery and equipment (and related parts) ranked first, representing 27 percent of U.S. imports from Mexico. Vehicles ranked second, and nuclear reactors, boilers, and related items were third. Interestingly, the United States’ top three exports to Mexico were these same three categories. Not only were Mexico’s exports to the United States quite similar to its imports, but Mexico’s exports were more concentrated in those big items.1 Current trade data show this same phenomenon of the United States importing and export- ing in the same product categories, thus challenging the predicted trade patterns of tradi- tional models of international trade. The chapter reviews several theories on the causes and consequences of trade. These newer approaches depart from trade theory as presented earlier by relaxing several assumptions employed in the basic trade model. Some of the implications of this relaxation will be presented in theories that incorporate differ- ences in technology across countries, an active role for demand conditions, economies of scale, imperfect competition, and a time dimension to comparative advantage. Finally, intra-industry trade (IIT)—a common element in several theories—will be discussed in detail, because it is a prominent feature in international trade of manufactured goods. It is important to recognize that the causes of trade are more complex than those portrayed in the basic Heckscher-Ohlin model. EARLY POST–HECKSCHER-OHLIN THEORIES OF TRADE The imitation lag hypothesis in international trade theory was formally introduced in 1961 by Michael V. Posner. Discussion of this theory paves the way for a better-known theory—the product cycle theory. The imitation lag theory relaxes the assumption in the Heckscher-Ohlin analysis that the same technology is available everywhere. It assumes that the same technology is not always available in all countries and that there is a delay in the transmission or diffusion of technology from one country to another. Consider countries I and II. Suppose that a new product appears in country I due to the successful efforts of research and development teams. According to the imitation lag theory, this new product will not be produced imme- diately by firms in country II. Incorporating a time dimension, the imitation lag is defined as the length of time (e.g., 15 months) that elapses between the product’s introduction in country I and the appearance of the version produced by firms in country II. The imitation lag includes a learning period during which the firms in country II must acquire technology and know-how in order to produce the product. In addition, it takes time to purchase inputs, install equipment, process the inputs, bring the finished product to market, and so on. In this approach, a second adjustment lag is the demand lag, which is the length of time between the product’s appearance in country I and its acceptance by consumers in country II as a good substitute for the products they are currently consuming. This lag may arise from loyalty to the existing consumption bundle, inertia, and delays in information flows. This demand lag also can be expressed in a number of months, say, four months. A key feature in the Posner theory is the comparison of the length of the imitation lag with the length of the demand lag. For example, if the imitation lag is 15 months, the net lag A Trade Myth The Imitation Lag Hypothesis 1Roy J. Ruffin, “The Nature and Significance of Intra-Industry Trade,” Economic and Financial Review, Fourth Quarter 1999, Federal Reserve Bank of Dallas. Final PDF to printer CHAPTER 10 POST–HECKSCHER-OHLIN THEORIES OF TRADE AND INTRA-INDUSTRY TRADE 175 app9062x_ch10_173-202.indd 175 06/01/16 09:38 AM is 11 months, that is, 15 months less 4 months (demand lag). During this 11-month period, country I will export the product to country II. Before this period, country II had no real demand for the product; after this period, firms in country II are also producing and supply- ing the product so the demand for country I’s product diminishes. Thus, the central point of importance in the imitation lag hypothesis is that trade focuses on new manufactured prod- ucts.2 How can a country become a continually successful exporter? By continually inno- vating! This theory has considerable relevance for present-day concerns about the global competitiveness of U.S. firms. Further, it seems to be more capable of handling “dynamic” comparative advantage than are the Heckscher-Ohlin and Ricardo models. The product cycle theory (PCT) of trade builds on the imitation lag hypothesis in its treatment of the role of time in the diffusion of technology. The PCT also relaxes several other assumptions of traditional trade theory and is more complete in its treatment of trade patterns. This theory was developed in 1966 by Raymond Vernon. The PCT is concerned with the life cycle of a typical “new product” and its impact on international trade. Vernon developed the theory in response to the failure of the United States—the main country to do so—to conform empirically to the Heckscher-Ohlin model. Vernon emphasizes manufactured goods, and the theory begins with the development of a new product in the United States. The new product will have two principal characteris- tics: (1) it will cater to high-income demands because the United States is a high-income country; and (2) it promises, in its production process, to be labor-saving and capital-using in nature. (It is also possible that the product itself—e.g., a consumer durable such as a microwave oven—will be labor saving for the consumer.) The reason for including the potential labor-saving nature of the production process is that the United States is widely regarded as a labor-scarce country. Thus, technological change will emphasize production processes with the potential to conserve this scarce factor of production. The PCT divides the life cycle of this new product into three stages. In the first stage, the new-product stage, the product is produced and consumed only in the United States. Firms produce in the United States because that is where demand is located, and these firms wish to stay close to the market to detect consumer response to the product. The characteristics of the product and the production process are in a state of change during this stage as firms seek to familiarize themselves with the product and the market. No interna- tional trade takes place. The second stage of the life cycle is called the maturing-product stage. In this stage, some general standards for the product and its characteristics begin to emerge, and mass production techniques start to be adopted. With more standardization in the production process, economies of scale start to be realized. This feature contrasts with Heckscher- Ohlin and Ricardo, whose theories assumed constant returns to scale. In addition, foreign demand for the product grows, but it is associated particularly with other developed coun- tries, because the product is catering to high-income demands. This rise in foreign demand (assisted by economies of scale) leads to a trade pattern whereby the United States exports the product to other high-income countries. Other developments also occur in the maturing-product stage. Once U.S. firms are sell- ing to other high-income countries, they may begin to assess the possibilities of producing abroad in addition to producing in the United States. If the cost picture is favorable (mean- ing that production abroad costs less than production at home plus transportation costs), The Product Cycle Theory 2The imitation lag hypothesis can also be applied in the case of new, lower-cost processes for producing an existing product. The demand lag in such a situation, however, is less meaningful than in the case of a new product. Final PDF to printer 176 PART 3 ADDITIONAL THEORIES AND EXTENSIONS app9062x_ch10_173-202.indd 176 06/01/16 09:38 AM then U.S. firms will tend to invest in production facilities in the other developed countries. If this is done, export displacement of U.S.-produced output occurs. With a plant in France, for example, not only France but other European countries can be supplied from the French facility rather than from the U.S. plant. Thus, an initial export surge by the United States is followed by a fall in U.S. exports and a likely fall in U.S. production of the good. This relocation-of-production aspect of the PCT is a useful step because it recognizes—in con- trast to H-O and Ricardo—that capital and management are not immobile internation- ally. This feature also is consistent with the growing amount of direct investment abroad by firms in many countries, such as by U.S. and western European firms in China and Southeast Asia and by Chinese investment in Africa. Vernon also suggested that, in this maturing-product stage, the product might now begin to flow from western Europe to the United States because, with capital more mobile inter- nationally than labor, the price of capital across countries was unlikely to diverge as much as the price of labor. With relative commodity prices thus heavily influenced by labor costs, and where labor costs were lower in Europe than in the United States, Europe might be able to undersell the United States in this product. Relative factor endowments and fac- tor prices, which played such a large role in Heckscher-Ohlin, have not been completely ignored in the PCT. The final stage is the standardized-product stage. By this time in the product’s life cycle, the characteristics of the product itself and of the production process are well known; the product is familiar to consumers and the production process to producers. Vernon hypothesized that production may shift to the developing countries. Labor costs again play an important role, and the developed countries are busy introducing other products. Thus, the trade pattern is that the United States and other developed countries may import the product from the developing countries. Figure 1 summarizes the production, consumption, and trade pattern for the originating country, the United States. In summary, the PCT postulates a dynamic comparative advantage because the coun- try source of exports shifts throughout the life cycle of the product. Early on, the innovat- ing country exports the good but then it is displaced by other developed countries—which in turn are ultimately displaced by the developing countries. A casual glance at product history yields this kind of pattern in a general way. For example, electronic products such as television receivers were for many years a prominent export of the United States, but eventually Japan, China, and the Republic of Korea emerged as competitors, causing the U.S. share of the market to diminish dramatically. The textile and apparel industry is another example where developing countries (especially China, Taiwan, Malaysia, and Bangladesh) have become major suppliers on the world market, displacing in particular the United States and Japan. Automobile production and export location also shifted rela- tively from the United States and Europe to Japan and later still to countries such as South Korea and Malaysia. This dynamic comparative advantage, together with factor mobility and economies of scale, makes the product cycle theory an appealing alternative to the Heckscher-Ohlin model. There is no single all-encompassing test (such as the Leontief test of Heckscher-Ohlin) to verify empirically the product cycle theory. Instead, researchers have examined par- ticular features of the PCT to see if they are consistent with real-world experience. For example, new product development is critical to the PCT, and it is often the result of research and development (R&D) expenditures. Therefore, economists hypothesize that, in the U.S. manufacturing sector, there should be a positive correlation between R&D expenditures and successful export performance by industry. A number of early tests indi- cated this result, including those by Donald Keesing (1967) and William Gruber, Dileep Mehta, and Vernon (1967). Kravis and Lipsey (1992) found that high R&D intensity Final PDF to printer CHAPTER 10 POST–HECKSCHER-OHLIN THEORIES OF TRADE AND INTRA-INDUSTRY TRADE 177 app9062x_ch10_173-202.indd 177 06/01/16 09:38 AM was positively associated with large shares of exports by U.S. multinational companies (MNCs). Furthermore, in recent years exports from U.S. MNCs abroad have displaced sales from U.S. plant locations, which is consistent with the direct-investment and export- displacement features of the PCT. In addition, in 1969, Louis Wells examined the income elasticity of demand of the fastest-growing U.S. exports and found that trade in “high- income”-type products indeed grew more rapidly than other products—again, an occur- rence consistent with the PCT. Early empirical work also found that the United States and other developed countries tended to export new products whereas developing countries tended to export older products, and that research-intensive U.S. industries had a high propensity to invest abroad.3 Raymond Vernon (1979) later suggested that the PCT might need to be modified. The main alteration concerns the location of the production of the good when the good is first introduced. Multinational firms today have subsidiaries and branches worldwide, and knowledge of production conditions outside the United States is more complete than it was at the time of Vernon’s original writing in 1966. Thus, the new product may be produced first not in the United States but outside the country. In addition, per capita income differences between the United States and other developed countries are not as great now as in 1966, so catering to high-income demands no longer implies catering to U.S. demands alone. Even with this modification, the salient features of scale economies, FIGURE 1 The Trade Pattern of the United States in the Product Cycle Theory Production, consumption of product U.S. production U.S. consumption Exports Imports t0 t1 t2 New-product stage Maturing-product stage Standardized-product stage Time From time t0 until time t1, the United States is producing the new product only for the home market and thus there is no trade. From time t1 until time t2, the United States exports the good to other developed countries (exports = production minus consumption) and may even begin importing the good from those countries (imports = consumption minus production). From time t2 onward, imports arrive into the United States from other developed countries and, increasingly, from developing countries. 3Hufbauer (1966); Gruber, Mehta, and Vernon (1967). Final PDF to printer 178 PART 3 ADDITIONAL THEORIES AND EXTENSIONS app9062x_ch10_173-202.indd 178 06/01/16 09:38 AM direct investment overseas, and dynamic comparative advantage still distinguish the prod- uct cycle theory from the Heckscher-Ohlin model. One hesitates, however, to distinguish the product cycle theory so clearly from the Heckscher-Ohlin model. Elias Dinopoulos, James Oehmke, and Paul Segerstrom (1993) constructed a theoretical model that has PCT-type trade emerging as a result of differing factor endowments across countries. The model utilizes three production sectors in each country: an innovating high-technology sector, an “outside-goods” sector that engages in no product innovation, and a sector that supplies R&D services to the high-technology sector. Like H-O, there are only two factors (capital and labor), identical production func- tions across countries, and constant returns to scale. Assuming that the R&D sector is the most capital-intensive sector, a capital-abundant country produces a great deal of R&D. This enables a firm in the high-technology sector in that country to obtain a temporary monopoly in a new product—with patent protection—and then to export the product. After the patent expires, production occurs abroad with some export from that location. While a complete explanation is beyond the scope of this book, Dinopoulos, Oehmke, and Segerstrom’s model generates PCT-type trade as well as IIT (a concept discussed later) and a role for MNCs. Thus, Heckscher-Ohlin and the product cycle theory may well be complementary, not competing, theories. In similar fashion, James Markusen, James Melvin, William Kaempfer, and Keith Maskus (1995, p. 209) introduced the idea of a life cycle for new technologies contain- ing elements of both the Dinopoulos, Oehmke, and Segerstrom model and the product cycle model. Noting the growing importance of technology in the trade of industrialized countries, Markusen et al. suggest that, just as there is a product cycle for consumer goods, there increasingly appears to be a cycle for techniques of production and machinery, as techniques and machines developed in industrialized countries eventually find their way into labor-abundant developing countries. This technology cycle is driven by the capital-abundant, high-wage countries where there is both a cost incentive and a sufficient market demand to warrant new labor-saving technology and new-product development. The capital-abundant countries thus produce a flow of new products and innovations, with firms often protected by a temporary monop- oly via patents to produce for the home market. Because the new labor-saving technologies are not consistent with the relative factor abundances in the labor-abundant developing countries, those countries initially have little economic incentive to acquire the innova- tions. Consequently, capital-abundant countries export the new products utilizing the new technology. Eventually, however, as incomes start to rise in developing countries and even newer technologies are produced in the developed countries, the machines embodying the original “new” technology are exported by capital-abundant countries and the final products start being produced in the labor-abundant countries. Later, as in the product cycle theory, the machines themselves may be produced in the developing countries and exported from them. This theory explaining the composition and pattern of a country’s trade was proposed by the Swedish economist Staffan Burenstam Linder in 1961. The Linder theory is a dramatic departure from the Heckscher-Ohlin model because it is almost exclusively demand oriented. The H-O approach was primarily supply oriented because it focused on factor endowments and factor intensities. The Linder theory postulates that tastes of consumers are conditioned strongly by their income levels; the per capita income level of a country will yield a particular pattern of tastes. (Note that Linder is concerned only with manufactured goods; he regards Heckscher-Ohlin as fully capable of explaining trade The Linder Theory Final PDF to printer CHAPTER 10 POST–HECKSCHER-OHLIN THEORIES OF TRADE AND INTRA-INDUSTRY TRADE 179 app9062x_ch10_173-202.indd 179 06/01/16 09:38 AM in primary products.) These tastes of “representative consumers” in the country will in turn yield demands for products, and these demands will generate a production response by firms in that country. Hence, the kinds of goods produced in a country reflect the per capita income level of that country. This set of particular goods forms the base from which exports emerge. To illustrate the theory, suppose that country I has a per capita income level that yields demands for goods A, B, C, D, and E. These goods are arrayed in ascending order of product “quality” or sophistication, with goods A and B, for example, being low-quality clothing or sandals while goods C, D, and E are farther up the quality scale. Now suppose that country II has a slightly higher per capita income. Because of its higher income, it may demand and therefore produce goods C, D, E, F, and G. Goods F and G may be quality products (such as silks or fancy shoes) not purchased by country I’s lower-income consum- ers. Each country is therefore producing goods that cater to the demands and tastes of its own citizens. Given these patterns of production, what happens if the two countries trade with each other? Which goods will be traded between them? Trade will occur in goods that have overlapping demand, meaning that consumers in both countries are demanding the par- ticular items. In our example, goods C, D, and E will be traded between countries I and II. The determination of the trading pattern by observing overlapping demands has an important implication for the types of countries that will trade with each other. Suppose that we introduce country III, which has an even higher per capita income than country II. Country III’s consumer demand may be for goods E, F, G, H, and J. Which goods will country III trade with the other two countries? It will trade goods E, F, and G with country II but will trade only good E with country I. For all three countries I, II, and III, Figure 2 portrays the income-trade relationships, recognizing that there is a representative range of individual incomes around each country’s per capita income level. Looking at the Linder model as a whole, the important implication is that international trade in manufactured goods will be more intense between countries with similar per cap- ita income levels than between countries with dissimilar per capita income levels. The Linder conclusion is consistent with aspects of the product cycle theory and fits with the observation that, for much of the post-World War II period, rapid growth in trade in manu- factured goods has taken place between developed countries. The Linder theory has been subjected to a number of empirical tests. A common type of test is formulated as follows: Suppose that we have figures on the absolute value of the per capita income differences between a given country I and its trading partners. Then we get information on the intensity of trade between country I and each of its trading partners. The Linder theory would hypothesize that the relationship between these two series is negative because the greater the difference between the per capita incomes of country I and a trad- ing partner, the less intensely the two countries will trade with each other. Studies, such as that by Joel Sailors, Usman Qureshi, and Edward Cross (1973), have indeed found a nega- tive correlation. However, a complicating factor is that countries with similar per capita incomes often tend to be near one another geographically, so that the intense trade may also reflect low transportation costs and cultural similarity. After correcting for geographic proximity and other shortcomings, studies by Hoftyzer (1975), Greytak and McHugh (1977), Qureshi et al. (1980), and Kennedy and McHugh (1980) found little or no evidence in support of the Linder theory. At this point, the primary tool employed in these studies was simple correlation analysis. More recently, gravity models in a multiple regression context have been used in the test- ing of the Linder theory. (The gravity model framework is discussed later in this chapter.) Final PDF to printer 180 PART 3 ADDITIONAL THEORIES AND EXTENSIONS app9062x_ch10_173-202.indd 180 06/01/16 09:38 AM FIGURE 2 Overlapping Demands in the Linder Model In the preceding three-country example, the level of per capita income in country I yields a demand for goods A, B, C, D, and E. Country II’s higher per capita income yields a demand for goods C, D, E, F, and G, and country III’s even higher per capita income is associated with demands for goods E, F, G, H, and J. According to the Linder hypothesis, there will be an interest in trade only where socio-income-induced product demands are similar or “overlap.” Thus, we would expect to see countries I and II trading goods C, D, and E with each other and countries II and III exchanging goods E, F, and G. Because their respective income levels do not generate common demands for any good except good E, countries I and III will trade with each other only in that good. Goods C ou nt ry I’ s de m an d an d pr od uc tio n Country I’s income Country II’s income C ou nt ry II ’s d em an d an d pr od uc tio n C ou nt ry II I’s d em an d an d pr od uc tio n Country III’s income Income levels A B C D E F G H J The gravity models focus on the interaction between the resistance (geographic distance) and attraction (similar demand patterns). The expectation is that controlling for geographic factors, countries with similar demand patterns will trade more intensively with each other. Two tests using gravity models found little or no evidence to support the Linder theory (Hoftyzer, 1984; Kennedy and McHugh, 1983). However, using a gravity model to control for distance between countries and other determinants of trade, Jerry and Marie Thursby (1987, p. 493) found that support for Linder’s hypothesis was overwhelming in their study of the manufactured goods trade of 13 European developed countries, Canada, Japan, the United States, and South Africa. Only Canada and South Africa failed to have a significantly negative regression coefficient for per capita income differences with a trading partner on the volume of trade with that given partner. Additional studies by Hanink (1988, 1990), Greytak and Tuchinda (1990), Bergstrand (1990), and McPherson et al. (2000) found evidence supporting Linder’s hypothesis using a gravity model. In addition, Bukhari et al. (2005), after controlling for size of trading partner and relative price levels, found that Final PDF to printer CHAPTER 10 POST–HECKSCHER-OHLIN THEORIES OF TRADE AND INTRA-INDUSTRY TRADE 181 app9062x_ch10_173-202.indd 181 06/01/16 09:38 AM imports into each of the South Asian countries of Bangladesh, India, and Pakistan were, in a statistically significant manner, negatively related to the absolute value of the per capita income differences between the respective South Asian country and its trading part- ners. Rauh (2010) found similar results for Germany’s trade with its European partners. These results are consistent with the expectations from the Linder model. Several studies have also indicated that a problem with omitted countries may have created a bias rejecting the Linder hypothesis. Finally, we need to make one very important point concerning the Linder theory. In our example of countries I, II, and III, the theory identified the goods that would be traded between any pair of countries. However, the Linder theory did not identify the direction in which any given good would flow. When we said that countries I and II would trade in goods C, D, and E, we did not say which good or goods would be exported by which country. This was not a slip in the model; Linder made it clear that a good might be sent in both directions—both exported and imported by the same country! This phenomenon was not possible in our previous models of trade, for how could a country have a comparative advantage and a comparative disadvantage in the same good? The answer to this question will be pursued later (see the final section of this chapter), but this type of trade could clearly occur, for example, because of product differentiation. This term refers to products that are seemingly the same good but which are perceived by the consumer to have real or imagined differences. Clearly two different makes of auto mobiles are not the same in the consumer’s mind. Nor does the consumer regard as equivalent two different brands of beer, tennis rackets, or word-processing programs. Linder’s theory can incorporate this notion of product differentiation, because country II might be exporting Hyundais to country III and country III might be exporting Ford Fusions to country II. Countries that export and import items in the same product classification are engaging in intra-industry trade (IIT). The topic of IIT, covered later in this chapter, is an aspect of Linder’s theory that has generated considerable theoretical and empirical work. Some alternative trade theories are based on the existence of economies of scale. In several of these models, the economies of scale are external economies pertaining to the industry rather than the firm. In such industries, as output increases, firms experience cost reduc- tions per unit of output because, for example, the industry growth is attracting a pool of qualified labor. In a two-country world where the countries have identical PPFs and demand condi- tions, there is normally no incentive to trade. If the two industries experience economies of scale, the model generates a potentially new reason for trade. In spite of the fact that both countries begin with identical autarky positions, a shock that results in each country mov- ing to specialization in different goods and trading would lead both countries to experience gains from trade. See Appendix A at the end of this chapter for the complete development of this model. While the gains from trade are clearly a result of the cost reductions that come from spe- cialization and the resulting economies of scale, there are a number of uncertainties in this model. First, there is no way to know which country will specialize in each good. Second, something unusual is needed to jolt production away from the autarky point, but there is no way to predict the cause of the shock. In spite of these uncertainties, the analysis opens up new possibilities for gains that do not exist in traditional models. Whether the introduction of increasing returns is more realistic than the constant-returns assumption is a debated question, but increasingly, economists do think that scale economies can be important. Economies of Scale Final PDF to printer 182 PART 3 ADDITIONAL THEORIES AND EXTENSIONS app9062x_ch10_173-202.indd 182 06/01/16 09:38 AM CONCEPT CHECK 1. If the imitation lag for a new product is nine months and the demand lag is two months, why will there be no trade in the product in the first month after the innovating country introduces it? 2. If firms in innovating country A build new plants in similar high-income country B during the maturing product stage of the product cycle theory, why might A’s exports to another high-income country, C, decline along with A’s exports to country B? 3. Suppose that country F has a per capita income of $3,000. Using the Linder theory, what is its relative intensity of trade with country G ($1,000 per capita income) com- pared with country H ($6,000 per capita income)? Explain. 4. If two countries have identical PPFs and demand conditioins, how do external econo- mies of scale generate potential gains from trade for both countries? MORE RECENT ALTERNATIVE TRADE THEORIES This theory of trade represents a family of newer trade models that has emerged since Heckscher-Ohlin. While Paul Krugman has developed other models, we refer to this widely cited model (November 1979) as the Krugman model. This model rests on two features that are sharply distinct from those of traditional models: economies of scale and monopolistic competition. In the Krugman model, labor is assumed to be the only factor of production. The scale economies (which are internal to the firm) are incorporated in the equation for determining the amount of labor required to produce given levels of output by a firm, as shown here: L = a + bQ [1] L stands for the amount of labor needed by the firm, a is a constant (technologically deter- mined) number, Q represents the output level of the firm, and b specifies the relation at the margin between the output level and the amount of labor needed. The equation works as follows: If a = 10 and b = 2, this means that when the firm’s output level is 20 units, then the labor required to produce that level of output is L = 10 + (2)(20), or 50 units of labor. However, suppose that output doubles to 40 units. The labor required to produce 40 units is L = 10 + (2)(40), or 90 units. What does this equation imply? It means that a doubling of output requires less than a doubling of input; that is, economies of scale in production exist. All firms in the economy are assumed to have this type of labor requirement equa- tion. It should be evident that this equation is not applicable to a Ricardian model, because constant costs of production would make the relevant labor-usage equation L = bQ; that is, the labor input has a constant relation to the amount of output. The second main characteristic of the Krugman model is the existence of the market structure of monopolistic competition. In monopolistic competition, there are many firms in the industry and easy entry and exit. In addition, there is zero profit for each firm in the long run. However, unlike the perfect competition of traditional trade theory, the output of firms in the industry is not a homogeneous product. The products differ from each other, and each firm’s product possesses a certain amount of consumer brand loyalty. Product differen- tiation leads to advertising and sales promotion as firms attempt to differentiate their prod- ucts in the minds of consumers. (For a review of monopolistic competition and the effect of changes in the price elasticity of demand, see Appendix B at the end of this chapter.) The Krugman model is most easily portrayed through Krugman’s basic graph (see Figure 3). On the horizontal axis, we place consumption of a typical good by any repre- sentative consumer in the economy, that is, per capita consumption, c. The vertical axis The Krugman Model Final PDF to printer CHAPTER 10 POST–HECKSCHER-OHLIN THEORIES OF TRADE AND INTRA-INDUSTRY TRADE 183 app9062x_ch10_173-202.indd 183 06/01/16 09:38 AM FIGURE 3 Basic Krugman Diagram The upward-sloping PP curve indicates that as per capita consumption (c) of the good rises, the price of the good will rise. The reason is that demand is assumed to become less elastic as consumption increases, and thus the profit-maximizing price P = MC[eD/(eD + 1)] increases. The downward-sloping ZZ curve reflects the fact that profit in the long run is zero. A greater amount of consumption brings the realization of scale economies, which in turn leads to price reductions and eventually to zero economic profit. Equilibrium occurs at the intersection point E. With the introduction of international trade, the size of the market facing the firm is increased; this is represented by a shift of the ZZ curve to the left or downward to Z′Z′. The consequence is that per capita consumption of the good falls but total consumption of each good increases. In addition, the fall in P/W means that the real wage (W/P) has increased. Z Z P P Per capita consumption, c P/W Z Z E E (P/W1) (P/W2) c2 c1 indicates the ratio of the price of the good to the wage rate, P/W. The basic notions of the model are illustrated in this figure and through explanation of the PP and ZZ curves. The upward-sloping PP curve reflects the relationship of the price of the good to mar- ginal cost. As consumption increases, demand becomes less elastic. This is like the ordi- nary straight-line demand curve studied in the introductory economics course—at lower prices and larger quantities, demand is less elastic than at higher prices and smaller quanti- ties. Thus, the expression [eD/(eD + 1)], which is developed in Appendix B, increases and, with constant marginal cost, profit maximization dictates a higher price. Thus, P/W rises as c increases, and the PP curve is upward sloping. The ZZ curve in Figure 3 reflects the phenomenon in monopolistic competition that economic profit for the firm is zero in long-run equilibrium. (Ignore the Z′Z′ curve for the moment.) To arrive at the downward slope, remember that zero profit means that price is equal to average cost at all points on the ZZ curve. From any given point on the curve, if per capita consumption (c) increases (a horizontal movement to the right), average cost is reduced because of the economies-of-scale phenomenon specified in this model. Hence, to maintain the zero profit and to move back to the ZZ curve, price must be reduced (a verti- cally downward movement); this yields a downward slope for the curve. Clearly, when the downward-sloping ZZ curve is put together with the upward-sloping PP curve in Figure 3, there is an equilibrium position. (We’re assuming that you’ve been Final PDF to printer 184 PART 3 ADDITIONAL THEORIES AND EXTENSIONS app9062x_ch10_173-202.indd 184 06/01/16 09:38 AM able to figure out where it is!) At point E, the representative monopolistically competitive firm is in equilibrium because it is charging its profit-maximizing price (and hence is on the PP curve), and this is a long-run equilibrium position because economic profit is zero (because the firm is on the ZZ curve). In Figure 3, the firm thus settles at (P/W)1, and the per capita consumption level of the product is c1. To introduce international trade, suppose that we designate the home country of this representative firm as country I. Let’s now introduce another country, country II, which is identical to country I in tastes, technology, and characteristics of the factors of production. (Country II could also be identical in size, although that is not necessary.) Traditional trade theory would conclude that, with these same general supply and demand conditions (and hence relative prices), the two countries would have no incentive to trade with each other. However, Krugman (and Linder) would disagree. When the two countries are opened to trade, the important point to note is that the market size is being enlarged for each representative firm in each country, because there are now more potential buyers of any firm’s good. And, when market size is enlarged, economies of scale can come into play and production costs can be reduced for all goods. In Figure 3, if the firm being considered is in country I, the opening of the country to trade with country II means that consumers in both countries are now consuming this product (as well as all other products)—country II’s consumers now add country I products to their consumption bundle, just as country I’s consumers add country II products to their con- sumption bundle. If the firm’s total output is momentarily held constant, there is thus, with the larger consuming population but with the spreading out of consumption to other, newly available products, less per capita consumption of this firm’s product at each P/W than was previously the case. This is equivalent to a leftward shift of the ZZ curve, represented by the Z′Z′ curve in Figure 3. [For example, if country II’s population is identical in size to country I’s population, then the size of the consuming population has doubled—this would lead to a shift to the left of ZZ by 50 percent (per capita consumption would be one-half of its previous value); if country II’s population were 25 percent of that of country I, the ZZ curve would shift to the left by 20 percent, because per capita consumption would now be 80 percent (=1/1.25) of its previous value.] Given the shift of ZZ to Z′Z′, there is thus disequilibrium at the old equilibrium point E, and movement takes place to the new equilibrium position E′. As movement from E to E′ occurs, P/W falls from (P/W)1 to (P/W)2 and per capita consumption of this firm’s good falls from c1 to c2. Notice that, although per capita consumption at the new equilibrium has declined in comparison with per capita consumption at the old equilibrium, it has not declined proportionately to the extent by which the size of the consuming population increased. [If it had, per capita consumption would be at the level on the Z′Z′ curve that is associated with (P/W)1.] Because per capita consumption has not decreased proportion- ately with the increase in the size of the consuming population, this means that total con- sumption of the firm’s product has increased; with this increased output by the firm, the scale economies have come into play and have reduced unit costs (and hence the price of the firm’s output). As noted, the opening of trade has reduced P/W in this country (and has done so in the other country, too) because economies of scale have been realized. However, if P/W has decreased, obviously its reciprocal W/P has increased. The significance of an increase in W/P is that real income has risen because W/P is the real wage of workers. Thus, trade causes an improvement in real income and a corresponding increase in output of all goods. Also, there is a less tangible but nevertheless very real additional benefit from trade— consumers now have foreign products available to them as well as home-produced prod- ucts. This increase in product variety and consumer choice should also be counted as a Final PDF to printer CHAPTER 10 POST–HECKSCHER-OHLIN THEORIES OF TRADE AND INTRA-INDUSTRY TRADE 185 app9062x_ch10_173-202.indd 185 06/01/16 09:38 AM gain from trade. Further, the trade between the countries in this model is trade of similar but differentiated products. As in the Linder theory, an exchange of similar goods emerges, that is, IIT, a result that conforms with the nature of much of international trade in the present-day world. Consequently, this model can explain trade between similar countries. Krugman has noted elsewhere (1983) that factor endowments can determine the broad range of types of goods a country will export and import; within that broad range, however, product differentiation and scale economies play a very important role in generating trade and the gains from trade. Finally, another potential result of the Krugman model’s trade is also important. The increased well-being from trade is available to all consumers. Thus, even if a person is a “scarce factor of production” in a Heckscher-Ohlin context and would tend to lose from trade, the gains for that person in the Krugman model both from a higher real wage due to the scale economies and from the increased variety of goods due to product differentiation can more than offset the loss from being a scarce factor. Hence, the “gainer-loser” income distribution aspects of trade do not necessarily occur if trade consists of an exchange of differentiated manufactured goods produced under conditions of economies of scale. The reciprocal dumping model was first developed by James Brander (1981) and was then extended by Brander and Paul Krugman (1983). (See also Krugman, 1995, pp. 1268–71.) As discussed in Chapter 8, a monopoly firm may charge a different (lower) price in the export market than in the home market. This price discrimination phenomenon in the context of international trade is called dumping, and it usually arises because demand is more elastic in the export market than in the domestic market. (As indicated earlier, with price discrimi- nation, markets are separated and the same good is sold in the different markets at different prices, with the lower price being charged in the market where demand is more elastic.) In the Brander-Krugman model, there are two countries (a home country and a foreign country) and two firms (a home firm and a foreign firm) producing a homogeneous (stan- dardized) good. An important feature is that there is a transportation cost of moving the good (in either direction) between the home country and the foreign country, so this is a barrier that can keep the markets separated. Suppose first that the transportation cost of moving the good between the countries is very high—each firm then may well produce only for its own home market, and each will have a monopoly position in that market. In such a situation, each firm will follow the usual criterion of producing at the output level where marginal revenue equals marginal cost, and of marking up price over marginal cost in accordance with the markup formula P = MC [eD /(eD + 1)] developed in Appendix B. Thus, each of the two firms is maximizing profit and is selling in only one market (the home firm in the home country and the foreign firm in the foreign country). Suppose, however, that the transportation cost is not so high, and the home firm notes that the price charged by the foreign firm in the foreign market exceeds the home firm’s marginal cost of producing a unit of output plus the transportation cost of moving that unit of home output to the foreign market. If this is so, then the home firm will want to sell in the foreign market as well as in the home market, since there will be some additional profit that can be made by doing so. Analogously, if the foreign firm notices that the price in the home market exceeds the foreign firm’s marginal cost plus the transportation cost of send- ing the good from the foreign market to the home market, then it will want to sell in the home country’s market, too. Thus, there clearly are possibilities for international trade to emerge in this model. Once the two firms start selling in each other’s country as well as in their own home countries, we enter a market structure of duopoly (two sellers in a market), and the price in each country will change from the previous monopoly situation because of the new rivalry. The Reciprocal Dumping Model Final PDF to printer 186 PART 3 ADDITIONAL THEORIES AND EXTENSIONS app9062x_ch10_173-202.indd 186 06/01/16 09:38 AM This duopoly structure gives rise to a situation where each firm must take account of the behavior of the other firm when choosing its own price and output. The recognized interde- pendence between the firms and the manner in which price and output decisions are made in this context are best addressed by game theory, a complicated subject about which we will have more to say in Chapter 15. In general, each firm determines an array of various profit-maximizing positions, one for each possible output level of the other firm. The two firms then interact with each other in accordance with these arrays; for the purposes of this present chapter, suffice it to say that an equilibrium price and output level will be deter- mined in each market for each firm. There will be this one outcome which is satisfactory to both firms, and, in this equilibrium position, each firm will be maximizing its profit for the given output level of the other firm. An additional aspect of the situation can also be usefully mentioned. Each firm is maxi- mizing profit in each market (MR = MC in each market), but note the nature of the marginal cost of selling in the foreign country’s (home country’s) market for the home (foreign) firm. That cost will include not only production cost but also the transportation cost. If demand structures are similar in the two countries, then, using the home firm as an example, the net price received in the foreign market (price in the foreign market less transportation cost) is likely to be lower than the price received in the home market (where there is no transporta- tion cost). It is in this rather particular sense that “dumping” is occurring in the model—the price received in the foreign market is less than the price received in the home market. Note, however, what the main point of the model is from the standpoint of trade theory. International trade in a homogeneous product is occurring, with each country both export- ing and importing the product. This result emerges importantly because of the imperfectly competitive market structure, and it could never emerge with perfect competition. We clearly have IIT here, and the model may help us to understand real-world trade flows consisting of the movement of similar products between countries. Finally, Brander and Krugman discuss welfare implications of the model. On one hand, welfare tends to increase for each country and for the world because previously monopolistic sellers in each country are now faced with a rival and this pro-competitive effect will put downward pressure on price. On the other hand, a negative welfare aspect exists in that there clearly is waste involved in sending identical products past each other on transporta- tion routes! (It would be better from a transportation cost perspective by itself to have each country supplying exclusively its own market.) Hence, in general, we cannot say whether this two-way trade in a homogeneous product is on balance welfare enhancing or welfare reducing—the result will depend on the particulars of the actual situation being considered. Another avenue of research that has been explored concerns vertical specialization-based trade (see Hummels, Rapaport, and Yi, 1998). In this research it is recognized that, increas- ingly, various stages in the production process of any particular good are taking place in different countries. Thus, some components of an automobile engine may be made in Germany and then sent to the United Kingdom, where the engine is assembled; the engine itself is then sent to the United States for placement in the automobile. Such offshoring4 by the U.S. auto firm, rather than making or having the components made domestically, has been growing noticeably in recent years. While there is no new “theory” of trade here, the approach recognizes that comparative advantage may pertain to trade in intermediate goods as well as in final goods (as in traditional theory). Vertical Specialization-Based Trade 4“Offshoring” refers to a domestic firm shifting part of its production process and/or production components to another country (outsourcing abroad). Fuller discussion of U.S. offshoring is contained in Chapter 16. Final PDF to printer IN THE REAL WORLD: NEW VENTURE INTERNATIONALIZATION Stage theory (Johanson and Vahlne, 1977) incorporates the idea that internationalization is a gradual process that occurs as firms establish themselves in the domestic market and then grow to the point where they have the managerial expertise and economies of scale needed to enter the international arena. However, since the late 1980s, researchers in international entrepreneurship have been observing an increasing num- ber of new ventures in countries around the world that seek to operate internationally at or near inception (McDougall, 1989). The acceleration of international activity by firms should be seen as a result of several changes on the global scene. Many of the changes have resulted in a reduction in the transaction costs associated with conducting business interna- tionally. Globally, barriers to trade and investments have been reduced through the World Trade Organization. In addition, regional agreements such as the European Union (EU) and the North American Free Trade Agreement (NAFTA) have fur- ther removed barriers to new ventures becoming internation- ally active. Technological advances (including the Internet and e-mail) and falling transportation costs have resulted in enhanced information flows between countries which facili- tate new venture internationalization (Autio, 2005; Reynolds, 1997). As the economy becomes increasingly global, infor- mation about foreign markets, potential clients, and possible foreign partners is more easily available. While there are many reasons to expect more interna- tional new ventures, there are also some special challenges. New ventures are typically more resource-constrained than larger, more established firms in terms of both financial and human capital (Coviello and McAuley, 1999). Also, new ventures are more likely to suffer the liabilities of newness (greater risk of failure and particular difficulties of being young) and liabilities of foreignness (a disadvantage rela- tive to local firms when operating in foreign markets) as compared to larger, more established firms (Hessels, 2008). New venture internationalization is not easily explained by the traditional trade theories that were developed to examine the countries involved in trade rather than the firms. Even the models that focus on firm characteristics were developed to explain internationalization among large firms (McDougall et al., 1994). As a result, cross-border entrepreneurship has become a growing area of research. Sources: Erkko Autio, “Creative Tension: The Significance of Ben Oviatt’s and Patricia McDougall’s Article ‘Toward a Theory of International New Ventures,’ ” Journal of International Business Studies 36, no. 1 (January 2005), pp. 9–19; Nicole E. Coviello and Andrew McAuley, “Internationalisation and the Smaller Firm: A Review of Contemporary Empirical Research,” Management International Review 39, no. 3 (1999), pp. 223–56; S.J.A. Hessels, International Entrepreneurship: Value Creation across National Borders (Rotterdam: Erasmus Research Institute of Management, 2008); Jan J.  Johanson and Jan-Eric Vahlne, “The Internationalization Process of the Firm—A Model of Knowledge Development and Increasing Foreign Market Commitments,” Journal of International Business Studies 8, no. 1 (Spring–Summer 1977), pp. 23–32; Patricia P. McDougall, “International versus Domestic Entrepreneurship: New Venture Strategic Behaviour and Industry Structure,” Journal of Business Venturing 4, no. 6 (November 1989), pp. 387–400; Patricia P. McDougall, Jeffrey G. Covin, Richard B. Robinson, Jr., and Lanny Herron, “The Effects of Industry Growth and Strategic Breadth on New Venture Performance and Strategy Content,” Strategic Management Journal 15, no. 5 (September 1994), pp. 537–54; Paul D. Reynolds, “Who Starts New Firms? Preliminary Explorations of Firms-in- Gestation,” Small Business Economics 9, no. 5 (October 1997), pp. 449–62. ● CHAPTER 10 POST–HECKSCHER-OHLIN THEORIES OF TRADE AND INTRA-INDUSTRY TRADE 187 app9062x_ch10_173-202.indd 187 06/01/16 09:38 AM This vertical focus on the production process has provided a new aspect of interna- tionalization and is often discussed under the concept of global logistics/supply chain management. While the product cycle theory examined international movement of con- sumption and production for an entire product, this newer approach focuses on the division of the production of the product into distinct stages. The distribution of different parts of the production process to many different countries results in a global network of producers that must be coordinated to produce and distribute the final product. If different aspects of the production vary in terms of capital and labor intensity, the production process is thus often spread across a variety of developed and developing countries. The key decisions for the firm in this model include identifying countries that possess comparative advan- tages in the stages of the production process, developing a logistic system to coordinate Final PDF to printer 188 PART 3 ADDITIONAL THEORIES AND EXTENSIONS app9062x_ch10_173-202.indd 188 06/01/16 09:38 AM the multiple inputs in the global supply chain, and maximizing the efficiency of produc- tion and sales globally. This internationalization of the production process has led to the formulation of newer models that focus on the characteristics of firms as opposed to the characteristics of countries. There are several theories related to the characteristics of firms and their relationship to international trading activity. The first of these is stage theory, originally advocated by Johanson and Vahlne (1977). Stage theory suggests that internationalization is a gradual process that requires the acquisition, integration, and use of knowledge about foreign mar- kets. As the firm grows, it accumulates resources, exploits economies of scale, and builds excess capacity. These resources enable management to direct greater efforts to exports when compared to smaller, younger firms (Bonaccorsi, 1992). Stage theory contains an element of “entrepreneurial learning” that takes place over time as owners and manag- ers develop intellectual capital used in the development of internationalization strategies and resource allocation (Orser et al., 2008). If this theory holds, then firms that export are larger, more established, and run by older, more experienced managers. An alternative firm-based explanation for involvement in the international market is resource-exchange theory. Zacharakis (1997) argues that exporting is a result of “orga- nizations entering into international transactional relationships because they cannot gener- ate all necessary resources internally.” The resources that must be accumulated include firm-level tangible and financial assets as well as intellectual resources, including human attributes like growth orientation, management experience and knowledge, networks and command of foreign languages (Oviatt and McDougall, 1994; Dhanaraj and Beamish, 2003, as cited in Orser et al., 2008; Oviatt and McDougall, 1994). Resource-exchange theory differs from stage theory in that it does not assume that acquisition of organizational resources proceeds in a linear manner. The resource-exchange theory also helps to explain the differences in export propensity associated with owners’ managerial or entrepreneurial experience (Dhanaraj and Beamish, 2003). A third firm-level theoretical approach is referred to as network theory. This model differs from its predecessors in that it is often cited as an explanation of international new ventures (Orser et al., 2008). The firms may access strategic resources externally through interdependencies among network players. While the direct relationships stressed in the two previous models provide control over resources through ownership, network theory focuses on the ability of collaborations to speed the internationalization by firms through synergistic relationships among partners at various stages in the supply chain (Dana et al., 2004; Jones, 1999, as cited in Orser et al., 2008). Network theory challenges the stage theory contentions that firms need to be large and well established with experienced management to trade internationally. Rather, network theory provides a model in which new firms can find the experience and international expertise they need externally through networking. These new theories are useful in understanding the trend in the international entrepreneurship literature of focusing on firms, known as international new ventures, that operate internationally from their inception.5 An older model that has recently begun to be widely applied to issues in international trade is the gravity model of trade. This model has a relatively long history. (For early for- mulations, see Tinbergen, 1962, Pöyhönen, 1963, and Linnemann, 1966; for more recent Firm-Focused Theories The Gravity Model 5An interesting application of network theory to interregional trade in France can be found in Pierre-Philippe Combes, Miren Lafourade, and Thierry Mayer, “The Trade-Creating Effects of Business and Social Networks: Evidence from France,” Journal of International Economics 66, no. 1 (May 2005), pp. 1–29. Final PDF to printer CHAPTER 10 POST–HECKSCHER-OHLIN THEORIES OF TRADE AND INTRA-INDUSTRY TRADE 189 app9062x_ch10_173-202.indd 189 06/01/16 09:38 AM discussion, see Disdier and Head, 2008, and Wang, Wei, and Liu, 2010.) It differs from most other theories (including traditional theory) in that it is trying to explain the volume of trade and does not focus on the composition of that trade. The model itself uses an equation framework to predict the volume of trade on a bilat- eral basis between any two countries. (The particular equation form need not concern us—the form has some similarity to the law of gravity in physics, which has resulted in the term gravity model being applied.) It is concerned with selecting economic variables that will produce a “good fit,” that is, that will explain at least in a statistical sense a substantial portion of the size of trade that occurs. The variables that are nearly always used in the equation as causes of, say, the flow of exports from a country I to a country II are: 1. A national income variable for country II (GNP or GDP), which is expected to have a positive relationship with the volume of exports from I to II because higher income in II would cause II’s consumers to buy more of all goods, including goods from country I. 2. A national income variable for country I (GNP or GDP), reflecting that greater income in I means a greater capacity to produce and hence to supply exports from I to II. 3. Some measure of distance between country I and country II (as a proxy for transpor- tation costs), with the expectation being that greater distance (greater transportation costs) would reduce the volume of exports from country I to country II. Sometimes other variables are introduced, such as population size in the exporting and/or importing country (to get at large market size and thus perhaps to economies of scale) or a variable to reflect an economic integration arrangement (such as a free-trade area) between the two countries. Empirical tests using the gravity model have often been remarkably successful, mean- ing that the volume of trade between pairs of countries has been rather well “explained.” In addition, by selecting different pairs of countries, other interesting questions can be addressed. For example, Helpman (1999, p. 138) discussed work in the literature that indirectly sought to distinguish between factor endowments and product differentiation as underlying causes of trade. The gravity equation worked best for similar countries that had considerable IIT with each other, better than it did for countries with different factor endowments and a predominance of traditional trade rather than IIT. At the minimum, these findings suggest that product differentiation is indeed a phenomenon to be consid- ered above and beyond factor endowments. Although the theoretical underpinnings of the gravity model have been debated, the theory has proved empirically useful for helping us understand influences on the volume of trade. These econometric analyses have also linked the volume of trade to important economic variables. Such work is important if we are to make headway in understanding the world economy, and the volume of trade is not considered by many trade theories. Marc J. Melitz (2003) set forth a model that has had widespread influence. In a framework similar in important ways to the Krugman model developed earlier in this chapter, the Melitz model specifies that each particular industry consists of monopolistically competitive firms with differentiated products and unrestricted entry and exit. Also, like Krugman, labor is the only factor of production, and each firm has a fixed overhead cost and a constant marginal cost. Krugman utilized a labor equation for the firm (see page 182 of this chapter) consisting of L = a + bQ, where L is the labor needed by the firm, a is a constant, Q is the amount of output, and b is the production relation between output and labor at The Melitz Model and Multiproduct Exporting Final PDF to printer 190 PART 3 ADDITIONAL THEORIES AND EXTENSIONS app9062x_ch10_173-202.indd 190 06/01/16 09:38 AM the margin. Meltiz’s new feature is that his equation is written as L = a + Q/ϕ, where ϕ is an index of productivity for the firm, and ϕ varies across firms in the industry. With a higher ϕ, the labor needed by a firm would be lower and the marginal cost would therefore be lower. Alternatively, higher productivity (an increase in ϕ) for a first firm in comparison with a second firm can be visualized as the first firm producing a higher-quality product than the second firm but at the same cost. The level of productivity for any given firm in the Melitz model is simply treated as a draw from a distribution of productivity levels. With all of this in place and after introducing demand conditions, there is initially estab- lished an equilibrium in a closed economy, with an equilibrium number of firms and an equilibrium amount of output, by a process that by itself is not critical for our understand- ing of the basics of this trade model. However, it is to be noted that the equilibrium has a cutoff productivity level ϕ*—firms with lower than that level of productivity will have exited from the industry. From this initial situation of a closed-economy equilibrium, consider what happens when the possibility of trade is introduced. (As with the Krugman and Linder models, the sequence in the models is from firms producing only for the domestic market to firms pro- ducing for export as well.) Firms will consider exporting, but to engage in export certain costs need to be incurred. Not only will there be some per-unit or variable costs such as transport costs, but there will also be fixed export costs (costs that are independent of the size of exports). Firms must become knowledgeable about the foreign markets, must inform the potential foreign buyers about the products, must investigate foreign regulations, and must establish distribution channels, among other tasks. Only the most productive firms in an industry that can bear these costs (or reasonably obtain financing) will be in a position to pursue exporting. Then, once the fixed costs have been incurred, they can be spread over a larger volume as exports grow, and the exporting firm becomes even more profit- able and productive. Overall, the average productivity level in the industry will have risen because of the exporting, and some lower-productivity firms will now be facing losses and will exit the industry. Further, the demand for labor by the exporting firms increases, with the consequence that the wage for the type of labor used in the industry rises. This wage increase will add to costs for all firms, and least productive firms may leave the industry for this reason as well. Of course, with the additional export costs, there will be an equilibrium cutoff productivity level ϕ*x that is higher than the cutoff productivity level for supplying the domestic market, so some firms will be successfully exporting while also selling at home while other firms in the industry will be producing for the domestic market but will be unable to engage in exporting. Overall, with trade, there has been an increase in aggregate productivity in this industry (and in every industry that is now engaged in exporting). Productivity in the industry will have increased because of the reallocation of production toward higher-productivity firms and away from lower-productivity firms (the least productive of whom have left the indus- try). The process has enhanced the country’s welfare through the increased productivity, a mechanism that was not included in a model such as Krugman’s (where firms in any given industry were identical). But, as with the Krugman model, the Melitz model realistically incorporates phenomena such as product differentiation and scale economies that did not exist in models that utilized perfect competition. In a later paper, Thierry Mayer, Melitz, and Gianmarco I.P. Ottaviano (2014) expanded on recent research that focuses on the real-world fact that many of the world’s exports originate from firms that are producing many different products or varieties of a product. Mayer, Melitz, and Ottaviano’s model spells out how, if there is an increase in competition in a particular export market, the existing exporting firms will lower the markup of price over cost on all goods exported to that market (thus providing welfare gains to consumers) Final PDF to printer CHAPTER 10 POST–HECKSCHER-OHLIN THEORIES OF TRADE AND INTRA-INDUSTRY TRADE 191 app9062x_ch10_173-202.indd 191 06/01/16 09:38 AM because price elasticity of demand has increased. Importantly, though, the firms will shift their export product mix toward their “better performing products” or “core products”. This shift toward the better products will imply a rise in overall productivity of the firms because the better-performing products will be the products in which the firms are most productive or have the greatest comparative advantage. The product mix of any given exporting firm has been narrowed toward the high-productivity goods, which leads to an increase in the firm’s overall productivity. The authors empirically test their predictions using a large sample of French manufacturing firms, and they find support. The French firms do seem to emphasize their better-performing products in their large export markets where the firms have much competition. This basic heterogeneous-product firm model has been extended in different ways. As one example, Richard Baldwin and Rikard Forslid (2010) have studied the implications of a model of this general type for welfare in an importing country. If trade is liberalized, sup- pose that, following the Mayer-Melitz-Ottaviano hypothesis, exporting firms to the import- ing country then narrow their product mix to the better-performing varieties. In addition, if some domestic firms are forced out because of the liberalization of imports, then the overall effect of the liberalization can be a reduction in the number of types of goods available to consumers in the importing country. This is in contrast to other models, such as the Krugman model, where expansion of trade results in a greater number of varieties. The “anti-variety” effect can be injurious to welfare in and of itself, although Baldwin and Forslid conclude that, on balance, the importing country will experience an increase in welfare, because the general positive welfare effect of trade will outweigh this negative anti-variety effect. We are only scratching the surface here regarding the new multiproduct firm models, but it is clear that these models have various potential implications for supplementing (or displacing) features of the traditional trade models. And even with the development of these newer models, there are still further modifications or additions to consider. For example, J. Peter Neary (2010) has criticized these models because they utilize only the structure of monopolistic competition, a situation in which firms do not differ greatly from each other (if at all). Neary judges that what is needed is an examination of firms in a set- ting of oligopoly, a setting considerably different from that of monopolistic competition. From the discussion in this chapter of early and more recent analyses, it is clear that trade theory is moving in directions neglected by traditional trade theory. The newer approaches enhance our understanding of the causes and consequences of trade beyond the insights pro- vided early on by the Heckscher-Ohlin model. We have looked principally at theories that allow for lags in diffusion of technology, demand considerations, supply chains, economies of scale, international capital mobility, dynamic comparative advantage, and imperfect com- petition. There is considerable theoretical analysis in this area, much of which we have not discussed. For example, there is a growing literature on government policy and how it can generate comparative advantage and alter the distribution of the gains from trade between countries. Examples from this literature will be given in Chapter 15. Further, yet another approach (by Paul Krugman) explores the role of location of production in the determination of comparative advantage and consequent trade patterns. Although the newer theories mainly focus on developed countries, what are their impli- cations for the developing countries? The imitation lag hypothesis and the product cycle theory do not lead to particularly optimistic conclusions about the future export perfor- mance of developing countries because they suggest that developing countries may be confined to exporting older products rather than new high-technology goods. On the other hand, these theories suggest that a potential exists for moving away from exporting prin- cipally primary products toward exporting more manufactured goods, a process that is Concluding Comments on Post–Heckscher-Ohlin Trade Theories Final PDF to printer IN THE REAL WORLD: GEOGRAPHY AND TRADE In a series of lectures at the Catholic University of Leuven, Belgium, in 1990, later published under the title Geography and Trade (1991), Paul Krugman examined various eco- nomic issues that arise when firms make interdependent spatial decisions regarding the location of production. He dubbed this exercise “economic geography” because the concept of “location” seemed too narrow and restrictive. Assuming the presence of economies of scale, transportation costs, and imperfect competition, he examined possible rea- sons for the concentration of manufacturing production, the localization of production across a broad spectrum of goods within the United States, and the role played by nations in interregional and international trade. In these lectures, Krugman introduced a new perspec- tive (although geographers might say “reintroduced an old perspective”) on the basis for trade in manufactured goods which rests on the observation that trade often takes place as a result of more-or-less “arbitrary specialization based on increasing returns, rather than an effort to take advan- tage of exogenous differences in resources or productivity” (p. 7). This strong accidental or serendipitous component of international specialization sets off cumulative processes that throughout history have tended to be pervasive. Thus whether one looks at Catherine Evans’s interest in tufting bedspreads in 1895 and the manner in which it generated a local handicraft industry that evolved into the center of the U.S. carpet industry in Dalton, Georgia, or the clas- sic examples of Eastman Kodak in Rochester, New York, the giant Boeing Company in Seattle, or Silicon Valley in California, dynamic comparative advantage in manu- factures often appears to have its roots in a quirk of fate which sets off important cumulative processes. Critical to these developments are, of course, economies of scale and transportation cost considerations. In addition, Krugman (p. 62) also points to Alfred Marshall’s belief that the pool- ing of labor and the readily available supply of specialized inputs also play a crucial role in promulgating specialized local production and regional and international comparative advantage. The existence of potential economies of scale is a crucial element in this approach in that firms have reason to con- centrate their production activities as long as the cost advan- tages related to larger size are not offset by transportation costs associated with either inputs or final products. Thus, production locates both with regard to the size of the market and the availability of inputs, given the objective of concen- trating production. Once established, production generates a dynamic of its own and tends to be self-sustaining. Nations are important from this perspective primarily because they adopt policies that influence economic decision making and the evolution of the critical cumulative processes. While policies are often enacted to inhibit the flow of goods and/or factors, government policies can also stimulate these critical processes, as was the case with the state government’s deci- sion to provide financial support for the Research Triangle Park in North Carolina. ● 192 PART 3 ADDITIONAL THEORIES AND EXTENSIONS app9062x_ch10_173-202.indd 192 06/01/16 09:38 AM underway in many developing countries. However, theories such as those of Linder and Krugman imply that trade may increasingly take place between countries of similar income levels. This forecast may not bode so well for developing countries who wish to break into developed-country markets, although the analyses suggest that they may beneficially trade more among themselves in the future. Finally, economies-of-scale models indicate the dif- ficulty of predicting future trade patterns but suggest potentially large gains from trade, as do the newer productivity models. CONCEPT CHECK 1. In the Krugman model, why does the opening of a country to a larger market (world market rather than domestic market alone) lead to lower product prices? 2. What is meant by “reciprocal dumping,” and why might it occur? 3. In the Melitz model, why does the introduc- tion of exporting in an industry increase pro- ductivity in that industry? Final PDF to printer CHAPTER 10 POST–HECKSCHER-OHLIN THEORIES OF TRADE AND INTRA-INDUSTRY TRADE 193 app9062x_ch10_173-202.indd 193 06/01/16 09:38 AM INTRA-INDUSTRY TRADE A characteristic of a country’s trade that has appeared in many new theories and is increas- ingly recognized as important in the real world is intra-industry trade. IIT occurs when a country is both exporting and importing items in the same product classification cat- egory. This trade differs from inter-industry trade, where a country’s exports and imports are in different product classification categories. Traditional trade theory dealt only with inter-industry trade, but IIT clearly constitutes an important segment of international trade. Table 1 indicates magnitudes and trends in the IIT in manufactured goods of selected coun- tries. (IIT is more important in manufactured goods than in nonmanufactured goods.) It can also be noted that other data (not shown in Table 1) indicate that IIT is typically the highest for more sophisticated manufactured goods such as chemicals, machinery, transport equip- ment, and electronics, where scale economies and product differentiation can be important. Table 2 (see page 196) provides more recent additional data on IIT. TABLE 1 Manufacturing Intra-Industry Trade as a Percentage of Total Manufacturing Trade 1992–1995 1996–2000 High and increasing intra-industry trade Czech Republic 66.3 77.4 Slovak Republic 69.8 76.0 Mexico 74.4 73.4 Hungary 64.3 72.1 Germany 72.0 72.0 United States 65.3 68.5 High and stable intra-industry trade France 77.6 77.5 Canada 74.7 76.2 United Kingdom 73.1 73.7 Switzerland 71.8 72.0 Spain 72.1 71.2 Ireland 57.2 54.6 Low and increasing intra-industry trade Korea 50.6 57.5 Japan 40.8 47.6 Low and stable intra-industry trade New Zealand 38.4 40.6 Turkey 36.2 40.0 Norway 37.5 37.1 Greece 39.5 36.9 Australia 29.8 29.8 Iceland 19.1 20.1 Note: Countries are classified as having a “high” or “low” level of intra-industry trade according to whether intra-industry trade is above or below 50 percent of total manufacturing trade on average over all periods shown and “increasing” or “stable” according to whether intra-industry trade increased by more than 5 percentage points over a specified time period. Source: OECD, “OECD Economic Outlook No. 71,” OECD Economic Outlook: Statistics and Projections (database, 2002), http://dx.doi.org/10.1787/data-00095-en. Final PDF to printer 194 PART 3 ADDITIONAL THEORIES AND EXTENSIONS app9062x_ch10_173-202.indd 194 06/01/16 09:38 AM Unfortunately, comparative advantage based on factor endowments is of little or no help in predicting IIT. In fact, IIT will be relatively greater (compared with inter-industry trade) the more similar are the capital and labor endowments of the countries being examined. In view of this deficiency of the Heckscher-Ohlin model, we now look at several possible explanations for the occurrence of IIT. (For an extensive groundbreaking discussion of reasons for IIT, see Herbert Grubel and P. J. Lloyd, 1975.) This explanation for IIT was outlined earlier. Briefly, many varieties of a product exist because producers attempt to distinguish their products in the minds of consumers to achieve brand loyalty or because consumers themselves want a broad range of character- istics in a product from which to choose. Thus, U.S. firms may produce large automobiles and non-U.S. producers may produce smaller automobiles. The consequence is that some foreign buyers preferring a large car may buy a U.S. product while some U.S. consum- ers may purchase a smaller, imported car. Because consumer tastes differ in innumerable ways, more so than the varieties of products manufactured by any given country, some IIT emerges because of product differentiation. In a physically large country such as the United States, transport costs for a product may play a role in causing IIT, especially if the product has large bulk relative to its value. Thus, if a given product is manufactured both in the eastern part of Canada and in California, a buyer in Maine may buy the Canadian product rather than the California product because the transport costs are lower. At the same time, a buyer in Mexico may purchase the California product. The United States is both exporting and importing the good. Another mechanism by which transport costs can lead to IIT is as specified in the reciprocal dump- ing model discussed earlier in this chapter. This reason is related to the product differentiation reason. If IIT has been established in two versions of a product, each producing firm (one in the home country, one in the foreign country) may experience “learning by doing” or what has been called dynamic economies of scale. This means that per-unit cost reductions occur because of experience in producing a particular good. Due to these cost reductions, sales of each version of the product may increase over time. Because one version was an export and the other an import for each country, IIT is enhanced over time because of this production experience. This explanation rests on the observation that IIT can result merely because of the way trade data are recorded and analyzed. If the category is broad (such as beverages and tobacco), there will be greater IIT than would be the case if a narrower category is examined (such as beverages alone or, even more narrowly, wine of fresh grapes). Suppose a coun- try is exporting beverages and importing tobacco. The broad category of “beverages and tobacco” [a category in the widely used Standard International Trade Classification (SITC) System of the United Nations] would show IIT, but the narrower categories of “beverages” and “tobacco” would not. Some economists think that finding IIT in the real world may be mainly a statistical artifact because of the degree of aggregation used, even though actual calculations use less broad categories than “beverages” and “tobacco.” Nevertheless, most trade analysts judge that IIT exists as an economic characteristic of trade and not primarily as a result of using aggregative classification categories. This explanation for IIT was offered by Herbert Grubel (1970). Even if two countries have similar per capita incomes, differing distributions of total income in the two coun- tries can lead to IIT. Consider the hypothetical income distributions plotted in Figure 4. Reasons for Intra- Industry Trade in a Product Category Product Differentiation Transport Costs Dynamic Economies of Scale Degree of Product Aggregation Differing Income Distributions in Countries Final PDF to printer CHAPTER 10 POST–HECKSCHER-OHLIN THEORIES OF TRADE AND INTRA-INDUSTRY TRADE 195 app9062x_ch10_173-202.indd 195 06/01/16 09:38 AM Country I has a heavy concentration of households with lower incomes, while country II has a more “normal” or less skewed distribution. Producers in country I will be concerned primarily with satisfying the bulk of country I’s population, so they will produce a variety of the product that caters to consumers with incomes, for example, between y1 and y2. Producers in country II will cater to the bulk of country II’s households, say, those house- holds between y3 and y4. Therefore, country II’s firms produce a variety of the good with characteristics that satisfy that group. What about a household in country I with a high income such as y6? And what about a household in country II with a low income such as y5? These consumers will purchase the good from the producers in the other country because their own home firms are not producing a variety of the good that satisfies these consum- ers. Hence, both countries have IIT in the product. This explanation can be applied in the context of the Linder model to help in predicting the pattern of IIT. In work that attempts to marry IIT with the Heckscher-Ohlin approach, Falvey (1981) and Falvey and Kierzkowski (1987) developed a model in which different varieties of a good are exported by countries with different relative factor endowments. Assuming that the higher-quality varieties of a good require more capital-intensive techniques, the model pro- duces the result that higher-quality varieties are exported by capital-abundant countries and lower-quality varieties are exported by labor-abundant countries. Thus Heckscher-Ohlin can, in this framework, yield IIT. In related work, and building on the assumption that the higher-quality varieties require greater capital intensity in production, Jones, Beladi, and Marjit (1999) hypothesized that a labor- abundant country (such as India) may export capital-intensive varieties of a good to high-income countries (such as the United Kingdom or the United States) and keep the lower-quality, labor-intensive varieties for the home market. A further complication for trade theory! Differing Factor Endowments and Product Variety FIGURE 4 Intra-Industry Trade from Differing Distributions of Income Country I’s producers supply varieties of the product catering to households with incomes between y1 and y2, while country II’s firms produce varieties to satisfy households with income levels between y3 and y4. A household in country I with income y6 and a household in country II with income y5 will therefore each consume an imported variety of the good. Intra-industry trade in this general product thus exists. y1 Household income Number of households y5 y3 y2 y6 y4 Country I Country II Country I Final PDF to printer 196 PART 3 ADDITIONAL THEORIES AND EXTENSIONS app9062x_ch10_173-202.indd 196 06/01/16 09:38 AM Work on IIT has gone beyond examination of reasons for IIT in any particular prod- uct. Attempts have been made to determine if the levels of IIT differ systematically by country, such as is suggested by Table 1. A study by Bela Balassa (1986) is an example of this research. Using a standard measure of IIT (see Appendix C to this chapter), Balassa examined a sample of 38 countries (18 developed and 20 developing countries) to test various hypothe- ses on factors associated with IIT. He hypothesized that a higher level of per capita income for a country is associated with a greater amount of IIT. Balassa’s reasoning followed Linder’s suggestion that, at higher levels of development, trade consists increasingly of differentiated products. Second, a positive association was postulated between IIT and total income of a country, because a larger national income permits greater realization of economies of scale. In his regression equations, Balassa also used independent variables representing items such as distance from trading partners, a common border with princi- pal trading partners, and degree of “openness,” or degree of absence of trade restrictions, of countries. In general, the various hypotheses were essentially confirmed. Greater per capita income, greater national income, greater openness, and the existence of a common border with principal trading partners were positively correlated with the extent of IIT. Distance from trading partners (a proxy for transportation costs) was negatively associated with IIT. Thus, commonsense intuitions on IIT seem to be statistically supported. Another finding was that developing countries had their IIT better “explained” by the analysis than devel- oped countries. To provide an additional look at IIT at the country level, Table 2 presents recent cal- culations for 2006 made by Marius Brülhart. The calculations are of IIT indexes that are a slight variant of the index formula discussed in Appendix C of this chapter. In such indexes, an index value of 0.0 would indicate that no IIT is taking place, and an index of 1.0 would indicate that “perfect” IIT is occurring, whereby basically the exports of a coun- try (whether absolutely or relatively or by some other measure, depending on the precise formula being used) exactly equal the country’s imports in that category. Recall the discus- sion on page 194 of this chapter of classification of commodities by the U.N.’s Standard International Trade Classification (SITC) system. Table  2 presents selected Brülhart results for the indexes at both the three-digit and the five-digit levels. The three-digit level The Level of a Country’s Intra- Industry Trade TABLE 2 Country Indexes of Intra-Industry Trade 2006, SITC 3-Digit and 5-Digit Levels Country SITC 3-Digit SITC 5-Digit Germany 0.570 0.419 United States 0.503 0.317 Japan 0.398 0.238 Brazil 0.373 0.137 China 0.305 0.182 Indonesia 0.291 0.117 Bulgaria 0.287 0.140 Morocco 0.150 0.091 Russian Federation 0.146 0.047 Saudi Arabia 0.070 0.011 Source: Marius Brülhart, “An Account of Global Intra-industry Trade, 1962–2006,” The World Economy 32, no. 3 Publisher Wiley-Blackwell (March 2009), pp. 410–11. Final PDF to printer CHAPTER 10 POST–HECKSCHER-OHLIN THEORIES OF TRADE AND INTRA-INDUSTRY TRADE 197 app9062x_ch10_173-202.indd 197 06/01/16 09:38 AM is the more aggregative of the two, so the three-digit index results, as expected, are higher than the five-digit results. Note from the table that developed countries appear to be more engaged in IIT than are developing countries. However, some developing countries (e.g., Brazil, China) are approaching relatively high levels of IIT. A final comment is necessary. IIT is an economic phenomenon that reflects the com- plexity of production and trade patterns in the modern world. This complexity is not fully captured by previous international trade models. IIT can bring with it greater gains than might be surmised from traditional literature; in particular, the product differentiation that is so important to the rise of IIT provides consumers with a wider variety of goods. The additional choice available to consumers also should be counted as a gain from interna- tional trade. SUMMARY This chapter has surveyed theories that introduce new consid- erations beyond factor endowments and factor intensities into the examination of the underlying causes of international trade. The theories relax assumptions contained in the traditional approaches, and they can be thought of as complementary to Heckscher-Ohlin and not necessarily as “competing” with H-O. The imitation lag hypothesis examines the implications of allowing for delays in the diffusion of technology across country borders. The product cycle theory relaxes several tra- ditional assumptions and emerges with a picture of dynamic comparative advantage. Other theories assign the components of the production process to different international locations. The Linder theory focuses on overlapping demands and on trade between countries with similar per capita income lev- els. It also has led to substantial investigation of intra-industry trade in the literature. The presence of economies of scale can create a basis for trade, even when countries have identical production possibilities and tastes. The focus on trade among similar countries has been carried further by Krugman, who incorporated scale economies but also introduced imperfect competition and product differentiation. Other models have added consideration of trade-induced productivity enhance- ments to the monopolistic competition context. Imperfect com- petition in conjunction with transportation costs can result in reciprocal dumping being a cause of IIT. Because many newer theories incorporate IIT, the chapter also examined other possi- ble causes of such trade. In a different vein and ignoring intra- industry considerations, the gravity model has been used by economists to analyze the determinants of the volume of trade between countries. KEY TERMS demand lag dumping duopoly dynamic comparative advantage dynamic economies of scale global logistics/supply chain management gravity model imitation lag imitation lag hypothesis inter-industry trade intra-industry trade (IIT) Krugman model Linder theory maturing-product stage Melitz model monopolistic competition net lag network theory new-product stage overlapping demand product cycle theory (PCT) product differentiation reciprocal dumping model resource-exchange theory stage theory standardized-product stage technology cycle vertical specialization-based trade QUESTIONS AND PROBLEMS 1. What factors are important in determining the length of the imitation lag and the length of the demand lag? Explain. 2. What products might be examples of goods that are cur- rently going through or have gone through the various stages outlined in the product cycle theory? 3. What would the Linder theory suggest about the prospects of developing countries in exporting goods to developed coun- tries? Do you think that this is a realistic suggestion? Why or why not? Final PDF to printer 198 PART 3 ADDITIONAL THEORIES AND EXTENSIONS app9062x_ch10_173-202.indd 198 06/01/16 09:38 AM Appendix A ECONOMIES OF SCALE We present in this appendix a representative economies-of-scale model that draws upon early work of Murray C. Kemp (1964). Such models are discussed in more detail in Bhagwati and Srinivasan (1983, chap. 26) and Bhagwati, Panagariya, and Srinivasan (1998, chap. 11). Assume a two-commodity world where both industries experience economies of scale. Further, the economies of scale are such that the PPF is drawn as convex to the origin, as in Figure 5. (It is to be noted that the presence of economies of scale in both industries does not necessarily gener- ate a convex PPF; the shape depends on the relative degree of the economies of scale in the two industries.) Suppose that the economy is initially located at point E, where the PPF is tangent to the price line reflecting autarky prices (PX /PY). An immediate difference between this autarky equilib- rium and the traditional autarky equilibrium with a concave PPF is that the autarky equilibrium is an unstable equilibrium. Thus, slight departures from E will not produce a return to E. Consider a point to the right and downward from E, such as point G, which has the same goods prices (PX /PY) as E. Because the (negative of the) slope of the PPF is (MCX /MCY), it is evident at point G that (PX /PY) > (MCX /MCY) or, alternatively, that (PX /MCX) > (PY /MCY).6 There is thus an incentive to
produce more of good X and less of good Y, and the economy will move from point G to point N
(with complete specialization in good X), not to point E. If the economy were located instead at point
H with given prices PX /PY, production would move from point H to point M (with complete special-
ization in good Y) instead of to point E.
4. While the recognition of economies of scale may make
trade theory more “realistic,” what does this recognition do
to the ability of trade theory to predict the commodity trade
patterns of countries? Explain.
5. Ignoring the mathematics, explain the operation of the
Krugman model in economic terms, and indicate the prin-
cipal lessons of it.
6. Why is an increase in the number of varieties of a good
regarded as a gain from trade? Can you think of economic
disadvantages associated with greater product variety?
Explain.
7. Is the existence of product differentiation a necessary
condition for the existence of intra-industry trade? Why or
why not?
8. Is the distinction between “intra-industry trade” and “inter-
industry trade” a useful distinction? Why or why not?
9. In recent years, U.S. firms have become very concerned
about the increasing production of “pirated” and “coun-
terfeit” goods abroad, especially in Asia. Successful U.S.
export products are copied by foreign producers without
payment of royalties and/or adherence to patent or copy-
right protection. How might this phenomenon affect the
product cycle and new product research and development
in the United States?
10. How is it possible that reciprocal dumping can be ben-
eficial for aggregate welfare if identical commodities are
moving between countries and transportation costs are
being incurred?
11. In the late 1970s, a large part of athletic shoe production
shifted from plants in the United States to plants in South
Korea. In late 1993, it was reported that South Korean
shoe firms had suffered a large reduction in jobs and sales
because, due to rising wages, shoe production had shifted
to Indonesia and China. (See Steve Glain, “Korea Is
Overthrown as Sneaker Champ,” The Wall Street Journal,
October 7, 1993, p. A14.) How might these moves in prod-
uct location fit the product cycle theory? Could Heckscher-
Ohlin also be of value in explaining these developments?
Why or why not?
12. (From Appendix C material) The exports and imports of
country A in year 1 are listed below. These are the only
goods traded by country A.
6We follow Kemp in assuming that the extent of external economies of scale is identical in the two industries.
This assumption permits the ratio of private marginal costs to equal the ratio of social marginal costs, and thus the
term marginal cost can be used without further qualification.
Good Value of Exports Value of Imports
T $100 $ 20
X 300 80
Y 100 300
Total $500 $400
Calculate country A’s index of intra-industry trade for year 1.
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CHAPTER 10 POST–HECKSCHER-OHLIN THEORIES OF TRADE AND INTRA-INDUSTRY TRADE 199
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Assuming that this country, call it country I, has somehow reached the autarky equilibrium
point  E, what are the implications of introducing international trade? As with many increasing-
returns-to-scale models, there is some uncertainty as well as some new results. Consider this country
again in Figure 6, where it is in autarky equilibrium at point E with the internal price ratio (PX /PY)I.
With the opening of the country to trade, suppose that the terms of trade TOTW [steeper than (PX /PY)I]
represent world prices. The country can specialize in the production of good X, and, as we have just
seen, the consequent movement downward and to the right from point E will, because E was an
FIGURE 5 A Convex-to-the-Origin Production-Possibilities Frontier (PPF)
The existence of economies of scale in the production of both good X and good Y can yield a PPF that is convex
to the origin. In this situation, point E is an unstable equilibrium, since the production location at point G(H)
will generate incentives to shift production to point N(M) rather than to point E.
Good Y
Good X
H
M
E
G
N
(PX/PY)
FIGURE 6 The Convex PPF and Gains from Trade
With a convex-to-the origin PPF, a country could move from autarky equilibrium point E [with relative prices
(PX /PY)I] to complete specialization point N. It could then export good X and import good Y along a trading
line associated with TOTW, and it would experience gains from trade. Another country with identical production
possibilities and identical tastes (tastes are not shown in the diagram) could move from point E to complete
specialization point M. This second country could then export good Y and import good X along a trading line
associated with TOTW and also gain from trade. Hence, unlike the situation in traditional models, two countries
can engage in mutually beneficial trade even though their supply and demand conditions are alike.
Good Y
Good X
TOTw
TOTw
E
N
M
(Px/Py ) I
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200 PART 3 ADDITIONAL THEORIES AND EXTENSIONS
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“unstable” equilibrium, cause production to go to the complete specialization point N. Obviously,
gains from trade occur because country I can export good X along a trading line associated with
TOTW and reach a higher indifference curve than was reached during autarky. (Indifference curves
have not been drawn in Figure 6, but you should be able to picture them in your mind!) And, because
country I has gone all the way to an endpoint of the PPF, the indifference curve attained will be “far-
ther out” than would be the case without complete specialization, other things equal.
But now consider another country, country II, which has an identical PPF to that of country I. In
addition, suppose that demand conditions in country II are also identical to demand conditions in
country I. Certainly, in the Classical model of Chapters 3 and 4, there were no incentives for trade
and no gains from trade in the situation of identical production possibilities; indeed, even in the neo-
classical, Heckscher-Ohlin model of Chapters 6 through 8 there were no incentives for trade and no
gains from trade when production possibilities and demand conditions were identical. (In both mod-
els, the autarky relative prices would be identical.) But, in this economies-of-scale framework, both
countries could gain from trade with each other. Note that, in Figure 6, terms of trade TOTW could
also be associated with production at endpoint M of this PPF, where the complete specialization is in
good Y and not in good X. Hence, even if both countries have the same PPF and identical demands,
country I can specialize in good X by producing at point N and country II can specialize in good Y
by producing at point M, and there can be mutually beneficial trade because both countries can attain
higher indifference curves than was the case under autarky.
Appendix B MONOPOLISTIC COMPETITION AND PRICE ELASTICITY
OF DEMAND IN THE KRUGMAN MODEL
Two features of the Krugman model in the chapter are briefly explained in this appendix: (1) the
short run and long run in monopolistic competition and (2) the relationship between price elasticity,
demand facing a firm, and the firm’s product price.
With respect to (1), analytically, the demand curve facing the monopolistically competitive
firm is not the horizontal demand curve of perfect competition. Rather, the demand curve is down-
ward sloping, and marginal revenue (MR) is less than price. The firm produces where MR equals
marginal cost (MC) rather than where price equals MC. In Figure 7, the profit-maximizing output
level is Q1 and the price charged is P1. We have drawn the marginal cost curve MC as horizontal,
reflecting Krugman’s assumption that marginal cost is constant. (MC in the Krugman model is
equal to the b coefficient in equation [1] times the wage rate.) At this equilibrium output position,
with price P1 and average cost AC1, the total profit for the firm is the area of the shaded rectangle
(AC1)(P1)FB.
Figure 7 refers to a short-run situation because there is positive profit for this firm and, with easy
entry into the industry, new firms will begin to produce this type of product. The demand curve
facing existing firms will shift down and will become more elastic because of the presence of more
substitutes. Price and profit will be reduced for existing firms, and in the long run there will be zero
economic profit, as in perfect competition. In a long-run equilibrium diagram (not shown) for the
monopolistically competitive firm, the demand curve is tangent to the declining portion of the AC
curve immediately above the MR/MC intersection—meaning no economic profit.
Regarding (2), the relationship between demand elasticity and price, the price elasticity of demand
for a good (eD) is the percentage change in quantity demanded divided by the percentage change in
price. Thus, if Δ stands for “change in,”
eD =
ΔQ/Q
ΔP/P
=
PΔQ
QΔP
Total revenue (TR) is equal to P  ×  Q. If price changes by ΔP, this will change quantity
demanded by ΔQ, so that total revenue after a price change (and subsequent quantity change) is
(P + ΔP) × (Q + ΔQ). Therefore, the change in total revenue that occurs because of a price change
(and subsequent quantity change) is
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app9062x_ch10_173-202.indd 201 06/01/16 09:38 AM
ΔTR = (P + ΔP) × (Q + ΔQ) − PQ
= PQ + PΔQ + QΔP + ΔPΔQ − PQ
= PΔQ + QΔP + ΔPΔQ
For a small price and quantity change, the term ΔPΔQ is very small and can be neglected. Thus, the
change in total revenue is PΔQ + QΔP.
Marginal revenue (MR) is the change in total revenue divided by the change in quantity; that is,
MR =
PΔQ + QΔP
ΔQ
= P + QΔP/ΔQ
MR/P = 1 + QΔP/PΔQ
However, QΔP/PΔQ in the last expression is simply the reciprocal of PΔQ/QΔP; that is, it is the
reciprocal of the elasticity of demand. Thus,
MR/P = 1 + 1/eD = (eD + 1)/eD
Therefore,
MR = P[(eD + 1)/eD]
or
P = MR
eD
eD + 1
[2]
FIGURE 7 Short-Run Profit Maximization for the Firm in Monopolistic Competition
The monopolistically competitive firm maximizes profit at the output level Q1, where MR = MC. The price
charged is P1, and the firm’s economic profit in the short run is indicated by the shaded rectangle. In the
long run, D would shift downward, as would MR, until D was tangent to AC immediately above the MR/MC
intersection and the firm would make a normal (zero economic) profit.
Price,
cost
F
P1
AC1
AC
B
MC
D
MR
Q1 Output
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202 PART 3 ADDITIONAL THEORIES AND EXTENSIONS
app9062x_ch10_173-202.indd 202 06/01/16 09:38 AM
For example, if the elasticity of demand is −2 and MR is $20, then price equals ($20)[(−2)/
(−2 + 1)] = ($20)[(−2)/(−1)] = ($20)(2) = $40. If the firm is in profit-maximizing equilibrium, that
is, marginal revenue = marginal cost (=$20 in this example), then the profit-maximizing price equals
MC[(eD)/(eD + 1)]. This equation plays an important role in the Krugman model. Krugman assumes
that eD becomes less elastic as individuals buy more units of the good. (Remember from microeco-
nomic theory that this is consistent with a straight-line demand curve—as more units are consumed,
demand becomes less elastic.) Thus, as consumption rises, the expression [(eD)/(eD + 1)] becomes
larger. For example, if eD = −1.5, the value is [(−1.5)/(−1.5 + 1)] or [(−1.5)/(−0.5)] = 3. The price
in the above example would be $60.
Appendix C MEASUREMENT OF INTRA-INDUSTRY TRADE
Given that intra-industry trade takes place within a commodity category, how can it be measured for
a country as a whole? A country measure is useful because it allows the tracing of the development
of IIT for a country through time or permits the comparison of different countries at a particular point
in time. The following measure has been developed. If we designate commodity categories by i,
represent exports and imports in each category by Xi and Mi , respectively, total exports and imports
by X and M, respectively, and call our index of intra-industry trade II , the formula for calculating the
degree of country IIT is
II = 1 −
Σ|(Xi/X) − (Mi/M) |
Σ[(Xi/X) + (Mi/M) ]
[3]
In this formula, Xi /X (or Mi /M) is the percentage of the country’s total exports (or imports) in
category i and |(Xi /X) −  (Mi /M)| indicates the absolute value of the difference between the share
of exports and imports in the category. The [(Xi /X) + (Mi /M)] indicates the sum of the export and
import shares in the category. The Σ sign means that we are summing over all the commodity cat-
egories, and the denominator must have a value of 2 because 100 percent of exports are being added
to 100 percent of imports.
This measure of IIT is best illustrated by example. Suppose that country A has only three catego-
ries of traded goods and that exports and imports in each category are as follows:
Good Value of Exports Value of Imports
W $500 $ 200
X 200 400
Y 100 400
Total $800 $1,000
This country’s index of IIT is
II = 1 −
|500/800 − 200/1,000| + |200/800 − 400/1,000| + |100/800 − 400/1,000|
(500/800 + 200/1,000) + (200/800 + 400/1,000) + (100/800 + 400/1,000)

II = 1 −
|0.625 − 0.200| + |0.250 − 0.400| + |0.125 − 0.400|
(0.625 + 0.200) + (0.250 + 0.400) + (0.125 + 0.400)
= 0.575
This country has a moderate amount of IIT. The index would equal 1.0 (“total” IIT) if the export and
import percentages were equal in each category. The index would be zero if, in each category, there
were exports or imports but not both.
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203
app9062x_ch11_203-225.indd 203 06/17/16 04:00 PM
CHAPTER
LEARNING OBJECTIVES
LO1 Distinguish the different ways in which growth can affect trade.
LO2 Discuss how the source of growth affects the nature of the production-
possibilities frontier.
LO3 Summarize how growth and trade affect welfare in the small country.
LO4 Assess how growth in a large country can have different welfare effects
than growth in a small country.
LO5 Identify possible terms-of-trade effects of growth in developing
countries.
ECONOMIC GROWTH
AND INTERNATIONAL
TRADE 11
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INTRODUCTION
There is a common misconception that China’s growth is taking place at the expense of its many
trading partners. This has prompted threats of trade policy retaliation on the part of many of the
trading partners, not the least of which is the United States. A useful overview of the Chinese
role in regional growth and development was provided by Phillip Day.1 He correctly points out
that even though exports of other Asian countries to the United States fell as those of China
increased, the total exports of those other countries grew in a complementary fashion through
increased trade with each other. The reason is that China was already the largest importer of
South Korean and Taiwanese goods as well as a substantial importer from Japan (if exports into
Hong Kong are taken into account). Interestingly, as China grew, it found itself on the midpoint
of a supply chain in that it imported high-tech components from East Asia, assembled them into
final commodities, and exported them to final end-markets throughout the world. Thus, instead
of hurting other countries in the region, China’s rapid growth and emergence as an export power-
house in the world economy had a positive impact on other East Asian countries. Unfortunately,
the politicians, trade groups, and companies that were critical of China’s export success also
ignored the fact that it was often foreign investment and foreign companies that underpinned the
Chinese export success.
China’s notable rate of growth in recent years and its growing impact on world trade and
globalization reflect the fact that the production possibilities for a country do not remain
fixed and are often fostered by the country’s economic policies. Growth in output poten-
tial is represented by outward shifts in the production-possibilities frontier (PPF), which
enable the country to reach a higher level of real income (a consumption-possibilities fron-
tier further to the right) and presumably a higher level of well-being. Growth comes about
by means of change in technology or through the acquisition of additional resources such
as labor, physical capital, or human capital. Inasmuch as international trade affects and
is affected by economic growth, it is important to examine several of the more important
economic implications of growth. This chapter begins by pointing out how growth influ-
ences trade through changes in both production and consumption. This is followed by a
discussion of the sources of growth and the manner in which they influence changes in the
economy. The chapter concludes by looking briefly at the effect of growth on the country’s
economic well-being when the country is participating in international trade.
CLASSIFYING THE TRADE EFFECTS OF ECONOMIC GROWTH
As real income increases, it affects both producers and consumers. Producers need to
decide how to alter production, given the increase in resources or the change in technol-
ogy. Consumers, on the other hand, are faced with how to spend the additional real income.
Both of these decisions have implications for the country’s participation in international
trade and thus for determining whether countries become more or less open to trade as
economic growth occurs. We begin this analysis by categorizing the alternative production
and consumption responses that accompany economic growth in terms of their respective
implications for international trade.
Let us assume that a small country is characterized by increasing opportunity costs and is
currently in equilibrium at a given set of international prices (see Figure 1), remembering
China—A Regional
Growth Pole
Trade Effects of
Production Growth
1Phillip Day, “China’s Trade Lifts Neighbors,” The Wall Street Journal, August 18, 2003, p. A9.
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CHAPTER 11 ECONOMIC GROWTH AND INTERNATIONAL TRADE 205
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that a small country cannot influence world prices.2 In panel (a), France is producing at
point A and consuming at point B. To do this, France exports wine and imports electron-
ics. As growth occurs, the PPF shifts outward, and French producers have the opportunity
to select a point on the new PPF that will maximize their profits. In general terms, they
have the possibility of producing (1) more of both commodities in the same proportion
as at point A, (2) more of both commodities but relatively more of one than the other, or
(3) absolutely more of one commodity and absolutely less of the other. These possibili-
ties can be demonstrated on our figure and will form the basis for categorizing the various
production trade effects that can accompany growth.
To establish the classification of the trade effects of growth, return to point A. This
will become the origin for new mini-axes, shown as dashed lines in panel (b). Points lying
to the left of the dashed vertical line reflect cases where the new production of wine is
less than at point A. Points to the right of this vertical line indicate cases where the new
production of wine is greater than at point A. Similarly, points lying above the dashed
horizontal mini-axis reflect greater production of electronics, whereas points below this
line indicate less production of electronics. Points lying above and to the right of point
A thus represent larger production of both goods. Production points lying on the straight
line passing through the origin and point A reflect outputs of electronics and wine that
are proportionally the same as at A; that is, the ratio of electronics to wine production is
a constant. Points beyond point A that fall on this line demonstrate a neutral production
effect because production of the export good and the import-competing good have grown
at the same rate.
2An alternative assumption to that of a small country is that prices are held constant to focus exclusively on real
income effects (regardless of country size).
Electronics
Wine
(a) France
Imports
Exports
B
A
Electronics
Wine
(b) France
A
IV
III
I
II
FIGURE 1 Production Effects of Growth
Assume that France is a (small) country and is in equilibrium as demonstrated in panel (a), producing at point A, consuming at point B, export-
ing wine and importing electronics. With growth the PPF will shift outward, permitting the country to choose different production combinations
of the two goods in question [panel (b)]. The various new production possibilities are located within the regions fixed by the mini-axes drawn
through the original production point A and the straight line drawn through the origin and point A. If the new production point lies on the straight
line passing through point A, growth is product neutral. If the new point lies in region I, it is protrade biased; in region II it is ultra-protrade
biased; in region III it is antitrade biased; and in region IV it is ultra-antitrade biased.
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206 PART 3 ADDITIONAL THEORIES AND EXTENSIONS
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The remaining production possibilities with growth conveniently fall into four regions,
which are isolated by the neutral ray from the origin and the mini-axes at point A. Region I
represents possible new production points that reflect increased production of both com-
modities, but where the change in the production of wine is relatively greater than the
change in the production of electronics. Because wine is the export good, this type of
growth has a protrade production effect, reflecting the relatively greater availability
of the export good. Region II contains production-possibilities points that demonstrate
increased production of wine but a decrease in production of electronics. New production
points lying in this region as a result of growth fall in the ultra-protrade production
effect category, suggesting an even greater potential effect on the desire to trade. New
production points lying in region III reflect higher production levels of both goods but
relatively greater increases in electronics than in wine. Because electronics are the import-
competing good, growth reflecting this production change has an antitrade production
effect. Finally, new production points lying in region IV, with increased production of
electronics and less of wine, are placed in the ultra-antitrade production effect category.
The actual point of production after growth will be the point where the new enlarged PPF
is tangent to the international price line. This point will necessarily fall in one of the afore-
mentioned regions.3
A similar technique can be used to describe the various consumption effects of growth.
In this case, we analyze the nature of consumer response to growth relative to the original
equilibrium at point B [Figure 1, panel (a)]. Figure 2 focuses on this initial equilibrium
point, which serves as the origin for new mini-axes.
Trade Effects of
Consumption Growth
FIGURE 2 Consumption Effects of Growth
With growth there is an increase in real income indicated by the rightward shift in the consumption-possibilities line (the international terms-of-
trade line). This allows consumers to choose combinations of electronics and wine previously not possible. The consumption effects of growth on
trade can be isolated by the mini-axes whose origin is at pregrowth consumption point B. If the new consumption point is on the straight line from
the origin through B, consumption of both goods will increase proportionally and the consumption trade effect will be neutral. Should the new
consumption point fall in region I, it is an antitrade consumption effect; if it falls in region II, it is an ultra-antitrade consumption effect; if it falls
in region III, it is a protrade consumption effect; and if it falls in region IV, it is an ultra-protrade consumption effect.
B
IV
III
I
Electronics
Wine
France
II
3We disregard the two borderline cases where production settles on either the vertical or horizontal dashed line.
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CHAPTER 11 ECONOMIC GROWTH AND INTERNATIONAL TRADE 207
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Points lying to the left of the dashed vertical axis reflect less consumption of wine,
while points to the right indicate greater consumption. Points lying below the dashed
horizontal axis reflect less electronics consumption, while points above that line indicate
more. Points lying beyond B on the straight line passing through point B and the origin of
the original axes indicate cases where goods are consumed in the same proportion as at
point B. Points so situated reflect a neutral consumption effect, because consumers have
not changed their relative consumption pattern with growth.
The remaining effects will be isolated in a manner similar to that used in the produc-
tion analysis. New consumption points lying in region I as a result of growth in real
income reflect a relatively larger increase in the consumption of wine than in that of
electronics. Because wine is the export good, the change in consumption reduces the
country’s relative willingness to export. This effect is called an antitrade consumption
effect. An even more extreme case of this type of behavior is found in region II, where
the consumption of wine increases and that of electronics falls. This response is called
an ultra-antitrade consumption effect. If growth causes consumption to move into
region III, where consumption of both goods increases but consumption of electronics
(the import good) increases relatively more than wine, a protrade consumption effect
occurs. Finally, if consumption of electronics increases and consumption of wine actually
falls with growth (region IV), an ultra- protrade consumption effect exists.4
The ultimate impact of economic growth on trade depends on the effects on both pro-
duction and consumption. The expansionary impact of growth on trade is larger whenever
both the production and the consumption effects are in the “pro” or “ultra-pro” regions.
The total effect of growth on trade is demonstrated with three different cases in Figure 3.
4Again, consumption could settle on the dashed axes themselves, but we ignore these cases.
FIGURE 3 The Effect of Growth on the Size of Trade
The effects of growth on trade reflect both the consumption and production effects. In panel (a) an ultra-antitrade production effect coupled with
an ultra-antitrade consumption effect leads to a reduction in trade, that is, a smaller trading triangle after growth compared with before growth.
In panel (b), a protrade production effect is combined with a neutral consumption effect, leading to a slight relative expansion of trade when
compared with income growth. In panel (c) an ultra-protrade production effect is combined with a protrade consumption effect, producing an
even larger relative expansion of trade compared with income growth.
Good Y
Good X
B
(a)
AR
R A
B
A
A
R
B
B
B
B
A
A
R
R
R
Good Y Good Y
Good X Good X
(b) (c)
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208 PART 3 ADDITIONAL THEORIES AND EXTENSIONS
app9062x_ch11_203-225.indd 208 06/17/16 04:00 PM
In panel (a), both production and consumption effects are in the ultra-antitrade category.
With growth, production moves from point A to point A′ and consumption from point B to
point B′. Note that commodity prices are fixed, because this is a small country. The result
of growth is a reduction in trade, reflected in the new trade triangle, A′R′B′, which is
smaller than the original triangle, ARB.
In panel (b), the production effect is a protrade effect and the consumption effect is
neutral. These effects can be observed in the position of point A′ and point B′ with respect
to point A and point B. The result is a relative expansion of trade (trade triangle A′R′B′).
In panel (c), an ultra-protrade production effect is coupled with a protrade consumption
effect. Again, trade expands relatively (from ARB to A′R′B′). As we move from panel
(a) to panel (c) in Figure 3, the new trading triangle gets successively larger. While the
volume of trade generally increases with growth, this is not always true. For example,
growth leading to ultra-antitrade consumption and production effects actually causes trade
to decline.
A useful way to summarize the net result of production and consumption effects on
the growing country’s trade is through the concept of the income elasticity of demand
for imports (YEM). This measure is the percentage change in imports divided by
the percentage change in national income. If YEM  =  1.0, then trade is growing at the
same rate as national income, and the net effect is neutral. If 0  <  YEM  <  1, trade is growing in absolute terms but at a slower rate than income; the net effect is antitrade. If YEM  <  0, trade is actually falling as income grows (ultra-antitrade effect). Finally, if YEM  >  1.0 (imports or trade growing more rapidly than national income), there is
a protrade or ultra-protrade net effect. (The algebraic distinction between protrade and
ultra-protrade is more complex and need not concern us.) As a general rule, if both the
production effect and the consumption effect are of the same type (e.g., both “protrade”),
then the net or overall effect will be of the same type as the two individual effects. If
one effect is protrade (antitrade) and the other is neutral, the net effect will be protrade
(antitrade). There are obviously various other combinations, and some of them require
more information on the precise size of each of the two effects before the net result can
be determined, such as with a protrade production effect that is coupled with an antitrade
consumption effect.
SOURCES OF GROWTH AND THE PRODUCTION-POSSIBILITIES FRONTIER
In the introduction to this chapter, we mentioned that growth can result from changes in
technology or the accumulation of factors such as capital and labor. Because they affect the
PPF in different ways, we will examine the two kinds of changes individually.
Technological change alters the manner in which inputs are used to generate output, and
it results in a larger amount of output being generated from a fixed amount of inputs. Let
us assume that we are dealing with two inputs, capital and labor. The new technology
may be factor neutral; that is, it results in the same relative amounts of capital and labor
being used as before the technology changed (at constant factor prices). However, smaller
amounts of inputs are used per unit of output. On the other hand, the new technology might
be labor saving in nature. In this instance, fewer factor inputs are required per unit of
output, but the relative amount of capital used rises at constant factor prices (i.e., the K/L
The Effects of
Technological Change
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IN THE REAL WORLD:
LABOR AND CAPITAL REQUIREMENTS PER UNIT OF OUTPUT
Figure 4 indicates the changes in the relative use of capi-
tal and labor that took place in six countries from the mid-
1960s to the mid-1980s. The changes are measured per unit
of output. The three points on each graph show the actual
level of capital and labor used, and the isoquants demon-
strate the nature of substitution between capital and labor
in the country for each year. Although the nature of the
adjustment has been different in the six countries, the use
of capital relative to labor has clearly increased in all of
them. Japan and Germany experienced the greatest increase
in the K/L ratio, and the U.S. ratio appears to have increased
the least.
FIGURE 4 Input of Capital and Labor Required per Unit of Output—Capital-Labor Isoquants
1964
1975
1985
1964
1975
1985
United States
1966
1975
1985
1966
1975
1985
Japan
14
12
10
8
6
4
2
10 12 14 16 180 2 4 6 8
1962
1975
1985
1962
1975
1985
Germany
1968
1975
19851968
1975
1985
France
1963
1975
1985
1963
1975
1985
United Kingdom
La
bo
r
in
pu
t p
er
u
ni
t o
f o
ut
pu
t
1966
1975
1985
1966
1975
1985
Canada
Capital input per unit of output
14
12
10
8
6
4
2
10 12 14 16 180 2 4 6 8
La
bo
r
in
pu
t p
er
u
ni
t o
f o
ut
pu
t
Capital input per unit of output
14
12
10
8
6
4
2
10 12 14 16 180 2 4 6 8
La
bo
r
in
pu
t p
er
u
ni
t o
f o
ut
pu
t
Capital input per unit of output
14
12
10
8
6
4
2
10 12 14 16 180 2 4 6 8
La
bo
r
in
pu
t p
er
u
ni
t o
f o
ut
pu
t
Capital input per unit of output
14
12
10
8
6
4
2
10 12 14 16 180 2 4 6 8
La
bo
r
in
pu
t p
er
u
ni
t o
f o
ut
pu
t
Capital input per unit of output
14
12
10
8
6
4
2
10 12 14 16 180 2 4 6 8
La
bo
r
in
pu
t p
er
u
ni
t o
f o
ut
pu
t
Capital input per unit of output
(continued)
CHAPTER 11 ECONOMIC GROWTH AND INTERNATIONAL TRADE 209
app9062x_ch11_203-225.indd 209 06/17/16 04:00 PM
ratio increases). Finally, the technological change could lead to a decrease in the K/L ratio
at constant factor prices. In this instance, we say that the technological change is capital
saving. In effect, a labor- (capital-) saving technological change has an effect equivalent
to increasing the relative amount of labor (capital) available to the economy. It is easy to
see why a technological change that reduces the relative labor requirement per unit of out-
put (labor-saving technological change) is not necessarily thought desirable in a relatively
labor-abundant developing country. We limit our analysis of technological change to the
factor-neutral type.
On the PPF, a factor-neutral change in technology that affects one commodity means
that the country is able to produce more of that commodity for all possible levels of
output of the second commodity. Thus, this commodity-specific change in technology
causes the PPF to move outward except at the intercept for the nontechnology-changing
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IN THE REAL WORLD: (continued)
LABOR AND CAPITAL REQUIREMENTS PER UNIT OF OUTPUT
Source: OECD (1988) Economic Studies No. 10, “Total Factor Productivity: Macroeconomic and Structural Aspects of the Slowdown,”
http://www.oecd.org/dataoecd/4/31/35237178 . ●
1964
1975
1985
1964
1975
1985
United States
1966
1975
1985
1966
1975
1985
Japan
14
12
10
8
6
4
2
10 12 14 16 180 2 4 6 8
1962
1975
1985
1962
1975
1985
Germany
1968
1975
19851968
1975
1985
France
1963
1975
1985
1963
1975
1985
United Kingdom
La
bo
r
in
pu
t p
er
u
ni
t o
f o
ut
pu
t
1966
1975
1985
1966
1975
1985
Canada
Capital input per unit of output
14
12
10
8
6
4
2
10 12 14 16 180 2 4 6 8
La
bo
r
in
pu
t p
er
u
ni
t o
f o
ut
pu
t
Capital input per unit of output
14
12
10
8
6
4
2
10 12 14 16 180 2 4 6 8
La
bo
r
in
pu
t p
er
u
ni
t o
f o
ut
pu
t
Capital input per unit of output
14
12
10
8
6
4
2
10 12 14 16 180 2 4 6 8
La
bo
r
in
pu
t p
er
u
ni
t o
f o
ut
pu
t
Capital input per unit of output
14
12
10
8
6
4
2
10 12 14 16 180 2 4 6 8
La
bo
r
in
pu
t p
er
u
ni
t o
f o
ut
pu
t
Capital input per unit of output
14
12
10
8
6
4
2
10 12 14 16 180 2 4 6 8
La
bo
r
in
pu
t p
er
u
ni
t o
f o
ut
pu
t
Capital input per unit of output
210 PART 3 ADDITIONAL THEORIES AND EXTENSIONS
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commodity (see Figure 5). In panel (a) of Figure 5, if the change in technology occurs in
autos, this is shown by the PPF that is the farthest out along the autos axis. On the other
hand, the PPF that is the farthest out along the food axis indicates what happens if the
technological change occurs only in food production. Finally, if the change in technol-
ogy affects both commodities in the same relative manner, the PPF shifts outward in an
equiproportional fashion, as demonstrated in panel (b) of Figure 5. This is commodity-
neutral technological change.
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Traditionally, technological change has been treated exogenously (i.e., as an indepen-
dent event from outside) in the growth literature, often at a fixed rate of growth.5 However,
in the late 1980s a series of long-run growth models began to appear in which the rate of
technological change was determined endogenously, or within the system, instead of being
imposed from outside. In these newer models, the rate of technological change is deter-
mined by such factors as the growth in physical capital and the increase in human capital.
New investment fosters and/or embodies new innovations and inventions which can, in
turn, stimulate additional technological change as experience with the new capital leads
to more change in a “learning-by-doing” environment. Similar “spillover” effects are also
linked to the acquisition of human capital as well as to expenditures on research and devel-
opment (R&D). These models, generally referred to as endogenous growth models, reflect
the basic idea that change in technology is the result of things that people do, not something
produced outside a particular economic system.6 In so doing, they have provided an expla-
nation of how rapid sustainable growth can take place, avoiding the traditional neoclassical
conclusion that economic growth would ultimately converge to the natural rate of popula-
tion growth due to the declining productivity of capital. Grossman and Helpman (1991)
importantly added to the literature on endogenous growth by examining the implications of
FIGURE 5 The Effects of Technological Change on the PPF
If technological change takes place only in automobile production, the PPF pivots upward, intersecting the auto axis at a higher point, as indicated
by the highest PPF along the autos axis in panel (a). If the change in technology affects only food production, the PPF intersects the food axis at a
higher point, as indicated by the PPF farthest out on that axis. If the change in technology affects both products equally, the PPF shifts outward in
an equidistant manner, as shown in panel (b).
Autos Autos
Commodity-specific
technological change
Commodity-neutral
technological change
Food Food
(b)(a)
5A typical way of incorporating technical change is demonstrated in the following traditional Cobb-Douglas
production function from micro theory:
Y = AegtKtαLtβ
where Y refers to GDP, A is an initial technology level, e is the base of natural logarithms, g represents the exog-
enous rate of growth of technology, Kt is the level of capital stock at time t, and Lt refers to the labor force at time t.
The exponents α and β are the respective elasticities of output with respect to capital and labor.
6In this framework, following Paul Romer (1989), the production function takes on the general form of
Y = f(Kt, Lt, At), where At refers to the economy’s level of technology at time t and now appears inside the pro-
duction function as an endogenous input. At is influenced, for example, by research and development, growth in
capital, acquisition of skills, and various spillover effects associated with increased capital and labor.
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IN THE REAL WORLD:
“SPILLOVERS” AS A CONTRIBUTOR TO ECONOMIC GROWTH
When a country’s trading partners experience economic
growth, it is clear that such growth can have effects on the
growth of any given domestic country, as noted in the open-
ing vignette to this chapter regarding China. The effects
can occur, for example, because the partners increase their
imports with growth—which in turn stimulates income in the
domestic country because of the boost in its exports—and
because the growing trading partners may transfer capital and
technology abroad through engaging in more foreign direct
investment. Two International Monetary Fund economists,
Vivek Arora and Athanasios Vamvakidis, have attempted to
provide quantitative estimates of such country “spillover”
effects.* Using data for 101 developed and developing coun-
tries over the 1960–1999 period, they sought to statistically
explain countries’ economic growth rates using traditional
variables such as investment in physical capital, investment
in human capital, and general openness to international trade.
However, Arora and Vamvakidis also included the real per
capita gross domestic product (GDP) growth of trading
partners as a variable in their regression analysis, as well as
the ratio of a domestic country’s real per capita GDP to the
country’s trading partners’ real per capita GDP. These last
two variables were designed to isolate the spillover effects
of trading partners’ growth on a domestic country’s growth.
The fact that such spillovers are important in the real
world was clearly confirmed. First, Arora and Vamvakidis
estimated that after controlling for other determinants of a
country’s growth, a 1 percentage point increase in the growth
rate of a domestic country’s trading partners was associ-
ated with a 0.8 percentage point increase in the growth rate
of the domestic country. Further, this positive impact had
increased over time because the spillover was larger during
the 1980–1999 period than it was for the 1960–1999 period
as a whole. Faster growth in trading partners can obviously
lead to a greater growth in demand for the domestic coun-
try’s exports, for example.
A second important result was that a developing coun-
try’s growth rate, after controlling for other factors, was
negatively correlated with the closeness of the level of
that country’s real per capita GDP to the average real per
capita GDP of its trading partners. Stated another way, a
developing country with a very low per capita income that
is trading mostly with high-income countries will receive
a greater spillover effect than it would if its income were
more similar to the incomes of its trading partners. This
greater spillover effect could reflect greater opportunities to
make larger leaps in technological advance through transfer
of the high technology of the trading partners through for-
eign direct investment. An implication of this finding is that
as a country’s income level approaches that of its trading
partners, the country’s growth rate, other things equal, will
slow down.
*Vivek Arora and Athanasios Vamvakidis, “Economic Spillovers,”
Finance and Development 42, no. 3 (September 2005),
pp. 48–50. ●
212 PART 3 ADDITIONAL THEORIES AND EXTENSIONS
app9062x_ch11_203-225.indd 212 06/17/16 04:00 PM
endogenous technological change for international issues including dynamic comparative
advantage, trade and growth, product cycles, and the international transmission of policies.
More recent literature has focused specifically on research and development as the key fac-
tor in endogenous growth models. A distinction is further made between “first-generation”
and “second-generation” endogenous growth models. In the former, the growth rate of
total factor productivity is proportional to the number of R&D workers; in the latter, modi-
fications are made to this assumption (such as diminishing returns to the number of R&D
workers). See Madsen, Saxena, and Ang (2010). We do not pursue these developments
in this book, however. For our purposes, whether technological change is exogenous or
endogenous, it still results in an outward shift of the PPF.
The second source of economic growth is increased availability of the factors of produc-
tion. We consider the impact of factor growth in terms of two homogeneous inputs, capital
and labor. In the real world, there are other primary inputs such as natural resources, land,
and human capital, and factors do not tend to be homogeneous. Labor and capital remain,
The Effects of Factor
Growth
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TABLE 1 Factor Endowments in Selected Countries, 1966, 1985, and 2014
Country 1966 1985 2014
Annual Average Growth
Rate, 1966–2014
United States:
Capital $785,933 $1,020,600 $5,794,794 4.25%
Labor 76,595 107,150 163,000 1.59
Land —742,400—
Japan:
Capital $165,976 $ 438,631 $3,080,499* 6.41
Labor 49,419 58,070 64,653 0.56
Land —31,396—
Canada:
Capital $ 76,537 $ 150,587 $ 721,831 4.79
Labor 7,232 11,311 19,954 2.14
Land —386,632—
Australia:
Capital $ 35,053 $ 47,761 $ 643,378 6.25
Labor 4,727 6,646 12,152* 2.03
Land —521,973—
France:
Capital $146,052 $ 233,089 $1,109,375 4.31
Labor 21,233 21,193 29,942 0.72
Land —46,560—
Mexico:
Capital $ 21,639 $ 72,753 $ 472,770 6.64
Labor 12,844 22,066 54,948 3.07
Land —176,100—
* 2013 figure
Note: The estimates of real capital stock are in millions of 1966 U.S. dollars, labor is in thousands of economically active individuals, and land is in thousands of
hectares.
Sources: The 1966 figures are from Harry P. Bowen, Edward E. Leamer, and Leo Sveikauskas, “Multicountry, Multifactor Tests of the Factor Abundance Theory,”
American Economic Review 77, no. 5 (December 1987), pp. 806–7. Capital figures for 1985 through 1994 were estimated by summing annual real gross domestic
investment flows (from annual issues of the World Bank’s World Tables) starting in 1975 and using an annual depreciation rate of 10 percent. For 1995–2014, foreign
exchange rates and real gross investment figures were obtained from the IMF’s International Financial Statistics Yearbook 2000 and www.elibrary-data.imf.org.
Price indexes for gross fixed investment, taken from the Economic Report of the President, February 1999 and February 2011, and data from https://research.
stlouisfed.org were used. Labor endowments for 1985 are from issues of the International Labor Organization’s Yearbook of Labor Statistics, and land endowments
are from annual issues of the Food and Agriculture Organization’s Production Yearbook. The 2013–2014 labor figures are from the ILO database obtained at http:
//laborsta.ilo.org/stp/d.
however, two of the most important inputs, and the insights gained from examining K and
L can be extended to the more general case. Estimates for the growth in capital and labor
for selected countries for 1966–2014 are presented in Table 1.
An increase in factor abundance can take place through increases in capital stock,
increases in the labor force, or both. The capital stock of a country grows as domestic and
foreign investment occurs in the country. The labor force expands through increases in
population (including immigration), increases in the labor force participation rate, or both.
If both labor and capital grow at the same rate, the PPF will shift out equiproportionally, as
in the case of commodity-neutral technological change. This factor-neutral growth effect
is demonstrated in panel (a) in Figure 6 with the new PPF that is farther out than the old.
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214 PART 3 ADDITIONAL THEORIES AND EXTENSIONS
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The matter is more complex if one of the factors grows and the other does not. Suppose
that the capital stock increases but the size of the labor force remains constant. How will
the PPF change? In answering this question, remember the production assumptions from
neoclassical theory and the Heckscher-Ohlin analysis. Assume that cutlery is capital inten-
sive and cheese is labor intensive. If the capital stock grows, it has the greatest relative
impact on the capital-intensive product. Think of this as an expansion of the Edgeworth
box (see Chapter 5) along the capital side, with the labor side remaining the same size. If
all the country’s resources are devoted to the production of cutlery, the expansion of the
capital stock permits the country to reach a higher output level (higher isoquant) than that
reached prior to the growth of capital. The growth in capital also permits a larger amount
of cheese to be produced for any level of cutlery because capital can be substituted to some
degree for labor. However, because cheese is the labor-intensive good, the potential impact
on production is less than it is for the capital-intensive good. Consequently, the PPF shifts
outward asymmetrically in the direction of the capital-intensive good. This shift is demon-
strated in panel (b) of Figure 6. An analogous argument can be made for growth in labor
when the capital stock is held constant. Then the PPF shifts outward in an asymmetrical
manner, with the labor-intensive product showing a greater relative response. The effect of
growth in the labor force is demonstrated in Figure 6(c).
FIGURE 6 The Effects of Factor Growth on the PPF
If both factors grow at the same rate, the PPF shifts out in an equiproportional manner as shown in panel (a). If only capital grows, production
of both goods can potentially increase, but the increase is relatively larger in the capital-intensive good. The impact of growth in capital only is
shown in panel (b). If only labor grows, the impact on production is relatively greater in the labor-intensive good, as shown in panel (c).
Cutlery
(K-intensive)
Factor-
neutral growth
(a)
Cheese (L-intensive)
Cutlery
(K-intensive)
Growth in
capital only
(b)
Cheese (L-intensive)
(c)
Growth in
labor only
Cheese (L-intensive)
Cutlery
(K-intensive)
CONCEPT CHECK 1. What is the difference between a protrade
production effect and a protrade consumption
effect? If they occur simultaneously, what it
is the net effect on trade?
2. What is the difference between an ultra-
protrade production or consumption effect
and a protrade production or consumption
effect?
3. How does the change in the PPF resulting
from growth in capital differ from that result-
ing from growth in labor? Why do they each
shift the PPF outward on both axes?
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CHAPTER 11 ECONOMIC GROWTH AND INTERNATIONAL TRADE 215
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FACTOR GROWTH, TRADE, AND WELFARE IN THE SMALL-COUNTRY CASE
A non-neutral growth in factors will shift the PPF in an asymmetrical manner and alter the
relative factor abundance in the country. The economic response to this change depends
on relative commodity prices. Let us continue to assume that the country is a small country
and cannot influence world prices, which remain constant. What happens to production in
this case when one factor, labor, for example, grows and capital stock remains fixed? We
already know that the PPF will shift outward relatively more along the axis of the labor-
intensive commodity. When this occurs, production takes place at the point of tangency
between the new PPF and the same set of relative prices (see Figure 7). This new tangency
occurs at a level of production that represents an increase in output of the labor-intensive
good and a decrease in output of the capital-intensive good. If the labor-intensive good
is the export good, this is an ultra-protrade production effect; if the labor-intensive good
is the import good, growth in labor produces an ultra-antitrade production effect. The
conclusion that growth in one factor leads to an absolute expansion in the product that
uses that factor intensively and an absolute contraction in output of the product that uses
the other factor intensively is referred to as the Rybczynski theorem after the British
economist T. M. Rybczynski. The economics that lie behind the Rybczynski theorem is
straightforward. Because, by the small-country assumption, relative product prices can-
not change, then relative factor prices cannot change because technology is constant. If
relative factor prices are unchanged in the new equilibrium, then the K/L ratios in the two
industries at the new equilibrium are the same as before the growth. The only way this
can happen, given the increased amount of labor, is if the capital-intensive sector releases
FIGURE 7 Factor Growth and Production: The Small-Country Case
With an increase in labor only, the PPF shifts outward proportionally more for labor-intensive good B than it does for capital-intensive good A.
Because this does not affect relative world prices in the small-country case, the increased availability of labor leads to an expansion of output
of the labor-intensive good. Because some capital is required to produce the additional output of B and this can be acquired only by attracting it
from the capital-intensive good, the production of A must decline as the production of B increases. Both production points represent tangencies
between (PB/PA)int and the old PPF and new PPF, respectively.
(PB/PA) int
Good A
(K-intensive)
Good B
(L-intensive)
B1B0
A1
A0
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216 PART 3 ADDITIONAL THEORIES AND EXTENSIONS
app9062x_ch11_203-225.indd 216 06/17/16 04:00 PM
some of its capital to be used with the new labor in the labor-intensive sector. When this
transfer of capital occurs, output of the capital-intensive good falls and output of the labor-
intensive good expands.
What effect does factor growth have on trade in the small-country case? The produc-
tion impact of factor growth on trade depends on whether the growing factor (labor in
our example) is the abundant or the scarce factor. If it is the abundant factor, there is an
ultra-protrade production effect, assuming the country is exporting the commodity that
is intensive in the abundant factor, in the manner of Heckscher-Ohlin. If it is the scarce
factor, there is an ultra-antitrade production effect. Other things being equal, therefore,
the expansionary impact on trade is greater with growth in the abundant factor than in
the scarce factor. The total effect on trade depends on both production and consumption
effects, however. As a general rule, if the consumption effect is protrade, then the country
will participate more heavily in trade if the abundant factor grows. If the scarce factor
grows, the total effect can be less participation in trade. A full assessment of the impacts
of factor growth on the country’s participation in trade requires estimation of both supply
and demand effects.
Consider the effect of growth on welfare. If capital grows or there is technological
change, there is an increase in well-being, because either of those changes will increase real
per capita income and permit the country to reach a higher community indifference curve.
It is assumed that the social benefits resulting from the increased output are not accompa-
nied by an increase in income inequality. However, if there is growth in the labor force,
the welfare implications of growth are less straightforward. The community indifference
curve map that existed prior to growth is no longer relevant, because the new members of
the labor force may have different tastes than the original members. It is, therefore, not
possible to use the two different indifference curve maps to make welfare comparisons.
In practice, economists use levels of per capita income to approximate changes in country
welfare. While this measure has deficiencies, it appears to correlate well with many other
variables indicative of welfare. It does not, however, take explicit account of changes in
income distribution.
If we adopt per capita income as the measure of welfare in the case of labor force growth,
what can be concluded about the impact of such growth on welfare? We have assumed
that our production is characterized by using two inputs and that there are constant returns
to scale. The definition of constant returns to scale states that if all inputs increase by a
given percentage, output will increase by the same percentage. If, however, only one input
expands, output will expand by a smaller percentage than the increase in the single fac-
tor. (See Concept Box 1 for additional discussion of this point.) Thus, if we use per capita
income as our measure of well-being, we conclude that an increase in population (labor) will
lead to a fall in per capita income and hence in country well-being, other things being equal.
GROWTH, TRADE, AND WELFARE: THE LARGE-COUNTRY CASE
The effects of growth on trade to this point have been based on the assumption that the
country cannot influence the international terms of trade. However, a country could influ-
ence world prices of a commodity if the country is a sufficiently large consumer or pro-
ducer. In that instance, we must also take into account the possible effects of economic
growth on the terms of trade.
Suppose we are dealing with a large country that can influence international prices and
that growth of the abundant factor, in this case capital, causes an ultra-protrade production
effect. Assume further that this is coupled with a neutral consumption effect. The total
effect on trade is that this country demands more imports and supplies more exports at the
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CONCEPT BOX 1
LABOR FORCE GROWTH AND PER CAPITA INCOME
Under the assumption of constant returns to scale, a 20 percent
growth in the labor force leads to a 20 percent growth
rate in the output of a particular commodity only if all other
inputs also grow at 20 percent. If all inputs grow by a fixed
percentage, the PPF MN shifts out to PPF M ′N ′ in an equi-
distant manner by a similar percentage, as shown in Figure 8.
However, if only labor grows, the PPF shifts out relatively
more for the labor-intensive good than for the capital-
intensive good, as indicated by the dashed PPF M ″N ″. But,
because only labor is growing, the outward shift from MN
to M ″N ″ must be less for all combinations of the two final
goods than was the case when all inputs and output increased
by the same percentage. It follows that whatever the combi-
nation of the country’s two products, the increase in income
represented by M ″N ″ is always less than that represented by
M ′N ′, other things being equal. Thus, a 20 percent increase
in the labor force leads to an increase in income that is less
than 20 percent, and per capita income therefore declines.
FIGURE 8 Changes in the PPF under Different Factor Growth Assumptions
If all factors grow by the same percentage, the PPF shifts outward in an equidistant manner as indicated by M ′N ′. If only labor grows,
the PPF changes in the manner indicated by the dashed PPF, M ″N ″. Because M ″N ″ necessarily lies inside M ′N ′ for a given level of
growth in the labor force, the percentage increase in income associated with only labor force growth is necessarily less than the percentage
increase in the labor force. Thus, per capita income falls if only the labor force grows. ●
K-intensive good
PPF
PPF
L-intensive good
M
M
M
N N N
CHAPTER 11 ECONOMIC GROWTH AND INTERNATIONAL TRADE 217
app9062x_ch11_203-225.indd 217 06/17/16 04:00 PM
current set of international prices [see panel (a) of Figure 9]. As a result of growth, this
country alters its “offer” at that particular set of prices on the world market. The increased
supply of the export good (good B) and the increased demand for the import good (good
A) reduce the international terms of trade [see panel (b) of Figure 9]. (For a discussion of
how the different types of growth affect the offer curve of a growing country, see Concept
Box 2.) The increase in the relative price of imports effectively reduces the possible gains
from growth and trade, because the country now receives fewer imports per unit of exports
(see Figure 11, page 220). Graphically, the international terms-of-trade line TOT1 is flatter
now than before growth (TOT0), and it is tangent to a lower indifference curve (IC2) than
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218 PART 3 ADDITIONAL THEORIES AND EXTENSIONS
app9062x_ch11_203-225.indd 218 06/17/16 04:00 PM
would be the case if prices had not been affected (IC1). Thus, some of the gains of growth
are effectively offset by the deterioration in the terms of trade. For growth to be beneficial
to the large trading country, these negative terms-of-trade effects must not completely off-
set the positive effects of growth.
Growth can result in declining well-being in two ways in the large-country case. First,
if labor is the abundant and growing resource, the loss in welfare linked to the resulting
decline in per capita income is further augmented by the deterioration in the international
terms of trade (increase in the relative price of imports). The result is essentially the same
as in the small-country case except it is intensified by the negative terms-of-trade effect.
Second, even if capital is the growing abundant factor (or there is technological change in
the export commodity) and the negative terms-of-trade effects are sufficiently strong, the
country could be worse off after growth (see Figure 12, page 220). In this case, the dete-
rioration in the terms of trade is so great that the new, flatter international terms-of-trade
line (TOT1) is tangent to a lower community indifference curve (IC2 at point C2) than it was
prior to growth (IC0 at point C0).When the negative terms-of-trade effects outweigh the
positive growth effects in this manner, the situation is referred to as immiserizing growth,
first pointed out by Jagdish N. Bhagwati (1958).
We need to discuss briefly the effects of growth in the scarce factor for a large country.
According to the Rybczynski theorem, growth in the scarce factor leads to an increase
in output of the import-competing good and a decrease in output of the export good.
Ignoring any offsetting consumption effects, for the large country this leads to a reduc-
tion in the “offer” of exports for imports by the expanding country since growth is ultra-
antitrade biased [see panel (b) of Figure 13, page 221]. The growth phenomenon leads to an
improvement in the terms of trade faced by this country, as the reduced amount of exports
places upward pressure on the price of the export good and the reduced import demand pro-
duces downward pressure on the price of the import good. The positive effects of growth
FIGURE 9 Large-Country Growth and Terms-of-Trade Effects
Growth in country I [panel (a)] leads to an ultra-protrade production effect and a neutral consumption effect, which enlarges country I’s desired
amount of trade (the dashed trading triangle) at initial world prices TOT0. This causes country I’s offer curve to pivot outward [panel (b)], lower-
ing international relative prices to TOT1. This terms-of-trade effect reduces the gains from growth compared with what would have happened if
world prices had not been altered by growth (see Figure 11).
Good A
Good B
Good A
Good B
Country I
Country II
Country I
(a) (b)
Country I
TOT0
TOT0 TOT1
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CHAPTER 11 ECONOMIC GROWTH AND INTERNATIONAL TRADE 219
app9062x_ch11_203-225.indd 219 06/17/16 04:00 PM
are enhanced by the terms-of-trade effects, causing the country to reach an even higher
indifference curve. This effect is shown in panel (a) of Figure 13, as consumer welfare rises
from IC0 before growth to IC1 with growth alone to IC2 after the terms-of-trade effects are
taken into account. Finally, if labor is the growing scarce factor, the positive terms-of-trade
effects can offset, at least in part, some of the loss in well-being due to declining per
capita income.
CONCEPT BOX 2
ECONOMIC GROWTH AND THE OFFER CURVE
When a country experiences economic growth, its offer
curve will shift. However, the extent and even the direction
of the shift depend on the type of growth that takes place.
(See Meier, 1968, p. 18.) In Figure 10, the pregrowth offer
curve of country I is OCI. If the net effect of country I’s pro-
duction and consumption effects is ultra-protrade growth,
its offer curve shifts rightward to OCUP, with a consequent
increase in the volume of trade and a deterioration of the
terms of trade with trading partner country II. If the net effect
is protrade growth, the offer curve of country I shifts to OCP,
with a smaller increase in the volume of trade and a smaller
deterioration in the terms of trade than with OCUP. But,
FIGURE 10 Offer Curve Shifts with Different Types of Growth
Starting with pregrowth offer curve OCI for country I, the four growth types of ultra-protrade, protrade, neutral, and antitrade all make
country I more willing to trade. Its offer curve shifts rightward in these cases to OCUP, OCP, OCN, and OCA, respectively; the volume of
trade with country II increases and country I’s terms of trade deteriorate. Only with ultra-antitrade-biased growth will country I’s offer
curve shift to the left (to OCUA) and lead to less trade and an improvement in country I’s terms of trade. ●
Country I’s exports,
Country II’s imports
C
ou
nt
ry
I’
s
im
po
rt
s,
C
ou
nt
ry
II
’s
e
xp
or
ts
OCUAOCI OCAOCN OCP OCUP
OCII
perhaps surprisingly, even with neutral growth, country I’s
offer curve still shifts to the right (to OCN). This result occurs
because, even though trade in relation to national income for
country I has remained constant (since the income elastic-
ity of demand for imports, YEM, equals 1.0), the absolute
willingness to trade increases. That the absolute amount of
trade increases is also true even with antitrade-biased growth
(offer curve OCA), despite the fact that trade is falling relative
to national income (0 < YEM < 1). Finally, a net effect of ultra-antitrade-biased growth shifts the offer curve of country I leftward to OCUA. Only in this case, other things equal, will the volume of trade decrease and the terms of trade improve. Final PDF to printer 220 PART 3 ADDITIONAL THEORIES AND EXTENSIONS app9062x_ch11_203-225.indd 220 06/17/16 04:00 PM FIGURE 11 Large-Country Growth, Terms-of-Trade Effects, and Welfare The decline in the terms of trade for country I from TOT0 to TOT1 after growth causes country I to produce less of export good B and more of import good A (the movement from E1 to E2) compared with what it would have done had relative prices not changed. At the same time, the relatively higher price of good A leads consumers to shift consumption from C1 to C2. The combined effect of these responses to the growth-induced change in the terms of trade is a reduction in the degree of specialization and trade, leading to a fall in well-being (represented by the shift from IC1 to IC2) compared with what it would have been had the terms of trade not changed. However, in this case country I is still better off with price changes and growth compared with the pregrowth situation (IC0). Good A Good B TOT 0 TOT 1 TOT 0 C 1 C 2 C 0 IC 1 IC 2 IC 0 E 0 E 2 E 1 FIGURE 12 The Case of Immiserizing Growth It is possible that the change in the terms of trade associated with growth of the large country can be large enough to leave the country less well-off compared with conditions before growth. Postgrowth TOT1 is so much smaller than pregrowth TOT0 that, after producers and consumers respond to the new set of relative prices (E2 and C2), country I finds itself less well-off than before it grew. Consumers are now attaining a lower indifference curve compared with the pregrowth situation (IC2 < IC0). This large-country growth effect is referred to as immiserizing growth. Good A Good B TOT 0 TOT 1 TOT 0 C 0 IC 1 IC 2 IC 0 E 2 C 1 C 2 E 0 E 1 Final PDF to printer CHAPTER 11 ECONOMIC GROWTH AND INTERNATIONAL TRADE 221 app9062x_ch11_203-225.indd 221 06/17/16 04:00 PM GROWTH AND THE TERMS OF TRADE: A DEVELOPING-COUNTRY PERSPECTIVE The preceding analysis of growth, trade, and welfare provides a useful background for examin- ing the interaction among growth, trade, and economic development. The importance of techno- logical change and the accumulation of capital in improving country welfare is certainly clear. In countries where population and thus labor is growing at a relatively high rate, some stimulus to production in addition to labor must occur if per capita incomes are to improve steadily. It is also important to consider the possible effect of growth on the international terms of trade. Although most developing countries are not large in an overall economic sense, many are sufficiently important suppliers of individual primary commodities to be able to influence world prices. Several important observations need to be made. First, economic growth based on expansion of production of these goods may well lead to adverse terms-of- trade movements. Although immiserizing growth does not appear to be common in the real world, adverse terms-of-trade movements clearly reduce the benefits of growth and trade to the developing countries. This observation provides strong support for considering product diversification in the development strategy to reduce the likelihood of growth contributing FIGURE 13 Growth in the Scarce Factor in the Large-Country Case Following the Rybczynski theorem, growth in the scarce factor leads to an expansion of output of the import good (good A) and a contraction of production of the export good (good B). If this ultra-antitrade production effect is not offset by a very strong consumption effect toward more trade, the desired level of trade at the initial level of prices, TOT0, falls. Should this happen, country I’s offer curve shifts inward, demonstrating the reduced willingness to trade after growth. This leads to an improvement in the terms of trade for country I (TOT1 > TOT0) and to production
and consumption adjustments. Postgrowth production shifts from E1 to E2, consumption from C1 to C2, and the level of well-being from IC1 to
IC2. The change in the terms of trade thus leads to greater specialization and trade and additional gains from growth compared with what would
have taken place at the original terms of trade.
Good A
Good B
E0
Country I
Good B
Good A
Country II
Country I
TOT1
TOT0
(b)(a)
TOT0
TOT0
E2
E1
C0
C1 C2
IC2
IC0
TOT1IC1
CONCEPT CHECK 1. How does growth affect production accord-
ing to the Rybczynski theorem? Is country
size (“small” or “large” in trade) important
for this result?
2. How can growth lead to a deterioration in
the terms of trade for the large country? Can
growth ever improve a country’s terms of
trade? If so, when?
3. Explain how the change in the terms of trade
accompanying growth can leave a country
worse off after growth compared with its
state of well-being prior to growth.
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222 PART 3 ADDITIONAL THEORIES AND EXTENSIONS
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IN THE REAL WORLD:
TERMS OF TRADE OF BRAZIL, JORDAN, PAKISTAN,
AND THAILAND, 1980–2014
The terms-of-trade behavior of four developing countries—
Brazil, Jordan, Pakistan, and Thailand—during recent
decades is presented in Figure 14. The graph indicates that
the greatest deterioration in the terms of trade over this time
period occurred for Pakistan and Brazil.
In Pakistan, there was an overall rise in its terms of
trade in the 1980s, general stability in the 1990s, and then
a rather sharp decline for the rest of the period. Pakistan
had a relatively large average annual GDP growth rate of
6.3 percent from 1980 to 1990 and average growth rates
of 3.8 percent from 1990 to 2000, 5.1 percent from 2000
to 2009, 3.1 percent from 2009 to 2013, and 5.4 percent in
2014. The experience in the 1990s and in the first years of
the 2000s shows some consistency with the expectations
from this chapter in that sluggish GDP growth in the 1990s
yielded little change in the terms of trade while faster growth
in the 2000s yielded terms-of-trade deterioration. However,
the rapid GDP growth of the 1980s would not, on the basis
of the analysis in this chapter, be expected to be associated
with an improvement in the terms of trade.
For Brazil, there was an improvement in its terms of
trade in the 1980s and until 1992, followed by a sharp drop
through 2001, an upward spike for two years, and a decline
through 2014. Brazil’s annual average GDP growth rate was
2.7 percent from 1980 to 1990 and again from 1990 to 2000,
3.6 percent from 2000 to 2009, 3.1 percent from 2009 to
2013, and a miniscule 0.1 percent in 2014. Because the aver-
age GDP growth rates in general varied little for Brazil while
Brazil’s terms of trade changed dramatically, other factors
besides growth of GDP were clearly at work on the coun-
try’s terms of trade.
Thailand also experienced a rather large terms-of-trade
decline over the 1980–2014 period as a whole. The decline
also appears to have occurred regularly throughout that
extended period. Thailand’s annual average GDP growth
rate from 1980 to 1990 was 7.6 percent, and these years
showed the greatest relative decline in Thailand’s terms of
trade. The annual average GDP growth rates of the coun-
try were 4.2 percent from 1990 to 2000, 4.6 percent from
2000 to 2009, and 4.2 percent from 2009 to 2013, followed
FIGURE 14 Terms of Trade of Brazil, Jordan, Pakistan, and Thailand, 1980–2014
0
20
40
60
80
100
120
140
160
180
200
Te
rm
s
of
T
ra
de
(2
0
0
5
=
1
0
0
)
220
240
260
280
300
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Brazil Jordan ThailandPakistan
(continued)
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by a sharp drop to 0.7 percent in 2014. Overall, Thailand
had fairly solid growth for most of the period (until 2014),
and we would expect that such steady growth might well
be associated, other things equal, with some decline in the
terms of trade.
Finally, Jordan’s terms of trade declined the least of the
four countries. There was a rather slow rise from 1980 to
1995, followed by a decline until the end of the period but
with the exceptions of a sharp run-up in 2008 and 2009.
Jordan’s annual average GDP growth rate was 2.5 percent
from 1980 to 1990, 5.0 percent from 1990 to 2000, 7.1 percent
from 2000 to 2009, 2.6 percent from 2009 to 2013, and
3.1 percent in 2014. The 2000s saw the greatest relative
decline in the terms of trade (from a value of 125.4 in 1999
to 83.8 in 2014), and GDP growth was greatest from 2000 to
2009 (although there was a pronounced drop in that growth
after 2009).
In overview, while there is a tendency in some of the
above instances for faster growth to be associated with a
decline in the terms of trade (Pakistan in the early 2000s,
Thailand in the 1980s, and Jordan in the early 2000s), the
overall relationship of GDP to the terms of trade is a com-
plex one. There are clearly many other factors besides GDP
growth that exert important influences on the behavior of a
country’s commodity terms of trade.
Sources: Terms of trade calculated from data obtained at elibrary-
data.imf.org; GDP growth rate data obtained from The World Bank,
World Development Indicators 2002 (Washington, DC: International
Bank for Reconstruction and Development/World Bank, 2002),
pp. 204–6 and The World Bank, World Development Indicators
2015 (Washington, DC: International Bank for Reconstruction
and Development/World Bank, 2015), pp. 82, 84–86, both
available at www.worldbank.org, and from the website data.
worldbank.org. ●
IN THE REAL WORLD: (continued)
TERMS OF TRADE OF BRAZIL, JORDAN, PAKISTAN,
AND THAILAND, 1980–2014
CHAPTER 11 ECONOMIC GROWTH AND INTERNATIONAL TRADE 223
app9062x_ch11_203-225.indd 223 06/17/16 04:00 PM
to negative terms-of-trade movements and the reliance on only one main product for export
earnings. A major world supplier of an export good such as coffee, cocoa, or groundnuts
that relies heavily on the particular commodity for its export proceeds could find itself in
difficult economic and financial straits if a bumper crop drives down world prices.
Second, keep in mind that growth may lead to changes in relative demand for final
products. We allowed this possibility in the discussion of the trade effects that accompany
growth. In general, various classes of commodities tend to behave in a predictable way
when income grows, and the different behavior patterns can be described by using the
income elasticity of demand (income elasticity of demand in general, not just the income
elasticity of demand for imports). For example, primary goods such as minerals and food
products tend to have income elasticities less than 1.0, while manufactures tend to be char-
acterized by an income elasticity greater than 1.0. To the extent that developing countries
export labor- and land-intensive primary goods and import manufactured goods, growth
in traditional export industries tends to generate protrade or ultra-protrade consumption
effects that may well generate balance-of-trade deficits in fixed exchange rate economies
or a depreciation of the home currency if the exchange rate is flexible.
Finally, from a broader perspective, countries that rely on exports of primary goods
for export earnings may find that the international prices of these goods do not rise as
rapidly as the prices of the manufactured goods they import due in part to the differences
in their income elasticities. This deterioration in the terms of trade certainly lowers the
gains from growth in the short run and reduces the future growth rate by diminishing
the ability to import needed capital goods. Economists such as Raul Prebisch (1959),
Hans Singer (1950), and Gunnar Myrdal (1956) argued that the terms of trade of the
developing countries declined over a long period of time, much to their disadvantage.
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224 PART 3 ADDITIONAL THEORIES AND EXTENSIONS
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KEY TERMS
antitrade consumption effect
antitrade production effect
capital-saving technological change
commodity-neutral technological
change
endogenous growth models
factor-neutral growth effect
factor-neutral technological change
immiserizing growth
income elasticity of demand for
imports
labor-saving technological change
neutral consumption effect
neutral production effect
protrade consumption effect
protrade production effect
Rybczynski theorem
ultra-antitrade consumption effect
ultra-antitrade production effect
ultra-protrade consumption effect
ultra-protrade production effect
SUMMARY
This chapter focused on how growth in a country’s real income
influences its international trade. Growth in output has an effect
on a country’s trade through both consumption and production
effects, which do not necessarily work in the same direction. The
chapter focused on technological change and factor growth as
the underlying bases for growth, and it explained the differences
between the two in terms of their impact on the PPF. The effect
of growth of a single factor is an expansion of production of the
commodity that uses it relatively intensively and a contraction
in production of the second good. The welfare effects of fac-
tor growth and technological change were positive in all small-
country cases with the exception of population growth. In that
case, population growth led to a fall in per capita income. The
large-country case was introduced to point out the implications
of growth that yields changes in the international terms of trade.
Output growth in the export good generates negative terms-of-
trade effects that offset some of the gains from growth. In the
extreme case, a country’s welfare can decline if the effects of
negative terms-of-trade change more than offset the gains from
growth. Growth in production of the import- competing good
can produce terms-of-trade effects that enhance the normal
growth effects. Finally, this theoretical framework was used to
discuss some implications of growth for the trade and develop-
ment prospects of developing countries.
These arguments are based not only on the different demand characteristics of the two
categories of products but also on the price effects of technological change. Technological
advances in developing countries are assumed to lead to decreases in the prices of developing-
country products, whereas in the industrialized countries, technological advances lead to
increased payments to the factors of production (instead of reduced prices for manufac-
tured goods). While it is not clear that a long-term decline in the international terms of trade
of developing countries in general has taken place, it is fairly clear that there have been
periods of marked short-run deterioration and improvement, often in response to unantici-
pated supply effects. Because primary goods tend to be less elastic than manufactures with
respect to both price and income, relative price instability is also potentially a more serious
problem for the developing countries than for industrialized countries. For this reason,
price stabilization proposals such as commodity agreements with buffer stocks and export
controls have been relatively common for developing countries (see Chapter 18).
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QUESTIONS AND PROBLEMS
1. In a small country, why does growth in only one factor lead
to either an ultra-protrade or an ultra-antitrade production
effect?
2. Can growth in the abundant factor ever lead to an expansion
of the trade triangle if the Rybczynski theorem holds in the
case of a small country?
3. What type of consumption effect will take place if the export
good is an inferior good?
4. Is it possible for growth in the scarce factor to lead to an
expansion of trade in a large country? Why or why not?
5. Why might a developing country that experiences a bumper
crop in its export good find itself less well-off than in a nor-
mal production year?
6. Explain why growth based only on a growing labor force can
on average leave people less well-off. Would your answer be
different if there were increasing returns to scale?
7. There was sluggishness in the Japanese economy in the
1990s, and Japan’s terms of trade improved at the same time.
Can you interpret and analyze this experience in the context
of what you have studied in this chapter? Explain.
8. Explain how the production-possibilities frontier of the
unified Germany might differ from the PPF of the former
Federal Republic of Germany (West Germany), keeping
in mind that West Germany, in the two-factor context, was
generally considered relatively capital abundant and the
German Democratic Republic (East Germany) was generally
considered relatively labor abundant. What would theory
suggest about the differences in relative output of capital-
intensive goods and labor-intensive goods of the former
West Germany compared with the unified Germany? What
would theory suggest, if anything, about the trade pattern of
the new Germany compared with that of the former West
Germany if it is assumed that the former West Germany was
capital abundant relative to its trading partners?
9. New manufacturing technologies are often viewed as
labor saving in nature. Using a production-possibilities
frontier with manufactured goods on one axis and (labor-
intensive) services on the other axis, illustrate and explain
how the introduction of labor-saving innovations in manu-
facturing would shift the PPF. What type of production
effect would occur at constant world prices (with the
country being assumed to be an exporter of manufactured
goods)?
10. In a two-good world (goods X and Y), consider the follow-
ing information for (small) country I, which is engaged in
trade:
2005 2010 2015
Production of good X 100 units 120 units 140 units
Production of good Y 60 units 66 units 86 units
Consumption of good X 80 units 92 units 110 units
Consumption of good Y 70 units 80 units 101 units
(a) What is the volume of trade and the trade pattern for
country I in 2005? In 2010? In 2015?
(b) What type of production effect occurs between 2005
and 2010? Between 2010 and 2015? Explain.
(c) What type of consumption effect occurs between 2005
and 2010? Between 2010 and 2015? Explain.
(d) What is the “net effect” on trade of this country’s
growth between 2005 and 2010? Between 2010 and
2015? Explain.
11. If a small country cannot influence its terms of trade, why
is it that small developing countries may have experienced
a decline in their terms of trade over time?
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CHAPTER
LEARNING OBJECTIVES
LO1 Identify the different types of foreign investment and the potential
determinants of such investment.
LO2 Indicate the costs and benefits associated with foreign direct investment.
LO3 Explain the motivation for labor migration and its effects on participating
countries, as well as the size and importance of international remittances.
INTERNATIONAL
FACTOR
MOVEMENTS12
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CHAPTER 12 INTERNATIONAL FACTOR MOVEMENTS 227
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INTRODUCTION
In this chapter, we step away from international trade in goods and services to examine
the international movements of factors of production—capital and labor. The theoretical
literature has long assumed that factors of production are mobile within countries, but it
has also traditionally assumed that factors of production do not move between countries.
This second assumption is patently false in today’s world, as we are constantly made aware
of the movement of investment and labor from one country to another. We need only to
note, for example, the controversies on the effect on U.S. workers of capital flows from the
United States to Mexico and Asia, or the continued concern over the inflow of migrants
to the United States and Europe. The constant U.S. concern about illegal immigrants from
Latin America reflects the anticipated impact of large-scale labor mobility. Further, devel-
oping countries are seeking ways to restrain the outflow of skilled labor (the “brain drain”).
This chapter seeks to provide an economic overview of causes and consequences of capital
and labor flows. We first describe the current nature of international capital movements,
discuss the principal factors that influence international investment decisions, and analyze
the various effects of such investment. This is followed by a discussion of the causes and
impacts of labor migration between countries.
INTERNATIONAL CAPITAL MOVEMENTS THROUGH FOREIGN DIRECT INVESTMENT
AND MULTINATIONAL CORPORATIONS
Few, if any, countries have ever experienced the kind of rapid economic growth that China has
achieved from the end of the 1970s until the present time. World Bank data indicate that the
annual average rate of increase in gross domestic product was 10.6 percent from 1990 to 2000,
10.9 percent from 2000 to 2009, and 8.7 percent from 2009 to 2013. These are growth rates that
yield a doubling of GDP in every 7 to 8 years! While China’s 2013 per capita income level of
$6,560 was still very low compared with that in high-income countries (e.g., per capita income
in the United States in 2013 was $53,470), the growth rate was extraordinarily impressive. When
allowance is made for the actual internal purchasing power of the Chinese yuan in terms of goods
and services and then converting to dollars, China’s per capita income in 2013 was $11,850 rather
than $6,560 and the country’s total GDP in 2013 was $16.1 trillion. This total GDP was the sec-
ond largest in the world, after the $17.0 trillion GDP of the United States. (Note: The data refer to
mainland China, exclusive of Taiwan and also exclusive of the separate high-income administra-
tive region of Hong Kong.)
While there have been many causes of this rapid growth, the general emphasis by economists
has been placed on the liberalization of the economy that began in 1978 and featured the con-
tinuous introduction of market-oriented reforms, including greater participation in international
trade. Also included in the liberalization has been the permitted entry of more foreign investors
into manufacturing; such foreign direct investment (FDI) has increased dramatically. The foreign
investment has been especially important in the emergence of the strong export sector—China
has become the top merchandise exporting country in the world in recent years—because about
one-half of Chinese exports come from firms in which foreign investors have at least some
ownership share.
Foreign Investors in
China: “Good” or
“Bad” from the
Chinese Perspective?1
1This discussion draws on material from the following sources: Lee G. Branstetter and Robert C. Feenstra, “Trade
and Foreign Direct Investment in China: A Political Economy Approach,” Journal of International Economics
58, no. 2 (December 2002), pp. 335–38; “Out of Puff: A Survey of China,” The Economist, June 15, 2002, p. 13
(survey follows p. 54); “The Real Leap Forward,” The Economist, November 20, 1999, pp. 25–26, 28; “Troubles
Ahead for the New Leaders,” The Economist, November 16, 2002, pp. 35–36; World Bank, World Development
Indicators 2015 (Washington, DC: World Bank, 2015), pp. 24, 28, 77, available at www.worldbank.org.
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228 PART 3 ADDITIONAL THEORIES AND EXTENSIONS
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Should China have allowed foreign investment to come into the country in such large
volume? In this chapter, we analyze general economic causes and consequences of flows
of capital and labor across country borders, but the Chinese case has an unusual twist that
illustrates that the decision to allow foreign investment cannot be entirely economic. In an
article entitled “Trade and Foreign Investment in China: A Political Economy Approach”
in the December 2002 Journal of International Economics, economists Lee Branstetter and
Robert Feenstra examined determinants of FDI into China during the years 1984–1995.
Policies played a critical role in attracting FDI, and the policies varied by province (of
which China has 30). In 1979, Guangdong and Fujian provinces on the southeast coast
became sites of “special economic zones” that gave favorable tax and administrative treat-
ment to foreign firms (more favorable treatment than to domestic Chinese firms). This
favorable treatment successfully enticed foreign investors but, because the authorities did
not want to endanger already-existing Chinese heavy industry, these zones were not located
in China’s developed industrial areas of that time. In 1984, other areas along the coast were
also permitted to give special treatment to foreign investors. In 1986, further rules permit-
ting special tax treatment throughout China were adopted, although local regions still had
regulatory powers of their own.
Branstetter and Feenstra were concerned with ascertaining the factors that influenced
the Chinese, by province, in their decisions regarding the allowance of greater foreign
investment. In particular, the Chinese planners were hypothesized to be trading off the
benefits of increased FDI (as well as increased international trade) against the losses that
would be incurred by state-owned enterprises (SOEs) if foreign investment entered and, by
competition against the SOEs, made the latter nonviable. To test the relevant determinants
of FDI in this context, Branstetter and Feenstra looked at the provincial consumption levels
of products that are provided by multinational firms who had undertaken FDI. They related
the consumption levels of these FDI products to the consumption levels of similar goods
produced by SOEs as well as to the levels of goods supplied as imports. An additional
determinant in their testing equation was a term incorporating the wage premium paid
by foreign investors, with the hypothesis being that if foreign investors pay higher wages
than domestic firms, this would be an enticement for the authorities to permit more FDI so
that Chinese workers would be better off. There was also a tariff revenue term, which was
comprised of tariff rates (which were and still are high) times the value of imports—if tariff
revenue is high, it means that potential foreign investors are supplying the Chinese market
by sending in imports rather than by producing within China.
What seemed to be the relationships between these various terms and production by
foreign investors? The general results were that less spending on the output of Chinese
state enterprises was associated with greater spending on the output of foreign investors
(there was a trade-off between the two types of output), as was a higher wage premium.
Higher tariff revenue collections, as expected, were associated with less foreign investor
output (because foreign investors would, other things equal, be supplying from outside
rather than within the country). Thus, there was a clear threat posed by FDI to production
by state firms, and FDI was “bad” in that sense. Further, the fact that higher imports and
consequently higher tariff revenues were associated with lower FDI meant that the govern-
ment got the revenues (“good” from the state’s standpoint), but the presence of high tariffs
was “bad” for consumer welfare. The higher wages paid by the foreign firms constituted
“good” results from the standpoint of worker/consumer welfare.
Branstetter and Feenstra then tried, in a complicated way, to integrate these results
into a mathematical function that would express the government’s relative desires to pro-
mote consumer utility (by raising consumption levels and promoting higher wages), col-
lect revenues from multinational firms (such as by imposing taxes and various fees), earn
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CHAPTER 12 INTERNATIONAL FACTOR MOVEMENTS 229
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profits from production by state firms, and collect tariff revenues for the government’s
coffers. The most significant finding was that, although the authorities wanted to pro-
mote both state-owned production and consumer welfare, they seemed to place four to
seven times as much weight on encouraging output by the SOEs as they did on promot-
ing consumer utility. There was indeed a trading off of benefits from foreign investment
against the threat of loss of viability of the state-owned production units. The politics
of communism clearly played a role in this result; the populace gained in the roles of
consumers and workers from having foreign investment present, but the government greatly
worried that state-owned firms would take a hit from the presence of the foreign competi-
tors. Thus, in the 1980–1995 period, China seemed to want foreign investors, but there
were strong political restraining forces.
When speaking of the international movement of “capital,” we need to distinguish two types
of capital movements: foreign direct investment and foreign portfolio investment. This
chapter covers FDI foreign portfolio investment is covered in international monetary eco-
nomics. FDI refers to a movement of capital that involves ownership and control, as in the
preceding Chinese example, where foreign ownership of production facilities took place. For
example, when U.S. citizens purchase common stock in a foreign firm, say, in France, the
U.S. citizens become owners and have an element of control because common stockholders
have voting rights. For classification purposes, this type of purchase is recorded as FDI if the
stock involves more than 10 percent of the outstanding common stock of the French firm. If
a U.S. company purchases more than 50 percent of the shares outstanding, it has a control-
ling interest and the “French” firm becomes a foreign subsidiary. The building of a plant in
Sweden by a U.S. company is also FDI, because clearly there is ownership and control of the
new facility—a branch plant—by the U.S. company. FDI is usually discussed in the con-
text of the multinational corporation (MNC), sometimes referred to as the multinational
enterprise (MNE), the transnational corporation (TNC), or the transnational
enterprise (TNE). These terms all refer to the same phenomenon—production is taking
place in plants located in two or more countries but under the supervision and general direc-
tion of the headquarters located in one country.
Foreign portfolio investment does not involve ownership or control but the flow of what
economists call “financial capital” rather than “real capital.” Examples of foreign portfolio
investment are the deposit of funds in a U.S. bank by a British company or the purchase of
a bond (a certificate of indebtedness, not a certificate of ownership) of a Swiss company
or the Swiss government by a citizen or company based in Italy. These flows of financial
capital have their immediate effects on balances of payments or exchange rates rather than
on production or income generation.
The United Nations Conference on Trade and Development (UNCTAD), an organization
that studies various international economic issues, has indicated that the stock of accu-
mulated FDI inflow to countries of the world was $26,039 billion as of 2014. This $26.0
trillion stock reflected rather rapid growth in the previous decades; the stock had grown at
an average annual rate of 9.4 percent from 1991 to 1995, 18.8 percent from 1996 to 2000,
13.4 percent from 2001 to 2005, 13.8 percent from 2005 to 2010 (with considerable annual
variability), and 8.0 percent from 2010 to 2014. Overall, the stock of inward foreign capital
of $26,039 billion in 2014 was more than 14 times as large as the stock that had been in
place in 1990.2
Definitions
Some Data on Foreign
Direct Investment
and Multinational
Corporations
2UNCTAD, World Investment Report 2007, p. 9, World Investment Report 2011, p. 24 and World Investment
Report 2015, p A7, obtained from www.unctad.org.
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230 PART 3 ADDITIONAL THEORIES AND EXTENSIONS
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To get a general picture of the size of FDI with respect to the United States, we present
information on the amount of U.S. foreign direct investment in other countries in Table
1 and on the size of FDI in the United States in Table 2. These figures represent the total
book value of accumulated FDI at the end of 2014; they are stock figures and not the
flow of new investment that occurred in 2014 alone. Book value means that the numbers
are basically the balance sheet figures recorded when the investments were made. Older
investments are thus substantially understated relative to current value because of inflation
since the time of purchase.
The data indicate that the largest portion of U.S. direct investments abroad is in
finance and insurance (14.4 percent) and manufacturing (13.5 percent). Geographically,
European countries are the host countries (i.e., recipients) of more than one-half of U.S.
FDI. Overall, the four largest recipients of U.S. direct investment in the world are the
Netherlands (15.3 percent), the United Kingdom (11.9 percent), Luxembourg (9.5 percent),
and Canada (7.8 percent).
Value ($, billions) Share (%)
(a) By Industry
Finance (except depository institutions) and insurance $ 708.9 14.4%
Manufacturing (chemicals $147.6; computers and
electronic products $99.1; food $65.7; transportation
equipment $56.0; machinery $52.9; primary and
fabricated metals $26.7; electrical equipment,
appliances, and components $12.8) 662.6 13.5
Wholesale trade 255.1 5.2
Mining 223.9 4.6
Information 161.3 3.3
Depository institutions 125.2 2.5
Professional, scientific, and technical services 108.2 2.2
Holding companies (nonbank) 2,357.6 47.9
Other industries 317.8 6.5
Total $4,920.7 100.0%
(b) By Region or Country
Europe (Netherlands $753.2; United Kingdom $587.9;
Luxembourg $465.2; Ireland $310.6; Switzerland
$152.9; Germany $115.5; France $76.8) $2,781.7 56.5%
Latin America and other Western Hemisphere
(United Kingdom islands in the Caribbean $287.5;
Bermuda $273.8; Mexico $107.8; Brazil $70.5) 897.7 18.2
Asia and Pacific [Australia $180.3; Singapore $179.8;
Japan $108.1; Hong Kong (China) $66.2; China $65.8] 738.8 15.0
Canada 386.1 7.8
Africa 64.2 1.3
Middle East 52.2 1.1
Total $4,920.7 100.0%
Note: Major components may not sum to totals because of rounding.
Source: Derrick T. Jenniges and James J. Fetzer, “Direct Investment Positions for 2014,” U.S. Department of Commerce,
Bureau of Economic Analysis, Survey of Current Business, July 2015, Table 1.2, obtained from www.bea.gov.
TABLE 1 U.S. Direct Investment Position Abroad, December 31, 2014
(Historical-Cost Basis)
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CHAPTER 12 INTERNATIONAL FACTOR MOVEMENTS 231
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Value ($, billions) Share (%)
(a) By Industry
Manufacturing (chemicals $340.1; transportation equip-
ment $110.4; machinery $91.6; food $83.7; primary
and fabricated metals $52.2; computers and electronic
products $51.1; electrical equipment, appliances, and
components $43.5) $1,045.5 36.0%
Finance (except depository institutions) and insurance 355.2 12.2
Wholesale trade 345.6 11.9
Depository institutions 219.3 7.6
Information 176.8 6.1
Professional, scientific, and technical services 118.2 4.1
Retail trade 59.3 2.0
Real estate and rental and leasing 53.0 1.8
Other industries 528.2 18.2
Total $2,901.1 100.0%
(b) By Region or Country
Europe (United Kingdom $448.5; Netherlands $304.8;
Luxembourg $242.9; Germany $224.1; Switzerland
$224.0; France $223.2) $1,977.2 68.2%
Asia and Pacific (Japan $372.8) 512.9 17.7
Canada 261.2 9.0
Latin America and other Western Hemisphere (United
Kingdom islands in the Caribbean $100.0) 127.0 4.4
Middle East 20.3 0.7
Africa 2.3 0.1
Total $2,901.1 100.0%
Note: Major components may not sum to totals because of rounding.
Source: Derrick T. Jenniges and James J. Fetzer, “Direct Investment Positions for 2014,” U.S. Department of Commerce,
Bureau of Economic Analysis, Survey of Current Business, July 2015, Table 2.2, obtained from www.bea.gov.
TABLE 2 Foreign Direct Investment Position in the United States, December 31, 2014
(Historical-Cost Basis)
For foreign investments in the United States in Table 2, note that investments held by
foreign citizens or institutions in the United States ($2,901.1 billion) are $2,019.6 billion
less than investments held abroad by U.S. citizens and institutions in Table 1 ($4,920.7 bil-
lion). The manufacturing sector easily accounts for the largest portion of FDI in the United
States. Over two-thirds of the investments have been made by Europeans. By country,
the United Kingdom is the largest source of the FDI (15.5 percent), followed by Japan
(12.9 percent), the Netherlands (10.5 percent), and Canada (9.0 percent).
Table 3 lists the 10 largest corporations in the world (measured by dollar value of rev-
enues). Table 4 then lists the 15 largest banks in the world (measured by total assets at the
start of 2014), a type of corporation of special interest to us because of banks’ involvement
in the financing of international trade and payments. The home country or “nationality” of
each firm is given in both tables following the name of the firm.
U.S. firms represent 2 of the largest 10 companies. China also has 3 firms in the top 10
(a very recent development). If the table were extended further, the United States would be
found to have 17 of the top 50 firms, China 8, France 4, Germany 4, and 3 each for Japan and
Italy. In banking, China has 4 banks in the top 15 (including the largest one), and the United
Kingdom, France, and the United States each have 3.
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232 PART 3 ADDITIONAL THEORIES AND EXTENSIONS
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It should be clear that there is considerable mobility of capital across country borders in the
world economy today. We cannot make a full examination of the reasons for this mobility,
but brief mention can be made of possible causes. Above all, economists view the move-
ment of capital between countries as fundamentally no different from movement between
regions of a country (or between industries), because the capital is moved in response
to the expectation of a higher rate of return in the new location than it earned in the old
location. Economic agents seek to maximize their well-being. Although many reasons for
capital movements have been suggested, all imply the seeking of a higher rate of return on
capital over time. We list and comment briefly on several hypotheses, many of which have
found empirical support.
Reasons for
International
Movement of Capital
Company Home Country Revenues ($, millions)
1. Wal-Mart Stores United States $485,651
2. Sinopec Group China 446,811
3. Royal Dutch Shell Netherlands 431,344
4. China National Petroleum China 428,620
5. Exxon Mobil United States 382,597
6. BP United Kingdom 358,678
7. State Grid China 339,426
8. Volkswagen Germany 268,566
9. Toyota Motor Japan 247,702
10. Glencore Switzerland 221,073
Source: “Global 500,” Fortune, obtained from www.fortune.com.
TABLE 3 World’s Largest Corporations by Revenues, 2015 (millions of dollars)
Bank Home Country Value of Assets ($, millions)
1. Industrial and Commercial Bank of China China $3,100,051
2. HSBC Holdings, PLC United Kingdom 2,671,318
3. China Construction Bank Corporation China 2,517,568
4. Mitsubishi UFJ Financial Group Japan 2,506,500
5. BNP Paribas France 2,482,608
6. JPMorgan Chase & Co. United States 2,415,689
7. Agricultural Bank of China Limited China 2,386,291
8. Credit Agricole France 2,353,229
9. Bank of China Ltd. China 2,273,581
10. Deutsche Bank AG Germany 2,222,314
11. Barclays PLC United Kingdom 2,161,178
12. Bank of America Corporation United States 2,102,273
13. Citigroup Inc. United States 1,880,382
14. Societe Generale France 1,703,575
15. The Royal Bank of Scotland Group United Kingdom 1,692,816
Source: Global Finance magazine rankings provided in “Biggest Global Banks 2014,” obtained from www.gfmag.com/.
TABLE 4 World’s Largest Banks by Total Assets, 2014 (millions of dollars)
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CHAPTER 12 INTERNATIONAL FACTOR MOVEMENTS 233
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1. Firms will invest abroad in response to large and rapidly growing markets for their
products. Empirical studies have attempted to support this general hypothesis at
the aggregative level by seeking a positive correlation between the gross domestic
product (and its rate of growth) of a recipient country and the amount of FDI flowing
into that country.
2. Similarly, because manufacturing and services production in developed countries
is catering increasingly to high-income tastes and wants (recall the product cycle
theory from Chapter 10), it can be hypothesized that developed-country firms will
invest overseas if the recipient country has a high per capita income. This sugges-
tion leads us to expect that there would be little manufacturing investment flowing
from developed countries to developing countries. However, per capita income must
be kept distinct from total income (GDP), because firms in developed countries are
eager to move into China because of its sheer market size and growth and despite its
relatively low per capita income.
3. Another reason for direct investment in a country is that the foreign firm can secure
access to mineral or raw material deposits located there and can then process the
raw materials and sell them in more finished form. Examples would be FDI in petro-
leum and copper.
4. Tariffs and nontariff barriers in the host country also can induce an inflow of FDI.
If trade restrictions make it difficult for the foreign firm to sell in the host-country
market, then an alternative strategy for the firm is to “get behind the tariff wall” and
produce within the host country itself. It has been argued that U.S. companies built
such tariff factories in Europe in the 1960s shortly after the European Economic
Community (Common Market) was formed, with its common external tariff on
imports from the outside world. Such U.S. investment continued in the 1990s as
Europe pressed for even closer economic integration and adopted a common cur-
rency for 11 countries in 1999 (now 19 countries).
5. A foreign firm may consider investment in a host country if there are low relative
wages in the host country, although studies indicate that low wages per se are not as
much an enticement for FDI as envisioned by the general public. Clearly, the exis-
tence of low wages because of relative labor abundance in the recipient country is
an attraction when the production process is labor intensive. In fact, the production
process often can be broken up so that capital-intensive or technology-intensive pro-
duction of components takes place within developed countries while labor-intensive
assembly operations that use the components take place in developing countries.
This division of labor is facilitated by offshore assembly provisions in the tariff
schedules of developed countries (see Chapter 13).
6. Firms also argue that they need to invest abroad to protect foreign market share.
Firm A, for instance reasons that it needs to begin production in the foreign market
location in order to preserve its competitive position because its competitors are
establishing plants in the foreign market currently served by A’s exports or because
firms in the host country are producing in larger volume and competing with A’s
goods. A recent example is Toyota Motors, which completed building production
facilities abroad because the high value of the yen had reduced its competitiveness in
foreign markets.3
3Chester Dawson, “For Toyota, Patriotism and Profits May Not Mix,” The Wall Street Journal, November 29,
2011, pp. A1, A16.
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IN THE REAL WORLD:
DETERMINANTS OF FOREIGN DIRECT INVESTMENT
Numerous econometric studies have attempted to ascer-
tain the factors that cause FDI flows between countries.
Reinhilde Veugelers (1991) examined data for 1980 on FDI
from developed countries to other developed countries to
determine why some recipient countries were chosen over
others. The dependent variable in Veugelers’s regression
analysis was the number of foreign affiliates (plants abroad
with at least some home firm control) of any country i
located in recipient country j as a percentage of the total for-
eign affiliates of country i. With respect to the independent
variables, a statistically significant positive relationship was
found with the GDP of the recipient country, weighted by
the degree of openness of the recipient. This finding reflects
the importance of market size and possible economies of
scale. The weight for openness was included in recognition
of the engagement of foreign affiliates in export and in rec-
ognition that a recipient country’s greater openness to trade
would permit greater exports from any affiliate. Veugelers
also found a positive relationship with FDI when the send-
ing and receiving countries shared a common language or
common boundaries. However, a negative relationship
was found with the ratio of fixed investment to GDP in the
recipient country; this was surprising because Veugelers had
expected that a high fixed-investment ratio would mean a
relatively large amount of infrastructure and thus an induce-
ment for foreign investors. Finally, labor productivity in
the recipient country, distance between the sending and
receiving countries, and tariff rates in both sets of countries
had insignificant impacts.
In an earlier study, Franklin Root and Ahmed Ahmed
(1979) examined possible influences on the inflow of FDI
into the manufacturing sector in a sample of 58 develop-
ing countries. Six variables seemed to be most important.
Other things being equal, the amount of FDI was greater:
(a) the higher the per capita GDP of the host country; (b) the
greater the growth rate in total GDP of the host country;
(c) the greater the degree of recipient country participation
in economic integration projects such as customs unions
and free-trade areas; (d) the greater the availability of infra-
structure facilities (e.g., transport and communication net-
works) in the recipient country; (e) the greater the extent of
urbanization of the recipient country; and (f) the greater the
degree of political stability in the host country.
A later study by Ray Barrell and Nigel Pain (1996) exam-
ined possible determinants of U.S. direct investment abroad
during the 1970s and 1980s. In their econometric work, they
found that world market size (as measured by the combined
GNPs of the seven largest industrialized countries) was a
stimulant to U.S. FDI, with a 1 percent rise in the combined
GNPs leading to an increase of 0.83 percent in the stock of
U.S. investment facilities abroad. In addition, they found a
positive relationship between U.S. FDI and the level of U.S.
labor costs relative to labor costs in Canada, Japan, Germany,
France, and the United Kingdom. The statistical estimate
(continued)
234 PART 3 ADDITIONAL THEORIES AND EXTENSIONS
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7. It has also been suggested that firms may want to invest abroad as a means of risk
diversification. Just as investors prefer to have a diversified financial portfolio
instead of holding their assets in the stock of a single company, so firms may wish
to distribute their real investment assets across industries or countries. If a recession
or downturn occurs in one market or industry, it will be beneficial for a firm not to
have all its eggs in one basket. Some of the firm’s investments in other industries
or countries may not experience the downturn or may at least experience it with
reduced severity.
8. Foreign firms may find investment in a host country to be profitable because of some
firm-specific knowledge or assets that enable the foreign firm to outperform the host
country’s domestic firms (see Graham and Krugman, 1995, chap. 2; and Markusen,
1995). Superior management skills or an important patent might be involved. At any
rate, the opportunity to generate a profit by exploiting this advantage in a new setting
entices the foreign firm to make the investment.
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IN THE REAL WORLD: (continued)
DETERMINANTS OF FOREIGN DIRECT INVESTMENT
was that an increase of 1 percent in relative U.S. labor costs
raised U.S. FDI by 0.49 percent. A positive association was
also evident between U.S. FDI and U.S. relative capital costs.
Further, there was some positive relation between U.S. FDI
and domestic profits in the United States—suggesting an
“availability of funds” cause. Besides these findings regard-
ing the role of market size, relative labor and capital costs, and
profits, an interesting result pertained to the exchange rate. An
expected rise in the value of the dollar relative to other cur-
rencies led to some temporary postponement of U.S. foreign
direct investment, suggesting that payments abroad associ-
ated with making the investment are delayed in anticipation
of the greater command over foreign currencies that the dollar
will have when the appreciation eventually takes place.
A 2002 paper by Romita Biswas examined econometri-
cally the determinants of U.S. foreign direct investment in
44 countries from 1983 to 1990. In particular, Biswas
focused on the influence of compensation paid per employee,
infrastructure in the receiving country (with infrastructure
being measured by installed capacity of electric generat-
ing plants per capita and by the number of main telephone
lines per capita), and total GNP. Further, political variables
such as type of regime in place (autocracy or democracy),
regime duration, rule of law, property rights (such as extent
of protection from expropriation by the government), and
amount of corruption in government were also included in
the empirical analysis. (Obviously, some of these variables
would be difficult to measure!) In general, infrastructure
was found to contribute positively and significantly to the
receipt of FDI, higher wages meant less FDI (although not in
all tests), and democracies were more attractive to FDI than
were autocracies. Greater protection of property rights also
enhanced FDI. Curiously, a longer duration of a regime sig-
nificantly reduced FDI. Biswas hypothesizes that this result
might have occurred because the longer a regime is in place,
the greater the chance that interest groups will form—groups
that decrease the flexibility and efficiency of government.
Finally, an interesting paper by Judith Dean, Mary
Lovely, and Hua Wang (2009) addressed the question of
whether environmental regulations have an impact on
incoming FDI. A standard hypothesis is that firms in high-
income countries will, other things equal, tend to locate
their production facilities in low-income countries rather
than in their own home countries because of the stricter
environmental standards in place in the high-income coun-
tries (often called a “race to the bottom” with respect to
environmental protection). Dean, Lovely, and Wang focused
on China in the 1990s, using a data set that contained almost
3,000 FDI joint-venture manufacturing facilities. (The joint-
venture enterprise involves combined ownership by the for-
eign investor and a host country firm/government and was
the common type of FDI in China during the time period.)
Because environmental standards differed across provinces
in China, the study attempted to determine whether these
different standards, after allowing for other influences on
FDI, were a factor in foreign investors’ choosing to locate
in low-standard provinces rather than in high-standard prov-
inces. Environmental regulations were represented by the
Chinese water pollution levy system, in which firms faced
a tax if certain types of pollutants were discharged or if
specified volume and concentration levels of pollution were
exceeded. The tax rate varied considerably across the prov-
inces. In the paper, the authors concluded that FDI in high-
pollution industries from ethnically Chinese sources (which
included Hong Kong, Macao, and Taiwan) was significantly
deterred from going into the provinces with the higher envi-
ronmental standards. However, the provincial location of
FDI from origins that were not ethnically Chinese did not
appear to be affected by the differing levels of environmen-
tal regulation.
In overview, there are clearly many different possible
factors leading to FDI. Important attention is being paid, and
rightfully so, to noneconomic variables as well as to tradi-
tional economic variables. ●
CHAPTER 12 INTERNATIONAL FACTOR MOVEMENTS 235
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9. Finally, differences in government policies can influence rates of return and therefore the
location of firms. For example, a contentious issue in the United States in recent years is
that some domestic firms have made the decision to merge with a foreign firm and locate
the headquarters of the combined firms abroad in response to the relatively more favor-
able tax treatment in the foreign location. This phenomenon is known as “inversion.”
A considerable amount of further empirical research is needed to determine the most
important causes of international capital mobility, and different reasons will apply to dif-
ferent industries, different periods, and different investors.
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236 PART 3 ADDITIONAL THEORIES AND EXTENSIONS
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THE EFFECTS OF INTERNATIONAL CAPITAL MOVEMENTS
The existence of substantial international capital mobility in the real world has various
implications for the output of the countries involved, for world output, and for rates of
return to capital and other factors of production. Economists employ a straightforward
microeconomic apparatus to examine these effects, and this section presents this analytical
approach. We return to this apparatus in our discussion of the international movement of
labor later in the chapter.
Figure 1 portrays the marginal physical product of capital (MPPK) schedules for coun-
tries I and II. The analysis assumes that they are the only two countries in the world, that
there are only two factors of production—capital and labor—and that both countries pro-
duce a single, homogeneous good that represents the aggregate of all goods produced in the
countries. In microeconomic theory, a marginal physical product of capital schedule plots
the additions to output that result from adding 1 more unit of capital to production when all
other inputs are held constant. With constant prices, this schedule constitutes the demand
for capital inputs derived from the demand for the product. Schedule AB shows the MPPK
in country I (MPPK I) for various levels of capital stock measured in a rightward direction
from origin 0. Analogously, schedule A′B′ indicates the MPPK in country II (MPPK II),
with the levels of capital stock measured leftward from origin 0′.
Assume in the initial (pre-international-capital-flow) situation that the capital stock in
country I is measured by the distance 0k1 and capital in country II is measured (in the left-
ward direction) by the distance 0′k1. The total world capital stock is fixed and equal to the
distance 00′, or the sum of 0k1 and 0′k1. With the standard assumption of perfect competition,
A Theoretical
Framework
for Analyzing
International Capital
Movements
FIGURE 1 Capital Market Equilibrium—The Two-Country Case
MPPKI MPPKII
MPPKI MPPKII
F E
C
B
C
B
A
r2
r1
k2
r2
r1
k10 0
A
Capital
The demand (MPPK I) for capital in country I is plotted from the left, and the demand for capital in country II (MPPK II) is plotted from the right.
The total available supply of capital in the two countries is demonstrated by the length of the horizontal axis from 0 to 0′. If markets are work-
ing perfectly, the productivity of capital (and thus the return) should be equal in both countries. Otherwise, there will be an incentive to shift
capital from lower- to higher-productivity uses. The equality condition occurs where the two demand curves intersect (point E). If E is attained,
the return to capital is the same in both countries (0r2 = 0′r′2) and 0k2 capital is employed in country I and 0′k2 capital is employed in country II,
exhausting the total supply of capital jointly available.
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IN THE REAL WORLD:
HOST-COUNTRY DETERMINANTS OF FOREIGN DIRECT
INVESTMENT INFLOWS
The United Nations Conference on Trade and Development
(UNCTAD), in its World Investment Report 1998, catego-
rized types of FDI and the general characteristics of host
countries that are considered by investors deciding whether
to undertake a project in any given country. These factors
have also been elaborated on in the context of developing
countries in a 1999 article in Finance and Development
(Mallampally and Sauvant, 1999).
The particular economic determinants of FDI, according
to the UNCTAD staff, depend on whether the FDI project
falls into one of three categories: (1) market-seeking FDI,
that is, firms that are attempting to locate facilities near large
markets for their goods and services; (2) resource-seeking
and asset-seeking FDI, that is, firms that are in search of
particular natural resources (e.g., copper in Chile) or par-
ticular human skills (e.g., computer literacy and skills in
Bangalore, a city in southern India often referred to as the
“Second Silicon Valley”); and (3) efficiency-seeking FDI,
that is, firms that can sell their products worldwide and are
in search of the location where production costs are the
lowest. These general economic determinants are listed in
the left-hand column of Table 5.
Beyond economic factors, foreign firms considering
investment in any given country will also be influenced by
various policies and attitudes of the host country’s govern-
ment. In addition, broader, more general characteristics of
the business environment (called “business facilitation”
by UNCTAD) will play a role in the investment decision.
These policy and business environment considerations, as
presented by UNCTAD, are listed in the right-hand column
of Table 5. In general, the table gives us a framework for
viewing the decision to undertake FDI in any given case. Of
course, the weights to be applied to each factor will differ
from potential host country to potential host country, and dif-
ferent weights will also be applied by different foreign firms.
Source: Padma Mallampally and Karl P. Sauvant, “Foreign Direct
Investment in Developing Countries,” Finance and Development
36, no. 1 (March 1999), p. 36. Originally appeared in United Nations
Conference on Trade and Development, World Investment Report 1998:
Trends and Determinants (Geneva: UNCTAD, 1998), p. 91. ●
Economic Determinants
Market-seeking FDI:
Market size and per capita income
Market growth
Access to regional and global markets
Country-specific consumer preferences
Structure of markets
Resource- or asset-seeking FDI:
Raw materials
Low-cost unskilled labor
Availability of skilled labor
Technological, innovative, and other created assets (e.g., brand
names)
Physical infrastructure
Efficiency-seeking FDI:
Costs of above physical and human resources and assets
(including an adjustment for productivity)
Other input costs (e.g., intermediate products, transport costs)
Membership of country in a regional integration agreement,
which could be conducive to forming regional corporate
networks
Policy Framework
Economic, political, and social stability
Rules regarding entry and operations
Standards of treatment of foreign affiliates
Policies on functioning and structure of markets (e.g., regarding
competition, mergers)
International agreements on FDI
Privatization policy
Trade policies and coherence of FDI and trade policies
Tax policy
Business Facilitation
Investment promotion (including image-building and investment-
generating activities and investment-facilitation services)
Investment incentives
“Hassle costs” (related to corruption and administrative
efficiency)
Social amenities (e.g., bilingual schools, quality of life)
After-investment services
TABLE 5 Host-Country Determinants of Foreign Direct Investment
CHAPTER 12 INTERNATIONAL FACTOR MOVEMENTS 237
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238 PART 3 ADDITIONAL THEORIES AND EXTENSIONS
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capital in country I will be paid at the rate equal to its marginal product (0r1), which is asso-
ciated with point C on schedule AB. Similarly, capital in country II will be paid at the rate
equal to its marginal product (0′r′1), which is associated with point C′ on schedule A′B′.
Remembering that total product is equal to the area under the marginal product curve at the
relevant size of capital stock, the total output (or GDP) in country I is equal to area 0ACk1
and the total output (GDP) in country II is equal to area 0′A′C′k1. (World output is of course
equal to the sum of these two areas.) The total output in country I is divided between the two
factors such that the rectangle 0r1Ck1 is the total return (or profit) of capital (i.e., the rate of
return 0r1 multiplied by the amount of capital 0k1), and workers receive the remaining output
(or income) consisting of triangle r1AC. In country II, by similar reasoning, capital receives
total return (or profit) of area 0′r′1C′k1 and labor receives the area of triangle r′1A′C′.
This situation will change if capital is permitted to move between countries because the
rate of return to capital in country I (0r1) exceeds that in country II (0′r′1). If capital mobil-
ity exists between the two countries, then capital will move from country II to country I as
long as the return to capital is greater in country I than in country II. (We are assuming that
the same degree of risk attaches to investments in each country or that the rates of return
have been adjusted for risk. We are also assuming that there is no international movement
of labor.) In Figure 1, the amount of capital k2k1 in country II moves to country I to take
advantage of the higher rate of return. This FDI by country II in country I bids down the
rate of return in country I to 0r2. On the other hand, because capital is leaving country II,
the rate of return in country II rises from 0′r′1 to 0′r′2. In equilibrium, the MPPK in the
two countries is equal, and this is represented by point E, where the two marginal physical
product of capital schedules intersect. At this equilibrium, the rate of return to capital is
equalized between the countries (at 0r2 = 0′r′2), and there is no further incentive for capital
to move between the countries.
What has been the effect of capital flow k2k1 from country II to country I on output in
the two countries and on total world output? As expected, total output has risen in country
I because additional capital has come into the country to be used in the production process.
Before the capital flow, output in country I was area 0ACk1, but output has now increased
to area 0AEk2. Thus, output in country I has gone up by the area k1CEk2. In country II, there
has been a decline in output. The before-capital-flow output of 0′A′C′k1 has been reduced
to the after-capital-flow output of 0′A′Ek2, a decrease by the amount k1C′Ek2. However,
world output and thus efficiency of world resource use has increased because of the free
movement of capital. World output has increased because the increase in output in country I
(area k1CEk2) is greater than the decrease in output in country II (area k1C′Ek2). The extent
to which world output has increased is indicated by the triangular shaded area C′CE. Thus,
just as free international trade in goods and services increases the efficiency of resource use
in the world economy, so does the free movement of capital—and of factors of production
in general. In addition, free movement of factors can equalize returns to factors in the two
countries, just as free international trade in the Heckscher-Ohlin model could lead to factor
price equalization between the countries. In recognition of these parallel implications of
trade and factor mobility for efficiency of resource use and returns to factors, economists
often stress that free trade and free factor mobility are substitutes for each other.
Some comments also can be made about the total return to each of the factors of produc-
tion in the two countries. The total return to country I’s owners of capital was 0r1Ck1 before
the capital movement, but it has now fallen to the amount 0r2Fk1 (a decline by the amount
r2r1CF). The return to country II’s owners of capital has increased from 0′r′1C′k1 to 0′r′2Fk1,
an increase by the amount r′1r′2FC′. While we know that owners of capital in country I have
been injured and those in country II have gained from the capital flow, we cannot say any-
thing about the sum of the two returns (and thus of world profits) unless more information
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CHAPTER 12 INTERNATIONAL FACTOR MOVEMENTS 239
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is available on the slopes of the MPPK schedules and the size of the capital flow. However,
because world output has increased, it is theoretically possible to redistribute income so that
both sets of capital owners could be better off than they were prior to the capital movement.
A similar conclusion applies to labor. Workers in country I have received an increase in
their total wages, because before-capital-flow wages consisted of area r1AC while after-
capital-flow wages are indicated by area r2AE (an increase in wages by the amount r2r1CE).
In country II, wages have fallen because workers now have less capital with which to work.
The wage bill in country II prior to the capital flow was area r′1A′C′, and it has decreased
to r′2A′E after the capital flow(a decrease by the amount r′1r′2EC′). Again, no a priori state-
ment can be made about the impact of the capital flow on total wages in the world without
more information, but the increase in world output (and income) suggests that all workers
could be made better off by income redistribution policies.
Finally, we can make unambiguous statements about the impact of the capital flow on
national income [or gross national product (GNP)—the product of a country’s nationals or
citizens] in both countries. The income of country I’s citizens consists of total wages plus
total profits. We have seen that the capital flow has increased total wages by area r2r1CE and
has decreased the returns to the owners of capital by area r2r1CF. Comparison of these two
areas indicates that the income of workers rises by more than the income of capital owners
falls in country I; we conclude that national income or GNP—the income of the factors of
production—in country I increases because of the capital inflow (by triangular area FCE).
(GDP—the total output produced within a country—for country I has risen by k1CEk2.
However, area k1FEk2 of that amount accrues to country II’s investors.) Analogously, the capi-
tal outflow in country II causes total wages to fall by area r′1r′2EC′ and the total returns to own-
ers of capital to rise by area r′1r′2FC′. National income (GNP) in country II thus increases by
amount C′FE. Country II has higher income (GNP) despite the fact that the output produced
in II (its GDP) has fallen from area 0′A′C′k1 to area 0′A′Ek2. Hence, both countries gain from
international capital mobility. Restrictions on the flow of FDI have an economic cost of lost
efficiency in the world economy and lost income in each of the countries.
In this section, we cover some of the alleged benefits and costs of a direct capital inflow
to a host country. (For an expanded discussion of many of these points, see Meier, 1968,
1995.) While there are also benefits and costs to the home country from capital outflow, we
focus only on host-country effects. The focus on impacts to the host country particularly
permits us to discuss developing countries more prominently.
A wide variety of benefits may result from an inflow of FDI. These gains do not occur
in all cases, nor do they occur in the same magnitude. Several of the potential gains are
listed here.
Increased output. This impact was discussed earlier. The provision of increased capi-
tal to work with labor and other resources can enhance the total output (as well as output
per unit of input) flowing from the factors of production.
Increased wages. This was also discussed earlier. Note that some of the increase in
wages arises as a redistribution from the profits of domestic capital.
Increased employment. This impact is particularly important if the recipient country is
a developing country with an excess supply of labor caused by population pressure.
Increased exports. If the foreign capital produces goods with export potential, the host
country is in a position to generate scarce foreign exchange. In a development context, the
additional foreign currency can be used to import needed capital equipment or materials to
assist in achieving the country’s development plan, or the foreign exchange can be used to
pay interest or repay some principal on the country’s external debt.
Potential Benefits
and Costs of Foreign
Direct Investment to
a Host Country
Potential Benefits
of Foreign Direct
Investment
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Increased tax revenues. If the host country is in a position to implement effective tax
measures, the profits and other increased incomes flowing from the foreign investment
project can provide a source of new tax revenue to be used for development projects.
However, the country must spend such revenue wisely and refrain from imposing too high
a rate of taxation on the foreign firm, as this high taxation might cause the firm to leave
the country.
Realization of scale economies. The foreign firm might enter into an industry in which
scale economies can be realized because of the industry’s market size and technological
features. Home firms might not be able to generate the necessary capital to achieve the cost
reductions associated with large-scale production. If the foreign investor’s activities realize
economies of scale, consumer prices might be lowered.
Provision of technical and managerial skills and of new technology. Many econo-
mists judge that these skills are among the scarcest resources in developing countries. If
so, then a crucial bottleneck is broken when foreign capital brings in critical human capital
skills in the form of managers and technicians. In addition, the new technology can clearly
enhance the recipient country’s production possibilities.
Weakening of power of domestic monopoly. This situation could result if, prior to the
foreign capital inflow, a domestic firm or a small number of firms dominated a particular
industry in the host country. With the inflow of the direct investment, a new competitor is
provided, resulting in a possible increase in output and fall in prices in the industry. Thus,
international capital mobility can operate as a form of antitrust policy. A recent example of
the potential for this is the effort by U.S. telecommunications firms to gain greater access
to the Japanese market. The difficulties associated with competition from foreign investors
were illustrated in 2011 when the Indian government decided to permit foreign investors
in the retail sector to form joint ventures with local retailers whereby the foreign investor
could have majority ownership. Domestic protests resulted in the government rescinding
this decision. The only foreign-investor-dominated joint ventures then permitted were for
single-brand retailers (e.g., Starbucks, Nike). However, it was decided in 2012 that many-
brand retailers (e.g., Walmart, Target) could also enter.
Some alleged disadvantages to the host country from a foreign capital inflow are listed and
briefly discussed.
Adverse impact on the host country’s commodity terms of trade. As you will recall, a
country’s commodity terms of trade are defined as the price of a country’s exports divided
by the price of its imports. In the context of FDI, the allegation is sometimes made that the
terms of trade will deteriorate because of the inflow of foreign capital. This could occur if
the investment goes into production of export goods and the country is a large country in
the sale of its exports. Thus, increased exports drive down the price of exports relative to
the price of imports.
Transfer pricing is another mechanism by which the host country’s terms of trade
could deteriorate. The term transfer prices refers to the recorded prices on intrafirm inter-
national trade. If one subsidiary or branch plant of a multinational company sells inputs
to another subsidiary or branch plant of the same firm in another country, no market price
exists; the firm arbitrarily records a price for the transaction on the books of the two subsid-
iaries, leaving room for manipulation of the prices. If a subsidiary in a developing country
is prevented from sending profits home directly or is subject to high taxes on its profits,
then the subsidiary can reduce its recorded profits in the developing country by understat-
ing the value of its exports to other subsidiaries in other countries and by overstating the
value of its imports from other subsidiaries. What happens is that the country’s recorded
terms of trade are worse than they would have been if a true market price was used for
these transactions.
Potential Costs
of Foreign Direct
Investment
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Decreased domestic saving. The allegation, in the context of a developing country, is
that the inflow of foreign capital may cause the domestic government to relax its efforts to
generate greater domestic saving. If tax mechanisms are difficult to put into place, the local
government may decide there is no need to collect more taxes from a low-income popula-
tion for the financing of investment projects if a foreign firm is providing investment capi-
tal. The forgone tax revenues can be used for consumption rather than saving. This is only
one of several possible mechanisms for achieving the same result.
Decreased domestic investment. Often the foreign firm may partly finance the direct
investment by borrowing funds in the host country’s capital market. This action can drive
up interest rates in the host country and lead to a decline in domestic investment through
a “crowding-out” effect. In a related argument, suppliers of funds in the developing coun-
try may provide financial capital to the MNC rather than to local enterprise because of
perceived lower risk. This shift of funds may divert capital from uses that could be more
valuable to the developing countries.
Instability in the balance of payments and the exchange rate. When the FDI comes
into the country, it usually provides foreign exchange, thus improving the balance of pay-
ments or raising the value of the host country’s currency in exchange markets. However,
when imported inputs need to be obtained or when profits are sent home to the country
originating the investment, a strain is placed on the host country’s balance of payments and
the home currency can then depreciate in value. A certain degree of instability will exist
that makes it difficult to engage in long-term economic planning.
Loss of control over domestic policy. This is probably the most emotional of the vari-
ous charges levied against FDI. The argument is that a large foreign investment sector
can exert enough power in a variety of ways so that the host country is no longer truly
sovereign. For example, this charge was levied forcefully against U.S. direct investment in
western Europe in the 1960s and it has often been raised against U.S. FDI into developing
countries. Also, the U.S. government has in place a Committee on Foreign Investment in
the United States (CFIUS) that examines proposed FDI projects in the United States with
respect to their impact on national security. If security is likely to be endangered, the FDI
will not be permitted.
Increased unemployment. This argument is usually made in the context of developing
countries. The foreign firm may bring its own capital-intensive techniques into the host
country; however, these techniques may be inappropriate for a labor-abundant country.
The result is that the foreign firm hires relatively few workers and displaces many others
because it drives local firms out of business.
Establishment of local monopoly. This is the converse of the presumed “benefit” that
FDI would break up a local monopoly. On the “cost” side, a large foreign firm may under-
cut a competitive local industry because of some particular advantage (such as in technol-
ogy) and drive domestic firms from the industry. Then the foreign firm will exist as a
monopolist, with all the accompanying disadvantages of a monopoly.
Inadequate attention to the development of local education and skills. First pro-
pounded by Stephen Hymer (1972), this argument has the multinational company reserv-
ing the jobs that require expertise and entrepreneurial skills for the head office in the home
country. Jobs at the subsidiary operations in the host country are at lower levels of skill and
ability (e.g., routine management operations rather than creative decision making). The
labor force and the managers in the host country do not acquire new skills.
No general assessment can be made regarding whether the benefits outweigh the costs.
Each country’s situation and each firm’s investment must be examined in light of these
various considerations, and a judgment about the desirability of the investment can be
clearly positive in some instances and negative in others. These considerations get us
Overview of Benefits
and Costs of Foreign
Direct Investment
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beyond the simple analytical model discussed earlier in this chapter, where the capital flow
was always beneficial in its impact.
Developed and developing countries often try to institute policies that will improve
the ratio of benefits to costs connected with a foreign capital inflow. Thus, performance
requirements are frequently placed on the foreign firm, such as stipulating a minimum
percent of local employees, a maximum percent of profits that can be repatriated to the
home country, and a minimum percent of output that must be exported to earn scarce
foreign exchange. In addition, the output of the firm may be subject to domestic content
requirements on inputs, or foreign firms may be banned altogether from certain key indus-
tries. Some progress toward eliminating such distortionary performance requirements was
made in the Uruguay round of trade negotiations in the 1990s.
Finally, brief mention can be made of the fact that clearly there are impacts of FDI on
the sending or home country of the investment as well as on the receiving or host country.
As noted in the discussion of Figure 1, the sending country (country II in the figure) experi-
ences a reduction in its GDP (although an increase in its national income or gross national
product), a reduction in total wages, and an increase in the total return to its investors.
The country could also undergo such effects as a loss of tax revenue from the investing
firms (depending on tax treaty arrangements between the sending and the receiving coun-
try of the FDI) and a loss of jobs. International trade could also be affected—for example,
exports from the FDI-sending country could rise if the new plants abroad obtained inputs
from home sources. Alternatively, exports from the sending country could fall if the new
plant was set up abroad to supply the foreign market from the foreign country itself rather
than through export from the home country (as in the product cycle theory in Chapter 10).
On the import side, imports into the home country could increase if the new FDI plant
assembles or produces relatively labor-intensive products in a relatively labor-abundant
host country and the home country is a relatively capital-abundant country. Other effects in
practice, of course, depend on the particular investment project being considered.
CONCEPT CHECK 1. What is the difference between foreign direct
investment and foreign portfolio investment?
2. Suppose that there is an increase in the
productivity of capital in country II. What
happens to the location of capital between
country I and country II?
3. What are the principal costs and benefits of
foreign direct investment to the host country?
What might be the principal costs and bene-
fits of foreign direct investment to the invest-
ing country?
LABOR MOVEMENTS BETWEEN COUNTRIES
The Winkelmann farming group, headed by two brothers, grew, in a relatively short time, from a
local asparagus farm in Germany to a position as one of the top 10 white asparagus suppliers in
the country. The firm relies heavily on temporary immigrant workers for harvesting its crops—
from a situation of owning 2.5 acres and using two migrant workers in 1989, the Winkelmanns
expanded into the former Democratic Republic of Germany (East Germany) after German reuni-
fication in 1990 and, in 2002, owned 2,500 acres of land and employed almost 4,000 migrant
workers. Workers, 80 percent of whom are Polish, are hired after a thorough recruitment process
Seasonal Workers
in Germany4
4This discussion as well as the next one, “Permanent Migration: A Greek in Germany,” are drawn from chapter 4
of Scott Reid, “Germany and the Gastarbeiterfrage: A Study of Migration’s Legacy in Germany, 1815–2003,”
senior thesis, Center for Interdisciplinary Studies, Davidson College, April 2003. We thank Scott Reid for permis-
sion to utilize his material.
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CHAPTER 12 INTERNATIONAL FACTOR MOVEMENTS 243
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that includes extensive background checks and training in the workers’ home country. The work-
ers are employed for three months per year, and they are then sent home, with transportation for
the trip home paid for by the Winkelmanns. (The Winkelmanns employ only workers who have a
job at home, a job to which they can return after the three months’ employment in Germany has
been completed.) While in Germany, the temporary migrants receive housing and insurance from
the Winkelmanns, and Polish workers can earn wages in the three months that are equivalent to
150 percent of a year’s pay in Poland.
This temporary migration system is of considerable value to the Winkelmanns and to other
farms like theirs, but it also appears to benefit Germany in its agricultural production. Germany
gains because it has been difficult to recruit Germans to harvest the asparagus, apparently because
the work is physically demanding and pays relatively low wages (relatively low for the Germans
but not for the Poles).
Hasan Touzlatzi is a Muslim from West Thrace, Greece, who lives in Espelkamp, a small town
in Germany. He grew up in a poor family in Greece, and he left West Thrace at age 20 in 1970
to go to Germany for temporary work. Hasan traveled to Germany with other temporary “guest
workers,” and the trip had been organized by the German government. He was provided with a
job in a firm in Espelkamp, and, at least partly because he began learning the German language as
soon as he arrived in the country, he advanced quickly with the firm. When the firm later folded,
Hasan decided on several successive occasions, although planning only for a short extension on
each occasion, to stay on in his new country. His wife joined him and, after children were born,
the Touzlatzis became permanent residents so that their children could benefit from the German
education system.
Hasan Touzlatzi has become a respected and prominent member of the Espelkamp commu-
nity, where he has lived for more than 30 years. He owns a flower shop, is active in a local club of
immigrants from West Thrace, and participates regularly in the Espelkamp Muslim prayer room
and mosque. He and his family and other fellow migrants are solid parts of the German com-
munity and economy, although ties continue with their homeland. (For example, two of Hasan’s
sons went to Greece to serve in the Greek army, and Hasan has kept his Greek citizenship.)
The Touzlatzis are permanent immigrants who have become integrated into their host country,
although they retain identification with their homeland.
These two vignettes offer examples of temporary migration and permanent migration
between countries. Just as capital moves in large volume across country borders, so too does
labor. The World Bank has estimated that, in 2013, 247 million people, or about 3.4 percent
of the world population did not reside in the countries in which they were born.5 On an indi-
vidual country basis, as examples, 23.9 percent of Australia’s population were foreign-born
in 2006, 9.7 percent of the United Kingdom’s population in 2005 had been born in another
country, and, for Spain, the figure was 13.1 percent in 2008.6 For the United States in 2012,
40.0 million people were foreign-born,7 which constituted 12.9 percent of the population.
In addition, of course, there has been, over the past few decades, considerable illegal as well
as legal migration into the United States, with the illegal immigration (generally thought
to be about 11 million people) having been extremely controversial. This number is lower
than other estimates, but it is also likely that the size of the illegal immigrant population
declined in several years immediately following 2007 and 2008, when recession conditions
dampened the job prospects for immigrants and led to a reduced inflow. While there are
many different reasons for large-scale migration, including economic, political, and famil-
ial ones, we focus mainly on the economic causes and consequences in this chapter.
Permanent Migration:
A Greek in Germany
5The World Bank, Migration and Development Brief 24, April 13, 2015, obtained from www.worldbank.org.
6Obtained from www.migrationinformation.org/datahub.
7U.S. Census Bureau, Table on “Population by Sex, Age, Nativity, and U.S. Citizenship Status: 2012” Obtained
from www.census.gov.
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IN THE REAL WORLD:
MIGRATION FLOWS INTO THE UNITED STATES, 1986 AND 2013
As is well known and has been the source of considerable
controversy, the number of annual migrants into the United
States has increased in recent decades. Table 6 gives data
on the total number of immigrants and their sources* for
1986 and 2013. In 1986 there were 601,708 immigrants;
in 2006 the annual inflow had more than doubled to
1,266,129, but declined by 2013 to 990,553. (Note, of
course, that there is likely to be some understatement in
the totals because it is very difficult to get a precise count
of all immigrants.)
Beyond these totals, Table 6 also indicates the regions
of origin of the migrants, as well as the leading countries
of origin. As can be seen, the two largest regional sources
are the Americas and Asia. Asian immigrants in 1986
constituted 44.6 percent of the total flow, while migrants
from Latin America and the Caribbean accounted for
41.5  percent. These two regions continued to dominate in
2013, with the number of immigrants from the Americas
falling slightly to 40.0 percent and those from Asia falling to
40.4 percent. Whereas the large majority of U.S. immigrants
in the late 19th and early 20th centuries came from Europe,
the European countries sent only 10.4 percent of the total
U.S. immigrants in 1986 and only 8.7 percent in 2013.
Looking at the countries of origin, Mexico was the lead-
ing source country in both years, with 11.1 percent in 1986
and 13.6 percent in 2013. The absolute number of Mexican
immigrants in 2013 was more than twice the number of
Mexican immigrants in 1986, although declining in number
in very recent years. China was the second-largest source
country in 2013 (7.2 percent of the total), while it had been
eighth-largest in 1986. The number of Chinese immigrants
in the annual flow nearly tripled between the two years. The
Philippines, which had been the second-largest source in
1986, was fourth-largest in 2013. India sent 68,458 migrants
(third-largest source at 6.9 percent) in 2013 (many of them
entering the United States under the H-1 skilled-labor visa
program), compared with 26,227 in 1986 (sixth-largest
source at 4.4 percent). Finally, the Republic of Korea, which
had been the third-largest source country in 1986, dropped
to eighth-largest in 2013.
*Inflow of new legal permanent residents by country of birth.
TABLE 6 U.S. Inflow of Foreign Population, 1986 and 2013
Region of Origin Number, 1986 Percentage of Total Number, 2013 Percentage of Total
Africa 17,463 2.9% 98,301 9.9%
The Americas 249,588 41.5 396,598 40.0
Asia 268,248 44.6 400,541 40.4
Europe 62,512 10.4 86,549 8.7
Other/Unknown 3897 0.6 8,558 0.9
Total 601,708 990,553
Largest Countries
of Origin Number, 1986 Percentage of Total
Largest Countries
of Origin Number, 2013 Percentage of Total
Mexico 66,533 11.1% Mexico 135,028 13.6%
Philippines 52,558 8.7 China 71,798 7.2
Korea, Republic of 35,776 5.9 India 68,458 6.9
Cuba 33,114 5.5 Philippines 54,446 5.5
Vietnam 29,993 5.0 Dominican Republic 41,311 4.2
India 26,227 4.4 Cuba 32,219 3.3
Dominican Republic 26,175 4.4 Vietnam 27,107 2.7
China 25,106 4.2 Korea, Republic of 23,214 2.3
Source: Migration Policy Institute, “MPI Data Hub,” obtained from www.migrationinformation.org/DataHub/countrydata/data.cfm. and
migrationpolicy.org/programs/data-hub. ●
244 PART 3 ADDITIONAL THEORIES AND EXTENSIONS
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Technically, the desire to migrate on the part of an individual depends on the expected
costs and benefits of the move. Expected income differences between the old and new
location, costs of the move, cost-of-living differences between the two locations, and other
nonpecuniary net benefits in the new location such as health facilities, educational oppor-
tunities, or greater political or religious freedom figure into the decision to migrate. Even
within this more general framework, expected wage or income differences are an important
factor. At the same time, the movement of labor can influence the average wage in both
the old and the new locations. For both countries, the movement of labor thus has welfare
implications similar to capital movements and trade in goods and services.
The economic implications of labor movements between countries can be observed most
readily by using a figure similar to that used for capital. Assuming that labor is homoge-
neous in the two countries and mobile, labor should move from areas of abundance and
lower wages to areas of scarcity and higher wages. This movement of labor causes the wage
rate to rise in the area of out-migration and to fall in the area of in-migration. In the absence
of moving costs, labor continues to move until the wage rate is equalized between the two
regions (see Figure 2). The labor force of both countries is represented by the length of the
horizontal axis. The demand (the marginal physical product) for labor in each country is
denoted by demand curves DI and DII. If markets are working perfectly and labor is mobile,
the wage in both countries should settle at 0Weq, and 0L1 labor will be employed in country I
and L10′ in country II. Suppose that the markets have not jointly cleared and that the wage in
country I remains below that of country II. This would be the result if 0L2 existed in country
I and country II had only L20′ labor. If labor now responds to the wage difference, labor
should move from country I to country II. As this takes place, the wage in country I should rise
while that in country II should fall until 0Weq exists in both countries. As these adjustments
occur, output falls in country I and rises in country II. The remaining laborers in country
I are better off both absolutely (due to the higher wage) and relatively, as the productivity of
Economic Effects of
Labor Movements
FIGURE 2 Labor Market Equilibrium—The Two-Country Case
WI ,MP PL I
D
B
L2L 10
A
WII ,MPP L I I
WII
WI
Weq
MPP L I I = D I IMPP L I = D I
F
G
C
Labor
W
ag
e
0
The demand for labor in country I (the MPPL I = DI) is graphed from the left, and the demand for labor in country II (the MPPL II = DII) is graphed
from the right. The total supply of labor available in both countries is indicated by the length of horizontal axis 00′. If labor markets are working
perfectly and there are no barriers to labor movements, labor will move between countries until the MPP of labor (and thus the wage) is every-
where the same. This occurs at point A with the resulting equilibrium wage, 0Weq; 0L1 labor is employed in country I, and L10′ labor is employed
in country II.
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the other factors falls with the reduced labor supply. In country II, the opposite takes place.
With the fall in the wage rate in country II, labor is less well-off. Productivity of the other
factors, however, has risen with the increased use of labor, so owners of these factors are
better off. The other factors in country II gain area ABFGD, while country II’s labor loses
area DBFG. The amount of income earned by the new migrants is L1ADL2.
What can be said about the change in overall well-being in country I, country II, and the
world as a result of the labor movement? Given the existence of diminishing marginal pro-
ductivity of labor in production, other things being equal, output (GDP) in country I falls at
a slower rate than the decrease in the labor force, leading to an increase in per capita output.
In country II, output (GDP) grows more slowly than the increase in the labor force, leading
to a decrease in per capita output. Finally, the world as a whole gains from this migration
since the fall in total output in country I (area L1ACL2) is more than offset by the increase
in output in country II (area L1ABL2) by the shaded area ABC.
An even clearer case of world gains from migration occurs if it is assumed that market
imperfections within country I lead to an initial excess supply of labor. Now not only do
wages differ between country I and country II, but also some labor remains unemployed
in country I at the institutional (traditional) wage rate. This above-equilibrium wage could
be the result of minimum wage laws and labor union-induced downward wage rigidity in
manufacturing or of the existence of an agricultural sector where families simply divide
up farm output among all members (workers thus receive their average product, not their
marginal product). This excess supply is often called surplus labor in the economic devel-
opment literature. Figure 3 shows distance L20′ as the amount of labor available in country
II, and distance 0L2 as the amount of labor in country I. The labor in country II is employed
at the domestic equilibrium wage of 0′WII while in country I the prevailing wage rate is 0WI
FIGURE 3 The Effect of Labor Migration in the Case of Surplus Labor
WI,MP P L I WII, MPP L I I
D IID I
B
A
D
C
Leq L 1 L 2
WII
W II
Weq
W I
W Ieq
WII
Weq
0 0
Labor
W
ag
e
An initial state of market disequilibrium exists with a wage rate of 0′WII in country II and of 0WI in country I. The wage difference is accom-
panied by unemployment of L1L2 workers in country I (I’s initial labor force is 0L2). The movement of these unemployed workers to country II
causes output to increase in country II and the wage in country II to decline to 0W′II. Because these workers were not employed in country I prior
to migrating, output in country I remains unchanged, and per capita income increases. Complete market adjustment (equalization of labor produc-
tivity and wages) requires that LeqL1 additional workers migrate from country I to country II. This movement causes the wage in country II to fall
even further (to 0Weq) while at the same time causing the wage in country I to increase to 0Weq.
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FIGURE 4 The Growth Effects of Labor Market Adjustment and Migration
(PT /PA)
Textilest1 t0
Autos
a1
a0
TextilesT1T0
Autos
A1
A0
(PT /PA)
Country I Country II
The movement of labor from country I to country II is indicated by the outward shift of the PPF for country II and the inward shift of the PPF
for country I. Assume that country I is the labor-abundant country exporting the labor-intensive good (textiles) and importing the capital-
intensive good (autos) prior to the labor migration and that the two countries in question are small countries. The Rybczynski theorem indicates
that this change in relative labor supplies will lead country I to contract production of textiles (the labor-intensive good) from t0 to t1 and expand
production of autos from a0 to a1. Country II, on the other hand, will expand production of textiles from T0 to T1 with the newly acquired labor
and reduce the production of autos from A0 to A1. Both production adjustments are ultra-antitrade in nature since factor flows have in effect
substituted for trade flows.
(instead of the lower, market-clearing 0W′Ieq), leading to only 0L1 people being employed.
L1L2 people are thus currently unemployed at the prevailing wage rate. Migration of unem-
ployed workers L1L2 from country I to country II in this case leads to an expansion of output
in country II without any reduction in output in country I. Complete equalization of wages
requires that additional LeqL1 workers move from country I to country II so that Leq0′ workers
are employed in country II. If this additional migration occurs, output in country I declines
because previously employed labor, LeqL1, leaves the country. The effect of migration result-
ing from surplus labor, while similar in direction to that in the earlier full-employment case,
produces different magnitudes of results. The gain in per capita output in country I caused
by the migration is clearly greater because the loss of unemployed workers, L1L2, does not
affect country I’s total output. The increase in total output and the decline in per capita
output in country II is the same as before (see Figure 2), and the net world gain (area ABC
plus area L1DCL2—the shaded area) is larger by L1DCL2, that is, the value of production for-
gone in country I as a result of the unemployment. This example points out that the greater
the number of market imperfections—in this case a domestic market distortion (failure of the
domestic labor market in country I to clear) and an international distortion (differential wage
rates across countries)—the greater the potential gains from removing these distortions.
Migration of labor (or capital) also affects the composition of output and structure of
trade in the countries involved. The inflow of labor into country II is similar in effect to
growth in the labor force discussed in Chapter 11 (see Figure 4). Given full employment, at
constant international prices, the increase in the labor force in country II leads, according to
the Rybczynski theorem, to an expansion of output of the labor-intensive good (textiles) and
a contraction in output of the capital-intensive good (autos). Assuming that country I is the
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labor-abundant country, that country II is the capital-abundant country, and that trade between
the two follows the Heckscher-Ohlin pattern, the effect of the labor movement between the
two can be examined. Output of the export good in country II declines and output of the
import good increases. Thus, the production trade effect is an ultra-antitrade effect.
In a similar fashion, the reduction in labor in country I causes production of the labor-
intensive good to fall and production of the capital-intensive good to rise. The production
effects in both countries are symmetric and are ultra-antitrade in nature. The total effect of
the labor movement on the volume and structure of trade will ultimately depend not only
on the production effects but also on the consumption effects, which reflect the income
changes and the income elasticity of demand for the two products in both countries. Finally,
this analysis assumes the absence of any price distortions in either country and assumes that
international prices do not change as a result of the factor movements. Price distortions and
changes in international prices could alter these conclusions. The analysis of factor move-
ments with price distortions and world price changes is beyond the scope of this text.
The previous models help us understand some of the basic issues that affect the politics
of labor migration. It is not surprising that labor in country II wants restrictions against
immigration because new workers lower the wage rate. For example, in early 2009, strikes
occurred in the United Kingdom as workers protested that the French oil firm Total had
awarded a U.K. construction contract to a company that would bring in foreign workers for
use in production in the United Kingdom.8 On the other hand, owners of other resources
such as capital favor immigration because it increases their returns. At the same time, labor
in country I favors out-migration (emigration), while capital owners tend to discourage the
labor movement. While the simple models are useful in providing an understanding of the
basic economics involved, several extensions of this analysis are important to discuss briefly.
First, the new immigrant might transfer some income back to the home country.
When this happens, the reduction in income (from home production) in country I is at
least partly offset by the amount of the transfer, while the increase in income resulting
from the increased employment in country II is reduced by the amount of the transfer.
Assuming that the transfer is between labor in the two countries, labor income in country I
is enhanced and total income (and per capita income) available to the labor force in country
II is further reduced. In fact, a study of remittances submitted by Greek emigrants indicated
that the income, employment, and capital formation benefits to Greece from these remit-
tances were substantial, while the costs of the emigration itself to Greece were limited
(see Glytsos, 1993). More recently, the top four remittance-receiving countries in 2014
were India (estimated to have received $70.4 billion), China ($64.1 billion), the Phillipines
($28.4 billion), and Mexico ($24.9 billion). In 2014, an estimate in total was that develop-
ing countries received $436 billion in remittances. Developed countries also, of course,
receive immigrant remittances ($146 billion in 2014).9 For comparison purposes, remit-
tances received by the developing countries were almost 3 times the amount of official
foreign aid received by these countries.
A second issue is the nature of the immigration. We have assumed so far that the immi-
gration is permanent, not temporary. A temporary worker, such as a Polish asparagus
worker in Germany in the earlier vignette, is often called a guest worker. In the preceding
analysis, all workers were assumed to be identical and the new immigrant thus received
the same wage-benefit package as the domestic worker. This is not an unrealistic assump-
tion because many countries do not permit employers to discriminate against permanent
Additional
Considerations
Pertaining to
International
Migration
8Neil King, Jr., Alistair MacDonald, and Marcus Walker, “Crisis Fuels Backlash on Trade,” The Wall Street
Journal, January 31–February 1, 2009, pp. A1, A6.
9World Bank, Migration and Development Brief 24, April 13, 2015, obtained from www.worldbank.org.
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IN THE REAL WORLD:
IMMIGRANT REMITTANCES
A neglected economic feature in the immigration debate
(both with respect to legal immigration and illegal immigra-
tion) is the flow of funds that occurs from the immigrants
to their relatives back in their home countries. These flows
can have significant effects on the countries from which the
migrants originated.
A 2011 set of estimates of the World Bank suggested the
magnitude and impact of these flows. Immigrant remittances
were estimated to be $416 billion during 2009, with $307 billion
of that amount going to developing countries. However, these
were only the recorded flows. In fact, unrecorded flows in
2009 to the developing countries were thought to be at least
50 percent larger than the recorded flows, which implies
a total annual flow of about three-quarters of a trillion dol-
lars [$307  billion  +  (1.50)($307  billion)  =  $768  billion].
In fact, even using only the recorded flows, the remittances
were the second largest item in external funds received by
developing countries (behind FDI). The funds were consid-
erably larger than the amount of foreign aid received from
developed countries. For specific countries as examples, data
indicate that in 2008, Bangladesh received $9.0 billion in
remittances and $2.1 billion in aid, Brazil received $5.1 billion
in remittances and $500 million in aid, and the Dominican
Republic received $3.6 billion in remittances and only
$200 million in aid. It has also been estimated that remittances
to Mexico were equivalent to 2.8 percent of Mexico’s GDP in
2008. Research suggests that remittance flows from the United
States to Mexico are influenced by a number of factors includ-
ing social capital, exchange rates, interest rate differentials,
income, and proximity of migrants to Mexico. Interestingly,
illegal immigrants to the United States from Mexico seemed
more likely to send funds back to their families than did legal
immigrants to the United States from Mexico.
Remittances of this size can clearly benefit the recipient
countries. An estimate by the World Bank is that such remit-
tances have reduced the poverty rate by almost 11 percentage
points in Uganda, 6 percentage points in Bangladesh, and
5 percentage points in Ghana. Such funds help the recipients
purchase consumer goods, housing, education, and health
care. The effect also seems to be countercyclical—when the
fund-receiving countries go into recession, for example, the
inflow of remittances seems to increase (in contrast to regular
private capital flows, which would decrease in that instance).
In addition, when substantial labor migrates abroad, this out-
migration can relieve some of a labor surplus in the sending
country and put upward pressure on wage rates.
The sizeable level of remittances does not necessarily
imply that the migrant outflow from the home countries is
therefore a positive force for those countries, however. When
the migrants leave, they often take substantial human capital
with them because the migrants can be high-skilled work-
ers. The tax base in the labor-sending countries is also being
eroded when the workers leave—one estimate was that in
2001, immigrant Indians in the United States were equiva-
lent to 0.1 percent of India’s population but equivalent to
10 percent of the national income of India. This fact meant
that India’s lost tax revenue was perhaps equal to 0.5 percent
of its GDP. In addition, large remittances into a country can
lead to a rise in the value of that country’s currency and thus
to a reduction in the country’s ability to export. Further, the
inflow of funds may have an adverse impact on the work
effort of the family members receiving the funds and thus
reduce economic growth.
In summary, the size of immigrant remittances pres-
ently being transmitted is substantial. There are positive and
negative effects associated with the migration flow and with
the remittances, and the net impacts on the home countries
receiving the funds will vary from case to case. In any event,
in today’s world, these flows and their impacts clearly need
to be included in any analysis of labor migration.
Sources: Dilip Ratha, “Remittances: A Lifeline for Development,”
Finance and Development 42, no. 4 (December 2005), pp. 42–43;
“Sending Money Home: Trends in Migrant Remittances,” Finance
and Development 42, no. 4 (December 2005), pp. 44–45; Gordon
H. Hanson, “Illegal Migration from Mexico to the United States,”
Journal of Economic Literature 44, no. 4 (December 2006), p. 872;
Kasey Q. Maggard, “The Role of Social Capital in the Remittance
Decisions of Mexican Migrants from 1969 to 2000,” Federal
Reserve Bank of Atlanta Working Paper 2004–29, November
2004; The World Bank, Migration and Remittances Factbook 2011,
2nd ed., obtained from www.worldbank.org. ●
CHAPTER 12 INTERNATIONAL FACTOR MOVEMENTS 249
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immigrants. A two-tier wage structure is thus not possible. However, these restrictions do
not often hold for guest workers or seasonal migrants.
If migrant labor is not perceived as homogeneous with domestic labor, it is possible for
the owners of capital in the recipient country to gain without reducing the income of domes-
tic labor (see Figure 5). If employers can discriminate against the migrant worker, they will
hire L1L2 short-term guest workers at the new market-clearing wage, 0W2, subsidize the
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initial level of domestic workers by the amount of the total wage difference, W2W1AB, and
gain area ABC. In this instance, country II clearly benefits because the permanent domestic
labor force is no worse off and the owners of capital are clearly better off. It is not surprising
that there is less opposition to temporary immigration than permanent migration, and there
seemed to be none in the earlier asparagus example. It also is not surprising to see home
labor discourage even seasonal labor immigration if it perceives that short-term migration
keeps average wage rates fixed in the presence of rising production and product prices.
We need to make some final observations about the nature of the migrant and the implica-
tions of migrant characteristics on both countries. The assumption that workers are homo-
geneous is certainly not true in the real world, and the welfare implications that accompany
migration can vary as a result. The labor force in each country possesses an array of labor skills
ranging from the untrained or unskilled to the highly trained or skilled. For this discussion, let
us assume that each country has only two types of labor, skilled and unskilled. The implica-
tions of out-migration on the home country vary according to the level of skill of the migrants.
The traditional migrant responding to economic forces tends to be the low-skilled worker
who is unemployed or underemployed in the home country and who seeks employment in
the labor-scarce country with the higher wage. The motive for the migration is not only the
higher wage in the host country but also the greater probability of obtaining full-time work,
along with other considerations. The movement of low-skilled workers based on expected
income differentials has effects on the two countries that are consistent with our previous
analysis. Total world output rises, output falls, and average low-skilled labor income rises
both absolutely and relatively in the home country, and output rises and average income of
low-skilled labor falls both absolutely and relatively in the host country. It is important to
note that the return to skilled labor in the host country, like capital, is likely to rise.
FIGURE 5 The Effects of Migrant Wage Discrimination
W
W 1
L1 L2
W2
A
B
C
DL
SDomestic + SMigrants
SDomestic
L0
Labor
W
ag
e
The immigration of labor leads to a rightward shift in the labor supply curve, producing a new equilibrium
wage, 0W2. By paying all labor the market wage 0W2 and then subsidizing each of the initial 0L1 domestic
workers by amount W1W2, domestic labor is left no worse off and the producer gains a net surplus of area ABC.
This gain can take place only if the producer can effectively discriminate between domestic and guest workers.
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The host country may also experience increased social costs through larger expenditures
for human safety-net programs (unemployment transfers, education, housing and health sub-
sidies, etc.) as the number of unskilled workers increases relatively and absolutely. Because
the unskilled worker tends to suffer greater employment instability, an increase in the rela-
tive number of unskilled workers is generally linked to higher social maintenance costs. An
increase in these indirect costs results in higher taxes, therefore reducing the net gain for
owners of other factors such as capital. The reduction in average low-skilled wages, includ-
ing the concomitant increased taxes, is thus greater than suggested by the fall in the market
wage alone. It is not surprising that most countries attempt to control the immigration of low-
skilled workers. In an attempt to avoid some of the indirect social costs of this immigration,
several European countries such as Switzerland have in the past adopted guest worker poli-
cies that allow low-skilled labor to immigrate for short periods of time, but the workers do not
qualify for citizenship and can be required to leave the country at the government’s request.
The movement of skilled labor, especially between developing and industrialized coun-
tries, is a relatively recent phenomenon. However, an increasing number of highly edu-
cated people [economists(?), physicians, research scientists, university professors, and
other skilled professionals] are leaving the developing countries for the United States,
Canada, and western Europe—a movement often referred to as the brain drain. Higher
salaries, lower taxes, greater professional and personal freedom, better laboratory condi-
tions, and access to newer technologies, professional colleagues, and the material goods
and services found in these countries explain this movement of labor. In many cases, the
person had received formal training in the industrialized country and found it difficult to
readjust, at least professionally, to life in the home country.
From an economic standpoint, if markets are working and labor is paid its marginal
product in both countries, the analysis of skilled-labor movements is similar to that of
unskilled labor, except for the differences in magnitude connected to the difference in mar-
ginal products. It is possible, however, that skilled labor is in such short supply in the home
country that the loss of these workers leads to a fall in per capita income, not an increase.
The opportunity cost to the home country may be even larger than indicated by the market
wage if the skilled worker generates other positive benefits (externalities) for the home
country such as a general improvement in the level of technology. In addition, to the extent
that the home country has subsidized the education of these people (i.e., invested in their
accumulation of human capital) the out-migration represents a loss of scarce capital on
which a reasonable social rate of return was expected. Finally, the cost to the home country
is even greater if markets are distorted by government regulation in a way that the indi-
vidual was receiving something less than the free-market wage. In that event, the wage
formerly received by the worker understated the true market value of the worker.
The opposite is true in the recipient country. The productivity of the immigrant skilled
worker is relatively higher, the possibility of positive externalities is greater, and expected
indirect social costs are lower than with the low-skilled migrant. In addition, the inflow
of the skilled professional reduces the domestic price of nontraded services such as medi-
cal care. In this case, the pressure against immigration will come from professional labor
groups, not from the overall labor force. In general, however, most industrialized countries
have done little to restrict the immigration of skilled workers, and in some cases have made
it easier for skilled workers to obtain work visas than is the case for unskilled workers.
The developing countries are in a quandary. The migration of skilled labor often rep-
resents a substantial static and dynamic cost to them. Because the combination of exter-
nalities, market wage distortions, and the opportunity cost of the human capital investment
frequently exceeds the income paid to the skilled worker, countries are often inclined to
restrict the out-migration of skilled labor. Until recently, for example, restrictions of this
kind were common in eastern Europe. However, the loss in personal freedom associated
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with labor movement restrictions makes such restrictions unappealing. Restriction of
personal freedoms may also lead to lower productivity and a loss of professional lead-
ership and entrepreneurship, which is important to these countries as they undergo eco-
nomic reforms. Several policies can be directed toward removing market imperfections:
(1)  paying skilled labor its marginal product, (2) subsidizing professionals so that their
income reflects their true social value including externalities, (3) taxing out-migrants or
requiring remittances from them to cover at least part of the investment in human capital,
(4) guaranteeing employment and high-quality jobs to those who return home following
training abroad, and (5) appealing to the nationalism of the skilled worker. These policies
may be more attractive than the restriction of free movement between countries.
While the movement of skilled labor from developing countries to the industrialized
countries may lead to an increase in efficiency and world output in the static sense, it con-
tributes to increased divergence of income between low-income and high-income coun-
tries. In addition, the loss of this very scarce resource alters the dynamics of change in
the developing countries. Thus, the correct policy response is not clear. The answer to
the question, Which is larger?—the social cost reflected in the loss in personal freedoms
caused by emigration restrictions or the social cost associated with free outward movement
of labor—must be sought beyond economic paradigms. In the end, individual freedom of
movement may well dominate any economic considerations.
We cannot leave this analysis of international labor movements without a brief discussion
of the large volume of research related to the economic impact of immigration on host coun-
tries in general and the United States in particular.10 Inasmuch as this research is directed
toward an examination of immigrant performance, impact on host-country labor markets,
and the likely impact of immigration policy, a brief presentation of some key findings is a
fitting way to conclude our discussion of the economic implications of international labor
movements. What emerges very clearly in the case of the United States is that the eco-
nomic characteristics of immigration have been changing in recent years both with respect
to initial migrant earning performance and the broader, longer-term implications for the
economy in general. Up through the 1970s, based on the stylized facts regarding immigra-
tion in the first half of the century, it was widely accepted that although immigrants as a
group were initially in an economically disadvantaged position, their earnings soon caught
up with the earnings of those domestic workers with similar socioeconomic backgrounds
and eventually surpassed them. What was interesting was that this adjustment took place in
a relatively short time, within 10 to 20 years on average, and appeared to have little or no
adverse impact on the domestic labor market. Much of this shift can be traced to the fact
that U.S. immigration laws were changed in 1965 toward favoring immigrants with existing
family ties to residents of the United States and away from a focus on the skill levels of the
immigrants. Only about 15 percent of new green cards recently issued were awarded for
work reasons, rather than for family relationships, humanitarian causes, and other reasons.11
Research by George Borjas (1992; 1994, p. 1686) also indicated that the origin of U.S.
immigrants had changed, with a marked increase in the proportion coming from devel-
oping countries. Concomitant with this change in country of origin, there was a decline in
the immigrants’ skill levels over much of the postwar period. Borjas therefore concluded
that it is not likely that the more recent wave of immigrants will continue to obtain wage
parity with domestic workers of similar socioeconomic backgrounds.12 This suggests not
Immigration and the
United States—Recent
Perspectives
10Much of this research is nicely summarized in Borjas (1994).
11Federal Reserve Bank of Dallas, 2010 Annual Report—From Brawn to Brains: How Immigration Works for
America, p. 14.
12Similar results have been observed by Wright and Maxim (1993) for Canada.
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CHAPTER 12 INTERNATIONAL FACTOR MOVEMENTS 253
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only that they will likely have a heavier participation rate in U.S. welfare programs but
also that this differential will carry over into second-generation wage and skill differences,
which will be reflected in widening ethnic income differences within the overall labor
market.13 In fact, some research suggests that immigrants with less than a high school
education are a net cost to the United States, in the sense that the value of the public ser-
vices they use exceeds the taxes they pay. For high-skilled immigrants, the reverse is true,
in that the taxes paid exceed the cost of the services used.14 There is also weak evidence
that the increasing numbers and declining skill levels of immigrants may have contributed
to the relative decline of domestic unskilled wages in the 1980s. For example, Borjas,
Richard Freeman, and Lawrence Katz (1992) concluded that perhaps one-third of the 10
percent decline in the relative wage of high school dropouts from 1980 to 1988 could be
explained by immigration flows. If these trends are indeed the case and continue into the
21st century, there will likely be far-reaching and long-lasting effects on the labor force,
net welfare costs, and income distribution in the United States. Countries that are able to
effectively control the skill characteristics of the new migrants will be able to negate some
of the aforementioned negative effects. However, in the United States, for example, the
H–1B visas that are awarded to skilled potential immigrants with a bachelor’s degree or
higher are strictly limited by an annual quota system and are applied for far in excess of
the number to be awarded.15 Such a limitation can potentially harm domestic workers in
that, for instance, a recent study suggested that U.S. cities with the largest inflow of highly
skilled workers had the greatest increases in wages for American-born college graduates in
those cities.16 However, this interesting result raises an issue which warrants further inves-
tigation. It is not surprising that immigration policy is a “hot topic” in government circles
in Washington, DC. Adding to the discussion is the emerging view that, without continued
immigration, the United States may soon see a marked slowdown in the growth of its labor
force as its population gets older.
13See Borjas (1993) for analysis of intergenerational characteristics of migrants.
14Federal Reserve Bank of Dallas, Annual Report 2010—From Brawn to Brains: How Immigration Works for
America, p. 12.
15Miriam Jordan, “Lottery Looms for Skilled-Based Visas,” The Wall Street Journal, April 2, 2015, p, A3.
16Josh Zumbrun and Matt Stiles, “Study: Skilled Foreign Workers a Boon for Pay,” The Wall Street Journal,
May 23, 2014, p, A6.
IN THE REAL WORLD:
IMMIGRATION AND TRADE
Some recent literature has been concerned with the links that
may exist between the stock of immigrants in a country and
the trading and other relationships of the host country with the
home countries of the immigrants. This literature makes the
broader point that labor movements between countries affect
not only labor markets per se in the receiving and sending
countries of the labor but also have secondary impacts on a
range of other economic variables.
An example of work that links immigration to trade is
provided in a paper by Roger White (2007). In this paper
White employed a gravity model (see the earlier discussion
in Chapter 10, pages 195–96) in an attempt to explain vari-
ous influences on U.S. trade. He empirically investigated the
trade of the United States with 73 trading partners for the time
period 1980–2001. Gravity model equations were run with
the dependent variables alternately being U.S. total trade, U.S.
exports, and U.S. imports. Standard independent variables
for the gravity model such as the GDP of the United States
and the GDPs of partner countries were included, as were
exchange rates and distance. Two of the other independent
(continued)
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IN THE REAL WORLD: (continued)
IMMIGRATION AND TRADE
variables were (1) whether or not there existed a free-trade
agreement between the United States and any given partner
(which would, other things being equal, increase the amount
of trade) and (2) whether or not English was an official lan-
guage of the partner (which would also increase trade).
The independent variable of prime interest was the num-
ber of immigrants from the given partner country who were
living in the United States. The central hypothesis in this
immigrant-trade literature is that trade will be enhanced
between the sending country of the migrants and the host
country because of, for example, the desire of the immigrants
to consume products to which they are specifically accust-
omed and that might not be produced with identical charac-
teristics in the host country. In addition, social and business
contacts and networks between the immigrants and residents/
firms in the home country may make it easier and less costly to
continue operating within those established relationships than
to develop a whole new set of relationships (that is, transaction
costs may be kept lower than otherwise would be the case).
The regressions that were run by White generally pro-
duced no surprises for the traditional variables. Of impor-
tance for this chapter was the finding that trade volume was
indeed increased by the presence of immigrants. For the full
sample of 73 countries, White estimated that, other things
being equal and on average, a 10 percent increase in the
stock of immigrants in the United States from any given
trading-partner country would increase U.S. imports from
that country by 1.3 percent and would increase U.S. exports
to that country by 1.1 percent. Further, a new finding—one
that had not been uncovered in previous studies—emerged
when White disaggregated the sample into high-income,
medium-income, and low-income partner countries. For
the low-income partners, a 10 percent increase in the stock
of immigrants from any given country would increase
U.S. imports from that country by 4.66 percent and would
increase exports to that country by 1.47 percent. Stated in
more concrete terms, for example, he estimated that the
average U.S. immigrant from China adds $11,442 annually
to the U.S.–China total trade, while examples of correspond-
ing numbers for other countries’ immigrants to the United
States are $10,724 for Bangladesh, $6,252 for Nigeria,
$718 for Nicaragua, and $164 for Vietnam. However, and
importantly, there did not appear to be any trade-increasing
effects of increased immigration from high-income and
medium-income trading partners. Thus, the overall impact
of the stock of immigrants on trade was in effect accounted
for by immigrants from low-income countries and not by
immigrants from the medium- and high-income countries.
These are intriguing findings that clearly call for more inves-
tigation as to the reasons for their occurrence.
An extension of this work into the broader area of culture
and values has been explored by White and Bedassa Tadesse
(2008). They investigated what they labeled as the “cultural
distance” between countries and the effects of that distance
on trade flows, and they employed data from World Values
Surveys and European Values Surveys to do so. These surveys
involve the completion of questionnaires by representative
samples of the population in many countries.* In the White/
Tadesse paper, the survey results used were from the 1998–
2001 time period, and they contained information on politics,
religion, gender roles, ethical considerations, and other such
matters. White and Tadesse constructed two indexes for the
United States and for each of 54 trading partners, and, for
each index, a greater difference in the given index between
any two countries indicated greater “cultural distance.”
Using these indexes and 1997–2004 trade data and other
relevant economic information, White and Tadesse then ran
gravity model regressions with U.S. exports and U.S. imports
used alternately as the dependent variable. Normal results
were generally obtained for the signs of traditional inde-
pendent variables, such as GDP and the existence of a trade
agreement. The independent variable of the stock of immi-
grants in the United States from any given country yielded
statistically significant positive signs regarding trade, as in
the White study discussed in the previous paragraphs. With
respect to the cultural indexes, both the export and the import
regression yielded statistically significant negative signs for
one of the two indexes, meaning that a greater cultural differ-
ence between the United States and any given trading part-
ner resulted in, other things being equal, less trade between
the United States and that partner. However, for the other
cultural index, the expected negative sign occurred for U.S.
imports but not for U.S. exports to the given partner (in fact,
that latter result was a positive sign). Hence, although cul-
tural distance does seem to play a role in some way with
regard to the volume of trade, further empirical (as well as
theoretical) investigation appears to be necessary.
*Further information on these surveys is available at www
.worldvaluessurvey.org.
Sources: Roger White, “Immigrant-Trade Links, Transplanted
Home Bias and Network Effects,” Applied Economics 39, no. 7
(April 20, 2007), pp. 839–52; Roger White and Bedassa Tadesse,
“Cultural Distance and the U.S. Immigrant-Trade Link,” The World
Economy 31, no. 8 (August 2008), pp. 1078–96. ●
254 PART 3 ADDITIONAL THEORIES AND EXTENSIONS
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IN THE REAL WORLD:
IMMIGRATION INTO THE UNITED STATES AND THE BRAIN DRAIN
FROM DEVELOPING COUNTRIES
Several studies have shed light on the type of labor that
decides to emigrate to the United States and the impact
of immigrants on the U.S. economy. While there is consid-
erable debate regarding the Borjas claim that current U.S.
immigrants are relatively less skilled than their earlier counter-
parts (and thus that current migrants are less likely to have a
positive impact on the economy than their predecessors),*
it appears clear that the typical person who has emigrated from
most developing countries in the past is relatively skilled.
In 1999 William J. Carrington and Enrica Detragiache
presented the results, using 1990 census data, of an exam-
ination of the educational background of the stock of
developing-country emigrants (not the flow of migrants,
which Borjas was examining) over 25 years of age who now
reside in the United States.† The first striking result in the
study was that individuals with no more than a primary edu-
cation (zero to eight years of schooling) accounted for only
about 7 percent of the total immigrants (i.e., about 500,000
of the total of 7 million immigrants). Approximately
53 percent (3.7 million of the 7 million) were persons from
other North American countries (which included Central
American and Caribbean countries in the Carrington and
Detragiache definition) who had at most a secondary educa-
tion. Most of these individuals were from Mexico. Almost
1.5 million immigrants (21 percent) were highly educated
individuals with a tertiary level of schooling (more than
12 years) from Asia and Pacific countries. (Note: this “highly
educated” measure does not include international students in
the United States, who were excluded from the “immigrant”
definition.) In addition, although small in number (128,000),
75 percent of immigrants into the United States from
Africa consisted of highly educated individuals. More than
60 percent of migrants from Egypt, Ghana, and South Africa
had a tertiary education, as did 75 percent of migrants to the
United States from India. Immigrants from China and South
American countries were about equally divided between the
secondary and tertiary education levels. Mexico and Central
American countries thus appeared to be an exception in that
most of the migrants from those countries had education
only through the secondary level.
An important point to make is that, in general, individuals
who emigrate to the United States tend to be better educated
than the average person in their home countries. Further, the
migrants often represent a sizeable portion of the similarly
skilled workforce in their own countries. Carrington and
Detragiache present some truly startling statistics in this
regard. They calculated the stock of immigrants of a given
education level in the United States from any given country
and then divided that number by the size of the population of
the same education level who remained in the home country.
For example, at the tertiary-education level, the number of
Jamaican immigrants in the United States divided by the size
of the Jamaican population with tertiary education gave a
figure of 70 percent. While the number of Jamaican immi-
grants is relatively small in absolute terms and the percentage
of the Jamaican population with tertiary education is likewise
small, this figure gives concrete force to the notion of brain
drain from developing countries. Other (small) developing
countries also had high numbers with regard to the tertiary-
education level—Guyana (70 to 80 percent), The Gambia
(60 percent), and Trinidad and Tobago (50 to 60 percent).
El Salvador, Fiji, and Sierra Leone had ratios greater than
20 percent. For many countries in Latin America, the ratios
that were the highest were those with respect to second-
ary education rather than tertiary education [e.g., Mexico
(20 percent), Nicaragua (30 percent)], but, even so, their
magnitude indicates a substantial outflow of skill.
This loss of tertiary-level (and secondary-level) individu-
als cannot help but impede the economic and social progress
of source countries spread throughout the world. However,
recent research suggests some mitigating factors. For exam-
ple, brain drain scientific personnel appear to interact with
peers in their home countries, sharing ideas and increas-
ing the flow of innovation from developed to developing
countries.
*See George Borjas, Heaven’s Door (Princeton, NJ: Princeton
University Press, 1999); Jagdish Bhagwati, “Bookshelf: A Close
Look at the Newest Newcomers,” The Wall Street Journal,
September 28, 1999, p. A24; Spencer Abraham, “Immigrants Bring
Prosperity,” The Wall Street Journal, November 11, 1997, p. A18;
“Immigrants to U.S. May Add $10 Billion Annually to Economy,”
The Wall Street Journal, May 19, 1997, p. A5; “The Longest
Journey: A Survey of Migration,” The Economist, November 2,
2002, p. 13 (where an estimate is presented that first-generation
migrants to the United States impose an average net fiscal loss of
$3,000 per person while the second generation yields an $80,000 net
fiscal gain per person); “Give Me Your Scientists,” The Economist,
March 7, 2009, p. 84.
†William J. Carrington and Enrica Detragiache, “How Extensive Is
the Brain Drain?” Finance and Development 36, no. 2 (June 1999),
pp. 46–49. ●
CHAPTER 12 INTERNATIONAL FACTOR MOVEMENTS 255
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CONCEPT CHECK 1. Could labor movements between countries
ever have a protrade effect? If so, under what
circumstances?
2. How could temporary migration movements
be encouraged by producers and not be
objected to by domestic workers?
3. From the standpoint of country per capita
income, does it make a difference whether a
high-skilled or a low-skilled person migrates?
Why or why not?
SUMMARY
This chapter discussed various aspects of international fac-
tor movements between countries. Causes and consequences
of international mobility of capital and of labor have been
examined, and particular attention has been devoted to some
implications for international trade and relative factor prices.
Movements of factors of production have received relatively
little attention in the literature on international economics
compared with movements of goods and services, and a sys-
tematic and comprehensive framework incorporating the many
facets of these movements remains to be formulated. In addi-
tion, judgments on the welfare and development implications
of factor flows differ according to who is making the assess-
ment and to the weights placed on various objectives. As capi-
tal and labor mobility become more prominent in the world
economy in the future, it will increasingly become necessary
to investigate further the causes, the consequences, and the
policy implications of the international movements of factors
of production.
KEY TERMS
brain drain
branch plant
foreign direct investment
foreign portfolio investment
foreign subsidiary
guest worker
host countries
multinational corporation (MNC)
[or multinational enterprise
(MNE), transnational corporation
(TNC), or transnational
enterprise (TNE)]
performance requirements
surplus labor
tariff factories
transfer pricing
QUESTIONS AND PROBLEMS
1. Describe the current net direct investment position of the
United States. In which countries is U.S. investment the
greatest? In which industries? What are the four largest
investor countries in the United States? In what industries is
foreign investment concentrated?
2. Compare and contrast the country ownership of the largest
industrial corporations with that of the largest banking firms.
3. What are principal reasons often cited for foreign direct
investment?
4. Explain how real capital investment in a developing coun-
try affects trade, using the Heckscher-Ohlin model and the
Rybczynski theorem.
5. What happens to output and the relative sizes of capital stock
if controls over foreign ownership keep the marginal pro-
ductivity of capital from equalizing between two countries?
6. Would the migration of highly skilled labor from a develop-
ing country to the United States have the same trade impact
as the migration of less-skilled production workers? Why or
why not?
7. Why might voters have a very different economic perspec-
tive on the immigration of skilled labor such as physicians
than would professional groups such as the American
Medical Association? What should the role of Congress be
in this dispute?
8. If two countries form a common market (no trade barriers or
barriers to factor movements), why is it difficult to predict
the nature and level of trade between them in the long run?
9. During the heated discussions in the United States about the
North American Free Trade Agreement (NAFTA), many
observers stated that adoption of the agreement would lead
to a surge of investment from the United States into Mexico
because of Mexico’s much lower wages. From the stand-
point of tariff elimination alone, how might NAFTA reduce
the amount of U.S. investment in Mexico?
10. Briefly explain why there is increasing concern about
immigration policy in the United States in recent years.
What effects might reducing the inflow of migrants, both
legal and illegal, have on the economy?
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CHAPTER
LEARNING OBJECTIVES
LO1 Describe the different features of tariffs employed to influence imports.
LO2 Discuss policies used to affect exports.
LO3 Summarize the different nontariff policies used to restrict trade.
THE INSTRUMENTS
OF TRADE POLICY 13
PART 4: Trade Policy
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INTRODUCTION
Vignettes from various news articles . . .
In November 2003, the European Union (EU) threatened to slap retaliatory tariffs on over
$2 billion of U.S. exports because of tariffs that the United States had placed on steel imports in
2002. In addition, the EU threatened to put sanctions on over $4 billion of U.S. exports because
of the U.S. policy of providing tax relief to U.S. companies that exported goods under a special
arrangement known as Foreign Sales Corporations, even though such tax relief had been declared
illegal by the supervising body for trade rules, the World Trade Organization (WTO).1
In the late 1990s and the early years of the new century, Mississippi Delta catfish farmers
found themselves subject to considerable competition from catfish being imported from Vietnam.
To their surprise, even some of the frozen catfish being served in Mississippi, the state that is the
heart of the U.S. catfish industry, came from Vietnam. In 2002, Congress therefore passed an
amendment to an appropriations bill that stipulated that, of the 2,000 types of catfish in existence,
only the American-born family could be called “catfish”—the Vietnamese could sell their catfish
in the United States only under the names “basa” and “tra.”2
In early 2009, Mexico announced that it would impose tariffs on 90 U.S. industrial and agri-
cultural goods coming into Mexico in retaliation for legislation contained in a bill signed by
President Obama. The bill contained provisions that terminated a pilot program whereby Mexican
long-haul trucks had free access to U.S. highways in delivering goods brought in from Mexico.
Although the United States claimed that the action was initiated for safety reasons, Mexico’s
Economy Minister responded that the U.S. action violated the NAFTA agreement of 1994.3
In 2012, the European Union protested against what it regarded as new Argentinian “protec-
tionist” barriers to imports. Import license requirements in that year were extended by Argentina
to all imports instead of being applied to only a few product categories. The EU trade commis-
sioner complained that the regulations now included major products such as autos, food products,
and cell phones.4
In 2010, China reduced the amount of its exports to the world of various “rare earth miner-
als” by 40 percent from 2009 levels. The reduction was accomplished by reducing the size of its
export quotas. These metals, of which China produces 97 percent of the world’s annual supply,
are inputs for a range of products such as iPhones, smart bombs, electric cars, and wind turbines.5
Clearly, countries can use a number of different measures to cause trade to diverge from the
comparative advantage pattern. A glance at any daily newspaper makes it clear that gov-
ernments do not adhere to free trade despite the strong case for the efficiency and welfare
gains from trade that has been developed in earlier chapters. Policymakers have proven very
resourceful in generating different devices for restricting the free flow of goods and services.
In this chapter, we describe some of the most important forms of interference with trade.
The first section discusses import tariffs and their measurement. Several of the more
common policy instruments used to influence exports are presented in the next section, fol-
lowed by an examination of various nontariff barriers (NTBs) that are commonly used to
reduce imports. The material in this chapter serves as background to the analysis of policy-
induced trade and welfare effects that follows in subsequent chapters.
In What Ways
Can Governments
Interfere with Trade?
1Neil King, Jr., and Michael Schroeder, “EU Trade Chief Warns of Sanctions,” The Wall Street Journal,
November 5, 2003, pp. A2, A15.
2“The Great Catfish War,” The New York Times, July 22, 2003, obtained from www.nytimes.com.
3Greg Hitt, Christopher Conkey, and José de Córdoba, “Mexico Strikes Back in Trade Spat,” The Wall Street
Journal, March 17, 2009, pp. A1, A12.
4Paul Geitner, “Europe to Challenge Argentina’s Trade Rules,” New York Times, May 25, 2012, obtained from
www.nytimes.com.
5“China’s Rare Earths Gambit,” The Wall Street Journal, October 19, 2010, p. A18; James T. Areddy, “China
Signals More Cuts in Its Rare-Earth Exports,” The Wall Street Journal, October 20, 2010, p. A17.
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IMPORT TARIFFS
A specific tariff is an import duty that assigns a fixed monetary (dollar) tax per physical
unit of the good imported. Thus, a specific duty might be $25 per ton imported or 2 cents
per pound. The total import tax bill is levied in accordance with the number of units com-
ing into the importing country and not according to the price or value of the imports. Tax
authorities can collect specific tariffs with ease because they need to know only the physi-
cal quantity of imports coming into the country, not their monetary value. However, the
specific tariff has a fundamental disadvantage as an instrument of protection for domestic
producers because its protective value varies inversely with the price of the import. If the
import price from the foreign producer is $5 and the tariff is $1 per unit, this is equivalent
to a 20 percent tariff. However, if inflation occurs and the price of the import rises to $10,
the specific tariff is now only 10 percent of the value of the import. Domestic producers
could rightly feel that this tariff is not doing the job of protection (after inflation) that
it used to do. The inflation that took place during and after World War II and again in
dramatic form in the late 1970s and early 1980s led countries to turn away from specific
tariffs, but they still exist on many goods.
The ad valorem tariff makes it possible for domestic producers to overcome the loss of
protective value that the specific tariff was subject to during inflation. The ad valorem tar-
iff is levied as a constant percentage of the monetary value of 1 unit of the imported good.
Thus, if the ad valorem tariff rate is 10 percent, an imported good with a world price of $10
will have a $1 tax added as the import duty; if the price rises to $20 because of inflation,
the import levy rises to $2.
Although the ad valorem tariff preserves the protective value of the trade interfer-
ence for home producers as prices increase, there are difficulties with this tariff instru-
ment because customs inspectors need to make a judgment on the monetary value of the
imported good. Knowing this, the seller of the good is tempted to undervalue the good’s
price on invoices and bills of lading to reduce the tax burden. On the other hand, customs
officials may deliberately overvalue a good to counteract undervaluation or to increase the
level of protection and tariff revenue. (Of course, the importer may further undervalue to
offset the overvaluation that is offsetting the undervaluation, and so on—you get the idea!)
Nevertheless, ad valorem tariffs have come into widespread use.
Finally, import subsidies also exist in some countries. An import subsidy is simply
a payment per unit or as a percent of value for the importation of a good (i.e., a negative
import tariff).
Other aspects of tariff legislation also deserve attention. This section briefly covers some
common features and concepts pertinent to tariff instruments and policy.
Preferential duties are tariff rates applied to an import according to its geographical
source; a country that is given preferential treatment pays a lower tariff. A historical
example of this phenomenon was Commonwealth or Imperial Preference, whereby Great
Britain levied a lower rate if the good was coming into Britain from a country that was
a member of the British Commonwealth, such as Australia, Canada, or India. At the
present time, preferential duties in the European Union enable a good coming into one
EU country (such as France) from another EU country (such as Italy) to pay zero tariff.
The same good usually would pay a positive tariff if arriving from a country outside the
EU unless some other special arrangement were in effect. An analogous situation applies
in the North American Free Trade Agreement (NAFTA) among Canada, Mexico, and the
Specific Tariffs
Ad Valorem Tariffs
Other Features of
Tariff Schedules
Preferential Duties
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United States. (Economic unions are discussed in Chapter 17.) Another prominent example
is the Generalized System of Preferences (GSP), a system currently in place where a
large number of developed countries permit reduced duties or duty-free entry for a selected
list of products if those products are imported from particular developing countries. This
duty-free entry exists even though a positive tariff is levied if those products come in from
developed countries or other, richer developing countries. The important point about pref-
erential duties is that they are geographically discriminatory in nature—with the term dis-
criminatory implying not necessarily undesirable treatment but simply different treatment.
Another feature of tariff legislation in widespread use is most-favored-nation (MFN)
treatment or, as now called in U.S. legislation, normal trade relations (NTR). The MFN
term is misleading because it implies that a country is getting special, favored treatment
over all other countries. However, the term means the opposite—it represents an ele-
ment of nondiscrimination in tariff policy. The new term NTR reflects the concept more
satisfactorily.
Suppose that the United States and India conclude a bilateral tariff negotiation whereby
India reduces its tariffs on U.S. computers and the United States reduces its tariffs on
Indian clothing. MFN treatment, or NTR, states that any third country with which the
United States has an MFN/NTR agreement (such as Kenya) will get the same tariff reduc-
tion on clothing from the United States that India received. Further, Kenya will, if it has
an MFN/NTR agreement with India, also get the same tariff reduction from India on com-
puters (if Kenya exported any computers to India) that the United States received. These
reductions for Kenya occur even though Kenya itself did not take part in the bilateral tariff
negotiations. In effect, they make the U.S. tariff on clothing and the Indian tariff on com-
puters nondiscriminatory by country of origin. In practice, MFN/NTR treatment has been
a hallmark of post–World War II multilateral tariff negotiations under the auspices of the
General Agreement on Tariffs and Trade [the international sponsoring organization known
as GATT, which was superseded by the WTO in 1995].
This feature of tariff legislation exists in several developed countries, including the United
States. Under offshore assembly provisions (OAP), sometimes referred to as production-
sharing arrangements, the tariff rate in practice on a good is lower than the tariff rate listed
in the tariff schedules. Suppose that the United States imports cell telephones from Taiwan at
$80 per phone. If the tariff rate on phones is 15 percent, then a $12 import tax must be paid on
each phone brought into the country, and (assuming the small-country case) the price to the
U.S. consumer would be $92. However, suppose that U.S. components used in the product
made by the Taiwanese firm have a value of $52. Under OAP, the 15 percent U.S. tariff rate
is applied to the value of the final product minus the value of the U.S. components used in
making that final product, that is, to the value added in the foreign country. Thus, when a cell
phone arrives at a U.S. port of entry, the “taxable value” for tariff purposes is $80 less $52, or
$28, and the duty is 15 percent times $28, or only $4.20. The price to the U.S. consumer after
the tariff has been imposed is $84.20. The consumer is better off with OAP because the tariff
rate as a percentage of the import price is only 5.25 percent ($4.20/$80.00 = 5.25%) rather
than the 15 percent of the tariff schedule.
Despite the consumer benefits, workers in the protected industry in the United States
(telephones) will object because assembly work that might otherwise have remained in the
United States is sent overseas to Taiwanese workers. On the other hand, workers in the
U.S. components industry will favor this legislation because foreign firms have an incen-
tive to use U.S. components to become more competitive in selling their product in the
United States.
Most-Favored-Nation
Treatment
Offshore Assembly
Provisions
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IN THE REAL WORLD:
U.S. TARIFF RATES
Table 1 lists the tariffs for the year 2015 on selected goods
imported into the United States. The column headed “MFN/
NTR” shows the tariffs applicable to goods coming from
most U.S. trading partners. These rates apply to countries
with which the United States has normal trade relations
(NTR), formerly referred to as most-favored-nation (MFN)
treatment—see the discussion on page 260. [There are, of
course, special exceptions to these rates in situations such
as the North American Free Trade Agreement (NAFTA)
and U.S. free-trade agreements with individual countries.]
The “Non-MFN/NTR” column refers to the higher tariffs
applicable to the remaining trade partners. In 2015, the
two countries facing these higher rates were Cuba and
North  Korea. It is quite possible that Cuba will receive
MFN/NTR treatment in the near future.
The U.S. tariff schedule maintains very fine divisions
of products and contains different degrees of restriction
for different goods. Note that some rates are specific tariffs
(e.g., grapefruit), some are ad valorem tariffs (e.g., music
synthesizers), and some are a combination of specific and
ad valorem tariffs (e.g., wristwatches).
MFN/NTR Non-MFN/NTR
Live turkeys 0.9¢ each 4¢ each
Roquefort cheese, grated or powdered 8% 35%
Spinach:
Fresh or chilled 20% 50%
Frozen 14% 35%
Grapefruit:
If entered August 1–September 30 1.9¢/kg 3.3¢/kg
If entered during October 1.5¢/kg 3.3¢/kg
If entered at any other time 2.5¢/kg 3.3¢/kg
Pecans:
In shell 8.8¢/kg 11¢/kg
Shelled 17.6¢/kg 22¢/kg
Mineral waters and aerated waters, not containing added sugar or other
sweetening matter nor flavored 0.26¢/liter 2.6¢/liter
Chloromethane (methyl chloride) 5.5% 125%
Dental floss Free 88¢/kg + 75%
New pneumatic rubber tires:
Of a kind used on motor cars, buses, or trucks, if radial 4% 10%
Of a kind used on motor cars, buses, or trucks, if not radial 3.4% 10%
Of a kind used on aircraft Free 30%
Of a kind used on motorcycles and bicycles Free 10%
Handbags:
With outer surface of reptile leather 5.3% 35%
With outer surface of other leather or composition leather:
Valued not over $20 each 10% 35%
Valued over $20 each 9% 35%
TABLE 1 Selected Tariffs in the United States, 2015
(continued)
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IN THE REAL WORLD: (continued)
(continued)
U.S. TARIFF RATES
MFN/NTR Non-MFN/NTR
Woven fabrics of cotton, containing 85 percent or more by weight of cot-
ton, weighing more than 200 g/m2, of yarns of different colors: denim 8.4% 20.9%
Round wire of stainless steel Free 34%
Men’s or boys’ suit-type jackets and blazers, knitted or crocheted:
Of wool or fine animal hair 38.6¢/kg + 10% 77.2¢/kg + 54.5%
Of cotton 13.5% 90%
Men’s or boys’ suit-type jackets and blazers, not knitted or crocheted:
Of wool or fine animal hair 17.5% 59.5%
Of cotton containing 36 percent or more by weight of flax fibers 2.8% 35%
Of other cotton 9.4% 90%
Women’s or girls’ dresses, not knitted or crocheted, of wool or fine
animal hair:
Containing 30 percent or more by weight of silk or silk waste 7.2% 90%
Other 13.6% 58.5%
Women’s or girls’ blouses and shirts, knitted or crocheted: cotton 19.7% 45%
T-shirts, singlets, tank tops, and similar garments, knitted or crocheted,
of cotton 16.5% 90%
Sunglasses 2% 40%
Files, rasps:
Not over 11 cm in length Free 47.5¢/dozen
Over 11 cm but not over 17 cm in length Free 62.5¢/dozen
Over 17 cm in length Free 77.5¢/dozen
Household- or laundry-type washing machines, of a dry-linen capacity
not exceeding 10 kg, fully automatic 1.4% 35%
Electronic calculators Free 35%
Electric sound amplifier sets 4.9% 35%
Automatic teller machines Free 35%
Nuclear reactors 3.3% 45%
Military rifles 4.7% on the value of
the rifle plus 20% on
the value of the tele-
scopic sight, if any
65%
Cellular telephones Free 35%
Motor cars, principally designed for the transport of persons (nine persons
or less, including the driver) 2.5% 10%
Motor vehicles for the transport of goods, except dumpers, with
spark-ignition internal combustion engine 25% 25%
Wristwatches, with case of precious metal or of metal clad with precious
metal: electrically operated, whether or not incorporating a stopwatch
facility, with mechanical display only, having no jewels or only one
jewel in the movement
51¢ each + 6.25% on
the case & strap, band,
or bracelet + 5.3% on
the battery
$2.25 each + 45% on the
case + 80% on the strap,
band, or bracelet + 35%
on the battery
Music synthesizers 5.4% 40%
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IN THE REAL WORLD:
THE U.S. GENERALIZED SYSTEM OF PREFERENCES
The United States currently gives GSP treatment to 106
developing countries (Note: The U.S. GSP program was
allowed to expire on July 31, 2013, but was reinstated retro-
actively on July 29, 2015.). In general, GSP imports coming
into the United States from these countries consist of a speci-
fied list of goods that are permitted duty-free entry up to a
certain maximum for each country. The developing countries
themselves maintain that the list of eligible goods is rather
restrictive; for example, textiles and clothing are ineligible
for GSP. In addition, some developing countries feel that
the countries eligible for GSP can change rather arbitrarily.
For example, the United States decided some time ago that
Malaysia, Taiwan, South Korea, and Hong Kong had “grad-
uated” from the list of countries needing this special trade
assistance. Within the last three years, Croatia, Equatorial
Guinea, Peru, and Trinidad and Tobago have been removed
from the list. Of note is that Equatorial Guinea was on the
“least developed” list in 2010, but the country’s growth has
been rapid and it was removed from both lists in 2011.
Table 2 lists the 106 countries currently receiving GSP treat-
ment. Besides these countries and not listed are 19 noninde-
pendent countries and territories (such as Anguilla, Gibraltar,
and the Falkland Islands) that also receive GSP treatment.
Further, 43 of the countries on the GSP list are desig-
nated “least developed” countries and are given an addi-
tional benefit (see Table 3). GSP-eligible products from
these countries have no ceiling on the quantities permitted
duty-free entry.
(continued)
IN THE REAL WORLD: (continued)
MFN/NTR Non-MFN/NTR
Ball point pens 0.8¢ each + 5.4% 6¢ each + 40%
Fountain pens 0.4¢ each + 2.7% 6¢ each + 40%
Source: U.S. International Trade Commission, Harmonized Tariff Schedule of the United States (2015) (Revision 1) (Washington, DC: U.S. Government
Printing Office, July 2015), obtained at www.usitc.gov.

U.S. TARIFF RATES
TABLE 2 Countries Receiving GSP Treatment from the United States, 2015
Afghanistan
Albania
Algeria
Angola
Armenia
Azerbaijan
Belize
Benin
Bhutan
Bolivia
Bosnia and Herzegovina
Botswana
Brazil
Burkina Faso
Burundi
Cambodia
Cameroon
Cabo Verde
Central African Republic
Chad
Comoros
Congo (Brazzaville)
Congo (Kinshasa)
Côte d’Ivoire
Djibouti
Dominica
Ecuador
Egypt
Eritrea
Ethiopia
Fiji
Gabon
Gambia, The
Georgia
Ghana
Grenada
Guinea
Guinea-Bissau
Guyana
Haiti
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IN THE REAL WORLD: (continued)
TABLE 3 Countries Receiving “Least Developed” Status in the U.S. GSP, 2015
Afghanistan Guinea Samoa
Angola Guinea-Bissau São Tomé and Principe
Benin Haiti Senegal
Bhutan Kiribati Sierra Leone
Burkina Faso Lesotho Solomon Islands
Burundi Liberia Somalia
Cambodia Madagascar South Sudan
Central African Republic Malawi Tanzania
Chad Mali Timor-Leste
Comoros Mauritania Togo
Congo (Kinshasa) Mozambique Tuvalu
Djibouti Nepal Uganda
Ethiopia Niger Vanuatu
Gambia, The Rwanda Yemen, Republic of
Zambia
Source: U.S. International Trade Commission, Harmonized Tariff Schedule of the United States (2015) (Revision 1) (Washington, DC: U.S. Government
Printing Office, July 2015), obtained from www.usitc.gov. ●
THE U.S. GENERALIZED SYSTEM OF PREFERENCES
India
Indonesia
Iraq
Jamaica
Jordan
Kazakhstan
Kenya
Kiribati
Kosovo
Kyrgyzstan
Lebanon
Lesotho
Liberia
Macedonia, former Yugoslav
Republic of
Madagascar
Malawi
Maldives
Mali
Mauritania
Mauritius
Moldova
Mongolia
Montenegro
Mozambique
Namibia
Nepal
Niger
Nigeria
Pakistan
Papua New Guinea
Paraguay
Philippines
Russia
Rwanda
Saint Lucia
Saint Vincent and the
Grenadines
Samoa
São Tomé and Principe
Senegal
Serbia
Seychelles
Sierra Leone
Solomon Islands
Somalia
South Africa
South Sudan
Sri Lanka
Suriname
Swaziland
Tanzania
Thailand
Timor-Leste
Togo
Tonga
Tunisia
Turkey
Tuvalu
Uganda
Ukraine
Uruguay
Uzbekistan
Vanuatu
Venezuela
Yemen, Republic of
Zambia
Zimbabwe
Source: U.S. International Trade Commission, Harmonized Tariff Schedule of the United States (2015) (Revision 1) (Washington, DC: U.S. Government
Printing Office, July 2015), obtained from www.usitc.gov.
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A prominent issue in tariff discussions concerns the height of a country’s average tariff or,
in other words, how much price interference exists in a country’s tariff schedule. The prob-
lem arises because all countries have a large number of different tariff rates on imported
goods. How do we determine the average tariff rate from this great variety?
One measure of a country’s average tariff rate is the unweighted-average tariff rate. Suppose
that we have only three imported goods with the following tariff rates: good A, 10 percent;
good B, 15 percent; and good C, 20 percent. The unweighted average of these rates is
10% + 15% + 20%
3
= 15%
The problem with this technique is that it does not take into account the relative importance
of the imports: if the country imports mostly good A, this unweighted average would tend
to overstate the height of the country’s average tariff.
The alternative technique is to calculate a weighted-average tariff rate. Each good’s
tariff rate is weighted by the importance of the good in the total bundle of imports. Using
the tariff rates from the unweighted case, suppose that the country imports $500,000 worth
of good A, $200,000 worth of good B, and $100,000 worth of good C. The weighted aver-
age tariff rate is
=
(10%)($500,000) + (15%)($200,000) + (20%)($100,000)
$500,000 + $200,000 + $100,000
=
$50,000 + $30,000 + $20,000
$800,000
=
$100,000
$800,000
= 0.125, or 12.5%
The weighted rate of 12.5 percent is lower than the unweighted rate of 15 percent, indi-
cating that relatively more low-tariff imports than high-tariff imports are coming into the
country. Nevertheless, the weighted-average tariff rate has a disadvantage related to the
law of demand. Assuming demand elasticities are similar across all goods, purchases of
goods with relatively high tariffs tend to decline because of the imposition of the tariff,
while those of goods with relatively low tariffs tend to decline to a lesser degree. Thus, the
tariff rates themselves change the import bundle, giving greater weight to low-tariff goods.
The weighted-average tariff rate is therefore biased downward.
The weighting problem can be illustrated in an extreme form with prohibitive tariffs. A
prohibitive tariff has a rate that is so high that it keeps imports from coming into the coun-
try. In the preceding example, a prohibitive tariff would exist if a good D had a tariff rate
of 80 percent, but there are zero imports of D because of this rate. The weighted-average
tariff rate for the country would still be 12.5 percent, because the 80 percent tariff has
zero weight. (The unweighted average would rise to 31.25% = 125%/4.) In the extreme,
a country that imports a few goods with zero tariffs but has prohibitive tariffs on all other
potential imports will have a weighted-average tariff rate of 0 percent, and the country
would look like a free-trade country!
In practice, the unweighted-average tariff rate may be as useful as the weighted-average
rate. A way to avoid some of the bias of the weighted-average rate is to calculate it by using
Measurement of
Tariffs
The “Height” of Tariffs
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weights of the goods in world trade, not the particular country’s trade. This procedure
reduces the bias associated with using the importing country’s own weights, because the
world weights are less influenced by the importing country’s tariff schedule. In addition,
in view of the ambiguities associated with measuring the degree of a country’s import pro-
tection, recent work has focused on developing a more comprehensive single measure of
such protection. This work involves the construction of comparable Trade Restrictiveness
Indices across countries. See Coughlin (2010) and Anderson and Neary (2005).
An additional issue concerns the choice of the appropriate tariff rate when evaluating the
impact of tariffs. This matter can be important when countries are negotiating tariff rate
reductions because the negotiation requires focusing on an appropriate rate. The issue
involves the distinction between the nominal tariff rate on a good and the effective tariff
rate, more commonly known as the effective rate of protection (ERP). The nominal rate
is simply the rate listed in a country’s tariff schedule (as discussed earlier), whether it is an
ad valorem tariff or a specific tariff that can be converted to an ad valorem equivalent by
dividing the specific tariff amount per unit by the price of the good. The ERP can best be
illustrated by a numerical example.
Economists employing the nominal rate are concerned with the extent to which the
price of the good to domestic consumers is raised by the existence of the tariff. However,
economists are concerned, when using the ERP, about the extent to which “value added”
in the domestic import-competing industry is altered by the existence of the whole
tariff structure (i.e., the tariff rate not only on the final good but also on the intermediate
goods that go into making the final good). Indeed, the ERP is defined as the percentage
change in the value added in a domestic import-competing industry because of the impo-
sition of a tariff structure by the country rather than the existence of free trade. Consider
a situation in which good F is the final good and goods A and B are intermediate inputs
used in making F. Assume that A and B are the only intermediate inputs and that 1 unit
each of A and B is used in producing 1 unit of final good F. Goods A and B can be
imported goods or domestic goods that compete with imports and thus have their prices
influenced by the tariffs on the competing imports. Suppose that, under free trade, the
price of the final good (PF) is $1,000 and the prices of the inputs are PA = $500 and
PB = $200. In this free-trade situation, the value added is $1,000 − ($500 + $200) = 
$1,000 − $700 = $300.
Now consider a situation where protective tariffs exist; a prime mark next to a price
(P′) indicates a tariff-protected price. Suppose that the tariff rate (tF) on the final good is
10  percent and that the tariff on input A (tA) is 5 percent and on input B (tB) is 8 percent.
If we assume that the country is a small country—remember, it takes world prices as
given and cannot influence them—then the domestic prices of the goods with the tariffs in
place are
PF′ = $1,000 + 0.10($1,000) = $1,000 + $100 = $1,100
PA′ = $500 + 0.05($500) = $500 + $25 = $525
PB′ = $200 + 0.08($200) = $200 + $16 = $216
The value added in industry F under protection is $1,100 − ($525 + $216) = $359. The
industry has experienced an increase in its value added because of the tariffs, and there-
fore the factors of production (land, labor, and capital) working in industry F are able
to receive higher returns than under free trade. There is thus an economic incentive for
factors of production in other industries to move into industry F. Because the ERP is the
“Nominal” versus
“Effective” Tariff Rates
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percent change in the value added when moving from free trade to protection, the ERP in
this example is
Value added under protection − value added with free trade
Value added with free trade
=
VA′ − VA
VA
= $359 − $300
$300
= 0.197 or 19.7%
Thus, the factors of production in industry F have benefited from the tariffs, although
consumers have lost. A more common formula for calculating the ERP for any industry j
utilizing inputs designated as i is
ERPj =
tj − Σiaijti
1 − Σiaij
where aij represents the free-trade value of input i as a percentage of the free-trade value
of the final good j, tj and ti represent the tariff rates on the final good and on any input i,
respectively, and the Σi sign means that we are summing over all the inputs. In the example,
the aij for input A is $500/$1,000 or 0.50, and the value of the aij for input B is $200/$1,000
or 0.20. The ERP in the example is the same as in the preceding calculation:
ERPF =
0.10 − [(0.50)(0.05) + (0.20)(0.08)]
1 − (0.50 + 0.20)
=
0.10 − (0.025 + 0.016)
1 − 0.70
=
0.10 − 0.041
0.30
= 0.059
0.30
= 0.197, or 19.7%
This second method of calculating the ERP has the advantage of illustrating three gen-
eral rules about the relationship between nominal rates and ERPs. These rules are (1) if the
nominal tariff rate on the final good is higher than the weighted-average nominal tariff rate
on the inputs, then the ERP will be higher than the nominal rate on the final good; (2) if the
nominal tariff rate on the final good is lower than the weighted-average nominal tariff rate
on the inputs, then the ERP will be lower than the nominal rate on the final good; and (3) if
the nominal tariff rate on the final good is equal to the weighted-average nominal tariff rate
on the inputs, then the ERP will be equal to the nominal rate on the final good.
IN THE REAL WORLD:
NOMINAL AND EFFECTIVE TARIFFS IN THE EUROPEAN UNION
Table 4 contains recent estimates of protection in several
agricultural sectors in the European Union. Note the striking
differences in the levels of protection indicated by the nomi-
nal rates and the ERPs for many of the sectors. The highest
ERP estimates were for sugar, livestock products, and paddy
rice (5.3, 6.5, and 3.8 times greater than the nominal rates,
respectively), and the lowest were for oilseeds (−1.6), dairy
(0), and processed rice (0), whose nominal rates were 0.0,
87.7, and 87.4 percent, respectively. These results clearly
indicate the importance of examining the entire tariff regime
when estimating the economic incentives associated with
tariffs on a final good.
(continued)
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IN THE REAL WORLD: (continued)
NOMINAL AND EFFECTIVE TARIFFS IN THE EUROPEAN UNION
Sector Nominal Rate ERP
Paddy rice 64.9% 245.3%
Cereals 23.1 56.1
Oilseeds 0.0 −1.6
Vegetables and fruits 14.5 17.1
Livestock products 41.2 266.4
Dairy 87.7 —
Processed rice 87.4 —
Sugar 77.5 411.1
Vegetable oil and fats 11.4 22.1
Textiles 8.3 8.2
Motor vehicles 7.8 10.2
Source: Alessandro Antimiani, Piero Conforti, and Luca Salvantici, “The Effective Rate of Protection of European
Agrifood Sector,” paper presented at the international conference Agricultural Policy Reform and the WTO: Where Are
We Heading?, Capri, Italy, June 2003, p. 9. Obtained from www.ecostat.unical.it/2003agtradeconf/.
TABLE 4 Levels of Protection in Selected European Union Agricultural Sectors, 2003

IN THE REAL WORLD:
NOMINAL AND EFFECTIVE TARIFF RATES IN VIETNAM AND EGYPT
Little recent work exists involving the calculation of effec-
tive rates of protection (ERPs) in high-income or developed
countries, but work on ERPs in developing countries is
becoming more frequent. Table 5 below indicates a sample
of nominal and effective tariff rates for sectors/industries
in Vietnam, drawn from a study by Bui Trinh and Kiyoshi
Kobayashi that estimated rates for 82 Vietnamese indus-
tries for the year 2009. As is evident, variation occurs
across and within industries in the levels of nominal and
effective rates and in the relationships of effective rates to
nominal rates. Table 6 then provides examples of nominal
rates and ERPs in Egypt in 2009, as calculated by Alberto
Valdés and William Foster. Clearly there are differences in
levels of nominal and effective rates and in the relationship
between the two types of rates in Egypt, just as is the case
in Vietnam.
Sector/Industry Nominal Tariff Rate Effective Tariff Rate
Agriculture, fisheries, forestry 2.194% 0.518%
Sugarcane 0.000 −2.129
Processed tea 25.140 34.381
Fisheries 8.942 20.060
TABLE 5 Nominal and Effective Tariff Rates, Vietnam, 2009
(continued)
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IN THE REAL WORLD: (continued)
NOMINAL AND EFFECTIVE TARIFF RATES IN VIETNAM AND EGYPT
Sector/Industry Nominal Tariff Rate Effective Tariff Rate
Mining and quarrying 1.551 1.516
Manufacturing 3.476 2.094
Processed, preserved meat and by-products 5.440 29.478
Textile products 7.177 31.863
Basic organic chemicals 0.564 −4.032
Computer and peripheral electronic devices 1.220 15.377
Source: Bui Trinh and Kiyoshi Kobayashi, “Measuring the Effective Rate of Protection in Vietnam’s Economy with Emphasis on the
Manufacturing Industry: An Input-Output Approach,” European Journal of Economics, Finance and Administrative Sciences, issue
44 (January 2012), pp. 94–95.
Sector/Industry Nominal Tariff Rate Effective Tariff Rate
Agriculture 8.30% 9.3%
Crude oil and extractive industries 3.39 1.7
Textiles 15.12 50.0
Gasoline 5.00 190.1
Cement 2.38 −1.6
Iron and steel 7.71 136.3
Aluminum and products 12.83 50.8
Construction 0.00 −17.0
Hotels and restaurants 0.00 −4.9
Source: Alberto Valdés and William Foster, “A Profile of Border Protection in Egypt: An Effective Rate of Protection Approach
Adjusting for Energy Subsidies,” Policy Research Working Paper 5685, The World Bank, Middle East and North African Region,
Poverty Reduction and Economic Management Unit, June 2011, p. 31, obtained from www-wds.worldbank.org. ●
TABLE 6 Nominal and Effective Tariff Rates, Egypt, 2009
Rule (1) incorporates an escalated tariff structure and reflects the situation in most
countries. It means that nominal tariff rates on imports of manufactured goods are higher
than nominal tariff rates on intermediate inputs and raw materials. This situation has par-
ticular relevance to trade between developed countries and developing countries.6 Because
the developed countries have escalated tariff structures with correspondingly heavier
6Tariff escalation can also be the case in developing countries. For example, a study for Indonesia indicated that
Indonesia’s average nominal tariff on final goods was 8.44 percent while the weighted-average nominal tariff
on inputs was 5.94 percent. See Mary Amiti and Josef Konings, “Trade Liberalization, Intermediate Inputs, and
Productivity: Evidence from Indonesia,” American Economic Review 97, no. 5 (December 2007), p. 1612.
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protection for manufactured goods industries than for intermediate goods and raw materi-
als industries, developing countries have maintained that this discriminates against their
attempts to develop manufacturing and that it consigns the developing countries to export-
ing products at an early stage of fabrication.
As final notes on the “nominal” versus “effective” tariff distinction, remember that an
industry does not always have an ERP higher than its nominal rate. Further, an ERP can
be negative, meaning that the tariffs on inputs are considerably higher than the tariff on
the final good. Thus, the structure of tariffs in this latter situation works to drive factors of
production out of the industry rather than draw resources in.
In overview, the nominal tariff rate is useful for assessing the price impact of tariffs
on consumers. For producers, however, the effective rate is more useful because factors
tend to flow toward industries with relatively higher ERPs. The nominal rate concept is
used in Chapter 14 because the focus is on consumer welfare; nevertheless, the effective
rate concept also should be kept in mind in evaluating the full impact of protection. In the
assessment of development prospects and economic planning in the developing countries,
a strong case can be made for ERPs as analytical tools, even more so than nominal rates
of protection.
CONCEPT CHECK 1. Why might consumers of an imported good
prefer a specific tariff to an ad valorem tariff
on the good?
2. Suppose that a friend tells you that the United
States should not give most-favored-nation
treatment to France because the French do
not deserve to be treated better than all our
other trading partners. How is your friend
misinterpreting the MFN concept?
3. Why and how does the existence of prohibi-
tive tariffs distort the weighted-average tariff
rate of a country?
4. Explain how the value added in a domestic
industry is enhanced if the nominal tariff rate
on imports of the industry’s final product is
increased while the nominal tariff rates on the
industry’s inputs are left unchanged.
EXPORT TAXES AND SUBSIDIES
In addition to interfering on the import side of trade by means of import tariffs, coun-
tries also interfere with their free flow of exports. An export tax is levied only on home-
produced goods that are destined for export and not for home consumption. The tax can
be specific or ad valorem. Like an import tax or tariff, an export tax reduces the size of
international trade. An export subsidy, which is really a negative export tax or a payment
to a firm by the government when a unit of the good is exported, attempts to increase
the flow of trade of a country. Nevertheless, it distorts the pattern of trade from that of
the comparative-advantage pattern and, like taxes, interferes with the free-market flow
of goods and services and reduces world welfare.
The export subsidy has been the subject of a great deal of discussion over the years.
For example, the United States and the European Community, after heated discussion and
threatened retaliatory tariff actions, agreed in November 1992 to reduce their agricultural
export subsidies 36 percent in value over a six-year period (see Economic Report of the
President, January 1993, pp. 19–20). In addition, U.S. manufacturers have often main-
tained that partner country export subsidies are an important element of “unfair trade”
in the world economy. Indeed, as of July 13, 2015, U.S. manufacturers had succeeded in
getting 60 “countervailing duties” in place against foreign export-subsidized goods coming
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into the United States. The duties were levied against goods from 12 different countries.7
Also, the U.S. government’s Export-Import Bank provides loans and loan guarantees to
selected domestic exporters. Opponents to the Bank state that such loans and guarantees
amount to export subsidies.
NONTARIFF BARRIERS TO FREE TRADE
Besides the use of tariffs and subsidies to distort the free-trade allocation of resources,
government policymakers have become very adept at using other, less visible, forms of
trade barriers. These are usually called nontariff barriers (NTBs) to trade, and they have
become more prominent in recent years. Economists have noted that as tariffs have been
reduced through multilateral tariff negotiations during the past 50 years, the impact of this
reduction may have been importantly offset by the proliferation of NTBs. Our purpose now
is to describe some of these NTBs.
The import quota differs from an import tariff in that the interference with prices that can
be charged on the domestic market for an imported good is indirect, not direct. It is indi-
rect because the quota itself operates directly on the quantity of the import instead of on
the price. The import quota specifies that only a certain physical amount of the good will
be allowed into the country during the time period, usually one year. This is in contrast to
the tariff, which specifies an amount or percentage of tax but then lets the market determine
the quantity to be imported with the tariff in existence. Nevertheless, the quota can be spec-
ified in “tariff equivalent” form. For example, the U.S. International Trade Commission
(USITC) estimated that, while the average U.S. tariff rate on apparel coming from coun-
tries subject to apparel import quotas by the United States in 2002 was 11.3 percent,
the quotas themselves, by restricting supply, acted like an additional 9.5 percent tariff.
In dairy products, the existing 10.0 percent average tariff was supplemented by another
27.8 percent tariff equivalent due to quotas.8
An alternative to the import quota is the voluntary export restraint (VER). It originates
primarily from political considerations. An importing country that has been preaching the
virtues of free trade may not want to impose an outright import quota because that implies
a legislated move away from free trade. Instead, the country may choose to negotiate an
administrative agreement with a foreign supplier whereby that supplier agrees “volun-
tarily” to refrain from sending some exports to the importing country. The inducement for
the exporter to “agree” may be the threat of imposition of an import quota if the VER is not
adopted by the exporter. There are also some possible direct benefits to the exporter from
the VER (see Chapter 14).
Besides quotas and VERs, there are other types of NTBs. We discuss several of them
here, with the main purpose of strengthening the point that governments employ many dif-
ferent types of devices that prevent a free-trade allocation of resources.
An object of discussion in recent years, as well as an object of an international code
of behavior in the 1979 Tokyo Round of trade negotiations, is legislation known as
government procurement provisions. In general, these provisions restrict the purchasing
Import Quotas
“Voluntary” Export
Restraints (VERs)
Government
Procurement
Provisions
7U.S. International Trade Commission, “Antidumping and Countervailing Duty Orders in Place as of July 13,
2015,” obtained from www.usitc.gov.
8U.S. International Trade Commission, The Economic Effects of Significant U.S. Import Restraints: Fourth Update
2004, USITC Publication 3701 (Washington, DC: USITC, June 2004), p. xvii, obtained from www.usitc.gov.
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of foreign products by home government agencies. For example, the “Buy American”
Act stipulated that federal government agencies must purchase products from home U.S.
firms unless the firm’s product price was more than 6 percent above the foreign supplier’s
price. This figure was 12 percent for some Department of Defense purchases, and, for a
time a 50 percent figure was used. (See Balassa, 1967; and Cooper, 1968.) In early 2009,
“Buy American” provisions regarding steel and other manufactured products used in pub-
lic infrastructure projects were contained in the $787 billion stimulus package passed by
Congress and signed into law by President Obama. Many state governments in the United
States also have “Buy American” statutes. As another example, the European Community
(EC) announced in 1992 that EC public utilities would be required to purchase inputs from
EC suppliers with a 3 percent price preference—which set off threatened retaliation by the
United States and an eventual compromise. A WTO–sponsored agreement on government
procurement designed to put foreign and domestic purchases on an equal footing went
into effect on January 1, 1996, but not all purchases or all WTO members are included. In
addition, government procurement provisions are increasingly being expanded to include
nonprice considerations.
Domestic content provisions attempt to reserve some of the value added and some of
the sales of product components for domestic suppliers. For example, this kind of policy
would stipulate that a given percentage of the value of a good sold in the United States
must consist of U.S. components or U.S. labor. A restrictive policy of this sort appeared
in trade bills (not enacted) before the U.S. Congress. These provisions can also appear in
developing countries. For instance, the attempt to produce automobiles in Chile during
the “import-substituting industrialization” phase of development in the 1960s contained
increasingly restrictive domestic content provisions. (See Leland Johnson, 1967.) More
recently, under NAFTA, members do not permit duty-free entry of automobiles from other
members unless 62.5 percent of the value of the automobile originates in the NAFTA
countries of Canada, Mexico, and the United States. These provisions clearly interfere
with the international division of labor according to comparative advantage, as domestic or
NAFTA-wide sources of parts and labor may not be the low-cost sources of supply.
A controversial NTB from the standpoint of U.S. firms concerns the European tax system.
The value-added tax (VAT) common in western Europe is what economists call an “indi-
rect” tax. The United States puts more reliance on direct taxes such as the personal income
tax and the corporate income tax. Direct taxes are taxes levied on income per se, while
indirect taxes are levied on a base other than income.
International trade implications arise from the different tax systems because the WTO
permits different treatment for indirect taxes than for direct taxes. With the VAT, any firm
that works on components at any stage of the production process, adds value to them,
and then sells them in a more finished form must pay a tax on the value added. This tax
is passed on to the buyer of the more finished good. Ultimately, the final price to the con-
sumer incorporates the accumulation of VATs paid through the production process. Under
WTO rules, any import coming into the country must pay the equivalent tax because it
too is destined for consumption, and both goods will then be on an equal footing. To U.S.
firms trying to sell to Europe, this border tax looks like a tariff, even though it is not labeled
as such.
European exporters, however, will have paid the accumulation of the VAT through
the prior production stages. But because the good is not destined for final use within its
country of manufacture, the exporter can collect a rebate for the accumulated VAT paid.
To U.S. competitors, this looks suspiciously like an unfair export subsidy. The whole indi-
rect-direct tax controversy arises because such border taxes and rebates are not permitted
Domestic Content
Provisions
European Border
Taxes
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for direct taxes. The reasoning comes from public finance literature on the ability of each
type of tax to be “passed on” to consumers. This is the source of the controversy over
the U.S. tax treatment of separately established Foreign Sales Corporations referred to
at the beginning of this chapter. The WTO regards the favorable tax treatment as akin to
a rebate of a direct tax, the corporate income tax. This procedure is not permitted, as a
direct tax is not the same as an indirect tax such as the VAT. Another point to consider is
that the European countries’ exchange rates against the dollar may negate the effects of
border taxes and subsidies. For example, if the tax on imports reduces imports from the
United States and thus reduces European demand for the dollar, the dollar will depreciate.
This depreciation thereby lowers the price of the U.S. good to European consumers. We
do not need to get into these issues, but it is clear that a potential distortion of free-trade
patterns exists.
The point here is straightforward. Because tariffs on goods coming into a country differ by
type of good, the actual tax charged can vary according to the category into which a good
is classified. There is some leeway for customs officials, as the following example makes
clear: In August 1980, the U.S. Customs Service raised the tariff rate on imported light
trucks by simply shifting categories. Before then, unassembled trucks (truck “parts”) were
shipped to the West Coast and assembled in the United States. The tariff rate was 4 percent.
However, the Customs Service ruled that the imports were not “parts” but the vehicle itself.
The applicable duty to the vehicle was 25 percent. Arbitrary classification decisions clearly
can influence the size of trade.
This is a widely discussed area at the present time, and we will cover it in greater extent in
Chapter 16. In short, many nontariff regulations restrict services trade. For example, for-
eign insurance companies may be restricted in the types of policies they can sell in a home
country, foreign ships may be barred from carrying cargo between purely domestic ports
(as is the case in the United States), landing rights for foreign aircraft may be limited, and
developing countries may reserve data processing services for their own firms. As another
example, Canada has required that television stations provide that a specified percentage
of their programs be Canadian during any given year and particular times during each day.
These kinds of restrictions are less visible or transparent than many restrictions on goods.
However, because services are growing in world trade, restrictions on them are becoming
more serious as sources of departure from comparative advantage.
Trade-related investment measures (TRIMs) consist of various policy steps of a trade
nature that are associated with foreign investment activity within a country. Examples
would be “performance requirements,” whereby the foreign investor must export a certain
percentage of output (and thus earn foreign exchange for the host country), and require-
ments mandating that a specified percentage of inputs into the foreign investor’s final
product be of domestic origin. These measures occur frequently in developing countries,
and they distort trade from the comparative-advantage pattern.
Developing countries facing a need to conserve on scarce foreign exchange reserves may
resort to generalized exchange control. In the extreme, exporters in the developing coun-
tries are required to sell their foreign exchange earnings to the central bank, which in turn
parcels out the foreign exchange to importers on the basis of the “essentiality” of the import
purchases. Thus, free importation cannot take place because foreign exchange is rationed.
This form of restriction can result in a severe distortion of imports from the free-trade pat-
tern. In addition, advance deposit requirements are sometimes used by developing coun-
tries. In this situation, a license to import is awarded only if the importing firm deposits
Administrative
Classification
Restrictions on
Services Trade
Trade-Related
Investment Measures
Additional
Restrictions
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funds with the government equal to a specified percentage of the value of the future import.
The deposit is refunded when the imports are brought into the country, but in the meantime
the firm has lost the opportunity cost of the funds.
Several types of policies aimed at the domestic market also have direct implications for
trade flows. Health, environmental, and safety standards are applied by governments to
both domestic and foreign products. Surely, domestic consumers of foreign goods should
be protected from impurities and sources of disease, but some economists claim that restric-
tions are excessive in some instances and contain an element of protectionism. An exam-
ple is the controversial European restriction on the import of U.S. genetically engineered
products. This restriction has been ruled illegal by the WTO, but it remains in place as of
this writing. Similarly, governments may require that all products, foreign and domestic,
meet certain packaging and labeling requirements. In addition, inconsistent treatment of
intellectual property rights (through patents, copyrights, etc.) across countries can distort
international trade flows. In the Uruguay Round of trade negotiations, completed in 1994,
agreement was reached on harmonization of such practices, commonly known as trade-
related intellectual property rights (TRIPs). See Chapter 16.
Additional Domestic
Policies That Affect
Trade
IN THE REAL WORLD:
IS IT A CAR? IS IT A TRUCK?
In early 1989, the U.S. Customs Service proposed that some
imported minivans and sport-utility vehicles (such as the
Suzuki Samurai and the Isuzu Trooper) be reclassified from
“cars” to “trucks.” This administrative change would have
raised the ad valorem tariff rate to 10 times its previous value,
because the U.S. tariff rate on automobiles is 2.5  percent
but that on trucks is 25 percent. Then-chair Lee Iacocca
of Chrysler declared that the reclassification was desirable
because it would bring in more tax revenue—$500 million
per year, which would help to reduce the U.S. federal gov-
ernment budget deficit. (It would be unseemly for him to
praise it for giving Chrysler a greater level of protection.)
The reaction to the proposed reclassification was a howl
of protest from imported car dealers and consumer interests.
In response, the Customs Service reconsidered the matter,
then issued rulings on which of the vehicles would be clas-
sified as cars and trucks. For example, if a particular sport-
utility vehicle had four doors, it was a car; if two doors, a
truck. If a minivan had windows on the side and back, and
rear and side doors and seats for two or more persons behind
the front seat, it was a car; if it lacked any of these features,
it was a truck.
Oddly enough, the proposed reclassification occurred
partly because of pressure from Suzuki Motors. Suzuki had a
small share of the Japanese VER of 2.3 million automobiles
annually, and it believed that the reclassification would help
its sales in the United States because trucks were not subject
to the VER. Despite the higher tariff rate, Suzuki judged that
it could be more successful in the U.S. market if it was not
limited to its small VER share. Another sidelight is that the
25 percent truck tariff itself had originated from retaliation
by the United States in 1963 against import duties placed
by the European Community on U.S. poultry exports (the
infamous “Chicken War”).
The classification controversy reappeared in 1993, when
the U.S. automobile industry pushed (unsuccessfully) for
a move of some minivans from the car to truck category.
Chrysler pledged to limit its own minivan price increases
if the reclassification step was undertaken. Chrysler’s advo-
cacy of the higher duties on minivans occurred despite the
fact that Chrysler’s share of the minivan market increased
substantially from 1992 to 1993.
Sources: “A Bad Trade Rule Begets Another,” The New York Times,
January 24, 1989, p. A20; Eduardo Lachica, “Imports Ruling for
Vehicles Is Eased by U.S.,” The Wall Street Journal, February 17,
1989, pp. A3, A9; idem, “Suzuki Samurai, Others to Be Treated
as Truck Imports with Higher Tariffs,” The Wall Street Journal,
January 5, 1989, p. C9; Eduardo Lachica and Walter S. Mossberg,
“Treasury Rethinks Increased Tariffs on Vehicle Imports,” The
Wall Street Journal, January 13, 1989, p. 85; Neal Templin and
Asra Q. Nomani, “Chrysler to Curb Minivan Price Rises If Japanese
Vehicles Get a 25% Tariff,” The Wall Street Journal, March 25,
1993, p. A3. ●
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IN THE REAL WORLD:
EXAMPLES OF CONTROL OVER TRADE
Countries have differing degrees of interference with free
trade. As examples, we summarize below some regula-
tions imposed by Australia, El Salvador, and Pakistan. The
material is drawn from the International Monetary Fund’s
Annual Report on Exchange Arrangements and Exchange
Restrictions 2014. The regulations for Australia are those
in effect as of January 31, 2014; those for El Salvador and
Pakistan are in effect as of December 31, 2013.
AUSTRALIA
For some goods, written authorization is required before
imports are allowed—examples are narcotics, firearms,
rough diamonds, and certain glazed ceramics. Most imports
of agricultural goods do not face any tariffs. There is a
maximum tariff rate of 5 percent on many manufactured
goods; clothing and some household textile products have
tariffs of 10 percent, but these rates were to fall to 5 percent.
Australia has free-trade agreements with Chile, Malaysia,
New Zealand, Singapore, Thailand, and the United States.
The Chile, Thailand, and U.S. agreements were not fully
implemented in 2014 but are scheduled to be completed by
the end of 2015.
On the export side, there are export controls on prod-
ucts with military application and items with applications
to biological, chemical, or nuclear weapons. Some export
certification procedures are in place with regard to agricul-
tural products; controls also exist pertaining to the export of
wood chips and whole logs. Exports to Iran and Syria of oil,
gas, and petrochemical products are prohibited, as well as
the export of gold and diamonds to government entities in
those two countries.
EL SALVADOR
Special authorization is required for the import of ethyl alco-
hol, weapons, and explosives, and an environmental permit
is necessary to import chemicals. There is a ban on the
import of “subversive material or teachings contrary to the
political, social, and economic order” as well as prohibitions
on importing lightweight motor vehicles greater than 8 years
old and heavy vehicles greater than 15 years old (with some
exceptions—for example, collector’s items and vehicles used
exclusively by disabled persons). El Salvador’s tariff rates
conform to the base rates consistent with its membership in
the Central American Common Market (CACM)—5 percent
and 10 percent on CACM-produced raw materials and inter-
mediate/capital goods, respectively. El Salvador’s average
tariff rate is 6.0 percent.
All exports must be registered. Exports that, in addition,
require special authorization include cane sugar, agrochemi-
cals, wildflowers and plants, domestic-grown beans, rice,
sorghum, dairy products, and coffee. There are no export
taxes. An interesting aspect of the El Salvador situation
is that the U.S. dollar is legal tender, and dollars circulate
within the country alongside the local colones (at a fixed rate
of 8.75 colones = $1).
PAKISTAN
There is a “negative list” of import products of 44 items
banned for religious and health reasons, and imports from
Israel are prohibited. In addition, a negative list on imports
from India contains 1,209 products. Taxes on imports
must be collected in advance at a rate of 5 percent for
some imports and 5.5 percent for others; in the case of a
foreign-produced film being imported for viewing, a tax of
12 percent of the value of the film applies. In addition, a for-
eign company operating in Pakistan faces a tax of 10 percent
on any remittance of dividends and profits by the company
to its headquarters located abroad. Provision of the neces-
sary foreign exchange for Pakistani college students’ tuition
and fees abroad is permitted without prior approval.
Export licenses are not required, but there is an “export
development surcharge” of 0.25 percent of the value of
exports. A tax of 1 percent also is levied on the foreign
exchange earnings from the export of goods. However,
exemptions from export taxes exist for exports of computer
software and information-technology services (until June
30, 2016), certain exports of carpets, leather, surgical goods,
sporting goods, and textiles, and certain exports of cooking
oil to Afghanistan.
Source: International Monetary Fund, Annual Report on Exchange
Arrangements and Exchange Restrictions 2014 (Washington, DC:
IMF, 2014), pp. 152–70, 907–23, 2059–76.

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IN THE REAL WORLD:
THE EFFECT OF PROTECTION INSTRUMENTS
ON DOMESTIC PRICES
In an attempt to ascertain the effects of tariffs, government
procurement provisions, import quotas, VERs, and other
such trade restrictions, economist Scott Bradford in 2006
calculated some revealing estimates. His guiding hypoth-
esis was that such barriers will cause differences between
the world price (landed import price) of a final good and
its domestic price in the importing country. This makes
good economic sense—a tariff will clearly generate a differ-
ence between the two prices, with the domestic price being
higher, and nontariff barriers will do the same thing.
Bradford focused on food items because agricultural
trade in particular is subject to a wide variety of NTBs
as well as tariff barriers to trade. He employed price data
from the Organization for Economic Cooperation and
Development for 1999 for about 50 traded goods for nine
countries (Australia, Belgium, Canada, Germany, Italy,
Japan, the Netherlands, the United Kingdom, and the United
States). He calculated, for each commodity in each country,
the ratio of the domestic price to the world price. The extent
to which the ratio exceeds 1.000 was used as a measure of
protection afforded to the domestic suppliers of the given
commodity. Further, Bradford separated the protection into
that due to NTBs and that due to tariffs. (Note: Although the
calculations pertain to 1999, as of this writing no multilateral
trade negotiations have been completed that would alter the
rates used in these calculations.)
Tables 7 and 8 give selected results for four products
for five countries, together with the weighted average for
all food goods for each country. Table 7 shows Bradford’s
results for the NTBs, and Table 8 does the same for tariff bar-
riers. As an example of the technique, consider the number
1.237 for dairy products in Canada in Table 7. This figure
means that, due to NTBs, Canadian dairy farmers receive
23.7 percent protection from NTBs in the sense that the price
for their products is 23.7 percent higher than it would be
with free trade (in which case the figure would be 1.000).
Analogously, in Table 8, the number 1.098 for vegetables,
fruit, and nuts for Japan indicates that tariffs alone in Japan
raise the price of those items by 9.8 percent above the free-
trade level.
When examining all of the items (not solely the four
items listed) considered by Bradford, the average figure—
the weighted geometric mean—it is clear that, for NTBs,
Japan has the greatest protection of the five countries
(90.8 percent because the figure is 1.908). The protec-
tion via NTBs is, in descending order, 21.9 percent for the
United Kingdom, 20.2 percent for Australia, 9.8 percent for
Canada, and 7.3 percent for the United States. With respect
to tariffs, the United Kingdom has the greatest protection in
food products on average (21.0 percent), followed by Japan
(14.9 percent), Canada (9.6 percent), the United States (8.2
percent), and Australia (3.6 percent).
(continued)
Food Item Australia Canada Japan United Kingdom United States
Fresh vegetables, fruit, nuts 1.055 1.046 2.048 1.317 1.203
Beef, sheep, goat, horse meat products 1.000 1.021 5.332 2.026 1.001
Dairy products 1.274 1.237 1.759 1.081 1.145
Processed rice 1.000 1.000 2.773 1.000 1.119
Weighted geometric mean 1.202 1.098 1.908 1.219 1.073
Source: Scott Bradford, “The Extent and Impact of Food Non-Tariff Barriers in Rich Countries,” Journal of International Agricultural Trade
and Development 2, no. 1 (2006), p. 139. Nova Science Publishers.
TABLE 7 Ratios of Domestic Prices to World Prices Generated by Nontariff Barriers, 1999
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IN THE REAL WORLD: (continued)
THE EFFECT OF PROTECTION INSTRUMENTS
ON DOMESTIC PRICES
Food Item Australia Canada Japan United Kingdom United States
Vegetables, fruit, nuts 1.009 1.053 1.098 1.119 1.064
Bovine cattle, sheep, and goat, horse meat products 1.000 1.192 1.497 1.000 1.108
Dairy products 1.006 1.099 1.250 1.083 1.082
Processed rice 1.000 1.006 1.000 1.120 1.054
Weighted geometric mean 1.036 1.096 1.149 1.210 1.082
Source: Scott Bradford, “The Extent and Impact of Food Non-Tariff Barriers in Rich Countries,” Journal of International Agricultural Trade
and Development 2, no. 1 (2006), p. 140. Nova Science Publishers.
TABLE 8 Ratios of Domestic Prices to World Prices Generated by Tariff Barriers, 1999

Subsidies to domestic firms also have direct implications for trade. Although a particu-
lar subsidy may not be intended to affect trade, a subsidy that reduces a firm’s cost may
stimulate exports. For example, U.S. lumber producers have long felt that the Canadian
provincial governments sell timber rights (stumpage fees) to Canadian firms at subsidized
and unfairly low prices, putting U.S. firms at a competitive disadvantage, and counter-
vailing duties have been imposed. In the case of an import-competing firm, the lowering
of a firm’s own costs through government subsidies can make the domestic firm more
cost competitive, leading to an expansion of output and employment and a reduction in
imports. A low-interest U.S. government loan to the Chrysler Corporation in the Carter
administration can also be thought of as a government subsidy program that had clear
trade implications. The global financial/economic crisis that started in 2007 led to large-
scale government subsidies and loans to industries in many countries, and especially in
the United States. Similarly, government-provided managerial assistance, retraining pro-
grams, R&D financing, investment tax credits or special tax benefits to domestic firms that
are producing traded goods can have a direct impact on relative cost competitiveness and
international trade.
In addition, spillovers from government-financed defense, space, and nonmilitary
expenditures can influence the international competitiveness of affected firms by their
impact on relative costs or product characteristics. The effect of such government pro-
grams or policies on trade flows will be even greater when such programs or policies allow
firms to experience economies of scale and be even more cost competitive.
In general, we see the presence of many policy instruments that directly and indirectly
affect international trade. We have mentioned only the most widely discussed instruments;
information on a particular country can be obtained only by studying that particular coun-
try. However, it is clear that free trade in the pure sense does not exist in the real world and
that various interferences can severely distort prices and resource allocation.
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CONCEPT CHECK 1. How can government procurement provi-
sions act like a tariff?
2. Which instrument does the use of domestic
content provisions resemble, a tariff or an
import quota? Why?
KEY TERMS
ad valorem tariff
advance deposit requirements
domestic content provisions
effective tariff rate [or effective rate
of protection (ERP)]
escalated tariff structure
export subsidy
export tax
Generalized System of Preferences
(GSP)
government procurement
provisions
import quota
import subsidies
most-favored-nation (MFN)
treatment [or normal trade
relations (NTR)]
nominal tariff rate
nontariff barriers (NTBs)
offshore assembly provisions
(OAP) [or production-sharing
arrangements]
preferential duties
prohibitive tariff
specific tariff
unweighted-average tariff rate
voluntary export restraint (VER)
weighted-average tariff rate
SUMMARY
The various instruments of trade policy have been discussed to
make the point that there are many different devices for altering
trade from its pattern of comparative advantage. Special atten-
tion was given to specific tariffs, ad valorem tariffs, export taxes
and subsidies, import quotas, and voluntary export restraints. In
addition, a number of the wide variety of NTBs to the free-trade
allocation of resources were briefly examined. Departures from
free trade are common because so many trade-distorting instru-
ments are in place. But what are the welfare effects of these
distortions? Can these policies really be good for the world as
a whole, for a country, or for particular groups within a country
given our conclusions on the virtues of unrestricted trade? The
next chapters attempt to answer these important questions in
detail.
QUESTIONS AND PROBLEMS
1. Explain why a country’s use of preferential duties is incon-
sistent with MFN treatment of trading partners by that
country.
2. Why do you suppose that there has been such a proliferation
of different instruments of protection?
3. Suppose, in a small country, that under free trade a final good
F has a price of $1,000, that the prices of the only two inputs
to good F, goods A and B, are PA = $300 and PB = $500,
and that 1 unit each of A and B is used in producing 1 unit of
good F. Suppose also that an ad valorem tariff of 20 percent
is placed on good F, while imported goods A and B face ad
valorem tariffs of 20 percent and 30 percent, respectively.
Calculate the ERP for the domestic industry producing good
F, and interpret the meaning of this calculated ERP.
4. Do you think that it is ever possible to obtain a good indi-
cation of the precise degree of protection accorded by a
country to its import-substitute industries? Why or why not?
(Remember that, in addition to tariffs, protection is also pro-
vided by various nontariff barriers.)
5. Suppose that a country announces that it is moving toward free
trade by reducing its tariffs on intermediate inputs while main-
taining its tariffs on final goods. What is your evaluation of the
announced “free-trade” direction of the country’s policy?
6. The nominal tariff rates on the 10 imports into the fictional
country of Tarheelia, as well as the total import value of each
good, are listed here:
Nominal
Rate Value
Nominal
Rate Value
Good A 10% $400 Good F 2.5% $400
Good B 5% $600 Good G 15% $100
Good C Free $500 Good H $0.50/
unit
$400
(100 units)
Good D 30% $300 Good I 40% $200
Good E 2% $200 Good J $2.50/
unit
$100
(10 units)
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(a) Calculate the unweighted-average nominal tariff rate for
Tarheelia.
(b) Calculate the weighted-average nominal tariff rate for
Tarheelia.
7. Suppose that recent inflation has resulted in an increase in
world prices and that all of the import values in Question
6 are increased by 25 percent (i.e., $400 becomes $500,
$600 becomes $750, and so forth). Given these new val-
ues, and assuming that the quantities of each import do not
change:
(a) Calculate the unweighted-average nominal tariff rate for
Tarheelia.
(b) Calculate the weighted-average nominal tariff rate for
Tarheelia.
8. Why can a case be made that the difference between the
domestic producer price of an import-competing good and
the world price of the good is a reasonable indicator of
the amount of domestic interference with free trade in the
good?
9. In the early stages of the Kennedy Round of multilateral
trade negotiations in the 1960s, U.S. officials claimed that
the European Economic Community (EEC) had higher aver-
age tariff rates than did the United States, and EEC officials
claimed that the United States had higher average tariff rates
than did the EEC. It so happened that both claims were cor-
rect. How is this possible?
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LEARNING OBJECTIVES
LO1 Illustrate how trade policies affect a product market in a small-country
setting.
LO2 Illustrate how trade policies affect a product market in a large-country
setting.
LO3 Explain the general equilibrium effects of protection.
LO4 Identify broader repercussions of trade policy instruments.
THE IMPACT OF TRADE
POLICIES14
CHAPTER
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INTRODUCTION
In March 2002 President George W. Bush, following a recommendation by the U.S. International
Trade Commission, an independent federal agency that investigates trade matters, imposed a
variety of tariffs on imports of steel into the United States. Ad valorem tariffs were imposed
for three years, with some of them having a downward-sliding scale over the years, and the
maximum tariff rate was 30 percent. The stated intent of the tariffs was to provide the U.S. steel
industry with “breathing room” so that it could upgrade its equipment and reduce labor costs in
order to become more competitive. Clearly, competitiveness had been slipping. Imports of steel
products had risen from 18 percent of U.S. steel consumption in 1990 and 1991 to 31.4 percent
in 1998, 27.7 percent in 1999, 28.7 percent in 2000, and 25.5 percent in 2001. The steel industry
applauded the decision, but some politicians didn’t think that the import restrictions went far
enough. For example, Senator Richard Durbin (D–IL) likened the actions to throwing a 30-foot
rope to someone who was “drowning 40 feet offshore.” Foreign exporting countries protested the
action. British Prime Minister Tony Blair said that the import restrictions were “unacceptable and
wrong,” and Germany and China in particular registered strong objections. In addition, U.S. steel
consumers faced sharply rising prices because of the tariffs, and they undertook such actions as
hiring public relations firms and organizing protests. One firm in Illinois saw its steel input costs
rise by more than 50 percent, and it had cut production by 15 percent. The objections by consum-
ers are understandable in view of an estimate by Gary C. Hufbauer of the Peterson Institute for
International Economics that, over the previous 30 years, various U.S. import protections had
cost steel consumers $120 billion. The objections became so heated that the Bush administration
soon implemented a number of exceptions to the tariff impositions and later repealed the tariffs.
As with all tariffs, the steel case discussed here indicates that there are gainers and losers
from actions that restrict international trade. The purpose of this chapter is to explore the
effects of the tools of trade policy that were discussed in Chapter 13 on the nation that
uses the tools. We thus examine the winners and losers when trade-distorting measures are
undertaken and the net effects on the country.
The initial or direct impact of a trade restriction takes place in the market of the com-
modity that is the focus of the specific instrument. When the analysis of a policy effect is
confined to only one market and the subsequent or secondary effects on related markets
are ignored, a partial equilibrium analysis is being conducted. While the most immediate
and, very likely, the strongest effects are felt in the specific market for which the instrument
is designed, it is important to remember the secondary effects. Because these secondary,
or indirect, effects are often important, economists try to examine the effects of economic
policy in a general equilibrium model. In this framework, the markets for all goods are ana-
lyzed simultaneously and the total direct and indirect effects of a particular policy are deter-
mined. Because both partial and general equilibrium impacts are useful for policy analysis,
we will use both approaches to examine the effects of trade policy instruments. The first two
sections are devoted to the analysis of trade restrictions in a partial equilibrium context, and
the third section to an analysis in a general equilibrium framework. The central thrust of the
chapter is that there is generally a net social cost to the country that employs trade restric-
tions, regardless of the type of instrument employed or the framework of analysis.
Gainers and Losers
from Steel Tariffs1
1This summary draws from the following sources: Robert Guy Matthews and Neil King, Jr., “Imposing Steel
Tariffs, Bush Buys Some Time for Troubled Industry,” The Wall Street Journal, March 6, 2002, pp. A1, A8; Neil
King, Jr., and Geoff Winestock, “Bush’s Steel-Tariff Plan Could Spark Trade Battle,” The Wall Street Journal,
March 7, 2002, pp. A3, A8; “Free Trade Over a Barrel,” The Wall Street Journal, July 9, 2002, p. A18; Neil King,
Jr., and Robert Guy Matthews, “So Far, Steel Tariffs Do Little of What President Envisioned,” The Wall Street
Journal, September 13, 2002, pp. A1, A12; “Steel Consumption and Imports,” obtained from www.steelnet.org,
the website of the Steel Manufacturers Association.
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TRADE RESTRICTIONS IN A PARTIAL EQUILIBRIUM SETTING:
THE SMALL-COUNTRY CASE
First, let us examine the market in which an economically small (price-taker) country
imports a product because the international price is less than the domestic equilibrium price
in autarky (see Figure 1).2 Because the country can import all that it wishes at the interna-
tional price (Pint), the domestic price (P0) equals the international price. If the small country
imposes an import tariff, the domestic price of the foreign good increases by the amount of
the tariff. With an ad valorem tariff, the domestic price now equals Pint(1 + t) = P1, where
Pint is the international price and t is the ad valorem tariff rate. (With a specific tariff, the
domestic price equals Pint +  tspecific.) With the increase in domestic price from P0 to P1,
domestic quantity supplied increases from QS0 to QS1, domestic quantity demanded falls
from QD0 to QD1, and imports decline from (QD0 − QS0) to (QD1 − QS1). What is the net
impact of these changes? Because the adoption of this policy involves both winners and
losers, we must turn to devices that allow us to evaluate the costs and the benefits accruing
to all those affected.
To measure the effect of a tariff, we employ the concepts of consumer and producer
surplus. The concept of consumer surplus refers to the area bounded by the demand curve
on top and the market price below. It reflects the fact that all buyers pay the same market
price regardless of what they might be willing to pay. Consequently, all those consumers
who pay less (the market price) than they would be willing to pay (as represented by the
height of the demand curve) are receiving a surplus [see Figure 2, panel (a)]. As market
price rises, this consumer surplus falls; as price falls, consumer surplus increases.
The Impact of an
Import Tariff
2This chapter deals with the case where the domestic good and the imported good are homogeneous, or identi-
cal. For a treatment of the more complex situation where the goods are close substitutes, but not identical, see
Appendix A to this chapter.
FIGURE 1 The Single-Market Effect of a Tariff in a Small Country
In the small country, the imposition of tariff rate t causes the domestic price to rise by amount tP0; that is, the
new price is equal to Pint (1 + t). The increase in price from P0 to P1 causes the quantity demanded to fall from
QD0 to QD1, the domestic quantity supplied to rise from QS0 to QS1, and imports to decline from (QD0 − QS0) to
(QD1 − QS1).
P
Q
0
D
P0
QS1QS0
(1+ t )
S
P1 Pint
QD1 QD0
Pint
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In a similar vein, the concept of producer surplus refers to the area bounded on top by
the market price and below by the supply curve. Because all producers receive the same
market price, a surplus occurs for all units whose marginal cost of production (represented
by the supply curve) is less than the market price received [see panel (b) of Figure 2].
Consequently, as price increases, producer surplus increases, and as market price falls,
producer surplus decreases. A change in market price thus leads to a transfer of surplus
between producers and consumers. With an increase in price, producer surplus is increased
and consumer surplus is decreased. For a price decrease, surplus is transferred from pro-
ducers to consumers. For our purposes, the changes in producer and consumer surplus that
result from the tariff-induced price change are of interest.
Let us now isolate the effects of a tariff on a market and estimate conceptually the vari-
ous effects accruing to the winners and losers. The two actors who gain from the imposi-
tion of a tariff are producers and the government. In Figure 3, a 20 percent ad valorem tariff
imposed on the market causes the domestic price to rise from $5 to $6, increasing producer
surplus by trapezoid area ABCJ. At the same time, the government collects the tariff ($1)
on each unit of the new level of imports; total receipts are represented by rectangular area
KCFG. The losers from this policy are consumers who have to pay a higher price and con-
sequently reduce their quantity demanded. This leads to a loss in consumer surplus equal
to trapezoid area ABFH. What is the net effect of this tariff? Part of the loss in consumer
surplus is transferred to the government (area KCFG) and part to producers (area ABCJ).
This leaves two triangular areas, JCK and GFH, which reflect losses in consumer surplus
that are not transferred to anyone. These areas are the deadweight losses of the tariff and
represent the net cost to society of distorting the domestic free-trade market price. They can
be viewed as efficiency losses resulting from the higher cost of domestic production on the
margin (area JCK) and the loss in consumer surplus accompanying the tariff (area GFH)
on the units consumers no longer choose to purchase. Because of the higher product price
resulting from the tariff, consumers switch to alternative goods that bring lower marginal
satisfaction per dollar.
FIGURE 2 The Concepts of Consumer and Producer Surplus
The amount of consumer surplus in a market is defined as the area bounded on top by the demand curve and on the bottom by the market price,
indicated by the shaded area in panel (a). Producer surplus is shown as the shaded area in panel (b). It is equal to the area bounded on top by the
market price and on the bottom by the supply curve.
Price
P
Quantity
D
S
Quantity0 0
Price
P
(a) (b)
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These changes in consumer and producer surplus allow us to place a value on the impact
of the tariff. For example, area ABFH (loss in consumer surplus with the tariff) is equal
to the area of rectangle ABFG plus the area of triangle GFH. Similarly, the value of the
gain in producer surplus is equal to the area of rectangle ABIJ plus the area of triangle JIC
(which, because the lines are straight lines, equals the area of triangle JCK). The value of
government revenue received is equal to the area of rectangle KCFG. Using the quantities
and prices from Figure 3, the various effects are
Change in consumer surplus (−) = ($1)(160) + (1/2)($1)(190 − 160)
= (−)$175
Change in producer surplus (+) = ($1)(100) + (1/2)($1)(120 − 100)
= (+)$110
Change in government revenue (+) = ($1)(160 − 120)
= (+)$40
Deadweight losses = (1/2)($1)(120 − 100) + (1/2)($1)(190 − 160)
= $25
There is thus a net cost to society of $25 due to the tariff (− $175 + $110 + $40). Care
must be taken, however, in interpreting these precise values in a welfare context. Because
one dollar of income may bring different utility to different individuals, it is difficult to
determine the exact size of the welfare implications when real income is shifted between
two parties, in this case from consumers to producers. In addition, part of the loss in con-
sumer surplus may be offset by government use of the revenue, which affects consumers in
a positive way. However, it is clear that there is a net efficiency cost to society whenever
prices are distorted with a policy such as a tariff. From Chapter 6, we know that free trade
FIGURE 3 The Welfare Effects of a Tariff in a Small Country
The 20 percent ad valorem tariff causes the domestic price to increase from $5 to $6. This causes a loss in con-
sumer surplus equal to area ABFH. Because of the increase in price, producers gain a surplus equal to area ABCJ.
The government collects revenue equal to area KCFG, the product of the tariff ($1) times the new quantity of
imports (40) existing with the new tariff. Lost consumer surplus that is not transferred either to producers or to the
government is equal to the sum of the areas of triangles JCK and GFH. These are referred to as the deadweight
efficiency losses of the tariff and reflect the net welfare effect on the country of the imposition of the tariff.
P
($)
Q
D
B
S
6.00 Pint
Pint5.00
A
I
J
C F
K G H
1000 120 160 190
(1+ t )
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benefits society because the losers could be paid compensation and some income could
still be “left over.” In reverse, the departure from free trade has reduced country welfare.
The preceding analysis suggests that a tariff produces a net efficiency (welfare) loss, so
the question arises, What are the effects of alternative trade policies such as quotas or
producer subsidies? Might they be preferred to tariffs on economic efficiency and welfare
grounds?
As explained in Chapter 13, a quota operates by limiting the physical amount of the good
or service imported. This reduces the quantity available to consumers, which in turn causes
the domestic price to rise. The domestic price continues to rise until the quantity supplied
domestically at the higher price plus the amount of the import allowed under the quota
exactly equals the reduced quantity demanded. The quota thus restricts quantity supplied,
causing price to adjust, in contrast to a tariff, which induces a quantity adjustment by
fixing a higher domestic price. The market effects in the two cases are exactly the same.
Return to Figure 3. The imposition of a 20 percent tariff caused the domestic price to rise
to $6 and the quantity of imports to decline from 90 units to 40 units, as domestic quantity
supplied increased and domestic quantity demanded decreased. The imposition of a quota
of 40 units would have produced the very same result! With imports restricted to 40 units,
the domestic price will rise and continue to rise until the combination of domestic quantity
supplied and the quota-restricted imports equals quantity demanded. Thus, every quota
has an equivalent tariff that produces the same market result, just as every tariff has an
equivalent quota.3
While the market effects of tariffs and quotas are identical, the welfare implications
are not. Since the price and quantity adjustments are the same under both instruments,
the changes in producer surplus, consumer surplus, and the consequent deadweight effi-
ciency losses are also the same. The government revenue effect is, however, not the same.
With a tariff, the government receives revenue equal to the amount of the tariff per unit
times the quantity of imports. No such tax is collected under a quota. In effect, the dif-
ference between the international price and the domestic price of the import good is an
economic quota rent, which may accrue to the domestic importer/retailer, the foreign sup-
plier/foreign government, or the home government or may be distributed among the three.
Domestic importers/retailers will receive the rent if foreign suppliers do not organize to
raise the export price or if the home government does not require that everyone importing
the good buy a license from the government in order to do so. Foreign suppliers receive the
quota rent if they behave in a noncompetitive, monopolistic manner and force up the price
they charge the importing country’s buyers. However, it is also possible that the foreign
government might step in and devise a scheme for allocating the supply of exports whereby
it receives the quota rent; for example, the foreign government sells export licenses at a
price equal to the difference between the international price and the domestic price in the
quota-imposing country. If either foreign suppliers or the foreign government captures
the rent, then the welfare loss to the home country is greater than it is with an equivalent
home country tariff, since the previous tariff revenue now accrues to the foreign country.
The mystery of what happens to the quota rent can be resolved to the quota-imposing
government’s benefit if it sells licenses to those who wish to import the good at a price equal
The Impact of an
Import Quota and a
Subsidy to Import-
Competing Production
The Import Quota
3This is not true over time after any initial equivalence. For example, if home consumer demand rises, no larger
quantity of imports can come into the country with the quota (assuming no change in the size of the quota), but a
tariff permits more imports as the demand curve shifts out. Also, any price rise caused by an increase in demand
is greater with the fixed quota than with the tariff.
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to the difference between the international price and the higher (quota-distorted) domestic
price. This generates government revenue equal to that achieved with the equivalent tariff.
One way this might be accomplished is to have a competitive auction of import licenses.
Potential importers should be willing to pay up to the difference between the international
price and the expected domestic price to have the right to import. However, this kind of
system, often called an auction quota system, will incur administrative costs that absorb
productive resources and become additional deadweight losses. Again, the country welfare
cost of the quota will likely exceed the welfare cost of the equivalent tariff, because these
administrative costs are likely to be greater than those of the tariff.
The static impact of a tariff and that of a quota on a market and welfare are essentially the
same, except for the distribution of the quota rent. This conclusion does not hold for gov-
ernment subsidies paid to the import-competing domestic supplier. If the intent of the tariff
or quota is to provide an incentive to increase domestic production and sales in the domes-
tic market, then an equivalent domestic production result could be achieved by paying a
sufficient per-unit subsidy to domestic producers, who are thereby induced to supply the
same quantity at international prices that they were willing to provide at the higher tariff
inclusive domestic price (see Figure 4). In effect, the subsidy shifts the domestic supply
curve down vertically (in a parallel fashion) until it intersects the international price line at
the same quantity that would occur were the tariff (or equivalent quota) in effect.
With an equivalent subsidy, producers are equally as well off as when the tariff was
in place. The subsidy not only provides them with an increase in producer surplus equal
to that under the tariff or quota but also compensates them for the higher production cost
Subsidy to an Import-
Competing Industry
FIGURE 4 The Single-Market Effects of a Subsidy to Home Producers
A government subsidy of $1 for every unit produced has the effect of shifting supply curve S down vertically
by $1 at each quantity to S′. Producers will now produce 120 units instead of 100 units at the international
price of $5. The combination of the $5 international price and the $1 subsidy leaves the producers in a position
equivalent to that with the imposition of a 20 percent tariff. The welfare effects, however, are different. Because
consumers continue to pay the international price, there is no loss in consumer surplus in this market. Producers
receive a transfer of area ABCK from the government, of which ABCJ represents a gain in producer surplus and
JCK represents a deadweight efficiency loss. The taxpayer cost of the subsidy is equal to the amount of the sub-
sidy transfer, that is, ABCK.
P
Q
6.00
5.00
1000 120 160 190
B
A J
K
C
S
S (with subsidy)
D
Pint
Pint
($)
(1+ t )
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CHAPTER 14 THE IMPACT OF TRADE POLICIES 287
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on the additional production. The cost to the government (area ABCK) is equal to the
quantity produced domestically (120 units) times the amount of the subsidy ($1) or $120.
Note, however, that there is no change in the domestic market price; it remains equal to the
international price in the case of a domestic producer subsidy. There is no loss in consumer
surplus and no deadweight loss for consumers. The increased domestic production at a
resource cost that exceeds international price on the margin leads, however, to a production-
efficiency loss. This is equal to area JCK and is the amount by which the subsidy cost
(ABCK) exceeds the increase in producer surplus (ABCJ). It can be viewed as the cost of
moving from a lower-cost foreign supply to a higher-cost domestic supply on the margin.
From a welfare standpoint, the production subsidy certainly is more attractive than a
tariff or quota. If the consumers are also the taxpayers, the cost of the subsidy ($120) is less
than the loss in consumer surplus ($175) that results from either a tariff or a quota. To the
extent that the consumers of the specific product are not the only taxpayers, then a subsidy is
more equitable. From a cost-benefit perspective, the cost of protection of a domestic indus-
try should be borne by those who receive the benefits of its larger output. If the protection of
the industry is judged desirable for the public at large (e.g., because the industry is deemed
to be valuable for national security), then the burden of the policy should be borne by the
public at large and not by the subset of the public that consumes this product.
Regardless of these last considerations, the subsidy to domestic import-competing pro-
ducers has a lower welfare cost to the country as a whole than does the import tariff. In our
numerical example, the net loss to society from the use of the subsidy is only $10 (triangle
JCK) rather than the $25 associated with the tariff (triangle JCK plus triangle GFH in
Figure 3). It is $10 because the increase in producer surplus of $110 (area ABCJ in Figure 4)
is $10 less than the subsidy cost of $120 (area ABCK in Figure 4). Thus, in the steel example
with which we began this chapter, the United States would have imposed upon itself a
lower welfare cost if the domestic steel industry were further subsidized (which, in fact, it
had been already by a mixture of federal as well as state and local government policies)4
rather than protected by the import tariffs.
To illustrate the various effects, two economists from the Peterson Institute for Inter-
national Economics, a Washington, DC, “think tank,” estimated (for 1990) the impact on
U.S. consumers of tariff and quota restrictions on a number of products.5 Selected results
for the annual loss of U.S. consumer surplus were as follows: benzenoid chemicals, $309
million; frozen concentrated orange juice, $281 million; softwood lumber, $459 million;
dairy products, $1.2 billion; sugar, $1.4 billion; apparel, $21.2 billion; and textiles, $3.3
billion. Taking into account offsetting producer surplus and tariff revenue gains, the “net”
welfare losses from the trade restrictions were smaller—“only” $10 billion in benzenoid
chemicals, $35 million in frozen concentrated orange juice, $12 million in softwood lum-
ber, $104 million in dairy products, $581 million in sugar, $7.7 billion in apparel, and $894
million in textiles. In mid-2015 prices those figures would be about 80 percent larger.
4See Robert Guy Matthews, “U.S. Steel Industry Itself Gets Billions in Public Subsidies, Study Concludes,”
The Wall Street Journal, November 29, 1999, p. B12.
5Gary Clyde Hufbauer and Kimberly Ann Elliott, Measuring the Costs of Protection in the United States
(Washington, DC: Institute for International Economics, 1994), pp. 8–9.
CONCEPT CHECK 1. How does a tariff affect consumer surplus?
Producer surplus?
2. Who gains from a tariff? Who loses? What
are the net effects for society?
3. How do the effects of a tariff differ from
those of a quota? Of a production subsidy?
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FIGURE 5 The Effect of an Export Tax
The imposition of an export tax (a $10 per-unit tax in this example) reduces the price received for each unit
of export by the amount of the tax. This causes the domestic price to fall from P0 to P1 as domestic producers
expand sales in the home market to avoid paying the export duty. The fall in the domestic price leads to a loss
in producer surplus equal to area ABFG, an increase in consumer surplus of ABCH, an increase in government
revenue of HJEG, and deadweight losses to the country of CJH and GEF.
P
S
P1
P0
Q0
D
B
A I
C
H
E FJ
Export
tax
G
Pint
Pint – tax
(30)
($70)
($80)
(40) (100)(90)
We examine here the impact of three types of export policies—an export tax, export
quota, and export subsidy—on the well-being of the country that is exporting the good.
The imposition of an export tax, a levy on goods exported, leads to a decrease in the
domestic price as producers seek to expand domestic sales to avoid paying the tax on
exports. The domestic price (P0) falls until it equals the international price (Pint) minus
the amount of the tax (see Figure 5). (Note that in the export situation the given interna-
tional price is above the intersection of the home demand and supply curves.) When this
occurs, gains and losses can again be measured using producer and consumer surplus.
As domestic price falls and quantity supplied contracts, there is a reduction in producer
surplus equal to the area of trapezoid ABFG. Part of this loss is transferred to domestic
consumers through the lower price, producing an increase in consumer surplus equal
to area ABCH. In addition, the government acquires tax revenue equal to area HJEG.
Finally, areas CJH and GEF reflect deadweight efficiency losses that result from the
price distortion. These areas represent losses in producer surplus that are not transferred
to anyone in the economy.
After summing up the effects of the export tax policy on the winners and the losers,
the net effect on the economy is negative. It should be emphasized that the domestic sup-
ply and demand responses lead to a smaller level of exports (distance HG) after tax than
before the tax (distance CF). Governments will thus overestimate the export tax revenue
that will be received if they form their revenue expectation without fully accounting for
the reduction in export quantity. The less elastic domestic supply and demand are, the
smaller the impact of the tax on the quantity of exports and the greater the revenue earned
by the government. The less elastic producer and consumer responses are, the smaller the
deadweight efficiency losses. With the numbers indicated in the parentheses in the graph,
The Impact of Export
Policies
The Impact of an
Export Tax
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IN THE REAL WORLD:
REAL INCOME GAINS FROM TRADE LIBERALIZATION
IN AGRICULTURE
One sector of most countries’ economies that gets substan-
tial protection from import competition is the agricultural
sector. Indeed, the disputes over liberalization in that sec-
tor caused a considerable delay in completing the Uruguay
Round of trade negotiations in the late 1980s/early 1990s.
Disagreements over agriculture also led to breakdowns in
the Doha Round of negotiations that had begun in 2001, and,
as of this writing, it is quite possible that the talks may not
be successfully concluded. (See Chapter 16.) Because of the
size and importance of the restrictions and interventions in
agriculture, the welfare effects of liberalization in that sector
can be substantial.
Stephen Tokaricka (2008) of the International Monetary
Fund surveyed various studies of the welfare effects of agri-
cultural trade liberalization through removing tariffs and sub-
sidies. He noted that removing tariffs will increase demand
on world markets and thus will increase world prices of the
affected goods. Likewise, removing production subsidies
will tend to shift resources from agriculture to other sectors
and thus also increase world prices. Therefore, net exporters
of agricultural products tend to gain and net importers tend
to lose from this liberalization. Overall, though, world eco-
nomic efficiency will be increased due to resource allocation
that is more in accordance with comparative advantage, and,
hence, world real income will be enhanced.
Two studies in his survey are briefly discussed here. One
of them, by Thomas Hertel and Roman Keeney,b utilized
a computer model with 2001 as the base year and with the
world economy divided into 29 regions. Another study, by
Tokarickc himself (2005), used 1997 as the base year and mod-
eled 19 world regions and employed higher elasticities of trade
responsiveness to price changes.
Overall, the Hertel and Keeney model generated the
results that agricultural trade liberalization would yield real
income gains for high-income countries of $41.6 billion
and gains for developing countries of $14.1 billion, giving
a total world real income gain of $55.7 billion. Tokarick’s
study, with his use of greater responsiveness of trade to price
changes, yielded real income gains of $97.8 billion for high-
income countries and $30.4 billion for developing countries–
thus giving a world gain of $128.2 billion.
Finally, in 2006 economist Scott Bradfordd estimated
the welfare impact on the world as a whole of the removal
of all nontariff and tariff barriers to trade in food products
that are in place in eight developed countries—Australia,
Canada, Germany, Italy, Japan, the Netherlands, the United
Kingdom, and the United States. (This study’s estimates of
the domestic price impacts of these barriers were discussed
in Chapter 13, pages 276–77.) With the elimination of all
such barriers by the eight countries, world welfare would
increase by an amount equivalent to 0.73 percent of world
GDP. This impact seems small in percentage terms, but it
would be close to $600 billion. Almost three-quarters of the
increase would accrue to the developed countries and the
remainder to the developing countries.
Although there are differences in these various estimates,
the important point is that liberalization of agricultural/food
trade could enhance world income by a substantial absolute
amount. Welfare is indeed restricted by trade barriers.
aStephen Tokarick, “Dispelling Some Misconceptions about
Agricultural Trade Liberalization,” Journal of Economic Perspec-
tives 22, no. 1 (Winter 2008), pp. 199–216.
bThomas Hertel and Roman Keeney, “What Is at Stake? The Relative
Importance of Import Barriers, Export Subsidies, and Domestic
Support.” In Agricultural Trade Reform and the Doha Development
Agenda, ed. by Kym Anderson and William Martin (Washington,
DC: The World Bank, 2006), pp. 37–62.
cStephen Tokarick, “Who Bears the Cost of Agricultural Support
Policies in OECD Countries?” The World Economy 28, no. 4 (April
2005), pp. 573–93.
dScott Bradford, “The Extent and Impact of Food Non-Tariff
Barriers in Rich Countries,” Journal of International Agricultural
Trade and Development 2, no. 1 (2006), pp. 149–50. ●
producer surplus would thus fall by [($80 − $70)(90 − 0) + (1/2)($80 − $70)(100 − 90)] 
= $900 + $50 = $950; consumer surplus would rise by [($80 − $70)(30 − 0) +  (1/2)
($80 − $70)(40 − 30)] = $300 + $50 = $350; tax revenue would rise by ($80 − $70)
(90 − 40) = $500; and the net result is (−)$950 + $350 + $500 = (−)$100. This $100 loss
is equal to triangle CJH ($50) plus triangle GEF ($50).
In the extreme case the export quota of a commodity can be zero, such as in effect
occurred when, in the 1970s, the U.S. Congress enacted a ban on U.S. exports of crude oil.
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In this situation, there is no quota rent, the domestic price falls to the price at the intersec-
tion of D and S in Figure 5, and the loss of producer surplus clearly exceeds the gain in
consumer surplus. At the time of this writing, there was pressure from several quarters for
an end to the export ban.
If an export quota instead of an export tax is employed, the effects are similar to those of
the export tax. However, the welfare impact of the two instruments may differ because, as
with the import quota, no government revenue is necessarily collected. The recipient of the
quota rent is unclear. The government in the exporting country can acquire the revenue by
auctioning off export quotas. In a competitive market, exporters should be willing to pay up
to the difference in price in the importing and exporting countries for the privilege to export
(assuming no transaction costs). If this occurs, the revenue from the auction quota system will
be equivalent to the revenue from an export tax. If this does not occur, exporters can orga-
nize and act like a single seller to acquire the quota rent by charging the importing country
the market-clearing price. If foreign importing firms are organized, they have the potential
to acquire the quota rent by buying the product at the market-clearing price in the exporting
country and selling it at the higher market-clearing price at home. In our numerical example
in Figure 5, the area HJEG ($500) would then be an additional loss to the exporting country.
The final instrument considered is the export subsidy. Its use and the interest that it has
sparked make it important to examine its effects. In Chapter 13, we noted that an export
subsidy is in effect a negative export tax. Consequently, the effects of this instrument can
be analyzed in a manner similar to that used with the export tax.
In a small country, the imposition of the subsidy directly raises the price received by the
producer for exported units of the product. For every unit exported, the producer receives
the international price plus the subsidy. Producers are thus given the incentive to shift sales
from the domestic to foreign markets to receive the government subsidy. The end result
is that the export subsidy reduces the quantity sold in the domestic market, increases the
price in the domestic market to where it equals the international price plus the subsidy, and
increases the quantity supplied by producers as they respond to the higher price, leading
finally to increased exports (assuming that the good is not imported).
These demand and supply responses are evident in the partial equilibrium analysis for
a small country (see Figure 6). The imposition of the export subsidy raises the domes-
tic price, which was equal to P0 = Pint ($100) without the subsidy, to P1 = Pint + Sub 
($100 + $10 = $110). The increase in price causes domestic quantity demanded to fall
from Q1 (60 units) to Q3 (50 units), the quantity supplied to rise from Q2 (85 units) to Q4 (95
units), and the quantity of exports to increase from distance Q1Q2 (25 units) to distance Q3Q4
(45 units). These market adjustments to the export subsidy lead to a fall in domestic con-
sumer surplus equal to area ABCJ and an increase in domestic producer surplus equal to
area ABFH. Assuming that taxes pay for the subsidy program, the taxpayer cost of the
subsidy program equals the amount of the per-unit subsidy times the new quantity of
exports, area ECFG. Finally, the net social cost of the export subsidy is equal to the two
deadweight triangles, ECJ and HFG. Area ECJ represents part of the transfer to producers,
which is paid for twice—once by a loss in consumer surplus and once by the cost of the
subsidy—and recaptured only once (by home producers). It can be thought of as a dead-
weight consumer/taxpayer loss. Triangle HFG is the usual production-efficiency loss that
results from the less efficient domestic production shown by the movement from Q2 to Q4.6
The Impact of an
Export Quota
The Effects of an
Export Subsidy
6It is important to note that this analysis assumes that domestic consumers cannot turn to the world market to
import the good at P0 = Pint. If they could, the domestic price would not rise above P0 and the only loss to the
country would be the deadweight loss of area HFG.
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Using the numbers in parentheses in Figure 6, consumer surplus falls by [($110 − $100)
(50 − 0) + (1/2)($110 − $100)(60 − 50)] = $500 + $50 = $550; producer surplus rises
by [($110  −  $100)(85  −  0)  +  (1/2)($110  −  $100)(95  −  85)]  =  $850  +  $50  =  $900;
the cost of the subsidy is ($110  −  $100)(95  −  50)  =  $450; and the net social cost is
−$550 + $900 − $450 = −$100. This loss is equal to the sum of triangles ECJ ($50) and
HFG ($50).
FIGURE 6 The Effects of an Export Subsidy
The availability of the export subsidy leads to an increase in the domestic price from P0 to P1. With the increase
in the domestic price, there is a loss in consumer surplus of ABCJ, a gain in producer surplus of ABFH, and
deadweight losses to society of ECJ and HFG. The taxpayer cost of the subsidy program is ECFG. The subsidy
expands production from Q2 to Q4 and increases exports from distance Q1Q2 to distance Q3Q4.
P
S
Q0
D
B
A
C
HE
F
J
G
Q4Q2Q1Q3
Pint + Sub
Pint
P1
P0
Export
subsidy
(50)
($100)
($110)
(60) (95)(85)
CONCEPT CHECK 1. In the case of an export quota, why is the dis-
position of the quota rent important for wel-
fare analysis?
2. How does an export tax differ from an export
subsidy? Which policy would domestic con-
sumers prefer? Why?
TRADE RESTRICTIONS IN A PARTIAL EQUILIBRIUM SETTING:
THE LARGE-COUNTRY CASE
To this point, we have been using the already familiar demand and supply curves for a good
in a small country whose trade policies have no impact on the world price. We now turn to
an examination of the effects of trade policies in the large-country setting, where an impact
on world price does occur.
To facilitate this discussion, we need to introduce a special demand curve and a special
supply curve: (a) the demand for imports schedule, as distinct from the total demand
Framework for
Analysis
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curve for a good, and (b) the supply of exports schedule, as distinct from the total supply
curve of a good. The demand for imports schedule applies to a particular segment of the
entire market for a good that is produced and consumed at home as well as imported, and
the supply of exports applies to a particular segment of the entire market for a good that is
produced and consumed at home as well as exported. The impact of trade policy hits directly
on these particular market segments, which in turn have an impact on the entire market.
Figure 7, panel (a), portrays the demand and supply for a homogeneous good within a par-
ticular country. The good might be shirts and the country the United States. Demand curve
Dh shows the quantity of shirts (whether made at home or abroad) that home consumers are
willing to purchase at each particular price during a time period. Supply curve Sh shows the
various quantities that domestic producers are willing to deliver to the market during this
period at various possible prices. Remember that imports are simply home demand minus
home supply. Thus, if the price of shirts is P0 ($40), consumers and domestic producers
are both satisfied with quantity Q0 (20 units), so there is no need for imports. In deriving
the demand for imports schedule in panel (b), the quantity of imports demanded at price
P0 (= Pm 0) is thus zero. However, suppose that the price in the United States is P1 ($36).
At this price, home consumers want to purchase quantity Q2 (24) in panel (a), but home
producers are only willing to supply quantity Q1 (16) at this lower and less profitable price.
Thus, there is excess demand of (Q2 − Q1) over home supply, which yields a demand for
imports of Qm1 (= Q2 − Q1 = 24 − 16 = 8), as plotted in panel (b) at price Pm1 (= P1 = $36).
Similarly, at price P2 ($30), there is excess home demand of (Q4 − Q3 = 30 − 10), which
Demand for Imports
Schedule
FIGURE 7 The Derivation of a Country’s Demand for Imports Schedule of a Good
Panel (a) portrays the demand for a good by home consumers (Dh) and the supply of the good by home producers (Sh). At price P0, quan-
tity demanded (Q0) by consumers equals quantity supplied by home producers, so the quantity of imports demanded [shown in panel (b)] at
Pm0 (= P0) is zero. At a lower price, P2, home consumers demand Q4 units and home producers supply only Q3 units, so the quantity demanded of
imports (excess demand) is (Q4 − Q3). This amount is shown as Qm2 in panel (b) at the price Pm2 (= P2). By plotting the excess of Dh over Sh at all
other prices below P0, the country’s demand for imports schedule, Dm, is generated.
Price
Quantity Quantity
Price
(b)(a)
Dh
P1
P2
P0
P3
Q1 Q2Q0Q30 0Q4 Q5
Sh
Pm1
Pm0
Pm2
Pm3
Qm1 Qm2 Qm3
Dm
(10)(16)(20)(24)(30)
($20)
($30)
($36)
($40)
($20)
($30)
($36)
($40)
(8) (20) (40)(40)
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translates into a demand for imports of Qm2 ($20) at price Pm2 ($30). Finally, note that
at price P3 ($20) in panel (a), all domestic production ceases. The quantity demanded of
Q5 (40) is all excess demand, and Q5 equals Qm3 in panel (b). Note that the resulting Dm
schedule is flatter than the Dh schedule. This means that the demand for imports schedule
generally will be more elastic than the demand for the good itself, although it should be
remembered that slope and elasticity are not identical terms. The greater elasticity reflects
the response of both domestic supply and demand to the change in price. Finally, observe
that Dm is identical to Dh at and below the price at which domestic production ceases.
The simple rule to remember when deriving the supply of exports schedule for a country
is that exports are equal to home production minus home consumption. The technique for
obtaining the home supply of exports schedule for any good is analogous to that of the
demand for imports schedule. Thus, schedule Sh in Figure 8, panel (a), shows the quantity
of the good supplied by domestic producers at various market prices, while schedule Dh
shows the quantities of the good home consumers are willing to buy at those prices. At
P0 (= Px0 = $40), there is no export supply since consumers are willing to purchase all of
the good produced by domestic firms. However, at higher price P1 ($46), there is excess
supply at home, because the higher price has caused home consumers to purchase smaller
quantities and home producers to offer more in the market. The excess supply at price P1 is
(Q2 − Q1 = 26 − 14), which translates in panel (b) into quantity Qx1 (12) at price Px1 ($46).
At the next-higher price, P2 ($52), there is a larger excess supply (Q4 − Q3 = 32 − 8); this
amount is supplied to the world market as exports Qx2 (24) because home consumers are
Supply of Exports
Schedule
FIGURE 8 The Derivation of a Country’s Supply of Exports Schedule of a Good
Panel (a) shows the demand for a good by home consumers (Dh) and the supply of the good by home producers (Sh). At price P0, the quantity
supplied by home producers (Q0) equals the quantity demanded by home consumers, so the quantity of exports supplied [shown in panel (b)] at
price Px0 (= P0) is zero. At a higher price, P2 for example, home producers supply Q4 units but home consumers demand only Q3 units, so the
quantity supplied of exports (excess supply) is (Q4 − Q3). This amount is shown as Qx2 in panel (b) at price Px2 (= P2). By plotting the excess of
Sh over Dh at all other prices above P0, the country’s supply of exports schedule, Sx, is generated.
Price
Quantity Quantity
Price
(b)(a)
Dh
P1
P2
P0
P3
Q1 Q2Q0Q3
0
Q4 Q5
Sh
Px1
Px0
Px2
Px3
Qx1 Qx2 Qx3
Sx
($60)
($52)
($46)
($40)
($60)
($52)
($46)
($40)
(8) (14)
0
(12) (24) (40)(40)(32)(26)(20)
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not purchasing that excess supply. Finally, all home production is supplied as exports at
P3 ($60). Export supply schedule Sx is identical to home supply schedule Sh at and above P3.
Note that Sx is flatter or more elastic than Sh up to price Px3 (which equals price P3), because
an increase in price affects the quantity of exports supplied both through increased quan-
tity supplied domestically and decreased quantity demanded. With these schedules now in
hand, we can examine various trade policy instruments.
Having explained how the import demand curve and export supply curve for large trad-
ing partners are obtained, we can now use these curves to demonstrate market equilibrium
between two large countries. Market equilibrium is indicated by the international price
where home import demand equals foreign export supply, that is, Dm = Sfx in panel (a) of
Figure 9. Equilibrium quantity (exports = imports) is measured on the horizontal axis. Given
this large-country equilibrium, let us examine how an import tariff affects the market.
In Chapter 13, it was noted that tariffs can be specific or ad valorem in nature. The impo-
sition of a specific duty is illustrated in Figure 9(b) and the ad valorem tariff in Figure 9(c).
Curve Dm in each panel is the demand for imports schedule for this good, and the Sfx
schedule is the supply schedule of foreign exports to this country. Prior to the imposition
of the tariff, the equilibrium price is located at the intersection of these curves, at price
Pm 0, and the equilibrium quantity sold is quantity Qm 0. When the specific tariff is imposed
(e.g., $1 per unit of the good imported) in panel (b), the relevant supply of exports curve
becomes S′fx instead of Sfx, as the schedule shifts up vertically at each quantity by $1 per
unit. (Each quantity of exports supplied has a price that is $1 higher on S′fx than on Sfx.)
Thus, the new supply of foreign exports schedule is parallel to the old schedule but above
it at each quantity by the amount of the tax. As a consequence of the import tax, the mar-
ket equilibrium is E′ rather than E. Consumers are now paying the higher price, Pm1, and
purchasing the smaller quantity, Qm1. The foreign supplier of the good receives a lower price
per unit—Pm2 rather than Pm 0. The lower price is received by the foreign firm because, with
The Impact of an
Import Tariff
FIGURE 9 Large-Country Market Equilibrium and the Imposition of a Specific and an Ad Valorem Tariff
In all three panels, the free-trade equilibrium is at E—the intersection of the home demand for imports schedule (Dm) and the supply of foreign
exports schedule (Sfx). With the imposition of a specific tariff in panel (b), Sfx shifts up vertically by the amount of the specific tariff per unit of the
imported good. S′fx is thus above and parallel to Sfx. The imposition of the ad valorem tariff in panel (c) causes Sfx also to shift up to S′fx. However,
S′fx is not parallel to Sfx in panel (c) since, for each given quantity, the price of imports on Sfx is raised by a constant percentage of that price rather
than by a constant dollar amount. Thus, S′fx “pulls away” from Sfx at the higher prices and quantities. The new equilibrium is at E′ in both panels
(b) and (c). Consumers pay higher price Pm1 per unit rather than Pm0, and foreign suppliers receive lower price Pm2 per unit rather than Pm0. The
tariff revenue collected is indicated by the shaded areas.
Price Price Price
Quantity Quantity Quantity
Pmo Pmo
Pm1
Pm2
Qmo Qm1 Qmo
E
Sfx
Dm
E
E
Sfx
S fx
Dm
E
E
Sfx
S fx
Dm
Pm1
Pm2
Qm1 Qmo
G G
F F
(a) (b) (c)
0 0 0
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the tax in place, there is a smaller quantity purchased from the foreign firm and the price is
bid down in this large-country setting, where the importing country can affect world prices
by imposing the tariff. Finally, the difference between the price paid by consumers, Pm1, and
the price received by the foreign producers, Pm2—or the distance (Pm1 − Pm2)—represents
the tariff per unit of the goods imported.
In this example, the total tariff revenue collected by the importing country’s govern-
ment is represented by shaded area Pm2Pm1E′F. Part of this tariff revenue is paid eco-
nomically by domestic consumers, area Pm 0Pm1E′G, in that a higher price is paid over the
free-trade price for each unit of the good imported. The other part of the tariff revenue is
paid economically by the foreign exporter, area Pm2Pm 0GF, in that the exporter receives
a lower price than that under free trade for each unit exported. The extent to which the
tariff is paid by one party or the other, the incidence of the tariff, depends importantly
on the slope/elasticity of the Sfx schedule. If this supply of exports schedule were flatter
or more elastic, more of the tax burden would be borne by the domestic consumer and
less by the foreign producer. In the extreme case where the home (importing) country is
a small country, Sfx would be represented by a horizontal line reflecting the given world
price. S′fx would be parallel to and above Sfx by the vertical amount of the tariff per unit
of the import. In this case, the tariff burden would be borne entirely by home consumers,
since the world price (the price received by exporters) would not change with the imposi-
tion of the tariff. It can also be noted that the division of the tariff between the two parties
depends on the slope of the Dm schedule. The flatter (or more elastic) the schedule other
things being equal, the more the tariff is paid by the foreign producer rather than by the
home consumer.
The imposition of an ad valorem tariff is shown in Figure 9(c). The only difference in
construction from the specific tariff in Figure 9(b) is that the new supply curve, S′fx, is no
longer parallel to the free-trade supply curve Sfx. The new curve “pulls away” from the old
curve at the higher prices because a constant percentage of a higher price is a larger abso-
lute amount, and thus the new curve is plotted at greater distances above the old curve as
we go up the vertical axis. In all other respects, the qualitative impacts in Figure 9, panel
(c), are the same as in panel (b)—the new price paid by consumers is Pm1, the new price
received by foreign producers is Pm2, the new quantity purchased in equilibrium is Qm1, and
the tariff revenue collected is area Pm2Pm1E′F.
In the small country, the entire negative welfare impact of the tariff is borne by consum-
ers in the imposing-country market. In the large country, however, the impact of the tariff
can be potentially shifted, at least in part, to the exporting country through a reduction in
international price. The reduction in international price means of course that the domestic
price inclusive of the tariff in the imposing (large) country is less than it would be if the
international price had remained the same, the loss in consumer surplus is less, and the net
cost of protection is less than that for a small country.
To see why the welfare cost is less, let us turn to a two-country framework similar to
that used with transportation costs in a large-country setting in Chapter 8 (pages 139–41).
Figure 10 depicts this situation, in which two large countries are engaged in trade. Because
country A [panel (a)] is the higher-cost producer of this commodity in autarky, it has an
incentive to import the product, resulting in the import demand curve Dma in panel (b).
Country B [panel (c)] is the low-cost producer and has an incentive to export the product,
resulting in the supply of exports curve Sx b in panel (b). When they trade, countries A and
B will arrive at an equilibrium international price, Pm 0 (= $100 in our numerical example),
which causes the desired quantity of imports into country A to be equal to the desired quan-
tity of exports from country B (Qm 0 = Qx0 = 30 units).
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If country A now imposes a specific tariff of $10 on this product [a shift of Sx b to S′x b
in panel (b)], the effect will be a rise in the price of the good above Pm 0 by the amount of
the tariff. When this happens, there will be an increase in the quantity supplied domesti-
cally by A’s producers, a decrease in the quantity demanded in country A, and a decrease
in desired imports. As the quantity of imports desired by country A begins to fall, country
B finds itself with an excess supply at Pm 0 and begins to lower its domestic price. The new
price in B leads to an increase in domestic quantity demanded, a decrease in quantity sup-
plied, and a decrease in available exports. The reduction in country B’s export price means
that the domestic tariff-inclusive price in country A begins to decline, stimulating greater
purchases of imports. Ultimately, price will adjust concomitantly in both markets until the
quantity of desired imports, Qm1 (17 units), in country A at the tariff-inclusive price, Pm1
($106), is equal to the desired level of exports of country B, Qx1 (17 units), at its export
(non-tariff-inclusive) price, Pm2 ($96). Prices in the two markets will always differ by the
amount of the tariff (assuming no transportation costs).
We can now analyze the welfare implications of the tariff.7 To the extent that the domes-
tic price rises in tariff-imposing country A, there will be a loss in consumer surplus, a gain
in producer surplus, a gain in government revenue, and the usual deadweight efficiency
losses (triangles a and b in Figure 10). The deadweight losses will be less than they would
have been if the domestic price in country A had risen by the full amount of the tariff,
as it did in the small-country case. Notice also that the tariff revenue is now represented
not by area c alone but by area c—paid by home consumers through a higher domestic
FIGURE 10 The Effects of a Tariff in a Single Market in the Large-Country Setting
The initial international equilibrium price is determined by the demand for imports and the supply of exports at Pm0 [panel (b)]. The imposition
of a specific tariff by the importing country A shifts the export supply curve from Sxb to parallel curve S′xb. The tariff reduces A’s purchases of
the import good, leading to a reduction in world demand and in the export price from country B. The world price falls until the amount of exports
supplied by country B at the new price equals the amount of imports demanded by country A at the international price plus the tariff, Pm1. The
reduction in the world price means that the price in country A does not rise by the full amount of the tariff. As a result, the deadweight losses
in country A, areas a and b, are less than they would be in a small country where the world price remains unchanged when a tariff is imposed.
Further, the fall in the world price due to the imposition of the tariff means that the exporting country is paying part of the tariff, shown by area
fhij in country B. Country A can benefit from the imposition of the tariff if area fhij is larger than the sum of the deadweight losses (a + b).
P
Q Q
P
Q
(a)
D
A
SA P
DB
a b
c
f j
h i k
Qm0 Qx0
Qm1 Qx1
Amount of
the tari�
Pm1
Pm0
(c)
Qm1 = Qx1
Qm0 = Qx0

Dma
(b)
S xb
Sxb
Pm0
Pm2
SB
Country A Country B
0 0 0
($106)
($100)
($106)
($100)
($100)
($96)
(66)
(60)
(=17)
(=30)
(83)
(90)
(57)
(50)
(74)
(80)
7For an analysis of the welfare effects of the tariff and other policy instruments that uses only the import demand
and export supply curves, see Appendix B to this chapter.
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price—plus area fhij in panel (c)—paid by the exporting country’s producers, who receive
a lower price for the good. In addition, the net effect of the tariff on country A’s welfare
depends on the relative size of triangles a + b (deadweight losses) and rectangle fhij (a gain
to A transferred from B because of the lower export price). If losses (a + b) are greater than
the gain transferred from country B (area fhij), country A loses from the tariff. However,
if losses (a + b) are smaller than the gain from area fhij, large country A can actually gain
from the imposition of the tariff. This is more likely to occur when domestic demand and
supply are more elastic in country A (the importing country) and demand and supply are
less elastic in the exporting country. Similarly, a large country is less able to shift the cost
of the tariff to the exporting country when domestic demand and supply are less elastic and
the exporting country’s demand and supply are more elastic.
In our numerical example in Figure 10, the deadweight loss area a has a value of
0.5($106 − $100)(66 − 60) = (1/2)($6)(6) = $18, and the deadweight loss area b has a
value of 0.5($106 − $100)(90 − 83) = (1/2)($6)(7) = $21. The total deadweight loss is
thus $18 + $21 = $39. However, area fhij of the tariff revenue (total tariff revenue equals
area c plus area fhij) is acquired as a transfer from the exporting country B. This area fhij
has a value of ($100 − $96)(74 − 57) = ($4)(17) = $68. Hence, the imposition of the tariff
by large country A, with these particular numbers, has led to a net gain in welfare for A
by the amount of $68 (the transfer from country B) − $39 (the deadweight losses) = $29.
Another way to look at this result is through observing, in country A, the changes in con-
sumer surplus, producer surplus, and tariff revenue. The change in consumer surplus in A
because of the imposition of the tariff is −[($106 − $100)(83 − 0) + (1/2)($106 − $100)
(90 − 83)] = −[$498 + $21] = −$519. The gain in producer surplus in country A is
[($106 − $100)(60 − 0) + (1/2)($106 − $100)(66 − 60)] = $360 + $18 = $378. Finally,
the total tariff revenue is area c [= ($106 − $100)(83 − 66)] plus area fhij [= ($100 − $96)
(74 − 57)], or [$102 + $68] = $170 (i.e., the specific tariff of $10 per unit multiplied by
the 17 units imported). Hence, the sum of the change in consumer surplus, the change in
producer surplus, and the tariff revenue, is −$519 + $378 + $170 = + $29 (a gain). Keep
in mind, though, that this gain is achieved at the expense of the trading partner country B,
and subsequently there might well be retaliatory tariffs placed by B on products coming
into B from country A. Also, the numbers easily could have been set up so that there was
a loss for country A rather than a gain—a gain is by no means a certainty.
CONCEPT CHECK 1. Why is a country’s demand curve for imports
of a good more elastic (or flatter) than the
consumers’ total demand curve for the good?
2. Why is a country’s supply curve of exports of
a good more elastic (or flatter) than the sup-
ply curve of the home producers of the good?
3. Why is it possible that a large country can gain
net welfare by the imposition of a tariff? Explain.
4. Other things being equal, why does greater
elasticity in the supply of foreign exports of
a good mean that the importing country’s
consumers of the good are more likely than
the foreign suppliers of the good to bear the
burden of an import tariff?
Just as in the small-country situation, an import quota in a large-country situation leads to
price adjustments because of the reduced quantity of imports purchased by the importing
country. Because the importing country is a large country, however, it has a noticeable effect
on world demand for the product and hence reduces world price. The impact of the quota
on the large importing country and the large exporting country (or the rest of the world) is
illustrated in Figure 11. Graphically, the impact of the quota looks exactly like the impact
of the tariff discussed in the previous section. The imposition of the import-reducing quota
The Impact of an
Import Quota
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leads to an increase in price in the importing country from Pm 0 to Pm1 and to a decrease in
price in the exporting country from Pm 0 to Pm 2. These are the prices at which the level of
desired exports by country B is equal to the import quota in country A. The impact of an
“equivalent” quota on price and the level of trade is thus the same as the impact of the tariff
discussed previously.
Turning to the welfare effects, there is a major difference between the tariff and the quota
because no tariff revenue is collected with a quota. Thus, the question of what happens to
the “quota rent” must be addressed before a welfare analysis can be completed. As in the
small-country case, the quota rent can be captured (1) by the home government through the
auctioning of import licenses, (2) by domestic importers/retailers that buy at the new inter-
national price (Pm2) and sell at the home price (Pm1), (3) by organized foreign producers that
sell at the new price in the importing country (Pm1), (4) by exporting-country governments
that auction off export licenses to their firms, or (5) by any combination of the first four. In
a situation where the entire quota rent ends up in the importing country (the first two cases
listed), the welfare impact is exactly the same as under the import tariff. The importing
country incurs deadweight losses of triangles a and b and a positive transfer from abroad of
rectangle fhij due to the reduced world price of the imports. The net effect of the quota is thus
the sum of these two effects and can be positive or negative depending on their relative size;
that is, the importing country can possibly benefit from the imposition of the quota because
of the ability to influence world price. In the cases where the entire quota goes abroad (the
third and fourth cases listed), the importing country not only incurs the deadweight losses a
and b but also loses the rectangle c, which is effectively sent abroad through higher domestic
import prices (Pm1 instead of Pm 0). The impact of the quota on the importing country is thus
clearly negative and equal to the sum of the three areas. Using the numbers in Figure 11 (the
same as in Figure 10), the loss for country A would thus be area a ($18) plus area b ($21)
plus area c ($102), a total loss of $141.
FIGURE 11 The Effects of an Import Quota in a Single Market in the Large-Country Setting
The imposition of an import quota, Qm1 (17 units), by large country A reduces its purchases of the import good. This leads to a fall in world
demand for the good and to a fall in the export price in country B. The world price declines until the amount of exports supplied from B, Qx1, is
equal to the quota amount, Qm1. If country A is able to keep the quota rent, then its welfare improves if area fhij is greater than the sum of areas a
and b; if country A is unable to obtain any of the quota rent, its welfare declines by areas a, b, and c. Exporting country B has deadweight losses
from A’s quota of area ghf and area ikj; country B will also lose area fhij if country A obtains the quota rent. If country B itself is able to get the
quota rent, the net welfare effect of the quota on B is positive if area c is greater than the sum of areas ghf and ikj.
P
Q Q
P
Pm0
P m 1
Country A
D A
S A
Country B
Pm0
P m 2
a b
c f j
g h i k
The quota
(a) (b)
Q m 1
S B
D B
Q x0Q m0
Qx1
($106)
($100)
($100)
($96)
(66) (83)
(90)(60)0 0
(57) (74)
(50) (80)
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CHAPTER 14 THE IMPACT OF TRADE POLICIES 299
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The impact of the import quota on the exporting country can also be identified. In the
cases where the entire quota rent goes to the importing country, the exporting country
incurs deadweight losses of triangles ghf and ikj as well as the transfer rectangle fhij. The
net welfare effect in this case is clearly negative. In the cases where the exporting country
captures the entire quota rent, the deadweight losses are offset, at least in part, by the trans-
fer from the importing country of rectangle c. Hence, should the exporting country be able
to capture the quota rent, the net welfare effects will be positive whenever rectangle c is
greater than the sum of the triangles ghf and ikj.
Possible results for exporting country B can be illustrated by using the numbers in
Figure 11. If the entire quota rent goes to importing country A, country B loses dead-
weight loss triangles ghf and ikj as well as the rectangle fhij. Area fhij was earlier cal-
culated in Figure 10 to be $68. Area ghf has a value of (1/2)($100  −  $96)(57  −  50)  = 
(1/2)($4)(7) = $14. Area ikj has a value of (1/2)($100 − $96)(80 − 74) = (1/2)($4)(6) = $12.
Thus, if the importing country captures the quota rent, the exporting country loses welfare
of the amount ($68 + $14 + $12) = $94. Alternatively, this loss can be thought of, for
the exporting country, as the amount by which country B’s loss of producer surplus (from
the lower price and the smaller quantity sold) outweighs country B’s gain of consumer
surplus (from the lower domestic price and greater domestic quantity consumed). The loss
of producer surplus in panel (c) of Figure 10 is [($100 − $96)(74 − 0) + (1/2)($100 − $96)
(80 − 74)] = $296 + $12 = $308. The gain in consumer surplus in exporting country B is
[($100 − $96)(50 − 0) + (1/2)($100 − $96)(57 − 50)] = $200 + $14 = $214. Hence, the
loss in producer surplus of $308 exceeds the gain in consumer surplus of $214 by $94, the
net loss for country B. However, if exporting country B were able to capture the quota rent,
it would not lose area fhij and it would gain area c from country A. Triangles ghf ($14) and
ikj ($12) are still lost, but area c is a gain to be offset against those losses. With the numbers
in Figure 11, area c = ($106 − $100)(83 − 66) = ($6)(17) = $102, and, hence, if B captures
the quota rent, the country gains $102 (area c) − $14 (area ghf) − $12 (area ikj) = $76.
To minimize any adverse welfare effect of foreign import protection on their econo-
mies, exporting countries have employed voluntary export restraints (VERs) to avoid the
importing country’s actively utilizing tariffs or quotas to reduce imports. (VERs can be
adopted at the behest of the importing country under the threat of an import quota if the
VER is not used. This might occur if the importing country did not want to look like it was
openly restricting trade by imposing an import quota—the VER looks less like the “fault”
of the importing country.) The effect of an equivalent VER is graphically the same as that
of the import quota described in Figure 11. The only difference is that the VER definitely
allows the exporting country to capture the quota rent associated with the reduced trade. It
thus results in an unambiguous welfare loss for the importing country and a possible wel-
fare gain for the exporting country if the positive transfer effect from the importing country
more than offsets the deadweight losses in the exporting country, as it did in our immedi-
ately preceding numerical example. However, it is important to note that the VER instru-
ment was disallowed in 1994 by the Uruguay Round Trade Agreement.8 (See Chapter 16.)
The impact of a tax imposed by an exporting country is demonstrated in Figure 12 for two
large countries. Graphically, it appears the same as the impact of a tariff and/or quota, dis-
cussed in the previous two sections, and we will use the same illustrative numbers as in
Figures 10 and 11. The mechanism by which the export tax operates (a $10 per-unit export
tax in our example) and the welfare effects on the two countries are, however, quite different.
The Impact of an
Export Tax
8Arvind Panagariya, “Core WTO Agreements: Trade in Goods and Services and Intellectual Property,” p. 21,
obtained from www.columbia.edu/~ap2231/Courses/wto-overview .
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With the imposition of the export tax, producers in the exporting country B are induced,
as in the small-country case, to lower their domestic price and sell more at home to avoid
paying the tax. This will take place until the difference between the price of the good in
country B and the world price is equal to the export tax. As a result of the tax, exports
decline due to both the increased local consumption and the reduced quantity supplied of
the export good. Because this is a large-country setting, the reduced supply of exports on
the world market results in an increase in the international price. Thus, the import price
for country A rises from the initial nondistorted price of Pm 0 ($100) to Pm1 ($106), and the
price of the good in exporting country B falls from Pm 0 to Pm2 ($96). Desired exports Qx1
(17 units) are then equal to desired imports Qm1, and the difference between Pm1 and Pm2
equals the export tax ($10). The government revenue received by the exporting country is
equal to the amount of the tax (Pm1 − Pm2) times the quantity of exports (Qx1), and this is
represented by the sum of rectangles c and fhij in Figure 12.
From a welfare standpoint, the export tax results in deadweight losses of triangle ghf
plus triangle ikj in the exporting country and an inward transfer of rectangle c from the
importing country because of the higher world price. In this instance, the importing country
effectively “pays” part of the export tax through the higher import price, and the exporting
country can benefit if the inward transfer from the importing country more than offsets the
deadweight losses resulting from the tax (i.e., if area c is greater than the sum of triangles
ghf and ikj). For the importing country, the imposition of the export tax leads not only to
deadweight losses of a and b but also to the transfer abroad of rectangle c. The potential
gains (losses) for the exporting (importing) country are greater the more inelastic are sup-
ply and demand in the importing country and the more elastic are supply and demand in the
exporting country. With our numerical example and the calculations done earlier, we see
FIGURE 12 The Effects of an Export Tax in a Single Market in the Large-Country Setting
With the imposition of the export tax, firms in country B attempt to avoid paying the tax ($10 in this example) by selling more at home. To do
this, they lower price until the price in B, Pm2, plus the export tax is equal to the international price. The resulting reduction in exports reduces
world supply and leads to an increase in the international price to Pm1. At this point, the desired amount of country A imports is reduced to where
it is equal to the desired amount of exports of country B, and the difference between Pm1 and Pm2 is equal to the amount of the export tax. Because
of the increase in the international price, part of the export tax is passed on to country A’s consumers and the domestic price in country B falls
by less than the amount of the entire tax. Country B can actually benefit from the tax if the sum of the two deadweight loss triangles, ghf and ikj,
is less than the amount of tax paid by consumers in country A (rectangle c). Welfare in country A clearly declines, as that country incurs not only
deadweight losses of triangles a and b but also the transfer to country B of rectangle c.
P
Q
P
Q
Country A Country B
D
A
S A
a b
c f j
g h i k
(a) (b)
P m 1
P m0
Q m0 Qx0
Amount of the
export tax S B
D B
Q x 1Q m 1
P m0
P m2
($106)
($100)
($100)
($96)
(66) (83)
(90)(60)
(57) (74)
(80)(50)
0 0
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CHAPTER 14 THE IMPACT OF TRADE POLICIES 301
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that the exporting country gains in this example from the export tax, although this does not
have to be the case conceptually. Rectangular area c ($102) exceeds the sum of triangles
ghf ($14) and ikj ($12) by $76. The importing country loses areas a  ($18) + b  ($21) + 
c ($102) = $141.
If the exporting country could lose from the export tax, however, why would it want to
impose the tax?9 We can briefly indicate some reasons, noting that export taxes are common
in developing countries. A very important reason for the use of export taxes by develop-
ing countries is to generate government revenue, because it is more difficult to implement
other forms of taxation such as income or property taxes. Another reason to impose export
taxes is to combat domestic inflationary pressures. Because the price of the good on the
domestic market falls, this could dampen the rise in the home price level. (However, the
export tax by itself is unlikely to be a successful anti-inflationary device unless a contrac-
tionary domestic macroeconomic policy is also employed.) Further, export taxes can be
used to redistribute domestic income. If the exported good is an agricultural product grown
by large and wealthy landowners and consumed by low-income urban dwellers, then the
lowering of the domestic price by means of the export tax can alter the income distribution
toward greater equality (see Leff, 1969). In addition, of course, if an export tax is imposed
and import prices do not change, the country’s terms of trade will improve.
IN THE REAL WORLD:
WELFARE COSTS OF U.S. IMPORT QUOTAS AND VERs
Robert Feenstra (1992) assembled a variety of industry
estimates and information to arrive at an overall figure of
the costs of protection related to major U.S. import quotas
and VER arrangements negotiated with trading partners. He
examined restrictions under U.S. import quotas and VERs
on automobiles, sugar, textiles and apparel, dairy products,
and steel products, and incorporated the effects of U.S. tar-
iffs on these goods that were also in place.
Feenstra’s welfare analysis framework was the large-
country situation represented in Figure 11. As a general
rule, the quota rents in these products are captured by for-
eign exporters because the quotas are administered abroad
and not by the United States. We discussed in the text the
welfare cost of such restrictions. Feenstra (p. 163) estimated
a welfare cost range (for years centering around 1985) of
$7.9 billion to $12.3 billion to the United States for areas
a and  b of Figure 11. He estimated a U.S. loss range of
approximately $7.3 billion to $17.3 billion for area c of
Figure 11. Thus the total U.S. welfare cost of the restric-
tions ranged from $15.2 billion ($7.9 billion + $7.3 billion)
to $29.6 billion ($12.3 billion + $17.3 billion). (Note: $1
in 1985 would be equivalent to $2.20 in midyear 2015.)
Other costs associated with the quotas and VERs were not
contained in the estimates. These would include the waste
of resources by U.S. firms in lobbying for protection and
the neglect of modernization of equipment by U.S. firms in
order to show the need for continued protection.
An interesting feature of Feenstra’s analysis was his calcu-
lation of the welfare impact on the world as a whole. Because,
in Figure 11, area c and area fhij are simply transfer areas
between countries, the world as a whole loses the sum of the
four areas a, b, ghf, and ikj. Feenstra estimated this “world
loss” to be in the range of $12.2 billion to $31.1 billion.
Because this range was very close to the U.S. loss range by
itself, the U.S. restrictions on balance did not help or injure
foreign suppliers because the quota rents were nearly equal to
the losses from reduced export sales.
It should be noted that the VERs on autos and the import
quotas on textiles and apparel no longer exist. A U.S.
International Trade Commission (USITC) estimate (2011,
p. ix) indicates that liberalization of significant U.S. import
restraints would lead to a U.S. welfare gain of $2.6 billion
annually by 2015, an amount well below the Feenstra esti-
mates. Hence, relatively, the earlier VERs and import quotas
appear to have imposed sizable welfare losses on the U.S.
economy. The projected gains from elimination of signifi-
cant import barriers have fallen dramatically in recent years
as the level of protection has declined. ●
9In the United States, the use of export taxes is prohibited by the U.S. Constitution.
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We now turn to the last policy to be examined in the large-country setting, the case of the
export subsidy. This case is depicted in Figure 13. Starting with an illustrative no-subsidy
price of $55, suppose firms now receive a per-unit payment of $10 when they export the
good. Thus, domestic suppliers will sell to their own home market only if they receive a
price equal to the revenue per unit (price plus subsidy) received by exporting. Assuming
that no imports are allowed, the domestic price in the exporting country B rises, leading
to a reduction in B’s consumption, an increase in B’s production, and an increase in B’s
exports. Because country B is a large country, the increase in exports will lead to a fall in
the world price. The price movements will continue until an import price (Pm1 = $49) in
country A is reached at which the quantity of desired imports Qm1 (=15 − 6 = 9 units) is
equal to the quantity of desired exports Qx1 of country B. The difference between Pm2 ($59)
and Pm1 ($49) is the amount of the per-unit export subsidy, and the cost of the subsidy to
the government of country B is (Pm2 − Pm1) × (Qx1). In our example, this cost is ($59 − $49)
(16 − 7) = $90. Note that the presence of the export subsidy leads to a fall in the interna-
tional price (from Pm 0 to Pm1) and to an increase in imports (from Qm 0 to Qm1) into country
A as A’s production of the good declines and consumption of the good increases.
Turning to the welfare effects in both countries, we observe that there is a net gain in the
importing country A, which experiences net gains of triangles a and b as well as the rect-
angle c due to the fall in the international price. These three areas represent the amount by
which the gain in consumer surplus in country A exceeds the loss of producer surplus in A.
In the exporting country, the resulting increase in the domestic price from Pm 0 to Pm 2 leads
The Impact of an
Export Subsidy
FIGURE 13 The Effects of an Export Subsidy in a Single Market in the Large-Country Setting
In the presence of an export subsidy ($10 in this example), firms in the exporting country B have a clear incentive to export because of the higher
revenues received per unit. Assuming that there is no possibility of importing the good at the international price, this leads to an increase in the
domestic price in country B to where it is equal to the international price plus the subsidy. However, at the same time, the resulting increase in
both domestic quantity supplied and exports by B leads to a fall in the international price. These price movements continue until the difference
between the domestic price in country B and the import price in country A, (Pm2 − Pm1), is equal to the export subsidy and desired exports by B
(Qx1) equal desired imports by A (Qm1). The lower import price results in welfare gains for country A of deadweight triangles a and b and the
rectangle c. On the other hand, country B experiences welfare losses of the deadweight triangles f and g as well as the transfer abroad of shaded
rectangle h through the lower world price.
P
Q
P
Q
Country A Country B
D A
S A
a b
c
f g
(a) (b)
P m0
P m 1
Q m 1
Qx0
S B
D B
Q x 1
Q m0
P m0
P m 1
P m2
Export
subsidy h
($55)
($49)
($59) ($59)
($55)
($49)($49)
(8)
(6)
(12)
(15)
(10)
(7)
(14)
(16)00
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CHAPTER 14 THE IMPACT OF TRADE POLICIES 303
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to deadweight losses of unshaded triangles f and g, if we assume that consumers are also the
taxpayers who pay for the subsidy (just as in the small-country case). However, there is an
additional cost to the exporting country associated with the fall in the international price.
Even though the per-unit subsidy amounts to (Pm2 − Pm1), or $10, prices received by country
B’s producers rise by only (Pm2 − Pm0), or $4, and the remainder of the subsidy, (Pm0 − Pm1),
or $6, is transferred abroad to country A through lower prices. The total amount transferred is
(Pm0 − Pm1) × (Qx1) and is depicted by the shaded rectangle h in panel (b) of Figure 13. The
net welfare effect on the exporting country is thus the two deadweight losses coupled with
the transfer abroad (also negative), or areas f, g, and h [= ($55 − $49)(9) = $54]. Thus, in
the case of an export subsidy, being a large country results in an additional welfare loss that
would not occur if the country were small. With our numbers, importing country A thus gains
area a [= (1/2)($55 − $49)(8 − 6) = $6] plus area b [= (1/2)($55 − $49)(15 − 12) = $9] plus
area c [= ($55 − $49)(12 − 8) = $24], or a total of $39. The exporting country B loses area
f [= (1/2)($59 − $55)(10 − 7) = $6] plus area g [= (1/2)($59 − $55)(16 − 14) = $4] plus area
h [= ($55 − $49)(16 − 7) = $54], for a total loss of $64.
CONCEPT CHECK 1. Is it ever possible for a large country to gain
from the imposition of an import quota? If so,
when?
2. How do the impacts of an export subsidy in
the large-country case differ from those in the
small-country case?
TRADE RESTRICTIONS IN A GENERAL EQUILIBRIUM SETTING
The discussion of the effect of trade restrictions has to this point focused largely on the
market of the particular good that is the target of the restriction in question. While this
is a useful exercise, remember that as this market adjusts to the policy, other parts of the
economy are also affected. Increased protection leads producers to reallocate resources to
the protected industry and consumers to find substitutes for the now more expensive good.
These economywide reverberations need to be taken into account if one is to assess fully
the welfare impact of the trade restriction.
To demonstrate the usefulness of the broader analysis of trade restrictions, let us return to
the general equilibrium framework to demonstrate the gains from trade. This framework
was discussed in Chapter 6. Assume that a small country is engaged in free trade (Figure 14).
Initially, consumers are consuming at point C0, producers are producing at point B0, the
country is exporting X0 of agricultural goods, and imports of textiles are equal to M0. Due
to successful lobbying by the textile industry, an ad valorem import tariff is now imposed.
In the small-country case, this increases the domestic price of textiles by t percent, and
the domestic price of textiles becomes Ptex(1 + t). Domestic relative prices now become
Pag/[Ptex(1 + t)], which are less than Pag /Ptex, the international relative prices. Producers
see the increase in the relative price of textiles as a signal to produce more textiles (and
consequently fewer agricultural goods) and adjust production until MCag /MCtex equals
Pag/[Ptex(1 + t)]. This occurs when the flatter domestic price line is tangent to the production-
possibilities frontier at point B1. This adjustment by producers represents a movement
away from specialization and reduces the consumption possibilities available to the coun-
try from line (Pag/Ptex)0 to parallel line (Pag /Ptex)1. The adjustment in production thus leads
to a reduction in real income and a consequent loss in welfare as consumers are forced to
choose from smaller consumption possibilities along (Pag /Ptex)1 instead of (Pag /Ptex)0 and
must therefore be on a lower indifference curve.
Protection in the
Small-Country Case
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IN THE REAL WORLD:
WELFARE EFFECTS OF RESTRICTIVE RICE POLICIES IN JAPAN
A useful study of the welfare impacts of protecting a domes-
tic industry through restricting imports and adopting other
measures has been carried out by Australian economists
James Fell and Donald MacLaren (2013). Japan has long
been known and criticized for its large-scale aid to its rice
farmers via various domestic measures and protective trade
policies. Following the conclusion of the Uruguay Round of
multilateral trade negotiations in 1994 (discussed in Chapter
16 of this text), Japan liberalized its restrictive policies to
some extent in 2004–2005. As of that time, there were still
several such policies in effect, however, including a produc-
tion stipulation program to control the amount of domestic
rice production, government purchases of rice to maintain
about a one-million-tonnes stockpile of rice, and a tariff quota
of 682,000 tonnes per year. (The metric measure “tonnes”
is equal to 1,000 kilograms or roughly 2,200 pounds.) If
imports are kept within the quota, there is no tariff but the
government, which does the actual importing through a state
enterprise, can add a markup of ¥292 per kg. when it sells
the imported rice to the public; if imports exceed 682,000
tonnes, a “tariff” or markup of ¥341 per kg. is added to the
world price when the rice is sold to the public in Japan. (As
of this writing, the exchange rate is about ¥125 = $1.)
The conceptual method used by Fell and MacLaren for
calculating the welfare effects of the restrictions follows
the methodological framework of this chapter. Taking into
account the various government direct-support policies as
well as the tariff quota system, Fell and MacLaren first con-
struct the “tariff equivalent,” meaning that they express as a
tariff rate the total impact of the various policies on raising
the domestic price of rice above the world price. They then
calculate, on the basis of a mathematical and econometric
model, the effects on consumer surplus, producer surplus,
and government spending of the removal of this tariff. From
the analysis in this chapter, we would expect the elimina-
tion of the tariff to enhance consumer surplus and to have a
negative impact on producer surplus. Government expendi-
ture will fall as the stockpiling and other such programs are
eliminated, and that decrease in spending can be thought of
as a rise in revenue that can be regarded as now available
for distribution to the economy to enhance well-being. The
overall welfare effect of removing all of the restrictions is
the sum of the change in consumer welfare (positive), the
change in producer surplus (negative), and the fall in gov-
ernment spending (positive).
An interesting aspect of the Fell-MacLaren paper is that
they introduce some elements of realism that are not always
included in studies that estimate the welfare effects of trade
policies. First, they assume that Japan is a “large” country in
the import of rice. This assumption means that, when Japan
removes its protection against imports, the world price will
rise as the new demand by Japanese consumers for imported
rice bids up the landed price of the imports. (Of course, the
domestic price of rice will fall with the removal of the restric-
tions.) Hence, the consumer welfare gain from elimination of
import restrictions, other things equal, will not be as large as it
would be if Japan were a “small” country in the import of rice.
Second, Fell and MacLaren regard imported rice and domes-
tically produced rice as being imperfect substitutes (i.e., the
two goods are differentiated products such as discussed in
Appendix A of this chapter). This treatment seems realistic, as
there are indeed many varieties of rice produced in the world.
Third, the authors allow for the fact that Japanese consumers
may have a specific preference for (or bias toward) domes-
tically produced rice over imported varieties of rice. (Such
“home bias” in general was discussed in Chapter 9, page 161.)
The various impacts of the removal of restrictions on rice
were calculated for 2004, 2005, 2006, and 2007 with two
different scenarios for each year—each scenario reflecting a
different assumption regarding the elasticity of supply
of imports to Japan. The smallest overall welfare gain
from re moval of the restrictions in the eight scenarios was
¥73 billion. This figure reflected the sum of a consumer
welfare gain of ¥133 billion, a producer surplus loss of
¥118 billion, and a government expenditure reduction (wel-
fare gain) of ¥58 billion. The largest Japanese welfare gain
in the eight cases was ¥150 billion, comprised of a consumer
surplus gain of ¥221 billion, a producer surplus loss of
¥191 billion, and a government expenditure reduction of
¥120 billion. Fell and MacLaren’s different calculations
of the “tariff equivalent” of the various policies ranged from
105 percent to 204 percent. The assumption that Japan is a
“large” country rather than a “small” country in the import of
rice made for a large difference in results—for example, the
¥73  billion estimate of welfare gain indicated above would
have become ¥1,645 billion if Japan had been treated as a
small country rather than as a large country. Nevertheless,
even with the large-country assumption, it is clear that
welfare losses for Japan do occur because of the restrictive
policies regarding rice.
Source: James Fell and Donald MacLaren, “The Welfare Cost
of Japanese Rice Policy with Home-Good Preference and an
Endogenous Import Price,” Australian Journal of Agricultural and
Resource Economics 57, no. 4 (October 2013), pp. 601–19. ●
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Consumers must make a new consumption choice, given their lower level of real income.
What point on the new consumption-possibilities frontier, (Pag /Ptex)1, will maximize their
well-being in this tariff-distorted world? Because they face the same tariff-distorted prices
as producers, they will try to find a point on the new consumption-possibilities line that
represents an optimal consumption choice, given relative domestic prices. This will occur
at a combination of agricultural goods and textiles that lies on (Pag /Ptex)1 and that results
in MUag /MUtex = Pag /[Ptex(1 + t)]. This choice is indicated by point C1 in Figure 14. At C1
the slope of lower indifference curve IC1 is equal to the domestic price ratio that contains
the tariff on textiles, Pag /[Ptex(1 + t)]. This is indicated by the tangency of IC1 to the dashed
line at point C1. The tariff thus has a negative welfare impact on the country, represented
by the shift from point C0 on indifference curve IC0 to point C1 on the community indif-
ference curve IC1. The precise location of C1 on the world price line (Pag /Ptex)1 cannot be
determined without more information on the height of the tariff and the exact shape of the
indifference curves. All that can be concluded in this general presentation is that point C1
will be located somewhere on that world price line between point B1 (representing a pro-
hibitive tariff) and point C2.10
FIGURE 14 The General Equilibrium Effects of a Tariff in the Small-Country Case
Under free trade, the country produces at B0, consumes at C0, imports M0 units, and exports X0 units. With an
ad valorem import tariff (t), the domestic price of textiles rises to Ptex(1 + t), causing the domestic relative price
ratio [Pag/Ptex(1 + t)] to be smaller than the international terms of trade Pag/Ptex. Producers now see a greater
incentive to produce textiles, and domestic production moves to B1, where the domestic relative price line is tan-
gent to the PPF. The new level of real income measured at international prices (or the consumption-possibilities
frontier) is now represented by (Pag/Ptex)1, which passes through new production point B1. Consumers, facing
the same set of domestic relative prices as producers, move to C1, where the slope of community indifference
curve IC1 is just tangent to the farther out of the [Pag/Ptex(1 + t)] lines, and are clearly less well-off than with
free trade. Finally, if an equivalent subsidy had been used to attain B1, consumers would still face international
prices and would choose C2 instead of C1. The equivalent subsidy would leave them strictly better off than with
the tariff but less well-off than with free trade.
Textiles
M0
AgricultureX0
C0
IC0
B0
C2
B1
IC1
IC2
( )
1
Ptex
Pag ( )
0
Ptex
Pag
( )Ptex (1 + t )
Pag
C1
0
10This analysis ignores the complications linked to the use of the tariff revenue. It is assumed that tariff revenue
is simply redistributed to individuals in the country. Indeed, it is equal to the vertical distance between the two
distorted domestic price ratio lines if measured in units of textiles.
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The general equilibrium effects of a quota (not shown in Figure 14) are similar to those
of the tariff as long as the quota rent remains in the country. This would be the case if
the government auctions the quotas or if importers receive the quota rent. Because every
tariff has an equivalent quota that produces the same change in relative domestic prices,
the imposition of a quota leads to the same producer and consumer adjustments. The only
static difference in the two instruments is that quotas fix quantities and let prices adjust to
clear the market, whereas a tariff alters prices and lets quantities adjust. If, however, the
exporting country receives the quota rent, for example, through the efforts of organized
exporters or the imposition of a voluntary export restraint (VER), the result is different.
The imposition of a VER has the impact of raising the price of the restricted good to the
importing country, thus worsening the importing country’s terms of trade and leading to a
position on an even lower indifference curve than did the tariff.
It is useful at this juncture to contrast the effect of a tariff with that of a production
subsidy to the import-competing industry. As indicated earlier, for every tariff, there
is an equivalent production subsidy that causes domestic production to be the same as
that under the tariff (see Figure 4 in this chapter). The subsidy leads to the same reduc-
tion in the gains from specialization and loss in real income. What is different, however,
is that consumers continue to consume at international prices. The loss in real income
means that consumers have to reduce consumption so that they are consuming on the new
consumption-possibilities curve in Figure 14 (Pag /Ptex)1. However, because they continue
to face international prices, they attempt to find the consumption point where an indif-
ference curve is tangent to the new consumption-possibilities frontier. This tangency is
indicated by point C2, which is on a higher indifference curve than C1. Again, if the gov-
ernment wishes to encourage production in the import-competing sector, it is preferable to
do so by direct subsidization of producers rather than through price-distorting mechanisms
such as tariffs. The smaller the negative effects of government intervention, the fewer
the number of economic actors that are affected. With the subsidy, the distortion directly
affects only producers, and the principal social cost of the subsidy is the loss in real income
resulting from decreased specialization along the lines of comparative advantage.
In the large-country case, the welfare impact of protection is less clear and concise. Because
the large country can influence international prices by its own actions, the impact of a tariff
is felt not only domestically but also internationally. With its tariff, the tariff-imposing
country reduces both its import demand and export supply; that is, it is less willing to trade.
Consequently, both the international demand for the import good and the world supply of
the export good are reduced. Both effects cause the international terms of trade to change,
increasing the price of the export good relative to the import good and improving the
terms of trade of the tariff-imposing country. The overall reduction of welfare in the tariff-
imposing country resulting from the smaller amount of trade is thus offset, at least in part,
by improved terms of trade. It is possible that the effects of the terms of trade could more
than offset the effect of the reduction in trade and leave the tariff-imposing country better
off, assuming, of course, that its trading partners do not retaliate. (See the later discussion
of the “optimum tariff rate” on pages 325–27 in Chapter 15).
The general equilibrium effects of trade restrictions in the large-country case can be
usefully examined through the use of offer curves. The offer curve concept was introduced
in Chapter 7. To illustrate the impact of a tariff in such a framework, consider first the
manner in which the curve shifts when a tariff is imposed. Figure 15 illustrates the offer
curve for country I, which is exporting good B and importing good A. Remember that the
curve was derived by plotting the willingness of the country to trade at alternative terms
of trade. Curve 0I shows that country I is willing to export quantity 0B1 of good B and to
Protection in the
Large-Country Case
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import quantity 0A1 of good A at TOT1. Similarly, at TOT2, the country is willing to export
0B2 and import 0A2. When a tariff is imposed, the country is less willing to trade at each
terms of trade. At TOT1 on new offer curve 0I′, the country is willing to export only amount
0B′1 and to import only 0A′1. The willingness to trade at TOT2 is indicated in corresponding
fashion. Thus, the offer curve shifts or pivots inward with the imposition of a tariff. The
same shift or pivot can also represent an export tax as well as an import tariff, because both
instruments indicate less willingness to trade at any terms of trade.
Consider the comparative impacts of tariffs and quotas. Figure 16 portrays the imposi-
tion of an import tariff along with the foreign offer curve. (Both countries I and II are large
countries in these diagrams.) Prior to the tariff, the free-trade equilibrium is at point E with
quantity 0B1 of good B exported from country I (and imported by country II) and quantity
0A1 of good A imported by country I (and exported by country II). With the imposition of
the tariff, offer curve 0I′ rather than 0I becomes the relevant curve. The quantity of exports
of country I falls to 0B2, and this quantity is exchanged for 0A2 of imports. Note also that
the terms of trade improve for the tariff-imposing country, since TOT2 is steeper than TOT1.
The offer curve analysis of import quotas and VERs is contained in Figure 17. In panel (a),
the offer curve of country I with an import quota is identical to free-trade offer curve
0I until quota amount 0A2 is reached (equal to 0A2 in Figure 16). Then the offer curve
ceases rising because no greater quantity of imports will be permitted, and the curve in its
entirety becomes 0RI′ (horizontal line RA2 after point R). Like the import tariff, the quan-
tity imported of good A is 0A2 at the new equilibrium E′, the quantity exported of good B
is 0B2, and the terms of trade are TOT2.
FIGURE 15 The Imposition of a Tariff in the Offer Curve Diagram
Free-trade offer curve 0I shows country I’s willingness to trade at various terms of trade (e.g., it will export
quantity 0B1 of good B in exchange for 0A1 of good A at TOT1). When country I imposes an import tariff, it is
less willing to trade at each terms of trade. Thus, for example, the country will then export only 0B′1 of good B
in exchange for 0A′1 of good A at TOT1. The offer curve 0I shifts inward to 0I′.
Good A
A2
A 2
A1
A 1
B 1 B 2B1B 2
TOT2
TOT1
I
I
W
W
X
X
0
Good B
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FIGURE 16 The Impact of a Tariff
With the imposition of the tariff, country I’s offer curve 0I shifts inward to 0I′. The equilibrium quantity of exports falls from 0B1 to 0B2, and the
quantity of imports falls from 0A1 to 0A2. Country I’s terms of trade improve from TOT1 to TOT2. An export tax by country I would be portrayed
in the same fashion.
Good A
A1
A2
B2 B1
TOT2
TOT1
I
I
E
E
II
0
Good B
FIGURE 17 An Import Quota and a VER
The use of an import quota by country I is shown in panel (a). The free-trade offer curve 0I becomes 0RI ′, indicating that country I is willing to
import up to quantity 0A2 of good A but no more than that quantity. The equilibrium position moves from point E to point E ′, and country I’s
terms of trade improve from TOT1 to TOT2.
Panel (b) illustrates the use of a voluntary export restraint (VER) by country II to limit exports to country I to quantity 0A2. Country II’s offer
curve changes from 0II to 0SII′, indicating that it will send up to 0A2 of good A to country I. With the shift in the equilibrium position from E to
E ″, country I’s terms of trade deteriorate from TOT1 to TOT3.
Good A
A2
A1
B2 B1
TOT2 TOT1
Good B
Good A
B3 B1 Good B
E
EI A2
A1
I
II
R
E
E
TOT1
TOT3
II
II
I
S
00
(a) (b)
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The VER is shown in Figure 17, panel (b). Because it is the foreign country that is
undertaking the measure, country II’s offer curve is the curve affected, not the offer curve
of country I. Because country II can now export no more than 0A2, country II’s curve
becomes horizontal at that quantity. Its offer curve in its entirety is 0SII′ rather than the
free-trade curve 0II. The new equilibrium is at point E″. Country I still imports 0A2 of good
A, but it now exports the larger amount (compared with the import tariff and the import
quota) 0B3 of good B. Note also that the terms of trade have deteriorated for country I com-
pared with the free-trade situation: they are now TOT3 rather than the original TOT1. In this
two-country graph, the deterioration of country I’s terms of trade constitutes an improve-
ment in those of country II. Clearly, country II prefers the VER to the import quota and the
import tariff if the terms-of-trade impact is the only consideration.
OTHER EFFECTS OF PROTECTION
We have examined the effect of protection from a direct static perspective using partial
and general equilibrium analyses. Now we need to mention several other possible effects
of protection. First, we need to reemphasize that restriction of imports is likely to lead to
a reduction in exports of the tariff-imposing country. This takes place as soon as domestic
resources are withdrawn from export production and used in the production of domestic
import substitutes at the higher relative domestic price of these goods. Further, there is
likely to be foreign country tariff and nontariff retaliation against the tariff-imposing coun-
try’s exports. Protection thus not only lowers real income in the imposing country but also
redistributes it from export industries to import-competing industries. These shifts take
place in the short run and reduce the incentive to invest in the affected export industries,
contributing to reduced ability to export in the future. A reduced ability to export could
be deadly to industries that rely on today’s investment in research and development to be
competitive in the future. The subsequent slowing down of technological change in the
comparative-advantage industries could be critical to efficiency and welfare in our increas-
ingly interdependent world.
Second, you will recall that trade restrictions have an impact on the distribution of
income among the factors of production. With the imposition of a tariff in the Heckscher-
Ohlin model, the scarce factor gains and the abundant factor loses. Or in the specific-
factors model, the fixed factor in the import-competing industry (export industry) gains
(loses), while the impact on the variable factor depends on consumption patterns. Income
distribution effects are discussed further in Chapter 15.
Third, the effect of protection in certain industries on total imports may be less than it
appears if only the change in imports of the protected goods is examined. This would be the
case if the increase in domestic production of the import-competing products required inter-
mediate inputs that have to be imported. Then, while protection reduces imports of the tar-
geted products, increased domestic production leads to increased importation of the required
intermediate products. This is an often-ignored aspect of protection that turned out to be criti-
cal for a number of developing countries that were pursuing an import- substitution policy to
reduce their total imports by producing the previously imported goods at home. Ignoring the
indirect import requirement of the expanding import-competing sector contributed to serious
mistakes in estimating the potential effectiveness of import-substitution strategies.
It is also important not to ignore the possible effects of protection on foreign supply.
History demonstrates that foreign suppliers will attempt to find ways to circumvent any
kind of trade restriction, whether it be a tariff or nontariff barrier. Faced with the import
barrier, foreign firms may devote even more time and resources to reducing costs of pro-
duction in order to compete with domestic producers. The ultimate irony occurs when a
portion of a quota rent is transferred to the foreign producer (either directly or indirectly
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IN THE REAL WORLD:
DOMESTIC EFFECTS OF THE SUGAR QUOTA SYSTEM
The U.S. sugar industry has received protection since 1934.
From 1934 to 1974, sugarcane and sugar beet growers were
protected through import quotas, subsidy programs, and
acreage restrictions. Since 1976, import tariffs, import fees,
and quotas have been used fairly extensively. Most recently,
the import limitation program consists of tariff-rate quotas,
whereby a low tariff is placed on a first specified amount of
imports, but the rate then rises as imports exceed that amount.
The tariff-rate quota is set annually at 1.2 million tons and
can be raised only under certain conditions. The effect of
these restrictions on the industry has been substantial, caus-
ing the domestic U.S. price to be considerably above the
world price. For example, in 1988 the average domestic price
was $0.2212/pound and the world price was $0.1178/pound;
that is, there was an equivalent tariff rate of 88 percent. In
1989, the world price was $0.1445/pound, and the average
U.S. price was $0.2281/pound, an equivalent tariff rate of
58 percent. This protection cost consumers an estimated
$1.2 billion in 1988, $1.1 billion in 1989, and $1.4 billion in
1990. The related net social losses from the program in those
years were estimated at $242 million, $150 million, and
$185 million, respectively. These estimates do not include
any of the indirect or “downstream” effects on industries
that use sugar as an input and whose costs of production
were consequently higher as a result of sugar protection.
A 2003 study (Beghin et al.) indicated that in 1998 sug-
arcane growers gained $307 million, sugar beet growers
$650 million, and processors $89 million because of the
program. Further, users of sugar lost $1.9 billion, and the
deadweight losses associated with the program were put at
$532 million. More recently the USITC in 2011 estimated
the net welfare cost of the sugar program to be $49 million.
In addition, an estimate by the Heritage Foundation is that, in
2013, each sugar farm in the United States received average
annual revenue that was $310,000 greater than would have
been the case without the protection given to the industry.
Further, the consulting firm Agralytica estimated that U.S.
sugar consumers, from 2002 through 2012, spent in a range
of $1.45 billion to $4.24 billion more per year because of the
restrictions, and 127,000 jobs were lost in the food manufac-
turing sector because of the higher cost of sugar (Heritage
Foundation and Agralytica estimates given in Leonard).*
The impact of protection, however, goes beyond the effi-
ciency and distribution effects reflected in the above esti-
mates. A 1990 Wall Street Journal article (see the sources for
this box) focused on the state and local effects of the sugar
program in a sugar beet–growing region of Minnesota. The
higher prices for sugar gave farmers an incentive to shift land
from other uses to the production of sugar beets, where they
could earn up to four times what they could growing corn
or wheat. However, the administration of the sugar program
does not give everyone the opportunity to grow sugar beets.
The sugar beet program is essentially administered through
sugar processors. These sugar refiners are guaranteed a target
price as long as they pay growers the support price.
Because there are no other restrictions, the amount
of sugar beets that can be grown depends on the process-
ing capacity of the local plant and the access of growers to
the plant. In southern Minnesota, growers gained access
to refining facilities by buying shares in the Southern
Minnesota Beet Sugar Cooperative, which was founded in
1974. Without membership in the cooperative, growers had
no place to sell sugar beets. Consequently, the benefits of the
program accrued only to those few farmers who were mem-
bers of the cooperative, and the program generated sizable
impacts on local income distribution, land use, and conse-
quently the entire social fabric of the community. Tensions
rose every day as the “Beeters” sought to acquire more land
from non–sugar beet growers and the evidence of their eco-
nomic gains became even more visible. (It was estimated
that large farmers reaped $100,000 to $200,000 in annual
benefits from the sugar program.)
Rural communities were wrenched apart. Families split
over the issue, formerly good friends no longer met for cof-
fee or spoke, churches and community organizations became
divided, and vandalism against supporters and nonsupport-
ers of the program occurred. The noneconomic social costs
of price distortions like those introduced by the sugar pro-
gram are too often ignored in policy analysis. For example
greater health risks might occur from the fact that the higher
domestic sugar price leads consumers to switch to sugar sub-
stitutes such as corn syrup. The social costs are, however,
very real in communities such as Maynard, Minnesota.
Removal of such price distortions would eventually lead
to a return to land use consistent with unrestricted supply and
demand considerations and would remove the source of the
distribution distortion and community stress. Of course, new
stresses would be introduced with changes in the distribution.
The noneconomic personal and community costs that have
already been incurred may, however, never be recouped.
(continued)
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IN THE REAL WORLD: (continued)
DOMESTIC EFFECTS OF THE SUGAR QUOTA SYSTEM
*In late summer 2015 the U.S. domestic price was about twice
the world price. This implies an equivalent tariff rate of roughly
100 percent.
Sources: U.S. International Trade Commission, The Economic Effects
of Significant U.S. Import Restraints, Phase II: Agricultural Products
and Natural Resources, USITC Publication 2314 (Washington, DC:
U.S. Government Printing Office, September 1990), chap. 2, Fourth
Update, 2004, USITC Publication 3701 (Washington, DC: June
2004), p. xvii, and Seventh Update, 2011, USITC Publication 4253
(Washington, DC: August 2011), p. x, obtained from www.usitc.
gov; Bruce Ingersoll, “Small Minnesota Town Is Divided by Rancor
over Sugar Policies,” The Wall Street Journal, June 26, 1990, pp.
A1, A12; Gary C. Hufbauer and Kimberly A. Elliott, Measuring the
Costs of Protection in the United States (Washington, DC: Institute
for International Economics, 1994), pp. 79–81; John Beghin, Barbara
El Osta, Jay R. Cherlow, and Samarendu Mohanty, “The Cost of the
U.S. Sugar Program Revisited,” Contemporary Economic Policy
21, no. 1 (2003), p. 106, obtained from www.econpapers.repec.org;
Bruce Odessey, “Bush Advisers View Sugar Program as Hurting U.S.
Consumers,” obtained from www.usinfo.state.gov; U.S. Department
of Agriculture, “U.S. Sugar Import Program,” obtained from www
.fas.usda.gov; Carolyn Cui and Bill Tomson, “Sugar Surges as U.S.
Acts to Boost Imports,” The Wall Street Journal, August 21–22,
2010, p. B1; Walter Williams, “Sweet Deals That Damage Our
Health,” The Charlotte Observer, July 22, 2010, p. 13A. Burleigh C.
W. Leonard, “U.S. Sugar Policy: Sweet for a Few, Sour for Most,”
The Wall Street Journal, November 3, 2014, p. A15. ●
through its government), which then uses it to make technological innovations and become
an even stronger competitor. This took place in the U.S. textile and apparel industry and
the automobile industry. Too often, protection seems to impair the pursuit of cost-reducing
innovations in the imposing country while increasing the cost-reducing incentives in the
exporting country. Unfortunately, this scenario leads over time to pleas for greater and
greater protection from the already-protected industry. The increased levels of protection
bring greater and greater net welfare losses to the trade-restricting country.
Finally, new thinking about the effects of reducing or eliminating trade restrictions
has emerged since the appearance of the Melitz (2003) model of trade. (See Chapter
10, pages 189–90) for a more complete discussion of this model.) The Melitz model
centered on the phenomenon that there are some one-time fixed costs for a firm when
engaging in exporting (e.g., learning about the characteristics of particular foreign mar-
kets, establishing product distribution channels abroad) as well as standard variable
costs of exporting a unit of a good such as transportation costs and special packing costs.
In the context of this model, a recent paper by George Alessandria and Horag Choi
(2014) addressed the matter of eliminating trade restrictions. Basically, domestic firms
are importing intermediate materials as part of their normal production process, and an
elimination of all tariffs and other barriers to trade will thus reduce a firm’s imported
input costs (and of course will reduce the landed price of any exports that the firm sells
abroad if foreign countries also reduce or eliminate tariffs). With this reduction in input
costs (as well as any increase abroad in sales of the firm’s goods), profits for the domes-
tic firm are enlarged and a greater number of domestic firms will now find it attractive to
cover the fixed/sunk costs of exporting. As a result, more firms begin to export, yielding
gains from trade. Taking account of this new exporting resulting from the trade bar-
rier reductions, it follows that any current trade restrictions in place are causing losses
beyond the traditionally recognized ones because these additional trade gains have been
foregone. With trade restrictions in place, there are fewer exporters in the country than
would otherwise have been the case.
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CONCEPT CHECK 1. How does protection of the import good
affect production of the export good in the
general equilibrium framework?
2. How can tariffs on the import good lead to
a decline in consumption of both the import
and export good?
SUMMARY
This chapter has looked at the ways trade-restricting poli-
cies affect a country. Both the partial and general equilibrium
approaches indicate that in the small-country case, restricting
trade leaves the country less well-off. In the large-country
case, trade restrictions can under certain conditions lead to
an improvement in well-being for the country imposing the
restrictions as long as the partner country does not retaliate.
Retaliation and the resulting trade war leave everyone worse
off. From the perspective of both cost and international pol-
icy, domestic subsidies remain the more desirable alternative
if countries wish to assist import-competing industries. The
subsidies also produce a domestic production distortion, but
because they affect only producers, they are less costly to
subsidy-financing consumers and have a smaller impact on the
level of imports coming into the country than either tariffs or
quotas.
KEY TERMS
auction quota system
consumer surplus
deadweight losses
demand for imports schedule
equivalent quota
equivalent subsidy
equivalent tariff
general equilibrium model
incidence of the tariff
partial equilibrium analysis
producer surplus
quota rent
supply of exports schedule
QUESTIONS AND PROBLEMS
1. Suppose that the free-trade price of a good is $12 and a
10 percent ad valorem tariff is put in place. As a result, domes-
tic production in a small country rises from 2,000 units to
2,300 units and imports fall from 600 units to 200 units.
Who are the winners and losers? What is the size of their
gains and losses? What is the net effect on society?
2. Using the example in Question 1, how does an equivalent
subsidy to the import-competing producer affect the market?
What is the cost to the government of this subsidy? Which
policy would consumers prefer, the tariff or a subsidy?
3. How does an import quota differ from a tariff? Can the gov-
ernment ever capture the quota rent? If so, how?
4. If you were an import-competing producer in a growing
market, which trade instrument would you prefer—a tariff,
an import quota, or a subsidy? Why?
5. What is the difference between an export tax and an export
subsidy? Which instrument are domestic consumers likely
to prefer? Why?
6. Why might a large country like the United States have a
greater incentive than a small country to use trade restrictions?
7. Using a general equilibrium approach, point out the real
income loss from a tariff to a country. What is the consumer
welfare loss? Why might consumers prefer a production
subsidy rather than a tariff?
8. Explain why an export subsidy is more costly in the case
of a large country than in the case of a small country, other
things being equal.
9. It has been said that U.S. consumers/taxpayers ended up
paying “twice” for a U.S. wheat export subsidy program. Is
there any basis for such a claim?
10. Suppose that a (small) country is an importer of good X,
for which the current world price is $8. At that price with
free trade, home producers are supplying 500 units of
good X and the country is importing 300 units. It is now
rumored that a 10 percent import duty will be imposed
on good X. Estimate the welfare impacts that would occur
with such a tariff, given that the elasticity of demand by
consumers for good X is −2.0 and that the elasticity of
home supply is 1.6.
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Appendix A THE IMPACT OF PROTECTION IN A MARKET WITH
NONHOMOGENEOUS GOODS
The analysis to this point has examined the welfare impact of trade policy–induced price distor-
tions, assuming that the product on which the tariff is placed is a homogeneous good that can
be represented with a single demand curve and price. However, if imperfect substitution exists
between the foreign- and domestic-produced good, then the pretariff prices of the two products
can be different and the single-market approach is inappropriate. With nonhomogeneous goods,
the increase in the price of the foreign import resulting from the tariff causes consumers to increase
their demand for the domestic substitute. This increase in demand leads in turn to an increase in
price of the domestic good and a subsequent loss in consumer surplus, even though the tariff does
not apply directly to it. An analysis of the impact of a tariff must take into account the indirect
effects of the tariff both on related goods and the good upon which it is levied. This idea is devel-
oped in this appendix. (For elaboration, see U.S. International Trade Commission, 1989, chap. 2.)
In the case of close but not perfect substitutes, we need to analyze the impact of the tariff in two
markets, not just one. See Figure 18, where panel (a) describes the situation in the market for the
domestic good and panel (b) describes the market for the imported good in this small-country case.
Because the two goods are assumed to be close substitutes, the demand for each good is linked posi-
tively (the cross-price elasticity is positive) to the price of the other. Consequently, when the domes-
tic price of one good changes, it leads to a change in demand for the other in the same direction.
In Figure 18, panel (b), the imposition of a tariff on the foreign good raises its price on the
domestic market from P′0 to P′1 = Pint(1 +  t), simultaneously reducing the quantity demanded of
the foreign good and causing the demand for the domestically produced good [panel (a)] to increase
FIGURE 18 Tariff Effects on Nonhomogeneous Goods
The tariff raises the domestic price of the import good from P′0 to P′1 = Pint(1 + t) as indicated in panel (b). At the same time, the increase in
the price of the foreign good leads to an increase in the demand for the substitute domestic product and a higher price. The increase in price of
the domestic substitute then leads to a subsequent outward shift in the demand for the foreign good. These simultaneous adjustments take place
until the markets are again in equilibrium. The outward shift of the demand curve for the domestic good [panel (a)] from Ddom to D′dom leads to a
higher domestic price (P0 to P1) and quantity supplied (Q0 to Q1). The average loss of consumer surplus in the domestic market is a′b′e′d′, which
is transferred to domestic producers. The demand adjustments cause the reduction in imports in the import market to be less than the initial reduc-
tion, that is, from Q2 to Q4 instead of to Q3. There is an average reduction of consumer surplus equal to the area abde in this market, where abdf
represents the tariff revenue received by the government and area fde the deadweight consumer loss. The total consumer loss from the tariff is the
sum of the losses in both the domestic substitute market and the import market.
PD
Ddom
D
P 1
P 1
P 0
b
c
e
da
P0
Q1Q0 QD0 0
dom
(a) The market for the domestic good
Sdom
PF
QF
D
D f
f
Pint
Q3 Q4 Q2
(b) Domestic demand for the foreign good
Pint (1 + t)
f
b
a
c
e
d
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(a shift to the right of the demand curve Ddom to D′dom). With a normal upward-sloping domestic supply
curve, the price of the domestic substitute increases, triggering an increase in demand for the foreign
good (a rightward shift in the demand curve for the foreign product). The imposition of the initial tariff
thus sets off demand shifts as the markets adjust to the price distortion. When the repercussions of the
tariff have worked through the two demand curves, both curves will have shifted to the right, and the
country will import an amount such as Q4 in panel (b), and there will be a higher price of the domes-
tic good, P1, as shown in panel (a). Because the price has increased in both markets, two groups of
consumers find that their consumer surplus has declined, not just one as with the homogeneous good.
Because both demand curves have shifted in the adjustment process, calculating the effects
of the tariff distortion is not as straightforward as with homogeneous goods. The measure of
the loss in consumer surplus differs according to the use of the pretariff demand curves or
the after-tariff demand curves. Because of the joint market adjustments, measuring the loss
in consumer surplus of the import good along pretariff demand curve Df ignores the cost to
consumers who choose to switch to the import good because of the higher cost of the domestic
substitute. Similarly, measuring the loss in consumer surplus along the tariff-ridden demand
curve D′f overstates the loss in consumer surplus because it includes individuals who chose not
to consume the import good—or to consume less of it—at the free-trade price but who would do
so now. It is common practice to use an average of the estimates under each demand curve—that
is, area abde in panel (b)—when measuring the loss in consumer surplus in the import market. A
similar argument in the domestic market leads to the use of area a′b′e′d′ as the estimate of loss
in consumer surplus due to the tariff on the foreign substitute. (It can be demonstrated theoreti-
cally that these are the appropriate measures of the loss in consumer surplus, assuming that the
demand curves are linear and that there are no income effects, i.e., that the demand curves are
“compensated” demand curves.)
The effects of the tariff are a government revenue gain of abdf and a consumer deadweight loss
of fde in the import good market. In the domestic market the consumer surplus loss a′b′e′d′ is equal
exactly to the gain in producer surplus.
An example of this kind of calculation with nonhomogeneous goods was provided by economist
William R. Cline in 1990. For the U.S. textile industry in 1986, using the technique of this appen-
dix, he calculated that the consumer welfare loss in the import market from import restrictions was
$1,275 million (or $1.3 billion). Further, the consumer welfare loss in the market for domestically pro-
duced goods from those same import restrictions was $1,513 million (or $1.5 billion). In the domestic
goods market, however, the transfer to producers was of course also $1,513 million, so there was no
net social effect in the domestic goods market. In the import market, there was a tariff revenue gain
of $488 million, and thus the net welfare effect in the import market (and therefore the net welfare
effect for the United States as a whole) was a loss of $787 million (= $1,275 million − $488 million).
Appendix B THE IMPACT OF TRADE POLICY IN THE LARGE-COUNTRY SETTING
USING EXPORT SUPPLY AND IMPORT DEMAND CURVES
This appendix demonstrates the price, quantity, and welfare effects of trade policies using only the
export supply/import demand diagram developed in the chapter. Thus, the demand and the supply
curves within each country are not portrayed, although they are the bases for the export supply and
import demand curves. We examine below the four basic instruments of trade policy—an import
tariff, an import quota, an export tax, and an export subsidy.
THE IMPACT OF AN IMPORT TARIFF
Figure 19 reproduces panel (b) of Figure 10 in this chapter with the relevant illustrative numbers.
Recall that the imposition of this specific tariff causes the free-trade price, Pm0 ($100) to increase
to Pm1 ($106) in the importing country and the quantity imported to fall from Qm0 (30 units) to Qm1
(17 units). The importing country’s government collects tariff revenue represented by the rectangle
Pm2Pm1E′F [= ($106 − $96)(17) = $170], and the foreign supplier now receives price Pm2 ($96).
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FIGURE 19 The Imposition of a Specific Import Tariff
The imposition of the tariff raises the price of the good in the importing country from Pm0 to Pm1 and reduces
the quantity imported from Qm0 to Qm1. Tariff revenue of area Pm2Pm1E′F is generated. The country’s welfare
increases if area Pm2Pm0GF is larger than area GE′E.
Quantity
Price
Qm1 Qm0
E
E
Sfx
S fx
Dm
Pm1
Pm0
Pm2
G
F
($106)
($100)
($96)
0
(17) (30)
Consider the welfare effects on the tariff-imposing (home) country. The sum of areas a and b in
Figure 10 conceptually equals the area of triangle GE′E in Figure 19 because the base of triangle
GE′E (Qm0 − Qm1 = 30 − 17 = 13) equals the sum of the bases of triangles a and b in Figure 10;
that is, the change in imports is the sum of the reduction in home consumption (base of triangle
b = 7) and the increase in home production (base of triangle a = 6). The height of triangle GE′E in
Figure 19 (Pm1 − Pm0 = $106 − $100 = $6) is the height of each of the triangles a and b in Figure 10.
Further, the part of the tariff revenue paid by home consumers (area c in Figure 10) equals area
Pm0Pm1E′G in Figure 19 [both are equal to ($106 − $100)(17) = $102], while the part of the tariff paid
by the exporting country (area fhij in Figure 10) equals area Pm2Pm0GF in Figure 19 [both are equal to
($100 − $96)(17) = $68]. Thus, the net welfare effect in Figure 19 for the importing country is negative
if deadweight loss triangle GE′E is greater than rectangle Pm2Pm0GF, and the net welfare effect is posi-
tive if the area GE′E is less than area Pm2Pm0GF. In our numerical example, because area GE′E = [(1/2)
($106  −  $100)(30  −  17)]  =  [(1/2)($6)(13)]  =  $39, and area Pm2Pm0GF  =  [($100  −  $96)(17)] 
=  [($4)(17)] = $68, there is a gain to the tariff-imposing country of ($68 − $39) = $29, just as
occurred back in Figure 10.
THE IMPACT OF AN IMPORT QUOTA
To illustrate the imposition of an import quota in the demand for imports (Dm)–supply of foreign
exports (Sfx) diagram, consider Figure 20. In free-trade equilibrium, quantity Qm0 (30 units) is imported
at price Pm0 ($100). Now the government, under pressure from domestic import-competing suppliers,
specifies that only amount Qm1 (17) of the good can be imported into the country. The effect of the
quota is that, at quantity Qm1, a vertical line is erected (line Qm1FS′fx). The supply of exports sched-
ule thus becomes RFS′fx, which is the normal supply of exports schedule from R to F (with point F
occurring at quota amount Qm1) followed by the vertical segment indicating that no more imports can
come in beyond quantity Qm1. The equilibrium position in the market with the quota in place is point
E′ at equilibrium price Pm1 ($106). Thus, as with the tariff, the domestic price has been increased
and the quantity has been decreased compared with equilibrium under free trade. The domestic con-
sumer pays a higher price than that under free trade—the increase in price is represented by distance
(Pm1 − Pm0 = $6)—and the foreign supplier receives a lower price than that under free trade; the
decrease is represented by the distance (Pm0 − Pm2 = $4). Because there is a price divergence between
what the consumer pays and what the producer receives for each unit of the import, the rectangle
(quota rent) Pm2Pm1E′F in Figure 20 is available for someone (as discussed in the chapter).
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What are the welfare effects on the home country of its import quota? In Figure 20 (as in
Figure 19), triangle GE′E is the sum of the deadweight losses related to decreased home consump-
tion and increased inefficient home production. However, if the government captures quota rent area
Pm2Pm1E′F as revenue by selling import licenses, or if domestic importing firms capture it when
the government does not sell licenses, then area Pm2Pm0GF is a transfer to the home country from
foreign exporters. If this area is larger (smaller) than GE′E, the country will gain (lose) from the
import quota. (Remember that we are assuming that trading partner countries do not retaliate.) In
our numerical example, area GE′E = $39 and area Pm2Pm0GF = $68. But if the entire quota rent
area, Pm2Pm1E′F, is captured by foreign suppliers or foreign governments with a rise in price of the
good, the rent is captured by the exporting country. The net welfare effect of the quota would then
be unambiguously worse than that of the tariff for the home (importing) country. The net welfare
effect of the tariff was gain area Pm2Pm0GF ($68) minus loss area GE′E ($39); the net welfare effect
of the quota if the foreign country captures the quota rent is a loss of both areas GE′E ($39) and
Pm0Pm1E′G [($106 − $100 × 17) = $102]. (Note: area Pm2Pm0GF is not a loss from the departure from
free trade because that area accrued to the foreign country under free trade as part of export receipts.)
A VER is illustrated like the import quota in Figure 20 because the impact on domestic price and
quantity of the import is the same. However, the important difference between the two instruments is
that the quota rent area is now virtually certain to be captured by the foreign supplier or government.
With the restricted quantity in place and under control of the exporting country, that country can raise
the price up to Pm1. The welfare effect for the importing country from the VER is thus a loss equal to
the loss from the import quota when the foreign exporters captured the quota rent. If foreign exporters
do not capture the import quota rent, the loss to the importing country from the VER exceeds the loss
from the import quota, which in turn could not be a loss smaller than that with a tariff.
FIGURE 20 The Imposition of an Import Quota
The free-trade equilibrium position is at point E, the intersection of RSfx and Dm. If an import quota of size Qm1
is imposed, the supply of exports schedule becomes RFS′fx and the quantity of imports falls from the free-trade
level, Qm0. The price to the importing country’s consumers rises from Pm0 to Pm1 because of the artificial scar-
city, while the price on the world market falls to Pm2. The shaded area represents the quota profit or rent. The
welfare impact of the quota importantly depends on who receives this rent.
E
E
Pm0
Price
Pm2 F
Qm1 Qm0
S
S fx
Quantity
Pm1
Dm
G
R
fx
($106)
($100)
($96)
(17) (30)
0
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FIGURE 21 The Imposition of an Export Tax
The free-trade position is at E, the intersection point of the supply of exports schedule (Sfx) and the demand for
imports schedule (Dm). With a specific export tax, Sfx shifts up to S′fx. With the tax in place, importing-country
buyers pay the higher price Px1 per unit rather than free-trade price Px0, and suppliers of the export receive lower
amount Px2 per unit (rather than Px0). The quantity of exports falls from Qx0 to Qx1 because of the imposition of
the tax. The export tax revenue is indicated by the shaded area. The tax-imposing country improves its welfare
if area Px0Px1E′G is greater than area FGE.
Quantity
Dm
Px0
Qx1 Qx0
fx
Sfx
S
E
E
F
Px1
Px2
G
($106)
($100)
($96)
0
Price
(17) (30)
THE IMPACT OF AN EXPORT TAX
The impact of an export tax by the foreign country on the welfare of that exporting country can be
analyzed in parallel fashion to an import tariff. (Hopefully this discussion is not getting too taxing!)
Again, the tax can be specific or ad valorem in nature, but the basic principles are the same. Figure 21
illustrates the imposition of a specific export tax. The supply of exports schedule, Sfx, slopes upward
and the demand schedule for imports, Dm, slopes downward in the usual fashion. Before the imposi-
tion of the tax, the market equilibrium is at point E with price Px0 and quantity Qx0. When the tax is
levied, the supply of exports schedule shifts upward (a decrease in supply) to become S′fx. With the
tax in place, the price of the export on the world market is Px1 ($106) and the quantity sold is Qx1 (17)
at the new equilibrium point E′. The large, exporting country has thus been able to force up the world
price to some extent because of the decrease in supply. However, the price that exporters receive after
paying the tax falls to Px2 ($96) because, with less of the good exported, more is sold on their home
market, driving down the domestic price. The exporting country’s government collects revenue of
shaded area Px2Px1E′F[($106 − $96)(17) = $170] from the tax. Some of the revenue is economically
paid by the importing-country buyer (area Px0Px1E′G [($106 − $100)(17) = $102]), and the remain-
der is paid by the producer (area Px2Px0GF) through receipt of lower revenues. The export tax hurts
the exporting country’s producers, but its consumers gain through a reduced domestic price. This is
opposite to the case of an import tariff by a country, where the importing country’s producers gain
through the higher domestic price and its consumers are hurt.
Let us now examine the welfare effects of this tax on the country imposing the tax, i.e., country
B back in Figure 12 of this chapter. In Figure 21, the exporting country’s export price rises from Px0
to Px1. If import prices remain the same, then the terms of trade (Pexports/Pimports) will rise because of
the export tax. Because of the improvement in the terms of trade, the welfare effect for the export-
ing country can be positive. In Figure 21, triangle FGE is the deadweight loss associated with the
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export tax; it corresponds conceptually to triangles ghf and ikj in Figure 12 in this chapter. It cor-
responds because the combined base of the two triangles in Figure 12 was the fall in exports, as
is (Qx0 − Qx1 = 13) in Figure 21, and the price reduction was the old, pretax price minus the new
domestic, after-tax price (Px0 − Px2 = $100 − $96), which equals (Pm0 − Pm2) in Figure 12. Potentially
offsetting the deadweight losses from the export tax in Figure 21 is rectangular area Px0Px1E′G, the
transfer of welfare as tax revenue to the government from importing country buyers of the export
good. The large country will gain (lose) from the export tax if area Px0Px1E′G is larger (smaller)
than area FGE. In our example, area Px0Px1E′G = ($106 − $100)(17) = $102 and area FGE = [(1/2)
($100 − $96)(30 − 17) = $26 so the exporting country gains ($102 − $26) = $76.
THE IMPACT OF AN EXPORT SUBSIDY
An export subsidy is in effect a negative export tax, and the analytics of the two devices are simi-
lar. In Figure 22, the equilibrium in the export supply–import demand graph is initially at point E,
with price Px0 ($55) and quantity exported Qx0. When the exporting-country government provides
an export subsidy, say, of $10 per unit, the Sfx schedule shifts vertically downward (an increase in
supply) to S′fx, which is shown as a parallel shift since we assume that a subsidy of a fixed monetary
amount per unit exported is paid. The new price at which the exporter can sell the good is Px2 ($49),
and the new equilibrium is at point E′ with quantity Qx1 (9 units). Because there is now a relatively
greater incentive for the producer of the good to export rather than to sell in its domestic market, the
reduced amount of the good in the exporting country causes the domestic price to rise to Px1. (With
price Px1, the firm receives the same total amount per unit of sales in each market, because price Px1
FIGURE 22 An Export Subsidy
The free-trade equilibrium position is at point E. With an export subsidy, the supply of exports schedule Sfx
shifts down vertically (to S′fx) by the amount of the subsidy per unit of exports. Because the producer can now
sell the good for the lower price, Px2, on the world market (rather than Px0), the quantity exported rises from Qx0
to Qx1. The price to domestic buyers rises from Px0 to Px1 because less of the good is available for consumption
in the exporting country. The shaded area represents the total expenditure by the government in the form of the
subsidy to exporting firms. Welfare unambiguously declines in the exporting country.
EPx0
Price
Px2
F
E
Qx1Qx0
S
Sfx
Quantity
Px1
DM
fx
G
($59)
($55)
($49)
0
(4) (9)
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equals export price Px2 plus the subsidy per unit received for exporting the good.) Thus, domestic
consumers are injured when their producers receive an export subsidy. An additional possible source
of injury to the exporting country is that the export subsidy (unlike the export tax or the import
tariff) does not bring in revenue to the government. Rather, the subsidy requires government expen-
diture. The amount of subsidy required for export quantity Qx1 (9 units) in Figure 22 is shaded area
Px2Px1FE′, which is the amount of the subsidy per unit of exports [vertical distance E′F—equal to
distance (Px1 − Px2)] times the number of units of the export (the horizontal distance from the origin
to export quantity Qx1). Hence, the total subsidy cost is ($59 − $49)(9) = $90.
Finally, regarding welfare in the large-country case of an export subsidy for the country employ-
ing the subsidy (i.e., country B back in Figure 13), triangle EFG represents the deadweight losses.
This area is conceptually equivalent to triangles f and g in earlier Figure 13. In that figure, the sum
of the bases of the two triangles was increased exports due to the export subsidy, as is length EG
or (Qx1 − Qx0 = 5) in Figure 22. Similarly, the height of triangles f and g in Figure 13 indicated the
difference between the market price in the exporting country with the export subsidy and the interna-
tional market price without the subsidy—as does length FG or (Px1 − Px0) in Figure 22. For welfare
purposes, the exporting country also loses area Px2Px0GE′, the amount of price reduction to the for-
eign buyers (because of the export subsidy) times the quantity of exports. Thus, the export subsidy
has a loss in the large-country case on the country that uses it, a loss that did not occur in the small-
country case. In this example, the total loss is thus area EFG [1/2($59 − $55)(9 − 4) = $10] plus area
Px2Px0GE′ [($55 − $49)(9) = $54], or a total loss of $64. This loss because of the lower export price
is a transfer of welfare from the export-subsidizing country to the rest of the world.
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15
CHAPTER
ARGUMENTS FOR
INTERVENTIONIST
TRADE POLICIES
LEARNING OBJECTIVES
LO1 Explain how trade policy instruments are often part of broader social
policy and why other policy instruments might be less costly.
LO2 Evaluate the effectiveness of trade policy in the presence of market
imperfections.
LO3 Examine protection as a response to international policy distortions.
LO4 Identify and assess invalid economic arguments for protection.
LO5 Analyze the role of trade policy in promoting strategic industries and
dynamic comparative advantage.
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INTRODUCTION
On almost a daily basis, there are articles in newspapers in which someone or some group is
arguing for the imposition of protection against imports of goods and services. Many of these
arguments have a long and colorful history and, surprisingly, continue to influence policymakers
and the general public. The following statements provide examples of the kind of arguments one
continues to encounter on a regular basis:
A 15 percent revenue tariff on all imported manufactures and goods in competition with American-
made goods would be a fitting way to declare our economic independence. (Patrick J. Buchanan, 1998)
I do not know much about the tariff, but I know that when we buy our own products we get both
the goods and the money, but when we import goods we get the goods and the exporting country
gets the money. (A statement often attributed to Abraham Lincoln)
We should subsidize smokestacks and erect tariffs to protect our manufacturers from foreign
competitors. (Eamonn Fingleton, In Praise of Hard Industries)
We need to impose tariffs and quotas to protect our manufacturers from cheap foreign labor.
It is important to restrict imports in order to stop the hemorrhaging of employment and the exports
of U.S. jobs to the rest of the world.
Which of these arguments have economic merit? Which do not? Obviously the public and
its representative elected officials are prone to be influenced on this matter because various
groups in the United States spend millions of dollars each year in an attempt to influence
policymakers to enact legislation that will restrict international trade. Given that, in prin-
ciple, most economists agree that trade increases the overall well-being of a country, it is
striking to note how much individual interests are willing to spend to reduce international
trade. In this chapter we present a number of these arguments for protection and then evalu-
ate the validity of each from an economic perspective. As a usual final step in each case, we
ask whether an alternative policy instrument might do a better job of achieving the objective
of the restrictive trade policy. Because economists think in terms of alternatives and benefits
versus costs, our procedure is essentially to ask, “Given the objective, what are the benefits
and costs of a restrictive trade policy compared with those of another policy?”
Finally, bear in mind (as nicely put in Ingram, 1986, p. 341) that the perspective from
which an argument for protection is put forth is important. For that reason, we have chosen
to organize the presentation of these arguments in terms of the nature of the policy question
being addressed. The presentation begins by looking at a number of arguments that tend to
be proposed from a national perspective, where trade policy instruments are part of a broader
social policy package that affects the nation as a whole. We then turn to proposals for pro-
tection that are suggested as ways of offsetting various kinds of market imperfections such
as those arising from imperfect competition and externalities of varying kinds. The third
category looks at arguments for protection that are undertaken as a response to policy distor-
tions arising from the actions of our trading partners. This is followed by a brief overview
of several miscellaneous arguments that reappear from time to time but that have little or no
economic basis. Finally, the last category contains some of the key arguments that focus on
temporarily restricting trade as a strategy to foster comparative advantages over time, particu-
larly in manufacturing. The chapter concludes with a brief summary and conclusions.
TRADE POLICY AS A PART OF BROADER SOCIAL POLICY OBJECTIVES FOR A NATION
Trade policy is often conducted as a component of a policy package that is directed toward
improving the well-being of different groups in society or reaching certain national and
international objectives. From this perspective, trade restrictions are promoted to the public
Calls for Protection
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at large in terms of, for example, influencing income distribution, strengthening national
defense, maintaining global power, and fostering international equity. In this section we
review a number of the more common arguments for protection that come into play as part
of a policy package directed toward broader social policy objectives.
For many countries, consumption taxes are an important source of government revenue.
This is particularly true in those cases in which it is difficult for governments to effectively
use taxes on income and property to generate the needed revenue to finance public expen-
ditures. In this instance, governments often turn to trade taxes along with other domestic
sales taxes to generate needed revenue. The decision to use trade taxes, as opposed to other
forms of taxation, to fund government expenditures in this broader social context turns
on issues of tax efficiency and equity. In certain large-country settings, it is also possible
that countries may be able to shift some of the incidence of the tax to trading partners.
This case clearly illustrates how the broader social policy objective of earning revenue
dominates and might well result in the imposition of trade taxes as a part of a set of broad
government revenue policies. In the longer term, however, changes in the institutional set-
ting that will permit the inclusion of a broader tax base (including property and income)
will likely prove to be more beneficial to the country. In the case of the United States, trade
taxes provide an extremely small portion of government revenue today, whereas prior to
a century ago, trade and consumption taxes were the principal source of government rev-
enue and income and property taxes were considerably less important. It is worth noting,
however, that trade taxes continue to be an important source of government revenue for
many countries in the world. Not surprisingly, the majority of these countries are in the
developing world.
The national defense argument for a tariff assumes that an industry is vital to a country’s
security because its product or the skills it develops are invaluable to the country during war-
time or periods of national emergency. If, during normal times, free trade is permitted in the
product of this industry, imports may capture the lion’s share of the market and either drive
domestic producers from the industry or reduce the size of the industry. However, in times of
national emergency or world conflict, normal trade patterns might be disrupted and import
supplies cut off. If a cutoff occurs, the country is left without adequate supplies of the prod-
uct and national security is threatened. To prevent this threat from becoming a reality in the
future, the industry must be protected now. With tariff protection, the industry will thrive,
and national security will not be undermined should world conflict or disruption occur.
What are we to make of this argument? The important point to recognize is that it is not
easy to identify which industries are vital to national defense. Indeed, in petitions for protec-
tion, almost all industries put forth some claim concerning their importance for the security
of the country. For example, the U.S. watch industry successfully obtained protection using
this argument, and (see Ingram and Dunn, 1993, p. 154) even the garlic and clothespin
industries petitioned for protection using the national defense argument. The determination
of which industries are truly vital is extraordinarily difficult and ultimately must be made
by the political process.
Once an industry has been determined vital to national security, the task of the econo-
mist is to point out that policies other than the tariff may have a lower welfare cost for
the country. For example, the good could be stockpiled, like U.S. oil with the Strategic
Petroleum Reserve, and thus be available when foreign supplies are cut off. Or, as in the
U.S. semiconductor industry, a joint business-government research and development firm
(Sematech) was formed in the 1980s to assist the industry, although the firm now operates
independently from the government. A production subsidy also could be given to keep
Trade Taxes as a
Source of Government
Revenue
National Defense
Argument for a Tariff
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IN THE REAL WORLD:
THE RELATIVE IMPORTANCE OF TRADE TAXES AS A SOURCE
OF GOVERNMENT REVENUE
Trade taxes continue to be an important part of government
financing in many countries of the world. This is particularly
the case in countries that do not have the institutional tra-
dition of financing government expenditures with income,
wealth, and property taxes. They thus rely on transaction
taxes, most often of a consumption nature, to finance gov-
ernment programs. A number of countries rely on trade taxes
because they are more easily collected upon import or export
and, in the large-country case, can be passed on in part to
countries that are importing the good. This is particularly true
in the case of countries that are exporting goods for which
foreign demand is relatively inelastic. In Table 1, the relative
importance of trade taxes is indicated for selected countries.
(We follow the World Bank’s classification of countries in
this table.) It is not surprising to note that trade taxes are
generally relatively unimportant for the high-income coun-
tries, but they are extremely important for a number of low-
income and middle-income countries.
TABLE 1 Trade Taxes as a Percentage of Central Government Revenue
Country Year Percentage Country Year Percentage
High-Income Countries
Australia 2012 2.01% Israel 2012 0.76%
Canada 2012 1.24 Japan 2012 1.65
Chile 2012 1.09 Rep. of Korea 2012 2.50
Iceland 2012 1.42 Switzerland 2011 5.74
Ireland 2012 0.07 United States 2012 1.24
Middle-Income Countries
Azerbaijan 2012 2.57% Macedonia 2012p 3.06%
Brazil 2012 2.72 Mauritius 2012 1.85
China 2011 4.72 Paraguay 2012 6.57
Egypt 2012p 4.24 South Africa 2012p 4.08
Georgia 2012 1.28 Thailand 2012 4.97
Indonesia 2012 3.71 Tunisia 2012 5.87
Low-Income Countries
Afghanistan 2012 4.22% Kenya 2012b 10.01%
Bangladesh 2011 24.56 Madagascar 2011p 40.71
Cambodia 2012b 16.43 Nepal 2012b 15.22
Dem. Rep. of Congo 2010 14.28 Tanzania 2012b 11.56
b budgeted amount for 2012; actual amount not available
p preliminary figure
Source: International Monetary Fund, Government Finance Statistics Yearbook 2013 (Washington, DC: IMF, 2014), various pages. ●
domestic firms in operation; as was noted in Chapter 14, a subsidy has a lower deadweight
loss than a tariff. In addition, the burden of protection of the industry would be borne by
all taxpayers (who all benefit from the “defense”) and not just by the consumers of the
particular product. Further, each year Congress reviews the merits of continuing a subsidy,
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so there is ample opportunity to reassess the value of the protection. On the other hand, a
tariff tends to remain in the tariff structure because no regular policy review is required.
Economists thus can suggest other instruments superior to the tariff.
The argument for a tariff to improve the balance of trade claims that the imposition of the
tariff will reduce imports. Assuming that exports are not affected, the obvious result is that
the balance of trade improves, because the balance of trade (the value of exports minus the
value of imports) becomes less negative (i.e., the trade deficit is reduced) or a deficit turns
into a surplus.
The economist responds to this argument by saying that it fails to recognize the economic
and political repercussions of this Mercantilistic action, and the end result when these reper-
cussions are taken into account may be no improvement in the trade balance and a reduction
in country (and world) welfare.1 Examples of these repercussions include the following:
1. Retaliation by trading partners.
2. A reduction in national income abroad and a reduced ability of foreign countries to
buy the home country’s products.
3. A reduction in exports of the home country if the imports now excluded were inputs
into the production process of the home country’s exports.
4. A reduction in exports and an increase in imports of the home country because of a
rise in the value of the home currency.
5. A reduction in exports and an increase in imports of the home country because of
inflationary pressures in the home country. Because the application of a tariff has the
effect of turning demand inward to home-country products, this new demand could
generate upward price pressures if the home country is close to full employment. If
inflationary tendencies appear, then home country firms become less competitive in
world markets and in the domestic market against the goods of other countries.
Thus, the use of a tariff is no guarantee that the balance of trade will improve. In addi-
tion, considerable discussion in recent years has centered on the trade deficit as essentially
a macroeconomic phenomenon and on the tariff by itself as having virtually no effect on
the balance of trade because it does not address the relevant macroeconomic variables.
The point concerning the macroeconomic interpretation of a trade deficit can be simply
made. In macroeconomic equilibrium in a simple national income model,
Y = C + I + G + (X − M)
where Y = national income
C = consumption
I = investment
G = government spending on goods and services
X = exports
M = imports
Tariff to Improve the
Balance of Trade
1The myopic view of the balance-of-trade argument was ridiculed beautifully by Henry George (1911, originally
1886, p. 117) when he stated that “on the same theory the more ships sunk at sea the better for the commercial
world. To have all the ships that left each country sunk before they could reach any other country would, upon
protectionist principles, be the quickest means of enriching the whole world, since all countries would then enjoy
the maximum of exports with the minimum of imports.”
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Rearranging this expression, we obtain
Y − (C + I + G) = (X − M)
Because (C + I + G) indicates domestic spending (by consumers, business, and govern-
ment), the conclusion is that if a trade deficit exists (i.e., if X < M), it occurs because Y < (C + I + G) or income is less than domestic spending. In other words, the country is spending beyond its means. The only way to reduce the deficit is to increase Y, to reduce spending, or to undertake some combination of the two. If the deficit is a macroeconomic problem, a tariff is unlikely to be of much help, especially if the economy is close to full employment and income therefore cannot be increased to any significant extent. Even ignoring the macroeconomic interpretation of the deficit, another policy besides a tariff might eliminate or reduce a trade deficit. Less welfare loss could be incurred if the coun- try adopted a policy that operates on the balance of trade in its entirety, namely, a devaluation or depreciation of the currency (assuming some fixed currency value was initially in place). The point to be made here is that policies other than a tariff may be able to accomplish the particular objective. The terms-of-trade argument for protection maintains that national welfare can be enhanced through a restrictive trade policy instrument. It acknowledges that world welfare will decline with a departure from free trade because the home country’s gains in welfare are more than offset by the losses of welfare occurring in other countries. In gaining at the expense of for- eign countries, the terms-of-trade argument resembles many other arguments for protection in that the protectionist policy is thus a beggar-my-neighbor policy. The terms-of-trade argument states that restrictive trade policy can raise the ratio of Pexports/Pimports  (PX/PM) and thus enhance a country’s welfare. Economically, the use of a tariff by the home country reduces demand for the foreign good on the world market. Consequently, the world price of the imported good will fall and PX/PM will rise. The use of a tariff therefore has the potential to increase home welfare, although foreign welfare will fall as the commodity terms of trade of foreign countries decline. We emphasize that only a large country can employ the terms-of-trade argument with any success because the tariff- imposing country must be able to influence its terms of trade. The terms-of-trade argument is best understood with an offer curve diagram. In Figure 1, OCI represents the offer curve of the home country (country I), while OCII is the offer curve of the foreign country (country II). In free trade, the terms of trade are TOT1. If country I imposes a tariff, its offer curve shifts to OC′I, establishing the new equilibrium at point E′. While country I’s exports are reduced from 0x1 to 0x2 and its imports from 0y1 to 0y2, the terms of trade have improved from TOT1 to TOT2. Thus, there is potential for increased well-being for country I because it is receiving more imports for each unit of its exports. Alternatively, it is giving up fewer exports for each unit of imports obtained. In a welfare sense, this means that country I is potentially “better off.” The terms-of-trade argument is not yet complete, however. What has not been taken into account in a welfare sense is that the quantity of imports has fallen with the imposition of the tariff. This quantity reduction, other things being equal, reduces the level of country I’s welfare because the country’s consumption of low-cost imports, for which home produc- tion is at a comparative disadvantage, has been reduced. In sum, country I gains because of a lower world price of the imported good but loses because of a smaller import quantity of that good. This additional consideration of forgone quantities is brought into the analysis through the concept of the optimum tariff rate. The optimum tariff rate is the rate that maximizes the country’s welfare. Conceptually, it is the tariff rate at which the positive dif- ference between the gain from better prices and the loss from reduced quantity of imports is at a maximum. If the tariff rate is higher than this optimum rate, then welfare is below The Terms-of-Trade Argument for Protection Final PDF to printer 326 PART 4 TRADE POLICY app9062x_ch15_320-358.indd 326 06/17/16 04:09 PM the maximum, because the additional gain from better terms of trade is more than offset by the additional loss from the reduced quantity of imports. Similarly, at a tariff rate below the optimum, the unexploited gains from improving the terms of trade exceed the losses from the additional reduction in quantity of imports. What characterizes the optimum tariff rate of a country? First, the optimum tariff for country I involves the intersection of I’s offer curve with country II’s offer curve in the elastic portion of II’s curve. If country I’s offer curve with a tariff intersected in the inelas- tic portion of the foreign offer curve, the tariff rate could not be “optimum” for I because an even higher tariff would improve country I’s terms of trade and increase I’s quantity of imports. (Remember that the inelastic portion of country II’s offer curve is downward sloping.) If country I’s offer curve with a tariff intersected in the unit-elastic portion of II’s curve, the tariff rate also could not be “optimum” because an even higher tariff would improve I’s terms of trade and still yield the same quantity of I’s imports. (Remember that a unit-elastic portion of II’s offer curve would be horizontal.) We do not pursue further the matter of the optimum tariff here, and in fact such a rate is extremely difficult to calculate. The most important point to remember is that improving the terms of trade does not neces- sarily mean that welfare will improve for the tariff-imposing country. How valid is the terms-of-trade argument as a guide for policy? Economists agree that the argument logically leads to the conclusion that the imposition of the tariff, other things equal, might enhance the (large) tariff-imposing country’s welfare. If a country’s objective is solely to improve its terms of trade, no domestic policy instrument, such as a subsidy to import-competing production, is superior to the tariff for doing so. However, the terms- of-trade argument is a beggar-my-neighbor argument because the welfare of the partner country falls. Because the partner country is injured by the tariff, it will likely retaliate with a tariff of its own. In that event, both countries will end up with reduced welfare compared I’s exports of good X, II’s imports of good X TOT1 OC II x1x2 y1 y2 I’s imports of good Y, II’s exports of goodY E E TOT2 OCIOC I 0 FIGURE 1 A Tariff to Improve the Terms of Trade The initial free-trade equilibrium is at point E, the intersection of country I’s free-trade offer curve OCI and country II’s free-trade offer curve OCII. Country I’s imposition of a tariff shifts its offer curve from OCI to OC′I, as the country is now less willing to trade at the previous terms of trade, TOT1. Because of the tariff, the new equilibrium is at point E′. Country I’s exports of good X fall from 0x1 to 0x2 and its imports of good Y fall from 0y1 to 0y2. However, the terms of trade for country I improve from TOT1 to TOT2, and each unit of country I’s exports now commands a greater quantity of imports. Final PDF to printer CHAPTER 15 ARGUMENTS FOR INTERVENTIONIST TRADE POLICIES 327 app9062x_ch15_320-358.indd 327 06/17/16 04:09 PM with their situations under free trade. If continual retaliation occurs, trade shrinks dramati- cally in the offer curve diagram, and neither country may end up with terms of trade better than during the initial free trade. The potential retaliation and other consequences (such as injury to other countries) may partly explain why large countries such as the United States and Japan do not have frequent large-scale tariff wars. (See, e.g., Petri, 1984, chap. 7.) The argument for a tariff to reduce aggregate unemployment runs as follows: given that a country has unemployment in slack times, the imposition of a tariff will result in a shift in demand by domestic consumers from foreign goods to home-produced goods. With this increase in demand, home industries will expand their output and, in the process, will hire more labor and thus contribute to the reduction of unemployment in the country. The new labor hired will also be earning spendable income and, by the familiar Keynesian multi- plier process, other industries will then expand and add new jobs. Therefore, the tariff has accomplished its stated objective. This argument tends to gain popularity during times of recession. After the worldwide financial/economic crisis began in 2007, many observers and many governments cautioned against rising protectionism, a surge that could lead to a global trade war. In assessing this argument, economists raise several points, most of which center around the possibility that very few new jobs will be created by the tariff. The home country might lose jobs in export industries to such an extent that the net effect on employment is negligible or even negative. The loss of jobs in the home export industries can occur for several reasons: 1. Expanded employment in the import-substitute industries in the domestic country comes about in a beggar-my-neighbor manner because jobs are lost in foreign countries. When the home country reduces its imports by the tariff, there is an equivalent loss of exports and attendant job losses in other countries. To avert this job loss, those countries may impose retaliatory tariffs that reduce export jobs in the home country. 2. Even without any retaliation, exports of the home country may decline because the reduction in exports in the foreign countries has lowered their national income. This causes a cut in spending on the home country’s export goods and reduces employment in the export industries in the home country. 3. If the home country has an exchange rate that is free to vary, then foreign currencies will depreciate when the home country imposes the tariff and buys fewer foreign goods. The purchase of fewer foreign goods implies that there is less demand for foreign currency with which to purchase those goods. The depreciation, or fall in value, of foreign curren- cies is equivalent to a rise in value of the home currency, which serves to reduce home exports (because it takes more units of the foreign currency to buy the home goods) and to increase home country imports (which are now relatively cheaper to home residents). The net effect of the rise in the value of the home currency is to reduce jobs in the home export and import-substitute industries. We could cite other repercussions to the imposition of the tariff, but the main point should be clear: there is no certainty that the tariff will accomplish the objective. In addition, econo- mists stress that if the goal is to increase employment, why use the tariff when other policies might accomplish the goal more directly and with more certainty? The other policies—the macroeconomic instruments of monetary and fiscal policy—could be used in an expansion- ary way to increase employment. Employment in foreign countries might also increase as the home country uses its expanded income to buy more imports and transmit some of its expan- sion to other countries. Thus, welfare everywhere could rise instead of fall as it would do with a tariff. If a problem such as aggregate unemployment exists, then the appropriate poli- cies to use are those aimed specifically at dealing with that problem. This notion is known as the specificity principle, and we shall employ it in several other arguments for protection. Tariff to Reduce Aggregate Unemployment Final PDF to printer 328 PART 4 TRADE POLICY app9062x_ch15_320-358.indd 328 06/17/16 04:09 PM The tariff to increase employment in a particular industry takes a microeconomic view of the employment question, arguing that if protection is granted to a given industry, demand shifts from the import to the home product because the price of the imported good rises rela- tive to the price of the home good. This shift in purchases then bids up the price of the home good, inducing domestic producers to supply a greater quantity. The production of these additional units results in the hiring of more domestic labor, thus increasing employment in the home industry. However, new jobs in the protected industry may be filled at the expense of employment in other industries. Thus, an addition to total employment in the country may not take place, but this is not the objective of the tariff. Rather, the goal is to increase employ- ment in the particular industry, and the tariff has succeeded in accomplishing this objective. Economists do not dispute that the tariff can augment employment in this industry. However, their interest in efficiency leads them to question whether the tariff is the best method of increasing employment. If the goal of adding to employment in this industry is accepted—even given that employment is being reduced elsewhere—a subsidy to production or employment is a welfare-superior way to attain the goal compared with using a tariff. (Chapter 14 discussed the superiority of a subsidy over a tariff.) Thus, while this argument for protection may be Tariff to Increase Employment in a Particular Industry IN THE REAL WORLD: INDUSTRY EMPLOYMENT EFFECTS OF TRADE LIBERALIZATION The imposition of a tariff can certainly increase employment in the protected import-competing industry. Various attempts have been made by economists to quantify such impacts. A 2011 study by the United States International Trade Commission (USITC)* addressed the employment effects by asking the following question: if trade liberalization occurred by the removal of significant U.S. import restrictions, what would be the impact on employment in the associated import- competing industries? The USITC utilized a large-scale computer model that took account of the many domestic and international interactions among sectors and projected the path of industry employment through 2015 after the hypothesized removal, taking into account the actual industry data from 2005–2010 and projections for each industry from 2011 to 2015. Table 2 indicates various industries that would have the largest percentage losses from 2005 to 2015 due to the removal of the import barriers in existence at the time the report was prepared. Clearly there could be important reallo- cations of workers from these industries to other industries in the economy if the import restrictions were eliminated. *USITC, The Economic Effects of Significant U.S. Import Restraints: Seventh Update 2011, USITC Publication 4253 (Washington, DC: USITC, August 2011), obtained from www.usitc.gov. Industry Change in Employment (%) Industry Change in Employment (%) Apparel −15.9% Tableware (china) −4.0% Yarn, thread, and fabric −9.2 Ball and roller bearings −3.7 Canned tuna −6.6 Costume jewelry −2.3 Ceramic tile −4.4 Sugar −1.8 Ethanol −4.4 Writing instruments −1.8 Textile products other than yarn, thread, and fabric −4.4 Footwear and leather products −1.7 Source: USITC, The Economic Effects of Significant U.S. Import Restraints: Seventh Update 2011, USITC Publication 4253 (Washington, DC: USITC, August 2011), pp. 2–3, obtained from www.usitc.gov. TABLE 2 Industry Impacts on Employment of Removal of Import Protection ● Final PDF to printer CHAPTER 15 ARGUMENTS FOR INTERVENTIONIST TRADE POLICIES 329 app9062x_ch15_320-358.indd 329 06/17/16 04:09 PM IN THE REAL WORLD: COSTS OF PROTECTING INDUSTRY EMPLOYMENT Tariffs can have an impact on employment in particular industries because the imposition of a tariff stimulates out- put of import-substitute industries as consumers turn away from the now higher-priced imports toward domestic goods. However, the costs to consumers and to the country as a whole can be large, and an appropriate question is whether the large costs are justified in view of the amount of employ- ment created by tariff. Economists Gary C. Hufbauer and Kimberly A. Elliott (1994) attempted to quantify the costs of employment protection. Table 3 provides a sampling of the effects in 12 industries of a variety of import restraints in the United States. The figures pertain to 1990. Estimates of this sort require many assumptions and are subject to a large mar- gin of error; nevertheless, some of the costs are staggering! (Note: $1 in 1990 would be equivalent to about $1.80 in mid-2015.) It is clear from the table that if a worker’s job is to be pro- tected, the consumer cost of doing so considerably exceeds worker wages in the listed industries. It would be cheaper to make a direct monetary transfer of the annual wage from consumers to workers (if this were politically possible!). Industry with Import Restraint Jobs Saved Consumer Cost per Job Saved Annual Welfare Cost to the U.S. Ball bearings 146 $ 438,356 $ 1,000,000 Benzenoid chemicals 216 >1,000,000 10,000,000
Costume jewelry 1,067 96,532 5,000,000
Dairy products 2,378 497,897 104,000,000
Frozen concentrated orange juice 609 461,412 35,000,000
Glassware 1,477 180,095 9,000,000
Luggage 226 933,628 26,000,000
Machine tools 1,556 348,329 35,000,000
Polyethylene resins 298 590,604 20,000,000
Rubber footwear 1,701 122,281 12,000,000
Softwood lumber 605 758,678 12,000,000
Woman’s footwear, except athletic 3,702 101,567 11,000,000
Source: Measuring the Costs of Protection in the United States by Gary Clyde Hufbauer and Kimberly Ann Elliott. Copyright 1994 by Peterson
Institute for International Economics. Reproduced with permission of Peterson Institute for International Economics in the format Textbook via
Copyright Clearance Center.
TABLE 3 Consumer Costs per Job Saved and Welfare Costs to the United States of Protection
of Various Industries, 1990
valid theoretically from its particular perspective, this validity does not mean that tariff protec-
tion should be granted. An alternative instrument for providing jobs in the industry—a subsidy
by the home government—can do the job (pun intended) at lower cost in a welfare sense.
The tariff to benefit a scarce factor of production is a more sophisticated and rigor-
ous argument than many arguments for protection. It makes no claim that the country
as a whole benefits from the protection; it is instead an argument for protection from the
perspective of an individual factor of production. Although the country as a whole suffers
reduced welfare from the trade policy, the country’s scarce factor gains. This analysis was
developed in Chapter 8 and will not be repeated here.
Tariff to Benefit a
Scarce Factor of
Production

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Two points can be made in assessing the argument, however. First, the country as a
whole loses welfare from the imposition of a tariff; a political decision to redistribute
income to labor (or the scarce factor) by a tariff does reduce national well-being. If politi-
cians wish to make this redistribution, economists will respond that a more efficient way to
accomplish the objective is to undertake (if the political process permits) a direct transfer
by taxing capital (or the abundant factor) and awarding the tax revenues to labor. This
direct process does not lead to the welfare loss associated with reducing the country’s par-
ticipation in international trade.
Second, it may be that countries do not have the complete factor mobility implied in
the argument. Recall the specific-factors model (see Chapter 8). If the assumptions of the
specific-factors model are more relevant in the real world than those of the Heckscher-Ohlin
model, the scarce-factor conclusion does not hold. If protection is adopted in the case of
labor being the scarce factor, the return to capital in the import-competing industry will rise,
the return to capital in the export industry will fall, and the money wage will rise. However,
the impact on real wages of workers depends on their consumption patterns. A gain occurs
if a worker’s consumption pattern is tilted toward consumption of the export good, but the
worker suffers a reduced real wage if the consumption pattern is tilted toward the import
good. No a priori judgment can be made on the impact on the scarce factor. Further, if
economies of scale and greater product variety are relevant (as discussed in Chapter 10), all
residents of a trading country can gain from trade regardless of scarce-factor status.
Pride in your country can clearly be thought of as a legitimate social objective. Countries
often take pride in being able to produce particular products in that such production serves
as an indication that they are as “modern” or capable or creative as other countries to
which they might be comparing themselves. This can, in a sense, be viewed as a social
externality that is not captured in the price of the domestically produced product. If it is the
physical production itself that produces this pride, then it may warrant a policy interven-
tion. However, as is often the case, a production subsidy will be a more cost-effective way
of achieving this end. Only when it is necessary to keep out all foreign goods to achieve
the desired objective would blocking all imports through the use of a prohibitive tariff or
product embargo be a logical policy choice.
Countries often have complex sets of targets or objectives that involve many different
policy instruments. This is especially true in the area of global objectives. Thus, it is not
uncommon to see a country adopt policy positions that may differ across its trading part-
ners. For example, a country can generally be in favor of reducing barriers to trade and yet,
at the same time, place a trade embargo on one or more countries for reasons linked to other
social or hegemonic objectives. We must always take care to acknowledge the social costs
of incorporating trade restrictions to meet the objective. Such differentiated policy treat-
ment can also work in a positive fashion. For example, a number of industrial countries
have adopted the Generalized System of Preferences (GSP) in dealing with some particular
goods coming from the poorer nations of the world. This policy is one that substantially
reduces the barriers to trade with respect to goods coming in from certain developing coun-
tries. It can, in essence, be viewed as part of a broader foreign aid package that might
involve bilateral and multilateral aid. While removing protection on all imports would be
preferable, this inconsistent policy treatment could be viewed as providing a short-term
advantage for the poor country so that country can become competitive. It is critical, of
course, that the GSP provision be applied to products for which the recipient country has a
potential comparative advantage. Otherwise, it will simply provide an incentive to misal-
locate scarce resources in the developing country.
Fostering “National
Pride” in Key
Industries
Differential Protection
as a Component of
a Foreign Policy/Aid
Package
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PROTECTION TO OFFSET MARKET IMPERFECTIONS
The externality argument is based on the notion that the social costs or benefits of a given
production or consumption process differ from the private costs or benefits of that produc-
tion or consumption process. In such a situation, there is market failure in that even a per-
fectly competitive market will not maximize social welfare.2 For example, if a production
process generates air pollution, or a “negative externality,” the producing firm itself may
not bear the full “cost” of its production because the pollutants (rather than having to be
cleaned up by the firm) can simply be passed into the atmosphere for the society at large
to deal with. Hence, the private cost to the firm of the production process is less than the
social cost of the production process (which would equal the private cost plus the pollution
cost). Because the cost paid by the firm is less than the “true” cost, the price paid by the
consumer (based on the private cost) is lower than it would be if all costs were included,
and hence more of the good will be produced than would otherwise be the case. Because
this price (a reflection of the benefit received by the consumer from purchasing one more
unit) is less than the true cost of producing that unit, society’s welfare actually declines
because of the production of that last unit. A “solution” to the problem is to tax the produc-
tion process in this case, and to tax to the extent of the difference between private cost and
social cost. With this tax in place, price will rise, fewer units of the good will be produced
because of the decline in quantity demanded, and welfare will rise because the units of the
good where social cost exceeds benefits are no longer produced.
Consider how such externality situations can form the basis for an argument for protec-
tion against imports. We will discuss two different types of externality from the one previ-
ously mentioned—a situation of a negative externality in consumption and a situation of a
positive externality in production. Following this discussion, an assessment of the case for
protection will be made.
A negative externality in consumption involves a situation in which the process of con-
suming a good can generate adverse externality effects. For example, if a person consumes
Scotch whisky, the person may do damage to society if he or she subsequently injures other
persons or damages property by driving an automobile while intoxicated. With respect to
consumption of this good, then, the economist would say that the private benefit to the
individual from consuming the last unit of the good is greater than the social benefit from
consuming that last unit because the social benefit is equal to the private benefit less the
utility lost because of the injury or the property damage. Further, because the price paid
for the good (which is assumed to reflect production costs and, in market equilibrium, also
to reflect the marginal benefit of consumption to the private individual) is greater than the
marginal benefit to society of the consumption of the last unit, welfare has been reduced
The Presence of
Externalities as an
Argument for
Protection
CONCEPT CHECK 1. Why is it difficult to assess the relevance of
the national defense argument for any par-
ticular industry?
2. Why might a tariff not affect a country’s bal-
ance of trade?
3. The terms of trade for a large country improve
with every successive increase in a tariff, so
why is the optimum tariff rate for the country
not infinite, even assuming no retaliation by a
trading partner?
4. Why does a tariff-induced increase in em-
ployment in a given sector not necessar-
ily increase aggregate employment in a
country?
2For an excellent critique of the presence of market failures as an argument for protection, see Jagdish Bhagwati,
Free Trade Today (Princeton, NJ: Princeton University Press, 2002), pp. 11–33.
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for society as a whole by the consumption of that unit. Hence, in terms of protection, the
argument is that, if an imported good has this negative consumption externality feature, a
way to increase social welfare would be to put a tariff on the imported good. This would
reduce consumption of the good, and the units no longer consumed are ones that would
have reduced social welfare. Hence, society has experienced an increase in its well-being
because of the imposition of the tariff.
A second situation involving externalities and protection involves a positive external-
ity in production. Suppose, for example, that a firm, when it employs workers, provides
those workers with skills that can be useful beyond the setting of this particular firm.
The particular firm, of course, cannot prevent some of those workers from moving to
other jobs at some future time. If a worker does leave and go to work for another firm,
the worker will take with him or her the skills acquired at the first firm, and the second
firm will therefore not have to bear the costs of training this worker. Hence, costs at the
second firm are lower than they otherwise would have been—the first firm is reducing
costs of production elsewhere in the economy. This means that the private costs being
incurred by the first firm are actually greater than the total social costs that should prop-
erly be allocated to it (because some of those costs should be absorbed by the second and
other firms). Hence, in the market, where the price of the first firm’s product covers that
firm’s private costs, price (or marginal benefit to consumers) exceeds the true marginal
cost to society of that particular firm’s output. Output by the first firm should therefore be
expanded, and the consequent expansion to units of output where benefits exceed social
cost would add to society’s welfare. In the context of this chapter, a way to encourage
expansion would be to put a tariff on imported goods that compete with the first firm’s
product. With this tariff in place, the firm would expand its production and would there-
fore add to society’s well-being.
What are we to make of these cases for protection? In general, economists would
respond with two main points. First, even if it is granted that a logical case for protec-
tion can be built in these two scenarios, there would remain the difficulty of actually
estimating the size of the externalities and deciding upon the appropriate tariff rate to
apply. It is highly unlikely that the concepts involved permit any precise estimate of
what rate to use. Second, and more importantly, we should ask why imports are being
singled out as the target for policy. For example, in the case of the imported whisky, an
equal case can be made that all whiskies (or all alcoholic beverages for that matter) have
the same negative externalities, whether they are imported or produced domestically.
The appropriate policy, therefore, would be to tax the consumption of all such goods,
whether foreign-made or domestically produced. There is no case for discriminating on
the basis of the location of production. In the case of the positive externality in produc-
tion, the appropriate remedy for the externality and its distortion is to provide a general
production subsidy for the good produced by the first firm. The use of the import tariff
would not be the welfare-maximizing device because it distorts consumption (with con-
sequent welfare losses) at the same time that it stimulates domestic production. What is
needed is the stimulus to domestic production (only), without any reduction in consumer
surplus because of a tariff (and which can be accomplished by the production subsidy
to the domestic firm). In sum, in these cases, as well as in a variety of other external-
ity cases, the policies needed are those dictated by the previously discussed specificity
principle. Choose the policy that gets directly to the problem, which in the first case
above would be a tax on consumption of the good (and not just on consumption of the
imported variety of the good) and in the second case would be a subsidy to production
of the domestic good.
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The analysis of a tariff to extract foreign monopoly profit3 was originated by James Brander
and Barbara Spencer (1981). In their framework, the home country faces a foreign monopoly
supplier of a good. The restrictive assumption is made that the foreign firm is the only supplier
of this product in the world market, and thus there is no home production—the home country
is entirely dependent on the foreign monopoly firm for the product.
Figure 2 illustrates the basic analysis. The demand curve represents the home country’s
demand for the foreign monopoly firm’s product. Because the firm faces a downward-
sloping demand curve (unlike the case in perfect competition, where the demand curve
facing an individual firm is horizontal), marginal revenue is less than price. Assume for the
sake of simplicity that marginal cost is constant (i.e., that each additional unit of output is
produced at the same cost as previous units) and that there are no fixed costs and no trans-
portation costs. Because of this, the marginal cost (MC) curve is horizontal and equals the
Tariff to Extract
Foreign Monopoly
Profit
p2
p1
Price and
cost
c2
c1
0
S
G
R
H F
MR
q2 q1 Quantity
D
MC + t = AC + t
MC = AC
Without the tariff by the home country, the foreign monopoly firm sells quantity 0q1 to the home market at price
0p1, determined by the intersection of MR and MC. With the tariff in place, the foreign monopolist’s marginal cost
of selling in the home market is MC + t, where t is the amount of the tariff per unit. The new profit-maximizing
quantity is 0q2 (where MR = MC + t). Consumers in the home country now pay price 0p2 and have their consumer
surplus reduced by the trapezoid p1p2SR. However, the home country gains tariff revenue of the amount c1c2GH,
which was formerly part of the foreign monopolist’s economic profit.
FIGURE 2 A Tariff to Extract Foreign Monopoly Profit
3This theory is usually called the tariff to extract foreign monopoly rent because the economic profit of the
monopolist is also a rent (i.e., a return above opportunity cost due to restricted supply). We use the profit terminol-
ogy because it may be more familiar to students who have taken only introductory courses.
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average cost (AC) curve. With free trade, the firm will set MR equal to MC to maximize
profit, and the quantity shipped to the home country will be 0q1. The price charged will
be 0p1 and the (economic) profit of the firm will be the rectangle, c1p1RF. Because the
producing firm is a monopolist, no competitive pressure is forcing price to become equal
to MC (or AC).
Now suppose that the home country wishes to obtain some of this foreign monopoly
profit. To do so could mean an increase in home-country welfare at the expense of the foreign
monopolist. If a tariff is imposed that must be paid on each unit by the foreign firm before it is
allowed to sell the good in the home country, then the marginal cost curve shifts up vertically
to MC + t, where t is the amount of tax per unit. To the foreign firm, this tax is simply another
“cost” associated with selling each additional unit of output in the home country, so profit
maximization now equates marginal revenue with “new” marginal cost MC +  t. Quantity
produced for the home country drops to 0q2, and the price charged per unit is 0p2.
To consider the welfare change in the tariff-imposing country, examine the profit of the
monopoly firm. Profit after the imposition of the tariff is rectangular area c2p2SG. What
about area c1c2GH? This area represents the tariff revenue, and it also represents former
profit of the monopolist that has been transferred to the home country. This gain for the
home country must be set against the lost consumer surplus by home-country consumers
in the amount of trapezoid p1p2SR. But if area c1c2GH is greater than area p1p2SR, then the
home country has succeeded in enhancing its welfare at the expense of the foreign pro-
ducer. Clearly, this intervention can be desirable for the home country.
While some economic profit has been transferred to the home country, economists do not
necessarily conclude that the protectionist action was beneficial even if the transfer of profit
outweighed the loss in consumer surplus. Due to the tariff, world efficiency and welfare are
reduced because, in a monopoly situation, efficiency and welfare are enhanced if actions
cause the monopolist to reduce price and to increase output—and the opposite has happened
with the imposition of this tariff on the monopolist’s product! Thus, a home-country welfare
gain can occur while the world as a whole loses (a beggar-my-neighbor situation). A full
analysis of whether or not to undertake the action also requires examining matters such as
the prospects for retaliation by the foreign country on goods coming from the home country.
For the situation in which a domestic monopolist is both selling in the domestic market
and exporting at the international price as a price taker, it is clearly possible for the
country to transfer well-being from the monopolist to consumers and the government
by imposing an export tax. In this case, it is assumed that the monopolist does not face
foreign competition because of import restrictions. The monopolist is thus the sole seller
in the domestic market and can sell all it wishes internationally at the international price,
Pint as shown in Figure 3. To maximize profits, the firm produces at Q1, where Pint is
equal to the firm’s MC. The firm sells Q2 in the home market, where Pint (= MC) crosses
the MR curve, and charges P0. The remainder (Q1 − Q2) is then exported. The imposition
of the export tax lowers the after-tax (or net) price to the firm for its exports, leading it
to now produce at Q3 and sell a larger quantity Q4 in the home market. To sell the larger
quantity at home, the domestic price is lowered to P1, resulting in an increase in consumer
surplus (abcd). The monopolist now exports the quantity Q3 − Q4 and the government
collects revenue equal to the per unit tax times the new quantity of exports (efgh). The
presence of the export tax thus offsets some of the monopoly leverage of the firm as it
drives the domestic price downward closer to MC, expanding domestic consumption and
generating government revenue. The monopolist is clearly less well off because producer
surplus has fallen as it receives a lower price for its product in both the domestic and the
international market.
The Use of an Export
Tax to Redistribute
Profit from a
Domestic Monopolist
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PROTECTION AS A RESPONSE TO INTERNATIONAL POLICY DISTORTIONS
Many countries have provisions in place that provide a way for them to respond quickly to
the actions of foreign governments and or firms that are perceived to be trade distorting in
nature and very costly to domestic firms. These are distortions that are seen to reduce not only
country welfare in the short and medium run but also world welfare to the extent they foster
less efficient production from the world perspective. These policies are often referred to as
“trigger-price” mechanisms that, upon substantiation of the distortion, provide a tariff response
to offset the initial distortion. In this section, arguments for protection are provided for distor-
tions related to foreign dumping, foreign subsidies, and apparent nontariff barriers to trade.
This argument, usually known as the antidumping argument for a tariff, has been used
prominently in the United States in recent years. It is first necessary to define dumping. To
economists, dumping occurs when a firm sells its product at a lower price in the export
market than in the home-country market. This definition says nothing about “selling below
cost”—the popular meaning of dumping. Rather, to the economist, dumping is simply a
form of price discrimination. As you recall, price discrimination occurs when a firm sells
the same product in different markets at different prices.
The argument for protection is that dumping by foreign firms into the home country is in
some sense unfair and constitutes a threat to domestic producers because of the low import
price; therefore, a tariff can offset the foreign firm’s unfair price advantage. The argument
was buttressed by the U.S. Trade Act of 1974, which added a second definition of dumping
distinctly different from that used by economists. In addition to recognizing the traditional
definition, the act also allowed “dumping” to be a situation in which the foreign firm is
selling below cost or “fair value.” Given this definition, the argument indeed takes on the
implication that this “unfair” behavior should be prevented through the imposition of a
tariff, that is, an antidumping duty.
How should we assess the validity of this argument for protection? In any assessment,
economists usually distinguish three types of dumping. In persistent dumping, the good
is continually sold at a lower price in the importing country than in the home country.
This situation is one in which the import good is simply being sold in different markets for
Tariff to Offset
Foreign Dumping
P
P0
P1
Pint
Pint – Export tax
Q2 Q4 Q3 QQ10
a
d
g
b
c
fe
h
Pint
Pint – Export tax
MC
MR
D
FIGURE 3 The Effect of an Export Tax on a Domestic Monopolist
The monopolist initially maximizes profits where MC equals MR, that is, Pint, thus producing Q1, selling Q2 in the
home market at P0, and exporting Q1 − Q2. With the imposition of an export tax, the monopolist reduces production
to Q3 and increases domestic sales to Q4 due to the lower “net” export price (marginal revenue). To sell Q4 at home,
the domestic price falls to P1, generating an increase of consumer surplus of abcd. The monopolist now exports
Q3 − Q4, and the government receives revenue efgh as a result of the tax on the new level of exports.
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different prices under profit-maximizing conditions. This is the price-discrimination phe-
nomenon discussed at the end of Chapter 8. Any trade barrier would result in a higher price
for consumers in the importing country, and the welfare effects discussed in Chapter 14 apply.
(This behavior could not persist in the long run under the selling-below-cost definition
because of producer losses, unless government provided a subsidy.)
However, the dumping may be not persistent but intermittent. Intermittent dumping can
be of two types: predatory dumping and sporadic dumping. In predatory dumping, a for-
eign firm sells at a low import price until home producers are driven out of the market; then
the price is raised because a monopoly position has been established. Domestic firms may
then be attracted back into the market, only to have the price reduced again to a low level.
There is a valid argument for protection against predatory dumping because of the associ-
ated wasteful resource movements. As factors of production move in and out of the indus-
try because of fluctuating import prices, real costs and waste are generated for society.
Sporadic dumping occurs when a foreign producer (or government) with a temporary
surplus of a good exports the excess for whatever price it will command. This type of
dumping may have temporary adverse effects on competing home suppliers (as in agri-
culture) by adding to the uncertainty of operating in the industry. This uncertainty, as
well as the welfare losses from possible temporary resource movements, can be avoided
by the imposition of protection, although other welfare effects (also applicable in preda-
tory dumping) should be brought into the analysis when considering trade restrictions.
However, sporadic dumping does not seem to justify protection when it is short-term.
The difficulty in practice is determining whether persistent, predatory, or sporadic
dumping is occurring. No policymaker has yet been truly able to identify the immedi-
ate motivation behind dumping. The general procedure followed in the United States in
response to alleged dumping is as follows.
1. Upon receipt of a petition from a domestic import-competing firm or industry, the
Department of Commerce determines from price and cost data (which may be dif-
ficult to obtain) whether dumping is occurring. If so, then:
2. The U.S. International Trade Commission (USITC), an independent federal agency,
determines from a study of the recent history of the industry whether this dumping
has been an important source of injury to the industry. If so, then:
3. Antidumping duties are imposed on the imported good. The size of the duties is
designed to offset the extent of the dumping.
Similar procedures exist in other countries that belong to the World Trade Organization
(WTO).
The basic point of the argument for a tariff to offset a foreign subsidy is that a foreign
government subsidy awarded to a foreign import supplier constitutes unfair trade with the
home country and that the amount of foreign subsidy should be matched by a home tariff
to restore equal footing to the home and the foreign industry.
In principle, an economist should have no difficulty in supporting a tariff to offset a
foreign subsidy under certain conditions, even though domestic consumers will pay higher
prices. Such a duty is known as a countervailing duty (CVD). If the subsidy allows the
foreign firm to be an exporter of the product when the foreign country does not have a com-
parative advantage in this good, then the subsidy generates a distortion from the free-trade
allocation of resources. World welfare is reduced because of the distortion—although the
importing country’s welfare may rise owing to the lower consumer price—and the offset-
ting of the distortion by an import tariff can aid in restoring the trade pattern to a more
efficient one. Note that the application of this general principle is difficult. It is not an easy
Tariff to Offset a
Foreign Subsidy
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IN THE REAL WORLD:
ANTIDUMPING ACTIONS IN THE UNITED STATES
The first U.S. antidumping law was the Antidumping Act
of 1916, which was superseded by the more-enforceable
Antidumping Act of 1921. The 1921 act served as the basis for
antidumping investigations by the Department of the Treasury
until 1979, when the investigations were transferred from the
Treasury to the Department of Commerce. In 1979 and 1995
U.S. antidumping law was amended to make it consistent with
GATT and WTO agreements. The underlying specification of
illegal action incorporated into U.S. legislation is that imports
are being dumped or sold at “less than fair value” when a for-
eign producer sells a good in the U.S. market at a price lower
than the price in the foreign producer’s home market, or at a
price judged to be below the cost of production. The compari-
son with the price in the exporter’s home market is replaced by
a comparison in a “third country” if there aren’t many sales in
the producer’s home market; if no “third country” market has
sufficient sales, either, a value is constructed that is based on a
cost-plus-profit approach. The investigation of whether or not
dumping is occurring can occur only if a petition has been filed
that is supported by producing firms or workers that account
for at least 25 percent of the domestic import-competing indus-
try’s output, among other criteria. As indicated in the main
body of this text, if dumping is determined by the Department
of Commerce to have occurred and if material injury or threat of
material injury to the U.S. import-competing industry is deter-
mined by the U.S. International Trade Commission (USITC)
to have taken place, then an antidumping duty equal to the dif-
ference between the U.S. price and the foreign or constructed
price is imposed. In addition, a “sunset review” is conducted
every five years after a duty is imposed to determine whether
injury to the U.S. industry would still be likely if the duty were
removed. If the injury would not continue, the duty is ended.
At the behest of U.S. import-substitute firms, the U.S.
authorities have very frequently undertaken antidumping
investigations in recent years. From 1980 through 2008 (fis-
cal years), there were 1,158 antidumping petitions where final
judgment had been made by the Department of Commerce/
U.S. International Trade Commission. In the 1,158 cases, an
affirmative finding was indicated by both Commerce and the
USITC (i.e., dumping was determined to have taken place and
injury or threat of injury was a consequence) in 505 instances,
or 43.6 percent of the cases [(505/1,158) = 43.6 percent]. A
negative finding was indicated by the USITC (i.e., no finding
of injury or threat of injury occurred even though dumping
had taken place) in 434 cases, or 37.5 percent of the total
cases [(434/1,158) = 37.5 percent]. The remaining 219 cases
(18.9 percent of the total) were terminated or suspended or it
was determined that dumping had not occurred (see Figures
4 and 5 for details of the 1980–2005 period—the latest avail-
able such figures). Termination or suspension can occur
before conclusion of the investigation in any given case if the
exporters of the good to the United States agree to eliminate
the dumping, to stop exporting the good to the United States,
to raise the price to eliminate the dumping, or to work out
some other arrangement (such as a VER) that will reduce the
quantity of imports. Indeed, the mere threat of an antidump-
ing investigation may cause foreign firms to raise their export
prices and thus to cease any dumping they were practicing.
Again, a “sunset review” is conducted every 5 years after a
duty is imposed to determine whether material injury to the
U.S. industry would still be likely if the duty were removed.
If injury is not likely, the duty is terminated.
To get a feel for the frequency with which antidump-
ing findings have been affirmative, note that, according to
the USITC, there were, on July 13, 2015, 261 antidumping
orders in place on goods coming from 38 different countries,
though a very small number of them had been terminated or
suspended. These totals reflected the cumulative number of
affirmative findings still in effect since their earlier imple-
mentation. One of the antidumping orders originated as far
back as 1977, and many of them dated to the 1980s. With
respect to countries, China had the most antidumping orders
in effect on its products (99), covering goods such as barium
chloride, carbon steel plate, ironing tables, and crawfish tail
meat. Taiwan ranked second with 20 antidumping orders
applied to its goods—many of them steel products. Other
countries with sizeable numbers of antidumping orders in
effect were India (15), Japan (15), and South Korea (13).
Sources: U.S. International Trade Commission, The Year in
Trade 2013: Operation of the Trade Agreements Program, USITC
Publication 4481 (Washington, DC: USITC, July 2014), pp. 52–53;
“Antidumping and Countervailing Duty Orders in Place as of July
13, 2015”; Antidumping and Countervailing Duty Handbook, 14th
ed., USITC Publication 4540 (Washington, DC: USITC, June 2015),
pp. i–6, iv–3, iv–4, iv–5; and Import Injury Investigations Case
Statistics (FY 1980–2008) (Washington, DC: USITC, February
2010), all obtained from www.usitc.gov.
(continued)
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IN THE REAL WORLD: (continued)
FIGURE 4 Antidumping Case Summary (by number of cases), Fiscal Years 1980–2005
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Terminated
Negative
A�rmative
10
15
9
28
25
12
8
14
12
29
13
16
36
20
26
12
14
37
4
15
17
3
14
21
3
9
17
2
4
15
6
40
19
4
47
38
16
9
11
4
26
29
3
6
9
2
2
9
2
7
14
0
11
22
6
24
20
2 9 2 10
15 43 21 11
18 40 12 14
6
5
4
0
A�rmative Negative Terminated
34
15
65
34
58
82
63
36 38
29
21
65
89
36
59
18
13
23
33
50
35
92
35 35
2004 2005
6 0
8 4
20 6
34
10
Number of cases
120
100
80
60
40
20
Source: U.S. International Trade Commission, Antidumping and Countervailing Duty Handbook, USITC Publication 3916 (Washington, DC:
USITC, April 2007), Appendix E, obtained from www.usitc.gov.
FIGURE 5 Top 10 Countries Cited in Antidumping Cases (by number of cases), Fiscal Years 1980–2005, Cumulative
China
10.2%
Japan
10.1%
Korea
6.2%
Germany
5.8%
Taiwan
5.5%
Canada
4.7%
Brazil
4.5%
Italy
4.2%
France
3.5%
Mexico
3.4%
All others
41.9%
Source: USITC, Antidumping and Countervailing Duty Handbook, USITC Publication 3916 (Washington, DC: USITC, April 2007),
Appendix E, obtained from www.usitc.gov. ●
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CHAPTER 15 ARGUMENTS FOR INTERVENTIONIST TRADE POLICIES 339
app9062x_ch15_320-358.indd 339 06/17/16 04:09 PM
task to determine whether a foreign subsidy is occurring, and many import-competing
firms are quick to assert that a subsidy exists because they are being undersold. In addi-
tion, conceptual issues surround the definition of a subsidy. For example, the United States
and Canada were embroiled in a dispute for many years as to whether Canadian exports of
softwood lumber to the United States are subsidized. The United States maintained that the
stumpage fees paid by Canadian firms for the right to cut logs on government-owned land
were “too low” and constitute a subsidy and unfair competition for U.S. firms cutting logs
on private U.S. land. Canadians deny that their firms are subsidized.
IN THE REAL WORLD:
COUNTERVAILING DUTIES IN THE UNITED STATES
The first U.S. countervailing-duty (CVD) law was passed in
1897, when duties were authorized against subsidized imports
of sugar. The current provisions of the law differ somewhat
from the original legislation. Originally, duties were to be
assessed on goods that benefited from an export subsidy, but
the U.S. Congress in 1922 extended the application of the
duties to subsidies on manufacture as well as subsidies on
export. Also, prior to 1974, there was no injury test necessary
to have CVDs imposed—a finding of the existence of the sub-
sidy was sufficient. In addition, since 1979, the Department
of Commerce has conducted the investigations on the exis-
tence of subsidies (previously done by the Department of
the Treasury), and the U.S. International Trade Commission
(USITC) has conducted the injury investigations (analogous
to the injury investigations regarding dumping). These injury
investigations are not generally required as a condition for
imposing a countervailing duty if the offending country is
not a member of the World Trade Organization (WTO, which
has 162 members as of this writing).
As with the antidumping investigations discussed earlier,
there have been a large number of industry petitions, which
have to meet certain criteria to be accepted, and subsequent
investigations in recent years. From 1980 to 2008, there were
474 petitions that received final action, of which 132 cases, or
27.8 percent [(132/474) = 27.8 percent], were decided in the
affirmative. Hence, in each of these 132 cases, the Department
of Commerce judged that a subsidy had been given by the
exporting country’s government and the USITC determined
that material injury or threat of material injury had occurred. In
200 of the cases, or 42.2 percent [(200/474) = 42.2 percent], the
result was negative, meaning that the USITC found no injury or
threat of injury even though the Department of Commerce had
found that a subsidy had taken place. Finally, in the remaining
142 cases (30.0 percent), the investigation was terminated or
suspended or Commerce did not find a subsidy (see Figures
6 and 7 for graphical portrayals pertaining to the 1980–2005
period—later such figures are not available). Termination can
occur if a petition is withdrawn (perhaps because some solution,
such as the negotiation of a VER, is worked out). A suspension
can occur if the subsidizing country or countries agree to elimi-
nate the subsidy, to stop exporting the product to the United
States, or in some way to eliminate any injurious effects on the
domestic industry. If these conditions are violated, the investi-
gation can begin again or the previously determined counter-
vailing duty can then be imposed. In either an antidumping case
or a countervailing-duty case, if the Department of Commerce
preliminarily finds evidence of dumping or a subsidy, then the
foreign exporter must put up funds equal to the potential value
of the duty even before the case is finally decided. If the ulti-
mate decision is not to put on antidumping duties or counter-
vailing duties, then these funds are refunded (but of course the
foreign firm has lost the use of the funds in the meantime).
As with antidumping duties, the number of CVD orders
in effect (the accumulation of orders over the years that are
still operative) gives a sense of the importance of this trade
policy instrument. As of July 13, 2015, there were 60 CVDs
in place against 12 countries. While not nearly as large in
number as the 261 antidumping orders in effect at that time,
the CVD number does indicate substantial use of the anti-
subsidy mechanism. The countries facing the most CVDs
were China (31) and India (9). There was some diversity
regarding type of product (e.g., pasta, woven ribbon, citric
acid, and lined paper), but there was a rather heavy concen-
tration on iron and steel products.
Sources: U.S. International Trade Commission, The Year in
Trade 2013: Operation of the Trade Agreements Program, USITC
Publication 4481 (Washington, DC: USITC, July 2014), p. 54;
“Antidumping and Countervailing Duty Orders in Place as of July
13, 2015”; Antidumping and Countervailing Duty Handbook, 14th
ed., USITC Publication 4540 (Washington, DC: USITC, June 2015),
pp. ii–14, iv–5, iv–6, iv–7; and Import Injury Investigations Case
Statistics (FY 1980–2008) (Washington, DC: USITC, February
2010), p. 4, all obtained from www.usitc.gov.
(continued)
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IN THE REAL WORLD: (continued)
Source: U.S. International Trade Commission, Antidumping and Countervailing Duty Handbook, USITC Publication 3916 (Washington, DC:
USITC, April 2007), Appendix E, obtained from www.usitc.gov.
Source: U.S. International Trade Commission, Antidumping and Countervailing Duty Handbook, USITC Publication 3916 (Washington, DC:
USITC, April 2007), Appendix E, obtained from www.usitc.gov.
FIGURE 6 Countervailing Duty Case Summary (by number of cases), Fiscal Years 1980–2005
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Terminated
Negative
A�rmative
9
55
2
42
53
18
3
2
3
6
8
8
18
12
8
9
7
10
3
1
4
4
3
3
1
0
2
1
2
1
5
3
1
1
25
18
0
0
1
3
6
2
0
0
2
1
0
0
1
4
1
3
1
7
6
5
6
0
0
1
2001
4
5
15
2002
2
1
1
2003
1
3
2
16
0
1
A�rmative Negative Terminated
66
113
8
22
38
26
8 10
3 4
9
44
11
6
11
17
24
4 6
2004 2005
3
1
1
0
0
2
5 21 1 12
17
Number of cases
0
20
40
60
80
100
120
140
FIGURE 7 TOP 10 Countries Cited in Countervailing Cases (by number of cases), Fiscal Years 1980–2005, Cumulative
Brazil
10.7%
France
8.1%
Italy
8.1%
Canada
7.0%
Korea
5.7%
Germany
5.9%
Spain
5.0%
United
Kingdom
4.8%
India
4.4%
All others
35.9%
Belgium
4.6%

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CHAPTER 15 ARGUMENTS FOR INTERVENTIONIST TRADE POLICIES 341
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Despite these uncertainties, the United States has a well-defined procedure, similar to
the antidumping procedure, for implementing a tariff to offset a foreign subsidy. Upon
receipt of a petition from a U.S. importing firm or industry, the Department of Commerce
determines whether or not a foreign supplier has been given a subsidy. If the answer is yes,
the USITC applies the “injury test.” If injury is occurring, then a countervailing duty is
imposed to offset the price impact of the foreign subsidy.
CONCEPT CHECK 1. Will a tariff designed to capture foreign
monopoly profit necessarily increase domes-
tic welfare in the importing country?
2. Why do markets have to be kept separate by
artificial or natural barriers for dumping to
occur?
3. How can an export subsidy by a country actu-
ally reduce world welfare?
MISCELLANEOUS, INVALID ARGUMENTS
Various arguments are continually encountered that, on the surface, seem logical but, upon
close examination, make little sense. Several examples of these arguments are discussed
briefly herein. One common argument is that a country should use protection to reduce
imports and “keep the money at home.” First, this is a pure Mercantilist argument that
seemingly places emphasis on holdings of money as central to the decision as opposed to
productivity, economic efficiency, and higher consumer well-being. Because money is of
value only in its ability to be used as a claim for desired goods and services, the money
that flows out of a country to acquire imports will ultimately return to the country in terms
of a claim on home exports. Because trade allows both countries to get goods cheaper,
the movement of money has increased the overall welfare of the countries involved, not
reduced it because the money left the country in exchange for desired goods.
Another commonly heard argument argues for protection to “level the playing field” in
terms of offsetting cheap foreign labor or other reasons for cost differences. In the extreme, it
is often referred to as the “scientific tariff,” that is, a tariff that equalizes product costs among
countries. It is obvious that such distortions in the extreme take away the very basis for
trade and hence the gains from trade. The view from the labor-abundant country is that the
capital-abundant country has unfairly cheap capital. If both countries protect in a symmetric
fashion, the cost basis for trade will be eliminated. Protection imposed to reduce competition
reduces world efficiency, denies consumers the right to get goods cheaper, and limits their
choice of goods. Arguments for protection based on a local producer’s “right to the market”
are similar in nature. In essence, this is just an argument for a consumer-to-producer transfer
through higher prices, and, as in the previous case, it reduces consumer choice.
STRATEGIC TRADE POLICY: FOSTERING COMPARATIVE ADVANTAGE
The use of trade policy as part of development and/or industrial policy has been around for
a long period of time. Underlying these ideas is the belief that governments can foster the
development of comparative cost advantages by providing firms with access to the domes-
tic market for a reasonably short period of time so that they have the opportunity to develop
the underlying comparative cost advantage through economies of scale and improved pro-
duction efficiency. One of the earliest approaches, which has endured over the years, is the
now-famous infant industry argument introduced by Alexander Hamilton and Frederick
List in the late 18th century. Although it was a little-used strategy earlier on, it became
much more popular during the 20th century, particularly in Latin America. This section
begins with a discussion of this still-present argument and then moves on to some of the
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newer theories for protection, often referred to as strategic trade policy theories, which
suggest how a country can benefit over time from the active use of trade policy instru-
ments, usually at the expense of trading partners. A distinguishing feature of the approach
in these more recent theories is that imperfect competition exists in the industries under
consideration—a departure from the competitive industries commonly employed in
traditional trade analysis. Other critical elements of this approach include recognized
interdependence of firms in a given industry and the presence of economies of scale. Within
this framework it can be demonstrated that policies that seek to expand exports or reduce
imports can potentially lead to the realization of dynamic, long-run cost advantage. In the
latter part of this section, we summarize several of these new theories to provide an insight
as to how trade policy might, in fact, be used to foster dynamic comparative advantages.
Economists generally agree that this long-standing argument for protection is valid from
the standpoint of enhancing the welfare of the world as a whole. The infant industry
argument rests on the notion that a particular industry in a country may possess, for various
reasons, a long-run comparative advantage even though the country is an importer of the
good at the present time. Suppose that the growth of the industry in a country is inhibited by
low-cost imports from a foreign country. Production in the foreign country may be occur-
ring because of historical accident, and the home-country industry is getting a “late start.”
If protection could temporarily be given to the industry in the home country, the argument
goes that firms in this industry will be able to achieve a reduction in unit costs through real-
izing economies of scale and/or through learning by doing. The economies of scale could be
internal to firms, which are now each producing a larger volume of output; that is, producers
in the home country will be moving down their downward-sloping long-run average cost
curves. Or the knowledge acquired by producing the good could lead workers and managers
to devise more cost-efficient methods, which would shift cost curves downward. Or the econ-
omies could be external to the firm but internal to the industry, in which case greater industry
output would reduce costs for the individual firm due, for instance, to the attraction of a pool
of skilled labor to an area. In any event, per-unit costs eventually fall to such an extent that the
industry in the home country becomes an exporter of the good. At this point, protection can
be removed as it is no longer needed. The home industry has a comparative advantage that
it cannot realize in the short run but can in the long run if temporary protection is imposed.
The consumers of the home country are asked to finance the long-run expansion of the indus-
try, but they will be more than “repaid” when the industry “grows up.” Indeed, with a new
comparative-advantage producer in the world market, the world as a whole benefits.
In practice, the infant industry argument is put forth more frequently in developing
countries than in developed countries. Developing countries often propound the argument
in the context of an import-substitution program, whereby reliance on the world market for
a good is to be replaced by home production, whether or not export potential is envisioned.
This application of the infant industry argument is a variant of the traditional version, but
it can be evaluated on similar grounds.
What are we to make of the infant industry argument? Even though economists gener-
ally agree that it is theoretically valid, not every industry that claims to be an infant should
automatically be granted protection. The difficulty in making this argument operational
centers around the identification of industries that are likely to become low-cost producers.
If an industry protected by this argument is not a true infant, then the country (and the
world) may be saddled with permanent protection of a high-cost industry and less efficient
resource use. This was noted long ago by American economist Henry George, who wrote
(1911, p. 97, originally 1886), “Nothing could better show the futility of attempting to
make industries self-supporting by tariff than the confessed inability of the industries that
we have so long encouraged to stand alone.”
The Infant Industry
Argument for
Protection
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IN THE REAL WORLD:
U.S. MOTORCYCLES—A SUCCESSFUL INFANT INDUSTRY?
A modern variant of the infant industry argument is found
in U.S. motorcycle production. The industry itself is hardly
an infant since the first motorcycle was manufactured com-
mercially in the United States in 1901, and there have been
about 150 U.S. producers since then. By 1978, however,
largely because of imports, Harley-Davidson was the only
remaining U.S.-owned producer.
Until the early 1980s, Harley-Davidson had produced
mostly heavyweight motorcycles with a piston displacement
of more than 1,000 cubic centimeters. Imports were of smaller
displacement and were rapidly increasing their market share.
Harley-Davidson petitioned the U.S. International Trade
Commission (USITC) for import relief in 1982. A USITC inves-
tigation found that imports were a substantial cause of injury to
Harley-Davidson, and in 1983, higher tariff rates were imposed
for a five-year period on imports in addition to already existing
quotas. One reason that the USITC granted the increased pro-
tection was that Harley-Davidson planned to improve its effi-
ciency and introduce a new line of smaller motorcycles (800 to
1,000 cubic centimeters); the USITC wanted to give the firm
an opportunity to implement these plans. It is in the context of
a new line of production (the smaller cycles) that the Harley-
Davidson case has infant industry characteristics.
After the new tariffs were imposed, the import share
in the U.S. motorcycle market fell from 60 to 70 percent
in the early 1980s to 31 percent by 1984. In response,
Japanese companies Kawasaki and Honda increased their
production within the United States. Harley-Davidson
itself changed management strategy, reduced costs, and
improved quality. Domestic production increased, but the
estimated cost to U.S. consumers (Hufbauer, Berliner, and
Elliott 1986, p. 268) was $400 to $600 per motorcycle and,
in 1984, $150,000 per job saved in the motorcycle indus-
try. Nevertheless, employment and output increased in the
mid-1980s, and Harley-Davidson’s share of the domestic
market rose.* The value of shipments from U.S.-based firms
has been estimated to have risen by 75 percent in real terms
from 1987 to 1993, importantly due to the popularity of the
cycle with engine capacity above 700 cubic centimeters
and to perceived greater safety in motorcycles. In addition,
exports from the United States increased at an annual rate of
37 percent from 1987 to 1991, although this growth slowed
thereafter. Some of the increase in exports was also attrib-
uted to the falling dollar, especially against the yen. Exports
of motorcycles and parts continued to grow at about a
12 percent annual rate from 2000 to 2005. Harley-Davidson
continued to be profitable in the 1990s and into the
new century. As an example, a share of Harley-Davidson
common stock bought in March 1997 for $35 split twice and
was worth more than $240 in March 2007. However, the
recent financial crisis and recession hit Harley hard. Profits
fell 30 percent in 2008. Further, between September 2008
and March 2009, Harley stock plunged 70 percent; its value
in April 2009 was about $15 per share. Nevertheless, the
company subsequently “roared” back due to such factors as
tightening its lending standards to customers, cutting costs,
and general streamlining of production. In recent years
Harley is selling its bikes well in India, China, and Vietnam,
and the company has also introduced new, easier-to-ride
sports and street models. The strong appreciation of the dol-
lar in 2014–2015, however, did somewhat “throw a rod”
into overall sales. In the future, the firm plans to produce a
battery-powered cycle, and perhaps that will help it “hog”
the market better. In mid-2015 Harley-Davidson stock was
selling at around $60 per share.
How does the motorcycle industry fit the infant industry
argument? A domestic firm had sought temporary protection
with the hope of gaining time to move into a new product.
The temporary protection was granted, the firm expanded
production, and eventually it became an exporter. The con-
sumer cost was high, however, and some of the export per-
formance was perhaps due to other factors (the exchange
rate improved safety perceptions).
*In fact, Harley-Davidson in 1987 concluded that it was then able
to compete with the Japanese and asked for removal of the higher
tariffs one year ahead of schedule.
Sources: “Harley Asks ITC to End Tariffs Firm Sought in ’83,”
The Wall Street Journal, March 18, 1987, p. 46; Gary Clyde
Hufbauer, Diane T. Berliner, and Kimberly Ann Elliott, Trade
Protection in the United States: 31 Case Studies (Washington, DC:
Institute for International Economics, 1986), pp. 263–69; “Reagan
Rebuffs Trade Bill in Motorcycle-Plant Tour,” The Wall Street
Journal, May 7, 1987, p. 6; U.S. Department of Commerce, U.S.
Industrial Outlook 1990, pp. 40–10 and 40–11; U.S. Department
of Commerce, U.S. Industrial Outlook 1993, pp. 37–7 and 37–8;
U.S. Department of Commerce, U.S. Industrial Outlook 1994, p.
37–9; International Trade Administration of the U.S. Department of
Commerce, “Top 20 U.S. Export Destinations for Motorcycles and
Parts,” obtained from www.ita .gov; Susanna Hamner, “Harley,
You’re Not Getting Any Younger,” New York Times, March 22,
2009, Sunday Business section, pp. 1–8; James R. Hagerty, “Harley-
Davidson Profit Roars,” The Wall Street Journal, October 20, 2010,
p. B8; “Uneasy Rider,” The Economist, May 9, 2015, p. 60; James R.
Hagerty, “Harley Bides Its Time on Electric Motorcycles,” The Wall
Street Journal, June 1,2015, p. B3. ●
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A century later, Gerald Meier (1987) reviewed empirical evidence on the infant industry
argument in developing countries. He noted (p. 830) that Anne Krueger and Baran Tuncer
(1982) concluded that Turkey’s protected industries did not experience decreasing costs
more than less protected industries did; further, the protected industries might well have
grown without the protection. Martin Bell, Bruce Ross-Larson, and Larry Westphal (1984,
p. 114) found that few protected firms in a number of developing countries increased pro-
ductivity sufficiently to attain international competitiveness. Meier also cites the point by
Westphal (1981, p. 12) that the initial costs in terms of domestic resources for infant indus-
try protection in developing countries might be twice the amount of foreign exchange
saved or earned by the protection.
Beyond the problem of identification, the economist should also ask whether the tariff
or another form of protection is the relevant policy—even if the industry is a qualifying
infant. For example, a case might be made, for attaining both internal and external econo-
mies and stimulating learning by doing, that a subsidy to the industry by the home-country
government is superior to a tariff. As noted in Chapter 14, a subsidy has a lower welfare
cost to the country than a tariff. A subsidy also comes up for reevaluation every year
when a government authorizes expenditure, so its benefits and costs are analyzed more
frequently than is possible with a tariff, which is placed in the schedules and does not need
to be brought up for annual review.
More fundamentally, however, the economist asks why the industry in the country is
unable to proceed on its own and why it needs protection. If internal economies of scale
and/or learning by doing could be realized from expansion, entrepreneurs in a market econ-
omy presumably know this and would undertake expansion on their own. They would bor-
row funds from financial institutions, invest in plant expansion, and use the profits from the
new dominance in the market to repay the loans. (However, this entrepreneurial expansion
would not necessarily occur in the case of external economies of scale.) If this process does
not get under way on its own, capital markets are probably operating inefficiently in allo-
cating funds. Therefore, a proper focus of policy should be on taking measures to improve
the operation of capital markets, perhaps through deregulation or government guarantees
for the loans. The focus on the capital market as the culprit is especially relevant for devel-
oping countries, because their financial institutions are often cited as biased toward mak-
ing short-term rather than long-term loans. An important cause of this bias in developing
countries may be the uncertainty surrounding the repayment of long-term loans.
An important contribution to the strategic trade policy literature came from economist
Paul Krugman (1984). In his model, Krugman assumes there are two firms in an indus-
try, a duopoly (a home firm and a foreign firm), that compete with each other in markets
throughout the world (including in each other’s markets). Krugman’s intention is to dem-
onstrate how import protection for one firm leads to an increase in exports for the protected
firm in any foreign market in which that firm operates. Two assumptions are particularly
critical: (1) marginal cost declines with an increase in output—that is, economies of scale
are associated with producing output, and (2) each firm takes the actions of the other firm
into account when making its own price and output decisions. The last point means, for
example, that the home firm perceives that its revenue depends positively on its own output
but negatively on the foreign firm’s output. This recognized interdependence does not
exist in a perfectly competitive model.
With recognized interdependence, we can conceive of reaction functions for each firm
in each market (see Figure 8). The symbol Xi on the horizontal axis refers to the sales of the
home firm in any market i, while Xi* on the vertical axis refers to the sales of the foreign
firm in the same market. HH is the reaction function for the home firm. The reasoning
Economies of Scale
in a Duopoly
Framework
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behind this function is that if the foreign firm increases sales in the market (an increase
in Xi*), the demand for the home firm’s product will fall and the price of its good will be
depressed. Thus, profit opportunities for the home firm are lessened so that the amount sold
by the home firm (Xi) will decrease. The reaction function for the home firm is downward-
sloping, and similar reasoning yields a downward-sloping reaction function, FF, for the
foreign firm. These reaction functions show the most profitable level of sales in market
i for each firm, given various levels of sales of the other firm. Note that these functions
are drawn for a given marginal cost, implying that each firm’s total output is constant but
the sales in any given market can vary. Finally, the equilibrium position is at point E, where
each firm is selling its profit-maximizing quantity, given the behavior of the other firm.
To see why point E is attained, consider point A. If the two firms are producing for this
market at A, then the home firm is satisfied with its sales of 0X1 but the foreign firm is
not satisfied with its sales of 0X1*. To maximize profit, the foreign firm cuts production
to 0X2* because the firm was producing “too much” at A for maximum profit. With this
change in foreign sales, point B is reached. However, B is not a profit-maximizing point
for the home firm, and the firm expands production to 0X2 so that it achieves point C. This
process will continue until point E is attained. This movement to E occurs because we
have drawn HH steeper than FF. If FF were the steeper of the two lines, the equilibrium
point would be unstable and forces would drive the firms farther away from E if they
were not at E. Because continual movements away from an equilibrium involving radical
A
B
H
E
F
C
H
F
(home-firm sales)
X1 X2
0
Xi
Xi*
X1*
X2*
(foreign-firm
sales)
FIGURE 8 Home-Firm and Foreign-Firm Sales in a Third-Country Market
The HH reaction function indicates the profit-maximizing level of sales in a third-country market for the home
firm, given various levels of foreign firm sales in that market. HH slopes downward because increased foreign
sales will depress price and profit for the home firm, so that firm will contract sales. The FF reaction function
shows the profit-maximizing level of sales for the foreign firm, given various sales levels of the home firm,
and it slopes downward for analogous reasons. At points such as A, B, and C, sales levels are altered until
equilibrium point E is attained.
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changes in market shares are not usually observed in oligopoly markets, Krugman regards
the slopes in Figure 8 as more relevant than the reverse case.
Now let us examine the total output level of each firm rather than the sales level in each of
the markets the firm serves. Remember the assumption that marginal cost decreases as out-
put increases. In addition, remember that a shift downward or decrease in the marginal cost
schedule leads to an increase in output, given the demand and marginal revenue curves. With
these relationships in mind, consider Figure 9(a). The horizontal axis measures the total out-
put of the home firm, which in turn is the sum of the sales in all markets served by the home
firm. The vertical axis represents home firm marginal cost. Curve MM reflects the assump-
tion that an increase in output (along the horizontal axis) causes marginal cost to decrease;
curve QQ reflects the reverse relationship, namely, that a decrease in marginal cost (along
the vertical axis) will cause an increase in output.4 Equilibrium for the firm will be at point T,
where there is no incentive for the firm to change its output level. Of course, a similar graph
(not shown), could portray the foreign firm, with that firm’s total output occurring where an
M*M* curve (analogous to MM) intersects a Q*Q* curve (analogous to QQ).
FIGURE 9 Home-Country Protection and Home-Firm Sales through Economies of Scale
In panel (a), curve QQ indicates that a fall in marginal cost will induce a larger total output for the home firm, where total output is the sum of
the firm’s sales in all markets i. Curve MM indicates the presence of economies of scale, because larger output levels lead to lower marginal cost.
Equilibrium for the firm occurs at point T, where the firm has no incentive to change its output level. An import tariff by the home government
shifts the home firm’s QQ schedule to Q′Q′, because the firm can sell more output in the home market at each level of marginal cost. With Q′Q′
in effect, the home firm’s marginal cost falls. The consequence of this decline in marginal cost is that, in panel (b), the home firm’s reaction func-
tion in any export market i shifts outward from HH to H′H′. Further, because the home-country protection has reduced sales by the foreign firm
in the home market, the foreign firm’s marginal cost rises and its reaction function in panel (b) shifts inward from FF to F′F′. Equilibrium there-
fore shifts from E to E′, with the home firm gaining sales in each market at the expense of the foreign firm.
4For reasons of stability of equilibrium, Krugman draws curve QQ steeper than curve MM. Support for this
assumption is empirical—firms do not experience the continually falling or rising marginal cost and output levels
implied when MM is steeper than QQ.
Marginal
cost
Q
Q
Q
M
T
T
M
Q
Output = 0 ΣXi
(a)
H
H
(b)
(foreign-
firm sales)
Xi0
(home-
firm sales)
Xi*
F
F
E
E
F
F
H H
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Given this setup, consider the impact of protection. Suppose the home-country govern-
ment imposes a tariff or import quota on imports of the good of the foreign firm, which
has the effect of reserving some of the home-country market for the home firm. The initial
impact of this protection is on the home firm’s output [Figure 9, panel (a)]. Because home-
firm output has increased for any given level of marginal cost, curve QQ shifts to the right
to Q′Q′, causing the firm’s equilibrium position to move to T′, where lower marginal cost
is incurred. In the analogous graph for the foreign firm (not shown), the Q*Q* curve of the
foreign firm would shift to the left. Less output is associated with each level of marginal
cost because some of the home-country market is now being denied the foreign firm. The
result would be an increase in marginal cost for the foreign firm.
Because marginal costs have changed for each firm, there is a feedback onto the reaction
functions because those functions were each drawn with a given marginal cost. In Figure 9,
panel (b), the decrease in marginal cost for the home firm causes home-firm sales to increase
for each given level of foreign firm sales in each export market; that is, HH shifts to the right
to H′H′. Similarly, the increase in marginal cost for the foreign firm causes FF to shift down
vertically to F′F′, because the foreign firm will sell a smaller amount of the good for each
given level of home firm sales. Thus, equilibrium in the duopoly situation in each market
is now at point E′ rather than E, and the home firm has gained sales in all markets at the
expense of the foreign firm. This theory of protection can be called the tariff to promote
exports through economies of scale because these new sales in all the i markets are exports
from the home country.
Krugman advanced the economies-of-scale analysis not as a recommendation for pro-
tection per se but as an explanation for phenomena such as Japan’s emergence in the 1970s
and 1980s as a leading exporter of several products whose domestic producers had initially
been protected (e.g., automobiles). In that light, it makes sense. However, when consider-
ing it as a basis for recommending protection, the foreign country would probably retaliate
by imposing its own tariff. Note that the end result would be market shares that are rela-
tively unaffected but a volume of trade that is greatly reduced. In addition, as in many of
these “new protectionist” arguments, the resources used to expand the protected industry
mean that output in other industries is given up, and these opportunity costs definitely need
to be considered (see Krugman, “Is Free Trade Passé?” 1987).
This approach to protection was also developed by Paul Krugman (1984). It has some
similarities to the economies-of-scale approach but emphasizes a different route by which
protection generates an increase in exports by a home firm. In considering this tariff to
promote exports through research and development, assume again that a duopoly mar-
ket structure of a home firm and foreign firm exists and that the firms are competing in
many markets. However, assume that marginal costs for each firm are constant with respect
to output (i.e., marginal cost curves are horizontal) but that, for any given level of output,
marginal cost depends on investment in research and development (R&D). The relation-
ship is negative, meaning that a greater amount of R&D expenditure (on new product char-
acteristics, new production processes, and so on) will lead to a reduction in marginal cost.
In turn, the amount of R&D expenditure is a positive function of the level of output, as
larger current output generates greater profits that can be used to finance additional R&D.
The key relationships in this R&D model are illustrated in Figure 10. The amount of
R&D spending by the home firm is measured on the vertical axis, while the home firm’s
output is measured on the horizontal axis as the sum of the firm’s sales in all the i mar-
kets. The upward-sloping line MM indicates that, as output increases, the amount of R&D
spending increases because of greater profits. The upward-sloping line QQ indicates the
dependence of output on R&D: As R&D increases, marginal cost falls, which, in turn,
Research and
Development and
Sales of a Home Firm
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enables the firm to sell a larger quantity of output. Mutual consistency of the two relation-
ships occurs when the firm is located at equilibrium point T.5 Analogous to this graph
would be a similar graph for the foreign firm (not shown), with an M*M* line plotted
against a Q*Q* line and with location of the firm at a T* analogous to T in Figure 10.
The consequences of protection in this model are similar to those in the economies-of-
scale model. Suppose the home-country government imposes a tariff to reserve some of the
home market for the home firm. The effect of this protection is that line QQ in Figure 10
shifts to the right to Q′Q′. This shift indicates that a greater amount of output is now linked
to each amount of R&D spending. But notice that the new equilibrium position T′ yields a
greater amount of R&D spending, which will bring lower marginal cost so that the firm is
able to take sales away from the foreign firm in all markets. The gain in sales at the expense
of the foreign firm is reinforced when we remember that the opposite process takes place
for the foreign firm. For that firm, there has been a decrease in output associated with each
level of R&D. The end result is a decline in R&D spending and a relative rise in marginal
cost for the foreign firm—leading to a decrease in sales by that firm in each of the markets
served by the duopoly.
5The QQ line is assumed to be steeper than the MM line for stability reasons.
M
Q
Q
T
T
M
Q Q
R&D
spending
Output = Σ Xi0
FIGURE 10 Home-Country Protection and Home-Firm R&D Spending and Output
The MM line indicates that, with an increase in total output by the home firm, R&D spending rises due to
greater profit. The QQ line reflects the fact that, as R&D spending increases, the firm’s marginal cost falls and
greater output is produced. The initial equilibrium point for the firm is at point T. With the imposition of a tariff
by the home-country government, the home firm can produce more output for the home market at each level
of R&D; that is, QQ shifts to the right to Q′Q′. This increase in output permits greater R&D spending as the
equilibrium moves to T′, and the greater R&D generates larger sales for the firm in all markets i.
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In assessing this argument, we must point to the possibilities of retaliation and the for-
gone opportunity costs of inducing more resources into the R&D–oriented industry. In
addition, the argument assumes that the firm’s sales are the primary determinant of R&D,
but factors other than sales, such as patent protection, may also be important. Further,
much R&D may be directed toward new-product development rather than toward reducing
the cost of producing existing goods.
The basic point concerning economies of scale and research and development in rela-
tion to protection in these two sections of this chapter is that import protection can poten-
tially generate exports, whether the mechanism operates by way of economies of scale,
generation of R&D spending, or other possible routes.
The export subsidy in duopoly approach to government intervention was originally
advanced by Barbara Spencer and James Brander (1983) and is presented in a less technical
and more accessible form by Gene Grossman and David Richardson (1985). The analysis
again assumes a duopoly context of a home firm and a foreign firm. The firms are compet-
ing for sales in the market of a third country, that is, in a market that is not the domestic
market of either of the two duopolists; and it is assumed that they do not sell any output in
their own domestic markets. The basic diagram is Figure 11, which reproduces the reaction
functions of Figure 8 in this chapter.
Export Subsidy in
Duopoly
FIGURE 11 The Effect of a Home-Country Export Subsidy in a Third-Country Market
Without the export subsidy, the home and foreign firms settle at point E, where the home firm sells quantity 0X1
and the foreign firm sells quantity 0X1*. If the home-country government gives an export subsidy to the home
firm, the home firm’s reaction function shifts from HH to H′H′ because costs of production paid by the firm
itself have decreased and more output is produced. The new equilibrium is at point E′; the home firm’s sales
rise to 0X2, while the foreign firm’s sales fall to 0X2*.
E
E
F
X1*
X2*
X1 X2
0
H
H
F
H
H
X3
(foreign-
firm
sales)
X i
(home-
firm sales)
Xi*
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Given this duopoly framework and the equilibrium position at point E, suppose that the
home firm wishes to enlarge its market share and profits by moving to point E′. (Ignore the
dashed H′H′ line for the moment.) Hence, the home firm threatens to expand sales to 0X2
from the current level of 0X1. If this expansion did occur, the foreign firm would reduce
its sales along its reaction function FF from 0X1* to 0X2*, a contraction of foreign sales
that does indeed give up market share to the home firm. However, given that the firms are
aware of each other’s operations, the foreign firm would not contract sales in response to
the home-firm threat to move to E′. The reason for this lack of response is that the foreign
firm knows that the threat is not believable because the home firm will always choose to
operate on the HH line to maximize profits. The foreign firm knows that if it continues to
produce 0X1*, the home firm would make a greater profit by producing 0X1 units rather
than 0X2 units.
In this situation, Spencer and Brander indicate that there is a potential role for an export
subsidy to the home firm by the home government. If this subsidy is granted and announced
ahead of time (a precommitment by the home government), then the home firm will be
willing to undertake expanded sales for each level of foreign firm sales. Line HH shifts to
the right to line H′H′ because of the subsidy. The shift in the home firm’s reaction function
makes the threat to increase export sales to 0X2 credible. The foreign firm now realizes that
it must reduce its own sales to level 0X2* because it wishes to stay on its reaction function.
The end result of the use of the export subsidy is that the equilibrium position becomes
point E′. The increased sales and profitability of the home firm enhance the home country’s
producer surplus, and the home country can, other things equal, consequently gain welfare
if the increase in producer surplus outweighs the cost of the subsidy. (In the model, there
is no reduced home-country consumer surplus because the good is not consumed at home.
If it were, the analysis would be more complicated, but a gain could still occur.) Of course,
the increased home-country welfare is at the expense of the foreign country, which has
lower producer surplus because of the fall in sales.
It should also be noted that the foreign-country government could respond to the home
country’s export subsidy by implementing its own export subsidy to the foreign firm.
This would shift FF upward and to the right in Figure 11, and the foreign firm would
regain market share. David Collie (1991) hypothesized a different response to the subsidy,
although his model is different in that he has the firms selling in each other’s markets. In
his model, the foreign country responds to the home country’s export subsidy by imposing
a countervailing duty rather than implementing its own export subsidy. This allows the for-
eign country to recapture as tariff revenue some of the foreign firm’s profit—a profit that
was transferred to the home firm by the original export subsidy. In a large-country case, the
countervailing duty worsens the terms of trade of the home country, and the home country
loses welfare from its export subsidy. Collie concludes that the potential use of the coun-
tervailing duty by the foreign country is likely to deter the home country from subsidizing
the home firm’s exports in the first place. In a later extension of Collie, Slotkin (1995,
chap. 3) considered, among other things, the fact that some home firms may be at least
partly owned by the foreign country’s investors. In this framework, some of the original
benefits (with no foreign-country countervailing duty) to the home country from the home
country’s export subsidy now accrue to the foreign country and its investors, and thus the
optimal export subsidy is smaller than would otherwise be the case.
The use of a subsidy for enhancing exports can be shown in a more concrete fashion by
a numerical example of a type that has become standard in the literature. Suppose that home
firm H and foreign firm F contemplate production for the world market of a good with sub-
stantial economies of scale. Figure 12 shows a “payoff matrix” for the four possible situa-
tions. The upper-left portion of the matrix indicates that, if both firms produce the good, each
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will lose $20 million because the market is not large enough for both of them to produce the
good economically. The upper-right portion of the diagram indicates that production by firm
H and no production by firm F would yield $200 million profit for the home firm while the
foreign firm would earn no profit. The lower-left part of the matrix is opposite to the upper-
right part, with producing firm F obtaining $200 million profit and nonproducing firm H
receiving no profit. Finally, if neither firm produces the good, profits are zero for each firm,
as shown in the lower-right portion of the matrix.
In Figure 12, the outcome of the “game” is uncertain. However, suppose that the home
firm’s government announces that it will grant a $50 million subsidy to firm H if it pro-
duces for the world market. With this commitment, the payoff matrix now appears as shown
in Figure 13. The upper-left and upper-right portions of the matrix reflect the $50 million
subsidy to the home firm. The home firm will produce the good no matter what the foreign
firm does because the home firm has a guaranteed profit. The subsidy ensures that firm
H will dominate the market; firm F will not produce because it never earns a profit when
the home firm produces. Note also that the government subsidy of $50 million generates a
Firm H
Firm F
Produces
–$20
–$20
$0
$200
$0
$0
$200
$0
Produces
Does not
produce
Does not
produce
FIGURE 12 Hypothetical Payoff Matrix for Home Firm and Foreign Firm
It is assumed that substantial economies of scale exist in the production of the good. If both firms produce the
good, they each lose $20 million; if neither firm produces the good, then no losses are incurred (and no profits
are received). If one firm produces and the other does not, the producing firm earns $200 million while the other
firm earns no profit. There is no certain outcome to this “game.”
Firm H
Firm F
Produces
–$20
$30
$0
$250
$0
$0
$200
$0
Produces
Does not
produce
Does not
produce
FIGURE 13 Hypothetical Payoff Matrix for Home Firm and Foreign Firm with
a $50 Million Subsidy to the Home Firm
With the home-government subsidy, the home firm will always choose to produce the good because a profit is
guaranteed. The foreign firm will lose $20 million if it also produces the good, so it will choose not to produce.
Thus, the outcome of this game is determinate.
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$250 million profit for the home producer, which can increase the home country’s welfare.
Of course, there is no guarantee that the foreign government will not retaliate with its own
subsidy. In addition, if home consumption exists, an export subsidy by a home government
raises prices to home consumers and thereby decreases consumer welfare. The chances of the
country improving its overall welfare through the subsidy are thereby reduced.
We now turn away from government trade policy designed to capture market share, rents,
or profit for particular firms to a more general model of government behavior with respect
to trade policy. An important result of this forthcoming analysis is that country govern-
ments each can be maximizing their own country’s well-being, given the behavior of other
governments, and yet world welfare as a whole is definitely not being maximized.
Consider first an analysis based upon the terms-of-trade or optimum-tariff analysis
of Chapter 15.6 Assume that there are two large countries—country I and country II. In
Figure 14, we depict a tariff reaction function for each country. The horizontal axis
indicates possible tariff rates for country I’s government to adopt, and the vertical axis
indicates the same for country II’s government. Suppose now that country II has a zero
tariff rate; that is, country II is practicing free trade. Because country I is a large country,
it can influence its terms of trade, and, with the objective of maximizing its own welfare,
it will apply tariff t1 (point A). Remember from earlier in this chapter (page 325) that the
optimum tariff is the one that results in the enhanced welfare from the improved terms of
trade more than offsetting the welfare loss from a reduced quantity of imports by the max-
imum amount. Next, suppose country II did not practice free trade but instead had tariff
rate t1* in place. Given this tariff rate, country I would choose a tariff rate that would
Strategic Government
Interaction and World
Welfare
Country II’s
tari� rate
Country I’s tari� rate
0
t3*
t2*
t1 *
t3 t2 t1
C
F
E
TIIB
A
TI
FIGURE 14 A Tariff Game by Governments
Curve T1 shows the various tariff rates by country I that maximize its welfare, given various tariff rates by country
II. Curve TII shows the opposite—the various tariff rates by country II that maximize its welfare, given various
tariff rates by country I. Point E is the equilibrium position; at E, each country is maximizing its own welfare
given the tariff rate of the other country. However, the universal free-trade point at the origin of the axes is the
point of maximum world welfare, and this point cannot be reached without negotiations between the countries.
6See Grossman and Richardson (1985, pp. 24–26); for the original article, see Johnson (1953–1954, especially
pp. 146–50).
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IN THE REAL WORLD:
AIRBUS AND BOEING
An example of government subsidization to stimulate interna-
tional competitiveness is the European airplane firm Airbus
Industrie. Formed in 1970, Airbus was originally a consor-
tium project by firms from France (38 percent of owner-
ship), Germany (38 percent), Great Britain (20 percent), and
Spain (4 percent). The governments of all four countries pro-
vided funds to the consortium project; although there is no
precise way to measure the extent of subsidization, the U.S.
Department of Commerce estimated in 1993 that the amount
received by Airbus as of that time was about $26 billion (cited
in Coleman, 1993). In 1996 a strengthening of Airbus occurred
when the partner companies agreed to convert the firm from a
loose consortium to a centralized, integrated company in order
to keep better control of costs and to enable Airbus to seek
funds from outside investors for financing a new and larger
jumbo jet. As a result of these measures, Airbus Industrie’s
market share reached 45 percent in 1997, a significant gain
from the 30 percent share attained in the early 1990s. By 2003,
Airbus and its U.S. competitor, the Boeing Company, each
had one-half of the passenger aircraft market, and Airbus had
more pending orders than Boeing. However, troubles began
to develop for Airbus when it devoted massive resources to
building and marketing a huge jumbo jet, the A380, which
was reputed to be the most spacious civilian airplane in his-
tory but that did not sell well. Scandal also was involved, and
senior executives lost their jobs. In the meantime, Boeing
became more competitive by outsourcing some work to China
and Japan and by streamlining its Seattle assembly plant.
Airbus is a Dutch-registered company which for several
years had the official name of European Aeronautic Defense
and Space Company (EADS); its name was changed to the
simpler name Airbus Group NV in 2014. The company
recently introduced the A320 single-aisle smaller aircraft that
has sold well and also introduced a new plane, the long-range,
wide-body A350. Both Boeing and Airbus in 2015 had very
large backlogs of orders, indicating strong demand for air-
craft. Boeing sold more jets (723) in 2014 than Airbus (629),
but Airbus booked a larger number of new orders.
Boeing and other U.S. producers complain about the sub-
sidies received by Airbus Industrie, although it was estimated
that by 1993 Boeing, General Dynamics, and McDonnell
Douglas had received $41 billion in “indirect subsidies”
through U.S. government military and space contracts. In
an attempt to control subsidies, the United States and the
European Community signed an accord in 1992 limiting
the subsidies to 33 percent of airplane development costs.
However, by 1997, dissatisfaction was evident in Europe, as
European Union trade officials felt that the 1993 restric-
tions placed on Europe’s direct subsidies posed a greater
burden than did the restrictions on the indirect subsidies in
the United States. Tensions continued, and a January 2005
U.S.–EU meeting tried to resolve differences. Then, in 2010,
the WTO ruled that both aircraft manufacturers were receiv-
ing illegal government subsidies. There was subsequent
disagreement regarding the extent to which the subsidies
should be removed. Heated competition continued as each
firm introduced new aircraft models.
Interestingly, Richard Baldwin (cited in “A Survey of
World Trade,” 1990, pp. 20–21) earlier estimated that because
of the Airbus subsidies, Europe probably lost welfare and that
the United States also lost because Boeing’s profits were
reduced by more than the gain experienced by aircraft users
from price reductions. The only winners appear to have been
other countries, where the airlines and their passengers have
gained from lower aircraft prices. Perhaps “strategic trade
policy” benefits only the countries who don’t engage in it!
Sources: “Airbus Pins Itself Down,” The Economist, January 30,
1988, pp. 50–51; Jeff Cole and Helene Cooper, “U.S., EU Open
Aircraft-Subsidy Talks as Europe Weighs Status of Boeing Deal,”
The Wall Street Journal, April 28, 1997, p. A20; Brian Coleman,
“Airbus Subsidies Are Invisible to Radar,” The Wall Street Journal,
March 4, 1993, p. A10; Charles Goldsmith, “Airbus Consortium
Plans to Centralize to Compete Better,” The Wall Street Journal,
July 9, 1996, p. A8; “A Survey of World Trade,” The Economist,
September 22, 1990, following p. 60; U.S. Department of
Commerce, U.S. Industrial Outlook 1994 (Washington, DC: U.S.
Department of Commerce, January 1994), pp. 20–26; Charles
Goldsmith, “After Trailing for Years, Airbus Aims for 50% of the
Market,” The Wall Street Journal, March 16, 1998, p. A1; Daniel
Michaels and Jeff Cole, “Airbus Beats Boeing in Jet Orders for
First Time,” The Wall Street Journal, January 13, 2000, p. A17;
J. Lynn Lunsford, “With Airbus on Its Tail, Boeing Is Rethinking
How It Builds Planes,” The Wall Street Journal, September 5,
2001, pp. A1, A16; J. Lynn Lunsford, “Boeing, Losing Ground
to Airbus, Faces Key Choice,” The Wall Street Journal, April 21,
2003, pp. A1, A8; “How Airbus Lost Its Bearings,” The Wall
Street Journal, May 24, 2006, p. A15; “Airbus Problems Lead to
Ouster of Key Executives,” The Wall Street Journal, July 3, 2006,
pp. A1, A2; “Hard Landing,” The Economist, February 17, 2007,
p. 68; www.eads.net; www.ustr.gov; www.airbus.com; “World
Trade Organization Forms Compliance Panel in Airbus Case,”
King & Spalding, Trade & Manufacturing Alert, May 2012;
“Another Nose in the Trough,” The Economist, September 16, 2011,
obtained from www.economist.com; John W. Miller and Matthew
Dalton, “WTO Finds EU Aid to Airbus Is Illegal,” The Wall Street
Journal, March 24, 2010, p. A10; Daniel Michaels, “Airbus’s Long
Strange Trip to a Simpler Name,” The Wall Street Journal, January
6, 2014, p. B1; Robert Wall, “Airbus Says Orders in ‘14 Were Near
$1 Trillion,” The Wall Street Journal, January 14, 2015, p. B3. ●
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maximize its welfare in this new situation. Because trade has already been restricted
to some extent by II’s tariff, country I will find that its new optimum tariff rate will be
somewhat lower than the original t1 because import quantity has already been somewhat
reduced compared with that under free trade by II’s reduced willingness to trade. Hence,
we suppose that tariff rate t2 is the optimum tariff for country I when country II has tariff
rate t1* in place (point B). Following the same reasoning, we can trace out schedule T1,
country I’s tariff reaction schedule showing the various levels of its tariff that would
maximize I’s welfare, given various tariff rates by country II.
Now consider country II. By an identical procedure to that used above for country I, we
can specify that optimum tariff rate t3* will be selected when country I has free trade (point
C), t2* will be selected when I has t3 in place (point F), and so forth. We thus delineate the
resulting schedule TII as country II’s tariff reaction function—it shows the various tariff
rates that maximize country II’s welfare, given various tariff levels by country I.
Clearly, point E is the point where the two countries will settle. Similar to our discus-
sion of Figure 8 in this chapter, but presented in terms of country welfare rather than firms’
profits, movement will take place to E from any other position in the diagram. However,
the important point is that E is not the world’s welfare-maximizing point, even though each
country is maximizing its own welfare given the behavior of the other country. Point E has
been attained by inward shifts of offer curves, and trade has correspondingly been reduced
from the free-trade level. Both countries have lost welfare in comparison with the free-
trade situation, and we know from trade theory that free trade maximizes world welfare.
In fact, the most desirable point on the graph from the standpoint of world welfare is at the
origin of the diagram, where each country has a zero tariff. Unfortunately, neither country
has an incentive to take unilateral action to move to the origin. If either country unilaterally
moved away from E, it would be moving away from its welfare maximization, given the
tariff rate of the other country.
The same general point can be made with the game theory payoff matrix shown in
Figure 15. In this matrix, we give each country’s government the choice of free trade
versus protection without permitting varying degrees of protection (varying degrees such
as were available in Figure 14). Nevertheless, the same general conclusion about world
welfare will emerge as the one that emerged from Figure 14.
Country I
Country II
Free trade
Protection
$100
$100
$120
$50
$60
$60
$50
$120
Free trade Protection
FIGURE 15 Two-Country Trade Policy Payoff Matrix
If country I engages in free trade, it will realize well-being of $100 if country II also engages in free trade but
only $50 of welfare if II practices protection. Likewise, if country II engages in free trade, it will attain welfare
of $100 if I also engages in free trade but only $50 of welfare if I practices protection. Each country has a domi-
nant strategy of protection, and so the outcome of the game is in the lower-right cell of the payoff matrix. This
location is inferior to universal free trade as represented by the upper-left cell of the matrix.
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With the matrix in Figure 15, note that if country I pursues free trade while country II
does also, they end up in the upper left cell, where country I’s welfare is $100 (somehow
measured) and country II’s welfare is also $100. If country I engages in free trade but II
adopts protection, country I has welfare of $50 while II has welfare of $120. These results
in the upper-right cell differ from those in the upper-left cell because II has applied its
optimum tariff, which has led to a gain at the expense of country I. Alternatively, in the
lower-left cell of the matrix, country I has adopted its optimum tariff (generating $120 of
welfare), while country II has free trade (and $50 of welfare). Finally, in the lower-right
cell, both countries have their optimum tariffs in place (analogous to point E in Figure 14),
and both have welfare of $60.
Where will the two participating governments in the game end up? Country I has what
is called a dominant strategy. A dominant strategy occurs when following one of the two
possible strategies always produces a superior outcome to following the other possible
strategy. For country I, if it pursues protection, it will obtain $120 of welfare if country II
pursues free trade and $60 of welfare if country II pursues protection. These outcomes are
superior to the comparative respective results of $100 and $50 for country I if it always
pursues free trade. Hence, protection is the dominant strategy for country I. Because the
matrix has been constructed with identical numbers for the two countries, country II also
has a dominant strategy—the strategy of protection rather than free trade. Clearly, with
both countries pursuing protection, the game ends up in the lower right cell, with $60 of
welfare being attained for each country.
Both in Figure 14 and in Figure 15, therefore, we find the two countries, when each
is pursuing its own self-interest, arriving at a predictable end result (point E in Figure 14
and the lower right cell in Figure 15). But, in both situations, there is a result that would
be superior for both of them as well as for the world as a whole (the origin in Figure 14
and the upper left cell in Figure 15). The strategic game will not get the countries to these
best positions. The only way to achieve these best positions is to have tariff negotiations
between the countries, and successful negotiations could bring each country’s tariff level
down to zero and thus maximize welfare. We discuss such negotiations in practice in the
next chapter.
The increase in globalization in trade and finance in recent decades has been accom-
panied by considerable dialogue on country competitiveness and the role of govern-
ment policy in promoting success in an increasingly integrated economic world. Within
the industrialized countries, the increased importance of international transactions has
been accompanied by relative changes in economic structure as the service sector has
expanded at a very fast rate. The relative growth in services, accompanied by a decline
in the share of the workforce in manufacturing, has produced considerable concern that
deindustrialization is taking place and that “good” manufacturing jobs are being shipped
abroad through rapidly growing imports of manufactures. Policy discussions often cen-
tered on ways in which governments could mitigate this trend by enacting industrial
policies which would promote high-wage, high-labor value-added or high-technology
industries. It was argued that, if successful, these policies would result in the evolvement
of new comparative-advantage products which would keep the country competitive in
the emerging global marketplace.
Not surprisingly, a number of economists were highly critical of these kinds of poli-
cies. It was quickly pointed out that while competitiveness is relevant for individual firms,
comparative advantage and not competition is what is relevant for countries. Further, it
is extremely difficult to determine which products might have a potential comparative
advantage and hence be the focus of such strategic trade policy. Focusing on high-wage
Concluding
Observations on
Strategic Trade Policy
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or high-labor value-added industries certainly does not provide a useful guideline, since
these industries tend to be very capital-intensive and expansion of them may not be an
efficient use of resources. Further, it is not clear why government policymakers will have
a better insight than the market with respect to which products should be fostered and
developed. The case for government intervention in the form of strategic industrial policy
thus appears to be the strongest when market failures result in the presence of positive
social externalities that result in insufficient private investment and product development.
While such may be the case in terms of certain high-technology products, the problem still
arises regarding identification of these goods. Caution regarding the active use of strategic
trade policy is indicated by the high social cost of Airbus Industrie and the failure of U.S.
policy initially to promote the flat-screen technology into a comparative-advantage good.
In sum, while there certainly may be instances when strategic trade policy can be useful
in stimulating dynamic comparative advantage and/or in providing an environment within
which a domestic firm may have a greater likelihood of being successful in an increasingly
firm-competitive world, it remains extremely difficult to identify likely candidates for sup-
port. There is, however, ample evidence of the high social cost associated with making the
wrong guess and supporting goods where comparative advantage does not emerge.
SUMMARY
This chapter has presented and examined many of the most com-
mon arguments for protection. In the first part of the chapter,
traditional arguments were grouped into several key categories
organized around the objectives of the action in question. It was
noted that protection could be undertaken as part of a broader
social objectives package, as a way of dealing with market
imperfections, and as a response to policy actions of a coun-
try’s trading partners. We focused attention on the possibility of
using welfare-superior alternatives to reach specific objectives,
the beggar-my-neighbor character of several of the arguments,
and the difficulty of applying the arguments in practice. In the
last part of the chapter we examined several of the arguments
that focus on the dynamic benefits of protection. These theories
build on the imperfect nature of competition in many industries
and stress that unilateral action can bring potential gains such as
a transfer of foreign monopoly profit and the realization of econ-
omies of scale that will lead to greater exports. An increase in
research and development spending, with subsequent enhanced
exports, can also be attained through home-market protection.
Further, export subsidies can be used to enhance the share of
home firms in overseas markets, thereby improving, in some
circumstances, home welfare. However, protection based on
these analyses does not necessarily guarantee an improvement
in home well-being because, among other things, foreign retali-
ation is ignored. In addition, the originators of the theories are
not necessarily recommending protection but are attempting to
show possible implications of departing from the perfect com-
petition assumption of traditional trade theory. Further, success-
ful implementation of strategic trade policy is not an easy or
straightforward matter. Attempts by trading partners to imple-
ment such policy can easily leave all the countries less well-off
if noncooperative trade “strategy” dominates cooperation and
trade negotiations. In addition, experience has shown that iden-
tification of potential candidates for government intervention
is far from easy and that “betting on the wrong horse” can be a
costly wager for the government policymaker.
1. In the Krugman research and development
model, what role does the positive depen-
dence of R&D spending on the level of the
home firm’s total output play in making a
case for protection?
2. In Figure 11, why is the threat by the home
firm to sell at level 0X2 without a government
subsidy not believable to the foreign firm?
3. In the payoff matrix in Figure 12, is a subsidy
to the home firm (assuming no retaliation)
beneficial to the home country if both the
home firm and the foreign firm could make
a positive profit when there is no government
intervention; for example, if the numbers in
the upper left were +$20 and +$20? Explain.
4. Explain what is meant by a country’s tariff
reaction function.
5. Why do the reaction functions in Figure 8
slope downward?
CONCEPT CHECK
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KEY TERMS
antidumping argument
antidumping duty
beggar-my-neighbor policy
countervailing duty (CVD)
dominant strategy
dumping
duopoly
economies of scale
export subsidy in duopoly
imperfect competition
infant industry argument
macroeconomic interpretation
of a trade deficit
national defense argument
optimum tariff rate
persistent dumping
predatory dumping
reaction functions
recognized
interdependence
specificity principle
sporadic dumping
strategic trade policy
tariff reaction function
tariff to benefit a scarce
factor of production
tariff to extract foreign
monopoly profit
tariff to improve the balance
of trade
tariff to increase employment
in a particular industry
tariff to offset a foreign subsidy
tariff to promote exports through
economies of scale
tariff to promote exports through
research and development
tariff to reduce aggregate
unemployment
terms-of-trade argument
QUESTIONS AND PROBLEMS
1. You are analyzing a tariff for extracting foreign monopoly
profit. Will the transfer of profit become greater or less, for
a given tariff amount, when the demand curve facing the
foreign monopolist becomes more elastic? Will the loss in
home consumer surplus become greater or less, for a given
tariff amount, when the demand curve becomes more elas-
tic? What can be concluded, if anything, about the relation-
ship between the elasticity of demand and the net welfare
gains to the home country from the tariff? Explain.
2. Suppose that the firm obtaining protection in a Krugman-
type framework has marginal costs that increase rather than
decrease with greater production. Would Krugman’s results
follow if this were true? Why or why not?
3. Suppose that the production technology of a self-proclaimed
“infant industry” permits economies of scale. Suppose also
that the same technology is available to foreign producers.
Is there a valid argument for protection in this situation from
the perspective of the world as a whole? Why or why not?
4. Why might the use of a tariff to decrease aggregate unem-
ployment in a country eventually generate an increase in
aggregate unemployment in that country?
5. As indicated in this chapter, a subsidy is preferable to a tariff
if the objective is to generate a given amount of employment
in an individual industry. Explain this point in language
understandable to someone untrained in economics.
6. Does persistent dumping into the domestic country neces-
sarily mean that a foreign government is subsidizing the
foreign exporting firm? Why or why not?
7. Evaluate this statement: If a tariff is imposed to reduce
imports, the balance of trade will surely improve as it is
safe to assume that exports will be unaffected by the tariff.
8. In Figure 8, suppose that the home firm’s reaction function
is flatter than that of the foreign firm. Use a diagram to
explain why a point away from equilibrium will lead the
firms farther away from the equilibrium position.
9. Suppose that a payoff matrix analogous to Figure 12 looks
as follows:
Home firm
Foreign firm
Produces
$20
–$30
$0
$100
$0
$0
$140
$0
Produces
Does not
produce
Does not
produce
Will the foreign firm produce the good? Why or why not?
Assuming no subsidy, will the home firm produce the
good? Why or why not?
10. In Question 9, suppose that a subsidy of $50 is given to
the home firm. (No subsidy is given to the foreign firm.)
Will this subsidy change the production pattern from that
of Question 9? If so, why? If not, why not? Is the subsidy
of benefit to the home country? Explain.
11. The following graph shows the demand curve (D) of a
home country facing the foreign monopoly supplier of a
good to the home country, the associated marginal revenue
curve (MR), the foreign firm’s horizontal marginal cost
curve when there is no tariff imposed by the home country
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21
19
$
16
12
MR
10 14 20 28 Quantity
D
MC + t (= AC + t)
MC (= AC)
(MC), and the foreign firm’s marginal cost curve plus the
cost of the tariff when a specific tariff is imposed by the
home country (MC + t):
Assuming that average cost (AC) equals marginal cost:
(a) Indicate the price charged to home-country consumers
by the foreign-monopoly supplier when there is no
home-country tariff.
(b) Indicate the price charged to home-country consum-
ers by the foreign-monopoly supplier when the home-
country tariff is in place.
(c) Calculate the loss in consumer surplus in the home
country because of the imposition of the tariff.
(d) Calculate the amount of former foreign-monopoly
profit that is transferred as tariff revenue to the home
country when the home country imposes the tariff.
(e) Does the home country gain or lose because of the
imposition of the tariff? What is the dollar value of the
gain or loss?
12. In Figure 14, suppose the countries are located at point F.
Explain why movement will take place to point E.
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16
CHAPTER
POLITICAL ECONOMY
AND U.S. TRADE
POLICY
LEARNING OBJECTIVES
LO1 Examine several basic concepts of the political economy of economic
policy.
LO2 Summarize critical developments in the history of U.S. trade policy and
multilateral trade negotiations.
LO3 Identify the broad bases for the conduct of trade policy.
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INTRODUCTION
In January 2004, U.S. Trade Representative Robert Zoellick proposed that all agricultural export
subsidies by countries be eliminated and that all tariffs on food and other agricultural imports be
cut dramatically. These and other proposals were made in a letter to the 148 member countries of
the World Trade Organization. The intent of the letter and the proposed measures was to put new
life into multilateral trade negotiations to reduce trade barriers worldwide. . . .1
In November 2003 the chief trade official of the European Union (EU), Pascal Lamy, threat-
ened that the EU would impose steep tariffs on $6 billion of U.S. exports to the EU unless the
United States altered two of its trade policies. First, the World Trade Organization (WTO) had
ruled that U.S. tariffs imposed in March 2002 on imported steel were illegal. Second, the WTO
had also ruled that favorable U.S. tax treatment of special divisions of U.S. companies set up to
promote exports was illegal, since the treatment constituted an export subsidy not permitted by
international trade rules. Lamy indicated that the EU was seeking “compliance” with agreed rules,
and that the EU intended to carry out its threat if no U.S. changes were made. . . .2
These contrasting vignettes indicate that a country, in these cases the United States, can
be pushing for freer trade, as in the first vignette, but at the same time be, as in the second
vignette, employing policies that depart from free trade according to comparative advan-
tage. Trade policy can involve conflicting and complex economic and political forces,
and outcomes are not so clear-cut as traditional trade theory would suggest. This chapter
first addresses the question of how the setting of trade policy is influenced by institu-
tions and the political process and then summarizes U.S. and multilateral trade policy
developments during the last several decades. We begin with a brief discussion of some
common analyses of the interaction between citizens and their elected representatives/
policymakers in the process of policy formulation and of the concerns reflected in a coun-
try’s trade stance. As will be seen, a minority of the population is often successful in
procuring policies that benefit that minority at the expense of general social welfare. We
then present an overview of U.S. trade policy since the 1930s. A central point is that the
past approximately 80 years have seen a dramatic liberalization of trade in the United
States and other industrial countries.
THE POLITICAL ECONOMY OF TRADE POLICY
As has often been pointed out, the one issue on which economists are in almost unanimous
agreement is the social gains to be made by specializing and trading on the basis of com-
parative advantage and, correspondingly, opposition to protectionism. In spite of this view,
the world continues to experience pressures to restrict the movement of goods, services,
and factors between countries. Indeed, countries seem to continue to find new and novel
ways to restrict these economic activities. Too often as one trade-restricting instrument
falls into disfavor and is reduced or eliminated, new trade-restricting provisions seem to
pop up. It is little wonder, then, that one is often asked, “If free trade is so beneficial to a
country, why are so many groups or individuals trying their best to reduce trade?” Why is
it that, as Robert Baldwin (1989, p. 119) so aptly pointed out, “international trade seems to
be a subject where the advice of economists is routinely disregarded”?
Contrasting Vignettes
on Trade Policy
1Neil King, Jr., and Scott Miller, “U.S. Trade Chief Moves to Revive Global Parleys,” The Wall Street Journal,
January 13, 2004, p. A2.
2Neil King, Jr., and Michael Schroeder, “EU Trade Chief Warns of Sanctions,” The Wall Street Journal, November
5, 2003, pp. A2, A15. Note that the United States did remove the March 2002 steel tariffs.
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The answer to this question lies in what is referred to as “the political economy of trade
policy.” In reality, trade policy takes place within a political-social milieu and is influenced
by individuals and groups who feel that they will be better off with restricted trade even
though the country as a whole may be worse off. As we have noted in previous chapters,
reducing the barriers to trade may make the country better off, but as the corresponding
structural adjustments are made, some individuals will be made better off and some worse
off. Politicians thus find themselves confronted with a vast array of groups attempting to
influence trade policy, and, consequently, they often ignore the advice of economists when
establishing the country’s trading regime. In the past several decades, an area of research
has emerged that focuses on analyzing the actual determinants of trade policy in the politi-
cal environment within which it is developed. We now turn to a brief discussion of several
of the more important strands of research on this topical issue.
The study of the political factors influencing trade policy has proceeded along two major
fronts. The first, and perhaps the most pervasive, focuses on the economic self-interest of
the political participants.3 Much of this literature is embedded in public-choice economics,
which essentially uses economic models to analyze governmental decision-making behavior.
In this approach, government decision makers are essentially utility maximizers whose level
of satisfaction is dependent upon being reelected and who act in a manner that maximizes the
probability that this will in fact take place.4 An immediate implication of this approach is that
the majority of the public will be served by public decision makers who enact legislation to
maximize their chances of remaining in office. This is the focus of the median-voter model,
which holds that the decision maker who votes in such a way as to satisfy the median voter will
maximize his or her reelection possibilities. In this approach each individual voter is assigned
a position along an array based on the expected costs or benefits of a particular policy. The
median voter is in the center of this array, that is, the middle voter. Should the majority expect
to benefit from a particular policy, the median voter will be in favor of the policy and support
the politician who favors it. Should the majority feel that they will be harmed by a particular
action, the median voter will not favor the policy and will not support a political candidate
who attempts to make a case for it. This is a natural model to use in studying international
trade policy because, as we have noted in previous theory chapters, trade policy inevitably
results in different welfare effects for different groups in the economy.
In the median-voter framework, should a greater number of voters expect to benefit
from a particular trade policy than incur a loss, the median voter would be in favor of the
proposed legislation and the policymaker would presumably vote in favor of the policy
measure. Should the policymaker not support the legislation in this case, the median voter
is likely to vote against the legislator in the next election. This approach would thus seem
to ensure that the will of the majority would be followed. Unfortunately, however, there
are a number of practical problems, which, if they arise, can circumvent the preferences
of the median voter and result in policies that are inconsistent with majority benefits. The
median-voter model rests on the assumptions that the voters have full information regard-
ing any gains or losses resulting from a particular policy and that they will actually vote
consistent with their preferences. Inasmuch as neither of these two assumptions always
holds in the real world, it is clearly possible that the preferences of the median voter do
not win out. For example, a tariff benefiting only a small group of individuals may end up
being supported by a voting majority.
The Self-Interest
Approach to Trade
Policy
3The early background literature on this approach was nicely reviewed by Hillman (1989).
4While a number of factors such as political ideology, place in history, personal gain, etc., undoubtedly influence
the policymaker, nonetheless, remaining in office is central to what the politician hopes to accomplish.
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IN THE REAL WORLD:
WORLD ATTITUDES TOWARD FOREIGN TRADE
A Pew Research Center survey in 2011, part of the Pew
Global Attitudes project, gathered opinions regarding inter-
national trade and business ties from citizens of 21 countries.
A sample of the results is given in Table 1. It is interesting
that, just when the world seems to be accepting and support-
ing globalization, households in the United States—a coun-
try that has been a longtime advocate of open markets and
freer trade—seem to be less favorably inclined toward trade
and business ties than the people of other developed coun-
tries and of some emerging-market countries. In fact, the
U.S. summed score of 67 was the lowest of the 21 countries.
Another interesting finding with respect to attitudes
toward trade has been offered by David Coe (2008).
According to Coe, public opinion surveys show that in indus-
trial countries, higher levels of income inequality are linked
to less positive attitudes toward the benefits of trade. Further,
he notes that similar surveys from the Euro area suggest that
globalization is viewed more positively if there has been
substantial redistribution toward the lowest 30 percent of the
population through government policies. In general, public
opinion surveys suggest that pro-trade attitudes are strongly
positively correlated with an individual’s economic status
level. Coe concludes that redistribution policies to compen-
sate those hurt by an expansion of trade are important for
gaining wider popular support for trade liberalization.
Sources: “International Trade Still Favored,” July 13, 2011,  chapter 5
of “Economic Issues” surveys, obtained from www.pewglobal.org;
David T. Coe, “Jobs on Another Shore,” Finance and Development
45, no. 1 (March 2008), pp. 48–51. ●
TABLE 1 Responses to the Question: Are Trade
and Business Ties Good for the Country?
Country Very Good Good Sum
Lebanon 50% 47% 97%
Spain 58 38 96
Germany 40 55 95
Kenya 58 33 91
China 25 64 89
France 27 56 83
India 48 34 82
Brazil 14 67 81
Mexico 29 50 79
United States 18 49 67
Source: “International Trade Still Favored,” July 13, 2011, chapter 5 of
“Economic Issues” surveys, obtained from www.pewglobal.org. Pew
Research Center’s Global Attitudes Project.
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There are a number of situations that can produce these seemingly contradictory results.
In the case where there are information-gathering costs as well as opportunity costs asso-
ciated with actually voting, some potential voters may simply choose not to participate,
particularly if expected gains are small and hence the expected net benefits negative. If, in
addition, the voter feels that one vote will not actually influence or “swing” the result, he
or she may simply accept the outcome without actually engaging in the political process. In
this case, voters are acting as “free riders,” that is, accepting the outcome without expend-
ing any effort or costs. Although this would not be a problem if every voter had an equal
probability of not participating, in reality, the differences in the amount of expected bene-
fits and costs (asymmetric gains and losses) strongly suggest that individuals will have dif-
ferent degrees of incentive and that interest groups will form. A particular policy action
such as sugar quotas may have only a minor individual or per capita impact on a large
group in society (e.g., consumers) but a large per capita impact on a minority (e.g., sugar
producers). The matter becomes even more complicated if allegations are true that recent
changes in some U.S. states’ voting laws regarding voter identification and early voting
deter participation by some potential voters.
Interest groups can influence political outcomes in a variety of ways. Because the
costs (benefits) of a policy are relatively great to these groups, they have an incentive to
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IN THE REAL WORLD:
U.S. ATTITUDES TOWARD INTERNATIONAL TRADE
The lack of enthusiastic support for trade by U.S. citizens is
not only evident in the worldwide Pew survey on page 362.
This absence of solid approval of international trade was
also emphasized in a Federal Reserve Bank of Dallas annual
report, according to which a November 2010 NBC poll
showed that Americans, by 47 percent to 23 percent, judged
that free trade “hurt” rather than “helped” the United States.
Another November 2010 poll, conducted by the Opinion
Research Corporation for CNN, revealed that one-half
of the U.S. respondents judged that the threats posed by
imports outweighed the benefits of those imports, while only
41  percent thought that trade represented an opportunity.
A particularly interesting point made in the Federal
Reserve Bank of Dallas report was that attitudes of U.S. con-
sumers toward trade seemed to vary according to trading part-
ner. An indication of this factor was that the average American
was almost twice as likely to think that trade with Canada was
good, in comparison to trade with China. Further, U.S. citi-
zens looked more favorably toward increasing the amount of
trade with Mexico than toward increasing the amount of trade
with South Korea. Hence, attitudes toward trade may involve
more than just the price and quality of the goods themselves,
as feelings toward the country source of imported goods also
seem to play a role in consumer satisfaction.
In more recent studies, Gallup public opinion polls
in 2013 and 2014 indicated that the views of Americans
began to change as of 2013. Gallup has asked respon-
dents, in a long series of polls, whether they view inter-
national trade as an opportunity for economic growth
because of increased exports or as a threat to the U.S.
economy because of imports. Over 20 years ago, in 1992,
48  percent of the respondents had said a “threat” and
44 percent had said an “opportunity”; the “opportunity”
responses then exceeded the “threat” responses until about
the beginning of 2005, with the high point for trade being
56 percent-36 percent in one poll. The “threat” responses
then prevailed until the February 2013 poll, when the
result became a majority for trade as 57 percent saw it as
an “opportunity” and only 35 percent as a “threat.” This
basic result continued in the February 2014 poll with a
54   percent-38 percent margin for the “opportunity” cat-
egory. Finally, another result in 2014 was that individu-
als with a bachelor’s degree or higher were considerably
more favorably inclined toward trade than were individu-
als without a college degree.
Sources: “Public Perception of Globalization’s Impact Shapes
Trade Realities,” Globalization and Monetary Policy Institute, 2011
Annual Report, Federal Reserve Bank of Dallas, February 2012,
pp.  21–25; Jeffrey M. Jones, “Americans Shift to More Positive
View of Foreign Trade,” February 28, 2013, and Lydia Saad,
“Americans Remain Positive about Trade,” February 21, 2014, both
obtained from www.gallup.com. ●
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influence political action and are more likely to overcome the free-rider problem of their
relatively small number of members. A small group of individuals who stand to gain much
from a policy intervention in the market thus obtain a certain group solidarity, participate
in the political process, and vote for the candidate who supports their position on protec-
tion. At the same time, however, the larger group of diverse consumers who stand to
lose with protectionism expect to gain little individually by making the effort to acquire
information and/or vote; consequently they do not participate. As a result, there is a small
voter turnout and the candidate espousing the views of the solid minority block wins. This
phenomenon can lead to a status quo bias against liberalizing trade policy through lower
levels of protection even though doing so carries the promise of improving aggregate
welfare. For a large number of people the net personal gains are so small (perhaps even
negative) or uncertain that they choose not to participate actively in the political process,
and the minority interest group gets its way. There is no doubt that groups such as this are
very influential in the conduct of trade policy formation. As Vousden (1990, p. 198) points
out, interest or pressure groups tend to be more successful if they are large enough to be
visible but small enough to control the free riding of their members, there is a well-defined
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commonality of interest, and the per capita organizational and information-gathering costs
are relatively low.
A second way in which special interest groups can influence political outcomes is
through the funding of political campaigns-both candidates’ immediate campaign fund-
ing and the funding of well-financed political action committees (super PACs). Funding
of campaigns not only contributes to candidate and issue visibility but also can be a rela-
tively low cost way of providing interest-group-centered information to potential voters
to motivate them to participate in the political process. In a similar vein, withholding
campaign funding or making implied threats to fund an opposition candidate also are
effective in getting a politician’s attention and support for a particular policy position.
Groups that attempt to influence policy in their favor through the use of campaign con-
tributions are said to be carrying on rent-seeking activity because the group is commit-
ting resources to the pursuit of benefits from protection. Note that the group would not
rationally expend resources in excess of the expected benefits that it would receive from
the policies in question. Rent-seeking activity can, of course, extend beyond simple cam-
paign contributions to the use of corruptive practices such as bribes to political decision
makers to influence their votes. Because the resources used in this type of activity are
not producing any good or service but are merely influencing the distribution of income,
these actions are often referred to as directly unproductive activity.
Rent-seeking activity can be further complicated when an interest group tacitly agrees to
support continued protection in other sectors, even if it means a loss in welfare for its own
members, in exchange for support for one’s own protection. The idea here is that the com-
bined support of several groups for protection provides a sufficient political critical mass to
get the protectionist candidates elected and the trade restrictions maintained. For example,
textile and apparel workers (along with sector-specific capital owners in textiles and apparel)
might well support the status quo on sugar and steel protection in exchange for the sugar
and steel sectors’ support of protection in the textile and apparel industry. In this instance,
the loss to their membership through higher prices for sugar and steel-using products might
well be small compared with the gains obtained through the continued protection of textiles
and apparel. This is another example, often called “logrolling,” of status quo bias in which
a group (or several groups) benefits at the expense of society as a whole. The median voter
has again been supplanted in terms of the policy action undertaken because of a large unin-
volved free-riding majority and the efforts of an interest-centered pressure group.
Before leaving this discussion, it is important to note that while the self-interest approach
has proved quite useful in better understanding the trade policy issue, it ignores the fact that
people do things that do not appear to be in their pure economic self-interest. No one would
dispute the fact that, although it may be relatively small, individuals have often demon-
strated the willingness to sacrifice some of their real income to improve overall welfare,
whether it be in their community, their country, or even the world. It is for this reason that
we turn to other approaches to political economy.
From this perspective, trade policy is conducted taking into account the well-being of dif-
ferent groups in society along with various national and international objectives. In this
environment, trade policy is promoted to the public at large in terms of broader social goals
such as income distribution, increased productivity, economic growth, national defense,
global power and leadership, and international equity. With regard to domestic income dis-
tribution, Corden (1974, p. 107) suggests that trade policy appears to have a conservative
bias in that governments often seem to give more weight to avoiding real income losses in
a particular segment of the economy and assign less weight to increasing the real income
of a particular group. Other social objectives which have been discussed in the litera-
ture involve minimizing consumer loss, improving the real income of the lowest-income
The Social Objectives
Approach
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IN THE REAL WORLD:
Actions by the Clinton administration in the 1990s to negoti-
ate a floor price on tomato imports from Mexico constitute
an excellent example of how the political process can result
in a protectionist measure that circumvents the median-voter
principle and rewards a small vocal minority (a small num-
ber of large Floridian growers) at the expense of the large
mass of unorganized free-riding tomato consumers. Led by
producer Paul J. DiMare, the Florida tomato producers, who
are controlled by a handful of wealthy growers, had argued
for years for protection from cheap foreign imports that
“are driving Florida farmers out of business.” Interestingly,
however, the Florida tomato industry has not collapsed even
though hurricanes, cold snaps, and other weather-related
woes have hindered production. Of concern to the growers
was the increase in imports from Mexico, which they feared
would become even larger as the North American Free Trade
Agreement (NAFTA, discussed in Chapter 17) accords
came into place. Even though the tariff on Mexican tomatoes
was  low (1.4 cents/pound) prior to NAFTA, DiMare and
others argued that the resulting increase in Mexican tomato
imports endangered thousands of U.S. jobs and that with-
out help the Florida tomato industry was “going down the
tubes.” The Florida growers got little sympathy from their
counterparts in California, whose summer crop competes
directly with Mexico’s crop. According to Ken Moonie,
vice president of the tomato operations of California-based
Calgene Inc., “All this is about protecting four big guys . . .
it is not like corn or any other agricultural commodity where
thousands of growers are involved.”
Imports of tomatoes from Mexico have cut into Florida’s
share of the winter market. Some of this market penetration
reflects the fact that the taste of the hand-picked, vine-ripened
Mexican tomatoes is thought to surpass that of the Florida
tomatoes, which are picked green and then gas-ripened prior
to shipping. DiMare did not see that consumer preference for
the juicier, more tasty vine-ripened fruit had anything to do
with the increase in imports, allowing that “it really doesn’t
matter” how tomatoes taste since they are condiments, sel-
dom eaten alone.
Under the accord reached in October 1996, Mexican
growers agreed not to sell tomatoes in the United States
below a certain price. Antidumping duties were put in place
on November 1, 1996, to ensure that prices would not go
below the level. The U.S. Department of Commerce stated
that this price would be the lowest average price during a
recent period when there was a clear absence of any “price
suppression” on the part of Mexican producers. This accord
was negotiated by Commerce Secretary Mickey Kantor and
the Clinton administration because Florida was considered
essential in the November 1996 elections. One Clinton strat-
egist worried not so much about losing the small number
of votes of tomato growers, but rather that negative public-
ity could result if no action were taken against the tomato
imports. In later years, the antidumping duties and investiga-
tions were suspended.
Sources: Helene Cooper and Bruce Ingersoll, “Playing Catch-Up:
With Little Evidence, Florida Growers Blame Tomato Woes on
NAFTA,” The Wall Street Journal, April 3, 1996, p. A1; Robert
S. Greenberger, “Mexico Agrees to Temporary Floor on Price of
Tomatoes Sold in U.S.,” The Wall Street Journal, October 14, 1996,
p. B3; George Anthan, “Politics Put Squeeze on Tomato Imports;
U.S. Growers Prevail,” The Des Moines Register, October 29, 1996,
p. 3A; United States International Trade Commission, “Antidumping
and Countervailing Duty Orders in Place as of September 10, 2008,
by Country,” obtained from www.usitc.gov. ●
POLITICS PUTS THE SQUEEZE ON TOMATO IMPORTS
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groups, minimizing or delaying adjustment costs for particular industries, and protecting
the relative income level of specific socioeconomic groups.5
Such a macro approach does, however, create problems. If a country talks a “free-trade
talk” and then proceeds not to “walk the free-trade walk” by protecting certain import com-
peting sectors for reasons such as those given earlier, it quickly loses credibility with the
voters. Once pressure groups learn that the government is concerned about income distri-
bution, the verbalized commitment to free trade and structural adjustment is compromised
and structural adjustment by both labor and capital slows. The expectation of trade policy
relief thus reduces the outward movement of factors from any given declining industry,
economic conditions in the industry continue to worsen, and greater and greater pressures
5See Baldwin (1989, pp. 126–30) for an excellent overview of these studies.
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CONCEPT CHECK 1. Explain theoretically why the median-voter
principle should result in the will of the
majority being revealed in policy decisions.
2. What are the critical assumptions underlying
the median-voter model?
3. What is the underlying basis for the social
objectives rationale for public policy decisions?
A REVIEW OF U.S. TRADE POLICY AND MULTILATERAL NEGOTIATIONS
The liberalization of trade can be divided into several stages beginning after the Tariff
Act of 1930, usually called the Smoot-Hawley Tariff, which established extremely
high protection in the United States (an average tariff level of about 50 percent). Other
are put on the government to intervene to maintain relative income levels and the status quo.
The expectation and likely realization of government support of the threatened industry
thus results in slowing down the necessary structural change, a loss in overall economic
efficiency, and little or no change in equity. The inability to commit to a free-trade policy
hence forces the country whose trade policy is influenced by income distribution concerns
to maintain protection. It is often argued that this type of analysis is useful in explaining the
high level of protection offered to textiles and apparel over time. Deardorff (1987) also sug-
gests that such concerns help explain why governments preferred voluntary export restraints
(VERs) to tariffs. Finally, Baldwin (1989, p. 129) argues that income distribution concerns
can also help explain why governments use protection instead of domestic subsidies to
help import-competing firms. With a tariff, quota, or VER, consumers who use the product
essentially bear the burden of the policy through higher prices. Inasmuch as they were the
group that initially benefited from the import-induced lower prices, an increase in domestic
price that returns them more-or-less to the initial higher price leaves them no worse off than
they were previously—even if the tariff revenue is not returned to them. Were a production
subsidy used to support the affected industry, the burden of the tax (to pay for the subsidy)
would presumably fall on all taxpayers, thus reducing the relative income of those who do
not consume the product and were not affected by the lower product price.
Foreign trade policy has also been used as part of the total foreign policy package. As
such, foreign policy concerns have been used to support both increased protection and
increased trade liberalization. Since World War II, the United States has been the major
hegemonic power in the world. During much of that time, U.S. foreign policy was directed
toward limiting the spread of communism and strengthening the noncommunist world eco-
nomically. U.S. trade and aid policy was clearly influenced by these concerns, and they
perhaps explain why the United States chose not to use its hegemonic power to improve
its international terms of trade. In more contemporary times, U.S. sanctions on trade with
Iran and the controversy surrounding their removal have been foreign-policy-related (seek-
ing to prevent Iran from becoming nuclear armed) rather than concerned with economic
impacts on the United States. In addition to hegemonic concerns, there is also evidence that
a number of countries have concerns about the international distribution of income that go
beyond their own self-interest. Examples of this include the amount of untied foreign aid
(i.e., aid that can be spent on goods from any country, not just from the donor country)
that has been given to the developing countries as well as the reduced trade restrictions
that have been granted both unilaterally and multilaterally through such programs as the
Generalized System of Preferences (GSP). Analysis of this type has been relatively com-
mon among political scientists in recent years.
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countries retaliated with their own stiff tariffs, and world trade shrank dramatically. An
estimate by Jakob Madsen (2001, p. 865) is that 41 percent of the decline in world trade
was due to the imposition of the new trade barriers and 59 percent was due to falling
incomes that resulted in less purchasing power to buy imports. Recognizing that there is
imprecision in such estimates and that tariffs and income are interrelated (higher tariffs
can reduce national income and falling national income can increase the calls for more
protection from imports), Madsen concluded (p. 867) that “the contribution of the impo-
sition of the discretionary trade barriers was about as important as the output decline in
explaining the contraction in world trade.” In any event, economists and policymakers
generally agree that this tariff worsened the Great Depression of the 1930s. The tariff
legislation since that time has occurred largely in response to this impact on the Great
Depression and the increasing economic interdependence of countries. We now give a
brief overview of trade agreements from 1934 to 1960, followed by examination of the
Kennedy Round (1960s) and the Tokyo Round (1970s) of trade negotiations. We next
discuss the most recent round that has been completed (1994), the Uruguay Round. We
then look at prospects for the current round of trade negotiations, the Doha Development
Agenda, and review several recent trade policy actions.
The long process of tariff reduction began with the passage by Congress of the Reciprocal
Trade Agreements Act of 1934.6 This act authorized the executive branch to engage in
bilateral negotiations with individual trading partners on tariff reductions. The act was
renewed every three years until the end of World War II. A particular feature of the nego-
tiation process was its employment of an item-by-item approach, meaning that rate
reductions on goods were bargained individually rather than uniformly agreed upon for a
broad range of categories. While significant reductions were made on many goods and on
the overall U.S. tariff level, the item-by-item approach does not permit smooth and quick
negotiation when many goods are encompassed by the proceedings.
At the end of World War II, tariff bargaining took the form of multilateral negotiations,
meaning that many countries took part simultaneously. The General Agreement on Tariffs
and Trade (GATT) took effect in 1947. Under this agreement, countries committed them-
selves to multilateral bargaining for the purpose of easing trade restrictions in all of the partic-
ipating countries. GATT became an ongoing organization that sponsored regular negotiations
of this type. From 1947 until 1962, five GATT rounds of trade negotiations were held, in
which the participating countries hammered out mutually acceptable reductions of various
barriers. The first round, held in Geneva in 1947, was reasonably successful. However, econ-
omists did not judge the next four rounds in 1949, 1951, 1956, and 1962, as having attained
much success. Nevertheless, some multilateral tariff reductions were achieved, and all these
early rounds embodied the most-favored-nation (MFN) principle (discussed in Chapter 13),
as did those that followed.
To put new life into the trade negotiation process and to avoid being shut out by the newly
forming European Economic Community, the United States led the way into a new round
of negotiations from 1962 to 1967. The key stimulus for the round was the U.S. Trade
Expansion Act of 1962. This legislation authorized the president to negotiate tariff reduc-
tions of up to 50 percent, and these reductions could be negotiated through an across-the-
board approach rather than an item-by-item approach. Broad categories of goods could
Reciprocal Trade
Agreements and Early
GATT Rounds
The Kennedy Round
of Trade Negotiations
6For a good review of tariff policy from 1934 into the 1960s, see “Some Aspects of United States Foreign Trade
and the Kennedy Round,” Federal Reserve Bank of Cleveland, Economic Review, September 1967, pp. 179–82.
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7“Labor Department Certifies Pillowtex Workers for Trade Adjustment Assistance,” www.dol.gov; “Trade
Adjustment Assistance Reform Act of 2002: Free Trade Agreement and Trade Beneficiary Countries,” 
www.doleta.gov.
be discussed all at once and a given rate reduction could apply to the whole group—a more
streamlined approach. The Trade Expansion Act also introduced a feature of trade policy
known as trade adjustment assistance (TAA), which means that, if a tariff reduction
injures workers or industries by causing an inflow of imports, displaced workers can, for
example, petition for additional unemployment compensation or for help in retraining for
other types of jobs. To most economists, this was a marked step forward for public policy,
because previously the only alternative considered was to reimpose the tariff (the “escape
clause”). Thus, TAA in a broad sense tries to promote internal adjustment to changing
international conditions and reduction in protection. It is an attempt to facilitate the move-
ment of the economy along the production-possibilities frontier (PPF). Without this assis-
tance, a country’s production point might initially move inside the PPF and get back onto
the frontier only after a considerable period of time has passed. The Trade Adjustment
Assistance Reform Act of 2002 created an additional program for a health coverage tax
credit and added a new benefit for older workers. Workers who lost their jobs because their
companies shifted production abroad to countries that were part of a free trade agreement
with the United States, or to some African and Western Hemisphere countries, were also
made eligible for TAA.7
With the passage of the Trade Expansion Act, the United States moved into multi-
lateral negotiations in Geneva in what became known as the Kennedy Round of trade
negotiations. Seventy countries participated, and tariffs on manufactured products were
reduced by an average of 35 percent, with at least some reduction occurring in 64 percent
of manufactured goods with tariffs. (See Ellsworth and Leith, 1984, p. 230.) Note that
this success was in terms of cuts achieved in manufactured goods; the Kennedy Round
achieved little progress in reducing barriers on agricultural products. In addition, the
Kennedy Round did little to ease nontariff barriers (NTBs).
With the completion of the Kennedy Round of tariff cutting in 1967, no further steps were
taken until 1973, when preliminary moves were initiated at a multilateral meeting in Tokyo
toward beginning another round of negotiations. A main impetus for the new round was
that, while tariff rates had been moving downward, NTBs had been rising and had offset
some of the benefits of the tariff reductions.
The Trade Act of 1974 enabled the United States to participate in this new round,
the Tokyo Round of trade negotiations. This act of Congress authorized the president
to enter into trade negotiations for the purpose of reducing tariff and nontariff barriers.
Reductions of up to 60 percent were authorized on existing duties greater than 5 percent,
and tariffs could be eliminated altogether on goods whose existing duties were less than
5 percent. In addition, authorization was granted to enter into individual-sector negotia-
tions to work for the liberalization of NTBs. Other features of interest in this bill were the
provision for introduction of the U.S. Generalized System of Preferences (GSP) for the
products of developing countries (see Chapter 13) and the provision for more generous
treatment of claims for TAA.
Finally, the Trade Act of 1974 attempted to systematize procedures on claims for import
relief by import-competing firms. Prominent provisions of the act in this respect (some of
which predate 1974) were as follows:
1. Section 201: This part of U.S. legislation permits import-competing firms to peti-
tion for relief from rapidly increasing imports (or “surges” in imports). The U.S.
The Tokyo Round of
Trade Negotiations
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International Trade Commission (USITC) then investigates whether the rapid
increases in imports are causing “substantial injury” to the U.S. industry and, if so,
makes a recommendation for protection to the president. The president may or may
not accept the recommendation.
2. Section 232: The president is authorized to restrict any good that “is being imported
into the United States in such quantities or under such circumstances as to threaten
to impair the national security.” This provision has seldom been used (principally on
petroleum in earlier years). In 1986, it was used to limit machine tool imports, which
resulted in VERs with Japan and Taiwan.8
3. Section 301: This unfair-trade portion of U.S. law permits the president to take retal-
iatory action in response to unjustifiable, unreasonable, or discriminatory restric-
tions on U.S. exports by foreign countries. Unjustifiable refers to any action that
violates the international legal rights of the United States; unreasonable refers to
unfair and inequitable practices, although these are obviously hard to define; and
discriminatory means actions that deny national or MFN treatment to the United
States.9 The range of U.S. possible actions is broad, and includes (among others) sus-
pending trade agreement concessions, imposing duties or other import restrictions,
and entering into agreements with the other country to eliminate the behavior or to
provide compensation to the United States.
In addition to this Section 301 provision, there is a Special 301 provision of
U.S. trade law whereby the U.S. Trade Representive (USTR), a cabinet-level officer
in the executive branch, identifies countries that are denying adequate or effective
intellectual property rights to U.S. industries or persons. Such identification can lead
to a designation of the offending countries as “Priority Foreign Countries” and be
followed by USTR initiation of Section 301 action.10
4. Section 701: This covers subsidies to exports by foreign countries. Petition is
made by import-competing firms to the Department of Commerce to ascertain the
existence of the subsidy; if affirmed, the USITC determines whether or not injury
is occurring.
5. Section 731: This portion of trade law consists of the antidumping provisions
discussed in Chapter 15, pages 335–38.
With this enabling legislation in hand, U.S. negotiators took part in the multilateral
negotiations in Geneva between 1974 and 1979, which resulted in agreement (see Allen,
1979) that (1) tariff rates on manufactured goods were to be reduced by an average of about
one-third in a phase-in process over eight years, and (2) new codes of behavior concerning
several NTBs were to be adhered to with respect to, for example, government procurement
procedures, subsidies and countervailing duties, and valuation of goods for customs duties
purposes. In addition, agreement was reached that tariff preferences should be given by
developed countries to various manufactured exports from the developing countries and
that the nonreciprocity principle should apply to developing countries. This principle
holds that, even though developed countries may reduce barriers on exports from develop-
ing countries, no corresponding behavior is required by developing countries on exports
8William J. Long, “National Security versus National Welfare in American Foreign Economic Policy,” Journal
of Policy History 4, no. 3 (1992), pp. 288–91.
9Economic Report of the President, February 1988 (Washington, DC: U.S. Government Printing Office, 1988),
p. 156.
10United States Trade Representative, 2012 Trade Policy Agenda and 2011 Annual Report (Washington, DC:
USTR, 2012), p. 178, obtained from www.ustr.gov.
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IN THE REAL WORLD:
TRADE ADJUSTMENT ASSISTANCE AND ITS IMPLEMENTATION
Although controversial, TAA has been supported politi-
cally for more than 50 years since its inclusion in the Trade
Expansion Act of 1962 and the Trade Act of 1974. More
recently, it was reauthorized and expanded within The Trade
and Global Adjustment Act of 2009 as part of President
Obama’s Economic Stimulus package. This authorization
lapsed in February 2011, but in October was restored through
2014 with the Trade Adjustment Act of 2011. After consid-
erable political controversy, centered on program costs and
effectiveness, the Congress passed the Trade Adjustment Act
of 2015. It amends the Trade Act of 1974 to extend through
December 31, 2020, renews the 2009–2010 eligibility and
benefit levels, and authorizes funding throughout the period.
It thus represents long-term support for this program in
contrast to the short term focus of previous legislation. The
longer-term focus is designed to improve the administration
of the program, reduce worker uncertainty about being able
to financially participate in the program, and provide a more
effective underpinning for all participants—firms, workers,
farmers, and communities.
Eligibility requirements to participate in this assistance
program have always been somewhat of an issue. What
economic situations seemed to be most likely to result in
the applicants being accepted into the trade adjustment pro-
gram because of expanding international trade? Christopher
Magee (2001) investigated empirically the determinants of
any given worker’s chances of being certified by the U.S.
Department of Labor to receive TAA. The actual statutory
procedure for seeking TAA is that a group of three or more
workers from a firm first files a petition with the Department
of Labor. Then the Department of Labor ascertains whether
a significant percentage of the workers in the petitioners’
firm has become partly or wholly separated from the firm or
is under a potential threat of being separated, whether sales
or production (or both) of the firm have declined in absolute
terms, and whether increases in imports of the petitioners’
firm’s product contributed in an important way to the separa-
tion or threat of separation. If the petition is approved, work-
ers received unemployment compensation for 12 months
(rather than for the 6 months in normal unemployment
situations), or 18 months if the workers are enrolled in a
retraining program. Between 1975 and 1994, the percentage
of applicants who were certified annually ranged from more
than 70 percent to 10 percent, depending on the year.
Magee’s empirical tests attempted to ascertain the actual
variables over the 1975–1992 period that seemed to yield a
good chance for workers to be certified to receive TAA. His
first result was that a higher level of tariff protection for the
industry in which the workers have been engaged yields a
greater chance of approval of petitions. His reasoning for this
finding is that industries with higher tariffs are causing more
of a production distortion than are industries with low tariffs.
With greater protection and distortion, therefore, there is an
incentive for officials to look more favorably upon provid-
ing TAA because the TAA might facilitate the removal of
the distortion. This is an efficiency-type argument for TAA.
Another way that Magee states this reasoning is that more
TAA must be given to get tariff reductions in the industries
with high tariffs; that is, “higher tariff industries require a
greater payoff in order to reduce protection” (p. 119).
Empirically, and as expected, there was a negative rela-
tionship between TAA certification and the tariff change
in an industry. In other words, a greater tariff reduction
(a more negative tariff change) was associated with a greater
positive chance of receiving TAA. This is common sense
because the greater tariff change will, other things equal,
lead to more workers being displaced.
All in all, this paper indicated that separated workers
likely to receive TAA come from high-tariff industries, from
industries in which tariff reductions have been great, and
from industries with high unemployment rates. Also, work-
ers are more likely to receive certification if they belong to
a union, if they are laid off from a low-wage industry, and if
the industry’s market has a large import component.
Source: Congressional Research Service, “Library of Congress
Summary,” in “Summaries for the Trade Adjustment Assistance
Act of 2015,” obtained from www.govtrack.us/ Christopher
Magee, “Administered Protection for Workers: An Analysis of the
Trade Adjustment Assistance Program,” Journal of International
Economics 53, no. 1 (February 2001), pp. 105–25. ●
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to them from developed countries. By embracing tariff preferences and nonreciprocity,
the world community basically affirmed the value judgment that the plight of the develop-
ing countries in the international economy and the relatively low levels of their per capita
income required special, discriminatory measures in favor of these countries.
After the implementation of the Tokyo Round tariff cuts, it was estimated that the
average tariff level in the United States on manufactured products had been reduced
to 4.3 percent. Other countries appeared to have relatively similar average tariff levels:
Canada 5.2 percent, France 6.0 percent, Japan 2.9 percent, United Kingdom 5.2 percent,
and West Germany 6.3 percent.11 Except for Japan, all of these rates were slightly higher
than the rate in the United States, but the differences were minor. The low Japanese rate
points out one difficulty with these calculations, because they do not adequately include
nontariff barriers. Nevertheless, the broad level of tariff rates was substantially lower
than the levels existing at the time of Smoot-Hawley.
Despite the presence of relatively low tariff rates in the industrialized world, a new round
of trade negotiations began in September 1986 and was to be completed by December
1990. These talks were initiated in Punta del Este, Uruguay, and became known as the
Uruguay Round of trade negotiations. Major objectives of this new round included a
continuation of the attempt to reduce NTBs, an enlargement of the negotiations to embrace
trade in services in addition to the traditional emphasis on trade in goods, and a determina-
tion to deal with restrictions on agricultural trade.
The Uruguay Round set forth an ambitious agenda. Members established 15 groups
to work on reducing restrictions in the following areas: (1) tariffs, (2) NTBs, (3) tropical
products, (4) natural resource–based products, (5) textiles and clothing, (6) agriculture,
(7) safeguards (against sudden “surges” in imports), (8) subsidies and countervailing
duties, (9) trade-related intellectual property restrictions, (10) trade-related investment
restrictions, and (11) services, as well as four other areas dealing with GATT itself
(e.g., dispute-settlement procedures and implementation of the NTB codes of the Tokyo
Round, especially on dumping).12 The biggest controversies in the negotiations involved
services, intellectual property, and agriculture.
The most heated controversy by far concerned agriculture. Most countries use a wide
variety of policies to assist the agriculture sector: price supports, direct production subsi-
dies, export subsidies, quotas on imports, acreage restrictions to raise commodity prices,
and others. These interventions lead away from the free-market and free-trade allocation
of resources, since they introduce price distortions. The United States initially proposed
a 10-year phaseout of all subsidies that affect agricultural trade and of all agricultural
import barriers. The proposal was similar to one made by the Cairns Group, a collec-
tion of 14 developing and developed countries with agricultural interests (e.g., Argentina,
Australia, Brazil, Canada, New Zealand). The European Community (EC) wanted to go
more slowly and to moderate the extent of reduction in agriculture support.13 By 1990, the
wide disparity in subsequent proposals overshadowed all other aspects of the negotiations,
and the four-year effort had seemingly ended with no signed agreement on the liberaliza-
tion of trade.
The Uruguay Round
of Trade Negotiations
The First Four Years,
1986–1990
11Alan V. Deardorff and Robert M. Stern (1986), p. 49.
12“GATT Negotiations Essential to Maintain Strong Multilateral Trading System,” IMF Survey, December 12,
1988, pp. 386–89.
13“GATT Negotiations on Agriculture,” IMF Survey, December 12, 1988, p. 388; “The General Disagreement,”
The Economist, November 26, 1988, p. 81.
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14Bob Davis, “Tough Trade Issues Remain as EC, U.S. Agree on Agriculture,” The Wall Street Journal, November
23, 1992, p. A6.
15For fuller discussion, see Bob Davis and Lawrence Ingrassia, “After Years of Talks, GATT Is at Last Ready
to Sign Off on a Pact,” The Wall Street Journal, December 15, 1993, pp. A1, A7; idem, “Trade Pact Is Set by
117 Nations, Slashing Tariffs, Subsidies Globally,” The Wall Street Journal, December 16, 1993, pp. A3, A11;
“Trade Agreement Mandates Broad Changes,” IMF Survey, January 10, 1994, pp. 2–4. See also Deardorff (1994),
pp. 10–11.
Despite the failure of the Uruguay Round talks to meet the originally scheduled comple-
tion deadline of December 1990, negotiations continued. President George H.W. Bush
requested and received from Congress in 1991 a two-year extension to continue the talks
under the fast-track procedure, also known as the Trade Promotion Authority. Under
this procedure, which has characterized past trade negotiations, Congress must simply vote
yea or nay on a negotiated agreement. No amendments can be made. The debate over fast-
track was heated because the authorization also applied to the negotiations for the North
American Free Trade Agreement (NAFTA), which is discussed in Chapter 17.
Hope of success for the Uruguay Round began to reappear at the end of 1992 owing to a
trade policy threat. The United States had been concerned about a EC agricultural support
program that harmed U.S. exports of oilseeds (e.g., soybeans) and had twice received back-
ing from GATT that the EC program should be modified. In retaliation for the EC subsidy,
the United States threatened to impose 200 percent tariffs on EC exports to the United
States, valued at $300 million; if the EC in turn retaliated against this tariff, the United
States was ready to impose a second round of tariffs on $700 million of manufactured
exports from the EC to the United States.14 With this stimulus to renewed negotiations
on agriculture, an accord was eventually reached by which the oilseeds export subsidies
were to be reduced 36 percent by value and 21 percent by quantity over a six-year period.
This positive development then set off activity to work again on many other aspects of the
Uruguay Round. Finally, after intense discussions, the 117 participating countries in the
Uruguay Round reached agreement on December 15, 1993 (the deadline date), and the
signing took place on April 15, 1994, in Marrakech, Morocco. After ratification by partici-
pating countries, the agreement took effect on January 1, 1995.
Only a brief look is provided here of the features of this broad agreement.15 First, tariffs on
average were cut by 34 percent (39 percent by developed countries) and were dropped alto-
gether in the developed countries on a variety of products such as pharmaceuticals, con-
struction and agricultural equipment, furniture, paper, and scientific instruments. Second,
the value of agricultural export subsidies was to be cut by 36 percent and most domestic
support for agriculture by 20 percent, and average developed-country agricultural tariffs
would be reduced by 36 percent over a six-year period. Third, textiles and apparel trade
were to be moved from the existing quota framework of the Multi-Fiber Arrangement into
the GATT framework, with tariffs to be phased out over 10 years. In fact, the quotas were
ended on January 1, 2005, but tariffs remain. In addition, Japan and South Korea promised
to open their markets to some extent for rice imports. Revised rules were also adopted
regarding dumping and export subsidies, and VERs were to be eliminated. Further, action
on trade-related intellectual property rights (TRIPs) provided for minimum standards for
trademarks, patents, and copyrights. (For example, patents are now in force for 20 years. In
the United States, the previous length had been 17 years.) Some trade-related investment
measures (TRIMs), such as local content requirements for foreign investors, were to be
eliminated within two years by developed countries, five years by developing countries,
and seven years by “least developed” countries.
Continued Negotiations
Lead to Success, 1993
Provisions of the
Uruguay Round
Agreement
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In retrospect, there is also a widely shared view pertaining to the Uruguay Round that
the results were relatively unbalanced and were detrimental to the developing countries.
One reason for this judgment was that the TRIPs features of the agreement hurt the devel-
oping countries through the payments that were expected to be made by them in the future
to the developed countries for the use of intellectual property. A second reason was that the
phase-out of the Multi-Fiber Arrangement and its replacement by tariffs caused the devel-
oping countries to lose the quota rents that they previously had been receiving. In addition,
the developed countries’ changes with respect to agriculture seemed very minor and were
not of much benefit to the developing countries (see Finger, 2008).
Considerable friction prevented attainment of some of the goals for services. An impor-
tant controversy involved France’s refusal to permit the import of U.S. motion pictures on
the scale the United States wanted. Nevertheless, a general agreement on trade in services
(GATS) calls for “national treatment” in services, meaning that any country is to treat
foreign service providers in the same fashion as domestic service providers, as well as
for MFN treatment for services. New procedures were also adopted for the settlement
of disputes. Finally, GATT itself was replaced by a new organization, the World Trade
Organization (WTO), which supervised the implementation of the Uruguay Round agree-
ment and is handling trade disagreements.
With the successful conclusion of the Uruguay Round, governments in the next several
years centered on the implementation of the measures that had been adopted. In addition,
further sectoral agreements were pursued (such as completed agreements in telecommuni-
cations and financial services) that would put specifics into the broad general framework
that had been laid out in the Uruguay Round for particular sectors. However, as the 1990s
drew to a close, there emerged a desire on the part of many countries to begin a new round
of multilateral trade deliberations. Many countries wished to attain further relaxation of
trade-restricting measures in agriculture and services, to reduce remaining tariffs further,
and to consider a variety of other matters pertaining to areas such as antidumping proce-
dures, procedures within WTO, and intellectual property rights. Further, there was a desire
by developed countries—but decidedly not by developing countries—to discuss the broad
general area known as “labor standards.” In addition, and again mainly by developed coun-
tries, there was pressure to include consideration of the environmental impact of trade and
international shifts in production location by firms.
The labor standards debate revolves around several issues—most importantly child
labor, health and safety features of the workplace, and hours of work per day and
days of work per week. For example, campus groups in the industrial countries have
protested the use of child labor (often children in the lower-teen years or younger) in
assembly plants in developing countries. Out of humanitarian concern, these groups
demand that their universities and colleges not deal with companies that employ such
labor. Similar protests are made, including objections by labor union groups and their
employers, in industrial countries regarding the dangerous work environments in devel-
oping countries, where little attention is paid to safety procedures, properly operated
equipment, and sanitary conditions in the plants. Developed-country labor and employ-
ers in labor-intensive industries, of course, claim that it is “unfair” that they have to
compete with goods made under such “sweatshop” conditions. The view is that, were
developing-country firms forced (by threat of sanctions against their goods by devel-
oped countries) to provide a safe, healthful environment and to adhere to the length of
workday and workweek adhered to by developed-country firms, the result would be
that all firms are competing on an equal basis.
Trade Policy Issues
after the Uruguay
Round
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IN THE REAL WORLD:
TARIFF REDUCTIONS RESULTING FROM THE URUGUAY ROUND
Given the broad guidelines of the Uruguay Round with
respect to tariff reductions, it is useful to examine the actual
differences between pre-Uruguay and post-Uruguay Round
tariffs at both the country/region level and the commodity
group level. WTO estimates of the pre- and post-Uruguay
Round weighted-average tariff levels are found in Table 2.
Note that developing countries have substantially higher
protection (both pre- and post-Uruguay Round) than devel-
oped countries and that, among products, textiles and
clothing have the highest weighted-average tariff rates.
TABLE 2 Average Tariffs on Industrial Products
Pre-Uruguay Round Post-Uruguay Round
(a) By Country/Region
Developed countries’ imports from
World 6.2% 3.7%
North America 5.1 2.8
Latin America 4.9 3.3
Western Europe 6.4 3.5
Central/Eastern Europe 4.0 2.4
Africa 2.7 2.0
Asia 7.7 4.9
Developing countries’ imports from
World 20.5% 14.4%
North America 23.2 15.7
Latin America 27.6 18.5
Western Europe 25.8 18.3
Central/Eastern Europe 18.4 15.1
Africa 12.3 8.0
Asia 17.8 12.7
(b) By Product
All industrial products* 6.3% 3.8%
Fish and fish products 6.1 4.5
Wood, pulp, paper, and furniture 3.5 1.1
Textiles and clothing 15.5 12.1
Leather, rubber, and footwear 8.9 7.3
Metals 3.7 1.4
Chemicals and photographic supplies 6.7 3.7
Transport equipment 7.5 5.8
Nonelectric machinery 4.8 1.9
Electric machinery 6.6 3.5
Mineral products and precious stones 2.3 1.1
Manufactured articles, not elsewhere specified 5.5 2.4
Industrial tropical products 4.2 2.0
Natural resource–based products* 3.2 2.1
*Excluding petroleum products.
Source: Report on “The Uruguay Round,” Committee on Trade and Development, Seventy-Seventh Session, November 21
and 25, 1994, obtained from the WTO website, http://www.wto.org/english/docs_e/legal_e/Idc2_512.htm. ●
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Generally speaking, economists are very skeptical of this line of thinking. As a promi-
nent example, Alan Greenspan, then-chair of the Board of Governors of the Federal
Reserve, told Congress in March 2004 that tying labor standards to trade agreements
would hurt the United States and that worries over job loss would be better handled by
improved education.16 Often the preceding arguments are being put forth by developed-
country labor under the mantle of humanitarian concerns when in fact the real motivation
for the “concern” is protection. The Heckscher-Ohlin and Stolper-Samuelson theorems
from Chapter 8 would lead us to expect that the scarce factor of production in the United
States and other developed countries (labor and, more specifically, relatively unskilled or
low-tech labor) would be injured by an expansion of trade and would gain from protec-
tion. Further, the specific-factors model in Chapter 8 also indicated that capital owners in
import-competing industries in capital-abundant countries lose from trade as well, which
can explain the desire of developed-country firms in import-besieged sectors to seek these
new, potentially persuasive arguments for protection. With regard to the child labor issue
per se, a case can be made that, without the work of children in developing countries, a
typical family might find itself in considerably greater economic difficulty. Children can
be economic assets in a developing-country setting, and production is also often carried
out by the family unit as a whole, such as in carpet weaving in parts of India.17 Also, the
imposition of rules from the outside regarding working conditions is not behavior that
developing countries will want to accept. Finally, according to Brown and Stern (2008),
labor standards need to be tailored to the conditions of a particular country in order to be
effective, and domestic support is necessary for the standards to be successful. In addi-
tion, moral suasion is more likely to alter social norms regarding labor standards than are
threats of trade sanctions and penalties.18
Along with the issue of labor standards, concern has been expressed with regard to the
role of environmental standards. The reservations expressed here are that freer trade and
investment have meant that companies, and therefore production, have been encouraged
to locate where environmental protection is the most lax. The upshot is that because lax
environmental standards mean that pollution-control equipment and the like does not
have to be installed, firms in the weak-standard countries (usually developing countries)
will be able to undercut firms (usually in developed countries) that must pay such costs.
Because of the differing environmental standards, firms in developed countries are thus
faced with “unfair” competition because their governments have tougher environmental
standards in place. Further, world pollution problems worsen because production centers
where environmental protection is weakest. In addition, because of the trade disadvan-
tage for firms in the less polluted countries, there is a tendency for those firms to press
their governments for a relaxation of standards. The argument then concludes that there
is a “race to the bottom” in terms of environmental protection. An alternative, of course,
is for developed-country governments to pressure developing-country governments for
tighter standards or to simply impose protection on the products coming from the devel-
oping countries.
16Greg Ip, “Greenspan Warns Trade Standards Will Harm U.S.,” The Wall Street Journal, March 12, 2004, p. A2.
17As a potentially useful alternative to child labor, developed countries or international organizations could pro-
vide education grants to offset income losses as well as to enhance the skill levels of the younger members of the
labor force (such as has been done in Brazil).
18Andrew G. Brown and Robert M. Stern, “What Are the Issues in Using Trade Agreements to Improve
International Labor Standards?” World Trade Review 7, no. 2 (April 2008), pp 331–57.
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19For discussion of some of these issues, see Edward Wilson, “Preparation for Future WTO Trade Negotiations,”
USITC International Economic Review, May/June 1999, pp. 15–21.
20In fact, Dartmouth economist Douglas Irwin entitled an opinion piece in The Wall Street Journal, “How Clinton
Botched the Seattle Summit” (December 6, 1999, p. A34).
Obviously, environmental concerns are worthy of attention. But an economic response
to these views is that the problem is essentially one of environmental protection per se,
not a matter of trade. The specificity principle of Chapter 15 applies in this context—the
solution to pollution problems lies in measures that reduce pollution, not in measures that
restrict trade. In addition, especially if multinational companies are engaged in exporting
from developing countries, the exporting companies often adhere to higher environmen-
tal standards than do domestic firms within the developing countries. If protection in the
developed countries restricts developing countries’ exports, then factors of production will
be forced to move to domestic firms, where even less attention to the environment is paid.
Finally, as noted in The Economist (October 9, 1999, p. 17), if trade indeed makes countries
better off, the countries will want a cleaner environment as they get wealthier, and they will
be able to devote more resources to that objective than was previously the case (a point that
has been supported by empirical studies). In other words, expansion of trade rather than
restriction of trade may be in order.
Besides these debates on labor standards and environmental protection, other matters
were proposed for inclusion in a new round of trade negotiations.19 In a series of meetings,
many countries expressed a desire to broaden and deepen trade rules regarding market
access for services, as well as a desire to consider foreign investment rules in more detail.
The European Union and Japan emphasized the need to include antitrust and competition
policy in the negotiations, as such differences across countries can yield different pricing
and behavior by firms. There was also concern by some developing countries about the
phase-out schedule (1995–2004) of the long-standing 1970s Multi-Fiber Arrangement on
textiles and clothing, and some developing countries as well as developed countries urged
full integration of agricultural goods into the WTO framework on the same comprehensive
basis as manufactured goods. Further issues related to treatment of electronic commerce
and progress on elimination of abuses of intellectual property rights.
At the end of November and beginning of December 1999, trade ministers from the
134 WTO member countries met in Seattle, Washington, to discuss and agree upon the
agenda for a next round of multilateral trade negotiations. It was widely anticipated that
the sessions would be contentious, but what was underestimated was the contentiousness
of various groups of non-WTO people opposing further relaxation of trade barriers world-
wide. The week of the ministerial conference was marked by large and noisy demonstra-
tions, and in fact by some violence, in Seattle. The groups demonstrating against the WTO
were a diverse lot—trade unionists concerned about the threat to their jobs and wages
from greater imports of labor-intensive goods from developing countries, “greens” con-
cerned about the environmental damage associated with trade expansion, and opponents of
child labor, among others. Also prominent were individuals and groups who (incorrectly)
viewed the WTO as an agency with massive power, in effect as an agency of supranational
status that could dictate all sorts of rules to its member nations.
The end result of the disagreements over the agenda, together with the disruptive dem-
onstrations, was that the conference ended with no agreement for a new round of nego-
tiations. This failure had, in addition, been facilitated by President Clinton, who, though
wanting a new round of negotiations, had spoken in Seattle of the desirability of incorpo-
rating labor standards into the WTO, a viewpoint which angered developing countries.20
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IN THE REAL WORLD:
NATIONAL SOVEREIGNTY AND THE WORLD TRADE ORGANIZATION
Publicity surrounding the World Trade Organization (WTO)
often conveys the idea that the WTO has sovereignty over
its member nations. This is a misinterpretation of the orga-
nization in that the WTO is an international institution com-
prised of member nations whose objective is to facilitate
agreements between member countries to reduce barriers to
trade and mediate any disagreements between countries that
may arise in carrying out the agreements in question. All
rules, principles, and agreements are made by or between
WTO members, not by the WTO itself. If there is any loss
of sovereignty in a given agreement, it is essentially a swap
in that access to the home market is exchanged for equally
valuable access to the foreign market. Further, any country
is free to abandon an agreement in question at any time.
However, it will likely lose its foreign access right in the
process, because it is unlikely that other members will main-
tain their side of the agreement if the one participant reneges
on its end. One objective of the WTO is to provide a mediat-
ing mechanism so that agreements are applied in a nondis-
criminatory manner and challenges to trade agreements do
not lead to trade wars and an unraveling of the world trading
system as happened in the 1930s.
Economists at the Organisation for Economic Co-oper ation
and Development (OECD) in Paris have usefully clarified
what WTO membership rules do not require:*
• WTO rules do not prevent member countries from estab-
lishing their own policy objectives or applying regula-
tory measures required to achieve those objectives.
• WTO rules do not require that member countries elim-
inate all barriers to imports.
• WTO rules do not require that member countries
adopt a uniform set of trade regulations or trade pro-
cedures but require only that the regulations or pro-
cedures be applied in a nondiscriminatory (MFN)
manner. However, even here, exceptions are permitted
for regional trade agreements as well as for measures
which may relate to a legitimate national or interna-
tional public policy objective.
• WTO rules do not require that member countries
reduce tariffs or barriers to foreign services. They do,
however, provide a mechanism for binding partici-
pants to an agreement in order to provide predictability
and market access when there is a freely negotiated
agreement.
• WTO rules do not prevent member countries from pro-
viding public funds to support domestic policies and
regulatory objectives.
• WTO rules do not require that member countries
accept each other’s product-quality, service, or safety
standards. Rather, the WTO membership has adopted
rules pertaining to the preparation, adoption, and
application of such standards as they relate to legiti-
mate country social objectives. WTO also encourages,
but does not mandate, regulatory cooperation directed
toward the harmonization of standards or the develop-
ment of mutual recognition agreements pertaining to
each member country’s standards.
In sum, the WTO is not a sovereign authority but, rather,
an institution made up of and controlled by member nations
for the purpose of facilitating the flow of goods and services
between members. It is an institutional mechanism for assist-
ing countries in making mutually acceptable agreements to
facilitate international transactions, carrying them out in a
nondiscriminatory manner, and holding each other to the
bargains to which they have agreed. For a WTO summary
of its nature and objectives, see the appendix to this chapter.
*Organisation for Economic Co-operation and Development,
Open Markets Matter: The Benefits of Trade and Investment
Liberalisation (Paris: OECD, 1998), pp. 125–27. ●
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After the failure of the ministerial meeting in Seattle, many observers were pessimis-
tic about the chances for a new round of trade negotiations, and multilateral trade matters
lay dormant for some time (although activity continued on bilateral and regional agree-
ments, see Chapter 17). Within two years, however, trade ministers met in Doha, Qatar,
in November 2001 under the auspices of the WTO to attempt to put in place a new mul-
tilateral trade negotiation round. (Some cynics maintained that remote Doha was selected
for the WTO meeting so that the number of protesters would be kept to a minimum.) And
indeed, on November 14, 2001, the 142 WTO members announced that a new round would
The Doha
Development Agenda
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21Much of the rest of this paragraph is drawn from “Seeds Sown for Future Growth,” The Economist, November
17, 2001, pp. 65–66.
22Ibid., p. 65.
23United States Trade Representative, “USTR Fact Sheet Summarizing Results from WTO Doha Meeting,”
November 14, 2001, obtained from www.ustr.org.
24Economic Report of the President, February 2004 (Washington, DC: U.S. Government Printing Office, 2004),
p. 236.
25Edward Wilson, “WTO Trade Negotiations after Cancun,” U.S. International Trade Commission, International
Economic Review, January/February 2004, pp. 9–10.
26Ibid., pp. 10–11; Scott Miller, “WTO Drug Pact Lifts Trade Talks,” The Wall Street Journal, September 2,
2003, p. A2.
begin,21 to be called the Doha Development Agenda. Promises were made to reduce trade bar-
riers further, including those in the agricultural sector. A particular focus of trade liberalization
was to be on making clearer and stricter the rules for imposing antidumping duties. Several of
the plans for the round were of considerable potential benefit to developing countries, such as
the intent to give developing countries cheaper access to pharmaceuticals (e.g., for combating
HIV/AIDS in Africa). In the words of The Economist, “In a sign of their increasing clout, poor
countries won a clear victory over the drug makers.”22 Other potential benefits to developing
countries could come from special trade preferences and from promised improved access for
agricultural exports to developed countries’ markets. Also, the fact that there were no com-
mitments made in regard to labor standards and trade was also regarded as a victory for the
developing countries.
Overall, the plans for liberalization were ambitious, as they could, for example, lead
to a future elimination of agricultural export subsidies as well as a reduction in domestic
agricultural support programs. In nonagricultural goods, no sectors or products were to be
excluded from the negotiations. Further, broad statements were made regarding commit-
ments to promote sustainable development, eliminate environmentally harmful trade pol-
icy measures, and make all border procedures more transparent and efficient. A statement
to strive for greater discipline in government procurement was made, with the intent of
fighting corruption, and a working group was to be established to examine the relationships
among trade, debt, and finance. Further, the ministers agreed to make the WTO dispute
settlement procedures more transparent and to attempt to identify core principles regarding
policy within countries toward anticompetitive practices and competition.23
The ultimate results of a successful trade negotiation round on these issues could be
important. One estimate was that world GDP would be $355 billion larger in the year
2015 than otherwise if the round is successful. Another estimate was that U.S. GDP would
increase by $144 billion per year greater than otherwise (or an additional $2,000 for a U.S.
family of four).24 A survey of the welfare effects of trade liberalization by Dewbre and
Brooks (2006) indicated that the total gains ranged from $44 billion to $518 billion. The
larger estimates reflected dynamic effects over time rather than simply the immediate static
effects of trade liberalization.
After this ambitious beginning, however, there were many disappointments. Various nego-
tiating groups met in 2002 and 2003 to discuss areas of contention, but not much progress was
made.25 On August 30, 2003, though, the WTO members did agree that developing countries
could import generic copies of drugs used against diseases of a substantial threat (e.g., AIDS
and malaria) and that the drugs could also be produced in developing countries with the capa-
bility to do so, as long as the drugs were then exclusively exported to developing countries
that needed them. There were several specific, detailed procedural provisions to be followed
before the drug shipments could occur, but this agreement constituted substantive progress.26
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Following these various developments, trade ministers met in September 2003 in
Cancun, Mexico, and again in Geneva in July 2004. The 2003 meeting was characterized
by disagreements regarding, for example, developed-country export subsidies, nonagri-
cultural market access, and competition policy, and met with little success. The Geneva
meeting ended more positively as it produced success in eliminating and/or reducing sub-
sidies and tariffs on manufactured goods.27 However, frustrations at a subsequent 2005
Hong Kong meeting resulted in the suspension of the Doha round in July 2006 by WTO
Director General Pascal Lamy. The suspension followed “the refusal of the United States
to make bigger cuts in farm subsidies if the EU and emerging developing countries such as
India, China, and Brazil did not reduce their tariffs on agricultural and industrial products
respectively.”28
After this suspension, trade ministers from approximately 30 key countries met in
Davos, Switzerland, in January 2007 and agreed to restart negotiations. Subsequent meet-
ings at various locations led to detailed draft agreements, but no final comprehensive
Doha Development Agenda agreement has yet been accomplished as of this writing. One
indicator of progress was the success in July 2015 in expanding an earlier Information
Technology Agreement so that tariffs on a very large number of exports in that sector will
be phased out.29 Earlier, at a WTO conference in Bali, Indonesia, in 2013, trade ministers
had approved a Trade Facilitation Agreement that, when put into effect, would speed up
clearance of goods at ports and other customs procedures. The agreement will not take
effect until two-thirds of the WTO’s members have ratified it; in mid-2015, the ratification
process among WTO members was far from complete.30
Finally, Bernard Hoekman, Will Martin, and Aaditya Mattoo of the World Bank have
indicated that there are three broad outstanding issues that must be resolved by the par-
ticipants in the Doha Round: (1) country disagreements on which agricultural products
should be designated as “special” or “sensitive” and thus be exempt from a general for-
mula for tariff cuts as well as the nature of the safeguard mechanisms against agricultural
goods; (2)  differing views on the specific manufacturing sectors to which liberalization
commitments should be applied; and (3) disputes on the scope and coverage of current
commitments on liberalization of services.31
Another development with some promise that was and is being considered by econo-
mists, the World Bank, the IMF, and the WTO is the concept of Aid for Trade. This is the
notion that developing countries may not be able to gain from trade if they lack the infra-
structure (ports, roads, power, etc.) for exporting, and, hence, trade liberalization measures
may need to be accompanied by assistance from the developed countries to increase their
ability to trade. Thus, developing countries might be more willing to engage in multilateral
negotiations if trade barrier reductions were paired with assistance from developed coun-
tries that could help to generate greater exports.32
28“WTO Talks Called Off,” EurActiv.com, July 24, 2006, obtained from www.euractiv.com.
29Office of the United States Trade Representative,” U.S. Leads WTO Partners in Clinching Landmark Expansion
of Information Technology Agreement,” obtained from www.ustr.gov.
30”Trade Facilitation,” WTO News, September 4, 2015, available at www.wto.org.
31Bernard Hoekman, Will Martin, and Aaditya Mattoo, “Conclude Doha: It Matters!,” World Trade Review 9,
no. 3 (July 2010), pp. 521–26.
27Neil King, A2; Wilson, “WTO Trade Negotiations after Cancun,” pp. 11–12. “The WTO Doha Development
Round,” EurActiv.com, May 11, 2009, obtained from www.euractiv.com.
32See, for example, “Aid for Trade,” South Centre T.R.A.D.E. Policy Brief, November 2005, available at www
.uneca.org, and various materials available at the website of the Centre for Trade and Development, www.centad.org.
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In this subsection we summarize several important policy matters in recent U.S. trade
policy. An area of contention in U.S. trade policy has pitted the United States against the
European Union. Specifically, since 1989 the EU has had a ban in place on the import
of hormone-treated beef from the United States. This particular instance of genetic engi-
neering poses, in the minds of many Europeans, unacceptable health risks in the form of
increasing the probability of developing cancer. (Can we say the EU “beefs about beef,” or
would you not put much “stock” in that remark?) In the beef situation the WTO has ruled
against the EU policy several times. Supporting the WTO and the U.S. position is the fact
that many scientists have given the opinion that the hormone-treated beef is safe for con-
sumption. In July 1999, retaliatory tariffs of 100 percent were levied by the United States
on a number of EU products, including French mustard, Roquefort cheese, and truffles.33
The EU ban has remained in place, however, and the matter has continued to simmer since
1999. Later developments in 2009 are discussed below.
A tax policy of the United States has also been in dispute. For a number of years, the
United States has attempted to give tax relief to U.S. firms engaged in exports to increase
the profitability and therefore the amount of those exports. However, repeatedly, the favor-
able tax treatment has been ruled illegal because it constitutes an “unfair” export subsidy.
Under the tax package, referred to at the beginning of this chapter, U.S. firms could export
goods through offshore subsidiaries and receive a partial exemption from taxes on the
profits earned from the exports if the exports contain substantial U.S. components. This
tax relief helped some companies immensely—for example, Boeing and General Electric
received benefits from this “extraterritorial income exclusion” of more than $1 billion each
during the period 1997–2002. The WTO has ruled that such treatment is illegal, and the
U.S. Congress has been attempting, without success, to come up with an alternative.34
Another controversial U.S. policy action was the imposition of steep tariffs on steel
imports in March 2002. President George W. Bush imposed tariffs in the face of surging
steel imports, tariffs that ranged up to 35 percent (see Chapter 14). However, in November
2003, the WTO ruled that these tariffs were illegal in an answer to the U.S. appeal of a
similar March 2003 WTO decision. The European Union then reiterated its earlier threat
to place high tariff duties on a number of U.S. exports (such as orange juice, motorboats,
sunglasses, and clothing), and these tariffs were especially designed to inflict injury on
U.S. states that had supported George W. Bush in the 2000 presidential election. The Bush
administration responded that it had imposed the tariffs to give the domestic steel industry
an opportunity to restructure itself and to become stronger. Nevertheless, in December
2003, the administration eliminated the steel tariffs that it had imposed. The European
Union then canceled its plans to retaliate against the United States.35
In late 2003, the Bush administration took another unilateral policy action. Temporary
import quotas were placed on several textile items imported from China—brassieres,
bathrobes, and knit fabrics (which had recently totaled $645 million of imports for the
Recent U.S. Actions
33See Helene Cooper, “U.S. Imposes 100% Tariffs on Slew of Gourmet Imports in War over Beef,” The Wall
Street Journal, July 20, 1999, p. A6; U.S. Trade Representative, “Snapshot of WTO Cases Involving the United
States, March 9, 2004,” obtained from www.ustr.gov.
34See Geoff Winestock, “WTO Rules Against U.S. on Tax Break,” The Wall Street Journal, July 27, 1999,
p. A19; Shailagh Murray, “Congress Stalls on Lifting Illegal Export Tax,” The Wall Street Journal, February 13,
2004, p. A4.
35Neil King, Jr., and Carlos Tejada, “Bush Abandons Steel Tariff Plan,” The Wall Street Journal, December 5,
2003, p. A3; Neil King, Jr., Scott Miller, and Carlos Tejada, “U.S. Steel Tariffs Ruled Illegal, Sparking Potential
Trade War,” The Wall Street Journal, November 11, 2003, p. A1; Don Evans, “Victory,” The Wall Street Journal,
December 5, 2003, p. A12.
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three items).36 There has been long-simmering resentment in the United States against
Chinese imports in general and textile imports in particular because of the resulting large
numbers of job losses in manufacturing in general and in textiles that are claimed to be
attributable to the Chinese imports. We say “claimed” because many economists think
that, at least for manufacturing as a whole, sizeable productivity increases have played a
more important role in leading to job losses than have imports. The Bush administration
indicated that the quotas were used to protect against “surges” in imports, and China had
agreed that such surges could be protected against when China joined the WTO in 2001.
In addition, there has been substantial feeling in the United States that China has been
“unfair” in its trade with the United States, such as with pirating of software and with
keeping the Chinese currency “too low” in value to stimulate exports.37
U.S.–Chinese relations were further aggravated when the long-standing Multi-Fiber
Agreement in textiles and clothing, which controlled such imports into developed coun-
tries from developing countries, expired on January 1, 2005. Chinese exports to the United
States then increased at a very rapid rate. China, after pressure, imposed taxes on the export
of such goods to the United States but later rescinded them after restrictive U.S. “safe-
guard” action occurred. The United States then placed quotas on 34 apparel products from
China in an agreement that was to run from January 1, 2006, to December 31, 2008. In
addition, China agreed to allow more beef and medical equipment imports from the United
States and to permit greater competition by U.S. firms for Chinese government contracts,
among other actions.38 In addition, in March 2007, the U.S. Department of Commerce
changed its policy regarding the use of countervailing duties (to offset foreign subsidies)
with respect to China. Previously, antidumping duties could be levied against imports from
state-controlled economies, but countervailing duties were not assessed because of the
difficulty in identifying the subsidies. The Commerce Department decided that counter-
vailing duties could now be imposed, and it levied preliminary duties on a variety of paper
products from China.39 In September 2009 the United States, via a decision by President
Barack Obama, announced new tariffs of up to 35 percent on imported automobile tires
from China (which was later given support by a favorable WTO ruling).40 It seems clear
that trade disagreements between China and the United States will persist for some time
since substantial tensions continue to exist in 2015.
Other noteworthy recent developments can be mentioned. Agreement was reached in
2006 pertaining to a long dispute between the United States and Canada with respect to
U.S. imports of Canadian softwood lumber. While the United States and Canada have a
free trade agreement and a long history as each other’s largest trade partners, there are
still disagreements. The two nations have had a long-standing dispute over U.S. imports
of Canadian softwood lumber. As mentioned in Chapter 15, the dispute has centered on
36Neil King, Jr., and Dan Morse, “Bush Sets Quotas on Some Imports of Chinese Goods,” The Wall Street
Journal, November 19, 2003, pp. A1, A4.
37“Bush Sets Quotas on Some Imports of Chinese Goods,” pp. A1, A4.
38Charles Hutzler, “Beijing Rescinds Textile Duties, Slams U.S., EU on Import Limits,” The Wall Street Journal,
May 31, 2005, pp. A3, A6; Office of the United States Trade Representative, “Facts on Textiles: Benefits from
Establishing Quotas on Certain Chinese Apparel Exports to the United States,” obtained from www.ustr.gov;
Greg Hitt and Andrew Batson, “U.S., China Set Some Trade Deals, But Thorny Piracy Issues Persist,” The Wall
Street Journal, April 12, 2006, p. A4.
39Mark Drajem, “Commerce Department Applies New Duties against China (Update 7),” March 30, 2007,
obtained from www.bloomberg.com.
40Elizabeth Williamson and Tom Barkley, “U.S. Wins China-Tire Fight,” The Wall Street Journal, December
14, 2010, p. A6.
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41“U.S., Canada Sign Lumber Agreement,” The Wall Street Journal, July 3, 2006, p. A7.
42Office of the United States Trade Representative, “United States Imposes Tariffs on Softwood Lumber from
Four Canadian Provinces Due to Canada’s Failure to Comply with the Softwood Lumber Agreement,” press
release, April 7, 2009, obtained from www.ustr.gov.
43“Encouraging Signs on Achieving Free Trade,” Miami Herald, May 11, 2009, obtained from www.
miamiherald.com.
the U.S. allegation of subsidies by Canada to such exports. The U.S. duties had been
27 percent in 2002 but had decreased to an average of 11 percent in 2006 because of vari-
ous reviews and rulings. Many thought that the softwood lumber agreement in October
2006 would put an end to this long-standing dispute. In the agreement, Canada pledged
to place taxes on its exports if the lumber price falls below a certain level, in exchange
for the removal of tariffs and quotas by the United States and refunds of some earlier
tariff revenues.41
In April 2009, the United States announced the imposition of a 10 percent ad
valorem customs duty on imports of softwood lumber from four Canadian provinces.
The action was in response to a decision from a tribunal operating under the auspices
of the London (Ontario) Court of International Arbitration that Canada breached the
2006 softwood lumber agreement by failing to calculate quotas properly during the
first six months of 2007. The 10 percent duties are to remain in place until the United
States has collected the $54.8 million from the ruling. The softwood lumber agreement
is expected to remain in force for seven years, with the possibility of extension for an
additional two years.42
In summary fashion, we can mention a prominent additional aspect of U.S. trade pol-
icy. This aspect is that the United States has, in recent years, been negotiating bilateral
and regional trade agreements. As far back as 1985, a U.S.–Israel free trade agreement
went into effect. This was followed by the NAFTA, which began in 1994 and is discussed
in the next chapter. In addition, free-trade agreements with 20 countries are in effect
as of this writing. This recent step-up in bilateral/regional trade negotiation activity is
partly attributable to the fact that fast-track (Trade Promotion Authority) was restored
to the president in 2002 (with a one-vote margin in the House of Representatives) and
partly attributable to the slow going in the Doha Round multilateral negotiations. The
lack of multilateral progress suggests to officials that freer trade may be achieved more
quickly on a selective basis. In 2007, the movement on bilateral agreements seemed to
stall. The fast-track authority expired and the Democratic-controlled Congress was skep-
tical about the usefulness of bilateral agreements. In addition, the rhetoric of the 2008
presidential campaigns included a strong protectionist sentiment from most candidates.
When President Obama took office in January 2009, free-trade agreements were stalled
for Colombia, the Republic of Korea, and Panama.43 After considerable controversy and
discussion, the free-trade pacts for the three countries were approved in 2011. In 2015
after contentious debate in Congress, fast-track authority was reinstituted. This restora-
tion of fast-track permitted the Obama administration to engage fully in the Trans-Pacific
Partnership (TPP) negotiations among the United States and 11 countries. The TPP will be
discussed further in Chapter 17.
Finally, a phenomenon that has caught the attention of the American public is the prac-
tice of foreign outsourcing (or offshoring). Outsourcing was discussed in Chapter 9 in the
context of U.S. firms purchasing materials inputs from abroad. The current or “new” use
of the outsourcing/offshoring term refers to U.S. firms’ purchases of services abroad, ser-
vices that would otherwise be provided in the United States. The classic example referred
to is the use of Indian personnel in call centers, whereby a U.S. service call via a toll-free
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telephone number is answered or dealt with by someone in an Indian city such as Bangalore
or Mumbai (Bombay). (These services utilize capital inputs as well as the foreign labor
inputs—capital inputs that are often put in place by U.S. firms operating abroad.) These
service jobs are usually white-collar jobs, not blue-collar jobs, and thus the domestic group
being hurt is not the import-competing manufacturing industries’ relatively less-skilled
labor à la an application of Heckscher-Ohlin to the United States. Outsourcing seems to
have “taken off” in the 1990s when the U.S. economy was booming and firms were seek-
ing to reduce costs in a labor market that was close to or at full employment. In 2007 Alan
Blinder, a Princeton economist and former vice chair of the Board of Governors of the
Federal Reserve, thought that up to 40 million U.S. jobs might be at risk in the next 10 to
20 years.44 The hue and cry has led some states to attempt to implement explicit legisla-
tion against outsourcing, and there has also been pressure on the federal government to do
likewise.
Economists in general, however, do not regard outsourcing or offshoring as a cause for
alarm. There is absolutely no question that there are severe short-run dislocations from
outsourcing. Workers lose their source of income, and retraining for or physical movement
to a new job takes time. In the long run, however, the economy benefits from this free
trade in white-collar services, but the long run may take a good while to arrive. But people
may be skeptical of waiting for the long run—there was considerable consternation within
the Bush administration and some congressional calls for resignation when N. Gregory
Mankiw, chair of the president’s Council of Economic Advisers, said in early 2004 that
outsourcing “is probably a plus for the economy in the long run.”45
Another point is that there is increasing mention being made of the fact that outsourc-
ing may also lead to more jobs in the United States. For example, one (U.S. industry–
sponsored) study indicated that the use of service labor abroad reduces U.S. labor costs,
leads to increased productivity for U.S. firms, and hence yields greater profits that can
lead to companies’ expansion at home and abroad.46 As an example, another Wall Street
Journal article featured a firm in New Jersey that sent work abroad to Mumbai, which
reduced costs so much that the firm obtained a sizeable number of new customers and
expanded its operations in the United States.47 Further, another benefit to the country send-
ing jobs offshore is that the country can experience a rise in real income because of the
lower prices of the final output embodying the outsourced services as well as, indirectly, an
increase in corporate profits and dividends for the companies doing the outsourcing. One
estimate is that perhaps 70 percent to 80 percent of the income gains from the offshoring/
outsourcing phenomenon go to the outsourcing country and the remaining 20 percent to 
30 percent to the country performing the outsourced services.48 In addition, business
writer Robert Samuelson pointed out that most estimates of annual U.S. job loss because
of outsourcing were around 300,000 to 500,000 jobs, and this is a very small percentage
44Clare Ansberry, “Outsourcing Abroad Draws Debate at Home,” The Wall Street Journal, July 14, 2003, p. A2;
David Wessel and Bob Davis, “Pain from Free Trade Spurs Second Thoughts,” The Wall Street Journal, March
28, 2007, p. A1.
45Bob Davis, “Some Democratic Economists Echo Mankiw on Outsourcing,” The Wall Street Journal, February
12, 2004, p. A4.
46Michael Schroeder, “Outsourcing May Create U.S. Jobs,” The Wall Street Journal, March 30, 2004, p. A2.
47Craig Karmin, “‘Offshoring’ Can Generate Jobs in the U.S.,” The Wall Street Journal, March 16, 2004,
pp. B1, B7.
48David Smith, “Offshoring: Political Myths and Economic Reality,” The World Economy 29, no. 3 (March
2006), pp. 251–52.
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of around 140  million U.S. jobs.49 Further, a study by Bradford Jensen and Lori Kletzer
(2008) indicated that while the number of U.S. jobs potentially being offshored (“losses”)
stands at about 15 to 20 million, there are job “gains” from growing U.S. exports of the
services of high-skilled workers (“inshoring”). In fact, they estimate that these “gains” will
offset the “losses.”50 Indeed, it is worth remembering that the United States has been a net
exporter of services for many years, and the United States is the largest services exporter
in the world. An interesting recent development is that some developing-country textile
firms may in fact be reversing the outsourcing process in that the firms are investing in the
United States due to rising labor and other costs at home.51
As should be evident from these policy examples and the debate over outsourcing, inter-
national trade policy continues to be controversial in the United States. As has been stated
many times in this book, there are gainers and losers from a policy of moving to freer trade,
and, though a country gains overall, compensation is not generally paid to the people who
lose. Hence, income distribution is affected by trade, and there will always be controversy
over policies in this area.
CONCLUDING OBSERVATIONS ON TRADE POLICY
International negotiations, both multilateral and bilateral, have clearly reduced the level
of trade restrictions over the long run in industrialized countries. Any continued advance
along these lines requires that countries remain willing to sit down at the bargaining table
to negotiate trade policies in their mutual interest. Chapter 15 discussed various arguments
for protection which indicate that sometimes an individual country can gain from the impo-
sition of a trade restriction, even though the welfare of the world is reduced. But a gain
under these circumstances tenuously depends on the absence of retaliation from adversely
affected trading partners. International negotiations serve the critical purpose of keeping
countries from unilaterally imposing new barriers. Historically, these negotiations have
demonstrated that it is in a country’s interest to reduce barriers rather than raise them.
Cooperation, not unilateral action, plays a vital role in enhancing both the welfare of the
world and the interests of individual countries.
Disputes regarding trade policy reveal an underlying broad conflict on the relative extent
to which the conduct of trade policy should be rules based or results based. A rules-based
trade policy is one that adheres to commonly accepted international guidelines and
codes of behavior on trade, such as those embodied in the WTO. This type of policy
embraces MFN treatment, preference for tariffs as the instrument of choice rather than
import quotas and VERs (which are more distortionary for resource allocation than tariffs
and also discriminatory by country), common procedures on antidumping and countervail-
ing duties, multilateral negotiations on trade barrier reductions, and so forth.
On the other hand, a results-based trade policy stresses that policy should seek,
through aggressive, unilateral action or threat of action, to achieve carefully specified
The Conduct of Trade
Policy
49Robert Samuelson, “Threat of Outsourcing Overstated,” The Charlotte Observer, January 17, 2004, p. 13A.
50J. Bradford Jensen and Lori G. Kletzer, “ ‘Fear’ and Offshoring: The Scope and Potential Impacts of Imports and
Exports of Services,” Policy Brief, Peterson Institute for International Economics, January 2008, p. 1.
51See, for example, Cameron McWhirter and Dinny McMahon, “Spotted Again in America: Textile Jobs,” The
Wall Street Journal, December 21–22, 2013, pp. B1, B4.
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objectives, such as the penetration of a particular foreign market for a particular good
by x percent, the limitation of imports of a particular good to y percent of the domestic
market, special protection and incentives to particular industries, and attainment of bal-
anced trade with specified trading partners. Or, the policy might be for a home country
to treat each individual trading partner country exactly as that partner treats the home
country with respect to trade—sometimes called the “new reciprocity approach to trade
policy.” (See Cline, 1983.) This more direct, results-based approach to the guidance of
resource allocation is also sometimes known as a form of industrial policy or as
managed trade.
Many observers of recent U.S. trade patterns feel that since other countries are more
interventionist in trade than the United States, the United States should respond by
according a stronger role to government. These observers advocate the results-based
approach. On the other hand, other observers (including most economists) indicate that
allocation of resources by government will be inferior to allocation of resources by the
market. The superior market allocation is best attained in an environment of an estab-
lished set of “rules.”
SUMMARY
This chapter examined political economy influences, such as
interest groups and social concern, on trade policy. This was
accompanied by a review of U.S. trade policy which high-
lighted the long-term trend of liberalization of trade, first
through bilateral and then through multilateral negotiations.
After the disastrous effects of the Smoot-Hawley Tariff of 1930,
the United States began a long process of reducing tariff barri-
ers. The Reciprocal Trade Agreements Act of 1934 initiated a
series of bilateral, item-by-item negotiations that achieved some
success. These procedures were superseded by the emergence
of GATT at the end of World War II, and GATT sponsored
eight rounds of multilateral negotiations that brought tariffs on
manufactured goods to relatively low levels. Although recent
years witnessed the rise of many nontariff barriers and of dif-
ficulties in the Uruguay Round with respect to services and
agriculture, nevertheless the Uruguay Round was successfully
concluded. Attempts to continue the path of long-term liberal-
ization of trade are obviously desirable from the standpoint of
increasing world welfare, but a failure to conclude the nego-
tiations on the Doha Development Agenda tentatively suggests
that further important multilateral liberalization is not highly
likely in the near future. However, there has been substantial
progress in bilateral and regional negotiations, as discussed fur-
ther in the next chapter.
KEY TERMS
across-the-board approach
Aid for Trade
bilateral negotiations
directly unproductive activity
Doha Development Agenda
fast-track procedure (or Trade
Promotion Authority)
GATT rounds of trade negotiations
General Agreement on Tariffs and
Trade (GATT)
industrial policy
item-by-item approach
Kennedy Round of trade
negotiations
managed trade
median-voter model
multilateral negotiations
nonreciprocity principle
outsourcing (or offshoring)
public-choice economics
Reciprocal Trade Agreements Act
of 1934
rent-seeking activity
results-based trade policy
rules-based trade policy
Smoot-Hawley Tariff (Tariff Act
of 1930)
status quo bias
Tokyo Round of trade negotiations
Trade Act of 1974
trade adjustment assistance (TAA)
Trade Expansion Act of 1962
Uruguay Round of trade
negotiations
World Trade Organization (WTO)
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QUESTIONS AND PROBLEMS
1. Explain two reasons a minority in a median-voter model is able
to obtain net benefits through a restrictive trade policy that
clearly harms the majority group and the country as a whole.
2. In what respects might bilateral trade negotiations be supe-
rior to multilateral trade negotiations? In what respects
might multilateral trade negotiations be superior to bilateral
trade negotiations?
3. The number of consumers in the United States far exceeds
the number of workers in textiles and apparel, for example,
so why do we see import restrictions on textiles and apparel
despite the obvious losses to consumers?
4. Explain why a government’s commitment to income distri-
bution issues can cause policy to be protectionist. Is such
policy inevitable if income distribution is a key target?
5. (a) Why might an economist see virtue in the concept of trade
adjustment assistance (TAA)? What difficulties might be
encountered in practice in the implementation of TAA?
(b) Some economists think that TAA is discriminatory
because special assistance is given to workers dis-
placed by imports while workers displaced by domes-
tic competition receive no such special favors. Do you
think this observation rules out TAA as a desirable
policy? Why or why not?
6. Why have tariff reductions been substantial over the years
while reductions in nontariff barriers have been minimal?
7. (a) Build a case in favor of the use of the nonreciprocity
principle for developing countries.
(b) Build a case against the use of the nonreciprocity prin-
ciple for developing countries.
8. If all interventions in agriculture were removed, what
would happen to food prices? To the incomes of farmers?
To world welfare? Might your answer be different for some
developing countries than for developed countries?
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LEARNING OBJECTIVES
LO1 Differentiate among the four basic levels of economic integration.
LO2 Identify the static and dynamic effects of economic integration.
LO3 Analyze the economic integration experience of countries in the
European Union.
LO4 Describe key integration agreements of the United States.
LO5 Summarize other important economic integration efforts in the world.
ECONOMIC
INTEGRATION 17
CHAPTER
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INTRODUCTION
The European Union (EU) began over 50 years ago with 6 members. The addition of Bulgaria
and Romania in 2007 brought the EU to its current membership of 27. The enlargements in 2004
and 2007 allowed an unrestricted flow of goods, services, people, and money to and from nations
that prior to 1989 were part of the Soviet bloc. The EU now stretches from the Atlantic Ocean to
the Black Sea.1 “Twenty years after its enactment, the North American Free Trade Agreement
(NAFTA) continues to divide Americans and cast a shadow over the US trade agenda.”2
In our previous discussions of trade policy, we generally conducted the analysis in a frame-
work whereby a country was raising or lowering trade barriers against all trading partners
simultaneously and uniformly. However, as suggested above, much international trade
is taking place in a context where countries find themselves increasingly integrated with
specific trading partners. This treatment usually occurs by way of economic integration,
where countries join together to create stronger economic and institutional ties although
such a process is not without controversy. What precisely is economic integration? What
are the benefits that cause all these nations to want to join an economic union? Are there
costs involved? In this chapter, we discuss several different types of economic integration,
present a framework for analyzing the welfare impacts of these special relationships, and
examine recent integration efforts in the world economy.
TYPES OF ECONOMIC INTEGRATION
When countries form economic coalitions, their efforts represent a partial movement to
free trade and an attempt by each participating country to obtain some of the benefits of a
more open economy without sacrificing control over the goods and services that cross its
borders and hence over its production and consumption structure. Countries entering spe-
cial trade arrangements soon realize that the more they remove restrictions on the move-
ment of goods and services between members of the group, the more domestic control of
the economy is lost. Consequently, actions taken to integrate economies often take place
in stages, and the first preferential agreement is potentially less threatening to the loss of
control than the later stages. Four basic types of formal regional economic arrangements
are usually distinguished.
The most common integration scheme is referred to as a free-trade area (FTA). In this
arrangement, all members of the group remove tariffs on each other’s products, while at the
same time each member retains its independence in establishing trading policies with non-
members. In other words, the members of an FTA can maintain individual tariffs and other
trade barriers on the “outside world.” This scheme is usually assumed to apply to all prod-
ucts between member countries, but it can clearly involve a mix of free trade in some prod-
ucts and preferential, but still protected, treatment in others. However, when each member
country sets its own external tariff, nonmember countries may find it profitable to export a
product to the member country with the lowest level of outside protection and then through
it to other member countries whose protection levels against world are higher. Without
rules of origin by members regarding the source country of a product, there is nothing to
Promise and Problems
of Integration
1“Europa: Gateway to the European Union,” http://europa.eu/pol/enlarg/overview_en.htm. © European Communi-
ties, 1995–2009. (Note that the the European Union now has 28 members after the 2013 addition of Croatia.)
2Gary Clyde Hufbauer, Cathleen Cimino, and Tyler Moran, “NAFTA at 20: Misleading Charges and Positive
Achievements,” Peterson Institute for International Economics, Number PB 14–13, p.1.
Free-Trade Area
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preclude nonmember countries from using this transshipment strategy to escape some of
the trade restrictions in the more highly protected member countries. The most prominent
FTA at present is, of course, the free-trade area set up in 1994 by Canada, Mexico, and the
United States under the North American Free Trade Agreement (NAFTA) discussed
later in this chapter.
The second level of economic integration is a customs union. In a customs union, all tar-
iffs are removed between members and the group adopts a common external commercial
policy toward nonmembers. Furthermore, the group acts as one body in the negotiation
of all trade agreements with nonmembers. The existence of the common external tariff
takes away the possibility of transshipment by nonmembers. The customs union is thus a
step closer toward economic integration than the FTA. In this situation, though, member
nations give up independence in setting tariff rates. An example of a customs union is that
of Belgium, the Netherlands, and Luxembourg (Benelux), which was formed in 1947 and
absorbed into the European Community (EC) in 1958.
The third level of economic integration is referred to as a common market. All tariffs are
removed between members, a common external trade policy is adopted for nonmembers,
and all barriers to factor movements among the member countries are removed. The free
movement of labor and capital between members represents a higher level of economic
integration and, at the same time, a further reduction in national control of the individual
economy. However, members give up sovereignty in immigration and capital flows. In
addition, factor integration has proven to be very difficult. The Treaties of Rome in 1957
established a common market within the European Community (EC), which officially
began on January 1, 1958, and which became the European Union (EU) on November 1,
1993. (The EU is discussed later in this chapter.)
The most comprehensive of the four forms of economic integration is an economic union.
Characteristics include all features of a common market but also implies the unification
of economic institutions and the coordination of economic policy throughout all member
countries. While separate political entities are still present, an economic union generally
establishes several supranational institutions whose decisions are binding upon all mem-
bers. When an economic union adopts a common currency, it has become a monetary
union as well. A problem is that, while this level of economic integration is often aspired
to, member countries find it extraordinarily difficult to give up the domestic sovereignty
the scheme requires. Giving up autonomy in monetary policy is also a concern.
Thus, there are several different forms of economic integration. Existing integration
units exhibit a wide variety of differing characteristics.
THE STATIC AND DYNAMIC EFFECTS OF ECONOMIC INTEGRATION
Economic integration implies differential treatment for member countries as opposed to
nonmember countries. Because this type of integration can lead to shifts in the pattern of
trade between members and nonmembers, the net impact on a participating country is, in
general, ambiguous and must be judged on the basis of each individual country. While inte-
gration represents a movement to free trade on the part of member countries, at the same
time it can lead to the diversion of trade from a lower-cost nonmember source (which still
faces the external tariffs of the group) to a member-country source (which no longer faces
any tariffs). These two static effects of economic integration, meaning that they occur
Customs Union
Common Market
Economic Union
Static Effects of
Economic Integration
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directly on the formation of the integration project, are called trade creation and trade
diversion. These terms were coined by Jacob Viner (1950), who defined trade creation
as taking place whenever economic integration leads to a shift in product origin from a
domestic producer whose resource costs are higher to a member producer whose resource
costs are lower. This shift represents a movement in the direction of the free-trade alloca-
tion of resources and thus is presumably beneficial for welfare. Trade diversion takes place
whenever there is a shift in product origin from a nonmember producer whose resource
costs are lower to a member-country producer whose resource costs are higher. This shift
represents a movement away from the free-trade allocation of resources and could reduce
welfare. Because both trade creation and trade diversion are clearly possible with economic
integration, we find ourselves in the world of “second best” because economic integration
represents only a partial movement to free trade. Whether or not it produces a net benefit
to participating countries is an empirical issue.
Let us approach this second-best problem (“first best” being completely free trade) by
examining the impact of economic integration in a market for a single good in one of the
member countries, country A. In Figure 1, DA is the demand curve by country A’s consum-
ers for the good and SA is the supply curve of country A’s home producers. Assume that
country A is importing the good from country B as well as producing it domestically prior
to the formation of the economic integration unit (e.g., a customs union). If country A is a
price taker in the world market at $1.00 per unit from country B and there is a 50 percent
tariff on the good, the domestic price in A is $1.50,3 the quantity consumed is 200 units,
3Throughout the analysis of this chapter, we are assuming no transportation costs between trading countries.
FIGURE 1 Trade Creation and Welfare
Price
SA
Quantity
c d
100
a b
160 200 250
$1.50
$1.00
0
PA = PB (1 + t )
PB
DA
Before the economic integration, the price of the good in country A is $1.50 (= the $1.00 price in country
B plus the 50 percent tariff). With integration between A and B, the tariff is removed, and A now imports
150 units (250 units − 100 units) rather than 40 units (200 units − 160 units) from B. Sixty units (160 − 100)
of the increased imports displace previous home production, and 50 units (250 − 200) reflect the greater
consumption at the new $1.00 price facing country A’s consumers. The net welfare impact is the sum of
areas b and d, or (1/2)(60)($0.50) + (1/2)(50)($0.50) = $27.50.
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IN THE REAL WORLD:
ECONOMIC INTEGRATION UNITS
Table 1 lists some of the regional economic groups in the
world today. The units differ in the extent of integration
desired or formed and in the degree to which they have actu-
ally carried out the intended integration. You can see that
a large number of the world’s more than 200 nations have
undertaken economic integration projects, and the impact
on trade can be significant. For example, the EU comprises
about 40 percent of world trade.
TABLE 1 Economic Integration Units in the World Economy
Andean Community (CAN)
Bolivia
Colombia
Ecuador
Peru
Associate Members:
Argentina
Brazil
Chile
Paraguay
Uruguay
Arab Maghreb Union (AMU)
Algeria
Libya
Mauritania
Morocco
Tunisia
Association of Southeast
Asian Nations (ASEAN)
Brunei
Burma (Myanmar)
Cambodia
Indonesia
Laos
Malaysia
Philippines
Singapore
Thailand
Vietnam
Caribbean Community
and Common Market
(CARICOM)
Antigua and Barbuda
Bahamas, The
Barbados
Belize
Dominica
Grenada
Guyana
Haiti
Jamaica
Montserrat
St. Kitts and Nevis
St. Lucia
St. Vincent and the Grenadines
Suriname
Trinidad and Tobago
Associate Members:
Anguilla
Bermuda
British Virgin Islands
Cayman Islands
Turks and Caicos Islands
Central American Common
Market (CACM)
Costa Rica
El Salvador
Guatemala
Honduras
Nicaragua
Common Market for
Eastern and Southern Africa
(COMESA)
Burundi
Comoros
Congo, Democratic Republic of
Djibouti
Egypt
Eritrea
Ethiopia
Kenya
Libya
Madagascar
Malawi
Mauritius
Rwanda
Seychelles
Sudan
Swaziland
Uganda
Zambia
Zimbabwe
Commonwealth of
Independent States (CIS)
Armenia
Azerbaijan
Belarus
Kazakhstan
Moldova
Russia
Tajikistan
Uzbekistan
Associate Member:
Turkmenistan
Participating, Unofficial
Member:
Ukraine
Economic and Monetary
Community of Central Africa
(CEMAC)
Cameroon
Central African Republic
Chad
Congo, Democratic Republic of
Equatorial Guinea
Gabon
The Gambia
Economic Community
of West African States
(ECOWAS)
Benin
Burkina Faso
Cabo Verde
Côte d’Ivoire
Gambia, The
Ghana
Guinea
Guinea-Bissau
Liberia
Mali
Niger
Nigeria
Senegal
Sierra Leone
Togo
European Free Trade
Association (EFTA)
Iceland
Liechtenstein
Norway
Switzerland
European Union (EU)
Austria
Belgium
Bulgaria
Croatia
Cyprus
Czech Republic
Denmark
Estonia
Finland
France
Germany
Greece
Hungary
Ireland
Italy
Latvia
Lithuania
(continued)
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IN THE REAL WORLD: (continued)
ECONOMIC INTEGRATION UNITS
Luxembourg
Malta
Netherlands
Poland
Portugal
Romania
Slovakia
Slovenia
Spain
Sweden
United Kingdom
Latin American Integration
Association (LAIA)
Argentina
Bolivia
Brazil
Chile
Colombia
Cuba
Ecuador
Mexico
Nicaragua
Panama
Paraguay
Peru
Uruguay
Venezuela
North American Free Trade
Agreement (NAFTA)
Canada
Mexico
United States
South Asian Association
for Regional Cooperation
(SAARC)
Afghanistan
Bangladesh
Bhutan
India
Maldives
Nepal
Pakistan
Sri Lanka
Southern African Customs
Union (SACU)
Botswana
Lesotho
Namibia
South Africa
Swaziland
Southern Cone Common
Market (MERCOSUR)
Argentina
Bolivia (suspended)
Brazil
Paraguay
Uruguay
Venezuela
Associate Members:
Chile
Colombia
Ecuador
Guyana
Peru
Suriname
West African Economic and
Monetary Union (WAEMU)
Benin
Burkina Faso
Côte d’Ivoire
Guinea-Bissau
Mali
Niger
Senegal
Togo
Source: Central Intelligence Agency, The World Factbook, obtained from www.cia.gov and http://europa.eu. ●
IN THE REAL WORLD:
TRADE CREATION AND TRADE DIVERSION IN THE EARLY STAGES
OF EUROPEAN ECONOMIC INTEGRATION
There have been numerous attempts to estimate trade cre-
ation and trade diversion in the real world. Many of them
have dealt with the European Community (EC) or the
“European Common Market” as it was traditionally called.
Estimates are difficult to make because the researchers are
comparing actual trade flows with trade flows that hypothet-
ically would have existed without the integration.
Bela Balassa was a leader in making creation-diversion
estimates. His approach (Balassa, 1974) utilizes the con-
cept of the ex post income elasticity of import demand
(YEM)—the average annual percentage change in observed
imports divided by the average annual percentage change
in observed GNP, with both changes evaluated at constant
prices (i.e., adjusting for inflation). For Balassa, after integra-
tion occurs, (a) a rise in the YEM for imports from partner
countries (intra-area imports) is denoted as gross trade cre-
ation, or increased imports from the partners whether or not
this new trade represents displacement of home production or
displacement of outside world production; (b) trade diversion
is indicated by a fall in the YEM for imports from the outside
(continued)
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IN THE REAL WORLD: (continued)
TRADE CREATION AND TRADE DIVERSION IN THE EARLY STAGES
OF EUROPEAN ECONOMIC INTEGRATION
world (extra-area imports); and (c) trade creation proper is
indicated by a rise in the YEM for imports from all sources
(partners and the outside world). A rise in the last YEM sug-
gests that the formation of the integration unit made the EC
more receptive to imports overall, meaning that there was a
relative turning away from domestic production. Underlying
the use of all three YEMs is the important assumption that the
YEMs would have remained constant if the formation of the
economic integration unit had not occurred.
Table 2 presents Balassa’s results, comparing the YEMs
before the EC took effect (1953–1959) with those of roughly
the first decade of the EC (1959–1970). It is clear that there
was substantial overall gross trade creation, since the YEM
for intra-area imports rose from 2.4 to 2.7. This means that,
before integration, each 1 percent rise in GNP yielded a
2.4 percent rise in intra-area imports, but after integration,
each 1 percent rise in GNP yielded a 2.7 percent increase in
these imports. Marked increases in this YEM took place in
fuels (from 1.1 to 1.6, an almost 50 percent increase), chemi-
cals, machinery, and transport equipment (all with increases
of over 20 percent). There was no overall trade diversion
because the total YEM for extra-area imports remained at
1.6. However, diversion occurred in nontropical food, bev-
erages, and tobacco; chemicals; and other manufactured
goods. The fall in nontropical food, beverages, and tobacco
reflected the adoption of import restrictions on the outside
world in connection with the EC’s Common Agricultural
Policy. Finally, overall trade creation proper of about
10 percent occurred because of a rise in the YEM for total
imports from 1.8 to 2.0. Major increases occurred in fuels,
machinery, and transport equipment.
It should be pointed out that these estimates involve more
than the static effects discussed in the text. The measures in this
table can move in unexpected directions (such as a rise in the
YEM for extra-area imports and a fall in the YEM for intra-
area imports) because of dynamic effects such as increased
economic growth and changes in tastes, or because of the
failure to allow for a change in the YEMs that would have
occurred even without integration. Finally, these estimates do
not directly address welfare impacts of the formation of the EC.
Nevertheless, they strongly suggest that welfare rose in the EC
at the initiation of what was to become the European Union.
TABLE 2 Ex Post Income Elasticities of Import Demand (YEMs), European
Community, 1953–1959 and 1959–1970
YEMs, 1953–1959 YEMs, 1959–1970
Intra-area imports (gross trade creation):
Chemicals 3.0 3.7
Fuels 1.1 1.6
Machinery 2.1 2.8
Nontropical food, beverages, tobacco 2.5 2.5
Raw materials 1.9 1.8
Transport equipment 2.9 3.5
Other manufactured goods 2.8 2.7
Total of above categories 2.4 2.7
Extra-area imports (trade diversion):
Chemicals 3.0 2.6
Fuels 1.8 2.1
Machinery 0.9 2.4
Nontropical food, beverages, tobacco 1.4 1.0
Raw materials 1.0 1.0
(continued)
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IN THE REAL WORLD: (continued)
TRADE CREATION AND TRADE DIVERSION IN THE EARLY STAGES
OF EUROPEAN ECONOMIC INTEGRATION
YEMs, 1953–1959 YEMs, 1959–1970
Transport equipment 2.2 2.5
Other manufactured goods 2.5 2.1
Total of above categories 1.6 1.6
Total imports (trade creation proper):
Chemicals 3.0 3.2
Fuels 1.6 2.0
Machinery 1.5 2.6
Nontropical food, beverages, tobacco 1.7 1.5
Raw materials 1.1 1.1
Transport equipment 2.6 3.2
Other manufactured goods 2.6 2.5
Total of above categories 1.8 2.0
Source: Bela Balassa, “Trade Creation and Trade Diversion in the European Common Market: An Appraisal of
the Evidence,” The Manchester School of Economic and Social Studies 42, no. 2 (June 1974), p. 97. ●
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and the quantity supplied domestically is 160 units. The quantity imported by A from B is
40 units. When the tariff is removed on country B’s good because of the union, the price of
the good in A falls to $1.00, the quantity consumed rises to 250, the quantity produced at
home falls to 100, and the quantity imported rises to 150 (= 250 − 100).
This is a trade-creating union in Viner’s sense because 60 units (160 − 100) have been
switched from home production in country A to lower-cost production in B. In addition to the
switch in the source of production, consumers gain from a larger quantity consumed. (Viner
neglected the consumption effect.) The welfare impact on country A is clearly positive.
Consumers have received the additional consumer surplus of areas a + b + c + d. Of this
amount, a is a transfer of producer surplus from country A’s suppliers, while c formerly was
tariff revenue that now accrues to A’s consumers. Therefore, the net welfare gain for the
country consists of areas b + d. In terms of the example, b = (1/2)(60 units)($0.50/unit) =
$15.00, while d = (1/2)(50 units)($0.50/unit) = $12.50. Country A as a whole has increased
its welfare by $15.00 + $12.50 = $27.50. The effect is unambiguous because this trade cre-
ation represents a movement in the direction of comparative advantage.
The ambiguity concerning the welfare effect of economic integration arises when
trade diversion occurs. This possibility is illustrated in the partial equilibrium analysis
in Figure 2. Suppose that we are examining three countries—A, B, and C. Let A be the
home country, B the potential union partner, and C the nonmember country. The produc-
tion cost in C is $1.00 and the cost in B is $1.20, but the product price in home country
A is $1.50 because A has a 50 percent tariff in place. In this instance, country A will buy
from country C because C’s price, including the tariff, is lower than the tariff-inclusive
price of country B, which equals $1.20 + 50% ($1.20), or $1.80 (not shown in Figure 2).
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Suppose now that country A forms a customs union with country B and drops its protection
against B’s good as part of the integration agreement, while at the same time maintaining
its protection against country C. Country A can now purchase the product for $1.20 from
country B, compared with the tariff-inclusive price of $1.50 from C. Even though C is still
the low-cost supplier in terms of real resource costs, C is no longer competitive in A’s
market because of A’s preferential treatment of country B. Consequently, country A shifts
from C to B as a source of this product. The impact in A is to reduce the domestic price
from $1.50 to $1.20, a change that produces a welfare gain equal to the two deadweight
triangles b and d.
The welfare gain in areas b and d is not the total welfare effect, however. Because
country A is now importing from country B and charging no tariff, the government in A
no longer collects any revenue. The revenue that was previously collected was equal to
the difference between the low-cost supply price ($1.00) in country C and the previous
domestic price ($1.50) for each unit imported. The value of this revenue is equal to the
area of rectangles c and e. Rectangle c reflects that part of the government revenue given
up after integration, which is transferred to domestic consumers through the reduction in
the domestic price. Rectangle e represents the difference in cost between the nonmember
source and the new higher-cost member source, and as such it is the cost of moving to the
less efficient producer in terms of lost government revenue. The net effect of economic
integration between country A and country B in this case depends on the sum (b + d − e).
There is no certainty that the sum of b + d will be larger than area e.
In Viner’s terms, area e represents the difference in cost per unit between country B
and country C ($1.20 − $1.00 = $0.20) times the amount of trade diverted—the original
FIGURE 2 Trade Diversion and Welfare
Price
DA
SA
Quantity
c
d
100
a
b
130 180 200
$1.50
$1.00
0
e$1.20
PA = PC (1 + t )
PB
PC
Before the union with country B, country A has a 50 percent tariff on imports of the good. Thus country C’s
tariff-inclusive price in A’s market is $1.50, and country B’s tariff-inclusive price is $1.80 (not shown). Before
the union, A imports 50 units (180 units − 130 units) from C. When the union is formed with B, country A
imports 100 units (200 − 100), all coming from partner B, which no longer faces a tariff. The net welfare
change for A is the difference between areas b + d (a positive effect due to the lower price in A) and area
e (a negative effect due to lost tariff revenue by A that is not captured by A’s consumers). In this example,
welfare is reduced because b + d = (1/2)(30)($0.30) + (1/2)(20)($0.30) = $4.50 + $3.00 = $7.50, while
e = (50)($0.20) = $10.00.
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CONCEPT BOX 1
TRADE DIVERSION IN GENERAL EQUILIBRIUM
The trade diversion impact of integration in the two-
commodity general equilibrium graphical approach is
presented in Figure 3. We begin with the country already
protecting its import good and consuming on indifference
curve ICt at point b. [Free-trade prices (Pw /Pa)ft are shown to
provide a basic reference point; consumption with free trade
would be at point a on indifference curve ICft.] If this coun-
try now forms a customs union with a country that cannot
produce autos as cheaply as reflected in (Pw/Pa)ft, economic
integration will lead to terms of trade in the union that are
greater than the tariff-distorted domestic prices (Pw/Pa)d but
less than (Pw /Pa)ft. If the prices in the new partner country,
(Pw/Pa)u1, for example, are sufficiently close to world prices,
the formation of the union generates a consumption possi-
bilities frontier that allows consumers to reach point c on a
higher indifference curve such as ICu1. If prices in the new
partner country do not involve sufficiently low auto prices,
for example, (Pw/Pa)u2, consumers may find themselves
restricted to a new consumption-possibilities line that leaves
them less well-off (such as at point f on ICu2). Consequently,
we again see that the static welfare effect of economic inte-
gration that involves trade diversion is ambiguous. Only by
examining a specific country and determining the extent to
which the effects of trade diversion offset the gains from
the partial movement to free trade can any conclusion be
reached about the effect of integration.
(continued)
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50 units (180 units − 130 units). This trade diversion has a value of ($0.20)(50) = $10.00.
Areas b and d again represent the consumer surplus gain that is not a transfer from
domestic producers and the government. Area b is actually a trade-creating (improved
efficiency) effect because 30 units of the good (130 units − 100 units) are now produced at
a lower cost in country B than they were in country A. This effect has a value of (1/2)(30)
($0.30) = $4.50. Area d represents the remaining consumer surplus gain from the lower
price to country A’s consumers, and is equal to (1/2)(20 = 200 − 180)($0.30) = $3.00.
Consequently, the net effect of integration between A and B in this market is a loss of
$2.50 ($4.50 + $3.00 − $10.00). If the customs union involves some trade diversion, it is
certainly possible that welfare can be reduced for country A. This conclusion can also be
derived in a general equilibrium context with the PPF and community indifference curves.
(See Concept Box 1.)
There are four general conclusions that can be make regarding trade creation/diversion:
(1) The more closely the price in the partner country approaches the low-cost world price,
the more likely the effect of integration on the market in question will be positive. (2) The
effect of the integration is more likely to be positive the higher the initial tariff rate, as
areas b and d will be larger. (At the extreme, if the tariff were initially prohibitive so that
country A’s imports were zero, there would be no welfare loss at all from trade diversion.)
(3) The more elastic the supply and demand curves, the greater the quantity response by
both consumers and producers; thus, the larger are b and d. (4) Integration is more likely to
be beneficial when there is a greater number of participating countries, because there is a
smaller group of countries from which trade can be diverted. (The extreme case occurs when
all countries in the world embrace integration because there could be no trade diversion.)
In addition to the creation/diversion effects, there are other static, more institutional
effects of economic integration that may accompany the formation of a union. First, eco-
nomic integration can lead to administrative savings by eliminating the need for govern-
ment officials to monitor the partner goods and services that cross the borders. Providing
General Conclusions
on Trade
Creation/Diversion
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CONCEPT BOX 1 (continued)
TRADE DIVERSION IN GENERAL EQUILIBRIUM
c
Autos
Wheat
b
f
j
a
n
m
h
(Pw /Pa) ft
(Pw /Pa)ft
(Pw /Pa)u1
(Pw /Pa)u2
(Pw /Pa)d
(Pw /Pa)d
ICu2
ICt
ICu1
ICft
FIGURE 3 Trade Diversion in General Equilibrium
With free trade, the country produces at point h and consumes at point a on indifference curve ICft. With a tariff in place on all auto
imports, production is at point j and consumption is at point b on ICt. If a trade-diverting union is formed so that the union partner’s prices
are (Pw /Pa)u1, production takes place at point m and consumption at point c on indifference curve ICu1. Because ICu1 represents a higher
welfare level than ICt, the country has gained. However, if the union partner’s prices are (Pw /Pa)u2 rather than (Pw/Pa)u1, production takes
place at point n and consumption at point f on indifference curve ICu2. Because ICu2 represents a lower welfare level than ICt, welfare
falls with the formation of the union. ●
CHAPTER 17 ECONOMIC INTEGRATION 397
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around-the-clock customs surveillance at all possible crossover points can be costly. Second,
the economic size of the union may permit it to improve its collective terms of trade vis-à-
vis the rest of the world compared with the average terms previously obtained by individual
member countries. Finally, the member countries will have greater bargaining power in trade
negotiations with the rest of the world than they would have had negotiating on their own.
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In addition to the static effects of economic integration, it is likely that the economic struc-
ture and performance of participating countries may evolve differently than if they had
not integrated economically. The factors that cause this to come about are the dynamic
effects of economic integration. For example, reducing trade barriers brings about a more
competitive environment and possibly reduces the degree of monopoly power that was
present prior to integration. In addition, access to larger union markets may allow econo-
mies of scale to be realized in certain export goods. These economies of scale may result
internally to the exporting firm in a participating country as it becomes larger, or they may
result from a lowering of costs of inputs due to economic changes external to the firm. In
either case, they are triggered by market expansion brought about by membership in the
union. The realization of economies of scale may also involve specialization on particular
types of a good, and thus (as was observed with the EC) trade may increasingly become
intra-industry trade rather than inter-industry trade. (See Chapter 10 for a discussion of
intra-industry trade.)
It is also possible that integration will stimulate greater investment in the member
countries from both internal and foreign sources. For example, massive U.S. investment
occurred in the EC in the 1960s. Investment can result from structural changes, internal and
external economies, and the expected increases in income and demand. It is further argued
that integration stimulates investment by reducing risk and uncertainty because of the large
economic and geographic market now open to producers. Furthermore, foreigners may
wish to invest in productive capacity in a member country in order to avoid being frozen
out of the union by trade restrictions and a high common external tariff.
Finally, economic integration at the level of the common market may lead to dynamic
benefits from increased factor mobility. If both capital and labor have the increased ability
to move from areas of surplus to areas of scarcity, increased economic efficiency and cor-
respondingly higher factor incomes in the integrated area will result.
Let us briefly summarize the conditions under which economic integration is more likely
to have overall beneficial effects. The higher the level of preunion tariffs and the lower the
common external tariff, the more likely the net effects will be positive. Along this same
line, the more elastic supply and demand in the member countries are, the more likely
the net results will be positive. The net positive effects will likely be larger the greater the
number of participating members and the larger the economic size of the group. Also, the
greater the ease of switching from a higher-cost domestic source to a lower-cost member
source, the greater the preunion per-unit cost differences between the two sources, and the
greater the scope for experiencing economies of scale and attracting foreign investment,
the larger the potential gains from integration. Finally, if transportation costs are consid-
ered, the closer the member countries are geographically, the more likely there will be
static and dynamic gains from integration.
With all the possible ways of gaining from integration, it seems logical to inquire why
economic integration has often failed. We have focused on the economic consequences
of integration in a representative country and have ignored two important issues. The first
Dynamic Effects of
Economic Integration
Summary of
Economic Integration
CONCEPT CHECK 1. Why is the formation of an economic inte-
gration project regarded as a second-best
situation?
2. In Figure 2, what would be the welfare
impact of the union on country A if the
partner were country C rather than country  B?
Explain.
3. Why is there an incentive for transshipment
in a free-trade area but not in a customs union
or a common market?
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relates to the distribution of benefits between member countries, and the second to the issue
of national sovereignty. Our static analysis pointed out the internal distribution effects on
consumers and producers, but it told us nothing about the distribution of benefits between
member countries. This issue has been a stumbling block to putting integration schemes
into place, as economic integration has often been viewed as a zero-sum game by potential
members. Each country wants access to other countries’ markets but is often unwilling to
give access to its own. The distribution problem has been enhanced by the unwillingness
of individual countries to give up the control of their economies required by joining an
economic integration plan.
It is not surprising that economic integration schemes have had a spotty record as an
economic policy strategy. This is particularly true historically in the developing coun-
tries where integration experiments such as the 1967–1977 East African Common Market
failed. In the case of the developing countries, one encounters country distribution and
sovereignty problems; also, the potential gains are not always obvious because potential
member countries often trade little with each other and are not very large economically.
Their respective economies sometimes produce different (not similar) goods destined
for the markets of industrialized countries. Finally, their domestic demand and supply
curves appear to be less elastic than those in similar markets in industrialized countries.
Consequently, the static gains do not appear great and the success of the economic integra-
tion scheme rests on the realization of dynamic gains resulting from the increased invest-
ment and the new industries that come into being to serve the larger group market. This, of
course, leads to controversies about location of new industries and the distribution of the
benefits of structural change among the member countries. Thus, while economic integra-
tion offers advantages of larger markets and possible economies of scale to developing
countries, the ability to take advantage of these dynamic development effects depends on
the countries’ willingness to give up some national economic control and on solving the
basic problem of how to distribute the benefits among member countries.
THE EUROPEAN UNION
With this conceptual background, we now turn to the most ambitious and best-known
integration unit in the world economy—the European Community, which, since November
1993, has been officially called the European Union. The formation of this unit4 formally
began in 1951 when the Treaty of Paris was signed by Belgium, France, West Germany,
Italy, Luxembourg, and the Netherlands. This treaty established the European Coal and
Steel Community for coordination of production, distribution, and other matters concern-
ing these two industries within the six countries. The countries then advanced their coop-
eration much further by signing two Treaties of Rome in 1957; one treaty established the
European Economic Community (EEC) and the other formed the European Atomic Energy
Commission (Euratom) for joint research, cooperation, and management in that field. The
two treaties went into effect on January 1, 1958, and with the earlier Treaty of Paris became
the constitution of the EC. The ultimate objective was the formation “of an integrated
market for the free movement of goods, services, capital, and people. These are known as
the ‘four freedoms’ . . .”5 The EC subsequently expanded from 6 to 15 countries with the
addition of Denmark, Ireland, and the United Kingdom in 1973, Greece in 1981, Portugal
History and Structure
4See Gary Clyde Hufbauer, “An Overview,” in Hufbauer (1990), pp. 1–64.
5Ibid., p. 1.
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IN THE REAL WORLD:
THE EAST AFRICAN COMMUNITY
The East African countries of Kenya, Tanzania, and Uganda
established the East African Community (EAC) in 1967.
The EAC was a step toward a considerable amount of inte-
gration. The enabling agreement, the Treaty for East African
Cooperation, created the East African Common Market
(EACM) with a common external tariff, free trade among the
members, harmonization of monetary and fiscal policies, fixed
exchange rates, and coordination of development planning
efforts. However, the EACM did not permit free movement of
labor and capital and did not extend the free-trade provisions
to agricultural products. In addition, a transfer tax was imple-
mented on some trade between members to protect less indus-
trialized Tanzania and Uganda from more industrialized Kenya.
The treaty also established the East African Development
Bank (with equal contributions from each of the three mem-
bers) to distribute investment funds among the countries. In
addition, common service organizations operated railways,
ports, telecommunications, and airways. Overseeing all
activities was the East African Authority, a board consist-
ing of the three country presidents—Kenyatta of Kenya,
Nyerere of Tanzania, and Obote of Uganda—with unanim-
ity required for decisions.
The three countries had cooperated with one another
since the time they were ruled as British colonies. Kenya
and Uganda had formed a customs union in 1917 and
Tanganyika (as Tanzania was known before the addition of
Zanzibar) had joined in 1923. There had been a common
income tax and a joint provision of some services, and a
common currency (the East African shilling) had been in use
from 1936 until the mid-1960s. It was thought that, with the
attainment of independence in the early 1960s, the new East
African Community of sovereign states had great promise.
The bright promise of the EAC soon faded, however. It
became evident that the gains from integration were unevenly
distributed. Kenya grew more rapidly than the other two part-
ners. Its average annual real GDP growth was 7.5 percent from
1967 to 1977, while Tanzania’s was 6.3 percent and Uganda’s
2.0 percent (Eken, 1979 p. 39). In addition, new firms located
in Kenya because of its better industrial base. The East African
Development Bank’s funds were also distributed dispropor-
tionately toward Kenya in comparison with the planned dis-
tribution. Further, trade diversion toward Kenya’s products
meant that Tanzania and Uganda were potentially losing from
the union, because a considerable amount of tariff revenue (an
important source of government financing) was given up. It
has been suggested (Eken, 1979, p. 39) that the union could not
really “create” trade between Tanzania and Uganda because
previous tariffs were not a factor that inhibited trade between
them. Both countries specialized in the same primary products
and were highly dependent on trade with developed countries;
exports to developed countries were 90 percent of total exports
for both Tanzania and Uganda. Finally, Tanzania and Uganda
each had large intra-union trade deficits with Kenya because
of their heavy importation of manufactured goods.
Political and ideological factors also caused difficulty.
The East African Authority never met after 1971 because
Julius Nyerere refused to deal with Uganda’s new president,
General Idi Amin, who had seized power from Milton Obote.
Amin was also displeased that Tanzania had offered a safe
haven to Obote. Ideologically, Tanzania was trying to create a
socialist state and deplored Kenya’s strong emphasis on capi-
talism. Kenya’s emphasis on the market also contributed to
its receiving the lion’s share of investment from the outside
world, which exacerbated the distribution of benefits problem.
With all of these political, ideological, and economic dif-
ficulties, the East African Community collapsed in 1977 after
several years of disintegrating events (e.g., expulsion of each
other’s citizens, imposition of exchange and import controls).
The integration experiment that had been so promising ended
after only 10 years of operation. Later, in the 1990s and at
present, the countries are again members of trading groups
both among themselves and with other countries, but the
overlapping arrangements were not always consistent with
each other and little success was attained. The EAC formally
reestablished itself in July 2000, and Burundi and Rwanda
became full members in July 2007. The hope is that the previ-
ous conflicts and problems will not reemerge. The new EAC
is evolving into more than a purely economic unit. In 2012
there were political institutions in place, such as the East
African Legislative Assembly and the Council of Ministers.
Further, there were also EAC institutions with a specific
focus—for example, the Lake Victoria Basin Commission
and the Inter-University Council for East Africa.
Sources: “Combustious Community,” The Economist, September
20, 1975, pp. 64, 66; Sena Eken, “Breakup of the East African
Community,” Finance and Development 16, no. 4 (December
1979), pp. 36–40; Arthur Hazlewood, “The End of the East African
Community: What Are the Lessons for Regional Integration
Schemes?” Journal of Common Market Studies 18, no. 1 (September
1979), pp. 40–58; Joseph Kakoza, “The Common External Tariff
and Development in the East African Community,” Finance and
Development 9, no. 1 (March 1972), pp. 22–29; “Three Fall Out,”
The Economist, January 4, 1975, pp. 38–39; Robert Sharer, “Trade:
An Engine of Growth for Africa,” Finance and Development 36,
no. 4 (December 1999), pp. 26–29; East African Community, “EAC
Quick Facts,” obtained from www.eac.int. ●
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and Spain in 1986, and Austria, Finland, and Sweden in 1995. Cyprus, the Czech Republic,
Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovak Republic, and Slovenia then
joined in 2004. The latest new members are Bulgaria (2007), Romania (2007), and Croatia
(2013), bringing the total to 28 countries.
To facilitate the attainment of the broad objective and to obtain greater political cohe-
sion, various supranational institutions were established. The European Commission, the
executive body, is charged with implementing the treaties and with general leadership.
The Council of Ministers is the decision-making unit on communitywide matters. The
European Council, comprised of the political leaders of the individual member countries,
sets broad policy guidelines. The European Parliament is elected by voters in the mem-
ber countries (with a specified number of seats allocated to each country), and it makes
proposals to the Commission. Finally, the Court of Justice interprets the constitution and
settles disputes.
The newly formed EC eliminated tariffs on intra-EC trade and adopted the common exter-
nal tariff by July 1968. Trade among the member states grew rapidly in the 1960s as did
world trade in general. In addition, the average annual growth rate of real GNP for the
Community as a whole from 1961 to 1970 was 4.8 percent, and the growth rate in GNP
per capita was 4.0 percent. This compared with a U.S. growth rate of 3.8 percent for GNP
and 2.5 percent for per capita GNP.6 Many attributed this impressive early growth perfor-
mance to the establishment of the EC itself, although some had doubts whether this was
the cause. Impressive growth was also associated during the late 1960s and early 1970s
with the implementation of 35 percent tariff cuts under the Kennedy Round. Indeed, the
origination of the Kennedy Round itself can be linked with the formation of the EC. U.S.
officials viewed a new round of tariff cutting as a way to offset some of the discrimination
against U.S. goods caused by the removal of tariffs within the EC and the erection of the
common external tariff. The U.S.–EC bargaining within the round was critical for the suc-
cess of the negotiations.7
The successful EC growth experience in the 1960s gave way to disappointments in the
1970s and 1980s. The oil crises of 1973–1974 and 1979–1980, accompanied by periods
of simultaneous recession and inflation, led to slow growth and rising unemployment in
Europe. Annual EC real GNP growth fell to 1.4 percent during the 1981–1985 period; in
contrast, the U.S. real GDP growth rate for 1981–1985 was 2.3 percent, and Japan grew
at a rate of 3.7 percent.8 Because of these relatively and absolutely low growth rates in
the EC and high European unemployment rates (sometimes above 10 percent), the term
“Eurosclerosis” was coined.9
Economic disappointments and the perception of a Europe “falling behind” the United
States and Japan became a concern to the members of the Community. Some thought
that the continued existence of internal barriers to fuller economic integration within the
Early Growth and
Disappointments
Completing the
Internal Market
6Central Intelligence Agency, Directorate of Intelligence, Handbook of Economic Statistics, 1990: A Reference
Aid (Washington, DC: CIA, 1990), pp. 39–40.
7See Bela Balassa, Trade Liberalization among Industrial Countries: Objectives and Alternatives (New York:
McGraw-Hill, 1967), p. 13; and Hufbauer, “An Overview,” pp. 3–4.
8Central Intelligence Agency, Directorate of Intelligence, Handbook of International Economic Statistics 1992
(Washington, DC: CIA, 1992), pp. 26–27.
9Hufbauer, “An Overview,” p. 6. The originator of the term is thought to be Herbert Giersch of Germany’s Kiel
Institute.
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Community itself was an important retardant to better European performance. Although
tariffs had been removed by 1968 on intra-EC trade, a variety of nontariff hindrances to
free trade remained. Therefore, in 1985 the European Commission issued a policy paper,
Completing the Internal Market: White Paper from the Commission to the European
Council, prescribing changes to eliminate various hindrances and restrictions. These inter-
nal market barriers essentially consisted of differences in technical regulations between
countries, delays at frontiers for customs purposes, and restrictions on competition for
public purchases and on certain service transactions (Emerson et al., 1988, p. 1).
The European Community’s members were receptive to this call for completing
the removal of internal barriers, and in February 1986 the Council of Ministers adopted
the Single European Act to implement the various recommendations. The date set for the
removal of all the internal market restrictions was December 31, 1992—the term EC92
came into existence to indicate the target for complete integration of the Community. There
were 282 different directives issued for implementation,10 and many (but by no means all)
were accomplished by or shortly after the deadline.
At that time, what were the expected consequences of the increased economic integra-
tion in the EU? The European Commission calculated that the annual GDP over the medium
term would be from 3.2 to 5.7 percent greater than it would have been without the increased
economic integration, with much of the increase coming from the liberalization of finan-
cial services and from supply-side effects. The supply-side effects reflect phenomena such
as realization of economies of scale, greater efficiencies brought about by the heightened
competition between producers, and the reduction of direct costs due to former techni-
cal barriers such as the lack of standardization of product inputs. Consumer prices were
expected to be from 4.5 to 7.7 percent lower than otherwise, and employment was to rise by
1.3  million to 2.3 million jobs (Emerson et al., 1988, p. 208). However, the immediate situa-
tion in the EC in the early 1990s was not optimistic. The worldwide recession of 1990–1991
hit the EC hard, and economic performance was poor. Real GDP growth in the EC was
1.7 percent in 1991, 1.2 percent in 1992, and negative 0.4 percent in 1993. It was then in
the 1.7–2.8 percent range for the next three years and subsequently averaged 2.6 percent
per year for 1997–2006. Although real GDP growth was 3.3 percent in 2007, the recession
that began in 2008 had lasting effects through 2014, with two negative growth years and a
high figure of 2.0 percent in 2013. The 2014 growth rate was 1.4 percent. The unemploy-
ment rate (euro countries only) averaged 9.2 percent for 1997–2006, dropped somewhat in
2007–2009, but was 10 percent or higher from 2010 to 2014 (11.6 percent in 2014). With
respect to inflation, the EU’s consumer price index rose 3.4 percent on average for the years
1997–2006 and then varied from lows of 0.5 percent (2014) and 0.9 percent (2009) to highs
of 3.7 percent (2008) and 3.1 percent (2011). Overall, inflation did not seem to be a serious
problem. (Data in this paragraph are from IMF, World Economic Outlook, various issues.)
A very important step in the European integration process was the task of undertaking
the adjustments necessary to move toward the goal of full monetary union by January 1,
1999. A series of macroeconomic criteria involving such matters as maximum ratio of pub-
lic debt to GDP and permissible inflation rates, exchange rates, and interest rates were set
for nations to qualify for participation. (We discuss the monetary aspects of European inte-
gration in our chapters on international monetary economics.) In May 1998, the European
Council confirmed that 11 nations had fulfilled the necessary criteria to adopt the euro
on January 1, 1999, which was also the date when the exchange rates of the participating
currencies were irrevocably set. Greece was a late qualifier (June 2000) and was included
10 Tony Horwitz, “Europe’s Borders Fade, and People and Goods Can Move More Freely,” The Wall Street
Journal, May 18, 1993, p. A10.
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on January 1, 2002, when the new euro banknotes and coins were introduced as the com-
mon European currency. The 12 participating members were Belgium, Germany, Greece,
Spain, France, Ireland, Italy, Luxembourg, Netherlands, Austria, Portugal, and Finland.11
At the time of this writing, there were 19 countries participating in the Economic and
Monetary Union (EMU), with the 12 being joined by Cyprus, Estonia, Latvia, Lithuania,
Malta, Slovak Republic, and Slovenia.
Finally, any assessment of the future of the EU and of the euro zone/monetary union
must recognize the considerable uncertainty that exists due to the external debt situation of
the governments of several member countries. Greece, Ireland, Portugal, and Spain were
all facing debt issues, with the Greek problem being the most serious. The situation in
Greece came about after joining the EMU in 2001 and subsequently understating its debt
position, failing to collect sufficient government revenue, experiencing high and increas-
ing unemployment (25 percent in July 2015), and increasing government expenditures. To
remain solvent, Greece negotiated two bailouts in five years from the EU and in spring
2015 found it necessary to obtain additional funds from the EU or possibly leave the EMU.
A crisis occurred as monetary union members demanded less spending and more taxes
to bring the debt problem under control (greater austerity). In July 2015, Greece voted to
reject the EMU austerity demands, and speculation arose that Greece might choose to exit
or be forced to leave the EMU. Costs would be high for Greece whether choosing the aus-
terity path or returning to the drachma (e.g., the inflationary consequences of the devalu-
ation of the drachma, as well as potentially greater unemployment). Eventually, Greece
chose to accept stronger austerity measures and to remain in the EMU. This decision eased
worry that a Greek exit could lead a to contagion among other debtor countries and lead
them to leave the monetary union as well. Although things have eased as of this writing,
critical issues related to this experiment in monetary union have yet to be resolved. These
kinds of issues will be addressed further in Chapter 28 when we examine the underlying
considerations related to optimal currency areas.
In overview, the integration of Europe has proceeded rapidly in historical terms since
its formation by the Treaties of Rome in 1957, and there are imposing challenges facing
it in the future. In viewing the process and the future prospects, it is important to real-
ize that the increasing integration of Europe involves more than economics. There are
political implications of establishing supranational institutions and of sacrificing some
autonomy and sovereignty by member states. There are also cultural and social dimen-
sions associated with the increased mobility of labor and capital and the “four freedoms”
declared at the EC’s formation. “Economic integration” is really much more than just
“economic,” and the scale of the already-attained integration in this broader sense in
Europe is impressive.
U.S. ECONOMIC INTEGRATION AGREEMENTS
A widely hailed movement toward economic integration occurred when the Canada–U.S.
Free Trade Agreement went into effect on January 1, 1989. It called for the elimination
of all bilateral tariffs between the two countries either immediately or in 5 or 10 equal
annual steps. The momentum toward greater regional free trade continued soon after the
Canada–U.S. accord. The executive branches of the governments of Canada, Mexico,
and the United States signed the North American Free Trade Agreement (NAFTA) in
11European Central Bank, Background to the Euro, www.euro.ecb.
NAFTA
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August 1992, agreeing to create a FTA with a combined GDP comparable to that of the
EU and EFTA combined which, at the time, had a GDP of $7.5 trillion and a population
of 372 million.12 This agreement took effect on January 1, 1994, and established free trade
between the United States and its first- and third-largest trading partners.13 NAFTA elimi-
nated tariffs among the three member countries over a 15-year period and at the same time
substantially reduced nontariff barriers. Because the United States and Canada already
had established a FTA, this discussion will focus on U.S.–Mexican policy steps. Several
of the more important sector agreements involved automobiles, textiles and apparel, agri-
culture, energy/petrochemicals, and financial services (Kehoe and Kehoe, 1994, p. 21). In
the case of automobiles, Mexican tariffs were immediately reduced from 20 to 10 percent
and were to decline to zero over the next 10 years. In addition, tariffs on auto parts were
reduced to zero, and rules of origin specified that to qualify for preferential tariff treatment,
vehicles must contain 62.5 percent North American content. Further, the requirement that
autos supplying the Mexican market be produced in Mexico was gradually eliminated
over a 10-year period. There was also additional easing of export restrictions on Mexican-
produced vehicles and on Mexican imports of U.S. or Canadian produced buses and trucks.
In the textile and apparel industry, trade barriers were eliminated on 20 percent of
U.S.–Mexican trade, and barriers on an additional 60 percent were removed over a six-
year period. In addition, rules of origin required that to receive NAFTA tariff preferences,
apparel must be manufactured in North America from the yarn-spinning stage forward.
In agriculture, tariffs were immediately reduced from initial levels of 10 to 20 percent to
zero for one-half of U.S. exports to Mexico, with the understanding that the tariffs on the
remaining agricultural products would be reduced to zero over the 15-year adjustment
period. Mexico’s licensing requirements for grain, dairy, and poultry were immediately
eliminated. Similarly, trade and investment restrictions were eliminated immediately on
most petrochemicals.
With respect to foreign investment and financial services in general, all barriers to
the movement of capital were immediately dropped. In addition, Mexico’s restrictions
on Canadian and U.S. ownership and provision of commercial banking, insurance,
securities trading, and other financial services were to be removed. Finally, U.S. and
Canadian financial firms are now permitted to establish wholly owned subsidiaries in
Mexico and to operate them in the same manner as Mexican firms operate. In like
manner, Canada, Mexico, and the United States are to extend “national treatment” in
services to each other, meaning that foreign-owned service firms are treated exactly like
domestic firms, and to guarantee MFN treatment in services. Agriculture was also an
important part of the agreement. (See Aguilar, 1993, pp. 14–15.) NAFTA was the first
regional agreement among countries with such diverse income levels, and an important
aspect of the agreement was the anticipated reinforcement that it would give to the
strong growth that Mexico had achieved at the time of NAFTA formation since adopting
structural, market-oriented reforms in the mid-1980s. In addition, and importantly, the
NAFTA agreement was accompanied by a side agreement pertaining to labor rights and
the enforcement of labor laws in each country and a side agreement aimed at address-
ing environmental concerns so that NAFTA provisions would be consistent with pro-
moting sustainable development and in compliance with existing laws and regulations
12Facts on File, January 13, 1994, p. 12.
13Canada was and is the largest U.S. trading partner. Mexico was third behind Japan at the time NAFTA began;
it is now third behind China.
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protecting the environment. (There were also side agreements with respect to freeing up
agricultural trade.)14
There is general agreement that the absolute volume of trade among the partners dramati-
cally increased after NAFTA went into effect, and the removal of all tariffs and quanti-
tative restrictions (which had ultimately been accomplished by January 1, 2008) clearly
played a role in this increase. As an example of the increase, merchandise exports from the
United States to Mexico and Canada combined almost quadrupled in dollar terms between
1993 and 2014. Looking at the shares of trade in partner countries’ exports and imports,
the percentage of U.S. exports that went to Mexico was 8.9 percent in 1993 and increased
to 14.8 percent in 2014, while the share of Mexican goods in U.S. imports increased from
6.8 percent in 1993 to 12.5 percent in 2014. However, even though trade between Canada
and the United States has grown significantly during the NAFTA years (total 2014 trade
was slightly over 3 times the 1993 trade), the percentage of U.S. exports going to Canada
fell from 21.5 percent in 1993 to 19.3 percent in 2014 because exports to the rest of the
world were increasing more rapidly in percentage terms than were exports to Canada.
Similarly, the share of U.S. imports of goods coming from Canada was 18.8  percent in
1993 and 14.8 percent in 2014. Viewed from the Mexican perspective, it sent 80.2 percent
of its exports to the United States in 2014 compared to 80.3 percent in 1993, but the dol-
lar amount of those exports was 530 percent larger in 2014 than in 1993. On Mexico’s
import side, its percentage of imports from the United States was 48.8 percent in 2014 as
opposed to 71.2 percent in 1993, although the dollar value of the 2014 imports from the
United States was over four times as large as the 1993 imports. With respect to Canada,
Mexico’s exports to that country fell from 3.0 percent in 1993 to 2.7 percent in 2014, but
the 2014 dollar value was almost seven times the 1993 value. Mexico’s imports from
Canada were 1.8 percent of its total imports in 1993 and 2.5 percent in 2014; the dollar
value in 2014 was well over eight times as large as the 1993 value. Over the 1993–2014
period, Canada’s exports to Mexico increased from 0.4 percent of Canada’s exports to a
1.0 percent share; its imports from Mexico rose from a 2.0 percent share to a 5.6 percent
share. During the same time, Canada’s exports to the United States fell from a 81.3 per-
cent share to a 76.8 percent share, even though the 2014 exports to the United States were
3.2 times the 1993 exports. Finally, U.S. imports constituted 65.0 percent of Canadian
goods imports in 1993 but declined to 54.5 percent in 2014, although the amount of the
trade was almost three times as much.15 It thus seems probable that trade among the part-
ners has increased by a greater absolute amount because of NAFTA than would otherwise
have been the case, although one never really knows what would have happened without
NAFTA. However, a careful study by Hufbauer and Schott (2005) of the Peterson Institute
of International Economics indicated that various models showed increases in U.S.–Mexico
two-way trade because of NAFTA that ranged from 5 percent to 50 percent, and they said
that “disentangling the effect of NAFTA on trade in the past decade is difficult, but the
available evidence points to a strong positive impact.”16
Effects of NAFTA
14For further information on the side agreements, see Office of the United States Trade Representative, 2012 Trade
Policy Agenda and 2011 Annual Report of the President of the United States on the Trade Agreements Program
(Washington, DC: USTR, March 2012), pp. 129–30, available at www.ustr.gov; and Christopher J. O’Leary,
Randall W. Eberts, and Brian M. Pittelko, “Effects of NAFTA on US Employment and Policy Responses,” OECD
Trade Policy Working Papers No. 131, Organization for Economic Cooperation and Development, February 24,
2012, pp. 8–10, available at www.oecd.org.
15Calculations made from data contained at the IMF website www.elibrary-data.imf.org.
16Quoted in Stephen W. Hartman, “NAFTA, the Controversy,” International Trade Journal 25, no. 1 (January–
March 2011), p. 13.
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17O’Leary, Eberts, and Pittelko, “Effects of NAFTA on US Employment . . . ,” pp. 24–27.
18Don P. Clark, “Intra-Industry Specialization in United States–Mexico Trade,” Global Economy Journal 10,
no. 2 (2010), obtained from www.bepress.com.
19Hartman, “NAFTA, the Controversy,” pp. 18–19.
The effects of NAFTA on economic variables besides trade are difficult to assess.
The accumulated amount of foreign direct investment (FDI) into the three countries has
increased substantially since NAFTA became operational. Such investment would be
attracted from nonmember countries because of the larger integrated market and from
members themselves into each other as trade barriers are eliminated and thus inputs and
output can flow more easily among the countries. In addition, the study by Hufbauer and
Schott (2005) concluded that the North American economy was more efficient in 2005
than at the inception of NAFTA, and they indicated that both Canada and the United States
had grown at average annual rates of well over 3 percent. Mexico’s growth was somewhat
less than that, but Mexico’s growth rate had been hampered by the peso crisis in 1994–
1995. Leary, Eberts, and Pittelko (2012), in surveying estimates by various economists,
noted that studies generally posited that there had been small overall production/employ-
ment effects of NAFTA on the U.S. economy, but there had been important effects on par-
ticular industries—losses, for example, in textile products, apparel, and leather but gains
in appliances, cotton, and motor vehicles and parts. In addition, trade diversion effects did
not seem to be important with the implementation of NAFTA.17 Much of the increased
U.S. trade with Mexico was of the intra-industry type rather than being inter-industry trade
(see Chapter 10), and intra-industry trade requires relatively less labor and other factor
adjustments and permits economies of scale. One estimate was that only one-third of U.S.
industries were candidates for factor adjustment pressures because of NAFTA; the sectors
most likely to have experienced pressures accounted for only 19 percent of U.S. imports
from Mexico.18
In a 2011 study, Stephen Hartman noted that over the period 1994–2003, the aver-
age annual rates of growth of GDP were 3.6 percent for Canada, 3.3 percent for the
United  States, and 2.7 percent for Mexico. However, despite the positive figure for
Mexico, most Mexican workers actually had lower real wages than when NAFTA began
(a decline that he attributed mainly to the 1994–1995 currency crisis). Hence, productiv-
ity growth in Mexico had not translated into wage growth. Further, Hartman hypoth-
esized that Mexico’s agricultural sector had been severely hurt by the increased imports
of agricultural products from the United States.19 Thus, although some early predictions
were that, of the three countries, Mexico might gain relatively the most from the forma-
tion of NAFTA, this result may not have revealed itself, or even occurred, because of a
non-NAFTA event such as the Mexican peso difficulties. (The currency problem was
traced to such phenomena as Mexico’s external debt problem and speculative financial
capital flows rather than to NAFTA.) Mexico has grown under NAFTA, but would it
have grown more rapidly without NAFTA? The same question has been posed for the
United States, but usually in terms of unemployment and trade balance impacts rather in
GDP growth impact.
Another issue related to NAFTA has to do with maquiladoras—manufacturing facili-
ties (usually foreign-owned) located close to the U.S./Mexico border where the principal
activity is that inputs are brought in from the United States and assembled into final prod-
ucts, after which the final products are sent to the United States. Such facilities are alleged
to be centers of poor, unsafe working conditions wherein workers are paid extremely low
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wages, and the charge that is often made is that NAFTA has increased dramatically the
amount of activity taking place in these maquiladoras. In fact, one study noted, “One of the
most drastic and disturbing results of NAFTA has been a boom in the Mexican maquila-
dora sector. . . . During the first six years after the signing of the trade pact (1994–2000),
there was a 110 percent growth in the Mexican sweatshop industry.”20 Nevertheless, some
recent econometric research on the effect of NAFTA on maquiladora employment led to
the conclusion that the “results of these tests are resoundingly negative. NAFTA did not
make maquiladoras grow faster.”21
In recent years there have been frequent calls for a discussion of revisions to NAFTA.22
However, there is no question that the global situation has changed in the 15 to 20 years
since the agreement went into effect. The rise of China and India as competitors with
Mexico for U.S. and Canadian investment is a much larger issue than in the early 1990s.
While trade growth between Mexico and the United States has been impressive, both legal
and illegal immigration from Mexico are major political concerns that have not been elimi-
nated by the agreement. Many special interest groups in all three nations would like to see
the addition or removal of certain provisions of the agreement. Reopening negotiations of
this nature is always a risky proposition, but given the uncertainty of the global economy
and the stalemate in the multilateral Doha negotiations, major breakthroughs related to
free-trade agreements are unlikely.
Generally speaking, many of the predicted impacts of NAFTA have not occurred or
were greatly overstated. The positive economic effects appear to have been relatively the
greatest in Canada but fairly minimal in the United States. Trade has expanded substan-
tially as tariffs have fallen, production structures have changed, new supply chains have
developed, and the three economies became more integrated. For example, it has been
estimated that 40 percent of the content of U.S. imports from Mexico originated in the
United States and 25 percent of the value of U.S. imports from Canada originated as U.S.
inputs.23 Thus, when estimating employment effects in the United States of NAFTA, this
additional employment in U.S. export industries must also be accounted for. Prices in all
three countries have declined for many products as tariff walls were eliminated and trade
increased. It is also likely that increased competition has enhanced production efficiency
in the three countries, especially in Mexico. However, it is difficult to assess the impacts
of NAFTA without a meaningful counterfactual. For example, relative wages between
the United States and Mexico have not converged to the extent that some observers
predicted, but perhaps they converged more than would have been the case without the
agreement.
At the conclusion of this discussion of NAFTA, it should be pointed out that Canada
and Mexico have been actively engaged in establishing free-trade pacts with many other
countries in addition to the United States. As of this writing, Canada has 10 such agree-
ments in force and has concluded two others, while Mexico has 12 free-trade agreements
in place.
20Council on Hemispheric Affairs, “The Tail End of Free Trade: A Preliminary Evaluation of the Impact of
NAFTA on the Manufacturing Sector,” press release, August 8, 2007.
21Hartman, “NAFTA, the Controversy,” p. 15.
22See, for example, Preston Whitt, “Negotiating a New NAFTA: What and Why This Is Needed,” Council on
Hemispheric Affairs, September 13, 2010.
23Mohammad Aly Sergie, “NAFTA’s Economic Iimpact,” Council on Foreign Relations Backgrounder,
February 14, 2014.
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IN THE REAL WORLD:
NAFTA—MYTHS VS. FACTS
Since NAFTA entered into force on January 1, 1994, the
year 2009 marked the 15th anniversary of the free-trade
agreement. NAFTA has been the center of a great deal of
controversy over its lifetime. In advance of this anniversary,
the Office of the U.S. Trade Representative (USTR) put
together a factsheet to address some of the common myths
that have been associated with NAFTA.* The following is a
list of the USTR’s responses to what are perceived as eight
common misconceptions about NAFTA.
Myth #1: After 14 years, we know NAFTA has not
achieved its core goals of expanding trade and invest-
ment between the U.S., Canada, and Mexico.
Fact: From 1993 to 2007, trade among the NAFTA
nations more than tripled, from $297 billion to
$930  billion. Business investment in the United States
has risen by 117  percent since 1993, compared to a
45 percent increase between 1979 and 1993.
Myth #2: NAFTA has cost the U.S. jobs.
Fact: U.S. employment rose from 110.8 million people in
1993 to 137.6 million in 2007, an increase of 24  percent.
The average unemployment rate was 5.1 percent in the
period 1994–2007, compared to 7.1 percent during the
period 1980–1993.
Myth #3: NAFTA has hurt America’s manufacturing
base.
Fact: U.S. manufacturing output rose by 58 percent
between 1993 and 2006, as compared to 42 percent
between 1980 and 1993. Manufacturing exports in 2007
reached an all-time high with a value of $982 billion.
Myth #4: NAFTA has suppressed U.S. wages.
Fact: U.S. business sector real hourly compensation rose
by 1.5 percent each year between 1993 and 2007, for
a total of 23.6 percent over the full period. During the
1979–1993 period, the annual rate of real hourly com-
pensation rose by 0.7 percent each year, or 11 percent
over the full 14-year period.
Myth #5: NAFTA has not delivered benefits to U.S.
agriculture.
Fact: Canada and Mexico accounted for 37 percent of
the total growth of U.S. agricultural exports since 1993.
Moreover, the share of total U.S. agricultural exports des-
tined for Canada or Mexico has grown from 22  percent
in 1993 to 30 percent in 2007. NAFTA access is most
crucial for agriculture, where Mexico has its highest
MFN tariffs. Mexico is the top export destination for
beef, rice, soybean meal, corn sweeteners, apples, and
dry edible bean exports. It is the second export market for
U.S. corn, soybeans, and oils and third largest for pork,
poultry, eggs, and cotton.
Myth #6: NAFTA has reduced wages in Mexico.
Fact: Mexican wages grew steadily after the 1994
peso crisis, reached pre-crisis levels in 1997, and have
increased each year since. Several studies note that
Mexican industries that export or that are in regions with
a higher concentration of foreign investment and trade
also have higher wages.
Myth #7: NAFTA investment provisions have put legiti-
mate U.S. laws and regulations at risk.
Fact: Nothing in NAFTA’s investment provisions
prevents a country from adopting or maintaining non-
discriminatory laws or regulations that protect the envi-
ronment, worker rights, health and safety, or other public
interest. The United States has never lost a challenge in
the cases decided to date under NAFTA, nor paid a penny
in damages to resolve any investment dispute. Even if the
United States were to lose a case, it could be directed to
pay compensation but it could not be required to change
the laws or regulations at issue.
Myth #8: NAFTA has done nothing to improve the
environment.
Fact: NAFTA created two binational institutions unique
to the agreement which certify and finance environ-
mental infrastructure projects to provide a clean and
healthy environment for residents along the U.S.–
Mexico border. To date, they have provided nearly
$1 billion for 135 environmental infrastructure projects
with a total estimated cost of $2.89 billion and allocated
$33.5  million in assistance and $21.6 million in grants
for more than 450 other border environmental projects.
The Mexican government has also made substantial new
investments in environmental protection, increasing the
federal budget for the environmental sector by 81 percent
between 2003 and 2008.
Critics of NAFTA have taken issue with a number of
the points made by the Office of the U.S. Trade Repre-
sentative in this list. For example, the critics indicate that the
huge increases in trade flows among the NAFTA countries
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IN THE REAL WORLD: (continued)
NAFTA—MYTHS VS. FACTS
have been associated with a massive increase in U.S. trade
deficits with Mexico and Canada.† Critics also indicate that
despite increases in U.S. manufacturing output, millions of
U.S. manufacturing jobs have been lost during the NAFTA
period. With respect to the benefits for agriculture, it is noted
that the number of U.S. family farms has shrunk during
NAFTA. Regarding Mexican wages, it is pointed out that
the rate of wage growth in Mexico has been slower since
NAFTA than it was before NAFTA.
In assessing these criticisms of the USTR’s statement,
remember that indicating a correlation between phenom-
ena does not equate with showing causation. For instance,
the reduction in the number of family farms is likely due
principally to technological change and the increased use of
capital in production, independent of NAFTA. In a similar
fashion, technological change of a labor-saving nature has
also clearly taken place in the U.S. manufacturing sector.
In addition, remember from earlier chapters that the gains
from trade are not determined by whether a country has a
trade deficit or a trade surplus. Gains from trade are attained
through increases in economic well-being due to exposure
to different relative prices and the resulting gains from both
specialization and exchange.
*“NAFTA Facts,” an official publication of the Office of the U.S.
Trade Representative, March 19, 2008, www.ustr.gov.
†“Debunking USTR Claims in Defense of NAFTA: The Real NAFTA
Score 2008,” Public Citizen, obtained from www.citizen.org. ●
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The U.S.–Central America/Dominican Republic Free Trade Agreement (CAFTA–DR),
signed on August 5, 2004, is an agreement that represents the first free-trade agreement
between the United States and a group of smaller developing countries (Costa Rica,
Dominican Republic, El Salvador, Guatemala, Honduras, Nicaragua). The five Central
American countries and the Dominican Republic together constitute the third-largest export
market for the United States in Latin America (after Mexico and Brazil). The CAFTA-DR
agreement eliminated 80 percent of the tariffs immediately upon entry into force, with the
remaining tariffs to be phased out over 10 years.
The CAFTA–DR entered into force between the United States and El Salvador,
Guatemala, Honduras, and Nicaragua in 2006, with the Dominican Republic in March
2007, and with Costa Rica in June 2009. Changes were introduced in 2008 to permit free
trade for the five Central American countries and the Dominican Republic for textiles
exported to the United States even if some inputs were sourced in Mexico, and reciprocally
by Mexico even if some inputs were sourced in the United States.24
The U.S.–Colombia Trade Promotion Agreement (CTPA) was signed on November
22, 2006, was passed by the U.S. Congress on October 12, 2011, signed into law by
President Obama on October 21, 2011, and went into effect on May 15, 2012. This is
a comprehensive agreement that eliminated import tariffs on about 80 percent of U.S.
exports to Colombia, with many of the remaining tariffs to be phased out over the next
5 to 10 years. Some agricultural tariff rate quotas will be phased out over a period of
up to 19  years. U.S. imports from Colombia are not expected to be affected to any
degree because most Colombian products currently enter the United States duty-free
either unconditionally or under provisions such as the Andean Trade Preference Act.
Recent U.S.
Integration
Agreements
24Office of the United States Trade Representative, “CAFTA Policy Brief—2005” and CAFTA-DR (Dominican
Republic–Central America FTA), obtained from www.ustr.gov.
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However, 99 percent of qualifying Colombian industrial products and textiles and 89 per-
cent of agricultural goods entering the United States officially became duty-free, while
other remaining tariff lines and some agricultural goods (except sugar) will be phased
out over a period of time of up to 15 years. Because the United States is Colombia’s lead-
ing trade partner, this is a significant agreement; the average Colombian tariffs on U.S.
industrial products ranged from 7.4 to 14.6 percent, whereas Colombia is a relatively less
important country for the United States, accounting for less than 1  percent of U.S. total
trade. In addition to the reduction of tariff barriers to trade, other provisions included
developing frameworks to deal with nontariff barriers, improved access to government
procurement markets, improved access to telecommunications products, and establishing
provisions focusing on all types of intellectual property. Major factors holding up pas-
sage of the bill by the U.S. Congress had been concern over violence against labor union
members in Colombia and the general need to protect the rights of workers in Colombia.
The agreement ended up containing specific commitments on labor rights as well as on
some environmental issues.25
The U.S.–Panama Trade Promotion Agreement was signed by Panama and the
United States on June 28, 2007, and after some renegotiations by the Obama adminis-
tration, was eventually passed by Congress and signed into law by President Obama on
October 21, 2011. Again, the impact on U.S. imports is not expected to be great; Panama
already possessed preferential duty-free access to the U.S. market by way of prefer-
ences contained in the Caribbean Basin Recovery Act and the Generalized System of
Preferences. This is a comprehensive agreement that eliminated duties on over 87 percent
of U.S. exports of consumer and industrial products to Panama (average tariff rate equals
7 percent, with some as high as 81 percent), with remaining tariffs being phased out over
10 years. In addition, over half of U.S. exports of agricultural goods received duty-free
status, with most of the remaining tariffs being phased out over a 15-year period.
The agreement also guaranteed U.S. access to Panama’s services markets, and provided the
United States with improved access to both government procurement markets and the tele-
communications sector. Panama also agreed to ensure effective enforcement of its labor
and environmental laws.26
In October 2011 the U.S. Congress passed, and President Obama signed into law, the
United States–South Korea Free Trade Agreement. This pact entered into force on
March 15, 2012. The original agreement had been negotiated in June 2007, but political
wrangling and various issues with this and the other two agreements had put this agree-
ment on hold until October 2011—including a delay regarding renewal of the U.S. Trade
Adjustment Assistance (TAA) Program. In addition, a major issue was that U.S. auto com-
panies and unions wanted a slowdown in the pace of reduction of U.S. tariffs on the import
of Korean automobiles. The U.S.–Korea agreement removed duties on thousands of goods
in the countries’ trade with each other; 80 percent of existing tariffs were eliminated when
the pact entered into force, and 95 percent of tariffs were to be removed within five years
of entry into force. The agreement is important, as two-way trade between the countries
25U.S. International Trade Commission, U.S.-Colombia Trade Promotion Agreement: Potential Economy-Wide
and Selected Sectoral Effects, Publication 3896 (Washington, DC: USITC, December 2006), obtained from
www.usitc.gov; “US-Colombia FTA,” King & Spalding, Trade and Manufacturing Alert, November 2011;
M. Angeles, “The U.S.-Colombia Free Trade Agreement: Background and Issues,” Congressional Research
Service Document, February 14, 2014, Summary.
26Office of the U.S. Trade Representative, “Key Facts of the U.S.-Panama Trade Promotion Agreement,” obtained
from www.ustr.gov; “US-Panama FTA,” King & Spalding, Trade & Manufacturing Alert, November 2011.
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exceeds $100 billion, and the United States is South Korea’s second-largest trading partner
while South Korea is the seventh-largest trading partner of the United States.27
OTHER MAJOR ECONOMIC INTEGRATION EFFORTS
In 1991 Argentina, Brazil, Paraguay, and Uruguay formed the Southern Cone Common
Market (MERCOSUR), which is a customs union that eliminates tariffs on goods and
services between member countries and establishes a common external tariff. In addi-
tion, the MERCOSUR countries established a separate reciprocal investment promotion
and protection agreement (the January 1994 Colonia Protocol) “that guarantees nondis-
criminatory treatment, prohibits performance criteria such as minimum exports or local
inputs, bans restrictions on capital repatriation and profit remittances, and prohibits
expropriation” (USITC, International Economic Review, October/November 1996,
p. 23). Further, an August 1995 protocol provides limited terms of reference on intellectual
property rights, and all member countries have accepted the intellectual property rules
negotiated as part of the Uruguay Round. There is no provision, however, for government
procurement because this activity is regulated in Brazil under its constitution. The four
original members have adopted a common set of customs tariffs and free transit of goods
and services.28 Chile, Colombia, Ecuador, Guyana, Peru, and Suriname currently have
associate member status. MERCOSUR officials also have held talks with representatives
from Mexico regarding possible FTA arrangements.
In June 1995, work was initiated at a meeting of 34 of the Western Hemisphere’s trade
ministers (Cuba did not participate) to create a Free Trade Area for the Americas
(FTAA). The purpose of this meeting was to take initial steps toward establishing a hemi-
spheric free-trade agreement that would build upon the ongoing evolution of the region’s
many subregional trade agreements, such as NAFTA and MERCOSUR. Seven working
groups (on market access, customs procedures and rules of origin, investment, standards
and technical barriers to trade, sanitary and phytosanitary measures, subsidies, and smaller
economies) were established in the resulting Joint Declaration and Work Plan, and provi-
sions were made for adding an additional four groups in the areas of government pro-
curement, intellectual property rights, services, and competition policy. This is the most
ambitious plan for hemispheric economic cooperation to date, and it undoubtedly will expe-
rience a number of serious obstacles that must be overcome prior to its implementation.
(See USITC, International Economic Review, 1995, pp. 11–12.)
The countries’ trade ministers formally launched negotiations in April 1998 in Santiago,
Chile, and numerous meetings have been held. In the eighth meeting, in November 2003,
the ministers reiterated their commitment to the FTAA, and they reaffirmed their “com-
mitment to the successful conclusion of the FTAA negotiations by January 2005, with
the ultimate goal of achieving an area of free trade and regional integration.”29 However,
rising political tensions between Venezuela and the United States since 2006 have impeded
progress toward the completion of FTAA.
MERCOSUR
FTAA
27Elizabeth Williamson, “Disputed Trade Pacts Advance,” The Wall Street Journal, October 3, 2011, pp. A1,
A6; Evan Ramstad, “On Eve of Trade Deal, Seoul Awaits Cheaper Fish, Cars,” The Wall Street Journal, March
15, 2012, p. A11; Office of the U.S. Trade Representative, “U.S.-Korea Free Trade Agreement,” obtained from
www.ustr.gov.
28Joanna Klonsky, “Mercosur: South America’s Fractious Trade Bloc,” Council on Foreign Relations, obtained
from www.cfr.org.
29“About the FTAA,” obtained from www.ftaa-alca.org.
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Beginning in the 1990s, successive Chilean governments have actively pursued trade-
liberalizing agreements. Chile signed FTAs with Canada, Mexico, and Central America.
Chile has also concluded preferential trade agreements with Venezuela, Colombia, Cuba,
Bolivia, Panama, Peru, and Ecuador. An association agreement with MERCOSUR went
into effect in October 1996. As part of an export-oriented development strategy, Chile
completed landmark free-trade agreements in 2002 with the EU and South Korea and an
agreement with the United States in 2004 that would lead to completely duty-free trade
within 12 years. Chile, as a member of the Asia-Pacific Economic Cooperation (APEC)
organization, is seeking to boost commercial ties to Asian markets. To that end, it has
signed 12 trade agreements in recent years since 2006, including agreements with China,
Japan, Turkey, Vietnam, and Hong Kong with Australia, New Zealand, Singapore, Brunei,
India, China, and Japan. Chile claims to have a greater number of trade agreements
than any other country. (See U.S. Department of State, Background Notes: Chile, April
2007 and December 2011, www.state.gov; Central Intelligence Agency, The World
Factbook, at www.cia.org; “Cuadro Resumen de Accuerdos,” obtained from www
.drecon.gob.cl. Information on Chile, Trade Agreements, obtained from www.sice.oas
.org.) While many of these agreements are having a positive impact on trade, Chile and
Mexico may have the fastest-growing commercial relationship in Latin America.30
In addition to free-trade agreements, Chile adopted a uniform 10 percent tariff rate on
goods coming from countries with no special trading arrangements in 1999 and reduced
that rate by 1 percent each year until it reached 6 percent in 2003.31 Chile has since main-
tained a 6 percent flat tariff on most imports, except for some goods with no tariffs (such as
capital goods) and goods that have bands of tariffs rather than a uniform tariff rate (wheat,
wheat flour, and sugar).32
The Asia-Pacific Economic Cooperation (APEC) forum was initiated in November 1989
at a ministerial meeting held in Canberra, Australia, with representatives from 12  countries
participating. The association now has 21 members (Australia, Brunei, Canada, Chile,
China, Hong Kong, Indonesia, Japan, the Republic of Korea, Malaysia, Mexico, New
Zealand, Papua New Guinea, Peru, the Philippines, Russia, Singapore, Taiwan, Thailand,
the United States, and Vietnam), many of which participate in other subregional trade-
liberalizing organizations. The trade liberalization efforts are focused on the development
and adoption of concrete steps to achieve free trade and investment in the Asia-Pacific area
by the year 2020. This work is fostered through annual forum ministerial meetings, with
the annual meeting host being the organization’s chair throughout the year. Inasmuch as
the Asia-Pacific region is the world’s largest and currently most dynamic region in terms
of combined GDP, APEC has the potential to become a major influence on the manner in
which international trade and investment is conducted over the next 30 years.
A broad new initiative for the United States in the area of regional trade agreements was
announced in November 2011. Nine countries indicated that they had adopted the out-
line of a trade/investment agreement with far-reaching implications. The nine countries
in this Trans-Pacific Partnership (TPP) were Australia, Brunei, Chile, Malaysia, New
Zealand, Peru, Singapore, Vietnam, and the United States. The group issued a statement
Chilean Trade
Agreements
APEC
Trans-Pacific
Partnership
30Diego Cevallos, “Chile-Mexico: Nothing Like Free Trade,” Inter Press Service News Agency, April 7, 2007.
31Mary Anastasia O’Grady, “Chileans Opt for Free Trade While the U.S. Dawdles,” The Wall Street Journal,
October 8, 1999, p. A19, citing remarks by Ricardo Lagos (later Chile’s president).
32International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions 2011
(Washington, DC: IMF, 2011), p. 591.
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IN THE REAL WORLD:
ASIAN ECONOMIC INTERDEPENDENCE LEADS TO GREATER
INTEGRATION
Asian economies have become increasingly important in
the world trading system. A 2008 comprehensive study by
the Asian Development Bank has concluded that Asian out-
put was roughly equal to the output of Europe and North
America, and some projections suggest that by 2020 it could
be 50 percent larger than theirs in purchasing-power-parity
terms (Kuroda, 2008). One response to the growing economic
importance has been a push toward greater integration. The 10
nations that make up ASEAN (Brunei, Cambodia, Indonesia,
Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand,
and Vietnam) are working in this direction. The group aims
for steps that go beyond tariff reforms to include the elimi-
nation of nontariff barriers, harmonizing and simplifying
customs procedures, and developing common product cer-
tification standards. In addition, there is an effort to develop
a new ASEAN framework encompassing investment pro-
tection as well as measures to promote and facilitate cross-
border investing (Foo, 2008).
The excitement over the integration efforts led the
ASEAN leaders to move forward the plans for the ASEAN
Economic Community by five years to 2015 (The Wall
Street Journal Europe, 2008). However, the excitement was
tempered by a realization of the difficulty of greater eco-
nomic integration as seen in the comments of Singapore’s
Prime Minister Lee Hsien Loong:
We have set a goal of a strong and cohesive Asean
Community. Year by year, we have gradually come closer
to the ideal. But we are still far from attaining it. Compared
to more established groupings such as the European Union,
ASEAN is still a long way from becoming a fully inte-
grated community. (The Wall Street Journal Europe, 2008)
Emphasizing this continuing commitment to integra-
tion, the ASEAN leaders met in Phnom Penh, Cambodia, in
April 2012 and reaffirmed their plan to establish the ASEAN
Economic Community (AEC) by 2015. This establishment
of the AEC is to be based on the four following “pillars”:
a single market, a competitive region vis-à-vis the rest of
the world, equitable economic development within the AEC,
and an integration of ASEAN into the world economy.
However, as the December 2015 deadline approached, it
was generally thought that the objectives of the free move-
ment of goods, services, skilled labor, and capital would
not be realized by the deadline. The slower-than-desired
progress was partly due to the fact that, unlike the situation
in the EU, the AEC has sought to maintain the sovereignty
of each of its member countries and to avoid interference
in purely domestic issues. Further, one observer noted
that “one wonders if the closer integration of the group-
ing’s 10 member states matters as much to Asean’s people
and companies as it does to the policymakers and business
leaders . . .” (Teck).
Sources: Sanchita Basu Das, “The ASEAN Economic Community:
A Work in Progress,” The Diplomat, May 23, 2015, obtained
from www.thediplomat.com; Lim Cheng Teck, “Asean Economic
Community Is Here–Now Make It Work,” Financial Times, May
29, 2015, obtained from http://blogs.ft.com/beyond-brics/. Alvin
Foo, “Asean Moves Closer to Economic Integration,” The Straits
Times, August 27, 2008; “ASEAN Pursues a Problematic Path to
Integration,” The Wall Street Journal Europe, October 8, 2008,
both obtained through Library.PressDisplay.com; Haruhiko Kuroda,
“Asian Economic Interdependence Will Lead into Integration,” The
Jakarta Post, September 29, 2008, p. 14; “Phnom Penh Declaration
on ASEAN: One Community, One Destiny,” obtained from www.
aseansec.org. ●
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that is basically an indication of intent with respect to the attainment of broad objectives,
and the countries would work toward a final, more-specific agreement that not only would
deal with the usual subjects of trade agreements (manufactured goods, agriculture, intel-
lectual property, and so on) but also would embrace other matters. These other matters
would include, for example, corporation regulatory systems within TPP countries, trade
and investment in digital technologies, production and distribution chains, and assistance
to small- and medium-sized firms. The outline adopted in 2011 was the culmination of nine
rounds of negotiations. Canada, Japan, and Mexico later joined the partnership, and the
likelihood of a successful conclusion of negotiations was enhanced when President Obama
was given “fast-track” authority in August 2015. During the negotiations, there were
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important differences among the 12 nations, including controversies over trade in auto-
mobiles, trucks, milk imports (especially into Canada), and sugar imports (into the United
States), among others.33 Nevertheless, at the time of this writing, negotiations had been
successfully concluded. However,detailed provisions were not generally known and,
importantly, the United States had yet to ratify the agreement.
In June 2013 President Obama, along with European Commission President José Manuel
Barroso and European Council President Herman Van Rompuy announced that the United
States and the EU would begin negotiation of a Transatlantic Trade and Investment
Partnership (TTIP) in July 2013. Principal objectives of the negotiations included
removing all tariffs on goods, working toward reducing various nontariff barriers to trade,
improving access for imported services, and strengthening rules-based direct investment
flows between the partners.34 Negotiations were underway at the time of this writing. High
hopes were expressed in a European Commission website statement that success of TTIP
“. . . means more business opportunities, more growth and more jobs. Lower prices, a wider
variety of products to choose from and confidence that products and services from across
the Atlantic meet the highest safety standards would also contribute to the prosperity of the
over 800 million EU and US citizens.”35
Transatlantic Trade
and Investment
Partnership
SUMMARY
This chapter examined the theory behind the formation of vari-
ous types of economic integration projects. When a discrimi-
natory trade policy regime of this sort is introduced, trade is
created through displacement of high-cost domestic producers
by lower-cost partner suppliers. This trade creation can enhance
welfare. However, trade diversion through displacement of
low-cost outside world sources of supply can also occur, and
this may reduce welfare. Any conclusions on whether welfare
will rise or fall must be based on an analysis of each particular
coalition formation. When dynamic effects such as the realiza-
tion of economies of scale and increased investment and tech-
nology flows are considered, the presumption is more likely that
the partners will benefit from the union, and the outside world
may also gain. The chapter also gave attention to the European
Union—a single-market project that has had important conse-
quences for international trade. Finally, important economic
integration is occurring in the Western Hemisphere with the
implementation of the North American Free Trade Agreement
(NAFTA), MERCOSUR, and the potential Free Trade Area for
the Americas and in Asia with APEC, ASEAN, and the Trans-
Pacific Partnership.
One note of caution should be made: there is considerable feel-
ing among economists that economic coalitions among regional
groupings of countries may not be as economically desirable as an
alternative—nondiscriminatory decreases in trade barriers world-
wide. In other words, the world may be moving toward blocs of
countries and away from global integration. Political tensions and
frictions can also result from the current discriminatory policy
actions. A major question in this debate is whether the second-
best route of discriminatory trade barrier reductions is more feasi-
ble than the first-best, nondiscriminatory reductions. The intense
disagreement during the Uruguay Round of trade negotiations
lends credence to this pessimistic view, although some success
was indeed achieved in the Uruguay Round. More recently, the
difficulties of reaching agreement in the Doha Development
Agenda negotiations further substantiate this view.
33“Trans-Pacific Partnership,” King & Spalding Trade & Manufacturing Alert, April 2012; Office of the U.S.
Trade Representative, “The United States in the Trans-Pacific Partnership,” obtained from www.ustr.gov;
Elizabeth Owerbach, “In the Wake of Trade Agenda Momentum, TPP Negotiations Continue,” King & Spalding
Trade & Manufacturing Alert, September 2015; “Pacific Trade Brinksmanship,” The Wall Street Journal, August
10, 2015, p. A12.
34Office of the United States Trade Representative, “Fact Sheet: Transatlantic Trade and Investment Partnership
(T-TIP),” June 2013, obtained from www.ustr.gov.
35European Commission, “About TTIP—Basics, Benefits, Concerns,” obtained from www.ec.europa.eu.
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QUESTIONS AND PROBLEMS
1. Suppose country A is considering forming a customs union
with country B. Country A produces only manufactured
goods and imports all its raw materials and agricultural
products. Country B produces only raw materials and agri-
cultural products and imports all its manufactured goods.
Remembering the concepts of trade creation and trade diver-
sion, is this union likely to be welfare enhancing? Why or
why not?
2. It is often said that developing countries have little to gain
from economic integration projects among themselves
because they trade very little with each other. What is the
reasoning behind this view? Do you agree with the conclu-
sion? Explain.
3. When Portugal and Spain (which import agricultural goods
from the United States) entered the EC in 1986, the United
States threatened to place heavy duties on imports from the
EC of wines, Scotch whisky, and other luxury-type goods
unless the Community permitted greater access to other U.S.
goods. What could have been the motivation behind the U.S.
action, and would you have supported the action?
4. The terms trade creation and trade diversion are often
applied in the context of assessing the impact of developed
countries’ tariff preferences for the products of developing
countries (the Generalized System of Preferences). How can
these terms be useful in the GSP context?
5. What expected impacts of further integration in the EU
could be detrimental to the United States? What expected
impacts could be beneficial? In general, do you think the
United States should be enthusiastic or worried about further
integration in Europe? Why?
6. Why might it be argued that the development of APEC and
the Trans-Pacific Partnership alongside integration efforts
in the Western Hemisphere increases the likelihood that
regional agreements may be a step to freer world trade in
general?
7. How would you explain reservations in the United States
about the implementation of NAFTA? Do you think that
NAFTA is a “good thing” or not? Explain.
8. “The countries of the world should follow the path of mak-
ing nondiscriminatory reductions in trade barriers worldwide
rather than the path of forming selective, discriminatory eco-
nomic coalitions.”
(a) Build a case in favor of this statement.
(b) Build a case against this statement.
KEY TERMS
Asia-Pacific Economic Cooperation
(APEC) forum
Canada–U.S. Free Trade
Agreement
common external tariff
common market
customs union
dynamic effects of economic
integration
EC92
economic union
European Community (EC)
European Union (EU)
Eurosclerosis
ex post income elasticity of import
demand (YEM)
free-trade area (FTA)
Free Trade Area for the Americas
(FTAA)
maquiladoras
MERCOSUR
monetary union
North American Free Trade
Agreement (NAFTA)
rules of origin
Single European Act
static effects of economic integration
trade creation
trade diversion
Transatlantic Trade and Investment
Partnership (TTIP)
Trans-Pacific Partnership (TPP)
transshipment
U.S.–Central America Free Trade
Agreement/Dominican Republic
(CAFTA–DR)
U.S.–Colombia Trade Promotion
Agreement
U.S.–Panama Trade Promotion
Agreement
United States–South Korea Free
Trade Agreement
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LEARNING OBJECTIVES
LO1 Identify the various characteristics of developing countries.
LO2 Explain how greater openness to trade can potentially contribute to more
rapid economic growth.
LO3 Discuss policies and strategies for enhancing the role of trade in
development.
LO4 Analyze the nature of and potential solutions to the external debt
problems of developing countries.
18
CHAPTER
INTERNATIONAL
TRADE AND THE
DEVELOPING
COUNTRIES
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CHAPTER 18 INTERNATIONAL TRADE AND THE DEVELOPING COUNTRIES 417
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INTRODUCTION
When the East Asian financial crisis hit in 1997, many thought that the region would suffer a
lost decade similar to Latin America after the debt crisis in the mid-1980s. Rather than a decade
of stagnation, the GDP of the region had almost doubled by 2005. An examination of other eco-
nomic indicators shows that the nations of the region increased the openness of their econo-
mies and moved toward greater regional integration. As a result, by 2005 exports of the region
accounted for one-fifth of the world’s total, and East Asia had become the largest destination for
foreign direct investment. In addition, fewer people were living in poverty and a new middle class
was emerging throughout the region.1
How might the changing economic conditions described in this vignette be related to inter-
national trade and finance? The purpose of this chapter is to explore these relationships.
We begin with a summary of various characteristics of developing countries.
AN OVERVIEW OF THE DEVELOPING COUNTRIES
In presenting the economic characteristics of emerging and developing countries (EDCs), it
should be kept in mind that they are not a homogeneous group; there are many differences
in levels of income, type of industrial structure, degree of participation in international
trade, and types of problems faced in the world economy. Despite this caution regarding
the diversity among EDCs, an examination of characteristics of these countries can be
useful for emphasizing that the developing countries are very different from the developed
or industrial countries (ICs). Table  1 provides data on selected economic and noneco-
nomic characteristics grouped into a framework used by the World Bank in its World
Development Report 2015. Low-income economies in this table are EDCs with annual per
capita incomes of $1,045 or less in 2013, while lower-middle-income economies are EDCs
with per capita incomes of $1,046 to $4,124. The category upper- middle-income econo-
mies embraces developing countries with per capita incomes of $4,125 to $12,745. Finally,
a fourth category, high-income economies, covers economies with per capita incomes
above $12,745. The data embrace 214 economies.
The table clearly indicates differences of the developing countries from each other.
In general, however, the EDCs can be characterized as having low per capita incomes.
Further, population growth rate, the share of agriculture in GDP, and infant mortality are
higher and life expectancy is shorter than in the high-income countries. However, the
growth rates in total GDP in the lower three groups have considerably exceeded the growth
rates in high-income economies. Exports as a percentage of GDP increased for two of
the three developing country groups. Finally, the share of manufactured exports in total
exports tend to be somewhat lower in developing countries than in high-income countries;
this lower share would be much more noticeable if China and India were excluded from
the figure for developing countries, but the precise figure is not available. Finally, going
beyond Table 1, it can be noted that the less-developed countries in Africa increased their
dependence on primary commodities and several low-income economies remained depen-
dent on service exports. In contrast, Asian economies have continued to diversify away
from primary goods and toward manufacturing.2
Recovery in East Asia
after Financial Crisis
1Indermit Gill and Homi Kharas, An East Asian Renaissance: Ideas for Growth (Washington, DC: The
International Bank for Reconstruction and Development/The World Bank, 2007), p. 1.
2United Nations Conference on Trade and Development, The Least Developed Countries Report 2008: Growth,
Poverty and the Terms of Development Partnership (Geneva: UNCTAD, 2008).
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THE ROLE OF TRADE IN FOSTERING ECONOMIC DEVELOPMENT
Having looked at these general characteristics, we now examine some of the links between
international trade and development and discuss several problems often associated with the
international sector of the EDCs. We also consider particular strategies and policies that
might be employed to overcome the problems and focus briefly on the manner in which
international trade can influence changes in a developing economy. Because the links
between growth and trade have already been discussed in Chapter 11, our concern here is
TABLE 1 Economic and Noneconomic Characteristics of Developing Countries and High-Income Countries
Low Income*
Lower-Middle
Income†
Upper-Middle
Income‡ High Income§
GNI per capita, 2014 (in dollars) 635 2,037 7,893 38,392
GNI per capita, 2014 (in PPP dollars) 1,593 6,073 14,184 40,842
Population, 2014 (in millions) 613 2,844 2,355 1,396
Average annual GDP growth rate, 2009–2014 5.8% 6.2% 6.3% 1.7%
Average annual population growth rate, 2000–2014 3% 2% 1% 1%
Urban population as percentage of total population, 2013 30% 39% 62% 80%
Agricultural value added as percentage of GDP, 2014 32% 17% 7% 2%
Exports of goods and services as percentage of GDP
2000 20% 26% 26% 25%
2014 24% 26% 28% 30%
Manufactured goods as percentage of goods exports, 2014 … 49% 74% 70%
Infant mortality rate (per 1,000 births)
1990 105 83 43 12
2013 53 44 16 5
Adult (15+) literacy rate, 2005–2013
Male 68% 79% 96% …
Female 54% 62% 92% …
Years of life expectancy at birth, 2013 59 67 74 79
… indicates that the figure is not available or that a group figure cannot be calculated due to missing data.
*Low-income economies (36): Afghanistan, Bangladesh, Benin, Burkina Faso, Burundi, Cambodia, Central African Republic, Chad, Comoros, Democratic Republic
of Congo, Eritrea, Ethiopia, The Gambia, Guinea, Guinea-Bissau, Haiti, Kenya, Democratic Republic of Korea, Kyrgyz Republic, Liberia, Madagascar, Malawi, Mali,
Mozambique, Myanmar, Nepal, Niger, Rwanda, Sierra Leone, Somalia, South Sudan, Tajikistan, Tanzania, Togo, Uganda, and Zimbabwe.
†Lower-middle-income economies (48): Armenia, Bhutan, Bolivia, Cabo Verde, Cameroon, Republic of Congo, Cote d’Ivoire, Djibouti, Egypt, El Salvador,
Georgia, Ghana, Guatemala, Guyana, Honduras, India, Indonesia, Kiribati, Kosovo, Laos, Lesotho, Mauritania, Federated States of Micronesia, Moldova, Mongolia,
Morocco, Nicaragua, Nigeria, Pakistan, Papua New Guinea, Paraguay, Philippines, Samoa, Sao Tome and Principe, Senegal, Solomon Islands, Sri Lanka, Sudan,
Swaziland, Syria, Timor-Leste, Ukraine, Uzbekistan, Vanuatu, Vietnam, West Bank and Gaza, Yemen, and Zambia.
‡Upper-middle-income economies (55): Albania, Algeria, American Samoa, Angola, Argentina, Azerbaijan, Belarus, Belize, Bosnia and Herzegovina, Botswana,
Brazil, Bulgaria, China, Colombia, Costa Rica, Cuba, Dominica, Dominican Republic, Ecuador, Fiji, Gabon, Grenada, Hungary, Iran, Iraq, Jamaica, Jordan,
Kazakhstan, Lebanon, Libya, Macedonia, Malaysia, Maldives, Marshall Islands, Mauritius, Mexico, Montenegro, Namibia, Palau, Panama, Peru, Romania,
St. Lucia, St. Vincent and the Grenadines, Serbia, Seychelles, South Africa, Suriname, Thailand, Tonga, Tunisia, Turkey, Turkmenistan, Tuvalu, and Venezuela.
§High-income economies (75): Andorra, Antigua and Barbuda, Aruba, Australia, Austria, The Bahamas, Bahrain, Barbados, Belgium, Bermuda, Brunei, Canada,
Cayman Islands, Channel Islands, Chile, Croatia, Curacao, Cyprus, Czech Republic, Denmark, Equatorial Guinea, Estonia, Faeroe Islands, Finland, France,
French Polynesia, Germany, Greece, Greenland, Guam, Hong Kong (China), Iceland, Ireland, Isle of Man, Israel, Italy, Japan, Republic of Korea, Kuwait, Latvia,
Liechtenstein, Lithuania, Luxembourg, Macao (China), Malta, Monaco, Netherlands, New Caledonia, New Zealand, Northern Mariana Islands, Norway, Oman,
Poland Portugal, Puerto Rico, Qatar, Russian Federation, St. Kitts and Nevis, St. Martin, San Marino, Saudi Arabia, Singapore, Sint Maarten, Slovak Republic,
Slovenia, Spain, Sweden, Switzerland, Trinidad and Tobago, Turks and Caicos Islands, United Arab Emirates, United Kingdom, United States, and U.S. Virgin
Islands, Uruguay.
Sources: The World Bank, World Development Indicators 2015, pp. xiii, 24–28, and inside back cover 2, available at http://www.worldbank.org, and World
Development Indicators tables, available at http://wdi.worldbank.org/table/1.1 and identical address with table numbers 2.1, 2.13, 2.21, 4.1, 4.2, and 4.4.
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CHAPTER 18 INTERNATIONAL TRADE AND THE DEVELOPING COUNTRIES 419
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not restricted to the changes in efficiency and capacity of the system but, rather, is with the
broader set of effects that relate to the ability of the economy to meet its citizens’ needs
and wants over time. We are thus concerned here with both static and dynamic effects on
the economic system that take place as a country exchanges goods and services with other
countries, as well as the manner in which these trade-related effects can be influenced by
economic policy.
The static effects of trade have been thoroughly developed in earlier chapters. Put simply,
if there is a difference between internal relative prices in autarky and those that can be
obtained internationally, then a country can improve its well-being by specializing in and
exporting the relatively less expensive domestic goods and importing goods that are rela-
tively more expensive. From a development standpoint, the change in economic structure
and factoral distribution of income that is assumed to accompany this adjustment is of clear
concern. Because the economic systems of the developing countries tend to be somewhat
unresponsive to changing price incentives, at least in the short run, factors of production
may not move easily to the expanding low-cost sectors from the contracting higher-cost
sectors. In this case the adjustment process takes on the characteristics of the specific-
factors model (Chapter 8), and the gains from specialization are reduced in the short run.
As noted in Chapter 6, however, even if a country’s production does not change at all, there
are still gains from exchange. In addition, the characteristics of the import good—either
in terms of quality for consumers or productivity in the case of capital and intermediate
inputs—may improve the economy’s ability to meet consumer desires. Imports may also
help relieve short-run domestic bottlenecks and permit the economy to operate closer to
its production-possibilities frontier—that is to say, more efficiently—on a consistent basis.
The static impact of trade on the production structure of the economy that occurs when
specialization follows comparative advantage will result in a relative expansion of the
sector(s) using relatively intensively the relatively abundant factor. For most developing
countries, this results in incentives to expand labor-intensive production instead of more
modern, capital-intensive production. This means expanding traditional agriculture, pri-
mary goods, and labor-intensive manufactures. International trade thus stimulates employ-
ment and puts upward pressure on wages, as suggested in the Heckscher-Ohlin explanation
of the basis for trade. However, to the degree that developing countries are characterized
by high degrees of unemployment, the impact of increased demand for labor on the wage
level is often limited at best. Also, given the economic characteristics of many primary
goods and labor-intensive manufactures, some observers question the desirability of a rela-
tive growth in the production of these traditional goods, particularly if this growth is at the
expense of modern manufacturing. Because of the lower income and price elasticities of
demand for these products and the instability of supply of agricultural and primary produc-
tion due to factors such as weather conditions, greater specialization in these goods can
result in a greater instability of income, even in the static sense. Income instability is also
of concern in the dynamic sense and will be addressed again in the following section.
Further, to the extent that the developing country is a large country in terms of export
goods, expansion of export supply may well lead to undesired terms-of-trade (TOT) effects
that will significantly reduce the expected static gains from trade and lead to a distribution
of the gains from trade that favors the more developed trading partner. Finally, expanding
production of basic labor-intensive products and relying on the industrialized countries for
technology and skill-intensive manufactures and capital goods not only can lead to a criti-
cal economic dependency but also inextricably links the economic health of the developing
country to that of the industrialized country.
The Static Effects of
Trade on Economic
Development
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In previous chapters we discussed the theoretical impact of trade on production assum-
ing there was full employment. However, full employment is seldom the case in many
developing countries. The situation suggests another potential gain from international trade
that has been elaborated by Hla Myint (1958) and may help to explain the rapid growth of
production and output of traditional agricultural and primary products in the developing
countries in the nineteenth century.3 Myint suggests that unemployment represents a poten-
tial production supply that exceeds domestic demand in the developing country. In this
instance, international trade can provide a vent for surplus, that is, a larger market that will
permit the country to increase its output and employment (conceptually, to move from well
inside its production-possibilities frontier to a point nearer or perhaps on the PPF). Myint
argues that vent for surplus is a more convincing explanation of why countries start to trade,
while comparative advantage helps us to understand the types of commodities countries
ultimately trade. From a development standpoint, the gains in income, employment, and
needed or wanted import goods can influence the development process in a positive manner.
In sum, the static gains from trade for the developing country originate from the
traditional gains from exchange and specialization as well as, perhaps, from a vent for
surplus. However, because of the inflexibilities in the traditional economies and the nature
of the traditional labor-intensive exports, the relative static gains from trade may be less
than those for the more flexible industrial economy and also may be reduced by the unde-
sirable effects of increased economic instability and TOT behavior.
As in economic integration, the biggest potential effect of trade on development likely rests
with the dynamic effects. On the positive side, the expansion of output brought about by
access to the larger international markets permits the EDC to take advantage of economies
of scale that would not be possible with the limited domestic market. Thus, industries that
are not internationally competitive in an isolated market may well be competitive by way
of international trade if there are potential economies of scale. Further, because compara-
tive advantages change over time and with economic development, international trade can
foster the development of infant industries into internationally competitive ones by pro-
viding the market size and exposure to products and processes that would not happen in
its absence. This, of course, is one of the reasons cited for using trade policy instruments
(Chapter 15) to restrict imports or promote exports, although there are problems with using
the policies in practice. Other dynamic influences of trade on economic development arise
from the positive antitrust effects of trade, increased investment resulting from changes in
the economic environment, the increased dissemination of technology into the developing
country (e.g., the product cycle), exposure to new and different products, and changes in
institutions that accompany the increased exposure to different countries, cultures, and
products.
Few would disagree that trade can have positive effects on economic development.
What is much less clear is the type of commodities a country should specialize in so
that, over time, international trade in goods and services continues to foster growth and
development, not hinder it. Because conditions in the developing countries differ so dra-
matically from the theoretical world of perfect competition and full employment utilized in
many theoretical models, the static application of comparative advantage may not be very
helpful in providing guidelines for trade and specialization in a dynamic EDC setting. It
is often argued that participating in free trade based on the guidelines of simple compara-
tive advantage may work against economic development in the developing country. It is
The Dynamic
Effects of Trade on
Development
3This idea is generally traced to Adam Smith’s 1776 The Wealth of Nations.
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important to examine briefly several of the more important disadvantages of unrestricted
trade for the developing country, particularly because these concerns can have important
implications for trade policy.
The possible negative effects of trade on development arise from economic factors
that are ignored when focusing on static comparative advantage to delineate exports and
imports. For example, market imperfections in developing countries generally result in
private costs and benefits being different from social costs and benefits, particularly in the
presence of externalities. Relying on private (market) prices in this environment can lead
to a pattern of trade that is not consistent with either relative social costs or long-run
development goals of the country (e.g., if an industry’s growth causes extensive environ-
mental damage). In a broader dynamic context, it must also be recognized that because
the economywide production linkages vary between different commodities or sectors, the
overall effect of growth in exports on the growth and development of the entire economy
is likely to vary from commodity to commodity. Some commodities thus act like “growth
poles” for the entire economy, while others such as primary production have little effect
outside their own sector.4 A further complication arises from the variation in the returns
to scale characteristic among commodities. Thus, a country might not appear to have a
relative cost advantage in a particular product at the level of production needed to fill the
home market, but there might well be a comparative advantage in that product at a higher
level of production. In a similar fashion, a product that appears to have a current cost
advantage but is characterized by decreasing returns to scale may find its export possibili-
ties very limited. Finally, from an internal perspective, remember that the domestic supply
and demand conditions that underlie both current and future comparative advantage have
been and will continue to be influenced both by the imperfect nature of the markets and by
government policy.
Another source of potential development problems that can arise with growth in
international trade is the fact that the operation of markets and the characteristics of traded
goods often differ between the developing countries and the industrialized countries. Many
argue that these differences result in the greater share of trade-related benefits going to
the industrialized countries and may even contribute to the furthering of underdevelop-
ment in the EDCs. Two issues related to these differences, export instability and long-run
changes in the TOT, have received considerable attention. We now look at these issues in
more detail.
Export instability refers to the fact that the export earnings tend to fluctuate annually
to a greater extent for developing countries than for industrialized countries. Often, the
focus is not on export earnings (prices of exports times quantities of exports) but on export
prices and their fluctuations. Whether the focus is on prices or on earnings, however, the
variability is regarded as a problem because, with the relatively high degree of openness
of many developing countries (i.e., a high ratio of foreign trade to gross domestic prod-
uct, GDP), variability in the export sector is often associated with variability in GDP and
the domestic price level. The internal instability is considered undesirable because of the
uncertainties generated for producers and consumers. It can also put a strain on the rather
ineffective macroeconomic policy instruments of the developing countries. In addition,
Export Instability
4This is particularly true in a foreign enclave that produces a product or products essentially for export only and
imports practically all intermediate inputs requiring capital and skilled labor. In this instance, the EDC experi-
ences little more than a small increase in employment of production workers and increased sales of any primary
inputs such as minerals or land used in the production process. The effect on the development of the economy in
this case can be negligible.
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planning for development is made more difficult. When export earnings are high in “good”
years, development projects can be started that use imported equipment, but when export
earnings subsequently decline, foreign exchange is not available to complete and to operate
the projects, resulting in waste and a disrupted planning process.
To account for price and earnings instability of the EDCs, economists usually list three
main reasons. All three reasons are associated with the fact that many developing countries
are relatively more engaged in the export of primary products than of manufactured goods.
For example, for the least developed countries, about 60 percent of their export receipts
are derived from primary commodities.5 The first two reasons pertain to price variability,
while the third reason focuses on total export earnings variation.
The first explanation for price instability in developing-country exports combines shifts in
the demand curve for their exports with an inelastic supply curve of exports. The situation is
illustrated in Figure 1, panel (a). Demand curve D1 indicates the demand for the developing-
country export good in time period 1, while curve D2 indicates demand in time period 2. The
supply curve S is assumed to apply to both periods. Note that the supply curve tends toward
vertical, reflecting the supply inelasticity characterizing primary products. (For example, at
the end of the harvesting period, a farmer has little choice but to sell most of the crop on the
market, regardless of price.) When the demand curve shifts from D1 to D2, price rises from
Potential Causes of
Export Instability
5David I. Harvey, Neil M. Kellard, Jakob B. Madsen, and Mark E. Wohar, “The Prebisch-Singer Hypothesis: Four
Centuries of Evidence,” Review of Economics and Statistics 92, no. 2 (May 2010), pp. 367–77.
FIGURE 1 Demand-Supply Shifts and Price Instability
Quantity
Price
E2
E1
D1
D2
P2
P1
0 0
E2
E1
S2 S1
Quantity
Price
P2
P1
(a) (b)
S (= S1 = S2)
D (= D1 = D2)
In panel (a), a shift of the export demand curve in period 1 (D1) to the export demand curve in period 2 (D2), in conjunction with a given inelastic
supply curve in the two periods, yields a relatively large price increase. A shift back in demand to D1 in a subsequent period would generate a
substantial price decline. In panel (b), with an inelastic demand curve D for the primary product in the two periods, a shift in the supply curve in
the first period (S1) to supply curve S2 in the second period likewise causes a relatively large price change. A shift back in supply to S1 in the next
period would generate substantial price instability for the two periods as a whole.
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P1 to P2. If in a third period, demand then shifts back to position D1, price will fall back to
P1. Obviously, there is considerable potential price instability in this scenario. A possible
way to reduce the price instability would be for economic conditions in the buying countries
(the ICs) to be stabilized. Hence, better macroeconomic measures in the industrialized or
developed countries can reduce instability in the less developed countries.
A second explanation for price instability [panel (b) of Figure 1] is the converse of the
first one. Suppose that demand for the export good is inelastic; this is usually the case for
primary products because either the demand is a derived demand for use in a final good
or the product is a food product that characteristically faces low price elasticities. Shifts in
the supply curve because of factors such as variable weather conditions in the producing
countries can then cause substantial price instability. In panel (b), a constant demand curve
is plotted against supply in the first period (S1) and the second period (S2). If weather condi-
tions (such as a failure of the monsoons in India) in the second period reduce production,
the price change is large, from P1 to P2. With a resumption of favorable conditions in the
next period, S2 shifts out again, and price again varies. In this case, the EDC may wish to
search out alternative exports whose production is not so dependent on random factors.
A third explanation offered for instability is the high degree of commodity concentration
in the export bundle, although this explanation has been debated in the literature. (See Love,
1990; Massell, 1990.) In some EDCs, one or two goods constitute a majority of the total
export earnings. This lack of diversification implies that dramatic price rises (or declines)
in the one or two goods will cause total export earnings to rise (or fall) dramatically. If
the bundle of goods were more diversified or less concentrated, then a price increase in
some goods could be offset by price declines in other goods, making for greater stability
in the total value of the export bundle. Examples of countries with relatively high degrees
of commodity concentration are Saudi Arabia, where crude and refined petroleum account
for 78 percent of total exports; Zambia, where copper is 45 percent of exports; and Chad,
where mineral fuels, oils, and so forth account for 96 percent of exports.6 Clearly there
could potentially be some benefit to such developing countries from undertaking policies
to increase the number of different types of goods exported, especially labor-intensive
manufactured goods.
The problem of long-run deterioration in the terms of trade refers to the allegation
that, over the span of several decades or so, there has been a persistent tendency for the
commodity TOT (price of exports/price of imports) to fall for developing countries. If the
world is viewed as consisting of two groups of countries—the EDCs and the ICs—then the
implication is that the commodity TOT have been improving for ICs, because exports from
EDCs are imports into ICs and exports from ICs are imports into EDCs. In other words, the
international economy is transferring real income from EDCs to ICs, an opposite transfer
to that which many people think is desirable. At the extreme, the TOT behavior can gener-
ate immiserizing growth (see Chapter 11).
This hypothesis of secularly declining TOT for EDCs is often referred to as the Prebisch-
Singer hypothesis because of its popularization by two longtime United Nations econo-
mists, Raul Prebisch and Hans W. Singer. The hypothesis emerged in response to statistical
studies showing that, particularly for Great Britain, the TOT had risen dramatically in the
50- to 100-year period ending with World War II. The inference was made that, because
the ICs’ TOT had improved, the EDCs’ TOT must have deteriorated.
Long-Run Terms-of-
Trade Deterioration
62013 data from International Trade Centre, obtained from www.trademap.org.
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A number of economists pointed out that such an inference was invalid. (See Baldwin,
1955; Ellsworth, 1956; Meier, 1968, chap. 3; Morgan, 1959, 1963.) One reason concerns
the way international trade data are recorded. Exports are usually recorded f.o.b. (free on
board), which means that insurance and transportation costs are not included; however,
imports are usually recorded c.i.f. (cost, insurance, and freight). Hence, Pexports/Pimports for
the ICs could have been rising because, as has been the case over the long run, transport
costs had been falling (which would reduce the denominator of the TOT expression). Thus,
the use of the reciprocal of the industrialized countries’ TOT as an indication of the devel-
oping countries’ TOT is invalid, because the recording procedure could be consistent with
improving TOT for both EDCs and ICs due to the decline in transportation costs.
Another reason for objection to long-run studies of TOT behavior concerns quality
changes in products. It is very difficult to incorporate quality changes into price indexes,
and a rise in price for a product may not indicate a true price increase if the quality of the
product purchased has also improved. Quality improvements have been greater in manu-
factured goods than in primary products in the long run. Thus, because the share of primary
products (manufactured goods) in EDC exports is larger (smaller) than in EDC imports,
even if Pexports/Pimports is falling this may not be a true “deterioration” in the TOT. While
the developing countries may be paying relatively more for their imports, they may also be
receiving relatively better products.
Other economists used direct data for several developing countries to ascertain
whether there had been a long-run deterioration in the TOT. (For a bibliography of such
studies, see Diakosavvas and Scandizzo, 1991.) As might be expected from economic
research, both rising and falling trends in EDCs’ TOT have been found. Many researchers
have chosen not to examine the developing countries’ TOT rather the long-run behavior
of primary product prices versus the prices of manufactured goods. Earlier important
research by Diakosavvas and Scandizzo (1991) and Spraos (1983, chap. 3) found a
long-run relative decline in primary-product prices. More recently, Harvey, Kellard,
Madsen, and Wohar (2010), using new econometric techniques, examined the behavior
of 25 individual primary product prices relative to the prices of manufactured goods
over very extended periods of time. For 12 of the commodities, price data began in the
seventeenth century, while 3 commodities’ price series began in the eighteenth century,
8 in the nineteenth century, and 3 in 1900. (The study covered through year 2005.) For
11 of the commodities, there was clear evidence of a long-run decline in their relative
prices. However, for the other 14 goods, no significant trends were found. As all of these
authors note, however, this is not identical to secular deterioration in EDCs’ TOT, since
ICs also export primary products and EDCs also export manufactured goods. Some
recent work has focused on a bilateral context. (See Appleyard, 2006, for India–U.K.
TOT behavior.)
Several reasons have been offered for the alleged long-run TOT decline of develop-
ing countries. (See the various studies cited so far in this section and Singer, 1987.)
A compelling reason for believing in a long-run TOT decline centers on differing income
elasticities of demand for primary products and manufactured goods. Empirical evi-
dence indicates that the income elasticity of demand is higher for manufactured products
than for primary products. It is usually greater than 1.0 for the former and less than 1.0
for the latter. Consequently, as EDCs and ICs both grow, they devote a larger (smaller)
percentage of their incomes to the purchase of manufactured goods (primary products).
Because many EDCs are net exporters of primary products and net importers of
manufactures, the prices of their imports will rise more rapidly than the prices of their
exports, other things equal.
Differing Income
Elasticities of Demand
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TITANS OF INTERNATIONAL ECONOMICS:
RAUL PREBISCH (1901–1986) AND HANS WOLFGANG SINGER
(1910–2006)
Raul Prebisch was born on April 17, 1901, in Tucaman,
Argentina. When he graduated with an economics degree in
1923 from the University of Buenos Aires, he had already
written nine professional journal articles, the first having
appeared when he was 17. He was professor of political
economy at his alma mater from 1925 to 1948, also serv-
ing simultaneously as director of economic research for the
National Bank of Argentina (1927–1930) and undersecretary
of finance for Argentina (1930–1932), among other posts.
He then embarked upon a career with the United Nations,
serving as executive secretary of the U.N.’s Economic
Commission for Latin America (ECLA) from 1948 to 1962
and as secretary-general of the United Nations Conference
on Trade and Development (UNCTAD, an organization
based in Geneva) from 1964 to 1969. He subsequently
became director-general of the U.N.’s Latin American
Institute for Economic and Social Planning.
Dr. Prebisch wrote several influential studies, with par-
ticularly noteworthy ones being “Commercial Policy in the
Underdeveloped Countries” (American Economic Review,
May 1959), The Economic Development of Latin America
and Its Principal Problems (1949), and Towards a New
Trade Policy for Development. Report of the Secretary-
General of the United Nations Conference on Trade and
Development (1964). His thesis of the secular deterioration
of the terms of trade of EDCs is his most widely cited contri-
bution, but he was concerned with problems of industrializa-
tion of the EDCs throughout his career. He appears to have
first crystallized the notion of a “center-periphery” in the
world economy, whereby systematic forces emanating from
the center (the ICs) cause great difficulties for the periphery
(the EDCs). His ability to articulate his views at the interna-
tional agency level has ensured that they have been and will
be long-lasting.
Raul Prebisch was awarded several honorary degrees,
including degrees from Columbia University and the Univer-
sidad de los Andes (Colombia). He also received the
Jawaharlal Nehru Award for International Understanding
in 1974, the Dag Hammarskjold Honorary Medal of the
German U.N. Association in 1977, and the Third World
Prize of the Third World Foundation in 1981.
Hans W. Singer was born in 1910 in Elberfeld (now
Wuppertal), Rhineland, Germany. He earned his diploma in
political science from Bonn University in 1931. He received
his Ph.D. in economics from Cambridge University in 1936,
doing his work during the formative years of Keynesian
economics at Cambridge. He served as assistant lecturer in
economics at Manchester University from 1938 to 1945,
as  economics research officer in the U.K. Ministry of
Town and Country Planning in 1945–1946, and as lecturer
in political economy at Glasgow University in 1946–1947.
He then undertook a U.N. career, building and serving in the
Economics Department of the U.N. Secretariat. He became
professor of economics at the University of Sussex and its
Institute of Development Studies in 1969 and remained on the
institute’s research team long after his “official” retirement.
Professor Singer’s early concern was with unemploy-
ment, and he published Unemployment and the Unemployed
in 1940. He then worked on problems of wartime planning.
He subsequently turned to the area of economic develop-
ment and made many contributions, including Economic
Development of Under-Developed Countries (1950),
International Development, Growth and Change (1964), and
Technologies for Basic Needs (1977). Another work used in
higher education was his text Rich and Poor Countries (with
Javed A. Ansari, 4th ed., 1988). His most famous article is
“The Distribution of Gains between Investing and Borrowing
Countries” (American Economic Review, May 1950).
Professor Singer’s work was of broad scope, extending
beyond the terms-of-trade issue to the structure of the world
economy, basic needs, food aid, and technology transfer. He
took the lead in spreading knowledge of Third World prob-
lems worldwide. His ideas and efforts served as constant
reminders that there is no “quick fix” to EDC problems and
that development should be approached from the perspective
of possible actions in ICs as well as in EDCs. In November
2004, Singer was awarded the first Lifetime Achievement
Award from the Development Studies Association.
Sources: Mark Blaug, ed., Who’s Who in Economics: A Biographical
Dictionary of Major Economists 1700–1986, 2nd ed. (Cambridge,
MA: MIT Press, 1986), pp. 696–97, 788–89; Luis E. Di Marco,
ed., International Economics and Development: Essays in Honor
of Raul Prebisch (New York: Academic Press, 1972), pp. xvii–xix;
Gerald M. Meier and Dudley Seers, eds., Pioneers in Development
(New York: Oxford University Press for the World Bank, 1984), pp.
173, 273–74; J. G. Palma, “Raul Prebisch,” in John Eatwell, Murray
Milgate, and Peter Newman, eds., The New Palgrave: A Dictionary
of Economics, Vol. 3 (London: Macmillan, 1987), pp.  934–36;
Who’s Who in the World, 1st ed., 1971–1972 (Chicago: Marquis
Who’s Who, 1970), p. 746; Who’s Who in the World, 10th ed.,
1991–1992 (Wilmette, IL: Marquis Who’s Who, 1990), p. 1004;
www.ids.ac.uk/ids. ●
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Another explanation for potential TOT deterioration is couched in terms of unequal
market power in product and factor markets in ICs and EDCs. The general point is
that primary products are sold in competitive world markets, while manufactured goods
are often sold in an imperfectly competitive market setting where prices can be higher than
would be the case with perfect competition. In addition, labor markets in ICs may contain
imperfectly competitive elements if labor unions are strong and thus wages are relatively
high, while labor in the primary-product sector in developing countries is not organized
and cannot exert upward pressure on wages and prices. The result is that prices for primary
products do not have the upward pressures put upon them that prices of manufactured
goods do; therefore, the TOT of the EDCs suffer. There may also be an asymmetry in price
behavior: primary-product prices may be slow to rise in the upswing of business cycles but
fall in downswings, while manufactured goods prices rise in upswings and are slow to fall
in downswings. Over the long run, developing countries’ TOT decline.
A third explanation for a possible long-run decline in the developing countries’ TOT is that
the nature of technical change has worked to reduce the growth rate of demand for primary
products. This reduction in the growth of demand has therefore, other things equal, resulted
in less upward pressure on primary-product prices. A principal factor that has reduced
relative demand growth (Singer, 1987) is the growth of synthetic products, which have
displaced natural products. Examples are synthetic rubber and fibers. It is also suggested
that newer production processes in manufacturing industries in industrialized countries
have economized on the use of raw materials. In the 1970s and 1980s, this process was
demonstrated in the case of petroleum by the development of energy-saving technology
and the search for alternative, economically feasible sources of energy such as solar power
or safe nuclear power. Also, the recent attention in ICs to recycling and to conservation is
expected to reduce further the growth of demand for primary products.
Finally, the behavior of multinational corporations (MNCs) through the mechanism of
transfer pricing can worsen the EDCs’ TOT. Suppose that an MNC operates a subsidiary in
a developing country that is sending inputs to another subsidiary in an industrialized coun-
try, and at the same time the subsidiary in the IC is sending inputs to the EDC subsidiary.
Because both subsidiaries are part of the same enterprise, such trade is called intra-firm
trade. In intra-firm trade, prices are not necessarily true market prices because the goods
do not pass through organized markets, and the recorded prices are merely bookkeeping
entries for the firm. (See Chapter 12, page 240.)
In this context, suppose that the developing country has high profits taxes and severe
restrictions on the repatriation of earnings, that is, on the transfer of profits back to the
IC. On the other hand, there are lower profits taxes in the IC and there is no problem of
repatriating profits. In such a situation, the MNC has an economic interest in enlarging
profits recorded on the balance sheet of the industrialized country subsidiary and in reduc-
ing profits on the balance sheet of the EDC subsidiary. A strategy for doing so is to record
the sales from the EDC subsidiary to the IC subsidiary at lower-than-market prices and to
record the sales from the IC plant to the EDC plant at higher-than-market prices. If this
strategy is followed, recorded profits will be lower in the high-tax, difficult-repatriation
EDC and higher in the low-tax and easy-repatriation IC than would otherwise be the case.
The MNC’s total after-tax profits will rise because of this behavior.
From the standpoint of the EDCs’ (ICs’) terms of trade, this behavior means that
Pexports/Pimports will be lower (higher) than it would be if the goods had been traded through
regular, organized markets. Hence, this institutional feature of MNCs can contribute to
Unequal Market Power
Technical Change
Multinational
Corporations and
Transfer Pricing
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worsened TOT for the EDCs. However, it must be shown that this behavior has become
increasingly more prevalent over time for the argument to explain a long-run trend in the
TOT. Empirical work on the importance of MNC transfer pricing is difficult to conduct
because of the privacy of individual firm data and because it is not known precisely what
prices would have existed if trade had occurred through organized markets. The EDCs
have been pressing for measures to regulate this type of intrafirm behavior, but they have
achieved little success so far.
One effort in the developed countries that is aimed at improving the actual prices received
by producers/farmers of export goods in developing countries is the “fair trade” movement.
This notion of fair trade is not the “fair” trade concept that economists use when they refer
to the absence of export subsidies, import quotas, and other trade-distorting measures in a
country’s international trade policy regime. Rather, in the fair trade movement, the term
is employed in the normative/ethical sense that developing countries’ indigenous growers
of coffee, cocoa, and other such products should receive a higher price for their products
than would otherwise have been the case. The fair trade organization purchases the good
from the farmer or the farmer’s cooperative, transports it, and sells it to consumers in the
developed world, and this process replaces the alternative, normal mechanism whereby the
product is purchased from the farmer by a local wholesale buyer and/or large corporation,
which then implements the process of delivering and selling the product to the developed-
countries’ consumers. The fair trade movement thus can eliminate a potentially exploitive
“middleman” in the process of connecting producer with consumer or serve to counteract
monopsony power of the buyer/corporation. The end result is that the producer can receive
a higher price for the product. In addition, the fair trade process also often requires the
grower of coffee (or whatever crop is involved) to use environmentally safe production
methods; further, there is also sometimes a specification that certain labor standards will be
adhered to by the farmer. In the end, “fair trade” coffee, chocolate, bananas, and so on are
usually bought by the final consumer for a higher price than would be the case through the
normal process. Buyers are willing to pay the higher price because they are receiving the
additional satisfaction (beyond the utility derived from consuming the good itself) of help-
ing low-income, indigenous farmers in developing countries. Because the price is higher,
the sending country may have had its TOT improved over the alternative scenario. Though
growing in importance in recent years, fair trade commodities constitute a very small per-
centage of international trade.7
The fact that there are some possible negative effects of trade on the growth and devel-
opment process has stimulated numerous studies examining the possible link between
exports, in particular, and economic growth.8 Early studies linking various measures of
export growth with growth in income suggested that they were significantly positively
correlated and that exports did appear to be the “engine of growth” often referred to since
the time of Smith and Ricardo. Some studies, however, suggest a less clear conclusion and
Empirical Evidence
on Trade and
Development
7For more information, see Eric J. Arnould, Alejandro Plastina, and Dwayne Ball, “Does Fair Trade Deliver on
Its Core Value Proposition? Effects on Income, Education Attainment, and Health in Three Countries,” Journal
of Public Policy and Marketing 28, no. 2 (Fall 2009), pp. 186–201, obtained from www.marketingpower.com;
and David R. Henderson, “Fair Trade Is Counter-Productive—and Unfair,” Economic Affairs, September 2008,
pp. 62–64, obtained from www.iea.org.uk. For an interesting account of a fair trade process for coffee emanating
from the ground up in Uganda, see Daniel Bergner, “Can Coffee Kick-Start an Economy?,” The New York Times,
April 6, 2012, obtained from www.nytimes.com.
8A useful summary of these empirical analyses is contained in Edwards (1993).
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raise a number of questions about the effect of trade on economic growth. Econometric
studies of individual countries over time (time-series analysis) and groups of countries at a
point in time (cross-sectional analysis) have indicated statistically significant relationships
between growth in both exports and imports and income growth. In a number of cases,
particularly for middle-income countries, there appears to be a strong positive relationship
between trade and growth through the direct effect of export earnings on GNP and the indi-
rect effects (balance-of-payments effects) associated with the increased capacity to import
needed capital and intermediate inputs. However, it is possible that increased income leads
to greater imports and increased efficiency leads to greater exports; thus, the causality may
run from growth to trade rather than from trade to growth.
Another group of studies has suggested that growth in exports has a positive effect on
growth and development because it stimulates increased saving and investment. These
effects on aggregate saving result from either the higher propensity to save in the export
sector or the effects on total saving of any changes in the distribution of income tied to the
growth in the export sector.
In sum, while empirical analysis often supports the idea of a positive connection between
the expansion of international trade and growth in income, a certain ambiguity remains.
The manner and degree to which trade influences growth and development are complex
and often country specific. The nature of the effect appears to vary with the degree of
development, the nature of the economic system, and world market conditions outside the
influence of the individual country. World business cycles in particular seem to play an
important role, and the relationship between trade and growth increasingly appears to be
more simultaneous than uniquely causal. While empirical analysis has not yet provided a
conclusive answer as to the links between trade and growth, some of the models of growth
through endogenous technological change that incorporate various effects of international
trade might prove more successful.9
Another “fly in the ointment” that has recently emerged in the literature is the idea that
institutional characteristics such as property rights, contracts, macroeconomic stabiliza-
tion tools, and regulatory agencies for transport and finance are extremely important for
growth. Indeed, some studies have found that, once such influences are allowed for, little
or no additional explanatory power regarding growth is provided by a country’s increased
trade and integration with the world economy.10 Thus, in general, while there is much
analysis that stresses that trade is an engine of growth, there remains some doubt on the
part of a number of observers.
9For examples of these models, see especially Romer (1986) and Grossman and Helpman (1991).
10Dani Rodrik and Arvind Subramanian, “The Primacy of Institutions (and What This Does and Does Not Mean),”
Finance and Development 40, no. 2 (June 2003), p. 32.
CONCEPT CHECK 1. What are three reasons the short-run or static
gains from international trade may be less for
the developing country than for an industrial-
ized country?
2. How can international trade stimulate change
in the economic system in the dynamic sense?
What factors can inhibit trade from positively
influencing the development process?
3. Why do developing countries have greater
problems with export instability than indus-
trialized countries?
4. What are two factors that contribute to possi-
ble downward pressure on the terms of trade
for developing countries?
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TRADE POLICY AND THE DEVELOPING COUNTRIES
We now turn to a brief examination of the manner in which trade policy can be used to
influence growth and development in developing countries. Our analysis is restricted to
three areas: export instability, TOT behavior, and inward- versus outward- looking devel-
opment strategies.
Several kinds of policies that conceptually can stabilize prices or export earnings have
been used at various times. We consider a few general policies, but none of them has been
judged very successful in practice.
A policy that has continued to receive attention is an international buffer stock agreement.
(The most well known of such agreements is the International Tin Agreement, which is
currently inoperative.) Indeed, proposals adopted at a special United Nations General
Assembly session in 1974 called for an expansion in the number of such agreements as a
means of generating greater benefits for EDCs in the world economy. In the international
buffer stock agreement, producing nations (often joined by consuming nations) set up an
international agency endowed with funds and a quantity of the commodity. If the world
price of the good falls below the floor, the agency will buy it to bring the price up to the
floor. On the other hand, if the world price rises above the ceiling, the agency will sell the
good to bring the price down to the ceiling. If the agency is successful, then producing
(and consuming) countries have realized greater stability than would otherwise have been
the case.
Another mechanism for introducing greater stability into EDC exports is an international
export quota agreement, exemplified historically by agreements on coffee conducted
since 1962 under the auspices of the International Coffee Organization. Quotas were in
place in a number of years until 1989 when they were suspended.11 In an export quota
agreement, producing countries choose a target price for the good (e.g., $2.50 per pound of
coffee) and make a forecast of world demand for the coming year. Then they determine the
quantity of supply that will, in conjunction with estimated world demand, yield the target
price. Suppose that the estimated necessary supply is 400 million pounds of coffee. The
agreement divides up the 400 million pounds among the supplying countries and stipulates
that no country can export more than its designated share. If the forecast of demand is cor-
rect and supplying countries adhere to their quotas, then the price in the coming year will
be at the target level.
The export quota agreement contains a mechanism for keeping prices stable. If the
world price falls because of a decrease in demand, the export quotas of the supplying coun-
tries will be tightened and the price will return to $2.50. Analogously, if the world price
rises, the quotas will be relaxed and the price will fall back to $2.50. Thus, greater stability
is provided with the agreement in place than would otherwise have been the case.
Another mechanism for dealing with export instability focuses on alleviating the con-
sequences of the instability for the developing countries. This mechanism is known as
compensatory financing. An international agency is provided with funding and forecasts
the growth trend of the export earnings of each participating EDC. (The International
Monetary Fund has had a compensatory financing facility since 1963.) Suppose that
Policies to Stabilize
Export Prices or
Earnings
International Buffer
Stock Agreement
International Export
Quota Agreement
Compensatory
Financing
11Additional information on the agreements can be obtained at www.ico.org.
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export earnings in 2015 for the developing country fall below the forecast level. The
agency responds by extending a short-term loan to the EDC, and the steady flow of foreign
exchange to the EDC for the purchase of development imports is thus sustained. If, in
2018, the cycle turns around and the developing country’s export earnings rise above trend,
the loan can be repaid. Advocates of this approach emphasize that it is superior to interna-
tional commodity agreements (ICAs) because compensatory financing does not interfere
with the allocative function of prices.
Given the developing countries’ interest in greater use of international commodity agree-
ments, it is useful to indicate potential difficulties with such arrangements. From the stand-
point of feasibility, the crucial features for success in a buffer stock agreement are the
levels at which the ceiling price and the floor price are set. If the designated price range
does not contain the long-run free-market equilibrium world price, then the agreement
may not be sustainable. Suppose that the designated price range is from $12.50 to $13.00
per pound of tin but that the actual long-run free-market world price is $12.30 per pound.
The result of the agreement will be that the agency will continually be purchasing the good
and will exhaust its endowment of funds. It will also accumulate quantities of the good
that can only be unloaded at a loss. Further, the price will not have been stabilized and the
agency will have no funds with which to continue its operations. If, instead, the long-run
equilibrium world price is $13.50 rather than $12.30, then the agency will exhaust its initial
endowment of the good. While it will have accumulated funds with which to set up a new
agreement at a higher price range, the buffer stock has not performed its stabilizing func-
tion. (See Johnson, 1967, chap. 5.)
There are also forecasting difficulties with export quota agreements. If long-run demand
is weaker than estimated, then the supply on the world market from the producing countries
will depress the price below what was desired. To raise the price, the countries must hold
back exports and will be faced individually with the problem of an accumulation of stocks
of the good. If long-run demand is stronger than estimated, individual country stocks will
be depleted and countries can no longer stabilize the price. Despite the inability to stabilize,
however, the latter situation benefits the EDCs because their export earnings will be higher
than anticipated.
A more fundamental difficulty of the export quota arrangement is that, even if the demand
and therefore price have been correctly estimated, the agreement must embody all exporters
of the good or it will be undermined. If there are n exporting countries but only n − 1 of them
participate, then the nth country will not be constrained in its exports. If it sells large quanti-
ties, the world price will fall below the target price. Further, the exporting countries in any
export quota agreement must honor their quotas. If they secretly sell more than their allotted
amounts, downward pressure on the good’s price takes place. For example the Organization
of Petroleum Exporting Countries (OPEC), a price setting organization, has had difficulty
in maintaining the target price of crude oil because individual members cut prices to sell
larger-than-agreed-upon volumes, and the emergence of other energy sources in the world.
Along the same line, consuming countries are often brought into export quota agree-
ments, and therefore it is necessary that the entire set of consuming nations be included
in the agreement. If this is not the case, the exporting countries will find outlets for addi-
tional sales in nonparticipating buying countries, and downward pressure will be put on
the price. In sum, without full participation and adequate enforcement procedures, export
quota agreements will not perform their stabilizing function.
Several general policy measures have been suggested for alleviating the alleged secular
deterioration of the TOT of EDCs. We now discuss these measures briefly.
Problems with
International
Commodity
Agreements
Suggested Policies to
Combat a Long-Run
Deterioration in the
Terms of Trade
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IN THE REAL WORLD:
MANAGING PRICE INSTABILITY
Primary goods prices have demonstrated considerable
price instability over the years, causing considerable eco-
nomic adjustment problems for the developing world. For
instance, at the time of this writing many primary goods
prices have fallen precipitously from previous peaks.
During the commodities boom of the first decade of the new
century, the export earnings of countries such as Peru and
Chile skyrocketed as, for example, the price of copper qua-
drupled. Wisely anticipating that the price of copper would
eventually decline, the Chilean finance minister, Andrés
Velasco, placed a large amount of the earnings from cop-
per sales into a “rainy day” fund that swelled to more than
$20 billion (more than 15 percent of Chile’s annual output).
By withstanding great political pressure to spend the funds
concurrently with the boom, this action not only reduced
the domestic inflation pressure that could result from short-
run consumption and investment surges, it also provided
a source of funding when the price of copper eventually
fell—which it did by 50 percent in 2008 in the midst of
the worldwide recession. In 2009, with recession pressures
building, Chile started pouring some of its massive sav-
ings into a very large stimulus plan, including public works
projects, tax breaks for businesses, investments to keep the
mines operating, and other demand-generating activities.
Seven hundred million dollars alone were put into an infra-
structure program creating 60,000 jobs in road construc-
tion, housing construction, and airport upgrades. Overall,
the Chile plan reflected an expenditure equal to 2.8 percent
of its GDP, in contrast to the 2 percent size of the Obama
plan in the United States, as it bootstraps its recovery from
the recession.
Source: Matt Moffett, “Prudent Chile Thrives Amid Downturn,”
The Wall Street Journal, May 27, 2009, p. A1. ●
IN THE REAL WORLD:
THE LENGTH OF COMMODITY PRICE SHOCKS
An article by Paul Cashin and Hong Liang of the International
Monetary Fund and C. John McDermott of the Reserve Bank
of New Zealand (1999) sought to determine the likelihood
of success of price stabilization schemes for primary com-
modities. As the history of such agreements suggests, there
is reason for pessimism regarding their viability.
The approach of Cashin, Liang, and McDermott was first
to note that about 25 percent of world merchandise trade was
accounted for by primary products. In addition, on average,
about one-half of export earnings of developing countries
were derived from primary commodities. Indeed, a single
product can often comprise a substantial portion of a coun-
try’s export earnings. Then Cashin, Liang, and McDermott
pursued the question of how long would intervention by a
price stabilization scheme have to occur in order to provide
for stability over time in any given commodity’s price, given
that price “shocks” take place frequently.
Assembling monthly price data for 1957–1998 on 44 com-
modities, Cashin, Liang, and McDermott calculated the length
of a typical deviation from trend of any given price shock or
disturbance. More precisely, they calculated the length of time,
after an initial disturbance in price (either up or down), that it
took for the amount of the initial disturbance to be dissipated
by one-half (that is, the half-life of the shock). The half-lives
were quantified in months, and results are given in Table 2.
Clearly, the length of time required for some prices to settle
down is very long. Such long reaction periods mean that a
stabilization scheme for any given product would not be likely
to be successful without substantial funding to continue the
program for several years. This can importantly account for
the failure of the International Sugar Agreement in 1984, the
International Tin Agreement in 1985, the International Cocoa
Agreement in 1988, and the International Coffee Agreement
in 1989. (Note that these four commodities all have long half-
lives.) However, the alternative to price stabilization schemes,
compensatory financing, might involve a very long commit-
ment of funds in order to offset the shortfall in earnings for
the duration of the effects from a downward price disturbance.
(continued)
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IN THE REAL WORLD: (continued)
THE LENGTH OF COMMODITY PRICE SHOCKS
Less than 1 Year 1 Year–4 Years 4 Years–8 Years More than 8 Years
Bananas Aluminum Beef Cocoa beans
Heating oil Fishmeal Coconut oil Coffee (robusta)
Hides Gasoline Copper Coffee (other milds)
Softwood (logs) Iron ore Groundnut oil Cotton
Softwood (sawn wood) Lamb Lead Gold
Sugar (European Union) Rubber Maize Hardwood (logs)
Tea Soybean meal Palm oil Hardwood (sawn wood)
Soybeans Phosphate rock Natural gas
Sugar (United States) Soybean oil Nickel
Wheat Wool (coarse) Petroleum
Wool (fine) Rice
Zinc Sugar (free market)
Tin
Tobacco
Triple superphosphate
Source: Paul Cashin, Hong Liang, and C. John McDermott, “Do Commodity Price Shocks Last Too Long for Stabilization Schemes to Work?” Finance and
Development 36, no. 3 (September 1999), pp. 40–43. ●
TABLE 2 Duration of Commodity Price Shocks, January 1957–December 1998
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One strategy is increased export diversification into manufactured goods by the EDCs.
If the export bundle increasingly contained relatively more manufactured goods, this would
circumvent in part the difficulties experienced by the EDCs both with respect to the dif-
fering income elasticities of demand and the effects of technological change. The man-
ufactured goods would presumably be labor-intensive goods in accordance with EDCs’
abundant labor supplies and the Heckscher-Ohlin theorem. Such a strategy is easier to rec-
ommend than to implement, and long-term measures such as increased education may be
necessary. Nevertheless, many developing countries have dramatically increased the share
of manufactured goods in their exports in the last two to three decades.
Another possible measure is the formation of an export cartel by developing countries. A
significant feature of the success of OPEC in the 1970s was that, although the dramatic oil
price increases caused difficulties for oil-importing EDCs, developing countries in general
looked positively on OPEC’s success because it demonstrated that at least some develop-
ing countries could organize to obtain a larger share of the gains from trade in the world
economy. (See Bhagwati, 1977, pp. 6–7.) However, a redistribution via the export cartel
route may not be a long-term solution to the difficulties of primary product exporters.
Export Diversification
Export Cartels
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To be successful, all exporting countries must be part of the process; there must not be
strong substitution possibilities for the good in question; and members of the agreement
must not cheat on the agreement. These conditions are most likely to be met where only a
few countries dominate the world market and where demand is inelastic both in the short
run and the long run. These conditions are not likely to be fulfilled for many primary prod-
ucts exported by developing countries.
A third policy option is the use of developing-country import or export restrictions to
improve the TOT. As discussed in Chapter 15, a country with the ability to influence world
prices can gain welfare by imposing its optimum tariff (assuming no retaliation). However,
economists are generally skeptical of the value to any particular developing country of
adopting such trade restrictions. To influence the TOT, a country must be large in the
economic sense in one or more of its export commodities, and this may not be the case for
many EDCs. While industrialized countries’ demand for primary products tends to be price
inelastic—and hence there is scope for EDCs to improve their TOT by restrictions—the
inelasticity applies to primary products as a whole and not to primary products from any
one supplier. Demand curves facing any individual country are more elastic than those
facing suppliers as a whole. Further, the difficulties of organizing many EDCs to act in
concert were mentioned above. Finally, any reduction in the volume of trade by the use of
restrictions will deprive EDCs of necessary development imports (e.g., machinery, trans-
port equipment, parts) from the ICs and will introduce price distortions into the economy
which can be disadvantageous for development.
A policy option receiving increased attention is the formation of economic integration
projects among the developing countries themselves. These projects may be, for example,
free-trade areas or common markets. The idea behind integration projects from the stand-
point of the TOT problem is that the EDC member countries can avoid the potential TOT
deterioration in their trade with industrialized countries by having increased trade among
themselves. In addition, more market power in world markets may be possible by acting
as a united front. Further, the enlarged market size within the region may stimulate invest-
ment, the emergence of manufactured goods production, and the diversification required
to avoid export instability and TOT deterioration. However, as noted in Chapter 17, such
unions run into difficulties regarding the sacrifice of national sovereignty and the distribu-
tion of benefits among the partner countries.
In recent years, there has been a resurgence of interest and participation in economic
integration on the part of many developing countries. The ever-growing list of partici-
pants includes Mexico (NAFTA, APEC), the countries of MERCOSUR, Chile (in many
FTAs), the Asian countries in APEC, the members of the Central American Common
Market, members of the Andean Pact, participants in the Caribbean Common Market
(CARICOM), and the Southern African Customs Union (SACU). What is of particular
note is that these various integration schemes increasingly involve groups of both develop-
ing and industrialized countries. These arrangements thus often facilitate the flow of new
technologies and promote development in the developing countries that takes best advan-
tage of their underlying comparative advantages. Given the experiences of a number of
the developing and semi-industrialized countries, it is clear that integration arrangements
will not automatically lock the developing country into specializing in the production of
primary products.
Import and Export
Restrictions
Economic Integration
Projects
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In view of the preceding discussion, what is the appropriate trade strategy for EDCs?
Economists and policymakers have debated two competing strategies regarding the trade
sector. An inward-looking strategy is an attempt to withdraw, at least in the short run, from
full participation in the world economy. This strategy emphasizes import substitution,
that is, the production of goods at home that would otherwise be imported. This can econo-
mize on scarce foreign exchange and ultimately generate new manufactured exports with-
out the export difficulties of primary products if economies of scale are important in the
import-substitute industries and if the infant industry argument applies. The strategy uses
tariffs, import quotas, subsidies to import-substitute industries, and other measures of this
type. In contrast, an outward-looking strategy emphasizes participation in international
trade by encouraging the allocation of resources without price distortions. It does not use
policy measures to shift production arbitrarily between serving the home market and for-
eign markets. In other words, it is an application of production according to comparative
advantage; the current expression is that the EDCs should get prices right. Some ana-
lysts go further and focus particularly on export promotion, whereby policy steps such
as export subsidies, encouragement of skill accumulation in the labor force and the use of
more advanced technology, and tax breaks are used to generate more exports, particularly
labor-intensive manufactured exports in accordance with the Heckscher-Ohlin theorem.
Does the choice of which trade strategy to employ make a difference in the performance of
the developing country economy? In an early study, the World Bank’s World Development
Report 1987 examined experience for 41 EDCs in an attempt to answer this question. It
classified countries according to four categories of trade strategy. A country was classified
as a strongly outward-oriented economy (SO) if it had few trade controls and if its cur-
rency was neither overvalued nor undervalued relative to other currencies and thus did not
discriminate between exports and production for the home market in incentives provided.
A country was classified as a moderately outward-oriented economy (MO) if the incen-
tives biased production slightly toward serving the home market rather than exports, effec-
tive rates of protection were relatively low, and the exchange rate was only slightly biased
against exports (i.e., home currency slightly overvalued). A moderately inward-oriented
economy (MI) clearly favors production for the home market rather than for export through
relatively high protection because of import controls, and exports are definitely discour-
aged by the exchange rate. Finally, a strongly inward-oriented economy (SI) exhibits
comprehensive incentives toward import substitution and away from exports through more
severe measures than in MI. The 41 countries were classified by their trade strategy for two
periods, 1963–1973 and 1973–1985. Only three economies were classified as SO in each
period: Hong Kong, South Korea, and Singapore. There was a predominance of African
and Latin American countries in the two inward-looking categories.
Inward-Looking
versus Outward-
Looking Trade
Strategies
Trade Strategy and
Economic Performance
CONCEPT CHECK 1. How can price instability in a product be
related to the demand and supply elasticities
of the product?
2. Why do economists tend to favor the use of
compensatory financing rather than inter-
national commodity agreements to enhance
efficient resource allocation in EDCs?
3. Why might diversification of EDC exports
into manufactured goods help to alleviate any
possible long-run deterioration in the EDCs’
terms of trade?
4. Why does the mere existence of transfer pric-
ing by multinational corporations in a man-
ner unfavorable to EDCs not automatically
imply that the transfer pricing has caused a
long-run deterioration in the terms of trade of
the EDCs?
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With respect to the comparative performance of countries operating under the differ-
ent trade strategies, the World Bank staff’s conclusions were strongly stated: “The fig-
ures suggest that the economic performance of the outward-oriented economies has been
broadly superior to that of the inward-oriented economies in almost all respects” (World
Bank, 1987, p. 85). Various criteria of economic performance were examined to reach this
conclusion. In terms of the average growth rates of real GDP, a ranking for 1963–1973
showed that, in terms of the four designations, SO > MO > MI > SI; for 1973–1985, the
average growth rate of MI countries slightly exceeded that of MO countries, but the rest
of the ranking remained intact. The same general pattern was true of growth rates of GNP
per capita, with an average growth rate of 6.9 percent in the SO countries and 1.6 percent
in the SI countries for 1963–1973. The average per capita GNP rates were 5.9 percent in
the SO countries and minus 0.1 percent in the SI countries for 1973–1985. Further, saving
as a percentage of GDP was greater for the two outward categories in the second period,
although this was not true for the first period. The growth rates of manufactured exports
among the outward countries substantially exceeded those of the inward countries in both
periods. Finally, capital was used more efficiently (as expressed in lower quantities of
capital required to get additional units of output) in the outward economies than in the
inward economies.
A measure that did not show superior performance for the countries with outward ori-
entation was the rate of inflation. These rates were close to each other in all four categories
in 1963–1973, but the MO economies had the highest rates in 1973–1985, and the average
rate for SO and MO countries exceeded that for MI and SI countries in those years. The
World Bank explained this phenomenon by indicating that an outward strategy ties a coun-
try’s inflation rate to that of the world economy to a greater extent than the inward strategy,
and world inflation was high in the 1973–1985 period.
In addition to the general findings on the better economic performance under an
outward-looking strategy, the World Bank suggests that outward orientation rather than
inward orientation may lead to a more equal income distribution (World Bank, 1987,
p. 85). A reason for this result is that the expansion of labor-intensive exports gener-
ates employment opportunities, while import substitution policies often result in capital-
intensive production processes that displace labor. Another benefit of the outward-looking
strategy is that foreign-exchange shortages are less common. With import substitution, an
initial saving of foreign exchange is often temporary because the replacement of imports of
final goods by domestic production requires imports of raw materials, capital equipment,
and components. The end result may be increased rather than decreased dependence on
imports. (See Krueger, 1983, pp. 7–8.)
The World Bank’s findings (see also World Bank 1991) and those of advocates of com-
parative advantage have led to the recommendation that the EDCs adopt more outward-
oriented policies. Indeed, the world economy starting in the late 1980s and continuing
to the present time, has seen a strong emergence of support for the market—witness the
economic reforms in Central and Eastern Europe and the former republics of the Soviet
Union, the growth success of China and India, and more recently the growth experience
of several African countries. However, despite the seeming advantage of outward-looking
policies, some economists and policymakers are reluctant to embrace the strategy whole-
heartedly. First, expansion of manufactured exports, such as that attained by Hong Kong,
South Korea, Singapore, Taiwan, and, recently, China, can run into protectionist barriers
in the industrialized countries. Because the labor-intensive manufactured exports threaten
long-existing industries in ICs (e.g., textiles and shoes), restrictions such as the earlier
Multi-Fiber Arrangement in textiles and apparel may have stifled this route to development
for many EDCs. In addition, the export path may require skills in the labor force that are
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not yet fully developed and will require a large commitment of resources in order to do so
(although import substitution runs into this same problem). Further, Paul Streeten (1982,
pp. 165–66) has pointed out that there is a “fallacy of composition” in the outward-looking
strategy because, while any one country may face high price elasticities of demand in
manufactured goods exports, the demand facing all developing countries is less elastic than
that facing any one country. Substantial price declines may occur if all EDCs follow the
same path. In addition, some empirical studies dispute any positive relationship between
exports and industrialization (see Chow, 1987) or suggest that the positive link occurs only
above some threshold income level (see Tyler, 1981). Nevertheless, looking at the trade/
growth experience of developing countries in recent decades The Economist in 2001, after
considering import substitution industrialization (ISI) and various objections to greater
openness, concluded, “On the whole, ISI failed; almost everywhere, trade has been good
for growth.”12
It should be noted that some mix or sequence of the two strategies may be appropriate
in some cases. For example, South Korea engaged in import substitution before embarking
on its export-led growth path (see Singer and Ansari, 1988, pp. 261–63). In cases of infant
industries, this may be a good strategy. In addition, some have suggested (see Todaro and
Smith, 2012, chaps. 12–13) that economic integration among developing countries may
offer benefits because it is a combination of an outward-looking strategy (through freer
trade with other EDC partners) and an inward-looking strategy in which the union as a
whole is turning away from the rest of the world economy. In any event, the precise extent
to which a country should turn outward or inward depends on the external and internal
characteristics of that country. The policies to be recommended can be decided only on a
case-by-case basis.
An excellent overview of the history of trade policy and economic development can
be found in a paper by Anne O. Krueger (1997). After reviewing the theoretical, policy,
and empirical work that had focused on this issue in the previous 50 years, she pointed
out several lessons that had been learned regarding the current state of knowledge in this
area. Not surprisingly, the first lesson she cited is that empirical research that tests for
the presence and relative importance of certain stylized facts is critical to the successful
application of theory and policy selection. Nowhere is this more in evidence than in trade
policy, where early policy decisions were based on facts that were often little more than a
mixture of “touristic impressions, half truths and misapplied policy inferences” (Krueger,
1997, p. 3). What had happened was a demonstration that developing countries can expand
export earnings based on, among other things, increased exports of manufactures. In addi-
tion, there was also clear evidence that producers in these countries did indeed respond
to economic incentives. The experience of the East Asian countries had been particularly
effective in demonstrating the viability of trade policies that promoted industrialization
through reliance on foreign markets (as opposed to domestic markets) and were based on
sound ideas of comparative advantage that went beyond reliance on primary commodi-
ties. Krueger suggested that the East Asian experience demonstrated that the earlier export
pessimism that underlay ideas of import substitution was perhaps more an indicator of
inward-oriented trade and payments regimes than an outward focus based on dynamic
comparative advantage. If nothing else, the East Asian experience put to rest the idea that
developing countries with an outward focus would lock themselves permanently into a pat-
tern of primary-product specialization.
In recent years, evidence has continued to accumulate that supports the notion that trade
liberalization is an important avenue for fostering economic growth in developing countries.
12“Globalisation and Its Critics,” The Economist, September 29, 2001, p. 12.
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IN THE REAL WORLD:
EMERGING CONNECTIONS BETWEEN ASIA AND AFRICA
Outward-looking strategies have generally focused on
expanded North–South trade between the developing coun-
tries and industrialized countries. An interesting twist on
this trade focus was recently noted by Broadman (2007). A
rapid growth in trade has been taking place between coun-
tries in Africa and Asia, particularly by India and China,
spawned by the rapidly growing middle classes in these
countries. This expanding trade differs from the North–
South trade between Africa and the United States and
Europe (which was driven by preferential trade agreements)
in that it appears to be based on emerging complementari-
ties between the two regions. Africa currently exports pri-
marily petroleum and raw materials to Asia in exchange
for manufactured goods. However, there are several signs
suggesting that the nature of these economic complemen-
tarities is changing. African countries appear to be moving
toward exporting more resource-based, value-added goods
and, at the same time, more broadly participating in global
supply chains. This is notable in production areas such as the
cotton-textile-garment vertical supply chain. However, for
Africa to gain the most from these growing trade flows, there
is a clear need for domestic reforms. These needed reforms
include changes in institutions that improve access to mar-
kets, foster a competitive environment, put in place effec-
tive incentives, establish sound governance, and improve the
flexibility of factor markets.
However, tying a region’s fate closely to another region
can be risky. For example, the recent falling growth rate of
the Chinese economy posed difficulties for some African
countries. Angola, for instance, had problems importing
grain and medicine after the reduction of earnings from
its oil exports to China. The slowing down of the sizeable
flow of investment by China in Africa also should not be
overlooked.
Sources: Harry G. Broadman, “Connecting Africa and Asia,”
Finance and Development 44, no. 2 (June 2007), pp. 36–39; Patrick
McGroarty and Matina Stevis, “Africa Reels from China Bets,” The
Wall Street Journal, September 9, 2015, p. A7. ●
CHAPTER 18 INTERNATIONAL TRADE AND THE DEVELOPING COUNTRIES 437
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David Dollar and Aart Kraay (2004) divided developing countries into “globalizers” and
“nonglobalizers.” Globalizers were countries in the top one-third of a sample of 72 coun-
tries in terms of growth in the ratio of trade to GDP between the late 1970s and the late
1990s; nonglobalizers were the remaining 48 countries. A key characteristic of the global-
izers, with their large increases of trade to GDP, was that they cut tariffs significantly while
the nonglobalizers did not do so. In terms of GDP growth rates, the globalizers (e.g., China,
India, Mexico) had an annual average increase in GDP of 2.9 percent in the 1970s, which
increased to 3.5 percent in the 1980s, which then increased to 5.0 percent in the 1990s. The
nonglobalizers (e.g., Honduras, Myanmar, Pakistan) had an annual average growth rate of
3.3 percent in the 1970s, 0.8 percent in the 1980s, and 1.4 percent in the 1990s.
Another look at the trade/growth relationship was carried out by Johnson, Ostry, and
Subramanian (2006). They examined 47 developing countries that had experienced rapid
growth at some time since the end of World War II. They found that countries with an
extended solid growth period, whom they designated as sustained-growth countries,
had several characteristics in common, such as relatively good economic and political
institutions—and the study of institutions has become very prominent recently in the eco-
nomic development literature. However, and importantly for this chapter, Johnson, Ostry,
and Subramanian discovered that trade liberalization was very much a characteristic of the
sustained-growth countries, as contrasted with the countries that had not undergone sus-
tained growth. A related key finding was that the sustained-growth countries did not have
the large overvaluations of their currencies that the other countries did.
Finally, in 2008, the international Commission on Growth and Development examined
growth in various countries since 1950. The panel noted that 13 countries grew at an aver-
age annual rate of 7 percent for a period of at least 25 years (e.g., Botswana, China, Japan,
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South Korea, Singapore). There were several common elements in the experiences of these
countries, such as political stability and high saving and investment rates, but one particular
element was a willingness to expand trade and to attract foreign direct investment.13 Also
in 2008, Romain Wacziarg and Karen Horn Welch examined the trade and growth experi-
ence of 118 developing countries over the period 1950–1998. The countries that liberalized
trade on average increased their ratio of trade to GDP by roughly 5 percentage points. This
liberalization raised their average annual GDP growth rates by about 1.5  percentage points
compared to their pre-liberalization growth rates. Further, the opening to trade raised the
ratio of investment to GDP by 1.5 to 2 percentage points.14
THE EXTERNAL DEBT PROBLEM OF THE DEVELOPING COUNTRIES
A final topic of concern with regard to the international sector and development is the
external debt problem of the EDCs. This problem is intimately bound up with the matter of
access to finance in the world economy. If industrialized country banks that have outstand-
ing loans to the developing countries experience difficulties because of this debt, underpin-
ning institutions in the world monetary system are placed in jeopardy. Table 3 provides an
overview of the size of the external debt of EDCs, with data on the debt and its relationship
to several key economic variables at the end of 2011.
Column (1) shows that emerging/developing Asia and, Latin America and the Caribbean
countries have the largest dollar value of external debt. However, for a variety of reasons,
including quicker adjustment policies to the debt problem and favorable export prospects,
these counries do not have as severe a debt problem as the central and eastern European
countries. Column (2) is a measure of the EDCs’ ability to carry the debt in relation to
13Reported in Robert Samuelson, “Globalization Is a Way Out of Poverty,” The Durham (NC) Herald-Sun, May
28, 2008, p. A8.
14Romain Wacziarg and Karen Horn Welch, “Trade Liberalization and Growth: New Evidence,” World Bank
Economic Review 22, no. 2 (2008), pp. 187–231.
External Debt
($ billions)
Debt as a Percentage
of GDP
Debt as a Percentage of
Exports of Goods and Services Debt Service Ratio
Emerging Market and Developing
Countries (152) $7,436.0 25.4% 83.7% 29.4%
Commonwealth of Independent
States and Georgia (12) 1,105.3 39.7 122.5 37.9
Emerging and Developing
Asia (29) 2,207.5 16.0 56.9 27.0
Emerging and Developing
Europe (12) 1,244.8 66.3 167.2 62.2
Latin America and the
Caribbean (32) 1,633.1 27.7 131.0 34.7
Middle East, North Africa,
Afghanistan, and Pakistan (22) 887.3 26.2 54.2 16.6
Sub-Saharan Africa (45) 358.0 22.5 75.9 13.1
Note: The number of countries in each group is given in parentheses.
Source: International Monetary Fund, World Economic Outlook database, obtained from www.imf.org.
TABLE 3 External Debt and Debt Ratios of Developing Countries, 2013
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annual productive capacity, that is, the flow of annual output that conceptually could be
available to repay the debt.
Column (3) emphasizes the point that even though a country may produce the goods
and services with which to repay debt, it still must convert these resources into foreign
exchange (i.e., hard, convertible currencies). Unless new external funds are forthcom-
ing, this generation of foreign exchange has to occur through successful exporting. That
is, in order to effectively transfer purchasing power back to the lenders as repayment,
developing-country exports must be stimulated and imports reduced so that sufficient for-
eign exchange is available. This transfer problem of freeing up resources to accomplish
repayment can be difficult indeed. The countries of Emerging and Developing Europe,
Latin America and the Caribbean, and the Commonwealth of Independent States and
Georgia have the highest debt/export ratios.
Finally, column (4) presents the debt service ratio, a measure that many economists
judge is the best indicator of the debt problem facing EDCs. The debt service ratio is
the percentage of annual export earnings that must be set aside for payment of interest
on the debt and the scheduled repayment of the debt itself. When debt service ratios are of
the order of Emerging and Developing Europe’s, 62.2 percent, the countries must devote
large portions of their foreign exchange earnings to debt service. These large fractions of
foreign exchange earnings are therefore not available for the purchase of needed imports,
and imports must be reduced dramatically if the country is to avoid drawing down its stock
of international reserves or incurring even more debt. (In the 1980s, many Latin American
countries compressed imports to such an extent that living standards fell drastically.)
Many factors have been suggested as having played a causal role in the debt problem.
However, the relative importance of the factors varies from country to country, and it is
difficult to make generalizations.
1. A prominent element in discussions of the debt problem consists of the oil price
increases of 1973–1974 and 1979–1981. The two “oil shocks” resulted in a huge increase
in the oil import bills of many developing countries, and borrowing was necessary to
finance the additional import expenditures. Much of the borrowing was from industrialized
countries’ commercial banks, which were recycling dollars deposited in them by members
of OPEC (petrodollars).
2. Related to the oil price increases were the recessions in the industrialized countries
in the 1970s and early to mid-1980s. The recessions resulted in large part from the oil
shocks but also from anti-inflationary macroeconomic policies adopted in industrialized
countries. From the standpoint of the EDCs, recessions in the ICs mean that purchases of
EDC exports grow slowly or decline. With slower or negative export growth, EDCs must
borrow more to continue a flow of imports.
3. The behavior of real interest rates was also important in generating and perpetuat-
ing the debt crisis. The real interest rate is equal to the nominal interest rate charged by
lenders minus the expected rate of inflation. In the 1970s, this real rate was low and some-
times negative due to expectations of high inflation, and borrowers (the EDCs) were thus
encouraged to undertake new loans. However, the rapid fall in inflation in the 1980s in the
United States in particular—associated with tight monetary policy—caused the real rate to
rise. This meant that any additional EDC borrowing to finance repayment of existing debt
imposed extra burdens on the developing countries.
4. In addition, primary-product prices declined dramatically in the 1980s. Because
primary products constitute a large fraction of the exports of developing countries, this
Causes of the
Developing Countries’
Debt Problem
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decline necessitated additional borrowing to finance needed imports for development.
Many of these prices rose in the early 1990s but then fell again. Another rise and subse-
quent fall took place in the first decade of the new century, followed by a rise early in the
second decade.
5. Domestic policies within the developing countries also played a role in generating
the debt problem. If loans are used for consumption rather than for productive investment,
or if the EDC inflates its price level rapidly by excessive monetary growth associated with
government budget deficits, then repayment prospects are poor and new borrowing must
be undertaken. Further, mismanagement of domestic financial institutions can exacerbate
the problem. The ability to finance development without resorting to external borrowing
is also hindered if domestic price controls inhibit an efficient allocation of resources or if
the EDC’s currency is pegged at an overvalued rate. Such overvaluation makes exports
“too expensive” to foreign buyers and imports “too cheap” to domestic buyers, leading to
a trade deficit.
6. Another factor associated with increasing indebtedness was capital flight from the
developing countries. This phenomenon is harder to document precisely than previous rea-
sons, but that the phenomenon exists is unquestionable. With very rapid inflations taking
place in Latin American countries, low real interest returns and political instability, many
domestic citizens sent funds to IC banks. With these funds not available for domestic use,
the EDCs had to borrow more capital on international markets.
7. Finally, the hypothesis has emerged that a considerable portion of EDC indebtedness
was due to “loan-pushing” by banks in the developed countries (Darity and Horn, 1988).
This view emphasizes that IC banks were awash in funds (importantly from the recy-
cling of petrodollars) and, accompanied by the deregulation of financial institutions in the
United States, were anxious to expand their loan portfolios. Hence, loans were often made
that were not necessarily associated with sound economic analysis and did not adequately
take risk factors into account. In many cases, the growing debt burden was effectively
ignored by banks as EDC officials were aggressively talked into taking on more debt than
their countries could absorb. Indeed, in the middle of 1982, “the nine largest U.S. banks had
loans outstanding to developing countries and eastern Europe amounting to 280  percent of
their capital, and most had over 100 percent of capital in loans to just Brazil and Mexico.”15
This large and concentrated amount of outstanding loans also led to fears of collapse of the
financial systems in industrialized countries if defaults occurred.
In seeking solutions to the developing-country debt problem, it is important to distinguish
between the liquidity problem and the solvency problem. The liquidity problem in this
context refers to the fact that although a debtor country will eventually be able to repay its
debts, there is a short-run problem of financing debt service payments because the coun-
try’s assets are not immediately convertible into a form acceptable to creditors. Hence,
policies should provide for temporary finance until longer-run adjustments can take place.
The solvency problem refers to the fact that the country is in such poor condition and has
such dismal economic prospects that it will never be able to generate the resources to repay
its debt. If the problem is insolvency, then some form of debt forgiveness must be instituted
or the country will have to default on its obligations. Until 1982, the debt problem was gen-
erally regarded as one of liquidity, but the announcement by Mexico (the second-largest
Possible Solutions to
the Debt Problem
15William R. Cline, “International Debt: From Crisis to Recovery,” American Economic Review 75, no. 2 (May
1985), p. 185.
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CHAPTER 18 INTERNATIONAL TRADE AND THE DEVELOPING COUNTRIES 441
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EDC debtor at the time, after Brazil) that it would not be able to meet debt service obliga-
tions due at that time set in motion a concern that the problem in many EDCs was really
one of insolvency.
In general, there are several broad categories of solutions that can be suggested for dealing
with the debt problem. First, EDCs can change their domestic policies so as to increase
their ability to service the debt. This strategy is a long-term one that regards the debt prob-
lem as a matter of temporary illiquidity. The emphasis of the International Monetary Fund
and the World Bank on structural adjustment policies falls into this category. When the
IMF negotiates with a debtor country concerning new loans, it will often approve the loans
only if the EDC undertakes various measures to strengthen its long-term repayment pros-
pects. The conditionality measures usually include reduction of government budget deficits
and control of the money supply (to reduce inflation and the accompanying balance-of-
payments deficits) and the adoption of a realistic exchange rate—meaning a devaluation
of the domestic currency.16 These steps are often called “austerity policies.” Devaluation
undertaken along with contractionary monetary and fiscal policies can improve the trade
balance and put the debtor country in a better position for servicing debt with hard for-
eign currency. Other recommended policies usually include the elimination of government
production and/or consumption subsidies and of distortionary price controls. These mea-
sures allow the market rather than government policy to allocate resources, which the IMF
argues will improve efficiency. The attachment of such conditions to new lending by the
IMF has generated considerable resentment among EDCs.
Another approach to the debt problem involves debt rescheduling. This approach also
treats the debt problem as basically a liquidity rather than a solvency problem. In resched-
uling operations, interest rates on the debt are often lowered, the time period of the loan is
lengthened, or the grace period before repayments start is made longer. There have been
a large number of reschedulings, particularly through the “Paris Club,” a consortium of
IC governments set up to deal with rescheduling of government (rather than commercial
bank) loans. These reschedulings have been particularly relevant for Africa, where the debt
is owed mostly to governments rather than to private banks. (Latin America’s debt to banks
is greater than to governments.)
Another approach focused on debt relief or debt reduction rather than on rescheduling.
A well-known earlier initiative along this line was the Brady plan, proposed by U.S.
Secretary of the Treasury Nicholas Brady early in 1989. Details varied from country to
country, but in this general strategy, a pool of money from the United States or from the
World Bank and the IMF was used to guarantee new bonds issued by developing-country
governments. These new bonds were offered to existing lenders in such a fashion that
the amount of debt outstanding was reduced. For example, $10 billion of new debt might
be issued to retire $20 billion of old debt. The advantage to the EDC is that its debt is
decreased, as well as its interest payments. For the lending bank, $20 billion of claims on
Changing Domestic
Policies
Debt Rescheduling
Debt Relief
16One study of 24 EDCs indicated that failure to have an appropriate exchange rate had strongly negative implica-
tions for such performance characteristics as per capita income growth rate, export growth rate, and net invest-
ment rate. See Joaquin A. Cottani, Domingo F. Cavallo, and M. Shahbaz Khan, “Real Exchange Rate Behavior
and Economic Performance in EDCs,” Economic Development and Cultural Change 39, no. 1 (October 1990),
pp. 61–76.
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the developing country have been swapped for only $10 billion of claims, but the smaller
amount is now guaranteed. An alternative procedure might involve no reduction in the
principal of the debt but a lower interest rate on the new debt than on the old debt. It was
also anticipated that the developing country would carry out market- and growth-oriented
reforms such as relaxation of price controls, elimination of distortions, and policies to
stimulate domestic savings and investment. For a discussion of an IMF-based debt relief
program, see the “In the Real World” box on the following page.
An interesting hypothesis that has emerged in the context of debt relief is that a reduc-
tion in debt might in fact enhance an EDC’s likelihood of repaying debt and that such a for-
giveness of debt by lending banks might actually help those banks. (See Krugman, 1989;
and Kenen, 1990.) The first part of the hypothesis that a reduction in debt can increase the
chance of repaying debt is straightforward. Suppose that a developing-country government
has a large debt to foreign banks or governments, and therefore has incurred large future
debt service obligations. In this situation, domestic investors in enterprises in the EDC
may come to expect future tax increases by the EDC government so as to pay the future
interest and amortization. This expectation of future higher taxes would dampen current
growth-creating investment because the expected after-tax rate of return to investors is
lower due to the anticipated increased taxes. Or suppose that it is general opinion that the
EDC’s current debt level is so high that it can never be repaid. In this case, default may be
likely by the EDC, and this default would confirm to any foreign private investor consid-
ering entering the country that the country is in trouble and is not a good place to invest.
Hence, there could be a halt to any inflow of potential growth-creating foreign investment
for at least some time in the future. Through scenarios such as these, a high level of EDC
debt per se can interfere with the developing country’s current economic performance. The
implication of the scenarios is that reductions in debt can stimulate domestic investment
(because of anticipated lower future tax burdens) as well as foreign private investment
(because of less likelihood of default and more optimistic assessments by foreign investors
of the country’s prospects).
This line of thinking on debt reduction as a means of stimulating EDC growth has led
to a useful graphical construct, and this construct also enables us to see the second part
of the debt reduction hypothesis—that it can be in the interest of foreign lending banks
to “forgive” some EDC debt. This graphical construct is the debt-relief Laffer curve,
brought to prominence by Paul Krugman (1989).17 To understand this construct, consider
the concepts of the face value of debt and the market value of debt. The face value of debt
is simply the nominal monetary value of the bonds or debt instruments, say, a $100 million
bond held by an industrialized country bank representing $100 million that the bank has
lent to the developing country. The face value of EDC debt is what is represented by the
dollar figures in Table 3 (page 438). The market value of debt refers to the actual trading
prices of the bonds or debt instruments. EDC debt instruments (and of course most kinds
of debt instruments) are sold (and bought) in a secondary debt market after the initial
issuance if a holder wants to exchange the bonds for other assets (or someone else wants
to exchange other assets for these bonds). Prices in these secondary markets are thought to
reflect the “true” value of the claims, and for EDC debt, prices have sometimes gone below
20 percent of face value.
17The analogy is to the Laffer curve (named after Arthur B. Laffer) used in consideration of fiscal policy, whereby
a reduction in the marginal tax rate can increase tax revenues.
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IN THE REAL WORLD:
THE HIPC AND MDRI DEBT RELIEF INITIATIVES
The Heavily Indebted Poor Countries (HIPC) Initiative
was started by the International Monetary Fund and the
World Bank in 1996. Working in conjunction with inter-
national financial institutions and governments, the objec-
tive of the program was to reduce the burden of debt by
cancelling the debt of low-income countries that had
incurred a severe, unsustainable amount of external bor-
rowing. In order to qualify for HIPC assistance, various
steps need to be undertaken by the potential recipient
country, including the adoption of sound macroeconomic
policies and other reforms as well as the design and imple-
mentation of an explicit poverty reduction program. When
the debt relief is granted, resources are freed up in the
recipient countries for use in social sector spending such
as in health and education. As of April 2015, debt-relief
programs had been worked out and were underway for
36 countries, and the packages were providing $76  billion
of relief over time. Three other countries had become
eligible for assistance. For the 36 countries receiving
assistance, it was estimated that, between 2001 and 2013,
the overall debt service obligations (interest and repay-
ment due on their total debt) paid by those countries had
been cut by an amount equivalent to about 1.8 percentage
points of their GDP.
In 2005, in order to help achieve the Millennium
Development Goals (MDGs) of the United Nations, the
Multilateral Debt Relief Initiative (MDRI) was added to
the HIPC Initiative. Under MDRI, three institutions were to
provide this debt relief that is additional to HIPC relief—
the IMF, the World Bank, and the African Development
Fund. The Inter-American Development Bank also began
participating in 2007. The IMF itself took the further step
of specifying that, whether or not a country was receiving
HIPC relief, if the country’s per capita income was less than
$380 and the country had outstanding debt to the IMF as
of the end of 2004, it became eligible for MDRI assistance
directly from the IMF’s resources. If the country’s per capita
income was above $380, the MDRI relief came from bilat-
eral donors (i.e., high-income countries) and was channeled
through the IMF. As of May 2015, 22 countries qualified
for MDRI under the below-$380 program and 14 countries
qualified under the above-$380 program. Total MDRI assis-
tance given under the auspices of the IMF at that time was
about $3.4 billion.
Sources: International Monetary Fund Factsheet, “Debt Relief under
the Heavily Indebted Poor Countries (HIPC) Initiative,” May 2015,
and International Monetary Fund Factsheet, “The Multilateral Debt
Relief Initiative,” May 2015, both obtained from www.imf.org. ●
CHAPTER 18 INTERNATIONAL TRADE AND THE DEVELOPING COUNTRIES 443
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18For an excellent exposition of the debt-relief Laffer curve, see “Sisters in the Wood: A Survey of the IMF and
the World Bank,” The Economist, October 12, 1991, pp. 24, 29–30, 33.
A debt-relief Laffer curve is shown in Figure 2.18 The face value of debt is measured
on the horizontal axis, and the market value of debt (the value in the secondary market)
is plotted on the vertical axis. If lenders expect the debt to be fully repaid (including
interest), the market value is equal to the face value, and the relationship is represented
by a 45-degree line from the origin. This is the case from the origin to point A (where
$120  million of debt  has a market value of $120 million). However, after point A,
lenders do not expect the debt to be fully repaid, and the EDC bonds sell at a discount in
the secondary market. Thus, at point B, $180 million of debt sells for $153 million, for the
market value is only 85 percent of the face value ($153 million ÷ $180 million = 0.85),
a discount of 15 percent. At point C, $200 million of debt would sell for $160 million in
the secondary market, or at a 20 percent discount. Finally, after point C, we get the situ-
ation where additional debt beyond $200 million actually reduces the market value; for
example, at point F, $240  million of debt has a market value of only $120 million. This
downward-sloping range after point C represents the situation of our earlier discussion that
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the level of debt so reduces domestic and foreign investment that the country’s growth and
debt repayment prospects become very poor. In this range, a reduction of the developing
country’s debt from $240 million to $200 million would actually increase the market value
of the debt from $120 million to $160 million. Hence, if the EDC is located beyond point
C, there is a clear case for voluntary debt reduction or write-offs by the lending banks.
Such action would increase the country’s growth prospects and ability to repay debt, and it
would also help the banks by raising the market value of their loan portfolios.
In the range between points A and C, the situation is somewhat different, but there is
still some incentive for debt reduction by both the EDC and the lenders. Starting at point
C and going to point A, lending banks could forgive $80 million of debt (= $200  million −
$120  million), and the cost of writing off $80 million would be only $40 million (the
reduction in the market value from $160 million to $120 million). Alternatively, if the
developing country could obtain $40 million of resources from some other source such as
the IMF or the World Bank or by its own efforts, it could “buy back” or cancel $80 million
of its outstanding debt to the banks by giving the banks this $40 million. In either event or
in some combination of buybacks and forgiveness, the EDC benefits from having less debt
and lower future interest and amortization payments, and it has reduced its debt at a cost
of 50 cents for each dollar of debt reduction. The banks will have reduced their holdings of
risky EDC debt by $80 million but at a maximum cost of only $40 million. The banks have
FIGURE 2 The Debt-Relief Laffer Curve
160
153
120
45˚
120 180 200 2400
A
B
C
F
M
ar
ke
t v
al
ue
o
f d
eb
t
Face value of debt
In the debt-relief Laffer diagram, in the range from the origin to point A, the outstanding debt of a less
developed country is expected to be fully repaid. The value of the EDC’s bonds in the secondary market is
consequently equal to 100 percent of the face value of the bonds. From point A to point C, the market value
of the debt increases with the face value but at a diminishing rate, being, for example, 85 percent at point
B (= $153 million ÷ $180 million) and 80 percent at point C (= $160 million ÷ $200 million). Beyond
point C, greater EDC debt is associated with a lower total market value. This reflects poorer growth and debt
repayment prospects by the country as more debt is incurred since, for example, domestic firms may undertake
less real investment because they expect taxes to be raised in order to service the very large debt.
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also increased the quality of the EDC debt that they continue to hold, as its market value
($120 million) is now 100 percent of its face value.
Given the debt-relief Laffer curve analysis, why have we not seen a greater amount of
debt reduction in practice? The reason is that, for the forgiveness or buyback actions such
as in the A to C range of the curve to be undertaken, negotiations must be successfully con-
cluded by the developing country with all the bank lenders as a group. If this is not done,
no individual lender has an incentive to do the debt reduction on its own. Suppose that there
are only four lending banks—banks I, II, III, and IV—and that each of the four banks holds
an equal face value of EDC debt of $50 million at point C. Suppose now that bank I forgives
$20 million of the $50 million debt owed to it, reducing the EDC’s total debt from $200
million to $180 million and moving the country from point C to point B. Given the shape of
the debt-relief Laffer curve, this forgiveness by bank I has reduced the market value of the
EDC’s total debt from $160 million to $153 million. What has happened? Bank I formerly
held $50 million face value bonds with a market value of $40  million (because the market
value at point C was 80 percent of the face value). It now holds $30 million of bonds (its
original $50 million minus the $20 million forgiven) with a market value of $25.5 million.
(The $25.5 million results because, at point B, market value is 85 percent of face value
and $30 million × 0.85 = $25.5 million.) Hence, this bank has forgiven $20  million of
debt, but it has done so at a cost of $14.5 million. (The original market value of bank I’s
holdings was $40 million, which has now been reduced to $25.5 million.) If all four banks
each had simultaneously undertaken $20 million forgiveness, we would have moved from
point C to point A on the curve, and the cost to bank I would have been only $10 million
for its $20 million of debt reduction. Hence, the individual negotiation has cost bank I
$4.5 million more (= $14.5 million − $10 million) than if all banks had negotiated reduc-
tions simultaneously. (Alternatively, in the case of a buyback by the EDC from bank I, the
country would have had to pay bank I $14.5 million for the $20 million debt reduction in a
single negotiation and only $10 million in the multiple negotiation.)
But matters are even worse for bank I when it alone forgives the $20 million debt.
Because of its unilateral debt reduction, its competitor banks II, III, and IV have actu-
ally gained. With bank I’s debt forgiveness to the EDC and the consequent movement
from point C to point B, the ratio of market value to face value has risen from 80 percent
($160 million ÷ $200 million) to 85 percent ($153 million ÷ $180 million). The $50 mil-
lion face-value bonds that each of these other banks still hold previously had a market
value of $40 million (= $50 million × 0.80) but now have a market value of $42.5 million
(= $50 million × 0.85). Bank I’s action has benefited each other bank by $2.5 million
(= $42.5 million − $40 million); each other bank is getting a “free ride” while bank I
imposes a cost on itself of $14.5 million. Therefore, any one bank would not undertake
the debt relief on its own. In this framework, then, without joint negotiations embracing
all lenders, no action can be expected by any one bank to reduce developing country debt.
A final broad type of strategy for dealing with EDC debt involves debt-equity swaps. In
this arrangement, a holder of a debt claim on a developing country exchanges the claim for
local EDC currency, which is then used to acquire shares of stock in a productive enterprise
in the EDC. Thus, the EDC reduces its debt and its interest obligations. In turn, the credi-
tor no longer holds a bond whose repayment is uncertain, but instead holds equity in an
ongoing company in the developing country. Whether this is advantageous to the creditor
depends on the future performance of the company involved.
We do not explore other plans in this book, but a large number of such plans for reduc-
ing the burden of debt on EDCs exists. That the burden has been great is reflected in the
fact that, for much of the 1980s, living standards fell in the debtor countries (particularly
Debt-Equity Swaps
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in Latin America) as they compressed imports and undertook austerity programs. Trade
surpluses were generated through such measures, and there was in fact a large net outflow
of capital from Latin America as repayments and interest exceeded new inflows. Indeed,
a former chief economist for the World Bank, Stanley Fischer, in conjunction with Ishrat
Husain wrote that the adjustments “were made at a high price. Investment and output lev-
els have fallen, domestic consumption and wages have been compressed. . . . As a result,
most of the countries in Latin America and Africa now look back at almost a decade of lost
growth” (Fischer and Husain, 1990, p. 24).
In addition to the preceding specific measures, industrialized countries can undertake
several general measures to lessen the severity of the developing-country debt problem.
These measures can also be of benefit to the ICs as well. For example, a decrease in levels
of tariff and nontariff protection against EDC export goods would increase the foreign
exchange earnings of EDCs and hence their ability to repay debt, as well as improve wel-
fare in the ICs via the standard arguments for freer trade. In addition, more rapid economic
growth in the industrialized countries not only would increase well-being in the ICs but
would stimulate EDC exports, foreign exchange earnings, and national income. Further, an
increase in the amount of foreign aid given to the developing countries not only would be
of use to them but, if such aid stimulates EDC growth, would also benefit the industrialized
countries through increased exports sold to the EDCs. There is certainly scope for such an
increase in aid as the United States, for example, in recent years has allocated two-tenths of
1 percent or less of its GDP to foreign aid. This aid can also be given indirectly if the IMF
issues new Special Drawing Rights (SDRs)19 and allocates proportionately more of them to
developing countries. Such an allocation of SDRs could assist the EDCs in maintaining a
flow of development imports, even when a large fraction of their current foreign exchange
earnings is being used for debt service.
19The SDR is an international reserve asset created by the IMF in 1970 to supplement the existing official reserves
of member countries. SDRs will be discussed in more detail in Chapter 29.
CONCEPT CHECK 1. Why do developing countries object to IMF
conditionality?
2. Explain the concept of the debt-relief Laffer
curve.
3. Explain the usefulness of the concept of the
debt service ratio.
SUMMARY
The emerging and developing countries in the world economy
are characterized by relatively low levels of per capita income,
a relatively high concentration of exports in primary products,
and export instability; they may also face long-run forces that
cause a deterioration in their commodity terms of trade. The
trade problem of export instability and its potentially adverse
implications for the EDCs is thought by many to be traceable
to the primary product orientation of their export bundle, and
they have focused on international commodity agreements as
a means to alleviate this problem. These agreements can, how-
ever, reduce EDC export earnings and welfare under some cir-
cumstances. The alleged long-run deterioration in the terms of
trade has various potential causes, several of which could be
addressed by increased diversification of exports of EDCs. The
countries face a basic choice of the extent to which they wish
to become active participants in the world economy through
outward-looking policies or to turn inward through import-
substitution policies. Some empirical evidence suggests that
the outward-looking approach may enhance economic perfor-
mance in comparison with the inward-looking approach, but
the outward-looking strategy is not without its difficulties. In
general, however, economists think that the outward-looking
approach may help the developing countries realize positive
static and dynamic development effects of trade. Finally, along
with trade problems, many developing countries face problems
with servicing and repayment of external debt. Recent steps
have begun to emphasize some elements of debt forgiveness
to reduce the potential burden of debt upon the growth process.
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KEY TERMS
Brady plan
commodity concentration
compensatory financing
debt-equity swaps
debt reduction
debt relief
debt-relief Laffer curve
debt rescheduling
debt service ratio
differing income elasticities of
demand for primary products and
manufactured goods
export cartel
export diversification into
manufactured goods
export instability
export promotion
get prices right
Heavily Indebted Poor Countries
(HIPC) Initiative
high degree of openness
import substitution
international buffer stock agreement
international export quota agreement
intra-firm trade
inward-looking strategy
long-run deterioration in the terms
of trade
moderately inward-oriented
economy
moderately outward-oriented
economy
Multilateral Debt Relief Initiative
(MDRI)
outward-looking strategy
Prebisch-Singer hypothesis
repatriation of earnings
secondary debt market
strongly inward-oriented economy
strongly outward-oriented economy
structural adjustment policies
transfer problem
unequal market power in product
and factor markets
vent for surplus
QUESTIONS AND PROBLEMS
1. Why might the static gains from trade for the developing coun-
try differ from those experienced by industrialized countries?
2. How can international trade influence economic develop-
ment positively over time?
3. The analysis in this book has heretofore indicated that all
participating countries gain from international trade. If this
is so, why do some observers argue that trade can actually
contribute to underdevelopment in EDCs?
4. Why is export price instability judged to be a problem for the
EDCs? Why might it seem more likely to occur for EDCs
than for ICs?
5. Why should we be concerned about a long-run deteriora-
tion in the commodity terms of trade of the EDCs? How can
such a deterioration be related to the concept of immiser-
izing growth discussed in Chapter 11?
6. This chapter has indicated that diversification of the EDCs’
export bundles so that they contain relatively more manufac-
tured goods that could potentially alleviate both the instabil-
ity problem and the possible terms-of-trade problem. Why
so? In your view, would such diversification necessarily
help developing countries? Explain.
7. In the context of external sector problems, what case can
you build for the formation of common markets among
EDCs? Considering Chapter 17 and this chapter together,
would you recommend that such international coalitions be
formed? Why or why not?
8. Build a case in favor of forgiveness of external debt of
developing countries.
9. Build a case against forgiveness of external debt of develop-
ing countries.
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CHAPTER
19 THE BALANCE-OF- PAYMENTS ACCOUNTS
LEARNING OBJECTIVES
LO1 Explain balance-of-payments accounting terms and concepts.
LO2 Understand the construction of a balance-of-payments statement.
LO3 Describe the recent balance-of-payments experience of the United States.
LO4 Discuss the meaning of the international investment position of a country.
PART 5: Fundamentals of
International Monetary Economics
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INTRODUCTION
In the United States, virtually any consumer is aware of the huge volume of imports arriving
from China. Indeed, there is so much concern about this “flood” of imports that there is continual
talk about imposing new trade restrictions on China and about trying to persuade the Chinese
to raise the value of their currency in order to make their goods more expensive to U.S. buyers.
A  consequence of the huge volume of imports is the fact that the United States has had a large mer-
chandise trade deficit with China in recent years—$315 billion in 2012, $319 billion in 2013, and
$343 billion in 2014. Dire statements and forecasts regarding the loss of American jobs and the
dangers facing the U.S. manufacturing sector and economy have accompanied these trade deficits.
It is useful to point out, however, that the trade balance situation of China with the United
States has not always been representative of China’s entire trading relations. For example, in
several recent years China’s overall merchandise trade surplus with all of its trade partners was
smaller than its surplus with the United States. This meant that China had overall merchandise
trade deficits with its other trading partners.
Despite the merchandise trade surpluses, China has had deficits in services in recent years.
Its balance of trade when combining goods and services together thus has been a surplus that is
smaller than the goods (merchandise) surplus. Finally, after allowing for factor income receipts
from and payments made abroad as well as for transfers, China’s surplus on goods and services
together was smaller than its current account surplus from 2003 through 2010 but the relative
sizes of the two surpluses reversed themselves beginning in 2011. These various balances and
other balance-of-payments matters are explained in this chapter.
To carry out the many transactions involved in international trade, money is obviously
necessary, but international transactions are also complicated by the fact that different
countries use different currencies. A purely domestic transaction, such as the purchase
of a chair made in North Carolina by a resident of South Carolina, involves no need to
convert one currency into another. The buyer’s “South Carolina dollar” is identical to the
“North Carolina dollar” desired by the chair manufacturer—they are the same currency
unit, the U.S. dollar. But the transaction is complicated when the North Carolina furni-
ture maker sells the chair to a French citizen. The seller wishes to receive U.S. dollars,
because that is the currency unit in which the firm’s workers, suppliers, and sharehold-
ers are paid, while the French consumer wishes to complete the transaction with euros.
Because each country participating in international trade generally possesses its own
national currency unit, a foreign exchange market is needed to convert one currency into
another. In a broad view, the foreign exchange market is thus the mechanism that brings
together buyers and sellers of different currencies. The nature and operations of the
foreign exchange market and the determination of the equilibrium exchange rate are dealt
with in the following three chapters.
This chapter will focus on how foreign economic transactions are recorded for any
specific country. The international transactions of a country encompass payments outward
from the country for its imports, gifts, and investments abroad and payments inward for
exports, gifts, and investments by foreigners. In recording these transactions, a country is
keeping its balance-of-payments (BOP) accounts. These accounts attempt to maintain a
systematic record of all economic transactions between the home country and the rest of the
world for a specific time period, usually a year. The placement of various types of transac-
tions in the accounts will be explained, along with how to interpret a country’s BOP state-
ment and the meaning of different balances in the accounts such as the “balance of trade”
and the “current account balance” that are frequently reported in the media. In addition, we
will discuss the meaning of a related term, the net international investment position of a
country. The stage will then have been set for understanding the foreign exchange market
and the determination of exchange rates in later chapters.
China’s Trade
Surpluses and
Deficits
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CREDITS, DEBITS, AND SAMPLE ENTRIES IN BALANCE-OF-PAYMENTS ACCOUNTING
In keeping track of a year’s international transactions for a country, the BOP accountant
employs a variety of procedures. We do not need to worry about all the details because we
are seeking only a working knowledge of the accounts for the purpose of interpreting and
understanding broad economic trends, events, and policies. Nevertheless, it is essential to
understand the classification system of credits and debits. As a general working rule, credit
items in the balance-of-payments accounts reflect transactions that give rise to payments
inward to the home country. The major items are exports, foreign investment inflows to
the home country, and receipts of interest and dividends by the home country from earlier
investments abroad. By convention, credit items (which give rise to a payments inflow)
are recorded with a plus sign. Debit items in the balance-of-payments accounts reflect
transactions that give rise to payments outward from the home country. The major items
are imports, investments made in foreign countries by domestic nationals, and payments
of interest and dividends by the home country on earlier investments made in it by foreign
investors. By convention, debit items (which lead to a payments outflow) are recorded with
a minus sign.
Our presentation of credit and debit items generally follows the traditional analytic
framework used by the International Monetary Fund, as well as by the U.S. Department of
Commerce in its presentation of U.S. data.1 In that framework, items are grouped into the
following three major categories.
Category I: Current account. Credit items (+ sign) consist of exports of goods and
services, income (such as interest and dividends) received from investments abroad as
well as other factor income (e.g., wages) earned abroad. A “unilateral transfer” item rep-
resenting gifts received from abroad is also classified as a credit item. In the recent revi-
sion by the IMF and the U.S. Department of Commerce, the “unilateral transfer” item is
now labeled as “secondary income,” and the income received such as dividends, interest,
and wages referred to above is labeled “primary income” received. Debit items (– sign)
are imports of goods and services, income paid to other countries’ residents from foreign
investments and foreign factor services in the home country (primary income paid), and
unilateral transfers representing gifts sent abroad (secondary income paid).
Category II: Financial/capital flows account (nonofficial). This category and the
next constitute the financial account in a country’s balance of payments.2 Category II
1The IMF (as of 2012) and the U.S. Department of Commerce have recently made some changes in their pre-
sentation of financial account transactions. Basic categories are similar, but departure is now made, in the offi-
cial presentations, from the standard credit/debit framework, and the placement of official governmental reserve
assets and liabilities is also changed. The new format records increases in assets held abroad with a plus sign, and
increases in foreign assets in the home country are labeled as increases in liabilities and also given a plus sign.
The financial account net change from the perspective of the home country is then the change in assets minus the
change in liabilities. The new format can be directly related to the traditional one, but we maintain the traditional
credit/debit framework in this chapter because we judge that framework to be more useful for instruction regard-
ing the underlying elements and structure of BOP accounting.
2The long-time traditional term for the items in categories II and III has been “capital account.” However, the IMF
and the U.S. Department of Commerce now call the set of items the “financial account.” The “capital account”
term now refers to very limited and specific types of transactions, such as government international debt reduction
or transactions involving purchase or sale of rights to an asset but not the actual purchase or sale of a physical
asset or financial asset itself. Capital account transactions are relatively very unimportant for the United States.
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includes changes in holdings of both long-term (maturity of one year or longer) and short-
term (maturity of less than one year) real physical assets and financial assets. If there is an
increase in assets in the home country held by foreign citizens, corporations, and govern-
ments (financial inflow to the home country), a credit entry (+ sign) is made; if a sale of
these holdings by foreigners causes a decrease, a debit entry (− sign) is made (financial
outflow from the home country). Alternatively, if domestic citizens, corporations, and
governments increase their holdings of assets abroad, a debit entry is made (financial
outflow from the home country); if a sale of these assets decreases holdings abroad by
the home country, a credit entry is made (financial inflow to the home country as the
sale proceeds are brought home). An easy way to remember this treatment is to note that
credits represent a net increase in holdings of assets in the home country by the foreign
country and debits represent a net increase in holdings of assets in foreign countries by
the home country.
In concept the transactions in this category are basically private; that is, they are car-
ried out by parties other than central banks or monetary authorities. Again, an increase
in foreign holdings of these assets in the home country is a credit item and a decrease is
a debit item. Alternatively, if the home country’s private sector increases its holdings of
these assets in foreign countries, the entry is a debit; a decrease is a credit.
Category III: Changes in reserve assets of official monetary authorities (central
banks). If foreign central banks acquire assets (e.g., bank accounts) in the home country,
this is a credit item; a decrease is a debit. On the other hand, if the home country’s central
bank acquires international reserve assets or assets of other countries (e.g., foreign bank
deposits), this is treated as a debit item in BOP accounting; a sale of or decrease in such
assets is a credit.
To obtain a better grasp of BOP accounting, it is helpful to use hypothetical transac-
tions. In this example and in all discussions of the balance of payments, it is crucial to
recognize that the principle of double-entry bookkeeping is employed. This means that
any transaction involves two sides to the transaction, so the monetary amount is recorded
twice—once as a debit and once as a credit. It follows that the sum of all the debits must be
equal to the sum of all the credits; that is, the total BOP account statement must always be
in balance. (Remember that the debits are recorded with a minus sign and the credits with
a plus sign. The “equality” of the sums really means equality of the absolute values of the
debits and the credits.)
Let us now turn to our hypothetical examples. We designate the home country as
country A (e.g., United States) and treat all foreign countries as one country—country B
(e.g., Britain). We will describe seven different transactions and indicate at each step the
manner in which the transaction is recorded.
Transaction 1. Exporters of country A send $6,000 of goods to country B, receiving in
exchange a short-term bank deposit (e.g., checking account deposit) of $6,000 in country B.
In this transaction, the two sides of the transaction would be recorded as follows:
Credit: Category I, Exports of goods, +$6,000
Debit: Category II, Increase in private assets abroad (portfolio investment), −$6,000
The credit entry is obvious. This particular debit entry occurs because country A’s export-
ers now have checking account deposits in country B. These deposits are classified as
short-term assets.
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Transaction 2. Suppose that country A’s consumers purchase $12,000 of goods from
country B firms and that payment is made by citizens of country A by transferring $12,000
to the bank accounts of country B firms in country A (e.g., in New York). For this transac-
tion, the entries made by the BOP accountant are
Debit: Category I, Imports of goods, −$12,000
Credit: Category II, Increase in foreign private assets in Country A (portfolio
investment), +$12,000
We list the debit entry first, using the practice in these examples of first recording the initial
part of the transaction or the initiating entry, followed by the “financing” part of the trans-
action. Imports have gone up in this instance, but remember that imports constitute debit
items; thus, a minus sign is affixed to the entry. In paying for the imports, home country
citizens have increased the bank accounts of country B firms in country A; this entry for the
financing of the imports has a positive sign because it is a net increase in foreign holdings
of assets in country A.
Transaction 3. Residents of country A send $1,000 of goods to country B’s citizens as
a gift. This is a special type of entry in the BOP accounts, and it differs from our previous
entries because no purchase or sale is involved. Nevertheless, there has been economic
interaction with foreigners, so it must be recorded somewhere. In this case, because goods
have been sent from the home country, the credit entry is “exports.” However, because
double-entry bookkeeping is involved, a debit entry is mandated even though no “pay-
ment” has taken place. The BOP accountant “creates” a debit entry in this instance, much
like a “goodwill” or “contributions” entry in an individual firm’s balance sheet when there
is no payment entry because a gift has been made. The entries for “transaction” 3 are
Credit: Category I, Exports of goods, +$1,000
Debit: Category I, Unilateral transfers made (secondary income paid), −$1,000
Transaction 4. Country A firms provide $2,000 of shipping services to country B firms.
Country B firms pay for these services by transferring some of their checking account
deposits in country A banks to the accounts of country A shipping firms in country A banks.
The transaction is recorded as:
Credit: Category I, Exports of services, +$2,000
Debit: Category II, Decrease in foreign private assets in country A (portfolio investment),
−$2,000
The debit entry is explained by the fact that the foreign firms have reduced their bank
accounts in home country banks and thus have fewer assets in country A.
Transaction 5. A country B firm sends $2,500 of dividends to its country A stockholders.
Payment is made by the country B firm writing checks on its bank account in a country A
bank. This transaction is recorded as follows:
Credit: Category I, Investment income receipts from abroad (primary income received),
+$2,500
Debit: Category II, Decrease in foreign short-term private assets in country A (portfolio
investment), −$2,500
The debit entry occurs because the foreign firm now has reduced assets in the home country.
Transaction 6. A firm in country A invests $5,000 in a production facility in Country B.
Payment is made by the A firm by deducting this amount from its bank account in country
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A and transferring the funds to the country A bank account of the country B firm selling the
facility. This transaction is an exchange of assets, and no goods are involved. The book-
keeping entries recognize that a real financial asset is acquired by the home country firm in
exchange for a financial asset (the checking account deposit).
Debit: Category II, Increase in real assets abroad (direct investment), −$5,000
Credit: Category II, Increase in foreign private assets in country A (portfolio investment),
+$5,000
Transaction 7. This transaction previews the operation of a foreign exchange market
when a country’s central bank participates in the market. Suppose that commercial banks
(which are regarded as “private citizens”) in country B wish to decrease their A-currency
balances (e.g., U.S. dollars) in country A banks by converting some of them into their own
country’s currency (e.g., British pounds). This desire to shift out of dollars may reflect,
for example, the anticipation by the commercial banks of a lower future value of the
dollar. One method of reducing dollar holdings is to sell them (for pounds) to the Bank of
England, and the Bank of England is willing to buy dollars if it is committed, as in a system
of fixed exchange rates, to keep the dollar from falling in value against other currencies.
Transaction 7 consists of the sale of $800 to country B’s central bank by B’s commercial
banks. The foreign central bank’s dollar accounts in country A banks are increased, and
the foreign commercial banks have reduced their dollar balances in country A banks. This
exchange of dollar account holdings in country A banks can and does occur if country A
is the United States, because foreign commercial banks as well as central banks maintain
balances in New York banks. The BOP accountant for country A records this change in
ownership of dollar assets in country A as follows:
Debit: Category II, Decrease in foreign private assets in country A (portfolio investment),
−$800
Credit: Category III, Increase in foreign official assets in country A (reserve assets),
+$800
There is no change in the total foreign holdings of dollar assets, but the distribution of such
holdings has been altered between the foreign private and public sectors.
ASSEMBLING A BALANCE-OF-PAYMENTS SUMMARY STATEMENT
We can now turn to the construction of country A’s BOP statement. In the real world,
there are millions of transactions in any given year for a country such as the United States.
But let us suppose that the seven transactions we worked through constitute the entire set
of international transactions in a given year, and from these we build the BOP statement.
We first list in T-account form in Table 1 the debit and credit items enumerated in the
previous section. The parenthetical numbers in the left-hand column indicate the trans-
action numbers. From these entries, we now assemble the BOP summary statement in
Table 2 and work through this statement.
Looking first at exports and imports of goods, country A has imported $5,000 more of
goods than it has exported ($7,000 of exports, $12,000 of imports). Adding the (+) exports
of goods and the (−) imports of goods (or the subtraction of imports of goods from exports
of goods) yields the balance on goods or the merchandise trade balance. When this bal-
ance is positive, the result is referred to as a merchandise trade surplus; when negative, the
result is a merchandise trade deficit. By convention, a surplus is often referred to as “favor-
able” and a deficit is referred to as “unfavorable”—terms carried over from the period
of Mercantilism (previously discussed in Chapter 2). The merchandise trade balance is
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usually quoted in newspapers and on the national television and radio news reports, and the
figure is released on a monthly basis. However, you should note that it is a very incomplete
measure of the balance of payments, since it omits many other items.
TABLE 1 International Transactions, Country A
Debits (−) Credits (+)
(1) Increase in private assets abroad
(portfolio investment)
−$ 6,000 Exports of goods +$ 6,000
(2) Imports of goods − 12,000 Increase in foreign private assets in
country A (portfolio investment)
+ 12,000
(3) Unilateral transfers made
(secondary income paid)
− 1,000 Exports of goods + 1,000
(4) Decrease in foreign private assets
in country A (portfolio investment)
− 2,000 Exports of services + 2,000
(5) Decrease in foreign private assets
in country A (portfolio investment)
− 2,500 Investment income receipts from
abroad (primary income received)
+ 2,500
(6) Increase in real assets abroad
(direct investment)
− 5,000 Increase in foreign private assets in
country A (portfolio investment)
+ 5,000
(7) Decrease in foreign private assets
in country A (portfolio investment)
−   800 Increase in foreign official assets in
country A (reserve assets)
+   800
−$29,300 +$29,300
TABLE 2 Balance-of-Payments Summary Statement, Country A
Category
I. Exports of goods (+$6,000 + $1,000) +$ 7,000
Imports of goods − 12,000
Balance on Goods (merchandise trade balance) −$ 5,000
Exports of services +  2,000
Imports of services − 0
Balance on goods and services −$ 3,000
Factor income receipts from abroad (primary income received) +  2,500
Factor income payments abroad (primary income paid) − 0
Balance on goods, services, and factor (primary) income −$ 500
Unilateral transfers received (secondary income received) + 0
Unilateral transfers made (secondary income paid) −  1,000
Balance on current account (current account balance) −$ 1,500
II. Increase (+) in foreign real assets in country A + 0
Increase (−) in real assets abroad (direct investment) −  5,000
Increase (+) in foreign private assets in country A (portfolio
investment) (+$12,000 + $5,000 − $2,000 − $2,500 − $800) + 11,700
Increase (−) in private assets abroad (portfolio investment) −  6,000
Official reserve transactions balance (overall balance) −$ 800
III.  Increase (+) in foreign reserve assets in country A + 800
Increase (−) reserve assets or reserve assets held in country B − 0
$ 0
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The balance on goods is but one of several balances that can be identified in a BOP
statement. To get to other balances and a broader picture of the international transactions
of a country, we must add in other items from the transactions in Table 1. The next step
is to add services to the merchandise trade balance. Because country A exported $2,000
of services and imported none, the services account has a surplus of $2,000 that is set
against the balance-of-trade deficit of $5,000. The resulting balance on goods and ser-
vices (often referred to in the press as “balance of trade”) of −$3,000 gives the net flow of
payments associated with goods and services transactions with other countries during the
time period. Beginning in January 1994, this balance has been published monthly in the
United States.
Continuing with category I items, we now enter factor income receipts and payments
(investment income, wages, and salaries). When our investment income receipt of +$2,500
is entered (there were no factor income payments to foreign countries in our examples), we
arrive at another balance—the balance on goods, services, and factor (primary) income
of −$500.
The next item to be included in our BOP summary consists of unilateral transfers or the
secondary income transfers. When transfers of −$1,000 are added to the balance on goods
and services and investment income, we arrive at the current account balance or balance
on current account of −$1,500.
The current account balance is important because it essentially reflects sources and
uses of national income. Exports of goods and services generate income when they are
produced, and gifts and factor income received from abroad are also a source of income
in the current time period. On the other hand, the home country’s citizens and government
use current income to purchase imports of goods and services and to make gifts and factor
income payments abroad.
Another way to view the current account balance is to relate it to aggregate income and
expenditure. Remember the basic macroeconomic identity:
Y = C + I + G + (X − M) [1]
where
Y = aggregate income
C = consumption spending
I = investment spending on plant, equipment, and so forth
G = government spending on goods and services
X = exports
M = imports
In reality, X consists of all the credit items in the current account, not only exports, because
they all generate income. Further, M consists of all current account debit items, which are
uses of current income, not just imports. Now rearrange the identity:
Y − (C + I + G) = (X − M) [2]
This rearrangement indicates that the current account balance is simply the dif-
ference between income of the country and (C +  I + G), and (C +  I + G) constitutes
spending by the country’s residents during the time period. If a country has a CAD
[(X  −  M) is negative], it means that (C  +  I  +  G) is greater than Y and the country is
spending more than its income and living beyond its means. This has been the case
in the United States since 1982. Of course, if a country has a current account surplus
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[(X − M) is positive], the country is spending less than its income; this has been the case
for Japan since 1981.
This relationship of the current account balance to macroeconomics can be carried fur-
ther. Besides expression [1], income can also be written as
Y = C + S + T [3]
meaning that income can be used only for the purposes of consumption (including imports
and transfers abroad), saving, and paying taxes. If we then utilize expressions [1] and [3]
by remembering that they both show equalities of variables with Y, we obtain
C + I + G + (X − M) = C + S + T
or
(X − M) = S + (T − G) − I [4]
If S is private saving and (T − G) is government saving (which can be negative), then the
current account balance is also the difference between a country’s saving and the country’s
investment. Thus, a CAD [(X − M) is negative] means that the country is saving less than
it invests (i.e., the country is not “saving enough”). This is another implication of the U.S.
CAD since 1982. Of course, a current account surplus [(X − M) is positive] indicates that
the country is saving more than it invests.
We now turn to categories II and III in the BOP statement in Table 2. A main point
to note is that, if the current account items have added up to −$1,500, the sum of these
financial account items by themselves must be +$1,500. Why? Because the sum of the
total credits (with a plus sign) and total debits (with a minus sign) of all the items in the
balance of payments must be zero due to the nature of double-entry bookkeeping. Hence,
when someone speaks of a “balance-of-payments deficit,” that person cannot be speaking
of all the items in the balance of payments because all of the items must sum to zero. The
loosely used term “balance-of-payments deficit” therefore refers only to some part of the
BOP statement, not to the entire statement. This part could be only the merchandise trade
balance, or the balance on goods and services, or the current account balance, for example.
The term “balance-of-payments deficit” is deficient because it lacks precision in indicat-
ing which items in the account are being discussed, and the term is clearly nonsensical if it
refers to all of the items in the balance of payments.
Now return to our sample entries by adding category II, the physical and finan-
cial assets account. First, there was a direct investment outflow of $5,000 and no direct
investment inflows. Second, with respect to financial or portfolio capital, there has been
a net increase in foreign portfolio private assets (credit item) in country A of $11,700
(= $12,000 + $5,000 − $2,000 − $2,500 − $800), and a debit item of an increase in port-
folio private assets abroad of −$6,000. Thus portfolio financial flows by themselves have
a net value of +$5,700 (= $11,700 − $6,000); when coupled with the direct financial flow,
the net result for category II is +$700 (= $5,700 − $5,000).
Finally, the cumulative balance after considering categories I and II is −$800. This bal-
ance is the one that is generally meant when economists use the broad term BOP deficit
(or surplus). This balance has historically been called the official reserve transactions
balance or overall balance, which reflects the net effect of all transactions with other
countries during the time period considered but excluding government short-term financial
transactions (“official reserve transactions”). Because categories I and II have a sum of
−$800, then category III must by itself have a value of +$800. This $800 is essentially a
measure of the amount of participation or intervention by the official monetary authorities
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IN THE REAL WORLD:
CURRENT ACCOUNT DEFICITS*
As noted in the text, a CAD for a country means that the
country is spending more than its income or, alternatively,
is saving too little relative to its investment. However, it
should not be assumed that a CAD is necessarily a “bad
thing” and that a country should focus its attention on adopt-
ing policies to obtain balance or a current account surplus.
In actuality, there are times when a CAD can be viewed in
a positive manner. For example, a CAD could reflect the
positive development that the country is recovering from a
recession more rapidly than are its trading partners. With the
rapid recovery the higher incomes are leading to the pur-
chase of more imports, while exports are not being boosted
by any significant rise in incomes abroad. Or the home coun-
try may be an attractive destination for foreign investment
because of expected high returns due to favorable business
conditions, technological change, or overall increases in
productivity. The investment inflows produce a financial
account surplus, which, as we will see must be associated
with a CAD. Yet another source of a financial account sur-
plus could be the liquidation of foreign production facilities
and the subsequent transfer of financial capital to a domestic
production site. Finally, net financial capital inflows associ-
ated with a CAD tend to put downward pressure on home
country interest rates, stimulating investment, growth, and
employment.
From a long-term perspective, developing countries may
require a net investment inflow (and therefore a CAD) to
assist them in their early efforts at industrialization. Even as
their growth picks up and they become less reliant on foreign
funds, the interest and/or dividend payments on the accumu-
lated foreign capital stock can result in a CAD. Ultimately,
however, if repayment is needed on some or all of the initial
foreign investment, the developing country will experience a
current account surplus and a financial account deficit. This
transition from a debtor (financial account inflow) nation
to a creditor (financial account outflow) nation has been
regarded by some economists as part of a natural sequence
in the development process.
It goes without saying, however, that continual CAD
cannot be ignored by policymakers (in both developing
and developed countries). The concern here is not with
the annual CAD per se, but with the potential growth in
payments of factor service income to foreign investors
that accompanies the increasing holdings of assets in the
country by foreign entities. Rapid growth of payments of
returns to foreign investment not only worsens the current
account balance further but also can quickly lead to the
emergence of a “debt trap,” where both the net debt posi-
tion of the country and the CAD increase rapidly. In 2001,
the U.S. CAD amounted to only 3.7 percent of GDP and
the net foreign debt position to 13.2 percent of GDP; in
2005 they were 5.7 percent and 14.2 percent, respectively;
in 2010, they were 3.1 percent and 16.8 percent, respec-
tively. In 2014 the ratio of the CAD to GDP was 2.2 percent
while the net debt ratio had risen sharply to 40.5 percent.
These percentages are sources of concern in that, if foreign-
ers become less willing to acquire U.S. investments (i.e.,
to finance the CAD), a “hard landing” for the economy
could occur, with a slowdown in U.S. growth and increased
unemployment as the economy adjusts to having to produce
more than it is currently using in order to meet the neces-
sary payments to foreign lenders.
*For useful discussion of many of these points, see “Schools Brief:
In Defence of Deficits,” The Economist, December 16, 1995, 
pp. 68–69; and Wynne Godley, “Interim Report: Notes on the U.S.
Trade and Balance of Payments Deficits,” Jerome Levy Economics
Institute of Bard College, Annandale-on-Hudson, NY, 2000; U.S.
Deparment of Commerce, Survey of Current Business, various
issues. ●
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in the foreign exchange market, the B central bank purchases of dollars in our example
(see page 453). In this context, economists sometimes use the phrases autonomous items in
the balance of payments and accommodating items in the balance of payments. The term
“autonomous items in the balance of payments” refers to international economic transac-
tions that take place in the pursuit of ordinary economic goals such as profit maximization
by firms and utility maximization by individuals. These transactions are undertaken inde-
pendently of the state of the country’s balance of payments and are reflected in categories I
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and II in the BOP statement. The term “accommodating items in the balance of payments”
refers to transactions that occur because of other activity in the balance of payments, that
is, the government items in category III.
We have now used all the entries in the sample transactions in country A’s balance of
payments, and it should come as no surprise that the net result of all the entries is a balance
of $0. Categories I to III as a whole must sum to zero because each transaction in each 
category has been entered twice—once as a credit entry and once as a debit entry. Further,
the current account balance (category I) must be equal but opposite in sign to the balance
of the two financial accounts (categories II and III) by themselves. This also is a result of
double-entry bookkeeping. Thus, our current account balance in the example (−$1,500)
matches the sum of categories II and III by themselves:
Category II +  $700
Category III +  800
Financial account balance +$1,500
This financial account balance constitutes an additional measure of “balance” in the bal-
ance of payments.
In assembling the BOP statement, we have thus identified six different measures of bal-
ance. These balances have different monetary values, and it is imperative when you hear or
read about a country’s “balance of payments” to understand which one is being discussed.
The balances in our numerical example were:
Balance on goods −$5,000
Balance on goods and services −3,000
Balance on goods, services, and primary factor income −500
Current account balance (balance on current account) −1,500
Official reserve transactions balance (overall balance) −800
Financial account balance +1,500
In practice, the decision of which balance to emphasize reflects the particular items that
the analyst has in mind for reasons of policy or academic interest. There is no one true
measure of a country’s balance; the different balances reflect concentration on different
items in the balance of payments. For example, the balance of trade may be the focus in
studying international competitiveness in goods alone. The current account balance may
be the focus in examining a country’s national income-spending relationship. Further, the
official reserve transactions balance may be the focus if interest centers on the amount of
official government intervention in foreign exchange markets. Regardless of the focus, the
assembling of the complete BOP statement is necessary if we are to analyze and interpret
the international economic transactions of a country with the rest of the world during any
particular time period.
CONCEPT CHECK 1. What does a balance-of-payments statement
portray? Why is the BOP always in balance?
2. What is the difference between the current
account balance and the balance of trade?
3. What rule do accountants follow in record-
ing transactions in the balance of payments?
In what manner would an export of wheat be
recorded? A purchase of a foreign stock?
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BALANCE-OF-PAYMENTS SUMMARY STATEMENT FOR THE UNITED STATES
Having worked extensively through the recording of sample transactions and the process
of assembling a BOP summary statement for a hypothetical country, we now present the
U.S. BOP statement for 2014 (Table 3).
The first point to note about this table is that it does not quite conform to the presenta-
tion discussed earlier. For approximately the last 40 years, the United States has not sepa-
rately listed category III (official assets account).3 This change in presentation means that
of the various balances above, only the merchandise trade balance; the balance on goods
and services; the balance on goods, services, and primary factor income; and the current
account balance are readily available in government publications. Prior to the change, offi-
cial measures of the official reserve transactions balance were also given. (The financial
account balance has very recently begun to be listed as net lending or net borrowing from
financial account transactions.)
At the top of Table 3, you will notice that the United States had a large merchandise
trade deficit of $741.5 billion in 2014. Except for 1973 and 1975, the United States has had
a merchandise trade deficit every year since 1971, when the traditional U.S. merchandise
surplus that had existed since the end of World War II ceased.
TABLE 3 U.S. International Transactions, 2014 (billions of dollars)
Current account:
Exports of goods +$1,632.6
Imports of goods −  2,374.1
Balance on goods (merchandise trade balance) −$  741.5
Exports of services +  710.6
Imports of services −  477.4
Balance on goods and services −$  508.3
Primary income receipts from abroad + 823.4
Primary income payments made abroad − 585.4
Secondary income (current transfer) receipts from abroad +  140.0
Secondary income (current transfer) payments made abroad −  259.2
Balance on current account −$  389.5
Capital transfer receipts and payments, net −0.045 or −  0.0
Financial account:
Change in: direct investment assets (−) and liabilities (+) −  225.4
Change in: portfolio investment assets (−) and liabilities (+) +  167.0
Change in: other investment assets (−) and liabilities (+) +  240.1
Change in: reserve assets (net increase, −) +  3.6
Change in: financial derivatives (net inflow, +) +  54.4
Statistical discrepancy +  149.9
Source: Derived from data in Table “U.S. International Transactions,” at the U.S. Department of Commerce, Bureau of
Economic Analysis website, www.bea.gov.
3The reasons for this change in official presentation involve the movement from relatively fixed exchange rates
to floating exchange rates in 1973 and need not concern us at this point.
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IN THE REAL WORLD:
U.S. TRADE DEFICITS WITH CANADA, CHINA, JAPAN, AND MEXICO
The United States has had a merchandise trade deficit since
1971 (with the exceptions of 1973 and 1975). An important
point to make with respect to this string of deficits is that
they have been concentrated with relatively few countries.
Figure 1 plots, for the period 1980–2014, the merchandise
trade balances of the United States with Canada, China,
Japan, and Mexico.
Sizable merchandise trade deficits have occurred with
Japan. In 2014, Japan was the fourth-largest buyer of U.S.
exports (after Canada, Mexico, and China) and the fourth-
largest supplier of U.S. imports (after China, Canada,
and Mexico). However, the trade is very unbalanced, as
can be seen in the figure. For the 1980–2014 period as a
whole, the cumulative deficit of the United States with
Japan was $2,031 billion ($2.0 trillion), and this comprised
about 16  percent of the total cumulative U.S. deficit of
$12,576 b illion ($12.6 trillion). The deficit with Japan aver-
aged more than $58 billion annually during this 35-year
period, with the highest deficit being $92 billion in 2006.
U.S. trade with China actually showed some small sur-
pluses before 1986. However, since that time, there have
been continuous deficits, with the deficits becoming larger
than the U.S. deficits with Japan in the 2000–2014 period. In
2014, China was the largest supplier of U.S. imports (many
of which are, à la Heckscher-Ohlin, labor-intensive goods)
and the third-largest buyer of U.S. exports. There has been
a cumulative U.S. merchandise trade deficit with China
over the 1980–2014 period of $3,646 billion, or $3.6  trillion
(an average of over $104 billion per year). This is about
29  percent of the cumulative U.S. total deficit from 1980
to 2014; thus, Japan and China together have accounted
for more than 45 percent of the total cumulative U.S. defi-
cit, and in one year (1991) the two countries accounted for
75 percent of the U.S. deficit.
Two other countries with which the United States has
had large trade deficits are its two partners in the North
American Free Trade Agreement (NAFTA). The United
States had a continuous deficit in the 1980–2014 period with
Canada. The cumulative deficit over those years was $1,065
billion, and the average annual figure was more than $65
billion from 2000–2014. In 2014 Canada was the second-
largest supplier of U.S. imports and the largest buyer of U.S.
exports. In its trade with Mexico, there have been occasional
U.S. surpluses but none since 1994. The total U.S. deficit
with Mexico during the 1980–2014 period was $949 billion
or, on average, a deficit of $27 billion per year. Mexico was
the second-largest country purchaser of U.S. exports and the
third-largest provider of U.S. imports in 2014.
Finally, it should be noted that, although there have been
very large deficits with Japan, China, Canada, and Mexico, as
well as smaller deficits with many other countries, there have
been some countries with which the United States has had trade
surpluses. For example, surpluses existed in 2014 with several
countries, including Turkey, Argentina, Brazil, Singapore,
Belgium, Luxembourg, the Netherlands, and Australia. For
Belgium, Luxembourg, and the Netherlands, there were con-
tinuous surpluses throughout the 1980–2014 period.
In overview, despite deficits and surpluses with particular
countries, the most important figure from the policy maker’s
perspective is the total annual deficit and not the trade bal-
ances with individual countries. Nevertheless, when deficits
are as large as those with Japan and China, they attract the
public’s attention, and officials may be pressured to tilt trade
policy toward the situation with those countries.
Sources: U.S. Department of Commerce, Bureau of Economic
Analysis, Survey of Current Business, June 1994, p. 104; July 2006, p.
80; BEA, Table 2.2, “U.S. International Trade in Goods by Area and
Country, Seasonally Adjusted Detail,” obtained from www. bea.gov.
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The merchandise trade deficit was somewhat offset by a surplus on services trade in
2014. The services surplus was $233.2 billion (exports of services of $710.6 billion minus
imports of services of $477.4 billion). Important items in services are tourist expenditures
and receipts, royalties and license fees, charges for telecommunications, banking, insurance,
and so forth. Primary income receipts from abroad ($823.4 billion) and primary income
payments (overwhelmingly investment income) to foreigners ($585.4 billion) resulted in a
positive figure of $238.0 billion. The balance on goods and services (−$508.3 billion) and
the balance on goods, services, and primary factor income (−$270.3 billion) both showed
smaller deficits in 2014 than did the merchandise trade balance.
(continued)
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IN THE REAL WORLD: (continued)
FIGURE 1 U.S. Trade Balance with Japan, China, Mexico, and Canada, 1980–2014
-400000
-350000
-300000
-250000
-200000
-150000
-100000
-50000
0
US Trade Balances
50000
19
8
0
19
8
2
19
8
4
19
8
6
19
8
8
19
9
0
19
9
2
19
9
4
19
9
6
19
9
8
2
0
0
0
2
0
0
2
2
0
0
4
2
0
0
6
2
0
0
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0
10
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0
12
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0
14
CanadaChina
Years
Japan Mexico

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Moving next in Table 3 to unilateral transfers (secondary income), the net result in 2014
was a debit (or net outflow) of $119.2 billion. When this deficit is coupled with the deficit
on goods, services, and primary income, the result was a U.S. CAD of $389.5 billion. This
was a reduction from the earlier 2006 CAD of $800.6 billion, the largest in history.
How is it economically possible for the current account balance to be negative? The
answer of course is that the BOP accounts must have an equal and offsetting capital
and financial account surplus, that is, a net inflow of funds from abroad. Let us now
look at the capital accounts for the United States in 2014 to examine this net financial
capital inflow.
Although the U.S. official BOP accounts no longer list financial capital flow items sys-
tematically in the framework of our categories II and III, we can still glean useful financial
information from the current U.S. presentation. As referred to in footnote 3 of this chapter
(page 450), a very small capital account item (officially labeled “capital account receipts
and payments, net”) now appears in the accounts. This item reflects special, one-time-type
transactions such government international debt operations or international transfers of
assets by migrants and does not consist of typical financial transactions.
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The “financial account” items can be seen as divided into several categories of flows
of funds. Direct investment, as noted in Chapter 12 (page 229) pertains to acquisition of
assets that involve ownership and control of productive facilities, such as the purchase
of a plant abroad. In 2014, U.S. investors acquired $357.2 billion of such assets abroad
and foreign investors bought direct investment assets in the United States in the amount
of $131.8  billion. Hence, the net result in 2014 was the net direct investment debit item
in Table 3 of −$225.4 billion (−$357.2 billion + $131.8 billion = −$225.4 billion). For
portfolio investment involving financial assets such as debt securities (e.g., bonds, notes)
and bank deposits, U.S. financial investors purchased $538.1 billion abroad while foreign
investors bought $705.0 billion of these assets in the United States, leaving Table 3’s net
figure of +$167.0 billion (−$538.1 billion + $705.0 billion = $166.9 billion, difference due
to rounding). The net amounts for the other financial assets/liabilities items in Table 3 are
+$240.1 billion of various other investment assets, including less marketable debt instru-
ments that do not fit neatly into the portfolio flow category, a very small +$3.6  billion for
reserve assets (such as gold and an IMF-issued central bank asset, Special Drawing Rights,
that will be discussed in Chapter 29), and a financial derivatives net entry of $54.4 billion.
Financial derivatives, examined later in Chapter 21, involve instruments that derive value
from other underlying assets rather than from their own intrinsic value per se; examples
are futures, options, and employee stock options. This category had a net credit entry of
$54.4 billion in 2014.
Looking back over Table 3 as a whole, remember that the current account balance was
−$389.5 billion (a CAD of $389.5 billion). Because double-entry bookkeeping means that
the capital and financial accounts should add up to +$389.5 billion, let’s check this result.
The financial account items and their net debit or credit values that we have identified are
as follows:
Capital account transactions, net −$ 0.0
Change in direct investment assets and liabilities − 225.4
Change in portfolio investment assets and liabilities + 167.0
Change in other investment assets and liabilities + 240.1
Change in reserve assets + 3.6
Change in financial derivatives, net + 54.4
+$239.7
What is wrong here? Why do the financial account items add up to +$239.7 billion
rather than +$389.5? The reason is that U.S. authorities use incomplete data in compil-
ing the BOP statement. The accountants are unable to get enough information to make
all the double entries in the double-entry bookkeeping framework. Data on trade are col-
lected from customs information as goods enter and leave the United States, but data on
the financing of trade and on financial flows are gathered independently from commer-
cial banks and other institutions. Some transactions escape the recording and accounting
framework altogether; this certainly applies to smuggling and money laundering, but it also
applies to legal transactions. Further, the timing of the current account items and related
flows in the financial account does not always exactly coincide with the same calendar
year. Thus, the accountant creates a special category, statistical discrepancy or net errors
and omissions, to deal with the fact that the sum of the debits and credits actually recorded
is not zero in practice. In Table 3, you will note that the statistical discrepancy entry has
a value of +$149.9 billion. (This item is often thought to consist primarily of unrecorded
short-term financial capital flows, but unrecorded exports may also be involved—see
Ott, 1988.) When the +$149.9 billion is combined with the financial account figure of
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+$239.7 billion, we arrive at +$389.6 billion, a figure that matches the current account
balance of −$389.5 billion (difference due to rounding).
This completes our discussion of BOP accounting, perhaps in too detailed a fashion for
your tastes(!). (For one of the authors, BOP accounting is his second favorite thing—the
first is root canal work.) However, we think that a grasp of the fundamental concepts of the
various balances and classifications is important for understanding international payments,
the foreign exchange market, and macroeconomic policy decisions. While we have pre-
sented actual U.S. data for the BOP, the concepts and classifications apply to all countries.
INTERNATIONAL INVESTMENT POSITION OF THE UNITED STATES
We conclude this chapter by looking at another kind of statement that portrays the inter-
national economic relationships of a country, using the United States as our example. This
statement indicates the international investment position of a country, or sometimes, if
presented with the opposite sign, the international indebtedness position of a country.
A country’s international investment position is related to the financial accounts in its
BOP statement, but it differs in an important way. The financial accounts in a BOP state-
ment show the flows of financial capital during the year being examined. In economics
terminology, the balance of payments is a flow concept, meaning that it portrays some
type of economic activity during a particular time period. Flow concepts are the kind most
frequently encountered in economic analysis, and familiar examples are national income
during a year, investment expenditure by firms during a year, or sales of a good during
a particular month. On the other hand, the international investment position is a stock
concept rather than a flow concept. A stock concept examines the value of a particular
economic variable at a point in time. Thus, the physical capital stock of a country at the
end of a year, the number of automobiles in existence at the end of a given month, and
the year-end size of the money supply are stock concepts. While the capital and financial
accounts in the balance of payments show the size of flows during a year, the international
investment position shows the cumulative size of a country’s foreign assets and liabilities
at a given point in time (usually defined as at the end of a particular year). The flows of
funds during the year will change the size of the cumulative stock, and the end-of-the-year
international investment position reflects this flow and all previous flows. The statement
of the end-of-the-year international investment position allows the observer to compare
the size of the country’s foreign assets with the size of its foreign liabilities (i.e., the total
assets of foreign countries in this country). If the assets exceed the liabilities, the country
is a net creditor country; if the liabilities exceed the assets, the country is said to be a net
debtor country.
Given this background, Table 4 shows the statement of the U.S. international invest-
ment position at the end of 2014. The table is fairly self-explanatory, given our previous
discussion of assets and liabilities with regard to the U.S. BOP statement. The broad cate-
gory “U.S. Assets” indicates the claims of U.S. citizens, institutions/corporations, and gov-
ernment on foreign persons and entities. (Some of the assets such as stock certificates may
be physically held in the United States.) The “U.S. Liabilities” broad category is the other
side of the coin, as it shows the claims of foreign citizens, institutions/corporations, and
governments upon U.S. persons and entities. The U.S.-owned stock of direct investments
held abroad of $7,124.0 billion is measured at market value—a recent change in account-
ing procedure by the U.S. Department of Commerce from the previously used valuation at
current cost. This stock held abroad is somewhat larger than the foreign direct investment
holdings in the United States listed under “U.S. Liabilities.” Portfolio capital investments
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such as bank deposits and purchases of bonds, currencies, and various securities are larger
in size than direct investments, and the fact that the U.S. liabilities figure of $16,917.1 bil-
lion greatly exceeds the U.S. portfolio assets figure of $9,572.5 billion clearly means that
foreign individuals, institutions/corporations, and governments (including central banks)
have judged these various U.S. financial instruments as being desirable to hold.
Looking at the other, smaller types of financial U.S. assets and liabilities, U.S. holders
of international financial derivatives do so to a slightly greater extent than foreign firms
and individuals have purchased U.S.-originated derivatives; the reverse is the case with
“Other investments.” Finally, the U.S. government’s official reserve assets (gold, Special
Drawing Rights issued by the IMF, foreign currencies, etc.) had a value of $434.3 billion
at the end of 2014. Note that there is no “reserve liabilities” item per se; any liabilities in
the United States (e.g., bank deposits) that are held by foreign governments and monetary
authorities would typically be classified as “portfolio investment” in the statement of the
U.S. international investment position.
The commonly cited figure for a country’s net international investment position is sim-
ply the difference between the country’s assets abroad and the foreign assets in the coun-
try. This figure for the United States for 2014 is indicated at the bottom of Table 4, minus
$7,019.7 billion. No country in the world has such a large negative net international invest-
ment position (i.e., net international indebtedness position).
There are certainly disadvantages to such a position for the United States. For exam-
ple, interest and dividends will have to be paid to overseas debt holders and stockholders
in the future (as well as perhaps debt principal), which eventually involves a transfer of
goods and real income abroad. (There is also worry that a “too large” amount of assets
held by foreign individuals, firms, and governments can threaten a loss of national sover-
eignty.) However, the cumulative financial inflows, if productively used, will have gener-
ated the income with which to make these future payments. In addition, some economists
TABLE 4 International Investment Position of the United States, December 31, 2014
( billions of dollars)
U.S. Assets:
Direct investment at market value $ 7,124.0
Portfolio investment 9,572.5
Financial derivatives other than reserves 3,224.5
Other investment 4,240.2
Reserve assets 434.3
Total U.S. assets $24,595.5
U.S. Liabilities:
Direct investment at market value $ 6,228.8
Portfolio investment 16,917.1
Financial derivatives other than reserves 3,150.7
Other investment 5,318.6
Total U.S. liabilities $31,615.2
Net international investment position of the United States (total U.S. assets minus total
U.S. liabilities = $24,595.5 minus $31,615.2)
−$ 7,019.7
Notes: Direct investment is valued at market value.
Source: Obtained from U.S. Department of Commerce, Bureau of Economic Analysis, Table, “U.S. Net International
Investment Position at the End of the Period,” www.bea.gov.
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think that the inflow of foreign funds may have kept U.S. interest rates lower than they
would have been otherwise. Beyond consideration of the net debtor position itself, how-
ever, a very important point is that the huge $24.6 trillion of U.S. assets abroad and the
huge $31.6 trillion of foreign-held assets in the United States are a striking indication of
the increased mobility of capital and the increased interdependence of countries in the
modern world.
CONCEPT CHECK 1. How would you characterize the current U.S.
balance-of-payments situation? How does it
relate to the claim that the United States has
been engaging in trade as though it had pos-
session of an international credit card?
2. Why is the current account balance not
exactly offset in practice by the financial
account balance? What recording brings the
BOP into balance?
3. What does it mean to say that the United
States is a net debtor country? How long has
this been the case?
IN THE REAL WORLD:
TRENDS IN THE U.S. INTERNATIONAL INVESTMENT POSITION
The international investment position of the United States
has deteriorated markedly in recent years. From the 1980
level of +$296.9 billion, the figure turned negative by 1988
and then reached −$7,019.7 billion at the end of 2014 as
shown in Table 4. The position over the 1976–2014 period
is shown graphically in Figure  2. Remembering that the
net international investment position shows the total stock
of U.S. assets abroad minus the total stock of foreign assets
in the United States, a decrease in the position reflects net
financial flows inward to the United States (a financial
account surplus/current account deficit). The dramatic
decline in the U.S. position can be regarded as a reflection
of the U.S. CAD. In turn, since the CAD reflected greater
spending than income by the United States (or inadequate
saving to finance investment), another way to view the
deterioration in the U.S. international investment position
is that foreign citizens, institutions, and governments have
been financing the excess spending through a funds inflow
to the United States.
A noteworthy departure from the pattern of the total net
international investment position is the behavior of the net
direct investment position. This category involves acquisi-
tion and startup of new factories and real production facili-
ties. In the 1976–2014 period, except for 2000 and 2001,
the stock of U.S.-owned direct investment assets abroad
has been greater than the stock of foreign-owned direct
investment assets in the United States. The stock of for-
eign direct investments in the United States increased dra-
matically from 1976 to 2014 (rising from $44.2 billion to
$6,228.8 billion), but U.S. direct investments abroad rose
from $80.5 billion to $7,124.0 billion, thus maintaining the
positive net position shown in Figure  2. It should also be
noted that the change by the Department of Commerce from
valuing direct investment at market value rather than at cur-
rent cost has added considerable variability to the net invest-
ment position.
Finally, the net international investment position, when
negative, implies that a country is a net debtor as referred to
in the text. However, do not confuse the U.S. net debtor posi-
tion with the popular term national debt (about $18  trillion).
That term is basically a misnomer because it refers to the
debt of the U.S. federal government only, and most of these
bonds (about 65 percent) are held by U.S. (not foreign)
citizens, agencies, and institutions. When assessing relative
claims of the United States versus claims of other nations on
the United States, the net international investment position
is a much more appropriate measure than the federal govern-
ment’s debt.
Source: U.S. Department of Commerce, Bureau of Economic
Analysis, table on “U.S. Net International Investment Position at the
End of the Period,” obtained from www.bea.gov.
(continued)
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IN THE REAL WORLD: (continued)
FIGURE 2 Net International and Direct Investment Positions of the United States, 1976–2014

Year
Billions of U.S. Dollars
-8000
-7000
-6000
-5000
-4000
-3000
-2000
-1000
0
1000
2000
3000
19
76
19
78
19
8
0
19
8
2
19
8
4
19
8
6
19
8
8
19
9
0
19
9
2
19
9
4
19
9
6
19
9
8
2
0
0
0
2
0
0
2
2
0
0
4
2
0
0
6
2
0
0
8
2
0
10
2
0
12
2
0
14
Net International Investment Position
Net Direct Investment Position
SUMMARY
A BOP statement summarizes a country’s economic transac-
tions with all other countries during a particular time period,
usually a year. In accordance with various accounting conven-
tions, the statement indicates debits and credits in goods and
services and factor income flows, unilateral transfers, and vari-
ous sorts of financial flows. The statement is broadly divided
into the current account and the financial account. A current
account imbalance must be matched by an equal (but of oppo-
site sign) financial account imbalance; for example, the large
CAD of the United States in recent years have been matched
by large financial account surpluses. The most widely cited bal-
ances in a BOP statement are the balance on goods (merchan-
dise trade balance) and the current account balance. These and
other balances are useful for interpreting economic events and
for guiding the decisions of policymakers. Finally, a country’s
statement of its net international investment position portrays
the total assets of the country abroad and the total foreign assets
in the home country. This statement indicates whether a country
is a net debtor or a net creditor vis-à-vis foreign countries at a
given point in time.
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KEY TERMS
balance-of-payments accounts
balance on goods or merchandise
trade balance
balance on goods and services
balance of goods, services and
primary factor income
credit items in the balance-of-
payments accounts
current account balance (or balance
on current account)
debit items in the balance-of-
payments accounts
double-entry bookkeeping
financial account balance
international investment position
of a country (or international
indebtedness position of
a country)
net creditor country
net debtor country
official reserve transactions balance
(or overall balance)
statistical discrepancy (or net errors
and omissions)
QUESTIONS AND PROBLEMS
1. Explain how the following items would be entered into the
U.S. balance of payments (the initiating entry):
A disaster relief shipment of wheat to Bangladesh
Imports of textile machinery
Opening a $500 bank account in Zurich
A $1,000,000 Japanese purchase of U.S. government bonds
Hotel expenses in Geneva
The purchase of a BMW automobile
Interest earned on a bank account in London
The Union Carbide purchase of a French chemical plant
Sales of lumber to Japan
The shipment of Fords to the United States from a Mexican
production plant; and the profits from that same plant
2. What is the difference between the financial account and the
current account?
3. What is meant by the “net international investment posi-
tion” of the United States? What would happen to this net
position if the United States experienced a current account
surplus? Why?
4. China has had current account surpluses for many years, and
sometimes these surpluses have been larger than China’s bal-
ance on goods and services and sometimes they have been
smaller. Explain in balance-of-payments accounting terms
why this can be the case.
5. If the financial account balance must exactly offset the
current account balance, why do government accountants
bother to record the financial account?
6. Explain why a current account deficit indicates that a coun-
try is using more goods and services than it is producing.
7. “Direct foreign investment affects both the financial
account and the current account over time.” Agree?
Disagree? Explain.
8. Suppose that two events occur simultaneously: (i) A firm
in country A exports $1,000 of goods to country B and
receives a $1,000 bank deposit in country B in exchange;
and (ii) a country A immigrant gives $500 to a relative in
country B in the form of a $500 buildup of the relative’s
bank account in country A.
What is the impact of these two events on country A’s
(a) merchandise trade balance, (b) current account balance,
and (c) official reserve transactions balance?
9. “Before the U.S. government began running budget sur-
pluses during the Clinton administration (which have of
course become large deficits since that time), Japanese
officials maintained that a key step for reducing the U.S.
current account deficits was not that foreign markets
should become more open to U.S. exports but, rather, that
the U.S. government should have reduced its budget defi-
cits of that time. Was there validity to that point? If so,
why? If not, why not?”
10. Japan has had a current account surplus in every year
since 1981. Explain to a noneconomist why there must
have been a net financial outflow from Japan in those
years.
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LEARNING OBJECTIVES
LO1 Summarize fundamental underpinnings of the foreign exchange market.
LO2 Explain the functioning of the spot exchange market and various
measures of the spot exchange rate.
LO3 Describe the roles of the forward and futures markets in foreign
exchange.
LO4 Indicate the links between the foreign exchange market and the broader
financial markets.
THE FOREIGN
EXCHANGE
MARKET20
CHAPTER
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INTRODUCTION
In March 2011 the Japanese yen hit a record high value against the U.S. dollar. The yen had
been rising since 2007, as, in relative terms, the financial crisis of 2007–2008 did not seem to hit
Japan’s economy as severely as it did the U.S. economy. In fact, in March 2011 a U.S. dollar was
commanding 34 percent fewer yen than in 2007. Because of this rise in the yen, the U.S. Federal
Reserve and several other countries’ central banks decided to intervene in currency markets to
keep the value of the yen in check. Immediately thereafter the yen fell by about 12 percent in three
weeks. The decline was attributed not only to the central bank intervention but also to expected
continued monetary policy ease by the Japanese authorities to counteract the disastrous effects
of the recent earthquake and tsunami. Further, because existing Japanese short-term interest rates
were near zero, currency traders were weakening the yen by sending money out of Japan to
higher-interest-rate countries such as Australia and Brazil.
The movement of financial assets and goods and services shown in the balance of pay-
ments takes place between many different countries, each with its own domestic currency.
Economic interaction can only occur in this instance if there is a specific link between
currencies so that the value of a given transaction can be determined by both parties in
their own respective currencies. This important link is the foreign exchange rate. This
chapter examines how this link is established in the foreign exchange market and underly-
ing economic factors that influence it, factors such as those mentioned in the preceding
paragraph’s typical news reports. The principal components of the market are analyzed
and various measures of the exchange rate discussed. Finally, we discuss how the foreign
exchange market and the financial markets are intertwined and the formal relationship that
exists between the foreign exchange rate and the interest rate.
THE FOREIGN EXCHANGE RATE AND THE MARKET FOR FOREIGN EXCHANGE
The foreign exchange rate is simply the price of one currency in terms of another
(e.g., U.S.$/U.K.£ or, alternatively, U.K.£/U.S.$). This price can be viewed as the result of
the interaction of the forces of supply and demand for the foreign currency in any particular
period of time. Although this price is fixed under some monetary system arrangements, if
a country is to avoid continual official reserve transactions (BOP) surpluses or deficits, the
fixed exchange rate must be approximately that which would result from market determina-
tion of the exchange rate. We will therefore proceed to examine the foreign exchange rate
assuming that it is the result of the normal market interaction of supply and demand. This
market simultaneously determines hundreds of different exchange rates daily and facilitates
the hundreds of thousands of international transactions that take place. The worldwide net-
work of markets and institutions that handle the exchange of foreign currencies is known as
the foreign exchange market. Within the foreign exchange market, current transactions for
immediate delivery are carried out in the spot market and contracts to buy or sell curren-
cies for future delivery are carried out in forward and futures markets. The nature of these
specific markets and the manner in which they function will be discussed in greater detail
later in the chapter.
Individuals participate in the foreign exchange market for a number of reasons. On the
demand side, one of the principal reasons people desire foreign currency is to purchase
The Yen Also Rises
(and Falls)1
Demand Side
1Sources: Binyamin Appelbaum, “Group of 7 to Intervene to Stabilize Yen’s Value,” The New York Times, March
17, 2011, obtained from www.nytimes.com; Alex Frangos and Tom Lauricella, “A Sharp, Swift Slide for Yen,”
The Wall Street Journal, April 7, 2011, pp. C1, C5.
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goods and services from another country or to send a gift or investment income payments
abroad. For example, the desire to purchase a foreign automobile or to travel abroad pro-
duces a demand for the currency of the country in which these goods or services are pro-
duced. A second important reason to acquire foreign currency is to purchase financial
assets in a particular country. The desire to open a foreign bank account, purchase foreign
stocks or bonds, or acquire direct ownership of real capital would all fall into this category.
A third reason that individuals demand foreign exchange is to avoid losses or make profits
that could arise through changes in the foreign exchange rate. Individuals who believe that
the foreign currency is going to become more valuable in the future may wish to acquire
that currency today at a low price in hopes of selling it tomorrow at a high price and thus
make a quick profit. Such risk-taking activity is referred to as speculation in a foreign cur-
rency. Other individuals who have to pay for an imported item in the future may wish to
acquire the needed foreign currency today, rather than risk the possibility that the foreign
currency will become more valuable in the future and would increase the cost of the item
in local currency. Activity undertaken to avoid the risk associated with changes in the
exchange rate is referred to as hedging. The total demand for a foreign currency at any one
point in time thus reflects these three underlying demands: the demand for foreign goods
and services (and transfers and investment income payments abroad), the demand for for-
eign investment, and the demand based on risk-taking or risk-avoidance activity. It should
be clear that the demands on the part of a country’s citizens correspond to debit items in the
balance-of-payments accounting framework covered in the previous chapter.
Participants on the supply side operate for similar reasons (reflecting credit items in the
balance of payments). Foreign currency supply to the home country results first from for-
eigners purchasing home exports of goods and services or making unilateral transfers or
investment income payments to the home country. For example, U.S. exports of wheat and
soybeans are a source of supply of foreign exchange. A second source arises from foreign
investment in the home country. Foreign purchases of U.S. government bonds, European
purchases of U.S. stocks and placement of bank deposits in the United States, and Japanese
joint ventures in U.S. automobile or electronics plants are all examples of financial activity
that provide a supply of foreign exchange to the United States. Finally, foreign speculation
and hedging activities can provide yet a third source of supply. The total supply of foreign
exchange in any time period consists of these three sources.
Before moving on to more technical aspects of the foreign exchange market, let us take a
moment to discuss in a general way how it operates (see Figure 1). The foreign exchange
market here is presented from the U.S. perspective and, like any normal market, contains
a downward-sloping demand curve and an upward-sloping supply curve. The price on
the vertical axis is stated in terms of the domestic currency price of foreign currency, for
example, $US/francSwiss, and the horizontal axis measures the units of Swiss francs sup-
plied and demanded at various prices (exchange rates). The intersection of the supply and
demand curves determines simultaneously the equilibrium exchange rate eeq and the equi-
librium quantity (Qeq) of Swiss francs supplied and demanded during a given period of
time. An increase in the demand for Swiss francs on the part of the United States will
cause the demand curve to shift out to D′Sfr and the exchange rate to increase to e′. Note
that the increase in the exchange rate means that it is taking more U.S. currency to buy
each Swiss franc. When this occurs, the U.S. dollar is said to be depreciating against
the Swiss franc. In similar fashion, an increase in the supply of Swiss francs (to S′Sfr)
causes the supply curve to shift to the right and the exchange rate to fall to e″. In this case,
the dollar cost of the Swiss franc is decreasing and the dollar is said to be appreciating.
Supply Side
The Market
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It  is important to fix this terminology in your mind. Home-currency depreciation or
foreign-currency appreciation takes place when there is an increase in the home cur-
rency price of the foreign currency (or, alternatively, a decrease in the foreign currency
price of the home currency). The home currency is thus becoming relatively less valuable.
Home-currency appreciation or foreign-currency depreciation takes place when there
is a decrease in the home currency price of foreign currency (or an increase in the foreign
currency price of home currency). In this instance, the home currency is becoming rela-
tively more valuable. Changes in the exchange rate take place in response to changes in the
supply and demand for foreign exchange at any given point in time.
The link between the balance of payments and the foreign exchange market can readily
be shown using supply and demand. For purposes of this discussion, consider the supply
and demand for foreign exchange as consisting of two components, one related to current
account transactions and the other linked to the financial flows including the speculative
and hedging activities (financial account transactions). In Figure 2, the demand and the sup-
ply of foreign exchange are each broken down in terms of these two components. Ignoring
unilateral transfers, DG&S and SG&S portray the demand and supply of foreign exchange
associated with the domestic and foreign demands for foreign and domestic goods and ser-
vices, respectively. The demand and supply of foreign exchange associated with financial
transactions are then added to each of the curves, creating a total demand and a total supply
of foreign exchange. If the financial desire for foreign exchange is assumed to take place
primarily for reasons such as expected profits, expected rates of return, and so forth (i.e., for
reasons independent of the exchange rate), the total curves are drawn a fixed distance from
the DG&S and the SG&S curves. If the exchange rate influences these financial flows, then the
e
e
Swiss francs (Sfr)
eeq
e
Qeq Q Q0
SSfr
S Sfr
DSfr
D Sfr
($/Sfr)
FIGURE 1 The Basic Foreign Exchange Market
The equilibrium rate of exchange, eeq, is determined by the interaction of the supply and demand for a particular
foreign currency (in this case the Swiss franc). An increase in domestic demand for the foreign currency is
represented by a rightward shift in the demand curve to D′Sfr, which causes the equilibrium exchange rate to
increase to e′. Because it now takes more units of domestic currency to buy a unit of foreign exchange, the
domestic currency (the dollar) has depreciated. In a similar fashion, an increase in the supply of foreign
exchange to S′Sfr leads to an appreciation of the dollar, that is, to a lower equilibrium exchange rate e″.
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relationship between the goods and services curves and the total curves is more complex.
For ease of discussion, however, we proceed with the curves as drawn in Figure 2.
The equilibrium exchange rate is now seen to be determined by the intersection of the
DTotal and the STotal curves. This is not necessarily going to be the same exchange rate that
would equilibrate DG&S and SG&S. This would only be the case if the current account was
exactly in balance at the equilibrium rate, eeq. In Figure 2, the equilibrium rate is below that
which would balance the current account. Consequently, at eeq there is an excess demand
(Q2 − Q1) for foreign currency for trade in goods and services (the current account) and an
offsetting excess supply (Q2 − Q1) in foreign exchange in the financial account. The supply
of foreign exchange arising from financial transactions (Qeq − Q1) exceeds the demand for
foreign exchange for financial transactions (Qeq − Q2) by (Q2 − Q1), the amount of the cur-
rent account deficit. Thus, we again see that a deficit in the current account will be exactly
offset by an equivalent surplus in the financial account at the market clearing exchange
rate. Similarly, any surplus in the current account will be exactly offset by an equivalent
deficit in the financial account at the equilibrium exchange rate.
THE SPOT MARKET
Having discussed the general nature of the foreign exchange market, we now turn to a more
rigorous examination of this market. We begin by looking at the operation of the daily or
Foreign exchange
e
eeq
SG&S
STotal
DG&S DTotal
QeqQ2Q10
FIGURE 2 The Foreign Exchange Market and the Balance of Payments
The demand and supply of foreign exchange are broken down into the transactions linked to the flows of goods
and services (ignoring unilateral transfers), that is, the current account (DG&S, SG&S), and the transactions linked
to financial transactions. Because the two must sum to DTotal and STotal, desired financial transactions are the
difference between the “Total” curves and the “G&S” curves. The equilibrium exchange rate eeq will be
determined by the interaction of DTotal and STotal. In this case, eeq is below that which would equate demand and
supply in the current account, DG&S and SG&S, leading to a current account deficit (Q2 − Q1). However, at eeq
the supply of foreign exchange resulting from financial transactions, (Qeq − Q1), is greater than the demand for
financial transactions (Qeq − Q2) by the amount (Q2 − Q1). The surplus in the financial account thus exactly off-
sets the deficit in the current account at the equilibrium rate of exchange.
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current market, referred to as the spot market, and then examine the market for foreign
exchange for future delivery (the forward and futures markets).
As was indicated in the previous section, the motivations for demanding or selling foreign
exchange are based in the transactions related to the current and financial accounts. These
actions involve individuals and institutions of all kinds at the retail level and the banking
system at the wholesale level. The major participants in the foreign exchange market are
the large commercial banks, although multinational corporations whose day-to-day opera-
tions involve different currencies, large nonbank financial institutions such as insurance
companies, and various government agencies including central banks such as the U.S.
Federal Reserve and the European Central Bank also play important roles. Not surpris-
ingly, the large commercial banks play the central role since the buying and selling of
currencies most often involves the debiting and crediting of various bank accounts at home
or abroad. In fact, most foreign currency transactions take place through the debiting and
crediting of bank accounts with no physical transfer of currencies across country borders.
Consequently, the bulk of currency transactions takes place in the wholesale market in
which these banks trade with each other, the interbank market. In this market, a large
percentage of these interbank transactions is conducted by foreign exchange brokers who
receive a small commission for arranging trades between sellers and buyers. The buying
and selling of foreign exchange by the commercial banks in the interbank market that is not
done through foreign exchange brokers, but directly with other banks, is called interbank
trading. While bank currency transactions are done to meet their various retail customers’
needs (corporations and individuals alike), banks also enter the foreign exchange market to
alter their own portfolios of currency assets.
As was indicated earlier, the foreign exchange market consists of many different markets
and institutions. Yet, at any given point in time, all markets tend to generate the same
exchange rate for a given currency regardless of geographical location. The uniqueness of
the foreign exchange rate regardless of geographical location occurs because of arbitrage.
As you recall, arbitrage refers to the process by which an individual purchases a product (in
this case foreign exchange) in a low-priced market for resale in a high-priced market for the
purpose of making a profit. In the process, the price is driven up in the low-priced market
and down in the high-priced market. This activity will continue until the prices in the two
markets are equalized, or until they differ only by the transaction costs involved. Because
currency is being bought and sold simultaneously, there is no risk in this activity and hence
there are always many potential arbitragers in the market. In addition, because of the speed
of communications and the efficiency of transactions in foreign exchange, the spot market
quotations for a given currency are remarkably similar worldwide, and any profit spread on
a given currency is quickly arbitraged away.
In a world of many different currencies, there is also a possibility for arbitrage if
exchange rates are not consistent between currencies. This point can be most easily seen in
a three-currency example. Suppose the dollar/sterling rate is $1.40/£, and the dollar/Swiss
franc rate is $0.70/Sfr. In this case, the franc/sterling rate must be 2 Sfr/£ for the three rates
to be consistent and for there to be no basis for arbitrage [($1.40/£)/($0.70/Sfr) = 2 Sfr/£].
Suppose that the dollar/sterling rate increases to $1.60/£. This rate is inconsistent with
the $0.70/Sfr and the 2 Sfr/£ rate, and there is a clear profit to be made by simultaneously
buying and selling all three currencies. For example, one could take $1.40 and acquire
2 francs, use the 2 francs to buy 1 pound sterling, and immediately exchange the £1 for
$1.60, thereby making a quick $0.20 profit. This is a situation of multicurrency arbitrage,
in this case called triangular arbitrage since it involves an inconsistency between three
Principal Actors
The Role of Arbitrage
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different currencies. The triangular arbitrage produces cross-rate equality, meaning that
all three exchange rates are internally consistent. Arbitragers are constantly watching the
foreign exchange market for any inconsistencies, and they immediately buy and sell for-
eign exchange to take advantage of such a situation. In the preceding example, the arbi-
trage process should tend to drive up the dollar-franc price, drive up the franc-sterling
price, and drive down the dollar-sterling price. These adjustments would take place until
a new consistent equilibrium emerged—for example, $1.54/£, $0.74/Sfr, and 2.08 Sfr/£.
(You should verify for yourself that there is no possibility for profitable arbitrage at these
new prices.) The arbitrage process is thus relied upon not only to maintain a similar indi-
vidual currency value in different foreign exchange markets but also to make certain that
all the cross rates between currencies are consistent.
The discussion of the foreign exchange market to this point has focused on some of the
more important conceptual factors underlying current or “on the spot” exchanges of cur-
rency between two countries. While this spot rate is certainly useful, it does not provide
information about what the spot rate should be, given the nature and structure of the two
countries; it does not provide any information on the change in overall strength of the
domestic currency with respect to all of the home country’s trading partners; and it does
not give any indication of the real cost of acquiring foreign goods and services in a world
of changing prices. To obtain information about these factors, we must turn to alterna-
tive measures, measures which are often cited in the international sections of major news
publications.
Let us look first at the problem of assessing the relative strength or weakness of a cur-
rency when a country has numerous trading partners, each with its own exchange rate.
Because different exchange rates are similar to different commodities, we cannot simply
add them together and take a mean. Just as in assessing economywide price changes, we
therefore construct an index wherein each commodity (currency) can be appropriately
weighted by its importance in a given country’s international trade. To avoid the aggrega-
tion problem associated with adding up different currencies, each exchange rate is indexed
to a given base year. The base year is assigned a value of 1 (or sometimes 100), and all
other observations for any given year are valued relative to it. For example, suppose we
want to consider the average strength of the U.S. dollar in terms of other currencies. The
dollar might, in the base year, be worth 0.6 British pound and 120 Japanese yen. Then,
in some later year, the exchange rates or prices of the dollar might be 0.75 British pound
and 90 Japanese yen. Clearly, in this example, the dollar has appreciated in terms of the
pound (from 0.6 pound to 0.75 pound) and depreciated in terms of the yen (from 120 yen to
90 yen). The index for the value of the dollar in the later year would thus be 1.25 in terms of
the pound (0.75/0.6 = 1.25) and 0.75 in terms of the yen (90/120 = 0.75). To find the change
in the dollar’s value on average from the base year to the later year, the procedure is then to
weight the value of the dollar in terms of a particular country’s currency by the percentage
of the country’s trade that is done with that particular country. Thus, in the United Kingdom
and Japan examples, if 20 percent of U.S. trade was with the United Kingdom, the weight
accorded to the pound price of the dollar would be 0.2; if Japan accounted for 15 percent of
U.S. trade, the yen price of the dollar would get a weight of 0.15. When this is done for all
currencies involved in the sample or in a country’s entire trade, the weights add up to 1.0.
The end result of this process, a trade-weighted index of the average value of a country’s
currency, is called the nominal effective exchange rate (NEER) of the currency.2
Different Measures of
the Spot Rate
2A nominal effective exchange rate index for the U.S. dollar appears daily in The Wall Street Journal.
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To see how a NEER is calculated, consider the historical information in Table 1 for the
United States and selected major trading partners for 2000 and 2008. The exchange rates
are expressed in terms of units of foreign exchange per U.S. dollar. The levels of trade
(exports plus imports) are indicated in column (5), the associated trade weights in column
(6), the average exchange rates in columns (2) and (3), and the associated indexes of the
price of the dollar for 2008 in column (4) (based on 2000 = 1.0). The NEER for 2008
can be calculated using the information [columns (4) and (6)] as shown in the table. The
fact that the NEER has a value of 0.793 indicates that, on average over the 2000–2008
period with this set of trading partners, the dollar depreciated by 20.7 percent. This result
occurs because, in recent years, the dollar depreciated against all of the currencies except
the Japanese yen and Mexican peso. This example illustrates the manner in which actual
NEERs of a currency are calculated. [Note: To practice the technique using the given
exchange rates, drop the EMU from the sample and recalculate the NEER. You should get
a lower rate of depreciation for the dollar (14.1 percent), indicating how NEERs are sensi-
tive to the choice of countries included in the sample.]
Another issue relates to the problem of interpreting changes in the exchange rate against
any one currency when prices are not constant. When the prices of goods and services are
changing in either the home country or the partner country (or both), we do not know the
change in the relative price of foreign goods and services by simply looking at changes in
the spot exchange rate and failing to take the new level of prices within both countries into
account. For example, if the dollar appreciated against the yen by 10 percent, we would
expect that, other things equal, U.S. goods would be 10 percent less competitive against
Japanese goods in world markets than was previously the case. However, suppose that, at
the same time that the dollar appreciated, U.S. goods prices rose more rapidly than Japanese
goods prices. In this situation, the decline in U.S. competitiveness against Japanese goods
would be more than 10 percent, and the nominal 10 percent exchange rate change would
TABLE 1 Nominal Effective Exchange Rate Calculation (U.S. trade in millions of dollars)
Exchange Rate U.S. Trade, 2008
Country 2000 2008 Index 2008 Exports and Imports wi
(1) (2) (3) (4) (5) (6)
EMU €1.0832/$ €0.6653/$ 0.614 653,142.1 0.267
Switzerland SFr1.6904/$ SFr.0734/$ 0.635 39,739.2 0.017
Sweden Skr9.1735/$ Skr6.3175/$ 0.689 17,449.9 0.007
United Kingdom £0.6598/$ £0.5284/$ 0.801 112,193.7 0.047
Canada C$1.4815/$ C$1.0411/$ 0.703 595,754.0 0.250
Japan ¥102.80/$ ¥107.58/$ 1.046 205,696.5 0.086
Mexico Peso9.459/$ Peso10.328/$ 1.092 367,867.0 0.154
China Yuan8.2784/$ Yuan6.8375/$ 0.826  408,981.3 0.172
Total 2,382,818.7 1.000
NEER = (0.614)(0.267) + (0.635)(0.017) + (0.689)(0.007) + (0.801)(0.047) + (0.703)(0.250) + (1.046)(0.086)
+ (1.092)(0.154) + (0.826)(0.172)
= 0.793
Note: EMU = Economic and Monetary Union in Europe—currently nineteen countries use the euro.
Sources: Data for exchange rates come from International Monetary Fund, International Financial Statistics online at www.imf
.org; trade information obtained from the U.S. International Trade Commission website, www.usitc.gov.
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be misleading. For this reason, a real exchange rate (RER) is often calculated, where the
RER embodies the changes in prices in the two countries in the calculation.
To illustrate, the average Japanese yen/dollar exchange rate in 1995 was ¥94.11/$1,
and in 2014 this nominal exchange rate was ¥105.86/$1. This was a 12.5 percent apprecia-
tion of the dollar against the yen [(105.86 − 94.11)/94.11 = 0.125], leading one to expect
reduced competitiveness on the part of U.S. goods against Japanese goods. To calculate the
RER, we must also look at prices. With 1995 = 100, U.S. consumer prices had risen to a
level of 155.3 in 2014; with 1995 = 100, Japanese consumer prices had risen slightly to the
level of 101.7. The real yen per dollar exchange rate would then be calculated as follows:
RER2014 = e¥/$, 2014 × (
U.S. price index2014
Japanese price index2014 )
Thus, in our example,
RER = 105.86 ×(
155.3
101.7)= 161.65
In this example, then, calculation of the RER indicates that, in terms of competitiveness
against Japanese products in international markets, U.S. goods are actually at a consider-
ably greater disadvantage than the disadvantage suggested by the nominal rate.
Another exchange rate concept, the real effective exchange rate (REER), calculates
an effective or trade-weighted exchange rate based on RERs instead of on nominal rates.
In this case, the exchange rate indexes (such as those in Table 1) are calculated using RERs
rather than nominal exchange rates. The resulting indexes are then weighted, as usual, by
the trade importance of the respective countries.
Another measure of the spot rate is concerned with identifying the true equilibrium rate
that would lead to the current account (and hence the capital account) being in balance. An
approach commonly used to estimate the underlying true equilibrium rate is the purchasing
power parity (PPP) approach and it exists in two versions, an absolute PPP version and a
relative PPP version.
The PPP approach rests on the postulate that any given commodity tends to have the
same price worldwide when measured in the same currency. This is sometimes referred
to as the law of one price, which many believe operates if markets are working well both
nationally and internationally. Under these conditions, arbitrage will quickly erase any
price differences between different geographical locations. In the presence of transpor-
tation and handling costs, arbitrage will not cause prices to equalize between different
geographical locations, but it is felt by proponents of the law of one price that this will not
distort the general one-price concept. If goods and services do in fact seem to follow the
law of one price, then, it is argued, the absolute level of the exchange rate should be that
level that causes traded goods and services to have the same price in all countries when
measured in the same currency. This is referred to as absolute purchasing power parity.
For example, if a bushel of wheat costs $4.50 in the United States and £3 in the United
Kingdom, then the exchange rate should be equal to $4.50 per bushel divided by £3 per
bushel, or $1.50/£. If we generalize over many goods, the absolute PPP estimate of the
equilibrium exchange rate would be
PPPabsolute = price levelUS/price levelUK
when the price levels are expressed in dollars and pounds, respectively.
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IN THE REAL WORLD:
NOMINAL AND REAL EXCHANGE RATES OF THE U.S. DOLLAR
As examples of the nominal and RERs of the dollar, con-
sider Figures 3 and 4. Figure 3 illustrates the behavior of
the nominal exchange rate (NER, or our usual e) of the U.S.
dollar in terms of the Canadian dollar over roughly the last
three decades, as well as the movement of the RER of the
U.S. dollar in terms of the Canadian dollar over the same
period. The graph shows that the nominal rate was above
the real rate in nearly every year prior to 2005 and below
the real rate in the years after 2005. Technically, this pat-
tern of difference in levels of the NER and RER reflects the
fact that 2005 was the base year (when the consumer prices
used in the construction of the RER were set equal to 100
in both countries) and the fact that Canada had slightly less
inflation throughout this period than did the United States.
This technical difference in levels is not of importance, how-
ever. What is important is that, for the 1982–2005 period,
(continued)
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Not surprisingly, the absolute version of PPP does not seem to be borne out empirically.
Factors such as transportation costs and trade barriers, which keep prices from equalizing
across different markets, combined with the difference in the composition and relative
importance of various goods, explain in part why the absolute version does not seem to
hold. In short, every country’s measure of the price level reflects a set of goods and ser-
vices unique to that country and not directly comparable to the goods and services of other
countries. For these reasons, a weaker version of PPP is often used that relates the change
in the exchange rate to changes in price levels in the two countries. This is referred to as
relative purchasing power parity (PPPrel).
In the PPPrel version, if prices in the home country are rising faster than prices in the
partner country, the home currency will depreciate. If prices in the home country are ris-
ing slower than prices in the partner country, the home currency will appreciate. Given an
initial base period exchange rate, the equilibrium rate (PPPrel rate) at some later date will
reflect the relative rates of price change in the two countries. More specifically, the PPPrel
rate (stated in terms of units of domestic currency per unit of foreign currency) should
equal the initial period exchange rate multiplied by the ratio of the price index in the home
country to the price index in the partner country. For instance, the U.S.–U.K. PPPrel for
2013, with 1995 as the base year, would be calculated as
2013 PPPrel$/£ = [e1995$/£ ] × [PI2013US /PI2013UK ].
Hence, if e1995$/£ = $1.59/£, PI2013US = 152.9, and PI2013UK = 146.6,
PPPrel$/£ = ($1.59/£) × (152.9/146.6)
= $1.66/£
Because the actual exchange rate in 2013 was $1.56/£, PPPrel suggests that the pound
was undervalued relative to the dollar in 2013 (the dollar was overvalued relative to the
pound), based on the rates of price increase in the two countries over the period from 1995
to 2013. This conclusion, of course, rests on the assumptions that the exchange rate in 1995
was an equilibrium market rate and that the two price indexes used accurately reflect the
changes in prices of traded goods. Changes in both the structure of relative prices between
traded and nontraded goods in the two countries and the composition of traded goods
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IN THE REAL WORLD: (continued)
NOMINAL AND REAL EXCHANGE RATES OF THE U.S. DOLLAR
the nominal value of the U.S. dollar appreciated slightly less
than did the real value. However, after 2005 the nominal
rate of the U.S. dollar depreciated slightly more than did the
real rate. Hence, the behavior of the nominal rate suggests a
smaller increase in competitiveness for U.S. goods relative
to Canadian goods than was actually the case as reflected in
the real rate. The very close relationship between the nomi-
nal rate and the real rate reflects the fact that these adjacent
countries are closely integrated economically.
Figure 4 portrays the behavior of the NEER of the U.S.
dollar during 1982–2014 against currencies of major trading
partners (weighted by the relative importance of trade with
the United States). In these rates, the year 2010 is the base
year, where both the NEER and the REER are equal to 100.
The real rate is above the nominal rate until the late 1990s.
Hence, in this period, the dollar was more expensive in real
terms than the nominal rate suggests, hindering U.S. com-
petitiveness. The real rate is then slightly below the nomi-
nal rate until 2005, after which time they remain almost
identical.
FIGURE 3 Nominal and Real Canadian Dollar/U.S. Dollar Exchange Rates, 1979–2014
0
0.5
1.0
1.5
2.0
1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Year
Nominal exchange rate (NER)
Real exchange rate (RER)
Canadian Dollar/U.S. Dollar
Note: Price indexes are 2005 = 100.
Sources: Calculated from data contained in various editions of International Monetary Fund, International Financial Statistics Yearbooks,
the Economic Report of the President 2012, and https://research.stlouisfed.org.
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CHAPTER 20 THE FOREIGN EXCHANGE MARKET 479
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IN THE REAL WORLD:
FIGURE 4 U.S. Nominal Effective and Real Effective Rates, 1982–2014
Year
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
U.S. NEER
U.S. REER
Indexes (2010 = 100)
30
20
10
0
60
50
40
90
80
70
120
110
100
150
140
130
Source: Data obtained from data.imf.org.
could cause serious estimation problems. Historically, estimated PPP exchange rates and
nominal (the actual market) exchange rates have differed considerably in their movements.
A creative approach to estimating the absolute PPP of currencies was introduced by The
Economist magazine about two decades ago when the magazine began constructing its Big
Mac Index. This index was originally introduced in humorous fashion, but it has on occa-
sion had remarkable predictive ability regarding the future movement of currencies. The
index is an absolute PPP measure of a currency based upon one commodity: a McDonald’s
Big Mac. The basic idea is that a particular commodity should cost the same in a given

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currency wherever it is found in the world—if the prevailing exchange rates are “true equi-
librium value” exchange rates. The estimate of the PPP rate (in units of foreign currency
per one U.S. dollar) for a given currency is simply the value of the ratio of the Big Mac
price in local currency divided by the U.S. dollar price. The currency is then determined
to be undervalued or overvalued depending on whether the Big Mac price ratio is greater
than the current spot rate (the local currency is then undervalued) or less than the current
spot rate (the currency is then overvalued). For example, the recent price of a Big Mac
in Mexico was 49 pesos, while the U.S. price was $4.79. The implied PPP exchange rate
(pesos/dollar) was thus 10.23 pesos/dollar (49 pesos ÷ $4.79 = 10.23). Because the actual
spot exchange rate at that time was 15.74 pesos/dollar, the Big Mac Index suggests that the
Mexican peso was undervalued by 35 percent [(10.23 − 15.74) ÷ 15.74 = −0.350].3
The Big Mac Index has proved to be surprisingly consistent with other more sophisti-
cated PPP measures over the years in spite of its many limitations. For example (to give
you something to chew on), the 1996 index turned out to be a useful predictor for the
direction of exchange rate movements of eight of twelve currencies of large industrial
economies. In addition, the directions of movement of six of the seven currencies whose
value changed by more than 10 percent were correctly indicated by the index. Further, the
index implied that the euro was overvalued when introduced in 1999, and the euro did
decline soon after its introduction. However, the euro recovered in late 2003 and early
2012 (i.e., played “ketch up”), and the index in early 2012 suggested very slight overvalu-
ation against the dollar.4 These various successes came about in spite of the fact that the
Big Mac Index assumes that there are no barriers to trade, including transportation costs.
In addition, no provision is made for different tax structures, relative costs of nontraded
inputs, or different market structures and profit margins.
3Data obtained from http://bigmacindex.org.
4See “Big MacCurrencies,” The Economist, April 12, 1997, p. 71, and “The Big Mac Index,” February 1, 2007,
obtained from www.economist.com; and http://bigmacindex.org.
CONCEPT CHECK 1. If the dollar/yen nominal exchange rate
increases, has the dollar appreciated or depre-
ciated? Why?
2. What is the difference between the nomi-
nal (actual) exchange rate and the real
ex change rate?
3. If the euro/dollar actual exchange rate is
below the relative PPP rate, why is the dollar
said to be undervalued?
THE FORWARD MARKET
Our discussion of the foreign exchange market to this point has focused on the current
or spot market for foreign exchange. Somewhere in the world foreign exchange is being
bought or sold at every time of the day. Thus, exchange rates are subject to change at any
moment. Although an individual can acquire relatively small amounts of foreign exchange
at the going spot rate immediately, the most common exchange of currencies takes place
two business days after the exchange contract has been struck. The two-day-later date, or
value date when the transaction is completed, allows the bank accounts involved in the
transaction sufficient time to clear. You can find daily quotations of the spot rate for the
currencies of many countries in major news publications and can get current information
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CHAPTER 20 THE FOREIGN EXCHANGE MARKET 481
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by contacting many banks and financial exchange centers. Note in Table 2(a) on page 484
that the quotations are for the previous day and are the wholesale or interbank rates for
transactions of $1 million or more. Retail customers pay a higher rate for foreign exchange;
the difference between the two rates is the bank’s charge for providing this service. Finally,
commercial banks also make money in the foreign exchange markets by buying foreign
exchange at a lower price than they sell it. For example, if you are traveling in England,
you might pay $1.60/£ when you purchase pounds and receive only $1.58/£ when you sell
back any unused pounds even though the exchange rate has not changed. The difference
between the buying and selling price is the retail spread or the retail trading margin.
These margins also exist at the wholesale level.
In many instances, however, transactions contracted at one point in time are not com-
pleted until a later date. For example, suppose that a U.S. automobile importer contracts
to purchase 10 Rolls-Royce automobiles at a cost of £100,000 per automobile, which at
the spot exchange rate of $1.50/£ would cost $150,000 per automobile, for a total contract
cost of $1,500,000. The delivery and payment date on the 10 automobiles is six months
from the time the contract was signed. Because the contract is written in pounds sterling,
the importer is faced with the possibility that the exchange rate may change within the six-
month period. For example, the exchange rate might fall to $1.40/£, causing the dollar cost
of the 10 cars to fall from $1.5 million to $1.4 million. On the other hand, the exchange
rate could increase to, for example, $1.60/£. In either case, the cost of the autos changes by
$100,000. The passage of time between when a contract is signed and the deal is finalized
interjects an element of risk at the future point in time. If the contract above had been writ-
ten in dollars instead of pounds sterling, the element of risk would have fallen on the U.K.
exporter instead of the U.S. importer.
Because the contract in this case is written in pounds sterling, the risk falls on the
importer. If the U.S. buyer does nothing and waits until the delivery day to purchase the
£1 million, he or she is taking what is referred to as an uncovered, or open, position.
Suppose that the importer was risk averse and wished to hedge against an unfavorable
change in the exchange rate. What, if anything, can be done to reduce the risk of the pound
appreciating against the dollar in the next six months? One alternative open to the importer
is to acquire pounds sterling today at the rate of $1.50/£, invest them in England for the six-
month interim period, then use the proceeds to meet the contract payment. This could of
course involve transaction costs as well as the opportunity cost of any earnings differential
if interest rates are higher in the United States than in the United Kingdom.
A second hedging option open to the importer is to contract today with a bank to
acquire £1 million on the delivery date for a specific number of dollars determined by the
forward exchange rate. The forward rate differs from the spot rate in that the delivery
date is more than two days in the future. Table 2(b) on page 485 gives an example of for-
ward exchange rate quotations. With a forward contract, the foreign exchange agreement is
made at the present time, but the actual exchange of currencies does not take place until the
day the foreign currency is needed. In making this contract, the importer is guaranteed the
contracted forward rate (e.g., $1.51/£) for the million pounds even if the spot pound price
should rise to $1.60 before the automobiles are delivered.
In this case, the bank or broker is operating as an intermediary between those who
are demanding pounds sterling for delivery in six months and those who desire to supply
pounds sterling in six months. Possible suppliers in this market are U.S. exporters who are
to receive pounds sterling on that day and wish to contract forward to hedge the risk of the
pound depreciating against the dollar. Another potential supply source consists of indi-
viduals or institutions who are willing to speculate (i.e., take an uncovered position) on the
dollar-pound exchange rate in six months. These speculators hope to make an immediate
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IN THE REAL WORLD:
SPOT AND PPP EXCHANGE RATES
Figure 5 illustrates the annual movements in the nominal
price of the euro in terms of the dollar from the time of the
introduction of the euro in 1999 until 2014. This nominal
exchange rate can be compared with the relative PPP rates
of the euro in terms of the dollar over the same period. The
average exchange rate for 1999 ($1.065/€) and U.S. and EU
Consumer Price Indexes (2005 = 100) were used in calculat-
ing the PPP rate. As can be seen, over this relatively short
period the nominal and PPP rates clearly do not coincide.
The actual euro was undervalued when compared with the
PPP rate during 2000–2002, but then became overvalued for
the remaining years, substantially so at the end of the period.
It seems evident that other factors beside relative goods
prices, such as sizable and varying capital flows, affect a
nominal exchange rate.
Figure 6 plots the nominal and relative PPP rates of the
British pound in terms of the dollar over the 1980–2013
period, with the 1980 exchange rate of $2.33 serving as the
FIGURE 5 Spot and PPP Dollar/Euro Rates, 1999–2014
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Year
PPP rate
Spot rate
$/Euro
0.6
0
0.9
0.8
0.7
1.2
1.1
1
1.5
1.4
1.3
1.6
0.5
0.4
0.3
0.2
0.1
Sources: Data obtained from www.imf.org, Economic Report of the President 2012, and Eurostat.
482 PART 5 FUNDAMENTALS OF INTERNATIONAL MONETARY ECONOMICS
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profit on the delivery day due to the difference between the contracted forward rate and
the current (spot) market rate on that day. If a speculator expects that the actual future spot
rate will be higher than the current forward rate, the speculator will purchase foreign cur-
rency forward (take a long position in foreign exchange). If the expectation is realized,
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FIGURE 6 Spot and PPP Dollar/Pound Rates, 1980–2013
Year
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
PPP rate
Spot rate
Dollars per Pound
1.0
1.5
2.0
2.5
Sources: Data obtained from www.imf.org and https://research.stlouisfed.org.
base. The United Kingdom experienced more rapid infla-
tion during this time than did the United States, so the rela-
tive PPP rate shows almost continuous decline. Despite
the fact that the more rapid U.K. inflation is incorporated
into the PPP rate, the actual pound was nevertheless
undervalued in comparison with PPP. The drop below the
PPP rate was especially severe in the early 1980s, but the
pound then strengthened somewhat. By 2007, it was very
near its PPP level, only to recede further below it in the
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forward foreign exchange is acquired on the delivery date at the contracted price and then
immediately resold at the spot price at that time for a profit. If it is expected that the actual
future spot rate will be less than the current forward rate, the speculator will contract to sell
foreign exchange forward, or take a short position.
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The forward market thus consists of parties demanding or supplying a given currency at
some future point in time for the purpose of either minimizing risk of loss due to adverse
changes in the exchange rate (hedging) or making a profit (speculating). Obviously, expec-
tations play an important role in this market, particularly on the part of those holding an
uncovered position. The opportunity cost of hedging in this market consists of the differ-
ence between the contracted exchange rate and the rate that actually exists on the con-
tracted delivery day. As a general rule, the more volatile the market in question, the greater
TABLE 2(a) Spot and Forward Exchange Rates
Currencies
U.S.-Dollar Foreign-Exchange Rates in Late New York Trading
Mon US$ vs.
YTD
Chg (%)
Mon US$ vs.
YTD
Chg (%)
Country/Currency In US$ Per US$ Country/Currency In US$ Per US$
Europe
Czech Rep. koruna .04192 23.854 4.3
Denmark krone .1522 6.5683 6.7
Euro area euro 1.1360 .8803 6.5
Hungary forint .003663 272.99 4.3
Iceland krona .008004 124.93 −2.1
Norway krone .1235 8.0950 8.6
Poland zloty .2688 3.7202 5.0
Russia ruble .01606 62.284 2.9
Sweden krona .1222 8.1832 4.8
Switzerland franc 1.0387 .9627 −3.2
Turkey lira .3417 2.9264 25.3
Ukraine hryvnia .0460 21.7270 37.3
UK pound 1.5347 .6516 1.5
Middle East/Africa
Bahrain dinar 2.6522 .3770 unch
Egypt pound .1277 7.8324 9.5
Israel shekel .2608 3.8347 −1.6
Kuwait dinar 3.3137 .3018 3.0
Oman sul rial 2.5974 .3850 unch
Qatar rial .2746 3.641 unch
Saudi Arabia riyal .2667 3.7491 −0.1
South Africa rand .0751 13.3198 15.2
Americas
Argentina peso .1064 9.3961 11.0
Brazil real .2657 3.7639 41.6
Canada dollar .7694 1.2998 11.8
Chile peso .001478 676.70 11.5
Colombia peso .0003490 2864.93 20.6
Ecuador US dollar 1 1 unch
Mexico peso .0607 16.4628 11.7
Peru new sol .3098 3.228 8.2
Uruguay peso .03434 29.1200 21.3
Venezuela b. fuerte .158729 6.3001 0.1
Asia-Pacific
Australian dollar .7362 1.3583 11.0
China yuan .1582 6.3226 1.9
Hong Kong dollar .1290 7.7501 −0.1
India rupee .01543 64.795 2.8
Indonesia rupiah .0000743 13468 8.4
Japan yen .008331 120.03 0.3
Kazakhstan tenge .003636 275.00 50.4
Macau pataca .1254 7.9749 −0.2
Malaysia ringgit .2420 4.1320 17.9
New Zealand dollar .6717 1.4888 16.0
Pakistan rupee .00958 104.425 3.6
Philippines peso .0219 45.694 2.2
Singapore dollar .7149 1.3988 5.5
South Korea won .0008740 1144.16 4.6
Sri Lanka rupee .0071250 140.35 7.0
Taiwan dollar .03093 32.328 2.2
Thailand baht .02829 35.350 7.4
Vietnam dong .00004475 22348 4.5
Sources: Tullett Prebon, WSJ Market Data Group, The Wall Street Journal, October 13, 2015, p. C5. The data pertain to Monday, October 12, 2015.
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5This paragraph has drawn heavily on Norman S. Fieleke, “The Rise of the Foreign Currency Futures Market,”
Federal Reserve Bank of Boston, New England Economic Review, March/April 1985, pp. 38–47. This article is an
excellent evaluation of the role of the futures market. Of particular interest is the observation (p. 47) that standard-
ization within the futures market is facilitated by the fact that the futures price and the spot price for a currency
converge as the futures contract nears maturity, providing a link between the two prices that allows hedging to
take place with relatively few maturity dates for futures contracts.
TABLE 2(b) Forward Exchange Rates for Canadian Dollar
(U.S. dollars per Canadian dollar, October 9, 2015)
Forward Contract Forward Exchange Rate
1 month US$ 0.7727/C$
3 months 0.7726
6 months 0.7723
1 year 0.7720
3 years 0.7758
5 years 0.7815
(spot) 0.7729
Source: Data from Pacific Exchange Rate Service, obtained at fx.sauder.ubc.ca.
the risk and hence the likely spread between the actual and the contracted rate. Compared
with the first hedging option involving the acquisition of foreign currency at today’s rate
and short-term investment of the funds in the foreign country, however, hedging through
the forward market is convenient and attractive to those unfamiliar with short-term invest-
ment opportunities in the foreign country in question.
In addition to the forward market, there are two additional possibilities for buying and
selling foreign exchange in the future. These two alternatives include buying or selling for-
eign exchange (major currencies only) in the foreign currency futures market or buying an
option on the futures market. Basically, a futures contract is similar to a forward contract;
it is an agreement to buy or sell a specified quantity of a foreign currency for delivery at a
future point in time at a given exchange rate. More specifically, however, it generally refers
to a futures contract entered into through a financial center market such as the Chicago
Mercantile Exchange (CME). Although they are remarkably similar, the futures contract
differs from the forward contract in several ways. In the futures market, the contractor is
represented by a foreign exchange broker who negotiates a contract for a standard amount of
foreign exchange at the best rate possible. Once signed, the CME stands behind the futures
contract and guarantees that the currency will be delivered and paid for on schedule. In addi-
tion, a margin deposit is required—generally a fixed percentage of the contract value. The
futures contract is, however, resalable up until the time of maturity, whereas the forward
contract is not. A final difference is the fact that a futures contract is available only for four
specific maturity dates (the third Wednesday of March, June, September, and December); in
contrast, forward transactions are private deals for any type of contract the two parties agree
upon (usually one, three, or six months) from any beginning day. Although the futures mar-
ket carries on activity similar to the forward market, it is argued that it is a useful element in
the foreign exchange markets that adds an element of competition. In addition, because the
futures market tends to be more highly centralized and standardized, it caters more to the
smaller customer and the speculator than the forward market. The cost of using the futures
market, however, appears to be higher than the cost of using the forward market.5 For an
example of currency futures quotations and how to interpret them, see Concept Box 1.
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CONCEPT BOX 1
CURRENCY FUTURES QUOTATIONS
Information on market activity on currency futures can be
found in the financial section of major newspapers and online.
The information in Table 3, from The Wall Street Journal
online is typical of such presentations. The table describes
market activity on Friday, September 25, 2015, and the terms
and numbers have precise meanings. “CME” refers to the fact
that these data originated in the Chicago Mercantile Exchange.
To demonstrate the nature of the information found in these
quotations, let’s examine the data relating to the euro that
describes contract activity in euro currency futures. As indi-
cated in the first line, for the euro, futures are traded in fixed
lots of 125,000 euros. Focusing now on December delivery
contracts of euros, the table indicates that the market opened
at a price of $1.1192/€, the highest bid during the day was
$1.1227/€, and the low bid was $1.1130/€. The market closed
or “settled” at a price of $1.1203/€, and there were 316,721
outstanding contracts (open interest) at the end of the day for
December delivery. This “settle” price represented a decrease
of $0.0031/€ from the settle price of the previous business trad-
ing day, and, at the settle price, the contract value of one lot was
$140,037.50 (= 125,000€ × $1.1203/€). The loss of $0.0031/€
on the day means that any party who has bought December
futures on margin from a broker or seller (i.e., the buyer put up
only a fraction—sometimes as low as 5 percent—of the value
of the contract and borrowed the rest from the broker or seller)
will pay a margin payment to the broker or seller reflecting the
amount of the price decrease. In this case, a shift of $387.50 
(= $0.0031/€ × 125,000€) is made. This shift is referred to as
daily settlement or marking to market.*
*See Robert W. Kolb, Understanding Futures Markets, 3rd ed.
(Miami: Kolb Publishing, 1991), pp. 10–13.
TABLE 3 Currency Futures
Open High Low Settle Change
Open
Interest
Japanese Yen (CME)-¥12,500,000; $ per 100¥
Dec 15 0.8330 0.8344 0.8260 0.8299 −0.0045 175,415
Mar 16 0.8346 0.8364 0.8281 0.8319 −0.0044 539
Swiss Franc (CME)-CHF 125,000; $ per CHF
Dec 15 1.0253 1.0292 1.0187 1.0231 −.0039 37,904
Mar 16 1.0310 1.0329 1.0230 1.0271 −.0039 52
Euro (CME)-€125,000; $ per €
Dec 15 1.1192 1.1227 1.1130 1.1203 −.0031 316,721
Mar 16 1.1199 1.1248 1.1154 1.1225 −.0031 1,702
Source: The Wall Street Journal, online at www.wsj.org. ●
Another way to participate in the forward market is by participating in foreign currency
options.6 A foreign currency option is a contract that gives the holder the right to buy or
sell a foreign currency at a specific exchange rate at some future point. Unlike the forward
or futures contract, however, the holder is not obligated to exercise the option if he or she
chooses not to. To participate in this market, one must either buy or sell an option contract.7
The option buyer (holder) acquires the right to exchange foreign currency with the option
6This discussion is based on Brian Gendreau, “New Markets in Foreign Exchange,” Federal Reserve Bank of
Philadelphia, Business Review, July/August 1984, pp. 3–12.
7A “European option” is one that can be exercised only on the expiration date, while an “American option” is a
contract that can be exercised anytime up to the expiration date.
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seller (writer) for a fee or premium. This fee represents the maximum loss the buyer would
experience should the option not be exercised. The completion of the option contract
involves the payment for the actual exchange of the currencies at the contract price.
There are basically two types of option contracts, puts and calls. The call option con-
tract gives the holder the right to acquire foreign exchange for dollars at the contracted
exchange rate, while the put option contract gives the holder the right to acquire dollars
for foreign exchange at the contracted rate. Because options themselves are negotiable,
there are four possible ways of participating in this market. One can buy a call option
(acquiring the right to purchase foreign exchange), sell a call option (transferring the right
to acquire foreign exchange), buy a put option (acquiring the right to purchase dollars), or
sell a put option (transferring the right to purchase dollars). Each of these carries different
risk and uncertainty. However, the most the option buyer can lose is the premium, while
potential gains fluctuate with the spread between the contract exchange rate and the mar-
ket rate. Symmetrically, the most the seller can gain is the premium, while potential loss
will fluctuate with the spread between the contract rate and the market rate at the time the
option is exercised. The buyer is thus paying the seller to undertake the risk associated with
exchange rate movements. The premium is the amount that is necessary for the seller of the
option to assume the risk associated with the change in the exchange rate. Option contracts
have been available since 1982. Foreign currency options provide an additional means of
managing the risk of foreign exchange movements, and they are of particular value to those
who wish to hedge against future transactions that may or may not occur.
THE LINK BETWEEN THE FOREIGN EXCHANGE MARKETS
AND THE FINANCIAL MARKETS
The foreign exchange market consists of the spot market, forward market, and futures/
options markets. Although our discussion treated these markets individually, in practice
the exchange rates in these different markets are determined simultaneously in conjunction
with the interest rates in various countries. To grasp why this is so, it is necessary to first
examine the reasons why commercial banks, individuals, and companies might choose to
buy or sell foreign assets, that is, assets denominated in currencies other than the home
currency. While trade in merchandise and services for many years received the bulk of
the attention in analyzing the foreign exchange market, the recent growth in the volume of
transactions in foreign currency assets is such that these transactions clearly dominate the
market today.
International financial flows include a wide variety of transactions. The various categories
include such items as bank lending of foreign currency, bank lending of domestic currency
to foreigners, foreign bonds, domestic bonds, foreign and domestic equities, direct foreign
investment, financial services such as banking and insurance, and various spot and forward
currency transactions. These various transactions can be further subdivided on the basis of
maturity into long-term or capital assets (a maturity one year or longer) and short-term or
money market assets (maturity of less than one year). Money market assets include short-
term government securities, certificates of deposit (CDs), and short-term corporate debt,
to name just a few. They are traded in highly competitive markets, tend to involve a fixed
rate of interest, and are highly liquid (easily convertible into cash). Capital markets, on the
other hand, include not only long-term CDs and bonds but also stocks, real investment, and
other forms of equity for which a less certain rate of return exists. (See the next chapter for
further discussion of international financial instruments.)
The Basis for
International
Financial Flows
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The decision to invest internationally rests on the expected rate of return on the inter-
national asset compared to domestic alternatives. If the expected rate of return is greater
abroad than at home, one would expect domestic residents to invest abroad. If the expected
rate of return on home assets is higher than that on foreign assets, foreigners would be
expected to invest in the home country. If there are no barriers to investment flows, funds
should move from areas of low return to areas of high return until the expected returns are
similar. However, it is not quite that simple because there is a major difference between
the domestic investment and the foreign alternative. The total return on the foreign asset
to a potential home country investor includes not only the specific return on the asset in
question but also any return associated with appreciation of the foreign currency against
the home currency during the time of the investment (or loss if the foreign currency depre-
ciates against the home currency). Thus, an investment in the United Kingdom made by
a U.S. resident that earned 8 percent per year would actually yield a 10 percent return if
the value of the English pound increased from $1.50 to $1.53 (a 2 percent appreciation of
the pound) over the year between the initial investment date and the time of reconversion
back into dollars. On the other hand, if the value of the pound had fallen to $1.47, the U.S.
investor would have realized only a 6 percent return on the U.K. investment. Depreciation
of the currency in which the investment is denominated can thus offset, or more than offset,
any apparent rate of return advantage of the foreign instrument.
The investor considers three elements when deciding whether to invest in the home
country or in a foreign country: (1) the domestic interest rate or expected rate of return,
(2) the foreign interest rate or expected rate of return, and (3) any expected changes in the
exchange rate. In this situation, equilibrium in the financial markets does not necessarily
lead to equality of interest rates or expected rates of asset yield between the two coun-
tries. To see why, let us examine the situation in which the investor would be indifferent
between investing in the home country or in the foreign country, setting aside for the
moment any consideration of differences in risk between the two investments. (We shall
return to the issue of exchange rate risk and using the forward markets to insure oneself
against it shortly.) Very simply, the investor would be indifferent between a domestic and
a foreign investment whenever he or she expects to earn the same return on both after tak-
ing into account any expected change in the spot rate before the maturity date. Using the
United States and the United Kingdom as an example, this parity condition for a 90-day or
3-month investment of $1 would be stated as follows:
$1(1 + iNY) = [($1)/(e) ] × (1 + iLondon) [E(e) ]
(1 + iNY)/(1 + iLondon) = E(e)/e [1]
where the interest rates are for 90 days, e is the spot rate in $/£, and E(e) is the expected
spot rate in 90 days. Under this condition, a dollar invested in New York for 90 days will
be worth the same amount as a dollar invested in London for 90 days (after converting the
dollar to pounds sterling at the current spot rate and reconverting the principal plus interest
back to dollars on the maturity date), given the interest rate in each of the two locations
and the expectation regarding the 90-day spot rate. Thus, suppose that the annual inter-
est rate in New York is 8 percent (= 90-day interest rate of 2 percent). Investing $1,000
in New York would produce an amount (principal plus interest) of $1,020 in 90 days.
Suppose that the current spot rate is $1.60/£ and that the annual interest rate in London is
12 percent (= 90-day interest rate of 3 percent). Investing $1,000 in London would yield
$1,000/($1.60/£)] or £625 plus (£625)(0.03) or £643.75 in 90 days. An expected 90-day
spot rate of $1.5845 would make the two investments equivalent [($1.5845/£) × £ 643.75 
= $1,020].
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Returning to equation [1], this equilibrium condition is often stated in a more general
manner. The right-hand side of the equation, E(e)/e, is equal to (1 + expected  percentage
appreciation of the foreign currency over the 90-day period). This is because, for exam-
ple, if E(e) = $1.76/£ and e = $1.60/£, then E(e)/e = $1.76/ $1.60 = 1.10, or 1 plus the
expected appreciation of the pound of 10 percent. Designating the expected percentage
appreciation of the foreign currency as xa, E(e)/e is equal to (1 + xa) and equation [1]
now becomes
(1 + iNY)/(1 + iLondon) = (1 + xa), which equals
(1 + iNY)/(1 + iLondon) − 1 = xa which can be written as
(1 + iNY)/(1 + iLondon) − (1 + iLondon)/(1 + iLondon) = xa
(iNY − iLondon)/(1 + iLondon) = xa [2]
This condition states that equilibrium in the international financial markets occurs when-
ever the expected appreciation (depreciation) of the foreign currency is roughly equal to
the difference between the higher (lower) domestic return and the lower (higher) foreign
return. Precise equilibrium condition [2] is usually approximated by
(iNY − iLondon) ≅ xa [3]
because (1 + iLondon) will not differ too much from 1. Because the investor is bearing all the
risk of changes in the exchange rate, this equilibrium condition is referred to as uncovered
interest parity (UIP). Should this condition not hold, for example, (iNY − iLondon) > xa,
investments in the United States are more attractive than those in the United Kingdom
and investment funds would flow into the United States. If (iNY − iLondon) < xa, investment funds would be flowing to the United Kingdom. It is important to note that a change in expectations about the future spot rate will lead to current investment flows, which force a change in the spot rate until the expected appre- ciation (depreciation) rate is again consistent with the difference in the two interest rates. Simply stated, the expected rate and the spot rate should move in tandem as long as the interest rate differential remains the same. Why does this take place? Assume that the financial markets are in equilibrium and that there is a sudden change in expectations regarding the dollar/pound exchange rate; for example, suppose the U.S. interest rate is 3 percent and the U.K. interest rate is 2 percent, and the expected appreciation of the pound then increases from 1 to 2 percent. This means that the expected return on U.K. invest- ments is now higher (4 percent) than the expected return on equivalent U.S. domestic investments (3 percent) and investors would start investing in the United Kingdom. This activity increases the demand for pounds on the spot market, causing the price of pounds to increase (the dollar to depreciate against the pound). Investment in the United Kingdom, with the accompanying upward pressure on the dollar/pound spot exchange rate, continues until the expected rate of appreciation of the pound is again equal to the difference between the interest rates in the two countries. What has happened in the process is that the increase in the expected appreciation of the pound (or expected depreciation of the dollar), the rise in E(e), has led to an appreciation of the pound in the spot market, a rise in e, until xa, which equals [E(e)/e − 1], is again 1 percent. Expectations thus play an important role in exchange rate movements. Of course, people do not have perfect foresight. Consequently, the actual return on the foreign investment in 90 days may not match what was expected when the investment deci- sion was made. For example, foreign returns may be less certain because of unexpected changes in the exchange rate, possible limitations on the transfer of earnings back home, and so forth. The investor who is bearing the risk of changes in the foreign exchange rate Final PDF to printer 490 PART 5 FUNDAMENTALS OF INTERNATIONAL MONETARY ECONOMICS app9062x_ch20_468-497.indd 490 06/23/16 10:41 AM and possible other factors may thus require an additional payment for undertaking the risk linked to these unanticipated developments. This additional financial factor is often called the risk premium (RP) and, expressed as a percentage, leads to a restatement of the previ- ous equilibrium condition: (iNY − iLondon) ≅ xa − RP [4] Thus, if the RP is 2 percent and iNY is 6 percent, then (iLondon + xa) must equal at least 8 percent because of the additional 2 percent RP in order for the New York investor to place funds in London. If payments for undertaking foreign risk are an important factor, then not only changes in the expected exchange rate but also changes in the RP can contribute to sudden investment flows and to changes in the spot rate even when interest rates remain unchanged. Up to now, our analysis has assumed that the risk of changes in the exchange rate is borne by the investor. Any risk associated with changes in the exchange rate can of course be hedged in the forward market if the investor does not want to go uncovered. Then the covered investment position includes the interest earned on the foreign investment plus the cost of the forward market hedge. The link between the spot rate and the forward rate is often discussed in terms of pre- mium and discount. When the exchange rate is stated in terms of domestic currency units per unit of foreign currency, the foreign currency is at premium whenever the forward rate is higher than the spot rate. If the forward rate is less than the spot rate, the foreign currency is at discount. It is common to define the link between the spot and forward rates in the following way: p = [efwd/e] − 1 where efwd = the forward rate of the relevant period and where p, the percentage premium, is positive when the foreign currency is at premium and negative when the foreign cur- rency is at discount. To illustrate, suppose that the actual pound price is $1.608/£ in the 90-day forward market and $1.600/£ in the spot market. The 90-day forward pound is then at a 0.5 percent premium [(1.608/1.600) − 1 = 0.5 percent]. The link between the foreign exchange market and the financial markets can readily be seen by examining two types of transactions that involve the spot rate, the forward rate, and interest rates. As you will recall, a several-month delay between the signing of an import–export contract for goods and services and the exercising of that contract interjects an element of risk into the transaction, because the exchange rate may change in the ensu- ing period of time. If the contract is written in the exporting country’s currency, this risk falls on the importer, who has the choice of going uncovered (and absorbing the risk) or of hedging the risk. The risk may be hedged by buying the foreign currency in the spot market now and investing the proceeds abroad until the delivery date, or by using one of the for- ward markets. Presumably, the importer will choose the least expensive method. This will involve comparing the difference in the cost of the contract at the forward rate versus the current spot rate with the opportunity cost associated with acquiring foreign currency now and investing it abroad at an interest rate different from what the money is earning (costing) at home. Similarly, the forward rate will be considered by a short-term financial investor sending funds abroad to protect against a decline in the value of the foreign currency by the time the investment funds are returned home. If the financial markets are working well, in equilibrium the risk-averse importer should be indifferent between hedging by using the short-term foreign investment and hedging by using the forward market, and the risk-averse short-term investor should be indifferent Covered Interest Parity and Financial Market Equilibrium Final PDF to printer CHAPTER 20 THE FOREIGN EXCHANGE MARKET 491 app9062x_ch20_468-497.indd 491 06/23/16 10:41 AM between the domestic and the foreign investments. The link between the spot market, for- ward markets, and the money markets that generates these equality conditions is achieved through covered interest arbitrage. Consider now an investor determining whether to place funds at home (e.g., New York) or overseas (e.g., London). If the investor chooses to protect against the risk of spot rate fluctuations, that is, to cover, the forward market will be used. In this case the equilibrium condition is $1(1 + iNY) = ($1)(1/e)(1 + iLondon)(efwd) [5] (1 + iNY)/(1 + iLondon) = (efwd)/(e) = p + 1 [(1 + iNY)/(1 + iLondon) ] − 1 = p [(1 + iNY)/(1 + iLondon) ] − [(1 + iLondon)/(1 + iLondon) ] = p (iNY − iLondon)/(1 + iLondon) = p [6] where e is the spot $/£ rate, efwd is the $/£ rate on 90-day forward currency, and p is the actual premium on 90-day forward pounds. This condition can also be approximated, following the procedure with UIP, by the following: iNY − iLondon ≅ p [7] In equilibrium, any difference in the interest rates between the two financial markets should be approximately offset by the foreign exchange premium. For example, if the iNY − 90 = 2.5 percent and the iLondon − 90 = 2 percent, the financial and exchange markets will be in equilibrium if the forward pound is contracted at a price which is 0.5 percent above the spot rate.8 In this case the person who invests in London is receiving 2 percent on the short-term investment plus a 0.5 percent return due to the forward premium. The sum of these two returns is equal to 2.5 percent; that is, the return that would be received on a short-term investment in New York. It is clear that interest rates will not necessarily equalize between countries even if markets are functioning efficiently. In fact, one would not expect them to be equal as long as forward rates are different from spot rates. Given the covered interest arbitrage condition, we can now predict the movement of financial investment between countries taking into account both the interest rates in the two countries and the foreign exchange markets. Whenever the interest rate differential (ihome −  iforeign) is greater than the premium (from the home-country perspective), funds would flow into the home country. Whenever the interest rate differential is less than the forward premium, investment funds would flow out of the home country. In equilibrium, we would expect no net short-term financial movements based on interest rate considerations. The equilibrium condition is presented in Figure 7. The interest rate differential between New York and London is plotted on the vertical axis and the forward premium on the pound on the horizontal axis. With the axes scaled in a similar manner, the points of equi- librium between the interest rate differential and the premium are on the 45-degree line that passes through the origin. This line is referred to as the covered interest parity (CIP) line. The points located above the CIP line indicate conditions of disequilibrium that will produce inflows of foreign financial investments into New York, while those points lying below the line indicate conditions when funds should flow from New York to London. 8It is critical that the interest rate and the premium be calculated over the same period. In this case of a 90-day forward rate, for example, the appropriate rate of interest could be approximated by iannual/4; in the case of a 180-day forward premium, iannual/2; and so forth. Final PDF to printer 492 PART 5 FUNDAMENTALS OF INTERNATIONAL MONETARY ECONOMICS app9062x_ch20_468-497.indd 492 06/23/16 10:41 AM FIGURE 7 The Covered Interest Parity Line .06 .05 .04 .03 .02 .01 .01 .02 .03 .04 .05 .06 .01 .02 .03 .04 .05 .06 .07 .08 .08 .07 .06 .05 .04 .03 .02 .01p(–) p(+) a b iNY– iLondon (–) CIPiNY– iLondon (+) International financial markets are in equilibrium when any interest rate difference (e.g., iNY − iLondon) between two countries is virtually equal to the foreign exchange premium p when financial transactions are costless. The possible equilibrium points are thus found on straight line CIP which passes through the origin and bisects the 90-degree angle (assuming that the scale on both the vertical and horizontal axis is the same). However, because financial transactions are not costless, the interest rate difference and the forward premium can differ in equilibrium by the amount of the transaction cost. Market equilibrium will thus lie in the neighborhood of the CIP line defined by the pair of dashed lines, whose distance from the CIP line reflects some average transaction cost. The discussion to this point has proceeded assuming that there are no transaction costs involved in the interest arbitrage activity. In fact, such financial transactions are not with- out cost. Because these costs are incurred, we would not expect CIP to obtain. The equilib- rium condition in this case needs to incorporate the transaction costs, so the approximate equilibrium condition becomes iNY − iLondon ≅ p ± transaction costs In Figure 7, the CIP line is bounded on either side by two dashed lines. These lines are drawn equidistant on either side of the CIP line at a rate of 0.25 percent, a commonly used rule of thumb for transaction costs. This is, at best, a general guideline, because costs vary considerably from transaction to transaction in response to many factors, including the size of the transaction. It is important to remember that transaction costs are incurred both in the financial transaction and in the acquisition and sale of foreign currency. Thus, it may not be an inconsequential consideration. Final PDF to printer CHAPTER 20 THE FOREIGN EXCHANGE MARKET 493 app9062x_ch20_468-497.indd 493 06/23/16 10:41 AM It is also important to note that additional factors may contribute to the difference between interest rates in two countries. Capital market imperfections, differential costs in gathering information about alternative investments, and noncomparability of specific assets all can contribute to the existence of interest rate differentials between countries beyond that explained by covered interest arbitrage. There is also the possibility that the political risk associated with investment in a foreign country will be a factor. Political risk, as noted earlier, reflects the fact that a foreign government can intervene in the financial markets and/or expropriate or freeze the capital assets of foreigners. The returns to assets can clearly be affected by the imposition of exchange controls and changes in government regulation. Another point to make at this juncture is that a diagram very similar to Figure 7 can be employed to illustrate the concept of UIP (discussed in the previous section). All that needs to be done is to relabel the horizontal axis from the premium on forward exchange, p, to expected appreciation of the foreign currency, {xa or [E(e) − e]/e or [E(e)/e] − 1}. The 45-degree CIP line then becomes a 45-degree UIP (uncovered interest parity) line. Then, if investors are located at a point such as point b in Figure 7, the expected appreciation of the foreign currency exceeds the interest rate differential. That is, xa > iNY − iLondon or
iLondon + xa > iNY. There is an incentive to send funds to London, which necessitates a spot
purchase of pounds. The e increases and [E(e)/e] − 1 falls. In addition, with funds leaving
NewYork, iNY may rise and iLondon may fall with the inflow into London. As you can see
from the (iLondon + xa > iNY) expression, this means that the two sides of the inequality are
converging. With complete UIP, the process would stop at the 45-degree line. In practice,
however, the UIP line will not quite be reached because of transaction costs.9
In view of Figure 7 and its conceptual modification to embrace UIP, a very important
point emerges. If CIP holds, this means that the premium on foreign currency is equal to
the difference in interest rates between the two financial centers. However, if UIP holds,
the expected rate of appreciation of the foreign currency is also equal to the difference in
interest rates between the financial centers. Hence, if CIP and UIP both hold, the result
is that the premium in the forward market equals the expected rate of appreciation of the
foreign currency. This is a situation of an efficient foreign exchange market in that the
forward rate is a measure of the expected exchange rate and that there are no further unex-
ploited opportunities to make a profit. We will return to the concept of market efficiency
in later chapters.
Although we have shown the conditions under which financial flows will take place and the
direction of their movement, little has been said about how the markets involved respond
and whether the flows themselves generate a movement toward equilibrium in the sense
used in this discussion. Let’s return to covered interest arbitrage and analyze the adjust-
ment process in our continuing U.S.–U.K. example, and examine four markets: (1) the
London money market, (2) the NewYork money market, (3) the dollar/pound spot market,
and (4) the dollar/pound forward market for time t. These four markets are presented in
Figure 8. We begin by assuming that the interest rate differential is greater than the forward
premium and that short-term investment thus has an incentive to flow to New York from
London. As English investors withdraw funds from the London money market to invest in
NewYork, the supply of loanable funds in London declines [shifts to the left in panel (a)],
Simultaneous
Adjustment of the
Foreign Exchange
Markets and the
Financial Markets
9Note that xa would also differ from the forward premium if there is a risk premium associated with uncovered
arbitrage. With the risk premium (and no transactions costs). iNY −  iLondon ≅ xa − RP = p in equilibrium and
therefore xa ≅ p + RP.
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exerting upward pressure on iLondon. These funds are then brought to the foreign exchange
spot market to be exchanged for U.S. dollars, which shows up as a rightward shift in the
supply curve of pounds sterling [panel (c)]. This influx of pounds has the effect of put-
ting downward pressure on the dollar/pound spot exchange rate (appreciating the dollar).
Because these investors are risk averse and wish to hedge against changes in the foreign
exchange rate, they will at the same time purchase pounds sterling forward. This increases
the demand for pounds (shifts the demand for pounds to the right) in the forward market
[panel (d)] and puts upward pressure on the forward rate. Finally, as British investors make
their desired investments in New York, there will be an increase in the supply of funds
in the New York money market [a rightward shift of the supply curve in panel (b)] and a
FIGURE 8 International Financial and Exchange Rate Adjustments
(a) London money market
iLondon
iL
i L
S£s
S £s
D£s
(b) New York money market
iNew York
iNY
i NY
S $
S$
D$
£s $
(c) Spot market
e0
e
S £s
S£s
D£s
(d) Forward market
efwde$/£
efwd
e fwd
S£s
t
t
D£s
t
D£s
£s£s
$/£
0 0
0 0
Assuming that iNY − iLondon > p ± transaction costs, funds should move from London to New York. When this happens, the supply of loanable
funds declines from S£s to S′£s, putting upward pressure on the London interest rate [panel (a)]. The conversion of pounds into dollars in the
spot market [panel (c)] increases the supply of pounds, putting downward pressure on the spot rate (appreciating the dollar). Investors covering
themselves against changes in the exchange rate then purchase pounds forward, increasing the demand in this market, putting upward pressure on
the forward rate [panel (d)]. Finally, when the funds are invested in New York, the supply of loanable funds increases there [panel (b)], placing
downward pressure on iNY. All of these price movements—the increase in iLondon, the decrease in the spot rate, the increase in the forward rate,
and the decline in iNY—work to reduce the initial inequality. Market equilibrium attains in London and New York when the interest differential
comes into line with the forward premium and transaction costs.
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downward pressure on iNY. Returning to our equilibrium condition, we note the nature of
these adjustment pressures with arrows:
(iNY ↓ − iLondon↑ )↓ and (efwd ↑ /e ↓ )↑ − 1 → p↑
Note that the movement of interest rates unambiguously makes the interest rate dif-
ferential smaller. At the same time, the movement in the exchange rates unambiguously
makes the forward premium larger.10 Investment will continue to flow from London
to New York until these movements of interest rates and exchange rates bring about a
new equilibrium.
The nature of this adjustment process is shown back in Figure 7 by the arrows at point
a and at point b. The adjustments from disequilibrium can take place through the foreign
exchange markets (horizontal adjustments), the money markets (vertical adjustments), or
some combination of the two. If interest rates are the adjustment mechanism, then move-
ments in equilibrium interest rates should be highly correlated between the countries with
major financial markets; in other words, increases (decreases) in interest rates in one
country will be associated with increases (decreases) in interest rates in other countries.
If exchange rates are doing the adjusting, then we would expect little or no correlation
between interest rate changes in the leading industrial countries. In general, recent research
as well as an earlier study by Kasman and Pigott (1988) suggests that much of the equi-
librium adjustment takes place through the foreign exchange markets rather than through
changes in interest rates.
The sensitivity of financial traders to the current conditions in both the foreign exchange
markets and the money markets is exhibited prominently in what is known as the carry
trade. This type of foreign exchange activity is focused on the borrowing of funds by
individuals of the currency of a low-interest-rate country for the purpose of investing the
funds in a high-interest-rate country. For example, the investor may borrow in the United
States and invest in Australia. The fact that this activity has been profitable in recent years
indicates that markets do indeed take time to reach equilibrium. If the money and for-
eign exchange markets operated as in the previous discussion in instantaneous fashion,
these carry trade opportunities would not persist. If exchange rates and/or interest rates do
not change sufficiently to eliminate these arbitrage opportunities, then uncovered interest
parity (UIP) and covered interest parity (CIP) may not hold, and there may a considerable
volume of capital flows between countries, which can lead to instability.11
Before leaving this discussion, it is important to point out several additional factors
that make it difficult to observe the adjustment process and that can cause the simple equi-
librium condition not to be met. The existence of varying transaction costs mentioned
earlier is one of these factors. A second factor that obfuscates the issue is the difficulty in
choosing a representative interest rate in the two countries that is sufficiently comparable.
Contributing to this problem is the fact that the variance of the distribution of returns on
alternative investments within the countries may be different due to such things as different
liquidities, different credit risks, and different tax treatments across what outwardly appear
to be similar types of investments. Finally, the operation of the equilibrating process in the
money and foreign exchange markets may be hampered by government policies and other
10Note also that, with an efficient foreign exchange market, a larger forward premium would also be matched by
a larger xa or expected appreciation of the pound in the situation of uncovered interest arbitrage.
11For interesting discussions of the carry trade, see Joanna Slater, “Dollar Weakness May Hit Players in Carry
Trade,” The Wall Street Journal, December 13, 2006, pp. C1, C5; Matt Phillips, “Assessing Carry-Trade
Candidates,” The Wall Street Journal, September 18, 2009, p. C2; “Economics Focus: Crash and Carry,” The
Economist, December 12, 2009, p. 86.
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institutional imperfections that slow or even impede altogether the adjustment process. The
slowdown in the adjustment processes could explain the continued profitability in the carry
trade discussed above. If governments attempt to hold interest rates constant by monetary
policy, then the short-run international financial market adjustment will necessarily fall
even more heavily on the foreign exchange markets.
CONCEPT CHECK 1. What is the difference between the forward
market, the futures market, and the options
market?
2. Does it ever make sense to make a financial
investment abroad at a lower interest rate
than at home? If so, when? Why?
3. What is the covered interest parity line?
4. What is an uncovered interest parity line?
SUMMARY
This chapter focused on foreign exchange rates and the opera-
tion of the foreign exchange market. Attention was directed to
the principal components of this market and how they influ-
ence the foreign exchange rate. The links between the spot
market, the forward market, and interest rates were developed,
and the market equilibrium condition between the money mar-
kets and the foreign exchange markets was established under
uncovered and covered scenarios. Testing for the presence of
uncovered parity is difficult in practice because of the problem
of ascertaining expectations on exchange rates. Although the
covered interest condition tends to hold empirically to some
extent, it can be affected by such things as government policies
in the participating countries, transaction costs, and the differ-
ing distribution of asset returns between countries. Some evi-
dence seems to suggest that international financial adjustment
takes place principally in the foreign exchange markets and not
in the domestic money markets, adding further to exchange rate
volatility under flexible exchange rates.
KEY TERMS
absolute purchasing power parity
arbitrage
at discount
at premium
carry trade
covered interest arbitrage
covered interest parity (CIP)
cross-rate equality
efficient foreign exchange market
expected percentage appreciation
of the foreign currency
expected spot rate
foreign currency option
foreign exchange market
foreign exchange rate
forward exchange rate
futures contract
hedging
home-currency appreciation (or
foreign-currency depreciation)
home-currency depreciation (or
foreign-currency appreciation)
interbank market
law of one price
long position
nominal effective exchange rate
(NEER)
purchasing power parity (PPP)
real effective exchange rate
(REER)
real exchange rate (RER)
relative purchasing power parity
retail spread (or retail trading
margin)
risk premium
short position
speculation
spot market
triangular arbitrage
uncovered interest parity (UIP)
uncovered (or open) position
value date
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QUESTIONS AND PROBLEMS
1. The United States presently has a current account deficit with
Japan. What would happen to the dollar/yen spot exchange
rate and the current account deficit if there were a decrease
in Japanese investment in the United States? Incorporate the
foreign exchange market into your answer.
2. Suppose that you observe the following exchange rates:
$2/£; $0.0075/¥; and £0.005/¥. Is there cross-rate equality?
If yes, why? If not, what would you expect to happen?
3. A dollar appreciation against the Swiss franc is no guaran-
tee that the dollar will “go further” than it previously did in
acquiring Swiss goods. Do you agree? Explain.
4. Explain the difference between the real exchange rate and
the PPP exchange rate. What is the purpose of each?
5. Suppose the peso price of a dollar was 10.78 pesos/$ in
2005 and 14.72 pesos/$ in 2014. With 2005 = 100, if the
price index for Mexico was 144.4 in 2014 and that for the
United States was 121.2 in 2014, was the dollar overvalued
or undervalued in 2014 according to PPP? Explain.
6. Suppose that iNY = 2 percent, iLondon = 6 percent, xa (expected
appreciation of the pound) = minus 1 percent (i.e., the pound
is expected to depreciate by 1 percent), and RP (risk pre-
mium for investing in London) is 2 percent. Assuming these
numbers all apply to the same time period, explain why this
is a disequilibrium situation and how uncovered interest par-
ity is attained.
7. You observe that the U.K. annual interest rate is 2.5 percent,
the U.S. annual interest rate is 3.8 percent, the 3-month
forward rate is $1.8180/£, and the spot rate is $1.8034/£.
Assuming that transaction costs are 0.2 percent, are the
financial markets in equilibrium?
8. Using the information in Question 7, assume that the inter-
est rate in the United Kingdom increases to 3.5 percent.
What financial adjustments would you expect to see?
9. On May 22, 2012, The Wall Street Journal reported the fol-
lowing (for May 21):
Prime interest rates: United States 3.25 percent;
Switzerland 0.52 percent;
Japan 1.475 percent
Spot rates: $1.0670 = 1 Swiss franc;
79.31 Japanese yen = $1
3-month forward rates: $1.0685 = 1 Swiss franc;
79.24 Japanese yen = $1
(a) In terms of the dollar, was the Swiss franc at a forward
discount or a forward premium? By what percent?
Looking at the prime rates of the United States and
Switzerland, is your calculated percentage discount/
premium reasonably consistent with covered interest
parity? Why or why not?
(b) In terms of the Japanese yen, was the U.S. dollar at
a forward discount or a forward premium? By what
percent? Looking at the prime rates of Japan and the
United States, is your calculated percentage discount/
premium reasonably consistent with covered interest
parity? Why or why not?
10. If you observe that the Swedish krona in terms of the dol-
lar is at a 1.2 percent 3-month forward premium, under
what conditions could you therefore say that the krona
is expected to rise by 1.2 percent relative to the dollar in
3 months? Explain.
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CHAPTER
21 INTERNATIONAL FINANCIAL MARKETS AND INSTRUMENTS:
AN INTRODUCTION
LEARNING OBJECTIVES
LO1 Summarize the fundamental components of international bank lending.
LO2 Examine the size and structure of international bond and stock markets.
LO3 Describe the linkages, types, and roles of various international currency
and monetary instruments.
LO4 Summarize the size and composition of the global derivatives market.
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INTRODUCTION
In spite of the many different issues and disagreements surrounding globalization, the phenom-
enon is currently perceived as present in nearly all aspects of economic life and is often taken for
granted. Further, it is generally viewed as a relatively recent phenomenon, particularly in the area
of capital flows and international finance. In a useful article, Alan M. Taylor provided a historical
look at the globalization of finance and pointed out some interesting facts.1 Capital flows indeed
surged in volume in the past few decades in both the developing and developed world, often
creating difficult challenges for policymakers. Surprisingly, a similar phenomenon took place
in an earlier period of globalization between 1870 and 1914. The striking parallels between the
two periods, roughly 100 years apart, have raised some interesting questions, particularly in light
of the collapse of the earlier globalization phenomenon starting in 1914 and continuing through
the 1940s and 1950s. While two world wars and a world depression certainly contributed to the
striking changes in global finance, it seems prudent to step back and examine the current global
capital phenomenon in terms of our earlier experiences. In fact, might the world financial crisis of
2007–2009 be a precursor of a possible collapse of the current system?
While the global capital market did begin to grow in the 1960s, it did not reach the previous
high levels of the 1870–1914 period until well into the 1980s. While the two growth periods were
quite similar in terms of the changes in communications and transportation that accompanied the
growth spurts, they did differ in terms of the type of foreign exchange regime in place and the chal-
lenges facing policymakers. The earlier period operated under a gold standard, while the current
system contains of a variety of systems anchored by flexible exchange rate arrangements between
the major world currencies. Taylor, did, however, point out an additional interesting difference
between the two periods. In the earlier period, the volume of capital flows to developing regions
was roughly equal to those flowing to the more wealthy countries. Today, relatively little capital is
flowing to the developing countries, and the bulk of the capital flows are between wealthy coun-
tries and are intended to reduce risk through asset diversification and the fine-tuning of portfolios.
In today’s rapidly globalizing world, where the value of foreign exchange transactions
involving international assets far exceeds the value of foreign exchange transactions involv-
ing goods and services, it is important to examine more closely the nature of these modern
transactions. The actors in the international financial system have developed a huge and
bewildering variety of different types of traded assets, with each asset designed to satisfy
particular liquidity, risk, and return demands of financial investors and asset holders. In this
chapter we survey different general types of assets that are exchanged internationally, and
we provide information on their size, characteristics, and markets. We begin by looking at
international bank lending and then examine international bonds and stocks (equities). We
then consider in some detail a number of specific financial instruments that belong to the
broad category “financial derivatives.” Our purpose here is to familiarize you in a general
way with the range of financial instruments available for transferring wealth across country
borders and to indicate the many possibilities that exist internationally for satisfying financial
investors’ particular preferences.
INTERNATIONAL BANK LENDING
In its coverage of money and banking, your introductory economics course made the
implicit assumption when examining banks’ balance sheets that loans and deposits of
the banks were entirely domestic in nature. In other words, deposits (which are assets of the
Financial
Globalization: A
Recent Phenomenon?
1Alan M. Taylor, “Global Finance: Past and Present,” Finance and Development (March 2004), pp. 28–31.
The article was based on the book, Global Capital Markets: Integration, Crisis, and Growth (Cambridge, MA:
Cambridge University Press, 2004), which Taylor coauthored with Maurice Obstfeld.
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depositors and liabilities of the banks) placed into banks (and other depository institu-
tions) were presumed to come from domestic citizens. These deposits provided checking
accounts with which the depositors could carry out economic transactions, and savings and
time deposit accounts from which the depositors could earn interest and thus provide for
future consumption. The deposits provided funds from which the banks could, after satisfy-
ing bank legal reserve requirements, make domestic loans (which are assets of the banks
and liabilities of the borrowers). However, this simple, straightforward textbook treatment
has become less and less realistic over the past several decades, as depositors now seek
international outlets for their savings and banks increasingly seek international borrowers
for their funds. In addition, the domestic banks themselves now often have many branches
located in foreign countries.
Table 1 shows why the exclusive domestic focus is no longer appropriate. The table
presents data on international bank lending. Such lending or financing, which constitutes
a loan across country borders, can occur for many reasons. For example, domestic banks
may lend funds to private firms abroad that wish to undertake real investment projects and
that find the domestic banks’ lending terms to be more favorable than bank lending terms
in the firms’ own countries. Or domestic banks may purchase foreign financial instruments
(such as certificates of deposit (CDs) offered by foreign banks) with excess reserves in
order to earn a higher return than is available domestically on comparable instruments. Or
foreign banks may borrow funds from domestic banks to obtain domestic currency work-
ing balances to meet various needs of their (the foreign banks’) customers.
The table gives a summary view of the cumulative stock of claims that has resulted from
international bank lending as of December 2014. The first row gives the estimate by the
Bank for International Settlements (BIS)2 of total cross-border claims, labeled “external
assets.” This figure refers to the claims of banks in a broad set of 44 countries, including all
major countries. These claims are loans made by banks to borrowers in other countries, and
they are obviously part of international lending. Row (2), “local assets in foreign currency,”
indicates loans by banks to domestic borrowers, that is, local claims by domestic banks, but
these loans have been made in foreign currency. Because the foreign currency was clearly
obtained from foreign sources at some time in the past, it also reflects an international loan.
The sum of these two items, row (3), represents the stock of gross international bank
lending—$32,597.1 billion, or $32.6 trillion, in December 2014 (when valued in dollars
using exchange rate conversions for the nondollar currency components).
TABLE 1 Gross and Net International Bank Lending, December 2014
(billions of dollars)
(1) External assets $28,495.2
(2) Local assets in foreign currency 4,101.9
(3) Gross international bank lending 32,597.1
(4) Minus: Interbank deposits 17,444.9
Local liabilities to banks in foreign currency 2,026.0
(5) Net international bank lending 13,126.2
Source: Bank for International Settlements, BIS Quarterly Review, June 2015, p. A7, available at
www.bis.org.
2The BIS is an institution located in Geneva, Switzerland, that sponsors conferences of central bankers on inter-
national monetary cooperation, acts as a clearinghouse for central bank settlements, and deals with various other
international banking matters.
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However, an adjustment to this gross lending figure is necessary if we wish to deter-
mine the net stock of lending that has occurred over time. Simply put, if a U.S. bank lends
$3 million to (i.e., deposits $3 million in) a German bank and a German bank lends the
equivalent of $2 million to (i.e., deposits the equivalent of $2 million in) a U.S. bank, the
net international flow of funds is only a $1 million outflow from the United States (whereas
the gross flow is $5 million). Row (4) makes this type of adjustment by subtracting such
interbank deposits. As is evident, this is a large figure—$17,444.9 billion. These interbank
deposits occur, for example, because domestic (foreign) banks may maintain deposits in
foreign (domestic) banks for the purposes of facilitating transactions with economic actors
in the foreign (domestic) country, of earning favorable rates of return on particular CDs in
the foreign (domestic) country, or of general portfolio diversification. In the case of portfo-
lio diversification, risk is reduced by holding a wide variety of assets (by not “keeping all
your eggs in one basket”), including foreign assets. Besides subtracting these cross-border
deposits, it is also necessary to subtract banks’ local liabilities to other banks when these
liabilities are denominated in foreign currency. Putting this additional subtraction together
with the subtraction of the cross-border interbank deposits gives the net international
bank lending figure [row (5)] for December 2014 of $13,126.2 billion.
It is useful to examine gross international bank lending in more detail. This lending
essentially consists of three components:
1. Domestic bank loans in domestic currency to nonresidents. This component would
be exemplified by a bank in France lending euros to a U.S. firm for the firm’s pur-
chase of French exports.
2. Domestic bank loans in foreign currency to nonresidents. An example of this type
of activity would be the lending of dollars by a bank in France to a U.S. firm so that
the firm could undertake the purchase of oil supplies from a Saudi Arabian exporter
who wishes to be paid in dollars (oil prices are in fact quoted in dollars).
3. Domestic bank loans in foreign currency to domestic residents. This situation would
be represented by a bank in France lending dollars to a French citizen for the pur-
chase of a U.S. Treasury bond.
In the literature, component 1 above (loans in domestic currency to nonresidents) is
generally referred to as traditional foreign bank lending.3 This type of activity has a
long history: banks are providing domestic currency to foreign citizens and firms for the
financing of international trade. However, components 2 and 3 of the gross lending (loans
in foreign currency to nonresidents and loans in foreign currency to domestic residents)
became of large size beginning only in the 1960s. These two situations reflect the use of a
currency outside the country that issues the currency, and they have been dubbed as rep-
resenting activity in the eurocurrency market. Indeed, a eurocurrency deposit is defined
as a deposit in a financial institution that is denominated in a currency other than the cur-
rency of the country in which the financial institution is located. Originally, this market was
called the eurodollar market because the major deposits involved were dollar deposits
located outside the United States, chiefly in Europe. With the rise in importance of other
currencies in this market, “eurodollar” is often broadened to “eurocurrency” to include
these other currencies. Of course, even the term eurocurrency is inadequate because such
deposits are now also located in financial centers outside Europe (particularly Singapore
and Hong Kong).
3See Johnston (1982, pp. 1–2). However, Johnston refers to international bank lending as comprising only com-
ponents 1 and 3 rather than components 1, 2, and 3.
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We now look in more detail at the origin and the implications of the eurodollar and euro-
currency markets. We focus in particular on eurodollars, because dollars constitute a larger
fraction of eurocurrency deposits than any other currency does and because the emergence
of eurodollars was the catalyst for the later use of other currencies in these markets.
There are a number of ways in which a eurodollar or eurocurrency deposit can arise.
A typical case4 would be a situation where a U.S. exporter sells goods to a British buyer
and receives dollar payment. (Assume that the foreign exchange market transaction to get
the dollars has been carried out by the British importer.) However, the U.S. exporter may
wish to leave the dollars abroad in a London bank (London is in fact the largest center for
eurodollars in Europe) so that the dollars will be conveniently available for use, say, for
foreign input purchases from British (or other European) firms. The London bank will keep
this deposit as a dollar deposit, and it will be matched by a claim by the London bank on
the U.S. bank in which the U.S. exporter has an account (and with which bank the London
bank has a “correspondent” relationship). Like any bank deposit, this London deposit
can now be loaned out by the British bank to customers who require dollars. Indeed, the
amount of eurodollar deposits can grow in multiple fashion because the British bank can
initiate the multiple-deposit expansion process associated with fractional reserve banking.
Thus, if the original deposit by the U.S. exporter is $1 million and the bank wants to
lend 90 percent of it, the loan of this $900,000 (say, to a London importing company for
the purchase of goods from a French firm that wishes to have dollars) could be redepos-
ited in Europe and would form the basis for another $810,000 loan (if 90 percent of the
$900,000 is again lent out). This series of loans (if 90 percent is always “re-lent”) can lead
to a cumulative multiple bank deposit expansion of $10 million in eurodollar deposits
($10 million = 1/0.10 ×  the initial deposit of $1 million).5 In this eurodollar expansion
process, the loans involved are usually loans of six months or less, and the banks mak-
ing the loans are referred to as eurobanks, even though the banks may be located outside
Europe (such as in Singapore). In addition, the interest rate on the loans normally consists
of a markup, the size of which depends on risk and market conditions, above the London
Interbank Offered Rate (LIBOR), the rate at which Eurobanks lend among themselves.6
Historically, the eurodollar market began to be of significance in the 1950s. (See
Kaufman, 1992, pp. 317–18, and Gibson, 1989, pp. 10–15.) At that time, due to Cold
War considerations, the Soviet Union shifted dollar deposits out of the United States and
placed them in London banks. In addition, dollar deposits in London were enhanced when
Great Britain, worried about its balance-of-payments deficits and hence about its ability to
maintain the value of the pound under the pegged exchange rates of the period, imposed
some controls on the use of the pound for import and capital-outflow transactions. The
consequence of this British government action was that British banks, desiring to con-
tinue financing these transactions, increasingly conducted them in dollars. Further, dollars
were becoming considerably more abundant in Britain and Europe because of the large (for
the time) official reserve transactions (ORT) deficits in the U.S. balance of payments. Another
factor at work, especially in the late 1960s, was the existence of legal ceilings (Regulation Q
of the Federal Reserve) on the interest rates that could be paid by U.S. banks on their time and
4For further discussion, see Kaufman (1992, pp. 311–25).
5However, it should be noted that, in the multiple expansion process, if a deposit of eurodollars is at any point
borrowed by a U.S. bank, the process will stop because the deposit is no longer a eurodollar deposit (because the
funds will be located in the United States). See Kvasnicka (1986, pp. 175–76).
6More precisely, LIBOR is the British Bankers’ Association average of rates offered for interbank dollar deposits
in London. The 3-month LIBOR is listed every day in The Wall Street Journal and other financial publications.
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savings deposits. With higher interest rates available in Europe, U.S. depositors chose to
place their dollars there, and the eurobanks were quite willing to receive them. An impor-
tant reason for the ability of the eurobanks to offer higher rates was that eurodollars were
not subject to any legal reserve requirements, unlike the situation with bank deposits in the
United States. Thus, because eurobanks could lend a larger fraction of any given deposit
than could U.S. banks, the eurobanks could earn higher returns from their deposits and
could offer higher rates of interest to depositors in order to attract funds.
Two other factors that led to a rise in the eurodollar (eurocurrency) markets should
be mentioned—one on the demand side and one on the supply side. On the demand side,
there was a general monetary tightening in the United States toward the end of the 1960s
because of inflationary pressures associated with the conduct of the Vietnam War. Due to
this tightening, borrowers seeking dollars found them to be more expensive in NewYork
and other American financial centers. This increasing difficulty in obtaining dollars from
U.S. financial institutions particularly burdened foreign borrowers because two additional,
restrictive policy steps had already been undertaken in the United States in the mid-1960s
to reduce the worsening U.S. balance-of-payments problem by limiting capital outflows.
These steps were the introduction by the Federal Reserve of voluntary foreign lending
“guidelines” for banks (giving specific recommended percentage reductions for loans to
particular geographic areas) and the imposition of the (nonvoluntary!) Interest Equalization
Tax on loans taken out by foreigners from U.S. institutions and markets. This tax discour-
aged foreign borrowing because it amounted to an extra charge above the regular interest
charge on the loans. Thus, due to these measures and the general monetary tightening,
dollar loans from the United States were more difficult to obtain and pressure emerged
for the buildup of dollar accounts abroad; rather than convert existing dollars abroad into
their own currencies, foreign holders found it profitable to keep the deposits in dollar form
overseas. In addition, some of the increased demand for eurodollars came from U.S. banks
themselves. Because money was tight in the United States, U.S. banks sought to get dollar
funds from their overseas branches and from foreign banks. This demand for eurodollars
was facilitated by the fact that lending rates in Europe tended to be lower than those in
the United States, even as deposit rates in Europe were higher. This rate structure existed
because eurobanks were able to operate with lower margins between lending and deposit
rates, in part because of the lack of reserve requirements on eurodollars, than were U.S.
banks. Other factors that we examine later in this chapter were also involved.
On the supply side, new dollar deposits abroad grew for several reasons. A very impor-
tant factor in their growth was the first “oil shock,” in 1973–1974, when the Organization
of Petroleum Exporting Countries (OPEC), after maintaining a partial export embargo,
startled the world with a virtual quadrupling of oil prices. With oil prices being quoted
and oil transactions being conducted in dollars, there was a vast inflow of dollars (known
as “petrodollars”) to the OPEC countries, and many of these dollars were deposited in banks
in London and in other European cities. Indeed, despite the dramatic fall in oil prices dur-
ing the 1980s, petrodollar deposits have continued at high levels ever since. For example,
Herbert Kaufman (1992, p. 318) notes that, after the Iraqi invasion of Kuwait in 1990, the
overthrown Kuwaiti government was still able to make a contribution to the financing of
Operation Desert Storm because the Kuwaiti ruling family had perhaps $10 billion invested
outside Kuwait, with a sizable amount in eurobanks. In addition, the outflow of dollars from
the United States associated with the large U.S. official reserve transactions (ORT) deficits
over several decades continually supplied dollars to the rest of the world.
With this background on the nature of the eurodollar and eurocurrency markets, we
now briefly consider the significance of these markets. The major consequence of the rise
of these markets is that the mobility of financial capital across country borders has been
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greatly increased. This means that interest rates (and general credit conditions) are increas-
ingly linked across countries although, due to such factors as differing risk, transaction
costs and other factors to be discussed later, interest rates are not equalized. Nevertheless,
because the majority of deposits in the euromarkets are interbank deposits—deposits of
one bank in another bank—and because banks are very sensitive to interest rate move-
ments, the link is indeed strong despite the fact that interest rate equality is not achieved.
To elaborate, consider a hypothetical large U.S. bank. This bank is interested in attract-
ing deposits and in earning interest from its subsequent loan of those deposits, and it is
cognizant of conditions in both domestic and foreign money markets.7 It compares the cost
of obtaining an additional domestic deposit with the return from placing that deposit in the
eurodollar market (either with a different bank or with an overseas branch of its own bank).
The cost of acquiring the new deposit involves the interest rate to be paid to the depositor
as well as the foregone opportunity cost incurred by holding any required reserves against
the deposit.8 However, in recent decades in the United States, the reserve requirement on
nonpersonal (corporate) time deposits has been eliminated, so the cost on these deposits is
basically only the interest cost. If this interest cost is less than the return in the eurodollar
market and if the return in that market is greater than the return on comparable domestic
assets, then placing the funds in the eurodollar market could be profitable. The outflow
of funds from the United States would thereby perform an arbitrage function because the
withdrawal of the funds from the U.S. money market would put upward pressure on U.S.
interest rates and the inflow of funds to the eurodollar market would put downward pres-
sure on eurodollar interest rates. The reverse pressures are set in operation when eurodollar
rates are less than domestic rates, for then the U.S. bank would borrow funds from the
euromarkets and lend them in the United States.
Thus the eurodollar and eurocurrency markets have been a force for moving interest
rates across countries toward each other, and these markets have hence played a major
role in enhancing financial integration across international borders. In addition, precisely
because the markets have been a force for international integration, the consequence is
that any country’s monetary policy with respect to interest rates is less independent than
would otherwise be the case. An attempt to raise interest rates in one country will lead to
an inflow of funds, which will dampen the rise in the initial tight-money country and put
upward pressure on interest rates in the other countries. Hence, it is no longer possible (at
least in developed countries) to conduct a completely independent monetary policy. This
increasing integration of financial markets could have been accomplished without the rise
of the euromarkets per se, because the general relaxation of barriers to capital flows in
recent decades would most likely have accomplished much the same result. Nevertheless,
the rise of the eurodollar and eurocurrency markets hastened the process.
Finally, it is important to note that many observers worried that the surge in interna-
tional bank lending in general contributed to economic instability. This fear was borne out
by the spread of financial distress worldwide in 2007 and 2008. Because a central bank of a
country does not have jurisdiction over deposits abroad, there is no effective control of the
amount of money in existence that is denominated in the country’s currency. For example,
eurodollars can be borrowed by U.S. banks for use in the United States, with the result
that an attempt by the Federal Reserve to implement restrictive monetary policy can be
7See Kreicher (1982, pp. 11–13).
8Additional costs in the United States are (1) any premium that needs to be paid for the deposit insurance associ-
ated with the deposit and (2) any applicable state and local taxes. On the other hand, the Federal Reserve now
pays banks a relatively low interest rate on required reserves held by the banks. We neglect these items in our
discussion for the moment.
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made more difficult. Or a foreign subsidiary of a U.S. multinational firm can borrow dol-
lars from German or U.K. banks and use these dollars to increase spending on U.S. goods
at the same time that the Federal Reserve is trying to reduce U.S. bank loans as part of an
anti-inflationary stance. Further, deposits denominated in dollars, say, in France, are also
not under effective control of the French central bank. The uncontrolled growth associated
with those deposits could potentially lead to undesirable consequences for France, too, if
France wished to adopt an anti-inflationary policy.
CONCEPT CHECK 1. What is a eurodollar deposit? Is the dollar
deposit of a French company in a NewYork
bank a eurodollar deposit? Why or why not?
2. What is the distinction between gross inter-
national bank lending and net international
bank lending?
THE INTERNATIONAL FINANCIAL MARKETS
Besides international bank lending, increasingly sizable activity has been taking place in
the last several decades in the international bond market. The issuance of bonds by
governments and corporations represents borrowing by the issuing entities, and the time
period of the loan is generally longer than one year. Within the general bond category, a
distinction is often made between notes, which have a maturity of less than 10 years, and
bonds, which have a maturity of 10 years or longer. We will generally use the term bonds
to refer to both of these types of debt instruments.
Bonds have a face value or maturity value (e.g., $1,000) which indicates the amount
that will be paid back to the lender at the end of the life of the bond, and interest pay-
ments (or coupon payments) are usually made each year [e.g., $60 per year or a 6 percent
(=$60/$1,000) coupon rate].9 In addition, the issuance of bonds often involves bond
underwriters, which are banks and other financial institutions that conduct the sale of the
bonds (for a fee) for the issuing entity. These underwriters purchase the bonds from the firms
or governments, and the underwriters thus assume the risk that the bonds might not be sold.
Further, in international bond markets, banks often join together to form a loan syndicate for
marketing the bonds.
In considering the international bond market, a distinction is made between two situa-
tions (see Mendelson, 1983, p. 5.1.3, and Magraw, 1983, pp. 5.3.3–5.3.4):
1. The borrower in one country issues bonds in the market of another country (the host
country) through a syndicate in the host country. The sale is mainly to residents of
the host country, and the bonds are denominated in the currency of the host country.
These transactions are said to be taking place in the foreign bond markets.
9The market price of a bond does not have to equal the maturity value. In a simple, extreme example, suppose
that an issuer of a bond is trying to sell the $1,000 face-value bond with the annual coupon payment of $60. If
interest rates on competing assets are 10 percent, this issuer will not be able to sell the bond for $1,000 because
the interest return to the buyer is only 6 percent. To induce a buyer to purchase the bond, the price would have
to be lowered to $600. This is so because only at a $600 price will the actual interest rate or yield (=$60 coupon
payment/$600 price) on this bond be equal to 10 percent, the yield that is obtainable on other assets in the market.
Similarly, if market interest rates are 4 percent, the $1,000 face-value bond with a $60 coupon payment could be
sold for $1,500 because then its yield would also be 4 percent (=$60/$1,500). The issuer would not be willing to
sell it for any amount less than $1,500 as that would mean that the issuer would be paying a higher interest rate
than is necessary for obtaining funds. Thus, an important feature of bond markets is that interest rates and bond
prices move inversely with each other. In practice, the swings in bond prices when market interest rates change
are not as wide as in this example for reasons that we need not go into, but the inverse relationship remains intact.
International Bond
Market (Debt
Securities)
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2. The borrower in one country issues bonds in the markets of many countries, with the
help of a multinational loan syndicate, to residents of many countries. The bonds can
be denominated in any of several different currencies (including the currency of the
country of the issuer but also other currencies that are not necessarily of the countries
in which the bonds are sold). These transactions are said to be taking place in the
eurobond markets.
The two types of markets—the foreign bond markets and the eurobond markets—
together constitute the aggregate international bond market. In actual practice, the distinc-
tion between foreign bonds and eurobonds is somewhat blurred (e.g., because one bank
may underwrite an offering by itself and use neither a domestic syndicate nor a multina-
tional syndicate). In either the foreign bond or the eurobond markets, the issued securities
themselves can pay a fixed interest rate or a variable (floating) interest rate (usually tied to
LIBOR). In addition, some bonds are sold at a substantial discount below face value and
issued as “zero-coupon” bonds. In this instance, there are no regular interest payments, and
the total interest is received when the bond matures at its face value.
Table 2 presents data on the size of the stock of international bonds (foreign bonds and
eurobonds) and notes in existence at the end of 2014. In addition, some very short-term
debt securities, called money market instruments, are listed. As can be seen from Part A of
the table, the broad stock of international debt securities stood at $20.9 trillion at the end
of 2014. The geographical locations of the issuers of the securities are listed in Part B—
about 75 percent are issued by borrowers located in developed countries. Bonds are also
issued in offshore centers, such as the Cayman Islands, the Bahamas, and Netherlands
Antilles. These centers are intermediary or “pass-through” locations for international
funds:10 because of tax or regulatory advantages, a branch of a U.S. bank in the Cayman
Islands, for example, borrows from its parent bank in the United States in order to make
loans to non-U.S. borrowers. The remaining issuers of the bonds in Table 2 are in develop-
ing countries or are multilateral institutions such as the World Bank and the International
Monetary Fund. As is also evident from Table 2 (Part C), the U.S. dollar, the euro,
the British pound, and the Japanese yen are the principal currencies of denomination of
the debt securities, and other currencies are used for only about 7 percent of the securities.
Finally, in Part D, we see the importance of commercial banks and other financial institu-
tions in the underwriting and issuance of bonds. Significant in this item have been bank
borrowing to finance mergers and acquisitions worldwide and, as globalization of asset
markets proceeds, the relative shift of the composition of balance sheets toward interna-
tional liabilities and away from domestic liabilities.
The growth of the international bond markets began in much the same way as did the
eurodollar market. The imposition of the interest equalization tax, or IET (see the discussion
earlier in this chapter on the origin of eurodollars), in mid-1963 is regarded as a main factor.
(See Mendelsohn, 1980, pp. 32–36.) This tax applied to the income from new and existing
foreign securities (mainly European) held by U.S. citizens, and the consequence of its intro-
duction was that the prices of such bonds fell in the United States in order to get Americans
to purchase them. (Higher interest returns on the bonds were needed to cover the tax and to
make the after-tax returns comparable with the returns on domestic bonds, and remember that
higher interest rates on bonds mean lower prices on bonds.) When this tax restriction was fol-
lowed in the mid-1960s by the “voluntary” lending restraints imposed on U.S. bank lending
abroad and by suggested government guidelines for foreign direct investment by U.S. firms
that aimed to reduce that investment, the consequence was that foreign borrowers moved
10See Eng and Lees (1983, p. 3.6.3).
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Part A: Type of Instrument
Money market instruments $ 887.9
Bonds and notes 20,002.2
$20,890.1
Part B: Location of Issuers of Instruments
Developed countries $15,637.8
United Kingdom $3,100.1
United States 2,127.4
Netherlands 1,816.7
France 1,442.1
Germany 1,174.5
Offshore centers 1,981.5
Developing countries 1,852.7
International organizations 1,418.1
$20,890.1
Part C: Currency Denomination of Instruments
U.S. dollar $ 9,008.2
Euro 8,051.5
British pound 2,005.7
Japanese yen 423.7
Other currencies 1,401.0
$20,890.1
Part D: Type of Issuer of Instruments
Commercial banks and other financial corporations $14,995.0
Non-financial corporations 2,913.1
Governments 1,563.4
Other issuers 1,418.6
$20,890.1
Source: Bank for International Settlements, BIS Quarterly Review, June 2015, pp. A113-A117, A123-A124,
available at www.bis.org.
TABLE 2 Stock of International Debt Securities Issues, March 2015
(billions of U.S. dollars)
away from the U.S. lending market and began issuing bonds in Europe. Foreign subsidiaries
of U.S. firms abroad (which might previously have issued bonds in the United States) also
issued bonds abroad. Hence, a stimulus was given to the growth of bond markets outside the
United States. With the relaxation of capital controls in Europe that had been accomplished
in the late 1950s and with the generally increasing economic integration taking place within
the European Community, the new bond issues abroad were denominated in a variety of
different currencies. By the mid-1970s, when the U.S. lending restraints and the IET were
removed, the European markets had become sizable and the growth was irreversible.
The economic implications of the eurobond markets are much the same as those of the
eurocurrency markets. Financial capital is increasingly able to flow across international
borders and thus to intensify the tendency for interest rates on similar assets to equal-
ize. From an economic perspective, the growth of these markets therefore results in a
more efficient allocation of financial capital. However, as was also true for the eurocur-
rency markets, interest rates will not become exactly equal even on two identical assets
(a domestic bond and a eurobond)—and not just because of transaction costs and other
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factors previously mentioned. An additional factor preventing equality is exchange rate
risk. If a German holder of a U.S. dollar–denominated bond (which may in fact have been
issued by a Swiss firm) judges that the dollar will fall during the life of the bond (or during
the period when the holder possesses the bond, which may not be its entire life), the owner
will need to be receiving a higher yield than would be received if the bond were denomi-
nated in euros and if there is any risk that cannot be covered or hedged. In a bond setting,
there is likely to be more uncovered risk than in markets for shorter-term assets, because
hedging instruments are not as available for the longer-term bond assets. Further, the avail-
ability and the frequency of use of hedging techniques decrease as the time period of bonds
themselves lengthens, leading to the necessity of even greater compensation for risk.
Another implication of the international bond market is, of course, that foreign exchange
markets themselves will be more active than would be the case if these markets did not
exist. Bondholders may choose to purchase bonds of a particular currency denomination
because they envision that interest rates differ more than is justified by exchange rate
expectations, and an exchange market transaction may thus be necessary to obtain the
particular currency in order to make the purchase. Similarly, at the bond’s maturity date,
an exchange market transaction may be mandated if the bond seller has no special need
for the currency at that time. Further, the original bond issuer may also need to make an
exchange market transaction to pay off the bond at maturity. Hence, the exchange markets
will be subject to greater buffeting than would otherwise have been the case.
IN THE REAL WORLD:
INTEREST RATES ACROSS COUNTRIES
As suggested in the text, increased mobility of financial
capital should set forces at work to narrow interest rate dif-
ferentials across countries. In theory, and with other things
equal, we would thus expect interest rates on similar assets
to be nearly identical. However, as noted in the text and as
will also be discussed at length later in the chapter, rates may
not equalize in practice because of exchange rate premia,
risk elements in the markets, and other reasons.
Nevertheless, with the increased integration of financial
markets in recent years, we would not expect interest rates to
diverge sharply from each other. In order to consider this con-
jecture with respect to bond markets, Table 3 gives data on
lending rates for 12 developed countries and 12 developing
countries in 2014. Column (1) lists nominal (market) interest
rates for these assets; however, this column is not particularly
meaningful because no allowance has been made for infla-
tion rates. As you may recall, the real interest rate is more
useful for making economic decisions. The approximate real
interest rate can be found by subtracting the inflation rate
from the nominal interest rate, and such an adjustment is nec-
essary, for example, because an investor earning a 10 percent
nominal return on a one-year security is in fact earning only
2 percent in real, purchasing power terms if the inflation rate
is 8 percent. Hence, column (2) of Table 3 indicates the 2014
inflation rate for the countries, and column (3) lists the result-
ing real interest rates on bonds.
Column (3) suggests that, for the developed countries,
there is reasonable similarity in real interest rates, but they
are obviously not identical. Also, because changes in price
levels are used to convert the nominal yields into real yields,
these price-level changes would necessarily have to move
in accordance with relative purchasing power parity (PPP)
to make real interest rates equal. However, the real rates
in Table 3 do differ by 2 percentage points or less from
the mean in 7 of the 12 countries, but there are relatively
large departures from the mean in Japan (4.3 percentage
points difference) and the United Kingdom (3.7 percentage
points difference).
Finally, the developing countries’ real rates show greater
dispersion than those of the developed countries, as the
developing countries are not as well integrated into the
world financial system. The range for these 12 countries is
from –1.45 percent to 12.52 percent, much larger than the
range in the developed countries.
(continued)
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IN THE REAL WORLD: (continued)
TABLE 3 Government Bond Yields in Developed and Developing Countries, 2014
(average yield to maturity in percent per annum)
(1) Nominal Yield (2) 2014 Inflation Ratea (3) Real Yield
Developed Countries:
Australia 5.95% 2.49% 3.46%
Canada 3.00 1.91 1.09
Czech Republic 4.64 0.34 4.30
Iceland 7.74 2.04 5.70
Israel 3.91 0.48 3.43
Italy 4.87 0.24 4.63
Japan 1.22 2.75 −1.53
Republic of Korea 4.26 1.27 2.99
Slovak Republic 5.76 −0.07 5.83
Switzerland 2.69 −0.02 2.71
United Kingdom 0.50 1.46 −0.96
United States 3.25 1.63 1.62
12 Developed-country mean 3.98 1.21 2.77
Developing Countries:
Angola 16.38% 7.28% 9.10%
Bangladesh 13.00 6.99 6.01
Botswana 9.00 4.40 4.60
Colombia 10.87 2.88 7.99
Costa Rica 14.90 4.52 10.38
India 10.25 6.36 3.89
Indonesia 12.61 6.40 6.21
Kenya 16.51 6.87 9.64
Malaysia 4.59 3.14 1.45
Peru 15.74 3.22 12.52
South Africa 9.13 6.38 2.75
Thailand 6.77 1.89 4.88
12 Developing-country mean 11.65 5.03 6.62
aInflation rates are percentage changes in consumer price indexes.
Source: International Monetary Fund data, obtained from data.imf.org; real yields calculated by the authors. ●
Finally, the existence of the international bond markets (as with the eurocurrency mar-
kets) can reduce the independence that exists for any given country’s monetary author-
ity. If the Bank of Canada wishes to drive down long-term interest rates to stimulate real
investment, this attempt will be frustrated if Canadian bondholders switch to the purchase
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of foreign bonds where yields are now relatively higher (and bond prices are therefore rela-
tively lower). This could result in a monetary outflow from Canada, possibly resulting in a
worsened balance-of-payments position (under fixed exchange rates) and a depreciation of
the Canadian dollar (under flexible exchange rates).
Other assets that have become more widely traded across international borders in recent
years are shares of common stocks (equities) of corporations. This type of asset differs from
bonds in that the holding of stock by individuals and institutions (e.g., insurance compa-
nies, pension funds) brings with it ownership of the company whose stock is held. Hence,
in theory, there is an element of control involved with stocks that is absent from bonds. In
practice, however, any one investor generally holds such a small relative amount of any
given corporation’s stock that effective control by that investor is precluded. Nevertheless,
the financial features of stock differ in a way that makes the purchase decision more com-
plicated than is the case with bonds and other debt instruments. An investor considering
the acquisition of a company’s stock is faced with making an uncertain projection of the
company’s future earnings, the variability of those earnings, the real factors lying behind
demand for and supply of the company’s product that may influence the firm’s future
courses of action, the ratio of the stock’s price to the company’s earnings per share, the
dividend payout rate, and many other performance indicators. In the international context,
expectations of the future exchange rate behavior of the foreign currency in which the
stock is quoted relative to the home currency of the investor are also important, as well as
the anticipated macroeconomic behavior of the country in which the stock is being sold.
An individual investor in recent years has been increasingly able to shift the analysis of
the selection of stock to mutual funds which bring together the financial resources of many
buyers and which specialize in transactions in international stocks, but the fund managers
themselves obviously still need to take account of all these influences.
Unfortunately, information on the size of stock purchases made across country borders
is difficult to obtain. A general consensus among observers and participants in the market
is that the volume of such equity transactions has been increasing with the spread of multi-
national companies, the increased mobility of capital in general, and the emergence and
maturing of stock exchanges in many developing countries. Because stock transactions
of the cross-border type have been increasing rapidly, it is possible that movements of
stock prices across countries will tend to become increasingly similar to each other. This
co-movement might arise because of the general result that occurs when markets become
less separated or segmented and arbitrage occurs between them. However, stock markets
can differ in this co-movement respect from usual markets because of the central role of
expectations in stock markets and the resulting potential volatility that can emerge from
sudden swings in those expectations. If the prices of stocks in market A soar while those
in market B languish, investors may shift from B to A and drive prices further up in A and
down in B because of expectations that A will continue to rise and B will continue to stag-
nate. On the other hand, the soaring prices in market A might yield the result that investors
will expect them to fall and thus will shift the composition of their portfolios toward stocks
in market B. In this case, the prices in the two markets might converge and, with regular
such behavior, might never have diverged to a great extent in the first place—any rise in
one market would cause a switch to the other market, causing a rise there. Of course, a
decline in a major financial market can cause a decline in other financial markets as well,
as was demonstrated in the recent worldwide financial crisis. Recently, stock markets in
developed countries have diverged significantly in their behavior because of unsettling
political and economic stresses. For example, in the first nine months of 2015 the stock
International Stock
Markets
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market index rose by 22 percent in Denmark, 26 percent in Hungary, and a whopping
208 percent in Venezuela, while falling by 17 percent in Singapore, 19 percent in Indonesia,
20 percent in Colombia, and 21 percent in Greece.11
A force that may generate a common trend movement of stock price indexes across
countries is the phenomenon of international portfolio diversification to reduce risk in
investors’ portfolios. (See Mayo, 1997, pp. 803–11.) If the price changes are not highly
correlated with each other across countries, there is an advantage to holding stocks in sev-
eral countries because a rise (fall) in one market will not be closely matched with a rise
(fall) in other markets. Because many investors are risk averse, the purchase of stock in
several markets will reduce the likelihood of wide swings in total portfolio value. Indeed,
mutual funds with global scope are doing precisely this type of diversified investing. But
if portfolios become diversified across international markets and if some balance between
the stocks across the various markets is maintained over time as portfolios grow, then the
markets may well move in somewhat parallel fashion.
Before concluding this look at international equity markets, we take note of the emer-
gence of a new investment vehicle for making such transactions across country borders. As
indicated briefly earlier, mutual funds have become increasingly important for such pur-
chases. (Mutual funds of this international type also have become prominent in bonds, but
we concentrate here on stock funds.) These funds collect the savings of small individual
investors as well as large institutional investors and place the pool of collected savings into
portfolios of financial assets comprising equities of companies located in many different
countries. From the standpoint of U.S. investors, there are four main types of such interna-
tionally focused mutual funds (Mayo, 1997, pp. 810–11):
1. Global funds purchase packages of equities that contain stocks of corporations both
in the United States and in other countries.
2. International funds do not hold U.S. securities but purchase exclusively the stocks
of companies located in other countries.
3. Emerging market funds hold a portfolio of stocks of companies in developing
countries—for example, in Argentina, the Czech Republic, Indonesia, and Malaysia.
4. Regional funds focus on securities of companies in particular geographic areas or
countries—for example, in Asia, Latin America, China, Germany, and Japan.
To participate in these funds—and there are thousands of such funds now—shares can
be purchased in some cases on organized stock exchanges and in other cases (more promi-
nent) directly from the mutual fund companies. Aside from the differing countries in which
the various funds invest, there are other differing characteristics among them: no-load
funds require no explicit charge for purchase or sale; low-load and load funds impose
a charge for entering the portfolio; redemption-charge funds levy a fee upon exit; and
closed-end funds are traded on regular stock exchanges and thus involve a broker’s fee
upon entry and exit. With mutual funds, the choice set for investors is indeed large.
An additional point to make is that stock markets in developing and transition countries
have been increasing dramatically in recent years with respect to their size and participa-
tion by investors (including foreign investors). Much of this increased activity is associ-
ated with the general liberalization of the various economies that has featured, inter alia,
reductions of tariff and nontariff barriers, relaxation of internal government controls on
11Data obtained from The Economist, October 3, 2015, p. 96.
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production and sale of goods, and privatization of former state enterprises. With this “free-
ing up” of the economies, however, market instability has increased, and the removal of
government provision of employment and income support has caused turmoil to emerge. In
addition, the prospects for increased income inequality have been enhanced with the arrival
of this riskier environment.
Finally, with respect to stock markets, we close by emphasizing again that, as with inter-
national bonds and international bank lending, the increasing integration of these markets
serves to facilitate the flow of capital toward its best use. As financial investors respond
to perceived profit opportunities beyond their own borders, they are transferring capital
to destinations where it can earn a higher return. As financial capital flows occur for the
purchase of the stock of a foreign company that is productive and profitable, this raises
the book value of the company and encourages its expansion because of its more favor-
able balance sheet.12 Encouragement of profitable, productive firms and discouragement
of poorly managed, unproductive companies of course serve to improve the allocation of
world resources. In the broad context of international monetary economics, however, the
use of international stock transactions to improve capital allocation potentially comes at a
price. This price, especially if the stock transactions involve speculative behavior due to
unfounded rumors and “bandwagon” effects, is the increased volatility in world financial
markets (and particularly in foreign exchange markets) that can occur. The fact that share
prices in stock markets can have pronounced downward movements was clearly exhibited
in 2008 throughout the world.
Thus far, we have focused in this chapter on international bank deposits and lending,
international bond markets, and stock market activity in an international context. In over-
view, these various asset markets have been growing dramatically in size and scope in
recent years. International investors now have open to them financial opportunities previ-
ously unavailable, and the activity in these increasingly integrated markets has meant that
countries are becoming linked ever more tightly together economically. The effects of
financial developments in one country spill over into other countries, and the new environ-
ment poses challenges as well as opportunities for economic actors.
12Because most stock purchases are of previously issued stock and not of newly issued stock, the funds flowing
in for a stock purchase are generally not flowing to the company per se. However, the company’s net worth or
capital value on its balance sheet increases as its stock rises in price, and the company is thus in a better position
to, among other things, obtain loans or issue new stock for the financing of expansion of the firm.
1. Distinguish participation by an investor in
foreign bond markets from participation by
that investor in eurobond markets.
2. Why do bond prices and bond yields move
inversely with each other?
3. Why would a financial investor wish to pur-
sue international portfolio diversification?
CONCEPT CHECK
FINANCIAL LINKAGES AND EUROCURRENCY DERIVATIVES
With this broad look at international banking, international bonds, and the international
purchase of stocks as background, we now turn to a more detailed examination of par-
ticular financial instruments and financial strategies employed in the international asset
and foreign exchange markets. As should be clear, the world of international finance is
becoming increasingly complicated; at the same time, however, it is becoming increasingly
fascinating.
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In the previous chapter we discussed the formal links between the foreign exchange mar-
kets and the financial markets. It was seen that the decision to invest at home or abroad
depends on the expected rate of return of the foreign and domestic alternatives under con-
sideration. If the expected rate of return on domestic assets is higher, the individual will
invest at home. Conversely, if the expected rate of return is higher on the foreign asset, the
individual would be expected to invest abroad. If there are no barriers to financial invest-
ment flows, then funds should move from areas of low rates of return to areas of high
rates of return until the expected returns are similar, differing only by the transaction costs
involved in moving between the two markets.
It is critical, as noted earlier, to remember that rates of return on foreign investments
result both from the return on the financial asset in question and from changes in the
exchange rate over the period of the investment. Thus, the domestic investor must take
into account (1) the expected rate of return on the domestic financial asset, (2) the expected
rate of return on the foreign asset, and (3) any expected change in the exchange rate. The
investor is thus indifferent between a foreign asset and a domestic asset only when he or
she expects to earn the same return on each possibility after taking into account any gains
or losses associated with expected changes in the exchange rate. This “parity” condition
was stated more formally in the preceding chapter in the following manner:
(1 + ihome)∕(1 + iforeign) = E(e)∕e
where: ihome = domestic rate of interest
iforeign = foreign rate of interest
e =  spot foreign exchange rate in units of domestic currency per unit
of foreign currency
E(e) = expected future exchange rate at the end of the investment period
This is more commonly expressed in terms of the expected percentage appreciation of the
foreign currency. If xa is used to represent the expected percentage appreciation of the for-
eign currency, then E(e)/e is equal to (1 + xa) and the preceding equation simplifies to
(ihome − iforeign)∕(1 + iforeign) = xa
which is often approximated by
(ihome − iforeign) ≅ xa
This condition states that equilibrium occurs in the financial market whenever any differ-
ence in the interest rates in the two countries is approximately offset by the expected change
in the exchange rate. (Ignore any transaction costs.) Because of the lack of perfect fore-
sight, the actual return on the foreign investment may not equal that which was expected
because of unanticipated changes in the exchange rate. Such unanticipated changes can
lead to the attachment of a risk premium if actors are risk-averse, and if the premium is
expressed as a percentage, RP, the preceding equilibrium condition is modified to become
(ihome − iforeign) ≅ xa − RP
From this basic exercise it is clear that the investment decision over time now involves
two sources of risk. The first is the aforementioned risk associated with changes in the
exchange rate, which affect the overall rate of return on the investment. The second source
of risk is the interest rate risk that arises if the financial transaction is not to be undertaken
and completed for a period of time.
Basic International
Financial Linkages:
A Review
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As we discussed in the previous chapter, the foreign exchange risk can be removed
(hedged) by using the forward market. In this case, the basic equilibrium condition in the
financial market can be expressed in the following manner:
(ihome − iforeign) ≅ p
where p is the actual premium on the forward exchange rate, that is, p = (efwd/e) − 1. Thus,
in equilibrium, any difference in the two interest rates must be approximately equal to
the foreign exchange premium contracted in the forward market. These forward contracts
can be purchased in the formal forward market, the futures market, or the options market.
Therefore, as was pointed out in our discussion of the foreign exchange market, in the
absence of capital controls or other market barriers, all credit markets (foreign and domes-
tic) are linked to one another through arbitrage and currency expectations.
The financial activities of participants in the financial markets, including borrowing,
lending, and the assignment of risk through hedging actions, ensure that the difference
between interest rates in the two countries equals not only the forward premium (via for-
ward contracts) but also the expected exchange rate change on the part of those who are
bearing the risk of changes in the foreign exchange rate. As was demonstrated at the end of
the previous chapter, if markets are efficient, the following should hold:
ihome − iforeign ≅ p = xa
However, to the extent that there is a risk associated with foreign exchange that cannot be
avoided by combining foreign exchange holdings with other assets (i.e., a foreign exchange
risk that cannot be diversified away), an additional risk premium, as noted earlier, would
be required by those going uncovered; that is,
ihome − iforeign ≅ p = xa − RP
Whether or not such a risk premium exists is still a subject of considerable debate among
financial researchers.
How does the eurodollar market enter into these financial considerations? The presence of the
eurodollar market in essence creates a second interest rate possibility in each currency. The
financial investment now includes the following six financial variables, using the United States
(home) and the United Kingdom (foreign) as the two country examples:
Interest rates: U.S. interest rate
U.K. interest rate
eurodollar interest rate (foreign-held dollar funds)
eurosterling interest rate (foreign-held British pounds)
Exchange rates: spot rate (dollars/pound)
forward exchange rate (dollars/pound)
Lenders and borrowers now have the alternatives of two different markets in which to
operate, one at home and one abroad. The relationship between the rates in these markets
would appear to be very straightforward. If all things were equal, eurobanks should pay
no less than the deposit rate in the United States. If they paid less, why would depositors
place their funds abroad instead of at home? Similarly, eurobanks cannot lend eurodollars
at a higher lending rate than that in the United States; and further, why should a eurobank
be willing to lend dollars at a rate lower than that in the United States? Thus, a priori, it
appears as though the borrowing and lending rates in the United States should establish
similar rates in the eurodollar market.
International
Financial Linkages
and the Eurodollar
Market
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However, because of the different institutional settings, it can be argued that U.S. inter-
est rates will likely bound the eurodollar rates, that is, the domestic lending rate lies above
the eurocurrency lending rate and the domestic deposit rate lies below the eurocurrency
deposit rate. This historically appears to have been the case, as was indicated earlier in
this chapter. The relatively lower eurocurrency lending rate and relatively higher deposit
rate can be explained from the standpoint of a foreign risk differential and an institutional
cost differential. Turning first to the risk dimension, if potential lenders or borrowers per-
ceive a relative difference in risk associated with the foreign deposit or loan, they will
require a risk premium in the form of a lower lending rate or higher deposit rate. When
U.S. borrowers or investors contract with a foreign bank, they become involved in a for-
eign jurisdiction. Thus the risk on the foreign deposits or loans is somewhat greater than
the risk on similar transactions within the United States. The two dollar markets are thus
separated by possible foreign government actions or restrictions that increase the risk of
doing business abroad instead of at home. Legal restrictions or potential policy actions that
might interfere with the movement of funds between, for example, a London bank and the
United States can drive a wedge between U.S. domestic rates and eurodollar rates in the
United Kingdom. Government policies can affect flows directly through restrictions on
capital outflows and foreign exchange controls that alter the nonresident convertibility of
the dollar holdings abroad. In addition, there is always the slight possibility that the assets
or liabilities of the eurobanks can be seized by the authorities where they operate. Further,
differences in liquidity or institutional structure related to such things as the number and
size of financial dealers and the accessibility of adequate financial information can also
influence the risk environment.
From the cost perspective, banks face additional costs when utilizing domestic deposits
compared with eurocurrency deposits. These additional costs arise whenever banks are
not subject to the reserve requirements or deposit insurance assessments on eurocurrency
deposits that can be required on domestic deposits. It is obvious that the bank could earn
more by being able to lend out a full deposit than by having to retain a certain percentage
as a reserve requirement. (The Federal Reserve now pays a relatively low interest rate to
banks on their required reserves, but this can be ignored in the subsequent discussion.)
In the presence of domestic reserve requirements, therefore, a U.S. domestic bank would
pay a lower rate on domestic deposits than could be earned on eurodollar deposits abroad.
Generalizing, the deposit rates on eurocurrency should exceed domestic deposit rates of the
same given currency by an amount equal to the relative cost of central bank regulation.13
With this expanded view of the international financial market in perspective, let us
again examine the nature of adjustments in the United States and the United Kingdom
when there is a change in credit conditions in one of the countries, for example, the
United States. This process is similar to that described in Chapter 20, except that there are
now six markets involved instead of four. The six markets are (1) the U.S. money market,
(2) the U.K. money market, (3) the eurodollar market, (4) the eurosterling market, (5) the
13An estimate of the higher rate on Eurocurrency deposits taking into account any reserve requirement and any
applicable deposit insurance fees charged on domestic deposits is therefore
Eurocurrency deposit rate = effective cost of domestic deposit
= (idomestic deposit + deposit insurance fees)∕(1 − reserve requirement)
Hence, if the reserve requirement is 5 percent, idomestic deposit is 8 percent, and the deposit insurance fee is 0.083
(=1/12) percent, then
Eurocurrency deposit rate = (0.08 + 0.00083)∕(1 − 0.05) = 0.08508, or 8.51%
This ignores any differential tax treatment or any difference in bank regulatory practices regarding the two types
of deposits.
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IN THE REAL WORLD:
U.S. DOMESTIC AND EURODOLLAR DEPOSIT
AND LENDING RATES, 1989–2014
Figure 1(a) illustrates the annual average bank deposit rate
in the United States and the LIBOR one-year rate on dol-
lar deposits as reported by the International Monetary Fund
for the 1989–2014 period. Figure 1(b) does the same for the
average lending rates. A simple estimate was made of the
LIBOR one-year lending rate, because the IMF does not
report that information. (The assumption was made that the
percentage-point difference between the LIBOR deposit rate
and the U.S. deposit rate also applied, in the reverse direction,
to the LIBOR lending rate and the U.S. lending rate.) As can
be seen from Figure 1(a), U.S. and eurodollar deposit rates
tracked each other closely over the period, although euro-
dollar deposit rates were higher. The one exception to this
rule occurred in 2007 with the severe disruptions that were
taking place in financial markets worldwide. Assuming that
eurodollar lending rates behaved in the manner described,
they also would track U.S. lending rates but be below them
(except in 2007), as shown in Figure 1(b).
FIGURE 1(a) LIBOR and U.S. Deposit Rates
(continued)
1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
LIBOR rate
U.S. rate
Year
(a)
Interest Rates
0
2
1
4
3
6
5
8
7
10
9
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spot market, and (6) the forward market. Suppose that the markets start out in equilibrium
and the following interest rate parity equilibrium rates prevail:
Lending iNY = 7% Lending iLondon = 8%
Lending iEurodollar London = 6.5% Lending iEurosterling NY = 7.5%
Deposit iNY = 5% Deposit iLondon = 6%
Deposit iEurodollar London = 5.5% Deposit iEurosterling NY = 6.5%
Spot e$/£ = $1.6912/£ 3-months forward e$/£ = $1.6869/£
IN THE REAL WORLD: (continued)
The LIBOR deposit rate has historically been above the U.S. deposit rate, and the LIBOR lending rate has historically been below the
U.S. lending rate. This pattern has greatly facilitated the development of the eurodollar market.
Sources: International Monetary Fund, International Financial Statistics Yearbook 1999 (Washington, DC: IMF, 1999), pp. 106, 110,
112; International Financial Statistics, March 2000, pp. 44, 48, 50; International Financial Statistics Yearbook 2003 (Washington, DC:
IMF, 2003), pp. 66, 69, 73; International Financial Statistics Yearbook 2006 (Washington, DC: IMF, 2006), pp. 65, 72; International
Financial Statistics, March 2012, pp. 39, 42, 46; and https://research.stlouisfed.org. ●
FIGURE 1(b) LIBOR and U.S. Lending Rates
0
2
6
10
4
8
12
1989 1991 1993 1995 1997 1999
Year
2001 2003 2005 2007 2009 2011 2013 2015
LIBOR lending rate
U.S. lending rate
(b)
Interest Rates
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It can be easily demonstrated that the covered interest arbitrage parity condition holds
across all pairs of rates, after dividing the annual interest rate difference by 4 so that it
approximates the three-month forward period. For example,
iNY − iLondon ≅ p
(0.07 − 0.08)∕4 ≅ ($1.6869 − $1.6912)∕$1.6912
−0.0025 ≅ −0.0025
Suppose that the Federal Reserve moves to raise U.S. domestic interest rates by 1/2 percentage
point. This will immediately make investments in New York more attractive to investors, and
the markets will begin to adjust to a new equilibrium position taking into account the new
interest rates in the United States. In all likelihood, the first adjustment to the rate changes in
New York will take place in the eurodollar rate abroad. For London banks to maintain their
dollar deposits, the eurodollar deposit rate will rise to 6 percent and the eurodollar lending
rate will be bid up to 7 percent, thus maintaining the same spread difference as existed prior
to the increase in the U.S. rates. At the same time, as U.K. investors attempt to take advantage
of the higher U.S. rates, they will increase their demand for dollars (supply of British pounds)
causing the spot dollar rate to appreciate. Simultaneously, investors who wish to insure them-
selves against unforeseen changes in the exchange rate will buy pounds forward (increase the
supply of dollars forward), leading to a depreciation of the dollar in the forward market, just
as was the case in the adjustment process discussed in the previous chapter. If U.K. interest
rates remain unchanged, all adjustment to market equilibrium will take place in the foreign
exchange market. However, upward pressure will come to bear on U.K. interest rates and the
eurosterling rate. Increases in these rates will reduce the degree of change in the exchange
rates to bring the markets into a new equilibrium position. With the new U.S. interest rates
and U.K. rates/eurosterling rates remaining unchanged, market equilibrium would again take
place if, for example, the three-month forward rate moved up (the dollar depreciated) to
$1.688/£ and the spot rate moved down (the dollar appreciated) to $1.690/£. Should interest
rates in the United Kingdom (and the eurosterling rates) start to increase, we would expect to
see the forward rates begin to decline and the spot rates begin to increase.
These financial adjustments are demonstrated in the six graphs in Figure 2. The tighter
money market in the United States causes domestic interest rates to rise [graph (a)]. This
immediately leads to an increase in demand for eurodollars, which drives up eurodollar
rates until they again differ from U.S. domestic rates by the risk-cost differential [graph
(b)]. The higher interest rates in the United States lead to an increase in the U.K. demand
for dollars (supply of pounds) for financial investment in the United States because of the
higher return [graph (c)]. At the same time, these investors will be selling dollars forward
to return to pounds at the end of the investment period [graph (f)]. The other markets
that might eventually be involved in the financial adjustment process are the U.K. money
market [graph (e)] and the eurosterling market [graph (d)]. As funds move from the
United Kingdom to the United States, upward pressure on U.K. domestic and eurosterling
interest rates will be experienced. Should the Bank of England choose not to intervene to
hold U.K. interest rates constant and consequently the U.K. rates rise, there will be further
readjustments in all six markets until equilibrium again attains.
Having observed how the foreign currency markets, the domestic financial markets, and
the eurodollar markets interact, we now turn to a discussion of how interest rate risk can be
reduced or eliminated in international financial markets.
A number of new international financial markets have emerged in recent decades to provide
alternative instruments for spreading risk related to both foreign exchange and future inter-
est rates. The appearance of these instruments can also contribute to worldwide financial
Hedging Eurodollar
Interest Rate Risk
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instability, as demonstrated in 2007 and 2008. Having discussed in the previous chapter
how foreign exchange forward, futures, and options markets provide a means for reducing
or avoiding foreign exchange risk, we now briefly introduce several of the more important
instruments or tools that are available in the international financial markets to hedge inter-
est rate risk. These financial instruments belong to a category of financial tools referred
to as derivatives. Derivatives are simply financial contracts whose value is linked to
or derived from an underlying asset. Examples of the underlying assets include stocks,
bonds, commodities, loans, CDs, and foreign exchange. For many financial institu-
tions, interest rate risk management is critical to their successful operation inasmuch as
they often can anticipate future lending and future borrowing actions both at home and
abroad and would prefer to reduce the risk of possible changes in the market interest rate
prior to when the anticipated borrowing or lending occurs. Several of the more com-
monly used types of financial instruments or tools from which the manager can choose
to hedge against unforeseen interest rate changes include (1) maturity mismatching,
(2) future rate agreements, (3) eurodollar interest rate swaps, (4) eurodollar cross-currency
interest rate swaps, (5) eurodollar interest rate futures, (6) eurodollar interest rate options,
7.5
i
7.0
5.5
5.0
D$
S’$
S$
D’$ D£D$
S$

S’£
D’£
(a)
7.0
iNY Money Market London Money Market
(eurodollars)
Spot Market
6.5
6.0
5.5
(b)
e$/£
$1.6912
$1.6900
(c)
i
7.5
6.5


D£D£


(d)
iNY Money Market
(eurosterling)
London Money Market Forward Market
8
6
(e)
e$/£
$1.6880
$1.6869
(f)
?
?
? ?
0 0 0
0 0 0
$ $ £
£ £ £
FIGURE 2 International Financial Adjustment in the Money Markets, Foreign Exchange Markets,
and Eurocurrency Markets
International financial adjustments in the presence of eurocurrency markets are demonstrated in these graphs. A tighter money market in the
United States [leftward shift in the supply curve in graph (a)] causes domestic interest rates to rise. This leads to increased demand for eurodollars
[rightward shift of the demand curve in (b)], which drives up eurodollar rates until they again differ from U.S. rates by the risk-cost differential.
The higher U.S. interest rates lead to an increased U.K. supply of spot pounds [rightward shift of S£ to S′£ in (c)], which are hedged in the forward
market [rightward shift of D£ to D′£ in (f)]. Further adjustments may occur in the U.K. money market and the eurosterling market that would lead
to higher interest rates in these markets [graphs (d) and (e)], although the result is uncertain because the Bank of England may intervene to offset
upward pressure on interest rates in the London money market. [Note: In graphs (a), (b), (d), and (e), the upper rates reflect lending rates and the
lower rates indicate deposit rates. The lending and deposit rates form a bracket around what would be the common equilibrium rate if lending and
borrowing rates were equal.]
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(7) options on swaps, and (8) equity financial derivatives. We will examine each one and
then conclude with a short discussion of the current size and importance of these transac-
tions in the international financial arena.14
Maturity mismatching is one of the easiest and simplest ways for financial institutions
to remove the risk of changes in the interest rate between now and some future time. It
is carried out by acquiring two or more financial contracts whose maturities overlap. For
example, suppose that a fund manager knows that her company will receive $100,000 in
three months and needs to hold those funds for dollar payment of a financial obligation six
months from now. Being concerned that the interest rate may fall prior to the receipt of the
funds, the fund manager looks for a way to lock in the current deposit rate for the three-
month period during which the $100,000 cash surplus will be held. She accomplishes this
by borrowing $100,000 for three months and investing it in a fixed-rate instrument for six
months, which will mature just at the time it is needed for the future expected payment.
When the $100,000 is received at the end of three months, it is then used to pay back the
initial three-month loan when it comes due, while the invested funds continue to earn a
known fixed amount of interest until they are needed six months from now. The cost of
fixing the future interest rate now is the difference between the deposit rate and the loan
rate for the first three months, that is, the three-month overlap. In similar fashion, if we
wished to lock in a lending rate for six months, beginning two months from now, this could
be accomplished by borrowing the needed funds today for an eight-month period, placing
the funds in a short-term fixed-rate deposit for two months, and at the end of two months
using the funds to pay the anticipated financial commitment. Again, by overlapping the
maturities of two financial instruments, the future lending rate is secured at a known inter-
est rate, and the cost of the hedge is the difference between the two-month deposit rate and
the eight-month loan rate for the two-month overlap.
A future rate agreement (FRA) is essentially a contract between two parties to lock in a
given interest rate starting at some given point in the future for a given time period. This
instrument originated in the early 1970s and is often referred to as a forward-forward. (It
is also sometimes referred to simply as a forward rate contract.) The procedure was modi-
fied in the mid-1980s through the development of a cash-compensation process whereby
compensation is paid for deviations of the market interest rate from the contracted rate
rather than through the actual borrowing or lending of funds between the two contract par-
ticipants. The process works as follows: The two contracting parties agree on a particular
lending or borrowing rate at some future date for a specific amount and loan period. For
example, Ms. Jones may wish to secure the interest rate on a $10,000 loan in three months
for a period of nine months. After negotiating through a broker over the future rate, a con-
tract will be signed between Jones and the seller of the contract (Mr. Brown) whereby a
loan rate of 7.5 percent is locked in for the time period under consideration. This contract
guarantees the interest rate for both parties but does not involve any commitments for the
loan itself. In three months, when Ms. Jones needs the funds, she obtains a nine-month loan
at the current market interest rate. If the market rate at the time of the loan is 7.8 percent,
the other party in the FRA (Brown) pays her the difference between the market rate and the
rate in the FRA, that is, 0.3 percent or 30 basis points,15 for the specified $10,000 loan for
Maturity
Mismatching
Future Rate
Agreements
14For in-depth discussions of the eurodollar derivative instruments introduced here, see the excellent presentations
in Bryan and Farrell (1996), Burghardt, Belton, Lane, Luce, and McVey (1991), and Dufey and Giddy (1994).
The Burghardt et al. volume also provides very thorough coverage of the legal features of these instruments.
15A basis point is defined as one one-hundredth of a percent; that is, 1 percentage point contains 100 basis points.
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nine months.16 Should the market rate have fallen to 7.25 percent, Ms. Jones would reim-
burse Mr. Brown the difference, that is, 0.25 percent for the specified nine-month loan.
Jones is thus hedged against any increase in the lending rate between now and the time of
the actual undertaking of the loan. She is, however, locked out of receiving any benefits
associated with a fall in the loan rate. Of course, if the market rate is the same as the con-
tract rate, then no offsetting payments are made by either party and the contract terminates.
In essence, Jones has contracted with Brown to exchange a floating or uncertain rate for a
fixed rate over a specific time period. Indeed, an FRA is often defined as a forward con-
tract in which two parties agree to exchange a floating rate for a fixed rate for some future
time period. LIBOR is commonly used as the floating rate in these agreements.
A eurodollar interest rate swap is similar to an FRA but involves several future periods.
In this case parties agree to exchange interest rates of two different kinds for several periods
in the future, each usually three or six months long. Again, one of the rates is generally the
appropriate LIBOR rate, and the contract often involves the exchange of a fixed rate for a
floating rate, as is the case in the one-period FRA. However, an interest rate swap can also
involve an exchange of two floating interest rates where one is LIBOR and the second is
another interest rate or an index of a package of rates, such as an index of eurocommercial
paper rates. The case in which both sides are contracting a floating rate is referred to as a
basis swap or a floating-floating swap. An interest rate swap works as follows: Suppose
Ms. Smith has a three-year eurodollar-based loan at 8 percent and wishes that it were
a variable-rate debt (perhaps because she expects interest rates to fall in the future) and
Mr. Brown has a eurodollar loan on which he is paying six-month LIBOR plus 30 basis
points (0.3 percent) and wishes to have a fixed-rate debt. Under the agreed-upon swap
arrangement, Smith agrees to pay Brown the six-month LIBOR plus 0.3 percent every six
months and Brown in turn agrees to pay Smith the 8 percent (perhaps plus some additional
amount, for example, 50 basis points per annum). Smith has thus converted her fixed-rate
commitment to a variable rate and Brown has converted his variable rate to a fixed rate. If
interest rates decline, Smith will benefit by obtaining a cheaper loan. Brown feels relieved
to have obtained a fixed rate more cheaply than obtaining a formal, new fixed-rate loan and
refinancing, and he effectively has reduced his interest rate exposure. Should interest rates
fall during the swap contract and threaten to rise again, Smith could phone a swaps trader
and enter into a second swap arrangement to again fix the interest rate commitment but this
time at the new, lower level.
The eurodollar cross-currency interest rate swap is a financial derivative that permits
the holder of a floating interest rate investment or debt denominated in one currency to
change it into a fixed-rate instrument in a second currency. It, of course, can also permit
the holder of a fixed-rate debt in one currency to convert it to a floating-rate debt in a sec-
ond currency. It thus links several segments of international capital markets. It has all the
characteristics of a normal interest rate swap except that it is a combination of an interest
rate swap and a currency hedge.
Eurodollar Interest
Rate Swaps
Eurodollar Cross-
Currency Interest Rate
Swaps
16The actual amount paid by Brown (the seller) at the time of the loan is
Cash = (0.078 − 0.075)(270∕360)($10,000)∕ [1 + (0.078)(270∕360) ]
= $22.50∕1.0585 = $21.26
The interest rate differential (0.003) is adjusted to reflect the nine-month period (270/360) as opposed to one year.
The entire amount is then discounted for the nine-month period because Brown will be meeting the contract pay-
ment at the beginning of the loan period and not at the end when the interest is due. The payment is thus reduced
by the interest that the contract payment will earn over the nine-month period of the loan.
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CONCEPT CHECK 1. How can maturity mismatching remove the risk
associated with a future interest rate change?
2. Why would a borrower want to use a future
rate contract? What opportunity is being lost
by doing so?
3. What is the risk being avoided by the use of
an interest rate swap? What additional risk is
avoided with a cross-currency interest rate
swap?
Just as in the foreign exchange market, there are eurodollar interest rate futures in addi-
tion to interest rate forwards. Similar to currency futures, interest rate futures are contracts
to deliver a certain amount of bank deposits at some future date at a specified interest rate
or price. These may take the form of either eurodollar time deposits or eurodollar CDs of a
major bank. They carry the locked-in interest rate that was agreed upon when the contract
was signed, and the gain (loss) of the contract will depend on whether the interest rate on
the day the contract comes due is less (more) than the contracted rate, multiplied by the
amount of the contract.
These contracts differ from a forward market transaction in several ways. They are trans-
acted or traded on organized exchanges such as the CME. Three-month futures interest
contracts are sold in $1 million units with maturity dates in March, June, September, and
December. Unlike the case in the forward market, where forward gains or losses are settled
on the maturity date, gains and losses are settled on a daily basis in the futures market.
Participants are required to maintain a “margin” account, and the daily gains or losses are
added or subtracted from this account depending on whether the current daily rate is below
or above the contract rate. Thus, for every 1 basis point decline (increase) in the current
interest rate compared with the final settlement rate on the previous day, $25 is added to
(subtracted from) the holder’s margin account for each forward interest contract.17 The daily
cash settlements are based on the daily final settlement price of three-month LIBOR occur-
ring during the last minutes of trading (Dufey and Giddy, 1994, p. 189). For an example of
interest rate futures and how to interpret them, see Concept Box 1 on the next page.
The futures market is thus useful for lenders/depositors who wish to lock into a specific
future interest rate in eurocurrencies. If you know that you will have funds to invest in the
future for a specific period of time, the futures market offers you the opportunity to avoid
a fall in interest rates by fixing the interest rate now through buying a futures interest rate
contract for eurodollar delivery at the expected future time. At the specific future date, the
futures contract is completed and the contract margin adjustment funds plus the anticipated
investment funds are invested at the current market rate of interest. If interest rates have
fallen by the time the investment is made and the futures contract is due, the holder of the
futures contract will settle the margin account payments due on the contract and invest
them along with the new funds at the then-current interest rate. At the end of the investment
period, she will earn approximately the same amount as the initial futures contract rate
even though there was an actual decline in interest rates. The gain in the futures contract,
which will be invested along with the newly acquired funds, will result in a rate of return
similar to the initial rate in the futures contract even though the entire amount is earning a
lower rate of market interest. This activity is referred to as a long hedge.
Similarly, potential borrowers in the future can guard against a rise in the borrowing
rate by selling a futures contract for the period in the future during which they are going
to be in need of borrowing funds (i.e., a contract to acquire funds at a specific loan rate).
This activity is referred to as a short hedge. If interest rates rise by the time that the loan
Eurodollar Interest
Rate Futures
17This occurs because each of the contracts is for $1 million for three months. Each 1-basis-point change thus
leads to a payment equal to ($1,000,000)(0.0001)/4 = $25. The minimum fluctuation in price is 1 basis point.
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18Intuitively, this takes place because the rate adjustment payments are made throughout the period prior to the
completion of the contract with a futures contract, whereas the payment reflecting the interest rate adjustment in a
forward contract is made at the end, when the contract is fulfilled. In this case, “time is money,” and the relatively
lower cost of the hedge with the futures contract reflects this fact.
CONCEPT BOX 1
EURODOLLAR INTEREST RATE FUTURES MARKET QUOTATIONS
The quotations in Table 4 pertain to the Chicago Mercantile
Exchange (CME), and the face value of each three-month
contract is $1 million. Each basis-point (0.01 percent)
change in the contract price is valued at $25 [=($1,000,000)
(0.0001)/4]. The eurodollar futures “yield” is calculated on
a 360-day basis. The price is equal to (100 − yield), or the
yield is equal to (100 − the quoted price). Thus, with a “settle”
price of 99.450 (row 3 in the table), the yield is 0.550 percent
(=  100  −  99.450). The prices listed are the various strike
(contracting) prices for contracts expiring in the months indi-
cated. On the actual expiration date, the third Wednesday of
the expiration month, the futures yield converges to the cash
market yield, that is, LIBOR. The “open” price is the initial
contract price of the day, the “high” and the “low” indicate
the ranges of price fluctuation during the day, and the “settle”
price or closing price is the reference price used to make the
daily adjustment of margin accounts. In the case of the CME,
the settle price is equal to (100 − spot LIBOR). “Chg.” refers
to the change from the previous business day. In the case of
Sept contracts (row 3 of the table), there was a change in price
from the previous business day of 0.015 and, hence, a margin
payment of $37.50 (= $25 × 1.5 basis points) was required.
“Open interest” refers to the number of outstanding contracts.
On the particular Tuesday presented in the table, futures con-
tracts could potentially be sold for as long as 10 years out
(to March 2022, not shown in Table 4). In fact, there were no
sales for the years 2021 and 2022. However, the number of
contracts declined as the length of time to the expiration date
increased. The yield required by the seller increased steadily as
the contract period moved further and further into the future.
TABLE 4 Quotes for Tuesday, May 29, 2012
Open High Low Settle Chg. Open Interest Vol.
Eurodollar (CME)—$1 million; points of 100%
July 99.490 99.495 99.490 99.495 0.010 30,199 71
Aug 99.465 99.470 99.460 99.465 0.005 5,961 68
Sept 99.430 99.450 99.430 99.450 0.015 919,854 122,370
Mr13 99.345 99.370 99.345 99.370 0.020 662,844 96,749
Mr14 99.240 99.265 99.235 99.260 0.015 598,955 56,400
Mr16 98.315 98.365 98.310 98.345 0.015 100,917 12,455
Note: We use this 2012 example rather than a later example, because, in very recent years, there has been little
variability in the quotes. This lack of variability reflects the existence of extremely low interest rates.
Source: The Wall Street Journal, Market Data Center, obtained from http://online.wsj.com. ●
is needed, the seller receives the funds associated with the daily margin adjustment, which
can be used to reduce the amount of the necessary loan. The result is that the borrower has
the necessary funds over the period needed at approximately the contracted rate because
the lower amount of the required borrowing offsets the higher market interest rate. More
simply, the gain from the futures contract offsets the increased cash borrowing costs. In
fact, the borrower actually ends up paying a slightly lower rate than would have been the
case if the same hedge had been made using the forward market.18 It should be pointed out
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that the eurodollar contract is unlikely to provide a perfect hedge as there is unlikely to be a
perfect match between the hedging instrument and the financial instrument being hedged.
The lack of a perfect hedge is often referred to as basis risk.
When it is desired to hedge against changes in the interest rate for periods longer than
three months, it is possible to do so by acquiring a series of successive futures contracts. For
example, if someone wished to fix his return for a one-year period starting in September,
he would simply purchase a December futures contract, a March futures contract, a June
futures contract, and a September futures contract. As the December contract came to
an end, it would be replaced by (rolled over into) the March contract, and that would be
rolled over into the June contract and that into the September contract. He would thus
be protected against shifts in the overall level of interest rates. This collection of multiple
short-term three-month futures contracts to hedge changes in interest rates for a longer
period is referred to as a eurodollar strip. Another way to hedge a more distant future
than is available directly in the futures markets is to acquire a shorter-term futures contract
or strip and replace it with new contracts closer to the desired time period as each of the
shorter contracts gains in liquidity. For example, you could acquire the strip just discussed,
hold it for the first three-month period and roll it over into a new 12-month strip, and keep
doing this until the desired period is attained, say, three years from now. Such hedging with
a short-term futures contract that is subsequently replaced with other contracts is referred
to as a stack.
Finally, it has become common to combine interest rate hedges with currency hedges
to provide interest rate protection in a particular currency. For example, a eurobanker in
France may be faced with needing to guarantee a French customer an interest rate for a
future three-month loan in Swiss francs. To do so, the banker would lock in the future
eurodollar interest rate with a eurodollar futures contract, and then couple that with both a
forward contract to buy Swiss francs at the time the loan is made and a forward contract to
sell Swiss francs three months later, when the loan is repaid.
All of the hedging contracts discussed to this point essentially obligate the two parties to
exchange something in the future. The eurodollar interest rate option, on the other hand,
gives one party the right, but not an obligation, to buy or sell a financial asset under a set of
prescribed conditions, including the relevant interest rate. As is the case with currency
options, there are two types of transactions, puts and calls. The buyer of a eurodollar call
option obtains the right to purchase a eurodollar time deposit bearing a certain interest rate
(e.g., 8 percent) on a specific date. This option will cost the buyer an up-front price called
the option premium. If the market interest rate is above 8 percent, then the holder of the
call option can choose not to exercise the option, place her funds in an account paying the
higher rate of interest, and simply lose the up-front premium. Should the market rate be
below 8 percent, then the buyer of the call will exercise the option and acquire the financial
instrument bearing the higher interest rate. The buyer of the call is thus insured against a
fall in the interest rate (without giving up the option of depositing at a higher rate later),
and the up-front premium is the cost of the insurance policy. The higher the likelihood that
interest rates will fall, the greater the likelihood that the option will be exercised and the
higher the up-front premium.
The investor who purchases a eurodollar put option acquires the right to sell a euro-
dollar time deposit (acquire eurodollars) to the writer of the option contract for a specified
interest rate at a future date. Again, should the spot rate on the date in question be above
the contracted rate, the option will be exercised and the recipient of the eurodollar funds
will have been protected against a rise in the cost of borrowing. On the other hand, if the
lending rate is less than the contract rate on the contract date, the purchaser of the put con-
tract will simply choose not to exercise the contract and will obtain the necessary funds at
Eurodollar Interest
Rate Options
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the lower market rate. The premium on the put option is thus the cost of insuring that the
borrower does not end up paying a higher borrowing rate.
In both the case of a put and that of a call, eurodollar interest rate options contain an
asymmetrical risk profile in that the purchaser can always choose not to exercise the option
if it is not to his or her advantage. The writer of the option contract thus bears all the risk
of an interest rate change and charges an option premium to compensate for that risk. In
the forward, future, and swap arrangements discussed previously, both the writer and the
buyer of the contract can potentially lose, depending on the nature of the interest rate change
(symmetrical risk profile). The result of this risk difference implies that eurodollar interest
rate options are most appropriate when expectations regarding interest rate changes on a
given instrument are nonsymmetrical. For example, if an investor in floating-rate securities
wants to ensure only against a likely fall in the market rate, purchasing a eurodollar call
option effectively places a floor under the interest rate. Similarly, if the financial outlook
suggests that interest rates may rise, the borrower wishing to protect herself against a rise in
the lending rate can hedge by purchasing eurodollar put options. In like manner, a financial
lender with a fixed-cap mortgage in place could protect himself against a rise in the market
rate above the interest rate cap by purchasing put contracts in eurodollars. In similar fashion,
lenders holding floating-rate notes guaranteeing never to pay less than some floor rate can
protect themselves against falling rates by purchasing eurodollar interest rate call options.
Caps, floors, and collars. The standard options interest rate derivatives just discussed
are similar to futures in that they are traded in the same financial centers in standardized
three month contracts in $1 million face-value units, with expiration dates in March, June,
September, and December. Option contracts for longer periods of time can be constructed
by combining several individual option contracts, as was done with futures contracts. The
multiperiod hedge over several interest rate periods is essentially a strip of put or call
options which provides a cap or a floor, that is, limits, on a floating interest rate. More spe-
cifically, a cap is a contract in which the seller agrees to compensate the buyer whenever
the interest rate in question exceeds the contracted “ceiling rate” throughout a medium- or
long-term financial transaction. As is the case with the futures contract, the buyer of the
cap pays a premium (generally up-front) to the seller for the insurance against having to
pay more than the contracted rate throughout the loan period. If, on the other hand, interest
rates fall below the contracted rate, nothing takes place, because this is another example
of an asymmetric risk contract. Take, for example, the hypothetical case of Small and
Company. Small has arranged to borrow $10 million for two and a half years at an assumed
six-month LIBOR of 7 percent. To guarantee that the company will not have to pay more
than 7 percent in each of the four subsequent six-month periods, the financial officer
purchases a cap, contracted at a 7 percent ceiling rate for which he pays a premium of, say,
0.3 percent (30 basis points) of the $10 million being financed up front. Should LIBOR rise
above 7 percent in any of the subsequent loan periods, the seller of the cap will pay Small
and Company the difference between the cost of the six-month loan at current LIBOR and
the 7 percent ceiling rate in the cap. Should the interest rate fall to 6.8 percent, nothing
takes place between the contracting parties because this contract covers only where the
interest rate rises above 7 percent. It is not uncommon to see an initial floating-rate loan
contract carry an interest rate provision in which the contracting parties agree that the loan
rate will never exceed a certain level, whatever happens to LIBOR. A floating-rate contract
with a built-in interest ceiling is referred to as a cap-floater.
Similarly, like a strip of eurodollar call options, a floor is a contract that establishes an
interest rate under which the financially contracted rate cannot fall for a series of future
periods. For example, Ms. Jones has just contracted to lend $5 million to the Thompson
Company for four years at six-month LIBOR, which at the time of the loan is at 7½ percent.
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To protect herself from earning less than 7½ percent should future LIBOR decline, Jones
purchases a floor contract for a premium of 0.4 percent (40 basis points) of the initial loan
amount, which fixes the floor at 7½ percent. Should LIBOR fall below 7½ percent in any
of the seven future loan periods, the difference between market LIBOR and the contracted
rate of 7½ percent will be paid by the seller of the floor. Jones is thus protected against
earning anything less than 7½ percent. In both of these cases a floating-rate instrument has
been modified into a fixed-rate instrument through use of the cap or floor contract. Finally,
the simultaneous purchase of both a cap and a floor creates a collar. In this instance the
borrower’s rate cannot rise above a certain rate, but neither can it fall below a certain inter-
est rate level. Caps, floors, and collars are similar to combinations of several short-term put
and call options and can therefore be traded like other financial assets.
Following on the success of caps, it did not take financial markets long to develop the
options on swaps derivative. These instruments offer an enormous amount of flexibility in
corporate finance transactions. Just as you would expect, these financial contracts give the
buyer the option to enter into a future swap or the right to cancel a future swap. In the first
case (sometimes referred to as a “swaption”), purchasing a call option gives the buyer the
right to receive a fixed rate in a swap and pay a floating rate. Purchasing a put option gives
the buyer the right to pay a fixed rate in the swap and receive a floating rate. In contracting
for the option to cancel a swap, buying a call option (a callable swap) gives the side paying
a fixed and receiving a floating rate the right to cancel. In purchasing a put option to cancel
a swap (a putable swap), the buyer paying the floating rate and receiving the fixed rate has
the right to cancel.
While commodity futures and options have existed for a long time and the derivative mar-
kets in currency and interest-bearing instruments have been exploding over the past two
decades, international equity derivatives have started to be utilized relatively recently. In
many countries such as the United States the equity option has existed domestically for
many years, but it is only recently that international options and swaps have become wide-
spread. With an equity swap, an investor can swap the returns on a currently owned equity
to another investor for a price. As financial markets have globalized, it is increasingly
common to find investors in one country contracting with market insiders or agents in
another country to buy and hold equities and pass on to the foreign investor any gains and
losses associated with the equity package for an agent’s fee. This derivative allows the
international investor to participate in a foreign equity market without having to pay local
market execution fees or having to be concerned about the risk of being unfamiliar with
local insider trading practices. It also protects the identity of the foreign investor. Thus, as
in the other derivative markets, the equity derivatives serve to assist the global investor in
the management of risk.
Options on Swaps
Equity Financial
Derivative
CONCEPT CHECK 1. Why would a potential borrower be inter-
ested in an interest rate futures contract?
Would this person sell or buy a futures con-
tract? Briefly explain.
2. Suppose the settle price of an interest rate
futures contract on the Chicago Mercantile
Exchange is 93.62. What is the yield on this
contract?
3. Suppose that, in March, you hold a call
option for May on a eurodollar time deposit
at 6 percent. If the interest rate in May is 5
percent, would you exercise your option?
Why or why not?
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THE CURRENT GLOBAL DERIVATIVES MARKET
Futures have been traded on a wide variety of metals and agricultural commodities since
the middle of the nineteenth century in the United States (and several centuries earlier in
other parts of the world). However, in roughly the past 30 years, there has been monu-
mental growth in the global use of foreign currency, interest rate, and equity derivatives.
Why has this development taken place? Very simply, the participants in the international
financial markets have found that the use of financial derivatives could increase their
returns and/or lower their risk exposure. They can literally unbundle and alter their expo-
sure to the foreign exchange risk, interest rate risk, and price risk embodied in assets and
liabilities. International investors can trade away the risks they are not comfortable with in
exchange for a risk exposure more suitable to their personal tastes and finances. Inasmuch
as different people are exposed to different types of risk, have different skills in assessing
risk, have widely differing capacity to absorb risk, and have different risk preferences,
the evolution of these derivatives has worked to make the global financial markets more
efficient. However, as was apparent in the global financial crisis of 2007–2008, these
instruments cannot eliminate risk, even though they do work to reassign it among various
market participants.
Table 5 and Figure 3 provide dramatic evidence of the rapid growth from 1987 to 2014
of a variety of derivative financial instruments available in world markets. The data origi-
nate from the BIS, and the dollar values refer to notional values, or reference amounts
based on the gross values of contracts. Part A of Table 5, “Exchange-traded instru-
ments,” indicates that the stock of interest rate futures rose from $488 billion in 1987 to
$25,348 billion in 2014, which works out to an annual average growth rate of 15.8 percent.
Likewise, interest rate options grew rapidly, from $123 billion in 1987 to $31,874 billion
in 2014, an annual average growth rate of 22.9 percent. The other components of Part A
are smaller in size, but stock market index futures and options both had rapid annual aver-
age rates of growth (18.0 percent for stock market index futures and 21.7 percent for stock
market index options). Part B of Table 5 provides data on “Over-the-counter instruments,”
TABLE 5 Values of Selected Global Derivative Instruments, Ends of Various Years, 1987–2014 (billions of dollars)
1987 1990 1994 1998 2002 2005 2010 2014
A. Exchange-Traded Instruments $730 $2,291 $ 8,863 $13,932 $ 23,810 $ 57,816 $ 67,947 $ 64,843
Interest rate futures 488 1,455 5,778 8,020 9,951 20,709 21,013 25,348
Interest rate options 123 600 2,624 4,624 11,760 31,588 40,930 31,874
Currency futures 15 17 40 32 47 108 170 234
Currency options 60 57 56 49 27 66 144 143
Stock market index futures 18 69 128 291 326 803 1,128 1,572
Stock market index options 28 94 238 917 1,700 4,543 4,560 5,671
B. Over-the-Counter Instruments 866 3,450 11,303 80,317 141,679 297,670 601,046 630,149
Interest rate swaps 683 2,312 8,816 36,362 79,120 169,106 364,377 381,028
Currency swaps 183 578 915 2,253 4,503 8,504 19,271 24,204
Interest rate options 0 561 1,573 7,997 13,746 28,596 49,295 43,591
Note: Exchange-traded instrument components may not sum to totals because of rounding; over-the-counter components are not all-inclusive.
Sources: Bank for International Settlements, 69th Annual Report (Basle, Switzerland: June 7, 1999), p. 132; International Monetary Fund, “International Capital
Markets: Developments, Prospects, and Key Policy Issues,” September 1999, tables 2.6 and 2.7; Bank for International Settlements, BIS Quarterly Review, March
2001, pp. 81, 83; March 2004, pp. A99, A104; March 2007, pp. A103, A108; March 2012, pp. A131, A136; June 2015, pp. A141, A146.
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meaning instruments whose contracts are negotiated through brokers and individual finan-
cial institutions rather than on organized exchanges. From the base of $866 billion in
1987, these instruments rose to a notional value of almost $630 trillion in 2014—this is
an annual average growth rate of 27.6 percent. Figure 3 plots the annual figures from 1987 to
As discussed in the text, derivative instrument activity has been increasing very rapidly since the late 1980s. Such growth reflects the increasing
interdependence of worldwide financial markets as well as the emergence of new financial instruments.
Sources: Bank for International Settlements, 69th Annual Report (Basle, Switzerland: June 7, 1999), p. 132; International Monetary Fund,
“International Capital Markets: Developments, Prospects, and Key Policy Issues,” September 1999, tables 2.6 and 2.7; Bank for International
Settlements, BIS Quarterly Review, March 2001, pp. 81, 83; March 2004, pp. A99, A104; March 2007, pp. A103, A108; March 2008, pp. A103,
A108; March 2010, pp. A121, A126; March 2012, pp. A131, A136; March 2013, pp. A141, A146; June 2015, pp. A141, A146.
FIGURE 3 Values of Global Derivatives, 1987–2014
0
100000
150000
50000
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
200000
250000
350000
300000
400000
450000
500000
550000
600000
650000
700000
750000
800000
Year
Exchange-traded instruments
Over-the-counter instruments
Billions of U.S. dollars
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2014 for exchange-traded instruments and over-the-counter derivatives. In a general over-
view, over-the-counter instruments increased rapidly from 1987 through 2007, declined
slightly in 2008, and hit another peak in 2013 before declining in 2014. Exchange-traded
instruments reached a peak in 2007 and since that time have dropped somewhat below the
2007 figure.
Some of the recent growth in global finance can be attributed to new developments in
the institutional aspects of lending. Individual bank lending to individual customers, which
has been the banking norm for years, has been complemented recently by the develop-
ment of the underwriting and syndication of financial credits and the subsequent trading
of these credits in the financial markets, generally between banks. The syndication of the
lending process occurs when a highly structured group of well-capitalized banks agree to
provide a particular loan and then sell shares of the credits to a wider range of smaller and
less well-informed banks. In the eurodollar markets the loan may thus originate in one
country, while the ultimate lenders or holders of the loan credits reside in other countries.
Administratively, it is typical for the syndicate to appoint a manager or agent who interacts
with the borrower, thus retaining in part the banking principal–lending-agent relationship.
The formal syndication loan agreement can take the form of a direct loan syndicate or a
loan participation syndicate. In the first case, the direct loan syndicate, participant banks
sign a common loan agreement that serves as the lending instrument. The participating
banks essentially are co-lenders in this form of syndication. In the second case, that of a
participation syndicate, a lead bank usually executes the loan instrument with the borrower
and then syndicates the loan by entering into participation agreements with other banks. In
this case, the participating banks are not formal co-lenders. Syndicated loan arrangements
protect the borrower from the undue influence of any one bank and, at the same time, pro-
tect a single bank from being excessively exposed to the credit risk associated with a par-
ticular borrower. This latter characteristic is of particular value to international lenders who
wish to diversify risk such as that associated with lending to sovereign borrowers. Perhaps
even more importantly, in the rapidly expanding world of global finance, traditional finan-
cial links are becoming less and less important. Syndication permits the managing or agent
bank to obtain funds for a particular borrower faster, in larger amounts, and likely at a
lower cost than does the traditional single-bank approach. Indeed, syndication is the most
prevalent way of lending in foreign markets whenever the borrowing amounts are large
and the lending period exceeds 12 months (Dufey and Giddy, 1994, p. 250). Growth in the
international financial markets has thus been fostered not only by the development of new
financial derivative instruments but also by changes in the forms of institutional lending
that have increased the efficiency of international finance.
SUMMARY
This chapter provided a general profile of the markets and
instruments that currently exist for facilitating financial capital
flows among nations. International bank lending and interna-
tional transactions in bonds and stocks are now huge in size and
take place in financial centers worldwide. Within these markets,
a wide variety of specific instruments, including many differ-
ent kinds of derivatives, has emerged. These instruments enable
international investors, particularly in eurocurrency markets, to
unbundle the various aspects of risk associated with the instru-
ments in order to better distribute and hedge the risks. A key
aspect of modern lending technology is the ability to separate
the currency of denomination of a particular financial instru-
ment from its respective jurisdiction. Thus, the characteristics
of a eurocurrency instrument can be separated or unbundled and
repackaged in a manner that is more profitable and/or contains
a risk profile that is more suitable to the individual investor.
The wide array of instruments for dealing with the risk associ-
ated with exchange rates, interest rates, and equity prices clearly
appears to be playing an important role in improving the effi-
ciency of rapidly globalizing international financial markets.
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KEY TERMS
basis points
bond underwriters
derivatives
direct loan syndicate
emerging market funds
eurobanks
eurobond markets
eurocurrency market
eurodollar call option
eurodollar cross-currency
interest rate swap
eurodollar interest rate futures
eurodollar interest rate option
eurodollar interest rate swap
eurodollar market
eurodollar put option
eurodollar strip
foreign bond markets
future rate agreement (FRA)
global funds
gross international bank lending
international bank lending
international bond market
international funds
international portfolio
diversification
loan participation syndicate
London Interbank Offered Rate
(LIBOR)
maturity mismatching
mutual funds
net international bank lending
options on swaps
regional funds
traditional foreign bank
lending
QUESTIONS AND PROBLEMS
1. What factors have been primarily responsible for the growth
of the eurodollar market? Should growth in eurodollars be
of concern to the U.S. Federal Reserve? Why or why not?
2. You notice in The Wall Street Journal that the interest rate
in the U.S. money markets is 7½ percent and the interest
rate in London is 9 percent. Would you expect the pound to
be at premium or discount? Why?
3. In addition to the interest rate information in Question 2,
you also note that the deposit rate in the United States
is 6½ percent and the lending rate is 8½ percent. Where
would you expect the eurodollar deposit and lending rates
to be? Why? What would you expect to happen to any dif-
ference between the above pairs of interest rates if U.S.
local tax rates on international financial activity were
reduced? Why?
4. What would you estimate the eurodollar deposit rate to
be if the domestic U.S. dollar deposit rate is 6½ percent, the
reserve requirement on time deposits is 2 percent, and the
combined cost of taxes and deposit insurance amounts to
10 basis points (1∕10 percent)?
5. Explain in terms understandable to a noneconomist why,
for example, when interest rates rise sharply, the subse-
quent headline in the newspaper may say “Bond Prices
Plunge in Active Trading.”
6. Why can a country’s nominal interest rate never be nega-
tive? Why can a country’s real interest rate indeed be
negative? If a country has a negative real rate, do you think
that this suggests that the country is not well integrated into
world financial markets? Explain.
7. Because futures contracts are short-term, three-month con-
tracts for fixed value, how can you use the futures mar-
ket to hedge against longer-term risk for larger amounts of
eurodollars?
8. Financial institutions have found themselves in short-run
financial liquidity problems because of overexposure in the
futures markets. Explain how this could happen if you took
a “long position” in a foreign currency or a “long hedge” in
a eurodollar deposit or CD.
9. Briefly explain the benefits that accrue to each of the con-
tracting parties in a eurodollar interest rate swap. What is
the difference between a normal swap and a basis swap? If
a swap contract is signed and one of the parties wishes to
return to his or her initial market position, for example, a
floating rate, what, if anything, can be done?
10. Why are futures contracts defined as symmetrical contracts,
while options, caps, and floors are described as asymmetri-
cal contracts? How is the asymmetry dealt with in the latter
type of contracts?
11. Explain how loan syndication has fostered international
financial growth, particularly with regard to loans to gov-
ernments (sovereign loans). What is the difference between
a participation syndicate and a direct loan syndicate?
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CHAPTER
LEARNING OBJECTIVES
LO1 Show how the supply and demand for money can affect a country’s
balance of payments under a fixed exchange rate.
LO2 Show how the supply and demand for money can affect a flexible
exchange rate.
LO3 Describe how other financial assets besides money can influence
exchange rates and international payments positions.
LO4 Explain how a changing exchange rate can initially overshoot its new
equilibrium value.
THE MONETARY AND
PORTFOLIO BALANCE
APPROACHES TO
EXTERNAL BALANCE
22
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INTRODUCTION
In early 2015, a huge amount of funds left the Eurozone in order to seek higher returns. The funds
headed most importantly, though not exclusively, to the United States. The principal reason was
that the European Central Bank, the official monetary authority of the Eurozone, was keeping
interest rates very low (there were even some negative deposit rates), while a general expecta-
tion was that the Federal Reserve would soon be exerting upward pressure on U.S. interest rates.
Because of the cash outflow, the euro had fallen by 22 percent in less than a year, from $1.39 per
euro to $1.05 per euro. Of course, any weakening of the euro could lead to expectations of a fur-
ther fall, adding to the downward pressure on the currency. Denmark also received a considerable
inflow of funds from the Eurozone and therefore reduced its interest rate four times in early 2015
so as to ameliorate the appreciation of its currency, the krone, against the euro.1
Building on the previous exchange rate and international monetary material in Chapters 20
and 21, the next two chapters will introduce the reader to additional frameworks and ter-
minology for understanding the determination of exchange rates. Increasingly important
in that determination are the monetary and financial adjustments associated with the glo-
balization of capital flows. These frameworks also provide the means for examining the
effect of policy changes and other exogenous shifts on domestic and foreign financial
markets. In this chapter, we examine two broad, aggregate approaches to the determina-
tion of a country’s balance-of-payments (BOP) position and the exchange rate. These
approaches emphasize the role of money and international asset exchanges as the primary
forces at work in the foreign exchange markets, reflecting the much greater importance in
recent years of financial transactions than trade flows in exchange market activity. More
specifically, we study the monetary approach to the balance of payments and the exchange
rate, which focuses on how a BOP deficit or surplus or a change in the spot exchange
rate reflects an imbalance in a country’s demand for and supply of money. The second
approach, called the portfolio balance approach (or the asset market approach), moves
beyond money alone and postulates that changes in a country’s BOP position or exchange
rate reflect changes in the relative demands and supplies of domestic and foreign financial
assets. The chapter ends with a consideration of the phenomenon of “overshooting” in
exchange markets and how this phenomenon contributes to exchange rate instability. In
overview, an important result of looking at the monetary and portfolio balance approaches
is that insights can be obtained as to how asset movements influence exchange rates and
why exchange rates can demonstrate considerable volatility in the real world. A discus-
sion of empirical work pertaining to these two approaches is found in the appendix to
this chapter.
THE MONETARY APPROACH TO THE BALANCE OF PAYMENTS
The monetary approach to the balance of payments emphasizes that a country’s bal-
ance of payments, while reflecting real factors such as income, tastes, or factor produc-
tivity, is essentially a monetary phenomenon. This means that the balance of payments
should be analyzed in terms of a country’s supply of and demand for money. In the inter-
national payments context, attention is principally focused on category III in the BOP
accounting framework that records changes in official reserves. If a country has a BOP
deficit (i.e., an official reserve transactions deficit), then there is an outflow of interna-
tional reserve assets. As we shall see, an outflow of international reserves implies that the
country’s supply of money exceeds its demand for money. Similarly, an official reserve
International
Interdependence
of Money
1Tommy Stubbington, “Torrent of Cash Exits the Eurozone,” The Wall Street Journal, March 23, 2015, pp. A1, A8.
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transactions surplus implies that the country’s money supply is less than its demand. If we
are concerned about forces causing a BOP deficit or surplus, we must focus on the supply
of and demand for money.
A country’s supply of money can be viewed through the following basic expression:
Ms = a(BR + C) = a(DR + IR) [1]
where: Ms = money supply
BR = reserves of commercial banks (depository institutions)
C = currency held by the nonbank public ]
central bank
liabilities
a = the money multiplier
DR = domestic reserves
IR = international reserves]
central
bank assets
The monetary approach utilizes either the M1 or M2 definitions of the money supply.
M1 is traditionally defined as currency held by the nonbank public (i.e., held outside finan-
cial institutions), traveler’s checks, and all checkable deposits in financial institutions. M2
includes the components of M1 but principally adds savings and time deposits (except for
very large time deposits—of $250,000 or more in the United States) and a few other items.
(This distinction between M1 and M2 per se is not important for our development of the
basic monetary approach.) The amount of deposits in turn is a function of the amount of
reserves of commercial banks (and other depository institutions such as savings and loan
associations and credit unions) and the money multiplier.
The money multiplier reflects the process of multiple expansion of bank deposits. For
example, if the required reserve ratio against deposits is 10 percent, an initial deposit of
$1,000 in a bank creates $900 of excess reserves because only 10 percent (or $100) is
required to be held by the commercial bank. The $900 of excess reserves can be lent out,
which, after being spent by the loan recipient, will be redeposited in another (or the same)
bank, which will generate 0.90 times $900 of new excess reserves (or $810) in the second
bank. This $810 can then be lent, which keeps the process going. In the end, the original
$1,000 gets “multiplied” by the money multiplier of 1/r, where r is the required reserve
ratio. In this example, with r of 10 percent, the original $1,000 deposit can lead to $1,000 
× (1/r) = $1,000 × [1/0.10] = $10,000 of “money.” The money multiplier in the example
is thus (1/r) or 10. However, this simple expression is unrealistic, as the money multiplier
must be adjusted for such factors as leakages of deposits into currency, different required
reserve ratios on savings and time deposits than on checkable deposits, and the holding of
excess reserves by banks. (See any standard money and banking text for elaboration.) We
are not interested in the mechanics, however, but in the fact that the a term in expression
[1] reflects a general money multiplier process.
The sum of reserves held by banks plus currency outside banks (BR + C) is usually
called the monetary base. This base originates on the liabilities side of the balance sheet
of the central bank (the Federal Reserve in the United States). Currency is issued by the
central bank, and part of the reserves of banks are held by the central bank (the other part
is held as vault cash by the depository institutions). Thus, any increase in assets held by
the central bank permits an increase in these liabilities and thereby permits an increase in
the money supply. On the asset side of the central bank, the most important assets for our
purposes are (1) loans and security holdings by the central bank, called domestic credit
issued by the central bank or domestic reserves; and (2) international reserves held by
the central bank, which consist of foreign exchange holdings and holdings of any other
internationally acceptable asset such as gold.
The Supply of Money
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It is important to understand the relationships between these assets (domestic and inter-
national reserves) and the money supply. Suppose that the central bank purchases govern-
ment securities (increasing domestic assets or extending domestic credit) in open market
operations. (During the recovery from the 2007–2009 Great Recession, the Federal Reserve
also purchased private mortgage-backed securities in addition to government securities.)
This will increase the reserves of commercial banks, lead to new loans, and thereby ulti-
mately increase the money supply by a multiplied amount. In addition, suppose that the
central bank purchases foreign exchange from an exporter; this acquisition of international
reserves also increases the money supply because the exporter will deposit the central
bank’s check into a commercial bank or other depository institution and set in motion
the multiple deposit expansion process. Thus, increases in central bank reserves permit a
multiple expansion of the money supply, and, analogously, decreases in these reserves will
lead to a multiple decrease in the money supply.
Consider now the demand for money. Remember that the term demand for money does
not mean the demand for “income” or “wealth.” Rather, it refers to the desire to hold
wealth in the form of money balances (basically either currency or checking accounts,
using the M1 definition of money) rather than in the form of stocks, bonds, and other finan-
cial instruments such as certificates of deposit. The demand for money (L) can be specified
in the following general form:
L = f [Y, P, i, W, E(p), O ] [2]
where: Y = level of real income in the economy
P = price level
i = interest rate
W = level of real wealth
E(p) = expected percentage change in the price level
O =  all other variables that can influence the amount of money balances a
country’s citizens wish to hold
What are the predicted relationships between Y, P, i, W, and E(p) (the independent
variables) and L?
We begin with the influence of the level of income. The relationship between Y and L is
expected to be positive, reflecting the transactions demand for money. As your income
rises, you will want to spend more on consumption. Thus, more money needs to be held to
finance these additional transactions.
A positive relationship is also expected between P and L, because a higher price level
means that more money, that is, a larger cash balance, is required to purchase a given
amount of goods and services.
The influence of the interest rate on the demand for money is negative. If the interest rate
rises, a smaller proportion of wealth is held in the form of money balances (currency and
checking accounts in financial institutions) and more in the form of other assets, which are
now more attractive. (Currency, of course, does not pay interest. Many checking accounts
also do not pay interest; those that do pay interest pay lower rates than certificates of
deposit or bonds.) Similarly, a fall in the interest rate will induce people to hold more of
their wealth in the form of money, because the opportunity cost of holding money balances
has fallen.2 This relationship of the interest rate to the demand for money is often called the
The Demand for
Money
Real Income
Price Level
Interest Rate
2When we speak of “the interest rate,” we are referring to a general average level of interest rates in the economy.
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IN THE REAL WORLD:
RELATIONSHIPS BETWEEN MONETARY CONCEPTS
IN THE UNITED STATES
An examination of a balance sheet of the Federal Reserve
banks provides an opportunity to illustrate the various mon-
etary concepts discussed in the text. This will be done by
examining a balance sheet for December 31, 2014.
Before turning to the balance sheet, we first note that the
average reserves of all depository institutions in the United
States at the end of December 2014 were $2,574.8  billion.
The amount of currency held by the nonbank public was
$1,341.6  billion. Hence, the monetary base obtained by
summing these two components was $3,916.4 billion.
(There are other minor adjustments employed by the
Federal Reserve in making the actual calculation that we
are ignoring here.) Required reserve ratios against check-
able deposits were 0 percent for the first $14.5 million,
3  percent for $14.5  million to $103.6 million, and 10 percent
for more than $103.6 million. The money supply (M1) in
December 2014 was $2,914.5 billion. The money multiplier
was thus $2,914.5 billion divided by the monetary base of
$3,916.4  billion or 0.74. It is highly unusual historically
for the money multiplier to be less than 1.0. This suggests
that banks are holding considerable excess reserves, likely
caused by a widespread risk aversion in the financial sector
that has been induced by the recent financial crisis.
Turning to the central bank, the Federal Reserve’s bal-
ance sheet on December 31, 2014 is shown in summary
form in Table 1. On the liabilities side of the balance sheet,
we see that banks and other depository institutions held
$2,378.0  billion on deposit at the Federal Reserve. The
item “Federal Reserve notes” represents currency issued by
the Fed. With respect to assets, the loans and open mar-
ket securities figure of $4,473.6 billion represents domestic
credit issued by the Fed or domestic reserves. (However,
within this broad category, there are $20.9 billion of for-
eign currency denominated investments and $1.5 billion
of swaps of liquidity with other countries’ central banks,
which are technically international reserves rather than
domestic reserves.) The gold and SDR (Special Drawing
Rights) accounts represent holdings of these international
assets. (These assets are discussed in the last chapter in this
book. Also, not all U.S. international reserves are held by
the Federal Reserve—some are held by the U.S. Treasury.)
The policy actions that were taken by the Federal Reserve
to address the global financial crisis and the slow recovery
from it resulted in some significant changes to its balance
sheet. For example, the total assets and liabilities quintupled
between April 2007 and December 2014. Loans and securi-
ties held by the Fed greatly increased as the Fed purchased
mortgage-backed securities and purchased government
securities in its program of quantitative easing. The goal of
the new policies was to relieve credit disruptions and restore
a flow of credit to households and businesses. An interna-
tional component was added with the establishment of the
previously-mentioned liquidity swap lines with foreign cen-
tral banks (providing dollars to foreign central banks which
are then loaned to banks in their countries). Provisions were
also made for central bank credit to primary security dealers
and money market mutual funds.
Sources: Board of Governors of the Federal Reserve System,
Statistical Release H.4.1, Factors Affecting Reserve Balances,
January 2, 2015 and Federal Reserve Statistical Release  H.6,
Money Stock Measures, October 1, 2015, both obtained from www.
federalreserve.gov.
Assets Liabilities and Capital Accounts
Gold certificates $ 11.0 Federal Reserve notes $1,298.7
SDR certificates 5.2 Securities sold under repurchase agreements 509.8
Coin 1.9 Deposits of depository institutions 2,378.0
Loans and open market securities (including foreign U.S. Treasury deposits 223.5
currency investments and central bank liquidity swaps) 4,473.6 Other deposits and liabilities 30.6
Other assets 6.1 Capital paid-in and surplus 57.1
Total assets $4,497.8 Total liabilities and capital $4,497.8
Sources: Board of Governors of the Federal Reserve System, The Federal Reserve Banks: Combined Financial Statements as of and for the Years
Ended December 31, 2014 and 2013 and Independent Auditors’ Report, obtained from www.federalreserve.gov.
TABLE 1 Balance Sheet, Federal Reserve Banks, December 31, 2014 (billions of dollars)

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“asset” demand for money. It reflects not only the opportunity cost phenomenon discussed
above but also the fact that, in order to undertake risk, wealth holders must be compen-
sated. When the interest rate rises, people move out of money balances and into more risky
assets because the compensation for doing so has increased.
An additional reason hypothesized by economists for the negative influence of the inter-
est rate on money demand involves the relationship between interest rates and bond prices.
(For elaboration, consult money and banking or intermediate macroeconomics texts such
as Froyen, 2005, chaps. 7 and 22.) As noted in the previous chapter, interest rates and bond
prices are inversely related to each other. Briefly, because a bond usually pays a fixed money
amount to the bondholder, say, $60 per year, the price of the bond in the bond markets deter-
mines the “yield” or interest rate that the holder of the bond is earning. This interest rate will
be in line with other interest rates in the economy (because of asset market competition). To
simplify, if the market price of the bond you hold is $600, then your receipt of $60 per year
of interest is a 10 percent return (=$60/$600). However, if the bond price rises to $800, then
your realized interest rate has fallen to 7.5 percent (=$60/$800). Similarly, if the price of the
bond falls to $500, then the interest rate is 12 percent (=$60/$500).
In the context of the demand for money, suppose that financial investors have some
conception of a “normal” interest rate and that the current interest rate is at that level. (Of
course, different investors may have different views of what is the “normal” rate.) If the
interest rate now rises above that level, investors will expect that it will fall back toward
that level eventually. Because the rise in the interest rate means that there has been a fall in
bond prices, individuals are thus expecting bond prices to rise when the interest rate falls
back toward “normal.” With the expected rise in bond prices, bonds are now an attractive
asset to hold in comparison to money not only because of the higher interest rate but also
because of the expected capital gain from the higher bond prices. Hence, smaller money
balances will be desired. In the other direction, a fall in the interest rate below the normal
level leads to an expectation that the interest rate will rise back toward normal. In other
words, there is an expectation that bond prices will fall. In this situation, investors prefer
money to bonds if the expected capital loss from the falling bond prices is larger than the
interest return. Hence, the interest rate–bond price relationship gives us another reason for
an inverse relationship between the amount of money demanded and the interest rate.
The income level, price level, and the interest rate are thought to be the major influences
upon the demand for money, but the remaining independent variables can also have an
impact. With respect to W, real wealth, the influence on the demand for money is expected
to be positive because, as a person’s wealth rises, that person wants to hold more of all
assets, including money.
With respect to the expected inflation rate, E(p), the hypothesized relationship is nega-
tive. If you expect prices to rise, you realize that this inflation will mean a decline in the
real value of a constant nominal amount of money balances. In such a situation, there is
an incentive to substitute away from holding money and toward holding nonmoney assets
whose prices may rise with the inflation.
Finally, the O term is included to incorporate other influences on the demand for money.
The O term reflects institutional features of the economy such as the frequency with which
people receive paychecks. If you are paid weekly, your average money balances will be
smaller than if you are paid on a monthly basis. Another institutional feature would be the
importance of credit cards in the transactions network in the economy. The greater the rela-
tive importance of credit card transactions, the less money you need on hand on any given
Real Wealth
Expected Inflation Rate
Other Variables
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day. These institutional features are not thought to vary to any great extent, especially dur-
ing relatively short time periods.
A frequently used and simple formulation of the demand for money hypothesizes that
the general functional expression in [2] can be given the specific form of
L = kPY [3]
where P and Y are defined as above and k is a constant term embodying all other variables.
This simple formulation will sometimes be used later in our discussion.
The money market is in equilibrium when the amount of money in existence (the money sup-
ply) is equal to the amount of cash balances that the public desires to hold (money demand).
In the most general case, this means that equilibrium is determined by using expression [1],
the supply-of-money expression, and expression [2], the demand-for-money expression:
Ms = L [4]
or

Ms L
a(DR + IR) = a(BR + C) = f [Y, P, i, W, E( p), O ] [5]
Alternatively, we can write a simpler equation for monetary equilibrium by using expression
[3] for money demand:
Ms = kPY [6]
This expression is often used and explicitly specifies that money demand depends primar-
ily on the price level and the level of real income.
With this background, we now discuss the manner in which the monetary approach
to the balance of payments uses the relationships between the supply of and demand for
money in explaining BOP deficits and surpluses. Suppose that the exchange rate is fixed.
Consider a situation where, from an initial equilibrium between money supply and money
demand, the monetary authorities increase the supply of money by purchasing govern-
ment securities on the open market (i.e., an increase in DR). Because the money market
was originally in equilibrium, this expansionary monetary policy leads, because of the
subsequent increase in BR and/or C, to an excess supply of money. (In the other direction,
a decrease in the money supply would, other things equal, cause an excess demand for
money and would be a contractionary monetary policy.) When Ms is greater than L, the
cash balances people have on hand and in bank accounts exceed their desired cash bal-
ances. When this happens, people attempt to reduce their cash balances, an action that has
several important effects on the BOP.
First, the presence of excess cash balances means that individuals will spend more money
on goods and services. This bids up the prices of goods and services (i.e., bids up P).
Further, if the economy is not at full employment because of money wage rigidity or other
rigidities, the level of real income (Y) rises. In addition, if part of any new real income is
saved, the level of real wealth (W) in the economy increases. What is the consequence of
these potential impacts, other things equal, on P, Y, and W on the current account in the bal-
ance of payments? A rise in P will lead to larger imports as home goods are now relatively
more expensive compared to foreign goods; the rise in P will also make it more difficult to
export to other countries. In addition, the increase in Y induces more spending, and some of
this spending is on imports. Finally, increased wealth enables individuals to purchase more
Monetary Equilibrium
and the Balance of
Payments
Current Account
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of all goods, some of which are imports and some of which are goods that might otherwise
have been exported. Hence, the excess supply of money generates pressures leading to a
current account deficit.
The presence of the excess cash balances also has an impact on private capital flows in the
BOP. Because an alternative to holding cash balances is to hold other financial assets, some of
the excess cash balances will be used to acquire such assets. This purchase of financial assets
bids up their price and drives down the interest rate. At the same time, the purchase of finan-
cial assets will include the acquisition of some foreign financial assets since financial inves-
tors wish to hold a diversified portfolio. There will thus be a capital outflow to other countries,
with the end result being a tendency for a deficit to occur in the private capital account.
Given these effects on the current account and the private capital flows, it is obvious that
a country with an excess supply of money has a tendency to incur a BOP deficit (official
reserve transactions balance). The total effect on the current and private capital accounts
combined is a net debit position, so the official reserves account ( category III) in the bal-
ance of payments must be in a net credit position to finance the official reserve transactions
deficit (a decrease in IR). A way of summarizing these various reactions to the excess sup-
ply of money is to say that the excess supply causes individuals to switch to other assets
than money, including physical assets (goods) as well as financial assets, and that some of
these assets are foreign goods and financial assets. In turn, the acquisition of foreign goods
and financial assets results in a BOP deficit. Clearly, a policy prescription for ending the
deficit emerges from this discussion: Eliminate the excess supply of money by halting the
monetary expansion.
In the monetary approach to the balance of payments, however, a policy action may not
be necessary to eliminate the excess supply of money. Consider the changes we specified
earlier: (1) Y is rising; (2) P is rising; (3) i is falling; and (4) W is rising. What do these
four developments have in common? They all increase the demand for money. This point
is important because it means that, even without policy action, the initial excess supply
tends to be worked off because the demand for money will be rising. Further, the supply
of money itself will be decreasing. This decrease occurs because the BOP deficit reduces
the country’s international reserves due to the excess demand for foreign exchange (to buy
imports and foreign assets) at the fixed exchange rate. This reduction in reserves leads to a
decrease in the money supply. The central bank might temporarily offset the decrease in the
money supply (called “sterilization” of the money supply from the BOP deficit) by expan-
sionary open-market operations, but this would set the whole process in motion again and
the central bank would ultimately run out of international reserves. Thus, the conclusion of
the monetary approach is that an excess supply of money will set forces in motion that will
automatically eliminate that excess supply. When the excess supply has disappeared, the
balance of payments is back in equilibrium.
One complicating factor not addressed thus far in our discussion of the adjustment process
to the excess money supply is the role of the expected inflation rate, E(p). If the mon-
etary expansion by the authorities generates expectations that prices will increase, this will
reduce the demand for money. This reduction in money demand will, by itself, enlarge
the excess supply of money, in contrast to the other four determinants of the demand for
money. Hence, other things equal, the presence of the inflationary expectations will add
to the BOP deficit and will mean that the job to be performed by Y, P, i, and W is greater.
As these other determinants begin to work, however, the inflationary expectations should
dampen unless the monetary authorities continue to pump new money into the economy.
Private Capital Flows
Balance-of-Payments
Deficit
Expected Inflation Rate
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We have focused to this point on a broad formulation of the demand for money, wherein
we have specified five particular determinants of that demand. More traditional in text-
book formulations of the monetary approach is the simple demand-for-money equation of
expression [3]. In that simple context, if there is always full employment (and Y is therefore
fixed), the introduction of new money by the monetary authorities has only one impact if
k is assumed to be constant: The level of prices (P) will rise. (Economists call this simpli-
fied approach the “crude quantity theory of money.”) The result is a BOP deficit because
of inflation’s effect on the current account, and the BOP deficit will continue until the
excess supply of money is dissipated and prices have stabilized again. This basic model is
instructive for emphasizing the link between the money supply, money demand, the price
level, and the balance of payments, but it obviously leaves out other factors that influence
the demand for money.
It should be evident that the general adjustment process to an excess supply of money in
the monetary approach works in reverse when there is an excess demand for money. If,
beginning from an equilibrium position, the monetary authorities contract the money
supply, an initial excess demand for money occurs. Individuals hold smaller cash bal-
ances than they desire. They restore their cash balances by reducing spending on goods
and services, which implies that the demand for imports falls. Income also falls because of
the reduced spending, as does the price level (assuming that prices are somewhat flexible
downward). When prices fall, exports increase and imports decrease. Thus, the current
account moves into surplus. In addition, cash balances can be increased by selling off
holdings of financial assets, including some sales to foreign citizens. These sales lead to a
surplus in the private capital account in the balance of payments. With the official reserve
transactions balance thus being in surplus, international reserves will be flowing into the
country and expanding the money supply. The excess demand for money and the BOP
surplus will eventually be eliminated.
In overview of the monetary approach to the balance of payments under fixed exchange
rates, we see that it contains an automatic adjustment mechanism to any disturbances to
monetary equilibrium. If the process is allowed to run its course, disequilibria in the money
market and BOP deficits and surpluses will not exist in the long run. Any imbalances in the
balance of payments reflect an imbalance between the supply of and demand for money,
and these imbalances can be interpreted as part of an adjustment process to a discrepancy
between the desired stock of money and the actual stock of money.
Other Comments
CONCEPT CHECK 1. What happens to the size of the money mul-
tiplier if the required reserve ratio increases?
Why?
2. Why, other things equal, do increases in real
income, real wealth, and the price level increase
the demand for money, while increases in the
interest rate and the expected inflation rate
decrease the demand for money?
3. Explain why an excess supply of money in
a fixed exchange rate regime will lead to a
deficit in the balance of payments.
THE MONETARY APPROACH TO THE EXCHANGE RATE
To this point in the monetary approach, the analysis has assumed that the exchange rate is
fixed. With that assumption, attention was drawn to the possibility of a deficit or surplus in
the balance of payments. We now turn to the monetary approach to the exchange rate
when the exchange rate is free to vary. With a flexible exchange rate, BOP deficits and
surpluses will be eliminated by changes in the rate, but we need to examine the exchange
rate changes in the context of money supply and demand.
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Suppose that we begin from a position of equilibrium where Ms equals L. Now assume
that the monetary authorities increase the supply of money and thereby create an excess
supply of money. Remember that with an excess supply of money, the cash balances of indi-
viduals exceed the cash balances desired in connection with existing prices, real income,
interest rates, wealth, and price expectations. The result of this money supply increase is
that more spending by individuals occurs on goods and services and on financial assets
in order to get rid of the excess money supply. With the increase in spending, there are
increased imports, a possible decrease in exports as some such goods are now purchased
by home-country citizens, and an increase in purchases of financial assets from foreign
citizens. With a flexible exchange rate, these factors are all working to cause a depreciation
of the home currency. Hence, whereas a money supply increase under a fixed exchange rate
leads to a BOP deficit, the money supply increase under a flexible rate leads to an incipient
BOP deficit (i.e., there would be a BOP deficit if the exchange rate did not change) and
therefore to a fall in the value of the home currency relative to other currencies. This depre-
ciation is thus a signal that there is an excess supply of money in the economy.
As with a fixed exchange rate, the excess supply of money is only temporary if no fur-
ther money supply increases by the authorities are introduced. This is because the depre-
ciation itself causes Y (if the economy is below full employment) and P to rise (because
foreign demand for exports and home demand for import-substitute goods is rising). The
level of wealth will also rise when saving occurs out of any new real income. In addition,
the interest rate will fall due to increased purchases of financial assets. These changes
generate an increase in the demand for money, and, ultimately, the excess supply of
money is absorbed by the growing money demand. (If we take a crude quantity-theory-of-
money view, the only home variable that will be changing in the adjustment process will
be P, but this change too will ultimately restore equilibrium between money supply and
money demand.)
As in the fixed-rate analysis, a potentially disturbing factor is the existence of chang-
ing inflation expectations, E(p). If the inflation resulting from the depreciation generates
a rise in E(p), this would decrease the demand for money and, other things equal, would
add to the excess supply of money. Therefore, the increase in L generated by changes in
Y, P, W, and i needs to be greater than it would be if these increased inflation expectations
were absent.
It should be clear that an excess demand for money will generate just the opposite reac-
tions. With an excess demand (due to, say, a contraction of the money supply), individuals
find that their cash balances fall short of those desired. Hence, spending is reduced on
goods and services, and financial assets are sold to acquire larger cash balances. There is
then an incipient BOP surplus (i.e., there would be a BOP surplus if the exchange rate did
not change), and the result is an appreciation of the home currency. This appreciation also
eventually comes to a halt because of the adjustment process. In overview, the monetary
approach under a flexible rate parallels that of the fixed-rate case, except that the phrase
balance-of-payments deficit is replaced by the phrase depreciation of the home currency
and the phrase balance-of-payments surplus is replaced by the phrase appreciation of the
home currency.
It is instructive to extend the monetary approach with a flexible exchange rate to a two
country framework. A straightforward way to do this is to return to the simple money
demand–money supply formulation in expression [6]. Assuming that the time period is
long enough for full price adjustment and that absolute purchasing power parity holds (see
Chapter 20), and defining the exchange rate e as the number of units of home currency per
unit of foreign currency,
A Two-Country
Framework
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PA = ePB or e = PA/PB [7]
where PA is the price level in country A (the home country), PB is the price level in country B
(the foreign country), and e is the exchange rate expressed in terms of number of units of
A’s currency per 1 unit of B’s currency.
Now utilize expression [6] from page 537. For country A, we can write
MsA = kAPAYA [8]
where: MsA = money supply in country A
PA = price level in country A
YA = real income in country A
kA =  a constant term embodying all other influences on money demand in
country A besides PA and YA
A similar expression can be written for country B, where all letters refer to the same
items as in [8] but the subscript B is employed:
MsB = kBPBYB [9]
Now divide each side of the equality in [8] by the corresponding side of the equality in [9]:

MsA
MsB
=
kAPAYA
kBPBYB
[10]
Because (PA/PB) = e by [7], we can obtain

MsA
MsB
=
kAYA
kBYB
× e [11]
A final rearrangement leads to
e =
kBYBMsA
kAYAMsB
[12]
This last expression is instructive because it shows the impact of changes in both
eco nomies on the exchange rate.3 For example, if the money supply in country A (MsA)
increases and everything else is held constant, then e will rise by the same percentage
as does the money supply. This is a strict monetary approach interpretation where, for
example, a 10 percent rise in the home money supply will lead to a 10 percent depreciation
of the home currency. (Remember that a rise in e is a fall in the relative value of the home
currency.) We can also see from [12] that a rise in MsB will lead to a proportional fall in e
(an appreciation of the home currency). Thus, the monetary approach puts crucial impor-
tance on changes in relative money supplies as determinants of changes in the exchange
rate. If a country is “printing money” faster than its trading partners are, its currency will
depreciate; if a country is more restrictive with respect to its monetary growth than its trad-
ing partners, its currency will appreciate.
3The relationships in [12] can also be examined through growth rates. Designating a percentage change by a
dot (.) over a variable, expression [12] in terms of growth rates is
e⋅ = (Y⋅ B − Y

A) + (M

sA − M

sB) [12′]
There are no k terms in [12′] because kA and kB are assumed to be constant.
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CONCEPT CHECK 1. Assuming a flexible exchange rate, explain
the impact of an exogenous reduction in a
country’s money supply upon the value of the
country’s currency.
2. In the monetary approach, other things
equal, what will happen to the exchange rate
between the currencies of countries A and B
if there is greater income growth in country B
than in country A? Explain.
Expression [12] can also be used to indicate the effects of income changes in either
economy. Suppose that national income in country A (YA) increases. What effect will this
have on e? As should be clear, e will fall when YA rises (which increases A’s demand for
money), meaning that the home currency appreciates. Similarly, a rise in YB will cause a
depreciation of A’s currency. Hence, the implication in the monetary approach is that the
faster-growing country will see its currency appreciate.
THE PORTFOLIO BALANCE APPROACH TO THE BALANCE OF PAYMENTS
AND THE EXCHANGE RATE
The portfolio balance or asset market approach to the balance of payments and
the exchange rate extends the monetary approach to include other financial assets
besides money. This literature has primarily developed since the mid-1970s, and there
is an extremely large number of asset approach models in existence. We will provide
only a general discussion of these models, all of which emphasize a few overriding
characteristics:
1. Financial markets across countries are extremely well integrated. Thus, individuals
hold a variety of financial assets, both domestic and foreign.
2. Although holding both domestic and foreign financial assets, individuals regard
these assets as imperfect substitutes. In particular, additional risk is generally thought to
be associated with the holding of foreign financial assets. Hence, there is a positive risk
premium (RP) attached to foreign assets. This premium was discussed in the preceding
two chapters.4
3. Asset holders, with the objective of maximizing the return on their asset portfolio as
a whole, stand ready to switch out of one type of asset and into another whenever events
occur that alter the expected returns on various assets. These adjustments in portfolios have
implications for the balance of payments (under some fixity in the exchange rate) and for
the exchange rate (when the exchange rate has some variability).
4. In addition, this literature recognizes the importance of investor expectations regard-
ing future asset prices (including the price of foreign exchange, which can be free to vary).
The most common procedure hypothesized for the formation of expectations is that of
rational expectations, whereby forward-looking, utility-maximizing investors utilize all
available relevant information and a knowledge of how the economy and the exchange
markets work in order to form forecasts.
As with the monetary approach, the portfolio balance approach specifies the factors
that influence the demand for money, but it also specifies the factors that influence the
demand for other financial assets. The general framework of the approach is that there
Asset Demands
4It is possible that the risk premium could be negative if foreign assets are deemed to carry less risk than domestic
assets. We ignore this possibility in our discussion.
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5We follow much of the literature in assuming that home-country citizens do not hold foreign currency. This is a
simplification but it makes the analysis more manageable than would otherwise be the case.
are two countries (a home country and a foreign country), two moneys or currencies
(domestic money and foreign money), and two nonmoney securities, usually classified
as bonds (a home bond and a foreign bond). The domestic bond yields an interest return
id, while the foreign bond yields an interest return if. In this framework we consider
below the demand functions for the various assets by home-country citizens. We des-
ignate demand for home money as L, demand for the home bond as Bd, and demand for
the foreign bond as Bf. The typical home individual is assumed to be able to hold any of
these three assets.5
Before proceeding with the demand functions, however, it is useful to discuss the rela-
tionship specified in portfolio balance models concerning interest rates in the two coun-
tries. Because the models assume mobile capital across countries, the uncovered interest
parity relationship of the previous chapters is assumed to hold. With somewhat imperfect
substitution between domestic and foreign assets, an RP is also included. Therefore,
id = if + xa − RP [13]
where xa is the expected percentage change in value of the foreign currency. A positive xa
is an expected appreciation of the foreign currency and a negative xa is an expected depre-
ciation of the foreign currency. (Alternatively, a positive xa is an expected depreciation of
the home currency, and a negative xa is an expected appreciation of the home currency.)
The more formal specific definition of xa is
xa =
E(e) − e
e
= E
(e)
e
− 1 [14]
where E(e) is the expected future spot exchange rate (expected future home-currency price
of foreign currency). The risk premium RP, expressed as a positive percentage, is the extra
percentage compensation needed to induce the home investor to hold the foreign asset.
With RP positive, (if + xa) will be greater than id in equilibrium.
Let us now specify the demand functions of a typical home-country individual for the
three assets of home money, home bonds, and foreign bonds (a parallel set of demand
functions exists for foreign individuals). Starting first with the home individual’s demand
for domestic money, consider the general functional form in expression [15]. (Note: The
general framework described here is an adaptation of that presented in an important article
by William Branson and Dale Henderson, 1985.)

− − − + + +
L = f(id, if, xa, Yd, Pd, Wd)
[15]
where, in addition to the already-identified id,if, and xa,
Yd = home-country real income
Pd = home-country price level
Wd = home-country real wealth
Note that RP is not included separately in [15] because, with id = if + xa − RP from [13],
RP is a residual and its influence is already embodied in the id,  if, and xa terms. In this
expression, the plus or minus sign above each independent variable indicates the expected
sign of the relationship between the independent variable and the demand for home money.
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How do we explain the predicted signs of expression [15]? First, the negative sign for
the id is clear from preceding discussions in this chapter. For similar reasons, a rise in if will
induce the domestic citizen to stop holding as much domestic money and add to holdings
of foreign bonds. The influence of xa works in the same manner as does if, for a rise in xa
indicates that the expected return from holding the foreign bond (which is denominated in
foreign currency) has risen. The signs on real income, the domestic price level, and home
wealth are as discussed earlier in the monetary approach.
Next consider the demand for domestic bonds or securities by the domestic individual
(Bd). We write the demand for the asset as a function of the same independent variables:

+ − − − − +
Bd = h(id, if, xa, Yd, Pd, Wd)
[16]
These signs are consistent with the investor’s motivations as discussed earlier. A rise in
id will make domestic bonds more attractive because of their higher return. A rise in if
causes the individual to desire to hold the now higher-yielding foreign bonds instead of
domestic bonds, so if has a negative sign. A rise in xa acts in the same fashion. The wealth
variable behaves as previously indicated for home money demand, but the signs on Yd
and Pd are negative in the case of home bond demand. Why so? The reason is rooted in
the transactions demand for money. Ceteris paribus, a rise in income causes an increase
in the transactions demand for money; if total wealth is assumed not to change because of
the ceteris paribus assumption, then the investor will have to give up some holdings of
domestic bonds in order to acquire money. Similar reasoning produces a negative sign for
the domestic price level.
The demand function for the third and final asset, the foreign bond (Bf), is expressed in
domestic currency by multiplying Bf by e and is given as

− + + − − +
eBf = j(id, if, xa, Yd, Pd, Wd)
[17]
In this demand function, the signs for Yd,Pd, and Wd can be explained in similar fashion as
for the demand for domestic bonds. The signs on the interest rates are reversed from those
in the domestic bond situation—a rise in id causes the investor to shift out of foreign bonds
and into domestic bonds, and a rise in if (and in xa) causes bondholders to prefer the foreign
bond to the domestic bond.
Once these various demand functions are specified in the portfolio balance model, a
key feature of such models is evident: All three assets are substitutes for each other, and
therefore any change in any variable will set in motion a whole host of adjustments on the
part of investors. Further, it should be noted again that we have only discussed one-half of
the demand functions, because foreign citizens are also going to have demand functions for
the two bonds and for foreign money. Clearly, a complicated model can emerge.
Given the various demands for assets as indicated earlier, the asset model then specifies
supply functions for each asset. As a simplification, we consider the supply of money in
each country to be under the control of each country’s respective monetary authority. If
so, then money supplies are exogenous to the model, meaning that they are determined by
outside factors.6 The supplies of the two bonds are usually treated as exogenous as well.
Portfolio Balance
6However, more complex models allow for an endogenous money supply. This means that the model itself will
generate changes in a country’s money supply; for example, under fixed exchange rates, a balance-of-payments
deficit results in a reduction in the deficit country’s money supply as holdings of international reserves by its
central bank decline.
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If the bonds are government securities, then fiscal policy can clearly affect the volume of
such securities in existence. If the bonds are private securities, decisions on their issuance
may also be assumed to be outside the model per se. These bond supplies, together with the
money supply (see MacDonald and Taylor, 1992, p. 9), define the wealth of the domestic
country (Wd) in terms of its own currency as
Wd = Ms + Bh + eBo [18]
where Ms is the money supply of the home country, Bh is the stock of home bonds (gov-
ernment and private) actually held by domestic residents, and Bo is the stock of foreign
bonds actually held by domestic residents. The stock of foreign bonds is multiplied by the
exchange rate e in order to put the value of those assets into domestic currency terms.
When the asset demands are put together with the asset supplies, financial equilibrium
is attained. It is important to note that equilibrium in the financial sector implies that all
the individual asset markets are in equilibrium simultaneously. Thus, in portfolio balance
equilibrium, the amount of each asset desired to be held is equal to the amount that is actu-
ally held—home money demand (L) equals the home money supply (Ms), home demand
for domestic bonds (Bd) equals the home bonds actually held by domestic residents (Bh),
and home demand for foreign bonds (eBf) equals the stock of foreign bonds actually held
by domestic residents (eBo). The attainment of this equilibrium results in the determination
of the equilibrium price of each bond, the equilibrium interest rate in each country, and the
equilibrium exchange rate. The exchange rate emerges from the model because, in moving
to equilibrium, any switches from (to) domestic bonds and money to (from) foreign bonds
involve new demands for (supplies of) foreign exchange.
Given that investors have reached equilibrium, we now consider several exogenous actions
in the economy that will set into motion various adjustments in the financial sector. The
overview of these adjustments is that an autonomous disturbance causes asset holders to
rearrange their portfolios. The previous equilibrium portfolio for each investor is no longer
an equilibrium portfolio; in response, the investors buy and sell the various assets in order to
attain their new desired portfolio, whereupon the investors reach a new equilibrium position.
1. Consider first the autonomous policy action of a sale of government securities in
the open market by the monetary authorities of the home country (i.e., a contraction of the
home money supply and an increase in the domestic bond supply). The immediate effect
of this action is an increase in the home-country interest rate (id). How do asset holders
react? One response is that the rise in id causes domestic citizens to reduce their demand for
home money. (See expression [15].) In addition, the demand for foreign bonds will fall (see
expression [17]) because of the negative relationship between id and eBf. This decreased
demand for foreign bonds occurs on the part not only of domestic asset holders but also of
foreign country asset holders (whose demand functions were not shown earlier). Further,
as indicated by expression [16], the quantity of domestic bonds demanded will rise because
of their higher yield. Finally, foreign-country investors will also switch from holding their
own currency to holding the home-country bond. (We did not show the demand function
of foreigners for their own currency, but it would parallel [15].) Thus, adjustments take
place in the markets for all four assets—the home and foreign currencies and the home and
foreign bonds.
These adjustments continue until a new portfolio equilibrium is attained by all inves-
tors. Of interest are some of the implications of the adjustment process. For example, what
is likely to happen to the foreign interest rate because of the rise in the domestic interest
rate? It should be clear that if will rise. This will happen because the reduced demand for
foreign bonds will drive down the price of foreign bonds and thus increase if.
Portfolio Adjustments
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In addition to the impact on if, of course, e will change if variability in the exchange rate
is permitted. In terms of expression [14],
xa =
E(e) − e
e
= E
(e)
e
− 1
Hence, e will fall (the foreign-currency depreciates) because there are fewer purchases of
foreign exchange in order to acquire foreign bonds and because there are greater purchases
of home currency by foreign citizens in order to acquire domestic bonds.7 Therefore, hold-
ing the expected future exchange rate E(e) constant, xa rises because e has fallen. In sum,
the previous uncovered interest parity (UIP) of id = if + xa − RP has been disturbed by a
rise in id due to the contraction of the domestic money supply. With id now greater than
(if + xa − RP), portfolio adjustments lead to a new equilibrium through a rise in if and a
rise in xa, that is, through a rise in the foreign interest rate as well as a rise in the expected
future appreciation of the foreign currency.8
We will carry this case of a monetary policy action no further, but note that other,
“second-round” effects will ensue after the adjustments already discussed. (For example,
the rise in id may reduce home-country real income.) Nevertheless, what we have said so
far indicates the complexity and yet the potential usefulness of the comprehensive view of
financial markets offered by the portfolio balance approach. The key point to be empha-
sized is that a contraction of the domestic money supply raises the home interest rate, the
foreign interest rate, and the expected depreciation (perhaps) of the home currency, as well
as causes an appreciation of the spot home currency.
2. As a second example of portfolio adjustments, consider a situation where, for what-
ever reason, home-country citizens decide that greater home inflation is likely in the future.
In other words, individuals in the home country now have greater inflationary expecta-
tions. With a flexible exchange rate and with some notion of PPP that is often embodied in
these models, the expectation of a future price rise at home implies that the home currency
will be expected to depreciate. In terms of our demand functions, xa rises. What is the out-
come from the standpoint of the portfolio adjustment process?
First consider the demand for home money. As expression [15] indicates, home money
demand will decrease (the sign of xa is negative). In addition, expression [16] shows us that
the demand for domestic bonds also decreases. Both of these demands are reduced because
investors are demanding more foreign bonds (see expression [17]) in anticipation of the
increased yield when converted into home currency at a later date. Thus, the adjustments
in the portfolio generate a depreciation of the home currency because there is an excess
supply of money at home and an outflow of funds to purchase foreign bonds. Clearly, the
expectation of a depreciation can cause a depreciation. A variety of additional effects could
be considered, but the important result is that greater inflationary expectations have gener-
ated a depreciation of the home currency. (Under a fixed exchange rate, the result would
be a BOP deficit.)
7Note that, in the portfolio balance model, a rise in id causes an appreciation of the home currency. (If the exchange
rate were fixed, the result would be a balance-of-payments surplus.) In the other direction, a fall in id would cause
a depreciation of the home currency (and a BOP deficit with fixed rates). The effect of the interest rate on the
exchange rate (or the BOP) is thus opposite to the effect in the monetary approach.
8We have also assumed that the risk premium remains unchanged. In addition, it should be noted that if the depre-
ciation of the foreign currency (the fall in e) leads to a revision of the expected future exchange rate E(e) itself
toward a further depreciation of the foreign currency [a fall in E(e)], then, in expression [14], E(e) and e will both
be falling and the rise in xa will be less pronounced or could even be negative. In that case, the equilibrating job
to be done for restoring uncovered interest parity by a rise in if in response to the rise in id will be even greater.
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3. Next, consider an increase in real income in the home country. By looking at the
signs of the Yd variable in [15], [16], and [17], we see the primary effect immediately.
With an increase in home income, investors want to hold more domestic money because
of an increased transactions demand for money. This point is familiar from the monetary
approach. However, the portfolio balance approach enables us to see more explicitly the
behavior involved. With increased income, individuals attempt to increase their money
holdings by selling both domestic and foreign bonds. (Real income has a negative sign
in [16] and [17].) Further, the sale of the foreign bond “improves” the balance of pay-
ments under a fixed exchange rate system and leads to an appreciation of the home cur-
rency under a flexible rate system. This is a result consistent with the monetary approach’s
view that an increase in income leads to a BOP surplus under fixed rates and to currency
appreciation with flexible rates. In the portfolio adjustment model, however, the process
is more evident.
4. Now consider an increase in home bond supply, for example, through issuance of
new corporate bonds to finance the purchase of physical assets. This rise in domestic
bonds/physical assets increases home-country wealth (Wd). What is the implication for the
exchange rate? With portfolio diversification, expressions [15], [16], and [17] tell us that
home investors will want to hold more domestic money, more domestic bonds, and more
foreign bonds. If the domestic money supply is unchanged, the increased supply of domes-
tic bonds will lead to a fall in home bond prices and a rise in id. Other things equal, the rise
in id will induce a capital inflow into the home country, and with a flexible exchange rate
the capital inflow will lead to an appreciation of the home currency. However, the increased
demand for foreign bonds associated with the domestic wealth increase alone will, ceteris
paribus, lead to a depreciation of the home currency. Hence, without more information on
the relative strength of these opposing effects, the direction of impact on the exchange rate
of the increase in home bond supply is indeterminate. Nevertheless, if domestic bonds and
foreign bonds are good substitutes for each other, the capital inflow from the relative rise
in id is likely to yield a substantial increase in the purchase of domestic bonds relative to
foreign bonds, offsetting any pure wealth effect on the demand for foreign bonds, and the
home currency will on net appreciate. This result seems prima facie most likely in practice.
5. Now consider another change: an increase in home-country wealth because of a
home-country current account surplus. First, why does a current account surplus increase
the wealth of the country with the surplus? Because, under BOP accounting, a country that
has a current account surplus must have a capital account deficit; that is, with a current
account surplus, the home country acquires foreign assets due to the net inflow of foreign
exchange on current account. This increase in wealth (Wd) will increase the home coun-
try’s demand for money (by expression [15]), its demand for domestic bonds (by expres-
sion [16]) and its demand for foreign bonds (by expression [17]). The increased demand
for money will work to increase id, while the increased demand for domestic bonds will
decrease id; hence, the net impact on id is indeterminate without more information. In the
foreign country (the country with the current account deficit), there is a reduction in wealth
and hence in that country’s demand for money and its own bonds. The effect on if is thus
also indeterminate. With uncertainty as to the effect on interest rates, therefore, no firm
prediction can be made regarding the effect on the exchange rate. If bond market effects
on interest rates dominate money market effects on interest rates, then id would fall relative
to if and the wealth transfer would lead to a depreciation of the home currency relative to
the foreign currency.
6. Now consider one final change: an increase in the supply of foreign bonds because
of a foreign government budget deficit (for elaboration, see Rivera-Batiz and Rivera-Batiz,
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1994, pp. 566–67). With an increase in the supply of already-risky foreign bonds, the RP
in the UIP expression [13] will rise (and the right-hand side of the expression will thus
fall). Other things equal, this would serve to appreciate the home currency (depreciate the
foreign currency). In addition, if the foreign government budget deficit is associated with
the expectation that foreign prices will rise, this too could cause a (purchasing-power-
parity type of) depreciation of the foreign currency (appreciation of the home currency).
Another useful way to think of the situation is that the increase in the supply of foreign
currency–denominated bonds requires a reduction in their price to sell some of the new
bonds to home-country investors. Such a price reduction to home investors can be accom-
plished by reducing e, because e multiplied by the foreign-currency price of the bonds
gives the price to home-country investors of those bonds. No matter how the mechanism
is viewed, the portfolio balance model suggests that a government budget deficit financed
by issuing new bonds will depreciate the currency of the country with the government
budget deficit.
Finally, it should be noted that, in the preceding six examples and in the portfolio
balance model generally, the existence of a BOP surplus or deficit, or of a home-currency
appreciation or depreciation, is only temporary. It occurs only while the adjustment pro-
cess to the new equilibrium portfolios is taking place. Once the new desired portfolios have
been attained, there is no longer any net flow out of or into foreign securities to or from
domestic money or bonds, and the BOP imbalance or the exchange rate change ceases. A
BOP deficit or surplus (and a depreciation or appreciation) will not exist once asset stock
equilibrium (i.e., a simultaneous equilibrium of demands and supplies of all financial
assets) has been achieved. Therefore, the presence of a continuing BOP imbalance or a
continuing exchange rate change must mean that equilibrium in portfolio holdings has not
been attained. The persistent disequilibrium occurs either from a slow adjustment process
or from continuing exogenous changes.
EXCHANGE RATE OVERSHOOTING
Many different asset market models exist in the literature, and we have barely scratched
the surface in discussing their characteristics. However, one additional feature of a large
number of these models is that (within a flexible exchange rate framework) they often
involve exchange rate overshooting. “Overshooting” occurs when, in moving from one
equilibrium to another, the exchange rate goes beyond the new equilibrium but then returns
to it. We present below two treatments of this phenomenon.
The first and most well-known explanation of overshooting draws upon the work of
Rudiger Dornbusch (1976). However, we adopt some simplifications to keep the discus-
sion consistent with previous material in this chapter. These simplifications mean that it
is not truly the Dornbusch model in some respects. Nevertheless, the general conclusions
are those of Dornbusch, and these conclusions have been very influential in the literature
and in interpretations of real-world events. As will be seen, Dornbusch focuses on two key
phenomena—short-run asset market behavior and long-run PPP behavior.
Turning first to the asset market, Dornbusch assumes that the home country is a “small
country,” which in this context means that the country has no effect on world interest rates.
In addition, perfect capital mobility is assumed, meaning that home and foreign financial
assets are perfect substitutes (and that there is no RP). These assumptions mean that an
equation similar to our earlier uncovered interest parity expression [13] (without the RP)
applies. Hence:
id = if + xa [19]
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TITANS OF INTERNATIONAL ECONOMICS:
RUDIGER DORNBUSCH (1942–2002)
Rudiger Dornbusch was born on June 8, 1942, in Krefeld,
Germany. He did undergraduate work in Geneva before
coming to the United States in 1966, whereupon he entered
the University of Chicago and received his PhD in 1971.
He was an assistant professor at Chicago in 1971 and at the
University of Rochester in 1972–1973 and an associate pro-
fessor at the Massachusetts Institute of Technology from
1975 to 1977. He was rapidly promoted to full professor at
MIT in 1977, and later he was appointed Ford International
Professor of Economics. He also held positions at Fundação
Getúlio Vargas in Rio de Janeiro and at the Universidad del
Pacífico in Lima, Peru.
Professor Dornbusch was an acknowledged expert on
macroeconomics in an open economy context. His best-
known work in that area is his “Expectations and Exchange
Rate Dynamics” (Journal of Political Economy, December
1976). This paper is a classic pioneering piece on “over-
shooting” of exchange rates beyond their equilibrium level:
it is cited on almost any occasion when overshooting is dis-
cussed, and it has been the source of a multitude of gradu-
ate examination questions. Also well known is his article
“Devaluation, Money and Non-traded Goods” (American
Economic Review, December 1973). This paper is a land-
mark for its incorporation of the nontraded sector into the
analysis of exchange rate changes—a necessary incorpo-
ration since such changes affect all relative prices in the
economy, not only the prices of traded goods. In addition, he
wrote a widely respected intermediate level textbook, Open
Economy Macroeconomics.
Professor Dornbusch also made his mark in other areas
of economics, an achievement that is rare in this age of
academic specialization. His paper (with Stanley Fischer
and Paul A. Samuelson) “Comparative Advantage, Trade,
and Payments in a Ricardian Model with a Continuum of
Goods” (American Economic Review, December 1977)
is regarded as the classic work on the extension of the
Ricardian international trade model to a multicommodity
world. More recently, Professor Dornbusch wrote on the
external debt of developing countries and liberalization,
which resulted in great demand for his consulting and advis-
ing services. In addition, in 1994 he coauthored a paper
(with Alejandro Werner) that predicted the soon-to-occur
Mexican peso crisis.
Besides his direct scholarly contributions and his pol-
icy advising, Professor Dornbusch served as co-editor of
the Journal of International Economics, associate editor
of the Quarterly Journal of Economics and the Journal
of Finance, and adviser to the Institute for International
Economics in Washington, DC. In addition, he was honored
as a Guggenheim Fellow and as a Fellow of the American
Academy of Arts and Sciences. He was also a vice president
of the American Economic Association in 1990. He passed
away on July 25, 2002.
Sources: Mark Blaug, ed., Who’s Who in Economics: A Biographical
Dictionary of Major Economists 1700–1986, 2nd ed. (Cambridge,
MA: MIT Press, 1986), pp. 227–28; Rudiger Dornbusch, John
H. Makin, and David Zlowe, eds., Alternative Solutions to
Developing-Country Debt Problems (Washington, DC: American
Enterprise Institute for Public Policy Research, 1989), p. xi; Who’s
Who in America, 47th ed., 1992–93, vol. 1 (New Providence, NJ:
Marquis Who’s Who, 1992), p. 896; Stanley Fischer, “Globalization
and Its Challenges,” American Economic Review 93, no. 2
(May 2003), pp. 1–30. ●
CHAPTER 22 THE MONETARY AND PORTFOLIO BALANCE APPROACHES TO EXTERNAL BALANCE 549
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where id and xa have the same meaning as in [13]. The term if in this expression refers to the
given world interest rate. Dornbusch assumes that, because perfect capital mobility exists,
there is extremely rapid adjustment in the asset market. Hence, the asset market equilib-
rium relationship in expression [19] quickly reestablishes itself if disturbed.
Let’s begin by reviewing asset/money market equilibrium. Consider how goods prices
and exchange rate behavior are reflected in equation [19] and how equilibrium is restored
following a disturbance. Suppose the home price level rises. A higher price level will lead
to an increase in the transactions demand for money and, with an assumed fixed money
supply, id will rise. Thus, for the moment, id is greater than (if + xa). Because if is fixed by
outside world conditions, the entire asset market adjustment in [19] must come through xa.
Now recall from our earlier discussions that an increase in the transactions demand for
money will lead to an appreciation of the exchange rate. This appreciation plays a crucial
role in restoring asset market equilibrium. The home currency must appreciate enough so
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that investors begin to expect it to depreciate toward its original level. More precisely,
because of the inflation the home currency must appreciate until its expected rate of depre-
ciation, xa, is high enough to make the right-hand side of [19] equal to the now higher
left-hand side. Thus, if id was originally 8 percent and if was also 8 percent, there was no
expected depreciation of the home currency (or expected appreciation of the foreign cur-
rency). However, if the price rise and the resulting increased home demand for money raise
id to 10 percent, xa must increase to 2 percent for equilibrium to be restored.
The equilibrium asset market schedule is shown in Figure 1 as line AA. The price level is
represented on the vertical axis and the exchange rate on the horizontal axis. The previous
paragraph has essentially explained the negative slope of this curve. Suppose that an initial
equilibrium position is point B, with price level P1 and exchange rate e1. If there is a rise in
the price level to P2, a vertical movement to point C occurs. However, the higher prices and
the accompanying increase in the demand for money set in motion an appreciation of the
home currency (a decrease in e). This appreciation continues until point F is reached, with
exchange rate e2. Although Figure 1 does not show xa directly, the expected depreciation
associated with e2 is such that the asset market is again in equilibrium. The line AA thus
shows all combinations of P and e that yield equilibrium in the asset market.
FIGURE 1 Asset Market Equilibrium in the Dornbusch Model
P2
F C
A
B
A
P1
P
e2 e1 e0
The AA schedule shows the various combinations of the price level P and the exchange rate e that satisfy the
asset market equilibrium condition that id = if + xa. If, from an initial equilibrium position such as point B,
the price level rises from P1 to P2, movement occurs to point C. This rise in prices increases the transactions
demand for money, which, with a fixed money supply, increases domestic interest rate id. The increase in
money demand causes the home currency to appreciate, indicated by the fall in e from e1 to e2. At new equi-
librium point F, the equilibrium condition id = if + xa is again satisfied. Because id has increased but the world
interest rate if is fixed, equilibrium requires that xa increase by the amount by which id exceeds if. In other
words, e must appreciate sufficiently to generate expectations of a future depreciation by the difference between
the domestic interest rate and the world interest rate.
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Let us now turn to the PPP feature of the Dornbusch model and consider how P and e
are related to each other in the goods market. In the short run in the goods market, there is
no particular neatly specified relationship because goods prices are assumed to be “sticky”;
that is, they adjust slowly to changing conditions. (In view of this price “stickiness,”
the Dornbusch model is often called a “fixed-price” monetary model as distinct from a
“ flexible-price” monetary model such as that used in the early part of this chapter.) This is
in contrast to the asset market, where there is very quick adjustment from one equilibrium
to another. However, in the long run, goods prices do adjust fully to the changed condi-
tions in the economy. In the simple version of the Dornbusch model considered here, the
economy is assumed to be at full employment and real income does not change. (A more
complicated Dornbusch version drops this assumption.) In this situation, a depreciation of
the home-country currency will, when goods prices eventually adjust, cause a proportional
change in the home price level. This PPP relationship is depicted by the straight line from
the origin, 0L, in Figure 2. (Ignore the other features of the graph for the moment.) The line
is upward sloping because depreciation of the home currency creates excess demand for
home goods. The excess demand arises because exports are now cheaper to foreign buyers
and because import substitutes produced at home are now relatively less expensive to home
consumers. This excess demand will eventually bid prices up in proportional fashion.
FIGURE 2 Adjustment to an Increase in the Money Supply in the Dornbusch Model
P2
L
A
GE
E’
A’
A’
P1
P
e2e1 e
A
e3
0
The ray 0L from the origin indicates the proportional relationship between changes in e and changes in P in the
long run when goods prices adjust. The AA line is the asset market equilibrium schedule from Figure 1. Starting
from long-run equilibrium point E, an increase in the money supply shifts AA to A′A′. With sticky goods prices,
the exchange rate moves from e1 to e2. This depreciation of the home currency occurs until (the new, lower) id
again equals if + xa at point G. The term xa must become negative to restore equilibrium in the asset market,
meaning that the home currency must depreciate until its expected appreciation matches the difference between
the fixed if and id. As goods prices eventually begin to rise, movement occurs along A′A′ until the new long-run
equilibrium position E′ is reached. Exchange rate overshooting has occurred because the exchange rate change
from e1 to e2 exceeds the long-run equilibrium rate change from e1 to e3.
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Given these relationships between P and e in the asset and goods markets, let us now
address the phenomenon of overshooting. In Figure 2 the asset market schedule AA from
Figure 1 and the goods market schedule 0L are put together. The initial equilibrium posi-
tion is at E, where both markets are in equilibrium. The equilibrium exchange rate is e1,
and prices are in equilibrium at P1. This is a long-run equilibrium position; therefore, e1 is
expected to persist. With e1 expected to persist, xa = 0.
From this equilibrium position E, suppose that the monetary authorities now increase
the money supply. The first effect of this action is a rightward shift in the AA schedule,
to A′A′. This shift occurs because there is now an excess supply of money at the old
equilibrium P and e. An elimination of this excess supply requires an increase in e and/or an
increase in P, both of which increase the transactions demand for money and serve to absorb
the excess supply. But, because goods prices are sticky and there is very rapid adjustment
in the asset market, the adjustment occurs through the exchange rate and the next step is
a horizontal movement from E to point G. This movement indicates a depreciation of the
home currency (from e1 to e2). The depreciation occurs because the increased money sup-
ply has lowered domestic interest rates, and thus asset holders will shift their portfolios
from home securities to foreign securities in order to earn a higher interest return. More
importantly, asset holders expect a future depreciation of the home currency because of
the money supply increase, and this will also cause home assets to be sold and foreign
assets to be bought. The capital outflow resulting from these motivations will depreciate
the home currency.
These adjustments take place quickly. The new equilibrium position in the asset market
is found on the new asset equilibrium schedule A′A′ at point G. Because asset market equi-
librium requires that id = if + xa, xa must be negative at point G because id has fallen while
if is fixed. In other words, in the new asset equilibrium position, the home currency has
depreciated so much that it is now expected to appreciate. (Remember that a negative xa is
an expected depreciation of the foreign currency or an expected appreciation of the home
currency.) This result occurs at e2.
What happens after point G is attained? Recalling that the asset market maintains itself
in equilibrium, upward movement takes place along the A′A′ schedule until E′ is reached.
This movement occurs because goods prices finally start to rise because of the excess
demand for goods associated with the depreciated value of the home currency. As goods
prices rise, the consequent increased transactions demand for money bids up the domestic
interest rate, which results in an appreciation of the home currency until E′ is attained. At
long-run equilibrium position E′, both the goods and asset markets are again in equilib-
rium. In comparison with original equilibrium E, expansionary monetary policy has raised
prices (from P1 to P2) and has increased the exchange rate (depreciated the home currency)
from e1 to e3.
There are two points to be emphasized. The most important one is that the exchange
rate has indeed “overshot” its long-run equilibrium level. From e1 it has risen to e2 (depre-
ciation of home currency) and then has fallen to e3 (appreciation of home currency).
Second, however, note that, in the adjustment from point G to point E′, the home currency
is appreciating at the same time that domestic prices are rising! This is hardly a result
that conventional theory would lead us to expect. The Dornbusch model, in overview, has
offered a mechanism that, in the opinion of many economists, has value in interpreting
experiences in the post-1973 period, when most industrialized countries have had floating
exchange rates.
Moving away from the Dornbusch model, with its incorporation of uncovered interest
parity, overshooting can also occur in a framework that emphasizes covered interest parity
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and hence the forward market. (See Melvin, 2000, pp. 178–81.) To begin, recall from pre-
vious chapters that the covered interest parity condition between money markets is
id = if + (efwd − e)/e [20]
where id is the domestic interest rate, if is the foreign interest rate (no longer necessarily
a fixed world rate), efwd is the forward rate for foreign currency, and e is the spot rate for
foreign currency. In other words, covered interest parity occurs when the domestic interest
rate is equal to the foreign interest rate plus the forward premium on the foreign currency.
If if is greater than id, then the foreign currency will be at a forward discount [i.e., a negative
forward premium because (efwd − e)/e will be negative]. If id exceeds if, interest arbitrage
will yield a positive forward premium.
How does [20] relate to [13] without the RP (or to expression [19])? The modern lit-
erature on exchange rates utilizes the concept of “efficiency” in the exchange markets.
Efficiency in this context exists when the current forward rate equals the expected future
spot rate. (Such efficiency was also discussed in Chapter 20, page 493.) The key to this
equality can be seen as follows: Suppose that the expected price of the Swiss franc in three
months [the expected future spot rate, E(e)] is $0.75 per Swiss franc and the current for-
ward rate on Swiss francs, efwd, is $0.73 per Swiss franc. In this situation, a speculator will
buy Swiss francs on the forward market at $0.73 per Swiss franc at the present time because
the speculator anticipates that, in three months, the Swiss francs can be sold for $0.75 per
Swiss franc. Clearly this will put upward pressure on the current forward rate of the Swiss
franc until an equilibrium is reached at which E(e) equals efwd (ignoring transaction costs).
Similarly, if the expected future spot rate is less than the current forward rate, speculators
will sell the Swiss francs forward because they anticipate that Swiss francs can be bought
in the future (to cover the forward sale obligation) at less than the forward price to be
received. This sale of forward Swiss francs drives efwd down until it eventually is equal to
E(e). Speculative activity thus ensures that E(e) = efwd. If E(e) is equal to efwd in practice—
an extremely difficult hypothesis to test because of the empirical problem of ascertaining
expectations—the exchange market is said to be an efficient exchange market. This term
means that there are no unexploited profit opportunities.
The implications of this discussion for expression [20] are straightforward. That expres-
sion can now be rewritten through substitution of E(e) for efwd (because the two terms are
equal to each other) as
id = if + [E(e) − e]/e
But [E(e)  −  e]/e is simply the expected percentage change in the current e. Hence,
[E(e) − e]/e = xa. Through further substitution we obtain
id = if + xa
which is expression [19] or expression [13] (without the RP), or uncovered interest parity.
Thus, with an efficient market, covered and uncovered parity both hold, or, alternatively,
the expected appreciation of the foreign currency is equal to the forward premium on the
foreign currency. Hence, a currency with a forward price above its spot price is expected
to increase in value, and a currency with a forward price below its spot price is expected
to decline in value.
Let us return now to overshooting, using [20]. Suppose that beginning at the equilibrium
position of [20], the domestic monetary authorities now increase the home money supply.
Assuming little slack in the economy, the increase in the money supply causes individuals
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to expect that the home price level will rise. Because the higher prices will produce the
expectation of an incipient BOP deficit, this means that market participants expect e to rise
along with the price level. But the new expected spot rate, E(e), will generate (as we have
just seen) a new forward rate equal to it, because E(e) must be the same as efwd. The result
is that, in [20], the term [efwd − e]/e will increase.
But wait a minute! In expression [20], id is equal to if + (efwd − e)/e, but we have just
increased the right-hand side at the same time that we have decreased the left-hand side.
The left-hand side (id) decreased because the increased home money supply has depressed
the domestic interest rate. How is covered interest parity able to be maintained? The
answer is that the two sides of the equation are made equal again by a rise in e, the cur-
rent exchange rate. In fact, e must rise by more than efwd to maintain interest arbitrage
equilibrium. If this adjustment in e did not occur, if + (efwd − e)/e would be greater than id
and interest arbitragers would have an incentive to send funds overseas by purchasing spot
foreign exchange and simultaneously selling forward foreign exchange. Thus, after the
increase in the money supply, interest arbitragers bid up e sufficiently so that the equilib-
rium in [20] is reestablished.
In this analysis, Melvin, like Dornbusch, hypothesizes that the prices of goods adjust
slowly relative to the speed of adjustment in the exchange markets. When the price level
finally does start to rise after the reestablishment of equilibrium in expression [20], there
is an excess demand for money in the home country (due to the higher price level), and id
therefore begins to rise. When id rises, there is an inflow of funds, so the home currency
begins to appreciate. When prices have eventually adjusted to their new equilibrium level,
the system settles down. The domestic currency has ultimately depreciated from its origi-
nal level (i.e., e has risen) because of the increase in the money supply, but notice that the
exchange rate adjustment (an overall depreciation) was accomplished by an initial larger
depreciation that was then followed by an appreciation. Hence, the exchange rate overshot
its new long-run equilibrium position, then returned to that position.
This concludes (thankfully?) our discussion of the phenomenon of overshooting.
Many models have been developed to explain this phenomenon, and they have emerged
in response to exchange rate behavior among the industrialized countries since 1973. As
well as emphasizing stock equilibrium positions and adjustments, differential speeds of
adjustment in different markets, and expectations, this literature has incorporated other
influences such as “speculative bubbles,” the role of surprising “news,” and policy “reac-
tion functions” on the part of the monetary authorities. While we do not go further in
our development of over shooting, it should be clear that the complexity of the real world
means that exchange rates do not always move smoothly and directly from one long-run
equilibrium position to another.
CONCEPT CHECK 1. Why can the existence of a risk premium mean
that (if + xa) can exceed id in equilibrium?
2. In the portfolio balance model, why does a
rise in domestic wealth lead to an apprecia-
tion of the home currency?
3. What will happen to the value of a country’s
currency in the foreign exchange markets if
the country’s citizens suddenly revise upward
their expectations of the home inflation rate?
Why?
4. In the Dornbusch overshooting model, how
is it possible that a country’s currency can be
appreciating at the same time that its price
level is rising relative to the price level in
other countries?
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SUMMARY
The monetary approach to the balance of payments interprets a
country’s BOP deficits or surpluses (with fixed exchange rates)
and currency depreciations or appreciations (with flexible
exchange rates) as the results of a disequilibrium between the
country’s supply of and demand for money. If there is an excess
supply of money, then a BOP deficit (or home-currency depre-
ciation) will occur during the process of moving to equilibrium.
Similarly, an excess demand for money generates a BOP surplus
(or home-currency appreciation). The approach enables the ana-
lyst to make predictions concerning the effect on the external
sector of changes in such economic variables as price levels,
levels of real income, and interest rates.
The portfolio balance approach goes further than the monetary
approach in that it incorporates expectations, other assets besides
money, and a risk premium because home and foreign financial
assets are imperfect substitutes. Investors hold an equilibrium
portfolio of the various assets, and changes in economic variables
and conditions affect the composition and size of the desired
portfolios. Recognizing that asset markets across industrialized
countries are well (though not perfectly) integrated, the conclu-
sion emerges that changes in absolute and relative demands and
supplies of assets will have impacts on interest rates and exchange
rates. A particular feature that has attracted widespread attention
is the conclusion that exchange rate “overshooting” can occur.
In overview of the monetary and portfolio balance
approaches, their objective is to explain the behavior of the
external sector in an environment where countries are closely
interrelated and where exchange rates change frequently and
sizably (such as among major industrialized countries since
1973). They focus not on the current account but on the asset
exchanges (financial/capital) that heavily influence exchange
rates today (especially in the short run). With these approaches
in mind, we turn next to other features of the exchange market,
including considerations of the current account.
KEY TERMS
asset stock equilibrium
contractionary monetary policy
demand for money
domestic reserves
efficient exchange market
excess demand for money
excess supply of money
exchange rate overshooting
expansionary monetary policy
incipient BOP deficit
incipient BOP surplus
international reserves
monetary approach to the balance
of payments
monetary approach to the exchange
rate
monetary base
money multiplier
portfolio balance (or asset market)
approach
rational expectations
transactions demand for money
QUESTIONS AND PROBLEMS
1. Suppose that there is an increase in national income in a
country. Under a fixed exchange rate system, according to
the monetary approach, will the country’s balance of pay-
ments (official reserve transactions balance) move toward
surplus or toward deficit? Why? How would you modify
your explanation (though not your conclusion) if you were
using the portfolio balance approach in a fixed exchange
rate context?
2. “A higher price level will increase the demand for money,
but expectations of a rise in the price level will reduce the
demand for money.” Is this statement true or false accord-
ing to the monetary approach? Why?
3. In the simple framework where Ms = kPY, suppose that k
increases because of a change in the institutions of pay-
ment (e.g., people get paid larger amounts on a less fre-
quent basis). What effect will this institutional change have
on the country’s exchange rate in a flexible exchange rate
system? Explain.
4. Why is relative purchasing power parity (PPP) more likely
to hold in a hyperinflationary period than in a more “nor-
mal” period of price behavior?
5. Do you think that the monetary approach is a satisfac-
tory explanation of a country’s exchange rate? Why or
why not?
6. In the portfolio balance model, what effect, other things
equal, will a foreign government’s budget deficit financed
by issuing bonds have on the home country’s currency
value and why? (Assume a flexible exchange rate.)
7. In the portfolio balance model, what effect will a rise in id
have on the value of the domestic currency with a flexible
exchange rate? Why? Why would this not be the result in
the monetary approach?
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9In the interest of simplicity, we are not listing all of Ujiie’s independent variables.
10The dependent variable in a testing equation is the variable on the left-hand side, the variable being “explained.”
The independent variables, on the right-hand side of the equation, are variables thought to have a causal influence
on the dependent variable. The terms such as b, c, and f show the extent of influence and are called the coefficients
of the independent variables.
11In his tests, Ujiie actually employed the concept of “permanent income” rather than current income, but this is
immaterial for our purposes.
12Hyperinflation is a situation where prices are rising extremely rapidly, such as more than 1,000 percent per
year. In Germany during 1920–1923, the wholesale price index (1913 = 1.0) was 14.40 in December 1920 and
1,200,400,000,000 in December 1923. See Graham (1930, pp. 105–06).
Appendix EXAMPLES OF EMPIRICAL WORK ON THE MONETARY
AND PORTFOLIO BALANCE APPROACHES
EMPIRICAL TESTING OF THE MONETARY APPROACH
There has been a considerable amount of empirical testing of relationships in the monetary approach
model. We present in this section a brief discussion of a few of these tests.
We turn first to tests of the monetary approach under fixed exchange rates, focusing briefly on one
early representative test. Junichi Ujiie (1978) did work on Japan for the fixed-rate period 1959–1972.
His general testing equation was9
BOP = a + b ΔD + c Δi* + f ΔY [21]
The dependent variable is the balance-of-payments position.10 If BOP is positive, there is an
official reserve transactions surplus (or an inflow of international reserves) while a negative number
constitutes a deficit (or an outflow of international reserves). On the right-hand side, a is a constant
term, ΔD represents the change in domestic credit (which influences the monetary base), Δi* indi-
cates the change in foreign interest rates, and ΔY indicates the change in Japanese real income.11
Ujiie hypothesized that an exogenous rise in domestic credit would worsen the BOP (a negative b),
an exogenous rise in foreign interest rates would reduce the foreign demand for money and thus lead
to a BOP surplus for Japan (positive c), and an exogenous increase in Japan’s income would increase
the demand for money, leading to a positive effect on the BOP (positive f).
After carrying out various tests, Ujiie’s general conclusion was that the domestic credit variable
clearly performed as expected (i.e., b was always negative in a statistically significant sense). On the
other hand, he could not make any firm statements as to the signs of c and f. Hence, this test is robust
with respect to the influence of changes in domestic credit and thereby the money supply, but uncer-
tainty exists regarding the relationships of foreign interest rates and domestic income to the balance
of payments. It seems fair to say that, considering Ujiie’s and others’ work with respect to a fixed-
rate system, the money supply does seem to have its predicted relationship with the BOP position.
However, there is disagreement as to the influence of other included variables.
We now turn to brief summaries of two empirical studies of the monetary approach under a
flexible exchange rate regime. The first study was done by Jacob Frenkel (1978), former economic
counselor of the International Monetary Fund, former governor of the Bank of Israel, and currently
Chairman of JPMorgan Chase International. The period examined is a favorite one chosen for study-
ing the monetary approach—the German hyperinflation after World War I.12 Frenkel employed
natural logarithms of variables, an approach which results in the estimated coefficients of the inde-
pendent variables being elasticities. Thus, a coefficient of 2.0 on an independent variable means that
8. “An increase in a country’s money supply can result in a
depreciation of the country’s currency that ‘overshoots’ its
long-run equilibrium level.” Defend this statement.
9. What reasons can you suggest to support the standard
assumption that asset markets adjust more rapidly to a dis-
equilibrium situation than do goods markets?
10. Why is if  +  xa equal to if  +  (efwd  −  e)/e in an efficient
exchange market (with no risk premium)?
11. In your view, what are the strengths of the portfolio balance
or asset market approach as an explanation of exchange
rate  determination? What are the weaknesses of the
approach?
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a 1  percent rise in the value of the independent variable would be associated with a 2 percent rise in
the value of the dependent variable.
The Frenkel testing equation for the behavior of the German exchange rate from February 1921
through August 1923 was
log e = a + b log Ms + c log E(p⋅ ) [22]
where: e = exchange rate (units of German marks per one U.S. dollar)
a = a constant term
Ms = German money supply
E(p⋅ ) = a measure of inflationary expectations in Germany13
If the monetary approach has validity, b would be positive. Indeed, if the exchange rate moves
proportionately with the money supply, we can make a stronger statement—that b should be 1.0. The
term c is also expected to be positive, because greater expected price rises lead individuals to reduce
their demand for money. This would generate an excess supply of money and a depreciation of the
currency. The term a has no expected sign a priori and is inconsequential for our purposes.
For the German hyperinflation period, Frenkel found b to be highly significant statistically, with
a value of +0.975. Thus, the exchange rate depreciated virtually proportionately with the money
supply. In addition, the c term was a highly significant +0.591. This result is also consistent with
the monetary approach. The Frenkel test (among others) gives substantial support for the monetary
approach to the exchange rate. In criticism, the point has often been raised that, in conditions of
hyperinflation, prices dominate all other influences and the money supply dominates prices to the
exclusion of all other factors. (Frenkel had also found a virtual identity of the movements of German
price indexes with changes in the German money supply.) Thus, strong support for the monetary
approach is almost inevitable. If more normal conditions rather than hyperinflation are selected,
critics of the monetary approach doubt that such powerful results could be found.
A test for a nonhyperinflationary period was conducted by Rudiger Dornbusch (1980). Dornbusch
considered the 1973–1979 period, during which there was sizable inflation by developed-country
standards, but by no means was there an experience similar to that of Germany in the 1920s. In addi-
tion, there was substantial flexibility in the exchange rates of major industrialized countries.
Dornbusch estimated the following equation:
e = a + b(ms − ms*) + c(y − y*) + d(i − i*)s + f(i − i*)L [23]
This equation was estimated for five industrialized countries (Canada, France, Japan, the United
Kingdom, the United States) as a group against West Germany, with the five countries being treated
as the “home” country and West Germany as the “foreign” country. In this equation, e refers to the
natural logarithm of the dollar-per-mark exchange rate.14 The term a is again a constant term with no
a priori expectation as to sign. The term ms is the logarithm of the group’s money supply, while m*s
is the logarithm of the West German money supply. Similarly, y is the logarithm of real income in
the group, while y* is the logarithm of West German real income. The i and i* terms refer to interest
rates in the five countries and in West Germany, respectively. The subscript S refers to short-term
interest rates and subscript L refers to long-term interest rates.
Consistent with the monetary approach, we expect b, d, and f to be positive. A faster rate of growth
of money in the other countries relative to Germany [as reflected in an increase in the (ms − m*s) term]
should result in an appreciation of the mark (i.e., e should rise). Similarly, an exogenous increase in
interest rates in the other countries relative to Germany [as reflected in an increase in the (i − i*)
terms] should cause an appreciation of the mark.15 On the other hand, a faster increase in real income
13We will not go into details on the inflationary expectations measure. Economists have devised several such
measures and have quarreled continuously over them.
14More precisely, it is the logarithm of the weighted-average value of the five countries’ currencies expressed in
terms of dollars per mark.
15Remember that in the monetary approach, a rise in the domestic interest rate reduces the demand for money,
leading to an excess supply of money. The excess money supply generates depreciation. In this test, an increase
in i will lead to depreciation of the five countries’ currencies, that is, an appreciation of the mark.
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in the other countries than in Germany [an increase in (y − y*)] should increase the relative demand
for money in the other countries (according to the monetary approach). This will lead to an apprecia-
tion of the other currencies and a depreciation of the mark. Hence, c is expected to be negative.
Dornbusch’s results were hardly encouraging for the applicability of the monetary approach for
explaining exchange rate movements. Only the coefficients on the interest rates were of the expected
sign and were also statistically significant. Dornbusch concluded that, at least from his testing, there
is “little doubt that the monetary approach . . . is an unsatisfactory theory of exchange rate determina-
tion” (Dornbusch, 1980, p. 151).
Given the sharply contrasting conclusions of Dornbusch and Frenkel with respect to the monetary
approach to the exchange rate, there has been controversy over the validity of this approach. In a
survey of relevant literature for the post-1973 period, when the exchange rates of major industrial-
ized countries have been fluctuating, MacDonald and Taylor (1992, p. 11) offered the summary
statement that the “monetary approach appears reasonably well supported for the period up to 1978”
but that this is not true for studies using sample years after that time (into which they place the
above Dornbusch study). In particular, Mark Taylor (1995, p. 29) noted that the later estimating
equations for exchange rates often contained incorrect signs. For example, estimates for the dollar/
mark exchange rate yielded results that implied that an increase in the German money supply would
cause the mark to appreciate. There has been controversy over this relationship, as some economists
think the unexpected sign is the result of misspecifications in the equations, especially with respect
to wealth effects. For instance, if wealth is increasing (perhaps due to an increase in the money sup-
ply itself), individuals might wish to hold more mark-denominated assets. This could raise the value
of the mark and more than offset the mark depreciation that would be expected under the monetary
approach when the German money supply increased.
Two factors have contributed to a revival in applied research on the economics of exchange rates.
The application of new time-series methods (known as nonstationarity methods) to exchange rate
analysis is the first. Frankel and Rose (1995) find that the monetary models received the most atten-
tion, but, in spite of new methods, they have not performed particularly well since the 1970s. Rogoff
(1999) also maintains a pessimistic view of the monetary models. On the other hand, MacDonald and
Taylor (1993, 1994), Chinn and Meese (1995), and MacDonald and Marsh (1997) have experienced
success with the monetary model. These results led MacDonald (1999) to hold a more optimistic
view of monetary models of exchange rates. The combination of new time-series methods and a
longer panel of data (larger data sets over more years) allowed Rapach and Wohar (2002) to find
support for the long-run monetary model in more than half of the 14 industrialized countries in their
study. In their analysis, they used data spanning the late 19th to the late 20th centuries to overcome
the problems associated with short periods.
A second contributing factor has been the opportunity to examine exchange rate trends in the
transition countries, particularly those slated for EU membership. Crespo-Cuaresma, Fidrmuc, and
MacDonald (2005) used the monetary approach in their analysis of exchange rates in the Czech
Republic, Hungary, Poland, Romania, the Slovak Republic, and Slovenia. Their results indicate that
the monetary model provides a relatively good explanation of the behavior of nominal exchange
rates in a panel of six central and eastern European transition countries. By computing the equilib-
rium exchange rates based on monetary and real developments in the nations, the results suggest that
the nominal exchange rates against the euro may have been overvalued particularly in the Czech
Republic and Slovenia.
The application of new time-series methods to examine exchange rate trends in transitional
countries has established two important points. The first is the importance of dealing with the
fact that means and variances of economic variables can change over time (nonstationarity) when
attempting to estimate the link between nominal exchange rates and monetary fundamentals (Groen,
1999). (Taking these changes into account is called cointegration.) The second is that use of data
for a relatively short period of time decreases the ability to detect these changes and thus can lead to
errors in analysis. Consequently, researchers have focused on combining data across countries with
data over time (panel data) to improve their estimates. Using this framework, Uz and Ketenci (2008)
include more countries and also test the predictability of the exchange rate for out-of-sample data that
have not been previously studied. In addition, they extend the model by including other monetary
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variables such as interest rate and price differentials. The enrichment of the monetary model by
including these two new variables permits a closer look at the relationship between exchange rates
and monetary variables in emerging economies. Using panel data, Uz and Ketenci found strong evi-
dence of the links between exchange rates and monetary behavior that are consistent with existing
literature. Thus, this study provided support for the long-run monetary model of exchange rate deter-
mination, even for emerging markets. In addition, the cointegration approach was used by Samih
Antoine Azar (2013) to examine the behavior of the U.S. dollar from January 1973 to July 2012.
He concluded that he could not reject the hypothesis that a given percentage increase (decrease) in
the U.S. money stock would be associated in the long run with a matching percentage depreciation
(appreciation) of the trade-weighted value of the dollar.
As noted, the continuing interest in the monetary approach to the exchange rate has involved
the extension of testing to embrace countries that are not high-income countries. Eduardo Loria,
Armando Sánchez, and Uberto Salgado (2010) surveyed the experience and determinants of the
Mexican peso–U.S. dollar exchange rate from 1994 to 2007. Using new econometric techniques that
attempt to ascertain the dynamic responses of variables to outside shocks, they tested for associations
of GDP, the money supply (M2), and interest rates, together with changes in those variables, with the
exchange rate. They concluded (pp. 551–52) that “the peso-USD exchange rate fluctuations depend
on the fundamentals in the direction suggested” by the monetary approach to the exchange rate. In
another study, Ehsan Ahmed Shaikh and Javed Iqbal (2014) examined the situation in Pakistan from
1972 to 2010. They concluded that an increase in Pakistan’s money supply was significantly associ-
ated with a depreciation of the Pakistan rupee, as would be expected from the monetary approach.
However, a proxy variable for national income gave the “wrong” sign—the monetary approach
would say that the rupee would appreciate when Pakistan’s income increased but their econometric
result suggested that the rupee would depreciate. Continuing in the vein of not testing for the highest-
income countries, Idil Uz and Natalya Ketenci (2010) examined the performance of the monetary
model for the relatively new members of the European Union (Cyprus, the Czech Republic, Estonia,
Hungary, Latvia, Lithuania, Malta, Poland, the Slovak Republic, and Slovenia) and for Turkey. They
found that, in general, exchange rates and monetary variables move together, although this does
not necessarily imply causality. However, utilizing different tests and observing whether particular
earlier exchange rate projections held up in practice, Uz and Ketenci p. 967 concluded that “there
is convincing evidence for a long-run equilibrium relationship between exchange rate and monetary
variables in all countries”. However, actual shorter-run behavior does not show consistency with
much of the monetary approach.
To add to the uncertainty concerning the validity of the monetary approach, two other tests are
noteworthy in that the tests are carried out for countries operating in a regime where the domestic
currency basically has a fixed exchange rate (with the U.S. dollar). Michael Howard and Nlandu
Mamingi (2002) evaluated the relevance of the monetary approach using data for Barbados over the
period 1973–1998. Employing the previously mentioned new econometric techniques for analyzing
time-series data, they concluded that the statistical evidence supported the monetary approach dur-
ing that period. In a study for Fiji during the period 1974–2003, Paresh Kumar Narayan, Raymond
Nilesh Prasad, and Arti Prasad (2009) found the expected negative association between changes in
domestic credit and changes in international reserves but concluded that this association occurred via
other mechanisms rather than via the mechanism of the monetary approach.
All in all, the monetary approach to the balance of payments and to the exchange rate has been
shown to be useful for explaining economic phenomena in some situations and not so useful in
others. Research obviously will therefore continue.
TESTING OF THE PORTFOLIO BALANCE MODEL
We briefly look now at empirical studies regarding the portfolio balance or asset market approach.
Relatively little work has been done on testing the portfolio balance or asset market model because
of difficulties encountered in relating the theoretical models to real-world data. In particular, as noted
in Taylor (1995, p. 30), questions arise as to which nonmoney assets to include and how to obtain
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uniform data across countries. Further, uncertainty exists as to how to quantify the RP that reflects
the imperfect substitutability of domestic and foreign assets.
The first test we examine is that of Jeffrey Frankel (1984). While all such studies face the problem
that there are inadequate data on the composition of portfolios, Frankel employed various assump-
tions to obtain estimates for the 1973–1979 period and then tested hypothesized relationships. The
dependent variable in his testing equations was the home currency/dollar exchange rate. (The “home
country” in his analysis consists of five developed countries—Canada, France, West Germany,
Japan, and the United Kingdom; the “foreign country” is the United States.) The independent vari-
ables were (1) wealth in the home country, Wh; (2) wealth in the foreign country (the United States),
WUS; (3) the supply of home currency–denominated assets on the world market, Bh; and (4) the sup-
ply of foreign currency–(dollar-) denominated assets on the world market, BUS. (Note: The B terms
have a slightly different meaning than they did in our earlier discussion because they apply to the
entire world market, not only to holdings by domestic citizens.)
In terms of the portfolio balance model, Wh was expected to have a negative sign because increased
wealth in the home country (e.g., West Germany) appreciates the home currency (see example 4 on
page 547 of this chapter and assume that the substitution effect between domestic and foreign bonds
dominates the pure wealth effect), and thus the mark/dollar rate will fall. An increase in U.S. real
wealth for analogous reasons causes the mark/dollar rate to rise and produces a positive sign for
WUS. An increase in the supply of mark-denominated bonds Bh (such as through a German govern-
ment budget deficit) would increase the mark/dollar exchange rate—generating a positive sign. (This
follows from the discussion in example 6 on pages 547–48.) Finally, for analogous reasons, a rise
in the supply of foreign (U.S.) assets would generate a negative sign for BUS. More than half of the
signs Frankel obtained for the 1973–1979 period were not as expected. While not all of these signs
were statistically significant in his test, it is clear that the results are not very satisfactory from the
standpoint of the portfolio balance model. The “wrong sign” occurred in two countries for Wh and Bh
(Germany and the United Kingdom) and in three countries for BUS (France, Germany, and the United
Kingdom); and only Canada had the correct sign for WUS.
Turning to other literature, attention has focused (despite the difficulties) on isolating the RP in
the uncovered interest parity equilibrium equation id = if + xa − RP. A study by Kathryn Dominguez
and Jeffrey Frankel (1993) attempted to measure the RP through survey data on exchange rate expec-
tations. The risk premium was then tested as to its relationship to exchange rate variations (of the
dollar/mark and dollar/Swiss franc rates) and to the composition of wealth between domestic and
foreign assets. Of importance for this chapter, there did seem to be an association between relative
size of domestic to foreign assets in portfolios and the RP that is consistent with the portfolio balance
model’s assumption that home and foreign assets are imperfect substitutes. (See also Taylor, 1995,
pp. 30–31.)
Among other studies, some interesting work was done by Richard Meese (1990) and by Meese
and Kenneth Rogoff (1983). They attempted to ascertain whether standard asset market models can
be of value in forecasting the exchange rate. The procedure first was to obtain, from several years
data, an equation with the exchange rate as the dependent variable, using independent variables sug-
gested by the monetary and portfolio balance models. Meese and Rogoff then used this equation to
forecast the exchange rate for later periods and compared the forecast with the actual exchange rate
that later did exist for those periods. The predictive success of the theoretical equation’s forecast of
the later spot rates was then compared with the success in predicting later spot rates (1) by using
only the current period’s forward rate for predicting next period’s spot rate and (2) by predicting
next period’s spot rate as differing from this period’s rate by only a random number (meaning the
exchange rate is a “random walk”). Sadly for the theoretical equation, it performed less well (or more
poorly) than did the random walk and the forward rate.
More recently, some interesting empirical work has been done focusing on U.S. exchange rates.
David Cushman (2007) used a modified portfolio balance approach to analyze the U.S.–Canadian
exchange rate. Equations for the modified portfolio balance model (using estimates of domestic pri-
vately held Canadian debt, Canadian government debt held by nonresidents, U.S. securities held by
U.S. residents, and U.S. securities held by Canadian residents) over the 1970–1999 floating exchange
rate period were used. Statistical testing suggested that the exchange rate is important to economic
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adjustments, though statistically modest. Further, Cushman’s simplified version of the empirical
model was able to outperform a random walk explanation for several forecasting exercises. Costas
Karfakis (2010) analyzed the impact of the portfolio balance adjustments on the recent movements
of the euro/dollar from 2000 to 2009, focusing on the role of asset supplies of the United States and
the euro area. He found that, in predicting the exchange rate, a ratio of U.S. federal debt to euro-area
government debt had a statistically significant impact beyond that of monetary fundamentals. This
lends support to the portfolio balance approach. In addition, Karfakis examined the effect of changes
in the official reserves of emerging and developing countries as possibly signaling that large dollar
holders are accumulating dollar-based assets, thus appreciating the dollar. Inclusion of this consider-
ation improved the ability of the model to predict exchange rates.
Finally, there have been many tests regarding whether an efficient foreign exchange market, an
aspect of the portfolio balance approach (as well as of the monetary approach), in fact exists in prac-
tice. As noted in this chapter (page 553), with such efficiency the forward rate of a currency would
be equal to the expected future spot rate of the currency (for the same time interval), which in turn
would be equal to the (risk-adjusted) interest rate difference between the financial centers. A paper
by José Olmo and Keith Pilbeam (2009) noted that the uncovered interest parity (UIP) condition had
been extensively studied in the literature and that the hypothesis that UIP was satisfied in the real
world had been widely rejected in that literature. Such a rejection could be due to factors such as a
time-varying risk premium or irrational speculation. Olmo and Pilbeam then conducted their own
study, employing a different econometric approach than the previous literature, and found support for
the existence of UIP. Hence, there is conflicting evidence as to the actual presence of an important
aspect of the monetary and portfolio balance approaches.
Hence, although the portfolio balance (and monetary) models have suggested particular influ-
ences on the exchange rate, considerable work remains to be done to document these influences more
convincingly. In view of the huge volume and rapid growth of international assets, as discussed in the
previous chapter, this work is important and necessary.
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CHAPTER
23 PRICE ADJUSTMENTS AND BALANCE-OF-PAYMENTS
DISEQUILIBRIUM
LEARNING OBJECTIVES
LO1 Explain how changes in exchange rates affect the movement of goods
and services and the trade balances of countries.
LO2 Summarize how the price adjustment mechanism functions under a
system of fixed or pegged exchange rates.
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INTRODUCTION
In his semiannual Monetary Policy Report to the Congress on February 11, 2004, Federal Reserve
Chair Alan Greenspan made the following comments about the depreciation of the U.S. dollar:
The recent performance of inflation has been especially notable in view of the substantial
depreciation of the dollar in 2003. Against a broad basket of currencies of our trading partners,
the foreign exchange value of the U.S. dollar has declined about 13 percent from its peak in early
2002. Ordinarily, currency depreciation is accompanied by a rise in dollar prices of imported
goods and services, because foreign exporters endeavor to avoid experiencing price declines in
their own currencies, which would otherwise result from the fall in the foreign exchange value of
the dollar. Reflecting the swing from dollar appreciation to dollar depreciation, the dollar prices
of goods and services imported into the United States have begun to rise after declining on bal-
ance for several years; but the turnaround to date has been mild. Apparently, foreign exporters
have been willing to absorb some of the price decline measured in their own currencies and the
consequent squeeze on profit margins it entails.1
This chapter examines how price adjustments—for example, the exchange rate changes
referred to by Alan Greenspan—affect the external sector and the economy as a whole.
Price changes in general, whether occurring in a system of flexible exchange rates or in
a system of fixed exchange rates, have implications for policy, and the policies them-
selves will be examined in later chapters. In this chapter, we first analyze the nature of the
response of traded goods and services to changes in the price of foreign exchange under
a system of flexible exchange rates and the effect that these responses have on the current
account balance. Particular attention will be paid to describing the market conditions that
are necessary for current account imbalances to be corrected by changes in the exchange
rate. In recent years, depreciation of a country’s currency has not always been immediately
accompanied by a reduction in its current account deficits, leaving the impression that the
foreign exchange market may not behave as theory suggests. We therefore examine this
issue from both a short-run and a longer-run perspective under flexible exchange rates. The
discussion of flexible-rate adjustment is followed by an analysis of the price adjustment
process when the exchange rate is fixed or not allowed to move outside certain limits.
This chapter describes how changes in the foreign sector trigger short-run and medium-
term price adjustments. The analysis underscores the difficulties of carrying out economic
policy in the open economy when changes in the exchange rate and prices must be taken
into account. Economic policy itself is the focus of later chapters.
THE PRICE ADJUSTMENT PROCESS AND THE CURRENT ACCOUNT
UNDER A FLEXIBLE-RATE SYSTEM
In this section we examine the manner in which changes in the exchange rate affect the
movement of goods and services between countries, that is, the nature of the current account.
In Chapter 20, that market was presented in terms of components describing the current
account and the financial account. The demand for foreign exchange needed to purchase
goods and services with respect to different exchange rates was graphed in a “normal”
downward-sloping manner, and the supply of foreign exchange earned from exports of
goods and services at various exchange rates reflected the positive relationship associated
with “normal” supply curves. In this normal market configuration, changes in the exchange
Price Adjustment:
The Exchange Rate
Question
1Testimony of Chair Alan Greenspan before the Committee on Financial Services, U.S. House of Representatives,
February 11, 2004, obtained from www.federalreserve.gov.
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rate triggered changes in expenditures between domestic and foreign goods consistent with
well-known standard market adjustments. For example, assuming a current account deficit,
an increase in the exchange rate (depreciation of the home currency) causes foreign goods to
become more expensive, leading consumers to reduce consumption of imports and increase
consumption of domestic alternatives. At the same time, home exports become relatively
cheaper to foreign buyers, causing them to switch expenditures from their own products
to the cheaper imports. The expenditure switching reflected in both of these responses
contributes to a reduction in the current account deficit. Underlying this adjustment is the
assumption that consumers and producers respond quickly to changes in the exchange rate
and that supply prices of traded goods do not change with the changes in expenditures in
either country (infinitely elastic supply). In addition, any possible effects on income, the
interest rate, the expected profit rate, or other factors are also ignored. The adjustment
to changes in relative prices brought about by changes in the exchange rate is called the
elasticities approach to adjustment in the foreign exchange market, or the price
adjustment mechanism that follows changes in the exchange rate. However, because cur-
rent account adjustments do not always appear to take place in the manner described, it is
important to take a closer look at this component of the foreign exchange market and its
adjustments.
If we are to anticipate the effects of changes in the foreign exchange rate on the current
account balance more accurately, it is critical to understand the basic forces underlying
this market. To do this, we turn to the sources of demand and supply for a currency within
the current account and examine the factors that influence them. As discussed in Chapters
19 and 20, the current account-based demand for foreign currency results from the desire
to purchase goods and services from another country and to make unilateral transfers. In
a sense, the demand for foreign currency is a secondary or derived demand because the
foreign currency is a means to acquiring something else.
Ignoring unilateral transfers, the demand for foreign currency in the current account
is thus determined by the factors that drive the demand for real goods and services. The
demand for real imports is influenced principally by the domestic price of any foreign good
or service, the presence of any tariffs or subsidies, the price of domestic substitutes and/
or complements, the level of domestic income, and tastes and preferences. The domestic
price of the foreign good or service is the product of the price expressed in foreign currency
times the appropriate exchange rate (e.g., PUS$ = PUK£ × e$/£). Because the demand for
foreign currency by the home country can also be viewed as the supply of home currency to
the foreign country, if we know the demand for foreign exchange in each of two countries,
the supply of foreign exchange to each country is also known.
To get a better feel for the nature of this unique relationship between a country’s
home demand for foreign currency (its consequent supply of domestic currency to the
exchange market), consider the following hypothetical demands for foreign exchange in
two countries, the United States and the United Kingdom (see Table 1). It is assumed that
the demand for foreign exchange for acquiring goods and services responds to changes
in the exchange rate because of its effect on the domestic price of foreign goods. The data in
the table were constructed under the assumption that the supply prices of the traded goods
are invariant with the quantity demanded [see column (3)]. In this example, the variation
in the domestic price of the foreign good(s) is brought about by altering the exchange rate
from $1.50/£ to $1.00/£ [column (1)]. When the U.K. pound becomes relatively cheaper
(depreciates), the dollar price of the U.K. goods falls as shown in part (a) of Table 1. As
this happens, the quantity demanded of the U.K. good rises due to normal income and
substitution effects [column (5)]. Given the constant British price of the import good, the
The Demand for
Foreign Goods and
Services and the
Foreign Exchange
Market
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increase in U.S. quantity demanded of the U.K. good leads to an increase in the quantity
demanded of pounds [column (6) of part (a)]. Hence, the quantity demanded of pounds var-
ies inversely with the price of the pound, and a normal downward-sloping demand curve
results. Changes in the exchange rate thus produce a movement along the demand curve
for foreign exchange and a corresponding change in quantity demanded. The position of
the demand curve, however, is determined by factors other than the exchange rate, and any
change in these variables will cause the demand curve to shift. For example, an increase in
income, an autonomous increase in domestic prices relative to foreign prices, and a shift
in tastes and preferences toward the import good would all cause the demand curve for
foreign exchange associated with goods and services to shift out.
Part (b) of Table 1 proceeds similarly with the U.K. demand for a U.S. good. The
depreciation of the pound from $1.50/£ to $1.00/£ (i.e., the appreciation of the dollar from
£0.67/$ to £1.00/$) causes the United Kingdom to reduce its quantity demanded of the
U.S. good [column (5)]. The smaller quantity demanded of the U.S. good at the lower $/£
exchange rate results in a smaller quantity demanded of dollars [column (6)]. This demand
for dollars is then converted into a supply of pounds in column (7) of part (b).
With this information, we can now proceed to graph the foreign exchange market for
the U.S. dollar and the U.K. pound. This will be done both from the U.S. perspective
[Figure 1(a)] and from the U.K. perspective [Figure 1(b)]. The demand curve for pounds
in the United States is found by plotting the quantity of pounds demanded against the vari-
ous exchange rates from part (a) of Table 1. The supply of pounds available to the United
States from the United Kingdom at the various exchange rates is found by plotting the first
and last columns of part (b) for U.S. goods. The intersection of the two curves indicates the
exchange rate that leaves the current account in balance. In this case, the equilibrium rate
lies somewhere between $1.25 and $1.50 per pound.
A similar procedure is followed in presenting the foreign exchange market from the per-
spective of the United Kingdom. The demand for dollars [column (6) of Table 1, part (b)]
is plotted against the appropriate exchange rate [column (2) of part (b)] to generate the
expected downward-sloping curve. It is important to note that the price on the vertical axis
is the inverse of the exchange rate in the earlier case, that is, £/$ rather than $/£. For the
supply of dollars, we turn to the information on U.S. demand for U.K. products at different
TABLE 1 The Demand for Imported Goods and Services and the Foreign
Exchange Market
(1) (2) (3) (4) (5) (6) (7)
(a) United States
 e$/£ (e′£/$)  PUK  (PUS)  QD − US  QD £/− US  QS $/− US
$1.50/£ (£0.67/$) £10 ($15.00) 100 units £1,000 $1,500
$1.25/£ (£0.80/$) £10 ($12.50) 140 units £1,400 $1,750
$1.00/£ (£1.00/$) £10 ($10.00) 180 units £1,800 $1,800
(b) United Kingdom
(e′$/£)  e£/$  PUS  (PUK)  QD − UK  QD$ − UK  QS£ − UK
($1.50/£) £0.67/$ $20 (£13.33) 100 units $2,000 £1,333
($1.25/£) £0.80/$ $20 (£16.00) 80 units $1,600 £1,280
($1.00/£) £1.00/$ $20 (£20.00) 60 units $1,200 £1,200
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exchange rates. The quantity of dollars supplied from the United States [column (7) of
Table 1, part (a)] at the various exchange rates is then plotted, and the intersection of the
supply and demand curves again provides the equilibrium exchange rate. In this case, it lies
somewhere between £0.67/$ and £0.80/$. (If we knew the equations for the demand curve
and the supply curve, we could solve for the exact equilibrium price.) Note that the equilib-
rium exchange rate is the same in both cases because the figures show two ways of viewing
the same market. One price is the reciprocal of the other. If, for example, the equilibrium
exchange rate is $1.38/£ from the U.S. perspective, it would be 1/($1.38/£) or £0.72/$ from
the U.K. perspective. Thus, it makes no difference whether the foreign exchange market is
presented in pounds or dollars, since the same equilibrium exchange rate results.
The market shown in Figure 1 is stable with respect to deviations of the exchange rate
from equilibrium. Comparative-statics analysis also suggests that shifts in demand and sup-
ply will lead to new equilibria appropriate to the changing market condition. For example,
an increase in U.S. income would increase the demand for foreign goods and, hence, the
demand for foreign exchange. This would cause the demand curve for foreign exchange
to shift to the right, creating a current account deficit and requiring an increase in the price
of pounds (a depreciation of the dollar) to balance the current account [see Figure 2(a)].
A similar effect would result from an increase in the U.S. price level relative to the U.K.
price level. However, in this instance both of the curves will shift. U.S. demand for pounds
will rise as consumers shift from the now higher-priced U.S. products to British goods and
services. At the same time, British demand for U.S. goods and services (and hence the sup-
ply of pounds) will fall as British consumers shift from the now more expensive U.S. goods
and services to the relatively cheaper domestic products. The result again is the increase in
the dollar price of pounds [see Figure 2(b)] that is necessary to bring the current account
FIGURE 1 The Demand and Supply of Foreign Exchange Resulting from Trade in Goods and Services
500 0 0 1,000 1,500 2,000 2,500
2.00
1.75
1.50
1.25
1.00
e£/$
1.4
1.2
1.0
0.8
0.6
(b)
$
D$
S$
e$/£
(a)
£
S£ D£
500 1,000 1,500 2,000 2,500
The market for foreign exchange that results from the demand for traded goods displayed in Table 1 is demonstrated in the two graphs. In panel
(a), the market is presented from the vantage point of the United States. It shows the demand and supply of pounds that result from each country’s
demands for the other country’s goods, at alternative dollar prices of the pound. In panel (b), the same demands are expressed in terms of the
demand and the supply of dollars, at alternative pound prices of the dollar. The market equilibrium that results is the same, in that the $/£ price is
the inverse of the £/$ exchange rate.
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into balance. Changes in expectations regarding future prices and exchange rates as well
as changes in tastes and preferences would also shift the supply and demand curves for
foreign exchange.
It is important to reiterate that exports and imports can be brought into balance in
this “normal” market example if the dollar depreciates when the demand for pounds
exceeds the supply of pounds and if the dollar appreciates when pound supply exceeds
pound demand.
Up to this point, we have assumed that the foreign exchange market is characterized by
normal downward-sloping demand curves and upward-sloping supply curves. This condi-
tion was important because it generated a market equilibrium that can be characterized as
being stable with respect to price (exchange rate). Market stability occurs when the char-
acteristics of supply and demand are such that any price deviation away from equilibrium
sets in motion forces that move the market back toward equilibrium. With downward-
sloping demand and upward-sloping supply curves, a price that is too low creates an excess
demand, causing consumers to bid up the price until supply again equals demand and the
excess demand is removed. Similarly, a price that is set too high creates an excess supply,
causing producers to begin lowering price until supply again equals demand. Thus, the
market is stable with respect to deviations of price away from equilibrium. Stability thus
ensures that price increases (currency depreciation) will remove an excess demand for
foreign exchange (current account deficit) and price decreases (currency appreciation) will
remove an excess supply of foreign exchange (current account surplus).
Market Stability and
the Price Adjustment
Mechanism
FIGURE 2 Adjustment in the Foreign Exchange Market
e$/£
(b)
e$/£
(a)
£0 0

D D’£ D’£
S’£

£
eeq
e’eq
e’eq
eeq

£
ΔD£ = f (ΔYUS) ΔD£ = f (ΔPUS)
ΔS£ = f (ΔPUS)
An increase in U.S. income increases the demand for U.K. goods and hence the demand for pounds as shown by the rightward shift in the demand
curve in panel (a). This, of course, leads to a current account deficit at eeq. Balance in the current account will be obtained only through deprecia-
tion of the dollar (i.e., a higher exchange rate). An increase in U.S. prices, on the other hand, leads to a shift in both the demand and the supply
curve of pounds, as U.S. consumers demand more of the now cheaper U.K. imports and U.K. consumers reduce their demand for U.S. goods and
services. The combined result of the reduced supply of pounds and the increased demand for pounds is an even greater current account deficit and
hence an even larger depreciation of the dollar to again reach a current account balance, as indicated in panel (b).
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If the price adjustment mechanism is to work, it is necessary that the demand and supply
curves have the appropriate configuration. In Figure 3, three different market configura-
tions are shown (for any good or service, not just for foreign exchange). In panel (a), the
supply and demand curves produce an excess demand when price is too low and an excess
supply when price is too high. The market is thus stable in the manner discussed earlier. In
panel (b), the demand curve has the usual negative slope, but the supply curve is backward
sloping. However, the supply curve is steeper than the demand curve, with the result that
there is still an excess demand when price is below the equilibrium price and an excess
supply when price is above equilibrium. Thus, the market is also stable with respect to
price. Finally, in panel (c) there is a third market configuration that is similar to (b) except
that the backward-sloping supply curve is flatter than the demand curve. In this instance,
a price below the equilibrium price leads to an excess supply, and a price above the equi-
librium price leads to an excess demand. Because an excess demand leads to increases in
price and an excess supply leads to decreases in price, any movement away from equi-
librium sets in motion forces leading to further movements away from equilibrium, not
movements back to equilibrium. Thus, this is an example of a market that is unstable with
respect to price.
Returning to the foreign exchange market, can we expect that market to be “normal” as
long as the demand for foreign goods and services is inversely related to price (i.e., there is
a downward-sloping demand curve)? To answer this question, consider the demand sched-
ule in the United Kingdom for U.S. goods in Table 2. Note again that the price of U.K.
imports rises [column (4)] to the British as the pound depreciates [columns (1) and (2)] and
that U.K. consumers behave in a “normal” fashion by demanding a smaller quantity of U.S.
goods and hence fewer dollars [column (6)]. However, even though quantity demanded
falls, British consumers end up supplying more pounds sterling for the imports they would
be willing to buy [column (7)]. If we now reconstruct this portion of the foreign exchange
market from the U.S. perspective using this new example (see Figure 4), we find that
we have a market characterized by a backward-sloping supply curve of foreign exchange
FIGURE 3 Market Stability
(c)
P
Peq
Q
SD
(b)
P
Peq
Q
S D
(a)
P
Peq
Q0 0 0
S
D
Panel (a) depicts a normal market with a downward-sloping demand curve and an upward-sloping supply curve. If price moves away from Peq,
forces of supply and demand are automatically set in motion to move price back to Peq. Panel (b) demonstrates a market that is also stable with
respect to price even though it has a downward-sloping supply curve. The fact that too low (high) a price still creates an excess demand (supply)
means that market forces are automatically set in motion to return the market to equilibrium at Peq. Panel (c), however, depicts an unstable
market. If price is set too low (high), an excess supply (demand) occurs that leads to a further movement away from Peq, not a movement back
to equilibrium.
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(pounds). However, because the supply curve is steeper than the demand curve, the market
is still stable with respect to deviations in price. This example indicates that a backward-
sloping supply curve of foreign exchange can occur even if foreign demand for imports is
normal. Whether it produces a stable or an unstable market depends on the slopes of both
the supply and the demand curves for foreign exchange. More about this later.
Let us examine the circumstances that produced the backward-sloping supply curve of
foreign exchange. If we return to the numerical examples in Tables 1 and 2 for the United
Kingdom, note that the change in the exchange rate produced two effects. First, as the dol-
lar became more expensive, more pounds sterling were required to buy each given unit of
imports from the United States; at the same time, however, the number of units was falling
because of the increase in price in terms of pounds. Whether the total quantity supplied of
pounds increased or decreased with the change in the exchange rate depended on the rela-
tive size of these two effects.
Explaining the
Backward-Sloping
Supply Curve of
Foreign Exchange
TABLE 2 An Alternative U.K. Demand for U.S. Goods
UK′
(1) (2) (3) (4) (5) (6) (7)
e′$/£  e£/$  PUS  (PUK)  QD − UK  QD$ − UK  QS£ − UK
($1.50/£) £0.67/$ $20 (£13.33) 92 units $1,840 £1,227
($1.25/£) £0.80/$ $20 (£16.00) 85 units $1,700 £1,360
($1.00/£) £1.00/$ $20 (£20.00) 75 units $1,500 £1,500
FIGURE 4 The Foreign Exchange Market
500 0 1,000 1,500 2,000 2,500 3,000
2.00
1.75
1.50
1.25
1.00
e$/£
£


The alternative U.K. demand for imports of U.S. goods and services (see Table 2) produces a supply curve of
pounds that is downward sloping (or backward sloping), not upward sloping. However, because the demand
curve is still flatter than the supply curve, the equilibrium remains stable with respect to changes in price
(foreign exchange rate).
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The nature of this relationship can be measured by using the familiar concept of price
elasticity of demand. This elasticity is simply the ratio of the percentage change in quan-
tity demanded to the percentage change in price. Because we are examining rather large
changes in both price and quantity and not small marginal changes in the neighborhood
of a given price and quantity, it is appropriate to use an arc elasticity measure rather than
a point elasticity estimate. This is done by using the means of the two quantity and price
points over which the change in quantity and price is being examined. The arc elasticity is
then defined as follows:
ηarc =
ΔQ/ [(Q1 + Q2)/2]
ΔP/ [(P1 + P2)/2]
In the first numerical example in part (b) of Table 1, as the U.K. price increased from
£13.33/unit to £16/unit [column (4)], the quantity demanded fell from 100 units to
80 units [column (5)]. The arc elasticity of demand for this change in price is equal to
(80 − 100)/[(100 + 80)/2] divided by (16.00 − 13.33)/[(13.33 + 16.00)/2], which equals
(−)0.222/0.182 = (−)1.22. Because the (absolute) value of the elasticity is greater than 1.0,
demand is said to be elastic. If a similar calculation were carried out for the second change
in the exchange rate in Table 1 (the increase in price from £16/unit to £20/unit), the arc
elasticity is 1.29, which is also greater than 1.0 and hence elastic. The results confirm what
we know about elastic demand. An increase in price leads to a decline in total expenditures
because the percentage change in quantity demanded is greater than the percentage change
in the price. Thus, whenever the partner country elasticity of demand for home-country
products is elastic, the supply curve of foreign exchange will be upward sloping.
What happened in the case in Table 2 to make the supply curve of foreign exchange
backward sloping? A quick calculation of the elasticity of demand for imports sheds some
light on this question. As price rose from £13.33 to £16/unit, the quantity demanded fell
from 92 units to 85 units. The arc elasticity over this range is equal to (−)0.079/0.182 or
(−)0.434, which is less in absolute value than 1.0. Hence, demand for imports is inelastic
in this range. After the price increase from £16 to £20/unit, quantity demanded fell from
85 units to 75 units. This indicates an elasticity of demand of (−)0.125/0.222 = (−)0.563,
which again is less in absolute value than 1.0 and is inelastic. The inelastic demand means
that at the higher import price in pounds, U.K. consumers are willing to supply more
pounds (see the last column of Table 2). The mystery of the backward-sloping supply
curve of foreign exchange is now solved. If foreign demand for home goods is inelastic, the
supply curve of foreign exchange is backward sloping (i.e., negatively sloped). If demand
is elastic, the supply of foreign exchange will be upward sloping. For this relationship in
the special case of a linear demand curve, see Concept Box 1.
Because a backward-sloping supply of foreign exchange will result whenever the partner
demand for imports is inelastic, under what conditions will an unstable foreign exchange
market result? In other words, will a depreciation of the home currency lead to a decrease
in the excess demand for foreign exchange? If it does (does not), the exchange market is
stable (unstable). Ignoring unilateral transfers and factor income flows, the problem is to
assess the change in the current account balance that results when there is a change in the
exchange rate.2 For a basic demonstration of the problem, consider the price and quantity
Exchange Market
Stability and the
Marshall-Lerner
Condition
2Because instability occurs whenever the demand curve is steeper than the (backward-sloping) supply curve, the
condition for stability must necessarily take the characteristics of both curves into account. For a simple deriva-
tion of the stability condition, see Appleyard and Field (1986).
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CONCEPT BOX 1
ELASTICITY OF IMPORT DEMAND AND THE SUPPLY CURVE
OF FOREIGN EXCHANGE WHEN DEMAND IS LINEAR
Recall that with a linear demand curve, elasticity varies as
we move from high prices to low prices. More specifically,
at prices above the midpoint of the demand curve, demand
is elastic; at prices below the midpoint, demand is inelastic;
and at the midpoint, demand is unitary elastic. Because the
U.S. price of the U.K. import good is being held constant,
the change in price in our calculations is due entirely to
changes in the exchange rate. In this case, the demand for
dollars with respect to changes in the exchange rate has the
same elasticity value as does the U.K. demand for imports
with respect to U.K. domestic price of imports over the
same range. Consider the U.K. demand curve for U.S. dol-
lars in Figure 5(a). Corresponding to each range is a seg-
ment of the supply curve of pounds sterling to the United
States [Figure 5(b)]. The elastic range of the U.K. demand
curve for dollars corresponds to the upward-sloping portion
of the supply curve of pounds. Because the price of foreign
exchange from the U.S. perspective is the inverse of the price
from the U.K. perspective ($/£ versus £/$), range a of high
prices in the United Kingdom corresponds to low prices of
foreign exchange in the United States. Consequently, as the
foreign exchange rate falls in terms of £/$, it is rising in terms
of $/£. Thus, as the exchange rate in £/$ is falling toward b,
the point of unitary elasticity, it is rising toward b in $/£. At
points below b, demand for dollars is inelastic and, hence,
the supply of pounds sterling is backward sloping (range c).
While these ranges hold specifically only for linear demand
curves, the general relationship between import demand
elasticity and the supply of foreign exchange holds. Inelastic
import demand produces a backward-sloping supply curve of
foreign exchange to the partner country, and elastic demand
produces a normal, upward-sloping supply curve.
FIGURE 5 Import Demand and the Supply Curve of Foreign Exchange
e$/£
(b) United States
£
S£e£/$
(a) United Kingdom
$0 0
|η| > 1
|η| = 1
|η| < 1 b c a b c a D$ The elastic range of the foreign (U.K.) demand for home-country (U.S.) goods and services exports in panel (a) generates an upward- sloping supply curve of pounds in panel (b). In like fashion, the inelastic segment of the U.K. demand curve for imports of goods and services from the United States generates a backward-sloping supply curve of pounds to the United States. Thus, a country facing an inelastic foreign demand for its exports will experience a backward-sloping supply curve of foreign exchange. An overall elastic demand for exports will, on the other hand, produce the normal upward-sloping supply curve of foreign exchange. ● Final PDF to printer 572 PART 5 FUNDAMENTALS OF INTERNATIONAL MONETARY ECONOMICS app9062x_ch23_562-589.indd 572 06/08/16 08:47 AM adjustments in Figure 6 (for expositional convenience, the demand curves are drawn as straight lines). Panel (a) shows the demand and supply schedules for the home country’s imports, assuming that the price of the partner’s [or rest of the world’s (ROW’s)] goods and services is constant. Panel (b) shows the demand and supply schedules for home- country exports (partner country’s or ROW’s imports) again assuming a constant price of the goods and services. The prices in both cases are expressed in home currency ($). The initial prices are p1 and p′1, with corresponding quantities q1 and q′1. Assume that there is a depreciation of the dollar (the home currency). When this happens, SM (or the supply of exports to this country from the rest of the world) shifts vertically upward to S′M in panel (a), and DX shifts to D′X (or the demand for imports from this country by the rest of the world) in panel (b). Because the domestic price of imports has gone up, the home country demands a smaller quantity. In the partner country, the domestic price of its imports has gone down even though the home-country export price has remained constant (because the partner country currency has appreciated), which causes its demand curve to shift to the right. This shift reflects the fact that foreigners are prepared to buy more home-country goods and services at each dollar price. The ultimate effect on the current account balance depends on the changes in expendi- tures associated with the change in the exchange rate. If home-country demand is elastic, then the current account balance unambiguously improves with depreciation, because the increase in domestic price of imports leads to a reduction in total expenditures on imports and the reduced price of exports to foreigners leads to an increase in their expenditures on FIGURE 6 Market Effects of a Change in the Foreign Exchange Rate PM p2 QM0 0 (a) (b) p1 p'1 q'1 q'2 ($) S'M SM (S' exports of ROW) (S exports of ROW) DM Home q2 q1 PX QX ($) SX (Home) DX (D imports of ROW) D'X (D'imports of ROW) Assuming that the supply of exports is infinitely elastic in both countries (i.e., the supply curve of imports and the supply curve of exports in the home country are horizontal), a depreciation of the home currency leads to (1) an upward shift in the supply curve of imports from SM to S′M (due to the higher domestic price of imports in the home currency) and (2) a rightward shift in the demand for exports from DX to D′X (because the foreign currency price of home-country exports has fallen relatively). The effect of the depreciation on the value of imports depends on the elasticity of the demand for imports. Given that import outlays before the depreciation were p1q1 and after the depreciation are p2q2, the depreciation reduces import outlays only if import demand is elastic. If demand is inelastic, the value of import outlays in dollar terms actually rises. The value of export receipts increases unambiguously because a larger quantity q′2 than the original q′1 is purchased at a constant-dollar price. The ultimate impact of depreciation on the current account balance thus depends on the sum of these two effects and can be positive or negative depending on the elasticity of demand in each country for the other country’s goods and services. Final PDF to printer CHAPTER 23 PRICE ADJUSTMENTS AND BALANCE-OF-PAYMENTS DISEQUILIBRIUM 573 app9062x_ch23_562-589.indd 573 06/08/16 08:47 AM home-country exports. Similarly, the trade balance improves if home-country demand is unit elastic because total expenditures on imports will be unchanged and foreign expen- ditures on home-country exports will increase. If domestic demand is inelastic, however, the effect of depreciation is ambiguous. In this instance, the increase in the price of for- eign goods and services leads to an increase in total expenditures for imports, which may or may not be offset by the increased expenditures by the partner country on exports. As long as the increase in foreign expenditures more than offsets the increased domestic expenditures on imports, the trade balance will improve with depreciation, and hence the foreign exchange market will be stable. If, however, the increase in domestic expenditures on imports is greater than the increase in expenditures on home-country exports, the trade balance will worsen with depreciation, and the foreign exchange market will be unstable. As it turns out, the unstable result will not occur as long as the sum of the absolute val- ues of the home-country price elasticity of demand for imports, ηDm, and the price elasticity of demand for home-country exports (partner country imports), ηDx, is greater than 1.0 in the case of initial balanced trade, that is, |ηDm|+|ηDx| > 1. In the case of unbalanced trade
(expressed in units of home currency), the condition becomes
X
M
|ηDx | + |ηDm | > 1
where X and M refer to total expenditures on exports and imports, respectively. This general
condition for exchange market stability is referred to as the Marshall-Lerner condition.3
In the situation just discussed, the supply curves of imports and exports were horizontal,
or “infinitely elastic.” If we examine the effect of the exchange rate change on the current
account balance when supply curves take their normal shape, the analysis is more com-
plicated than in the previous case. In Figure 7, depreciation of the dollar shifts the supply
curve SM vertically upward by the percentage of the depreciation to S′M. Thus, for example,
the price p3 associated with point F is 10 percent higher than price p1 (associated with
the point E) if the depreciation of the dollar is 10 percent. Such a 10 percent vertical shift
occurs everywhere along SM. Price p3 would in fact have been the new equilibrium price if
the SM schedule had been horizontal, as in Figure 6(a). However, in Figure 7, the final price
p2 is lower than p3. The final change in import outlays due to the depreciation thus involves
looking at not only the elasticity of DM but also the elasticity of S′M. These elasticities in
turn reflect the elasticities involved in the underlying conditions of consumption and pro-
duction in both trading countries. We do not examine these underlying elasticities in this
chapter, but clearly matters become more complex.
A similar analysis would apply to the export side. In a diagram for the export case
(not shown), a depreciation of the home currency would shift DX to the right along an
upward-sloping SX curve, and the export good’s price would rise [whereas it does not
in Figure 6(b)]. For market stability in cases of upward-sloping SM and SX curves, the
Marshall-Lerner condition becomes more complicated. An extension for these cases is,
however, beyond the scope of this text.4
3For a mathematical derivation of this result, see the appendix at the end of this chapter. We are discussing the
balance in terms of the home currency because BOP accounts are kept in the home currency. The balanced-trade
result is the same if examined in terms of foreign currency, but the unbalanced condition is then
|ηDx | +
M
X
|ηDm | > 1
4In the case of upward-sloping supply curves, it can be shown through more advanced treatments (and can also be
reasoned out through graphs) that the simple Marshall-Lerner condition is a sufficient condition but no longer a
necessary condition for depreciation to improve the current account balance. In other words, the absolute demand
elasticities can sum to < 1 and the balance can still improve. Final PDF to printer 574 PART 5 FUNDAMENTALS OF INTERNATIONAL MONETARY ECONOMICS app9062x_ch23_562-589.indd 574 06/08/16 08:47 AM Estimating the actual elasticities in international trade is a difficult job given the com- plex and changing nature of trade. Considerable controversy has existed over estimates of these elasticities, particularly with respect to the econometrics employed. Although some statistical results suggest that these elasticities are quite low, the general consensus from various studies appears to be that market responses to price changes are sufficiently large to generate a stable foreign exchange market. Because long-run elasticities are higher (in absolute value) than short-run elasticities, the time frame can be important. The short-run versus long-run nature of elasticities will be discussed in the next section. FIGURE 7 Import Market Response to Changes in the Foreign Exchange Rate When Foreign Supply Is Not Infinitely Elastic PM p2 QM0 p1 ($) SM S'M DM p3 F E E' If foreign supply of traded goods is not infinitely elastic, the supply curve slopes upward to the right. Depreciation of the home currency will thus lead to an upward shift in the curve equal to the percentage change in the exchange rate. S′M thus lies above SM by a constant percentage of the price and not by a fixed amount (i.e., S′M will diverge from SM). The resulting change in the market price of imports will reflect both the elastic- ity of demand and the elasticity of supply of the traded goods and will be less than the percentage change in the exchange rate. This is demonstrated here, where the new equilibrium price p2 reflects a smaller increase in domestic price (relative to p1) compared with the effect of the depreciation of the currency EF. CONCEPT CHECK 1. What is the difference between a stable market equilibrium and an unstable equilibrium? Will a downward-sloping supply curve always pro- duce market instability? Why or why not? 2. What condition is required for stability in the foreign exchange market if both domestic and foreign supplies of traded goods are infi- nitely elastic? 3. How does the analysis of foreign exchange market stability relate to the impact of depre- ciation on the current account balance? In the previous section, we established that depreciating the currency would reduce current account deficits and appreciating the currency would reduce current account surpluses as long as the sum of the absolute values of the foreign and domestic elasticities of demand for imports was greater than 1.0 (the Marshall-Lerner condition for market stability). In this situation, the changes in the exchange rate bring about appropriate switches in expenditures between domestic and foreign goods. Assuming a current account deficit, an increase in the The Price Adjustment Process: Short Run versus Long Run Final PDF to printer CHAPTER 23 PRICE ADJUSTMENTS AND BALANCE-OF-PAYMENTS DISEQUILIBRIUM 575 app9062x_ch23_562-589.indd 575 06/08/16 08:47 AM IN THE REAL WORLD: ESTIMATES OF IMPORT AND EXPORT DEMAND ELASTICITIES In a study carried out at the Board of Governors of the Federal Reserve System, Peter Hooper, Karen Johnson, and Jaime Marquez (1998) estimated trade elasticities for the Group of Seven (G-7) countries. The estimates utilized quarterly data beginning in the mid-1950s or early 1960s and ending in late 1996 or early 1997 for Canada, Japan, the United Kingdom, and the United States. For Germany, France, and Italy, the study utilized quarterly data beginning around 1970 and also ending in late 1996 or early 1997. Both short-run and long- run price elasticities for total imports and total exports were calculated. These estimates are listed in Table 3. In the context of the Marshall-Lerner condition, the long- run estimates suggest that stability obtains as a general rule in all countries except France and Germany, where the sum of the absolute values of the two elasticities is less than 1.0. The elasticities were generally found to be lower for the con- tinental European countries than for the other countries, and Cooper, Johnson, and Marquez suggest that this result may be attributable to the low elasticities of demand for petro- leum (which looms large in continental European imports). The estimated long-run elasticities, however, show much greater responsiveness than do the short-run elasticities. In all cases, though, the short-run estimates are very small (very inelastic) and are not close to meeting the Marshall-Lerner condition for market stability. This suggests that current account behavior may appear to be unstable in the immedi- ate aftermath of a change in the exchange rate, for example, worsening in the presence of a currency depreciation. Federal Reserve interest in export and import demand elasticities did not end with the work of Hooper, Johnson, and Marquez. In work sponsored by the Federal Reserve Bank of Chicago, Leland Crane, Meredith A. Crowley, and Saad Quayyum (2007) attempted to replicate and extend the previously discussed work of Hooper, Johnson, and Marquez. Crane, Crowley, and Quayyum utilized import data from 1960–2006 and export data from 1981–2006. Countries included in this later study were the same as in the earlier study, although there were some differences in the estimation methods employed. With respect to results, many of the import price elas- ticities are more negative (i.e., have larger absolute value) in this later study that extended the data to 2006, suggest- ing increased responsiveness of import quantities to price changes in recent years. The higher import price elasticities may be associated with falling trade barriers, which allowed consumers to switch more easily to lower-cost producers. Crane, Crowley, and Quayyum find the greatest respon- siveness of import quantities to import prices in the case of Canada and the lowest import responsiveness in general in the cases of Germany, Italy, and Japan. On the export side, their price elasticities vary substantially from those reported in Hooper, Johnson, and Marquez but not in a systematic way. Overall, in the context of the Marshall-Lerner condi- tion, these estimates suggest that, in the long run, stability obtains as a general rule in all the countries studied, with the possible exceptions of Italy and Japan. Two studies of interest are Seema Narayan and Paresh Kumar Narayan (2010) and William Hauk (2011). Narayan and Narayan studied imports and exports of Mauritius and South Africa and concluded that demand elasticities were TABLE 3 Estimated Price Elasticities of Demand for Imports and Exports Country Short-Run Import Price Elasticity Short-Run Export Price Elasticity Long-Run Import Price Elasticity Long-Run Export Price Elasticity Canada −0.1 −0.5 −0.9 −0.9 France −0.1 −0.1 −0.4 −0.2 Germany −0.2 −0.1 −0.06 −0.3 Italy 0.0 −0.3 −0.4 −0.9 Japan −0.1 −0.5 −0.3 −1.0 United Kingdom 0.0 −0.2 −0.6 −1.6 United States −0.1 −0.5 −0.3 −1.5 Sources: Peter Hooper, Karen Johnson, and Jaime Marquez, “Trade Elasticities for G-7 Countries,” Board of Governors of the Federal Reserve System, International Finance Discussion Papers no. 609, April 1998, pp. 5–8. (continued) Final PDF to printer 576 PART 5 FUNDAMENTALS OF INTERNATIONAL MONETARY ECONOMICS app9062x_ch23_562-589.indd 576 06/08/16 08:47 AM exchange rate (depreciation of the home currency) causes foreign goods to become more expensive, leading consumers to reduce consumption of imports and increase consumption of domestic alternatives. At the same time, home exports become relatively cheaper to for- eign buyers causing them to switch expenditures from their own products to the cheaper imports. It was generally assumed in this analysis that consumers and producers responded quickly and that supply prices did not change with the switch in expenditures in either coun- try (infinitely elastic supply). Any possible effects on income, the interest rate, the expected profit rate, or other variables were also ignored. In addition, it was assumed that a change in the exchange rate registered fully as a change in goods prices facing consumers in the buying country. Hence, for example, a 10 percent depreciation of the home currency results in a 10 percent reduction in the prices of the home country’s goods to foreign consumers and a 10 percent rise in the prices of the foreign country’s goods to home consumers. Such a situation is said to be one of complete exchange rate pass-through. Given these assumptions, the Marshall-Lerner condition is sufficient to bring about the desired change in expenditures. As indicated earlier, short-run elasticities of supply and demand tend to be smaller (in absolute values) than long-run elasticities. On the demand side, consumers do not often adjust immediately to changes in relative prices. Because it may take time for consumers to alter consumption plans or product commitments, they may be slow to react to changes in the exchange rate. In many cases, contracts may already have been signed that com- mit importers to a certain volume of imports at the previous exchange rate. Under certain IN THE REAL WORLD: (continued) ESTIMATES OF IMPORT AND EXPORT DEMAND ELASTICITIES low enough that the Marshall-Lerner condition might not be satisfied for either country. Hauk undertook the task of estimating import and export demand (and export supply) elasticities at very detailed levels of disaggregation (some- times at the 10-digit level). Not surprisingly, a wide range of results occurred for the sizes of the elasticities. However, the signs of the estimated elasticities were correct and statisti- cally significant in a large majority of cases. Hauk made no overall judgment pertaining to the Marshall-Lerner condi- tion. Later, a 2014 study by Bahmani-Oskooee and Hosny examined the trade elasticities of Egypt in its trade with the United States for 36 industries. Employing data from 1994–2007 they concluded that the Marshall-Lerner condi- tion was met in 28 of 36 industries, including the four larg- est industries which accounted for 60 percent of the trade. These results suggest that depreciation of the Egyptian pound against the dollar should lead to an improved trade balance with the United States. Elasticity studies are likely to continue to take place, both because of the importance of the issue being addressed and because of the difficulties involved in determining actual elasticities. As noted in this chapter, the fact that long-run elasticities are more likely to satisfy the Marshall-Lerner condition than are short-run elasticities fits with common sense, because economic agents do respond in greater degree to price changes as time passes. Given that long-run estimates seem generally to satisfy Marshall-Lerner, econo- mists can expect that real-world trade balances may indeed respond to currency changes in the theoretically predicted manner over time. Sources: Peter Hooper, Karen Johnson, and Jaime Marquez, “Trade Elasticities for G-7 Countries,” Board of Governors of the Federal Reserve System, International Finance Discussion Papers no. 609, April 1998, pp. 5–8, obtained from www.federalreserve .gov; Leland Crane, Meredith A. Crowley, and Saad Quayyum, “Understanding the Evolution of Trade Deficits: Trade Elasticities of Industrialized Countries,” Federal Reserve Bank of Chicago, Economic Perspectives 31 (4th Quarter 2007), pp. 2–17, obtained from www.chicagofed.org; Seema Narayan and Paresh Kumar Narayan, “Estimating Import and Export Demand Elasticities for Mauritius and South Africa,” Australian Economic Papers 49, no. 3 (September 2010), pp. 241–52; William R. Hauk, Jr., “U.S. Import and Export Elasticities: A Panel Data Approach,” Empirical Economics, published online March 27, 2011; Mohsen Bahmani-Oskooee and Amr Samir Sadek Hosny, “Price and Income Elasticities: Evidence from Commodity Trade between the U.S. and Egypt,” International Economics and Economic Policy 11, no. 4 (December 2014), pp. 561–74. ● Final PDF to printer CHAPTER 23 PRICE ADJUSTMENTS AND BALANCE-OF-PAYMENTS DISEQUILIBRIUM 577 app9062x_ch23_562-589.indd 577 06/08/16 08:47 AM IN THE REAL WORLD: ESTIMATES OF EXCHANGE RATE PASS-THROUGH Jiawen Yang (1997) of George Washington University con- firmed that complete pass-through of exchange rate changes does not generally occur in the case of foreign exports to the United States. Yang used a sample of imports in 87 U.S. manufacturing industries to calculate the elasticity of exchange rate pass-through during the December 1980– December 1991 period. This elasticity on an industry basis is the percentage change in the import price index for a good (in dollars) divided by the percentage change in the (nominal effective) exchange rate. If there is complete pass- through of an exchange rate change into import prices, the elasticity would be equal to 1.0, meaning that the exchange rate change is fully reflected in the dollar price of the good to U.S. consumers. If there is no pass-through, it would be equal to zero, indicating that, despite the exchange rate change, the dollar price to U.S. consumers does not change. If the elasticity is between 0 and 1, there is partial exchange rate pass-through. Similarly, complete pass-through on the export side would mean that, for example, if a country’s cur- rency depreciated by 10 percent, then exporting firms of the country would not offset all of this 10 percent fall in the foreign price by raising the domestic price of their export goods. If the domestic price were raised but by less than 10 percent , the pass-through would be partial. In Yang’s estimates of short-run pass-through (“short- run” meaning the impact of an exchange rate change dur- ing one quarter on the import price in the succeeding quarter),Yang’s estimates were that, in 77 of the 87 indus- tries, the elasticities of pass-through were positive but less than 1.0. This partial pass-through was reflected in an aver- age elasticity of 0.3185, with elasticities in the 77 industries ranging from 0.025 in hardwood veneer and plywood to 0.757 in printing trades machinery. In general, he found that the nonelectric machinery and instruments industries had greater pass-through than did other industries. His estimates for long-run elasticities (using a slightly smaller sample) were higher, with some of the nonelectric machinery indus- tries approaching a value close to 1.0. A later study by Giovanni Olivei (2002) of the Federal Reserve Bank of Boston also presented calculations of the elasticities of exchange rate pass-through for the United States. Olivei worked with data for 34 industries, imports of which accounted for about 75 percent of nonenergy mer- chandise imports into the United States. Using data from the 1981–1999 period, he obtained short-run elasticities of exchange rate pass-through on import prices as low as 0.06 (footwear), 0.07 (rubber manufactures, not elsewhere specified), and 0.09 (radio broadcast receivers). On the other hand, some of the long-run elasticities were as high as 0.92 (nonferrous metals), 0.89 (aluminum), and 0.87 (electri- cal circuitry equipment). To see if any changes had taken place over the period, he made separate estimates for the 1980s and the 1990s. For the 1980s, the industries’ average long-run elasticity of pass-through was 0.50 (pass-through of 50  percent), but this fell to 0.22 in the 1990s (22 percent pass-through). Some recent studies also suggest that exchange rate pass- through is incomplete and weak. For example, with respect to U.S. imports of automobiles and auto parts, Turkcan and Ates (2009) estimated the pass-through for the 1998–2006 period to be about 25 percent, consistent with earlier stud- ies. In beer imports, Hellerstein (2008) determined that the median pass-through to retail prices over a recent four-year period for various brands was 23 percent. Such low pass- through elasticities imply that it takes a substantial deprecia- tion of the currency to have any significant impact on the trade balance. Other recent literature is also noteworthy. Ben Cheikh (2012) estimated that, for Eurozone countries, import pass- through elasticities are higher for larger exchange rate changes than for smaller exchange rate changes. Further, for some countries the pass-through was greater for currency depreciations than for currency appreciations. Choudhri and Hakura (2012), studying elasticities in the short run, found for 18 advanced economies that import price pass-through (average value of 0.60) was greater than export price pass- through (average value of 0.39); for 16 emerging/develop- ing countries the import price pass-through (average value of 0.54) was only slightly larger than the export price pass- through (average value of 0.51). Finally, Bussière, Chiaie, and Peltonen (2014) studied 40 countries and importantly concluded that export price pass-through is higher for emerging/developing countries than for advanced countries and that pass-through elasticities are lower in the United States than in other developed countries. Sources: Rebecca Hellerstein, “Who Bears the Cost of a Change in the Exchange Rate? Pass-Through Accounting for the Case of Beer,” Journal of International Economics 76, no. 1 (September 2008), pp. 14–32; Giovanni P. Olivei, “Exchange Rates and the Prices of (continued) Final PDF to printer IN THE REAL WORLD: JAPANESE EXPORT PRICING AND PASS-THROUGH IN THE 1990s The concept of complete exchange rate pass-through, as noted earlier, involves a change in goods prices to foreign buyers by the same relative extent as the change in relative currency values. Thomas Klitgaard (1999) of the Federal Reserve Bank of New York sought to determine if this was the case with some particular Japanese exports to the United States in the 1990s. During that time, the yen strongly appreciated relative to the dollar from 1991 to 1995 and strongly depre- ciated from 1995 to 1998. He found that, for the particular goods and in both directions of movement of the yen, export prices from Japan did not move to the same degree as did the exchange rate. In other words, when the yen appreciated, for example, Japanese exporters reduced their profit margins to some extent to prevent the goods prices from rising as much as the price of the yen rose. (The analogous result occurred when the yen depreciated.) In general, Klitgaard concluded that a 10 percent change in the price of the yen would lead to roughly a 4 percent offsetting change in the profit margin (relative to the profit margin on goods sold in Japan). This finding suggests an offset of about 40 percent (4%/10% = 0.4) and therefore a pass-through of about 60 percent. Utilizing exchange rate and price data, as well as other relevant information pertaining to costs and prices, Klitgaard constructed estimating equations for the behavior of prices in four prominent Japanese export industries—industrial machinery, transportation equipment, electrical machin- ery, and precision equipment. He was then able to use the estimating equations to simulate time paths of goods price changes that would follow upon a change in the value of the yen. These time paths are portrayed in Figure 8, pan- els (a) and (b). Although there are occasional irregularities, the export price changes for three of the aggregated prod- ucts (industrial machinery, transportation equipment, and electrical machinery) converge within 18 months to about a 4 percent change, while the prices of precision equipment products converge within 18 months to about a 2 percent price change. Thus, pass-through is ultimately fairly sub- stantial although not complete. Source: Thomas Klitgaard, “Exchange Rates and Profit Margins: The Case of Japanese Exporters,” Federal Reserve Bank of New York, Economic Policy Review, April 1999, pp. 41–54. (continued) IN THE REAL WORLD: (continued) ESTIMATES OF EXCHANGE RATE PASS-THROUGH Manufacturing Products Imported into the United States,” Federal Reserve Bank of Boston New England Economic Review (First Quarter 2002), pp. 3–18; Kemal Turkcan and Aysegul Ates, “An Examination of Exchange Rate Pass-Through to U.S. Motor Vehicle Products and Auto-Parts Import Prices,” Global Economy Journal 9, no. 1 (March 2009), Article 3; Jiawen Yang, “Exchange Rate Pass- Through in U.S. Manufacturing Industries,” Review of Economics and Statistics 79, no. 1 (February 1997), pp. 95–104. Nidhaleddine Ben Cheikh, “Asymmetric Exchange Rate Pass-Through in the Euro Area: New Evidence from Smooth Transition Models,” Economics: The Open-Access Open-Assessment e- journal 6, October 26, 2012, pp. 1–28; Ehsan U. Choudhri and Dalia S. Hakura, “The Exchange Rate Pass-Through to the Import and Export Prices: The Role of Nominal Rigidities and Currency Choice,” IMF Working Paper 12–226, September 2012, pp. 1–33; Matthieu Bussiere, Simona Della Chiaia, and Tuomas A. Peltonen. “Exchange Rate Pass-Through in the Global Economy: The Role of Emerging Market Economies,” IMF Economic Review 62, no.1 (April 2014), pp. 146–78. ● 578 PART 5 FUNDAMENTALS OF INTERNATIONAL MONETARY ECONOMICS app9062x_ch23_562-589.indd 578 06/08/16 08:47 AM scenarios, the quantity of imports may even rise if importers view the initial change in the exchange rate as the first of several rises and purchase more now to avoid an even higher domestic price in the future. It is not surprising, then, to see the quantity of imports demanded and hence (other things equal) the amount of foreign exchange needed remain relatively constant in the short run even though the domestic currency is depreciating Final PDF to printer IN THE REAL WORLD: (continued) FIGURE 8 Short-Run Response of Export Prices to a 10 Percent Yen Appreciation –1 –2 –3 –4 –5 –6 –7 Months after appreciation (a) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Industrial machinery Percent change Percent change Transportation equipment 17 18 –1 –2 –3 –4 –5 –6 –7 Months after appreciation (b) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Precision equipment Electrical machinery The simulated price patterns in the four industries portrayed suggest that Japanese export prices do fall to offset some of a simulated appreciation of the yen. The pass-through is about 60 percent for industrial machinery, transportation equipment, and electrical machinery and about 80 percent for precision equipment. Source: Thomas Klitgaard, “Exchange Rates and Profit Margins: The Case of Japanese Exporters,” Federal Reserve Bank of New York, Economic Policy Review, April 1999, p. 48. Used with permission. ● CHAPTER 23 PRICE ADJUSTMENTS AND BALANCE-OF-PAYMENTS DISEQUILIBRIUM 579 app9062x_ch23_562-589.indd 579 06/08/16 08:47 AM (i.e., the short-run demand for foreign exchange is vertical).With the passage of time, the demand curve for foreign exchange will more closely approximate the long-run demand curve as more normal quantity responses occur. On the supply side of foreign exchange, the supply of exports may not increase imme- diately in response to depreciation simply due to the decision-making lags involved. These lags include (a) a recognition lag with respect to the change in the exchange rate, Final PDF to printer 580 PART 5 FUNDAMENTALS OF INTERNATIONAL MONETARY ECONOMICS app9062x_ch23_562-589.indd 580 06/08/16 08:47 AM (b) a decision-making lag, (c) a production/inventory replacement lag, and (d) a delivery lag. The supply of exports also may not rise if producers choose to raise the domestic price in response to the increased foreign demand and to increase short-term profit margins at the expense of increased sales (i.e., incomplete pass-through). In addition, contracts may already have been signed agreeing to provision of certain quantities at the old exchange rate. If the quantity of exports does not rise in the short run with depreciation of the cur- rency, then the short-run supply curve of foreign exchange will be backward sloping as long as domestic prices remain constant or do not increase as fast as the exchange rate. However, with the passage of time, the supply curve will tend to take on the characteristics of the long-run response. As an example, a relatively recent study by Mohsen Bahmani- Oskooee and Hanafiah Harvey (2009) found that, for Indonesia in its trade with five lead- ing partners (Canada, Japan, Malaysia, Singapore, and the United Kingdom), a currency deprecation would worsen the trade balance in the short run but would lead to improve- ment in the long run. However, working against the J-curve hypothesis was the result that, for eight major trading partners, the short-run worsening also persisted into the long run. If the short-run responses of producers and consumers are similar to those described earlier, they can theoretically create certain problems with respect to the price adjust- ment mechanism. In Figure 9, panel (a), the normal long-run supply and demand for foreign exchange are shown with an equilibrium exchange rate that produces a current account deficit, although there is overall equilibrium in the balance of payments at rate eeq. Suppose that there is now a reduction in the supply of foreign exchange, due, for example, to less foreign investment in the United States. This would immediately put FIGURE 9 Adjustment Time and the Foreign Exchange Market e eeq f g DG&S Dtotal SG&S S'total Stotal Foreign exchange 0 0 e SG&S SG&S DG&S Foreign exchange (a) (b) SR DG&S SR The equilibrium foreign exchange rate represented in panel (a) produces a deficit (fg) in the current account. A reduction in the supply of foreign exchange (to S′total) would immediately depreciate the currency and reduce or possibly eliminate the current account deficit if the market responds in the short run in the manner depicted by supply and demand curves SG&S and DG&S. However, in the short run, consumers and producers may be unable or unwilling to respond to the price signals given by the exchange rate change. The short run may thus be characterized by supply and demand curves of foreign exchange in the current account similar to those depicted by the dashed lines SSRG&S and DSRG&S in panel (b). In such an instance, depreciating the currency leads to a worsening of the current account deficit in the short run; that is, the gap between the two dashed curves gets wider with depreciation. Given enough time, consumers and producers respond in a manner consistent to that described by SG&S and DG&S in panel (a) and the depreciation leads, as expected, to a reduction in the current account deficit. Final PDF to printer CHAPTER 23 PRICE ADJUSTMENTS AND BALANCE-OF-PAYMENTS DISEQUILIBRIUM 581 app9062x_ch23_562-589.indd 581 06/08/16 08:47 AM upward pressure on the exchange rate, presumably leading to a reduction in the current account deficit. However, suppose that short-run supply and demand curves for foreign exchange for goods and services have the shapes described earlier [as indicated by the dashed lines in Figure 9(b)]. With a vertical demand curve for foreign exchange and a backward- sloping supply curve, an increase in the exchange rate will lead to a larger current account deficit, not a smaller one. In the short run, this will cause the dollar to depreciate even further as demand for foreign currency continues to exceed supply. The current account deficit will continue to worsen in this case until sufficient time has passed for quantities supplied and demanded to adjust to the change in relative prices and for the longer-run supply and demand configurations to come about. As this adjustment takes place, the current account deficit will begin to decline, and the market will seek a new long-run equilibrium consistent with the change in market conditions. This current account adjust- ment to changes in the exchange rate is often plotted against time, producing a graph like that shown in Figure 10. Due to the shape of the response curve, it is often referred to as the J curve. With the current account in deficit, a depreciation of the currency would presumably lead to a removal of the deficit. However, if consumers and producers are unresponsive in the short run, depreciation actually leads to a short-run worsening in the current account before it ultimately gets better. The longer both groups remain unresponsive to the change in the exchange rate, the deeper is the J curve response. Such an adjustment response is of concern to policymakers because it adds to the uncertainty already present in the market, although some evidence appears to suggest that there is a lag between exchange rate changes and trade adjustment. If short-run market conditions do not meet the Marshall-Lerner condition for stability, the exchange rate can overshoot the new long-run equilibrium rate and then adjust back down as the longer-run responses become evident. FIGURE 10 The J Curve X – M (+) (–) Time (X – M) = f (e, time) Point of depreciation If consumers and producers do not respond immediately to changes in prices of traded goods and services resulting from shifts in the exchange rate, depreciation of the currency may actually lead to a worsening in the current account balance in the short run. If with the passage of time, however, the price effects do have an impact on both consumers and producers, the deficit will begin to narrow. The lagged adjustment response of the current account balance to depreciation of the currency traces out a locus that resembles the letter J. Hence, it is referred to as the J curve. Final PDF to printer 582 PART 5 FUNDAMENTALS OF INTERNATIONAL MONETARY ECONOMICS app9062x_ch23_562-589.indd 582 06/08/16 08:47 AM Thus, considering the J curve, changing the exchange rate eventually leads to the predicted current account effects. In addition, other economywide indirect effects of an exchange rate change may have a bearing on the nature of the adjustment in the foreign sector. For example, depreciating the currency may stimulate income and employment as long as the export- and import-competing goods sectors and their intermediate good suppliers are at less than full employment. However, depreciation in an economy with little or no excess capacity may do nothing more than stimulate domestic price increases, which offset the initial effects of depreciation and lead to little or no change in the cur- rent account. Depreciation may also stimulate investment in export- and import-compet- ing industries and shift it away from other domestic uses. If such structural changes are not consistent with the long-run comparative advantages in the country, they can actually decrease growth of output, income, and employment. In a similar fashion, appreciation will stimulate contraction in export goods and import-competing goods. As such, it will IN THE REAL WORLD: U.S. AGRICULTURAL EXPORTS AND EXCHANGE RATE CHANGES While the growth in net exports is related to changes in the effective exchange rate, changes in foreign growth rates are also critical for this growth. This can be seen in the analysis of exports in the 2009 Economic Report of the President: Real exports of goods and services grew at a 7 percent annual rate during the first three quarters of 2008, follow- ing solid growth of at least 7 percent over the preceding 4 years. The rapid pace of export expansion over the past 5 years coincided with strong foreign growth from 2003 to 2007, as well as changes in the terms of trade between 2002 and mid-2008 that made American goods cheaper relative to those of some other countries. Recently, how- ever, economic growth among our major trading partners has slowed considerably, with the Euro zone, Japan, and Canada posting negative growth. Because foreign growth and U.S. exports are closely related, the global economic slowdown will likely weigh on U.S. exports in the future. The role of foreign growth rates is particularly evident in the exports of the agricultural sector of the U.S. economy. Agricultural goods comprised 27 percent of U.S. exports in 2007. The economists with the United States Department of Agriculture (USDA) Economics Research Service said that the direct impact of the 2007–2009 recession on agricul- ture would be modest. Domestic customers would continue to buy food, although types might change, including meat selections. However, the major impact would be indirect effects, stemming from the economic growth of overseas markets, including the value of other international curren- cies to the U.S. dollar. But the USDA economists stated, “U.S. agricultural exports of high-value agricultural prod- ucts tend to be more sensitive to changes in foreign income growth and less sensitive to exchange rate changes than those of bulk commodity exports.” The USDA economists continued by pointing out that changes in the exchange rate generally help meat exports more than crops, because meats are a high-value export and grain is a bulk commodity. The subsequent actual export experience of the United States from 2007 to 2014 was consistent with these USDA predictions. U.S. agricultural exports grew by 67.2 percent during that period, while total U.S. exports grew by only 41.4  percent. Within agricultural exports, bulk goods (grains, oilseeds, cotton, and tobacco) increased by 42.0  percent from 2007 to 2014, while high-value goods (containing diverse items such as fresh fruits and vegetables, flour, processed meats juice, wine) grew by 84.7 percent over that period. These increases occurred during worldwide recovery from recession, and as the real effective exchange rate of the dol- lar fell from 103.6 in 2007 to 95.1 in 2011 (an 8.2 percent depreciation of the dollar) before rising to 98.0 in 2012, 99.1 in 2013, and 101.2 in 2014. Foreign income and exchange rate changes do seem to play an influential role in the perfor- mance of U.S. agricultural exports. Sources: Economic Report of the President, February 2009 (Washington, DC: U.S. Government Printing Office, 2009); Stu Ellis, “Farm Prosperity Depends on the Future Value of the US Dollar,” The Farm Gate, University of Illinois, April 9, 2009, obtained from www.farmgate.uiuc.edu/archive/2009/04/farm_ prosperity.html; ers.usda.gov; data.imf.org. ● Final PDF to printer CHAPTER 23 PRICE ADJUSTMENTS AND BALANCE-OF-PAYMENTS DISEQUILIBRIUM 583 app9062x_ch23_562-589.indd 583 06/08/16 08:47 AM tend to have a deflationary effect on the economy. To the extent the deflationary effect reduces income growth and hence imports, the indirect effects will again offset some of the direct effects of the appreciation. In cases where the indirect effects are further influenced by monetary or interest rate effects on investment, the short-run effect of changes in the exchange rate via the price adjustment mechanism becomes even less clear. In sum, while the price adjustment mechanism seems to function with certain regularity in long-run situ- ations, the short-run effects are relatively more volatile and less certain.5 THE PRICE ADJUSTMENT MECHANISM IN A FIXED EXCHANGE RATE SYSTEM Instead of letting the foreign exchange market determine the value of the exchange rate, countries often fix or peg the value of the domestic currency. In the case of a gold standard (as operated successfully in the world economy from 1880 to 1914), currencies are valued in gold, and all currencies that are pegged to gold are therefore automatically tied to each other. The price is maintained because the government stands ready to buy and sell gold to all customers at the pegged value. For example, if the dollar is fixed at $50 per ounce of gold and the pound sterling is fixed at £25 per ounce of gold, then the dollar/pound mint par exchange rate is $2/£. Should this rate or any of the related cross-rates get out of line, arbitrage will quickly bring them back in line. Because the exchange rate is not allowed to change in this system, some other type of adjustment must be relied upon to make certain that the demand for foreign exchange is equal to the supply of foreign exchange. To ensure proper adjustment, the following rules of the game are assumed to hold under a gold standard: 1. There is no restraint on the buying and selling of gold within countries, and gold moves freely between countries. 2. The money supply is allowed to change in response to the change in gold holdings in a country. 3. Prices and wages are assumed to be flexible upward and downward. The operation of a gold standard is straightforward. Consider the foreign exchange market in Figure 11(a) describing the dollar/pound exchange rate in a gold standard con- text. Assume that the market is initially in equilibrium at the pegged rate of $2/£. Now assume that the demand for pounds sterling rises due to an increase in income in the United States (shown by D′£).With the increase in demand for pounds, there is now an excess demand at the pegged rate. The excess demand for pounds sterling will produce upward pressure on the exchange rate to remove the market disequilibrium. The fact that govern- ments stand ready to buy and sell currency at the pegged rate means that there is automati- cally an upper and lower limit to the amount that the exchange rate can change. Buyers and sellers of foreign exchange know that they can always buy or sell the foreign currency at mint par by using gold as a medium of exchange. By buying gold domestically and then shipping it to the partner country, the mint par rate of exchange can be obtained. In fact, if the transaction costs and shipping costs associated with the movement of gold were zero, the exchange rates would never vary from the mint par value, because any difference in market value from the mint par value would quickly be arbitraged away. However, because the transaction/transport costs associated with the use of gold are not zero, the Gold Standard 5For a literature review, see Mohsen Bahmani-Oskooee and Scott William Hegerty, “The J- and S-Curves: A Survey of the Recent Literature,” Journal of Economic Studies 37, no. 6 (2010), pp. 580–96. Final PDF to printer 584 PART 5 FUNDAMENTALS OF INTERNATIONAL MONETARY ECONOMICS app9062x_ch23_562-589.indd 584 06/08/16 08:47 AM exchange rate can vary slightly as long as its movement away from mint par value does not exceed the amount of the costs associated with the exchange of gold. To illustrate, assume that the cost of acquiring gold, shipping it to the partner country, and then exchanging it for the foreign currency is 2 percent of par value. In our exam- ple, this would mean that the cost would be $0.04 on either side of the mint par value of $2.00/£. As the exchange rate inches upward due to the increase in the demand for pounds, demanders will pay up to $2.04/£ but no more, because they can acquire all the pounds they wish at the rate of $2.04/£ by using gold as a medium of exchange. The supply of pounds sterling becomes perfectly elastic at this “break-even” price because it is assumed that an unlimited amount of pounds can be acquired at this price ($2.04/£) by buying and exporting gold to England and acquiring pounds at the pegged value. Similarly, a shift in the supply curve to the left, which would raise the exchange rate above $2.04/£, would cause domestic residents who desire pounds to use the gold mechanism to acquire them at $2.04/£ instead of using the more costly foreign exchange market. Thus, the demand curve for foreign exchange becomes horizontal at $2.04/£ as well. The upper break-even price at which the supply and demand for pounds become perfectly elastic is often referred to as the gold export point. From the English perspective, a similar point exists at a price of $1.96/£. The English never need pay a higher price for dollars or receive a lower price for pounds than $1.96/£ (£0.51/$) because that is the cost associated with acquiring gold in England, ship- ping it to the United States, and exchanging it for dollars at the pegged rate. Thus, if the exchange rate starts edging downward from $2/£, it will never go beyond $1.96/£ because FIGURE 11 The Foreign Exchange Market under a Gold Standard e$/£ $2.00 S£ D£ D'£ £ e$/£ $2.04 $2.00 $1.96 S£ D£ Mint par £0 0 (b)(a) Under a fixed exchange rate system, an increase in the demand for foreign exchange to D′£ in panel (a) will put upward pressure on the exchange rate and the home currency (the dollar) will begin to depreciate. However, assuming that the transaction/transport cost for acquiring and using gold to acquire pounds is 2 percent, a U.S. resident need never pay more than $2.04/£ [as indicated by the upper solid lines in panel (b)]. Hence when e approaches this point, gold will be purchased and used to acquire the needed foreign exchange; that is, gold exports from the United States will take place. Similarly, the British need never pay more than $1.96/£ [the lower solid lines in panel (b); $2.00 minus the 2 percent trans- action/transport cost]. At that price, they can acquire all the dollars they wish by first buying gold and then exchanging the gold for dollars; that is, gold would flow into the United States. The unrestricted acquisition and use of gold as an intermediary between the two currencies will thus maintain the market exchange rate within the band around the mint par value determined by transaction/transport costs. Final PDF to printer CHAPTER 23 PRICE ADJUSTMENTS AND BALANCE-OF-PAYMENTS DISEQUILIBRIUM 585 app9062x_ch23_562-589.indd 585 06/08/16 08:47 AM at that point gold will start moving into the United States to be exchanged for dollars. From the U.S. standpoint, the demand for pounds sterling also becomes perfectly elastic at this point because if the exchange rate fell below this level, it would immediately be profitable to acquire pounds sterling with dollars, purchase gold with the pounds sterling, ship it to the United States, convert it to dollars, and make a profit. This floor on the exchange rate set by transaction/transport costs is referred to as the gold import point, because any excess supply of pounds at that price will be converted into gold and shipped to the United States to be exchanged for U.S. dollars. Thus, the actual exchange rate in the foreign exchange market is automatically maintained within this narrow band by the unrestricted move- ment of gold between trading countries, relying on nothing more than free-market arbitrage and the government’s commitment to stand behind its currency at the pegged value. The foreign exchange market under a gold standard thus takes on the configuration described in Figure 11(b), with the ceiling and floor to the rate set by the gold import and export points. If the exchange rate remains fixed within these narrow bounds, does this mean that there is no price adjustment mechanism to correct any structural imbalance leading to gold flows? While relative price changes via exchange rate changes basically cannot occur, an aggregate price adjustment takes place as the money supply responds to the gold flow. Assuming a link between money and prices through a quantity theory of money relationship (Ms = kPY from the preceding chapter), as gold leaves a country the money supply falls, leading to a fall in prices. Assuming in addition that the demand for tradeable goods is elastic, the fall in prices in the “deficit” country tends to reduce import outlays and increase export receipts. This effect is strengthened by the fact that the money supply and prices are increasing in the surplus country receiving the shipments of gold. Thus, the “price adjustment mechanism” that operates through the gold standard is an aggregate price effect operating through changes in the money supply resulting from the movement of gold. However, flexibility in wages and prices is obviously required for this mechanism to work. Price-wage rigidities in practice will thus be a hindrance to effective adjustment. The change in the money supply can also lead to interest rate and income effects. Indeed, for many economists, the principal effect of changes in the money supply is on the level of interest rates and then indirectly on income and prices. From this perspec- tive, a fall in the money supply will lead to an increase in interest rates, which will reduce investment, income, and hence aggregate demand in the economy. The fall in demand will lead to excess inventories and falling prices and wages. With the fall in prices comes an adjustment in the foreign exchange market similar to that discussed earlier. In addition, the increase in the interest rate will attract short-term capital from abroad (as appears to have been important in the actual gold standard period). An inflow of gold produces the opposite effects. Again, any price effect is an aggregate phenomenon, not a direct adjust- ment occurring only in the foreign sector. Hence, the price adjustment mechanism in the gold standard works as a strong disciplin- ary force against inflation in a country because the inflation causes a “deficit” and sets the adjustment mechanism into motion. It should be noted, though, and as we develop further in Chapter 29, that countries with substantial upward price pressure in the modern world are reluctant to undergo the discipline of the gold standard and have adopted various other exchange rate arrangements. Exchange rates can, of course, be pegged without any direct reference to gold. Under a pegged rate system, governments fix the price of their currency and stand ready to support the fixed price in the foreign exchange market (government intervention). If an increase The Price Adjustment Mechanism and the Pegged Rate System Final PDF to printer 586 PART 5 FUNDAMENTALS OF INTERNATIONAL MONETARY ECONOMICS app9062x_ch23_562-589.indd 586 06/08/16 08:47 AM in the demand for foreign currency threatens to drive the exchange rate up beyond some stated limit, the government must stand ready to supply a sufficient amount of foreign exchange to hold the exchange rate within the limits or band it has agreed to. Similarly, any increase in supply of foreign exchange that will drive the exchange rate below the lower limit must be offset by sufficient government purchases of the foreign currency. The central bank thus stands ready to intervene by buying foreign currency when the domestic currency is strong and by selling foreign currency when the domestic currency is weak, in order to maintain the pegged value. This type of system differs from a gold standard in that the initiative comes from central banks buying and selling foreign currencies in the intervention process rather than from individuals buying and selling gold. This requires that governments that peg their cur- rencies must have a sufficient supply of foreign exchange reserves to defend the value of their currency. The adjustment effects under a pegged system are similar to those of the gold standard. Upward pressure on the exchange rate brought about by an increase in the demand for foreign exchange will cause the central bank to supply the market with foreign exchange (sell foreign exchange for domestic currency). The purchase of domestic cur- rency by the central bank will lead to a reduction in the money supply and to macroeco- nomic adjustments in interest rates, income, and prices. Symmetrically, a market increase in the supply of foreign exchange will lead to the purchase of foreign currency by the central bank with domestic currency, which will increase the money supply and stimulate expansionary macro effects on interest rates, income, and prices. If any of these automatic adjustment effects are to take place under a fixed-rate system, whether a formal gold standard or a pegged system, the central bank must allow the actions being taken in the foreign exchange market to exercise their influence on the domestic money supply. Thus, the central bank loses control of the money supply as a policy tool for other purposes, and shocks in the foreign sector result in a direct macro adjustment through changes in interest rates, income, and prices. Structural disequilibria in the foreign sector can thus become the “tail that wags the dog” because the problem can be solved only by an economywide adjustment under a fixed-rate system. This will be discussed in greater detail in following chapters. CONCEPT CHECK 1. Explain why producers and consumers respond differently to price (exchange rate) changes in the short run relative to the long run. 2. What effect can lagged consumer-producer response to exchange rate changes have on the current account balance? On price adjust- ment in the foreign exchange markets? 3. How would a decrease in the demand for for- eign exchange affect a country’s supply of gold under a gold standard? Why? SUMMARY This chapter focused on issues related to price adjustments and balance-of-payments disequilibrium. The conditions underly- ing the demand and supply of foreign exchange were exam- ined and the market stability conditions analyzed with respect to price adjustments. The link between the demand for traded goods and services and the elasticities that characterize the current account were developed, and the Marshall-Lerner condition for market stability was considered. Assuming mar- ket stability, the price adjustment mechanism under flexible exchange rates causes expenditure switching between foreign and domestic goods and services as relative prices change with changes in the exchange rate. This expenditure-switching occurs to the extent that exchange rate changes influence goods prices (i.e., to the extent that “pass-through” occurs). Final PDF to printer CHAPTER 23 PRICE ADJUSTMENTS AND BALANCE-OF-PAYMENTS DISEQUILIBRIUM 587 app9062x_ch23_562-589.indd 587 06/08/16 08:47 AM KEY TERMS complete exchange rate pass-through elasticities approach elasticity of exchange rate pass-through expenditure switching gold export point gold import point gold standard J curve market stability Marshall-Lerner condition mint par partial exchange rate pass-through pegged rate system price adjustment mechanism rules of the game QUESTIONS AND PROBLEMS 1. “The existence of a downward- (or backward-) sloping sup- ply curve of foreign exchange is a sufficient condition for the generation of an unstable equilibrium position in the foreign exchange market.” Assess the validity of this statement. 2. “The existence of a downward- (or backward-) sloping supply curve of foreign exchange is a necessary condition for the generation of an unstable equilibrium position in the foreign exchange market.” Assess the validity of this statement. 3. Suppose that both the supply curve of imports to country A and the supply curve of exports from country A are horizon- tal (as in Figure 6). Assume that at a predepreciation value of A’s currency, country A sells 975 units of exports and pur- chases 810 units of imports. (You do not need to know the actual prices of imports and exports, but assume that trade is initially balanced.) Suppose now that there is a 10 percent depreciation of A’s currency against foreign currencies and that because of the depreciation exports rise to 1,025 units and imports fall to 790 units. Would the simple Marshall- Lerner condition suggest that country A’s current account balance has improved or deteriorated because of this depre- ciation of its currency? Explain carefully. 4. The U.S. dollar depreciated markedly against the yen in the early 1990s, and yet U.S. net imports from Japan contin- ued to rise in the short run. How might this counterintuitive behavior be explained? 5. Do you as a consumer think that there is much of a time lag between when a price change of an imported good in your market basket occurs and when you react (if at all) to this price change? If so, why? If not, why not? If your reaction time is shared by all consumers of imports, what implication would there be for the impact of a change in currency values on the current account balance in the short run? Explain. 6. Sometimes the charge is made that a country (e.g., China) is arbitrarily enhancing its current account surplus by keep- ing its currency at “too low” a value, that is, that exchange market intervention by the central bank is keeping the country’s currency depreciated below the free-market equi- librium value. How would such behavior influence the coun- try’s exports and imports? What assumption is being made regarding demand elasticities in making the charge of arbi- trary enhancement of the surplus? Explain. 7. Suppose that under the gold standard the mint par of 1 ounce of gold is $40 in the United States, £20 in the United Kingdom, and 60 pesos in Mexico. Assume that the cost of transporting gold between any pair of countries is $1 (or equivalent in £ or pesos) per ounce. (a) Calculate (in $/£) the gold export point from the United States to the United Kingdom and the gold import point to the United States from the United Kingdom. (b) Calculate (in peso/£) the gold export point from Mexico to the United Kingdom and the gold import point to Mexico from the United Kingdom. (c) Calculate (in peso/$) the gold export point from Mexico to the United States and the gold import point to Mexico from the United States. 8. It has been argued that the appreciation of the yen against the dollar in the early 1990s did not have the anticipated effect on U.S. imports from Japan partly because the extent of pass-through was reduced by Japanese exporters during this period. Briefly explain what is meant by “pass-through” and how Japanese exporters would have been behaving if the allegation in the previous sentence were true. In addition, in the real world, time lags in the adjustment pro- cess can produce a J-curve effect. In the adjustment process under fixed-rate systems, any price adjustment takes place at the macro or aggregate level in response to changes in the money supply accompanying the gold or foreign exchange movements that are required to maintain the fixed rate. This macro adjustment process works best when “rules of the game” are followed. Final PDF to printer 588 PART 5 FUNDAMENTALS OF INTERNATIONAL MONETARY ECONOMICS app9062x_ch23_562-589.indd 588 06/08/16 08:47 AM Appendix DERIVATION OF THE MARSHALL-LERNER CONDITION The requirements for stability in the foreign exchange market were discussed in the chapter, accom- panied by a brief intuitive explanation. A more formal derivation of this important condition follows. Given the following definitions: Px, Pm = domestic prices of exports and imports, respectively Qx, Qm = quantities of exports and imports, respectively Vx, Vm = value of exports and imports, respectively the domestic trade balance, B, is defined as B = Vx − Vm = QxPx − QmPm [1] and the change in the trade balance, dB, is defined as dB = Px dQx + Qx dPx − Pm dQm − Qm dPm [2] Assuming that the supply prices of traded goods and services do not change, that is, the supply curves are perfectly elastic over the range of quantity change, then the change in the prices of traded goods and services is attributable only to changes in the exchange rate. Because we are viewing the trade balance in terms of domestic currency in this example, dPx is therefore equal to 0, whereas Pm changes by the percentage increase in the exchange rate, k. Therefore, dPm is equal to kPm. [If the exchange rate increases (the domestic currency depreciates) by 10 percent, the domestic price of imports increases by 10 percent.] We utilize the following definitions of export and import demand elasticity: ηx = (dQx/Qx)/ [d(Px/e)/(Px/e) ] [3] ηm = (dQm/Qm)/(dPm/Pm) [4] where Px/e is the price of domestic exports in foreign currency. Turning to equation [3], the elasticity definition is reworked to obtain an expression for dQx in terms of ηx: ηx = (dQx/Qx)/{ [(edPx − Pxde)/e2 ]/(Px/e)} = [(dQx/Qx)(Px/e) ]/ [(edPx − Pxde)/e2 ] = (dQx/Qx)/ [(dPx/Px) − de/e] Because dPx/Px is assumed to be 0, then ηx = (dQx/Qx)/(−de/e) thus, ηx = (dQx/Qx)/(−k) and ηx(−k)Qx = dQx [5] Using equation [4], we can rewrite dQm in terms of the import demand elasticity ηm, that is, (ηmQmdPm)/Pm = ηmQmk = dQm [6] For a depreciation to improve the trade balance, the increase in the value of exports must exceed any increase in the value of imports. If demand for imports is elastic, that is no problem, because the value of total imports falls with the increase in price of foreign goods and services. If, however, demand for imports is inelastic, then depreciation of the currency leads to an increased expenditure Final PDF to printer CHAPTER 23 PRICE ADJUSTMENTS AND BALANCE-OF-PAYMENTS DISEQUILIBRIUM 589 app9062x_ch23_562-589.indd 589 06/08/16 08:47 AM for imports. We now return to equation [2] and rewrite it in terms of the two demand elasticities using [5] and [6], taking note that if depreciation is to improve the balance, dB > 0:
dB = Pxηx(−k)Qx − PmηmkQm − QmkPm > 0
or
PxηxkQx + PmηmkQm + QmkPm < 0 thus, PxηxQx + PmηmQm < −QmPm and ηx(PxQx/PmQm) + ηm < −1 [7] or, stating the elasticities in absolute value terms, |ηx | (PxQx/PmQm) + |ηm | > 1 [8]
The expressions in [7] and [8] constitute the Marshall-Lerner condition. In the case of balanced trade,
PxQx/PmQm = 1, and thus the sum of the absolute values of the two elasticities must be greater than 1
if depreciation is to improve the balance. This is the basic Marshall-Lerner condition. When trade is
not balanced, the condition is modified as indicated in [7] and [8] when the value of trade is measured
in domestic currency.
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590
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LEARNING OBJECTIVES
LO1 Show how the incorporation of a foreign trade sector into a Keynesian
income model alters the determination of income equilibrium compared
to a closed-economy model.
LO2 Explain the autonomous spending multiplier process in an open economy.
LO3 Discuss the concepts of internal balance and external balance.
NATIONAL INCOME
AND THE CURRENT
ACCOUNT24
CHAPTER
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INTRODUCTION
In March 2000, economist Catherine Mann of the Institute for International Economics, a think
tank in Washington, DC, wrote the following:1
The United States is enjoying an economic boom that is fueling the growth of its trade defi-
cit. At current exchange rates, the strength of the U.S. economy, combined with slow growth in
demand in many other parts of the world, will lead to further widening of the U.S. trade deficit. . . .
A change in the value of the dollar alone would narrow the trade gap for a while, but the deficit
would soon begin to widen again. To put the U.S. current account and trade deficits back on a
sustainable path will require structural reforms in the United States and its trading partners that
encourage faster global growth, boost U.S. household savings rates, better prepare U.S. workers
for technological changes in the global economy, and open up markets for U.S. exports.
This chapter is devoted to providing the analytical structure to interpret easily a state-
ment such as this one by Catherine Mann. We examine the manner in which the macro-
economy influences and is influenced by changes in exports and imports. Thus, we move
away from price relationships linking the external and internal sectors of the economy
to the interrelationships between the two sectors that involve real national income. To
accomplish this task, we develop the macroeconomics of an open economy—an economy
with foreign trade—in the context of Keynesian income analysis. The basics of Keynesian
income analysis, named after the British economist John Maynard Keynes, are commonly
presented in introductory courses in economics. The traditional single-country focus is
supplemented here by examining the real income response to exogenous factors when
countries are linked through international trade. The last section of the chapter is a synthe-
sis of price and income effects.
THE CURRENT ACCOUNT AND NATIONAL INCOME
In a Keynesian income model, the focus is on aggregate spending in the entire economy.
Aggregate spending consists of the desired expenditures on the economy’s goods and ser-
vices. An assumption is made that prices are constant, so the focus is on real income move-
ments and not on price changes. In addition, monetary considerations such as the interest
rate are assumed to be constant. It is also generally assumed that the economy is not at full
employment, usually because of downward money wage rigidity. For example, because of
institutional features such as unions or a desire by employers to keep the best workers from
leaving due to wage decreases during slack times, the wage rate does not fall to clear the labor
market during such periods. This model pertains to short-run macroeconomic situations (e.g.,
at a point in time or behavior during a business cycle) rather than long-run economic growth.
In the simple open-economy Keynesian model, desired aggregate expenditures (E)
during a time period consist of consumption spending by the economy’s households on
goods and services (C), investment spending by firms (I), government spending on goods
and services (G), and export spending by foreign citizens on the country’s products (X).
In addition, because some of the domestic spending is on imports (M), these must be sub-
tracted to obtain the demand for home goods and services. Hence, desired expenditures or
aggregate demand can be written as
E = C + I + G + X − M [1]
Does GDP Growth
Cause Trade Deficits?
The Keynesian
Income Model 
1Catherine L. Mann, “Is the U.S. Current Account Deficit Sustainable?” Finance and Development 37, no. 1
(March 2000), pp. 42–43.
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TITANS OF INTERNATIONAL ECONOMICS:
JOHN MAYNARD KEYNES (1883–1946)
John Maynard Keynes was born in Cambridge, England, on
June 5, 1883. The son of an economist (John Neville Keynes),
he attended Eton and then King’s College, Cambridge,
where he received a degree in mathematics in 1905. He then
studied under the neoclassical economist Alfred Marshall,
who pleaded with him to become an economist. Keynes
entered the British Civil Service in the India Office, and his
first book, Indian Currency and Finance (1913), assessed
the Indian currency system as an example of a gold/pegged
exchange rate system. He attained widespread fame in
1919 when he wrote The Economic Consequences of the
Peace. This book, as well as later famous journal articles,
castigated the Treaty of Versailles for the heavy burdens it
placed on Germany in connection with reparations payments
after World War I. Keynes’s view was that the price adjust-
ments required for Germany to earn the foreign exchange
to make the payments (i.e., the price changes needed to
increase exports and decrease imports sufficiently that the
current account surplus would match the required capital
outflow associated with the payments) would be excessive.
They would deteriorate Germany’s terms of trade and wel-
fare greatly, and the payments might never be accomplished
because of their harshness.
Keynes then published the influential A Treatise on
Probability in 1921. However, his most important academic
contributions occurred in the 1930s—A Treatise on Money
(1930) and, especially, The General Theory of Employment,
Interest and Money (1936). The General Theory was a broad-
side attack on the apparatus of Classical economics with its
view that the economy would settle automatically at the
full-employment level of income. (The Classical view was
very hard to sell to anyone during the Great Depression!) He
emphasized the role of aggregate demand and the possibil-
ity of attaining national income equilibrium at less than full
employment. The demand for money and its relationship to
the interest rate also received revolutionary treatment and
played a major role in his aggregate demand formulation.
Keynesian analysis assigned a prominent role to fiscal pol-
icy in affecting national income and employment—which
had been denied in the Classical model. Keynes also met
with Franklin D. Roosevelt, who was later to use public
works expenditures as a measure for attempting to get out
of the Depression. Although Keynes is reported not to have
been impressed with FDR’s economic knowledge, FDR
wrote in a letter to Felix Frankfurter (later a long-time U.S.
Supreme Court Justice), “I had a grand talk with K and liked
him immensely” (quoted in Harrod, 1951, p. 448).
Keynes’s life was a whirlwind of activity. Aside from
his roles as policy advisor to the British government and
Cambridge don, he was a patron of the arts, a collector of
rare books, editor of The Economic Journal, first bursar
of King’s College, and chair of the board of the National
Mutual Life Insurance Company. He also amassed a per-
sonal fortune through shrewd financial investments. In
addition, Keynes was a member of the Bloomsbury circle,
a group of artists, intellectuals, and writers that included
Lytton Strachey and Virginia Woolf. Further, he married a
premiere Russian ballerina in 1925, giving rise to the ditty,
“There ne’er was such union of beauty and brains, as when
Lydia Lopokova wed John Maynard Keynes.”
Keynes’s final years were spent successfully negotiating
a large war loan for Britain from the United States during
World War II and hammering out the Bretton Woods agree-
ment for the formation of the International Monetary Fund.
With his usual persuasive powers, personal charm, and mag-
netism, he forcefully presented and fought for his proposals
for the postwar international monetary system. In the end, the
new Bretton Woods system (see the last chapter in this book)
resembled more closely the American plan than the British
plan, but he had been the dominant figure at the extended con-
ference. John Maynard Keynes died on Easter Sunday, 1946.
Sources: R. F. Harrod, The Life of John Maynard Keynes (New
York: Harcourt, Brace, 1951); Robert L. Heilbroner, The Worldly
Philosophers: The Lives, Times, and Ideas of the Great Economic
Thinkers, 3rd ed. (New York: Simon and Schuster, 1967), chap. 9;
Don Patinkin, “John Maynard Keynes,” in John Eatwell, Murray
Milgate, and Peter Newman, eds., The New Palgrave: A Dictionary
of Economics, vol. 3 (London: Macmillan, 1987), pp. 19–41. ●
What determines the amount of C? Keynes hypothesized that the most important deter-
minant of a country’s current consumption spending is the amount of current income (Y) in
the economy. In general terms, then, consumption depends on or is a function of disposable
income of households; that is,
C = f (Yd) [2]
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where disposable income (Yd) is income in the economy (Y) minus taxes (T); that is,
Yd = Y−T [3]
The general expression [2] is usually written in a more precise way:
C = a + bYd [4]
This equation is a standard Keynesian consumption function. To put numerical content
to it, suppose we specify
C = 100 + 0.80Yd
This equation indicates that if disposable income is $600 (e.g., in billions), then consump-
tion spending is equal to $100 plus (0.80 × $600), or $100 plus $480, or $580. If dispos-
able income rises to $700, then consumption spending is equal to $100 plus (0.80 × $700)
= $100 + $560 = $660.
In this consumption function, the a term (or $100 in the example) is designated as
autonomous consumption spending, meaning that this amount of consumption spending
is determined by other things besides income. These “other things” can consist of the level
of interest rates, the size of the population, attitudes toward thrift, the level of accumulated
wealth, expectations of future income, and so forth. The part of consumption that does
depend on current income is labeled bYd, or 0.80Yd, and is known as induced consumption
spending. Within the induced consumption component bYd, a key feature is the term b, or
0.80 in our example. The b is known as the marginal propensity to consume, or MPC.
The MPC is defined as the change in consumption divided by the change in disposable
income, that is, the fraction of additional Yd spent on consumption goods. Therefore, des-
ignating “change in” by Δ,
MPC = ΔC∕ΔYd [5]
In addition to this consumption propensity, the marginal propensity to save, or MPS, is
defined as the change in saving (S) divided by the change in disposable income, that is, the
fraction of any additional Yd allocated to saving:
MPS = ΔS∕ΔYd [6]
Because any change in income can be allocated only to consumption and saving, it follows
that
MPC + MPS = 1.0 [7]
In our sample consumption function, where MPC = 0.80, the MPS must equal 0.20.
Finally, the consumption function C = a + bYd immediately tells us the nature of the
saving function for households in the economy. Remembering that by definition dispos-
able income can be allocated only to consumption and saving, the saving function can be
easily obtained:
Yd = C + S
= a + bYd + S
S = Yd − (a + bYd )
= −a + (1 − b)Yd
or
S = −a + sYd [8]
where s (= 1 − b) is the marginal propensity to save.
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The consumption and saving functions are illustrated in Figure 1. Panel (a) portrays
the consumption function for C = 100 + 0.80Yd and panel (b) shows the associated saving
function S = −100 + 0.20Yd. Relating Figure 1(a) to the consumption function equation,
the a term (or 100) is the height of the intercept on the vertical axis, while the slope of the
consumption schedule is b, that is, the MPC (or 0.80). Because the MPC is constant, the
slope is constant, meaning that the consumption function is a straight line. Similarly,
the intercept in Figure 1(b) is negative a (or − 100), and the slope is s, the MPS (or 0.20).
We now turn to investment spending. Remember that investment decisions (in the sense
of real investment spending on plant and equipment, residential construction, and changes
in inventories, not in the sense of financial investment in stocks, bonds, etc.) are made
by business firms and not by households. Thus there is no necessary direct link between
consumption spending and investment spending. In this simple income model, invest-
ment is usually assumed to be entirely autonomous or independent of current national
income in the economy, meaning that investment spending is determined by factors other
than income (e.g., interest rates, wage rates, and the expectations of firms concerning the
future). When investment is assumed to be independent of current income, the investment
equation is written as
I = I [9]
where the bar means that investment is fixed at a given amount for all levels of income.
Thus, the equation I = 180 would indicate that investment spending by firms is $180 no
matter what the level of income in the economy. The assumption that I is independent of
income is clearly unrealistic in a strict sense. However, it may well be the case that interest
rates, wage rates, technological change, and so forth, are more important for the invest-
ment decision than is the current level of national income. The graphical depiction of the
autonomous investment function is given as the line I = 180 in Figure 2.
FIGURE 1 Consumption and Saving Functions
Panel (a) shows a typical Keynesian consumption function. The autonomous component (100) is consumption that is independent of disposable
income. The induced component of consumption is 0.80 times the disposable income level, with 0.80 being the marginal propensity to consume
(MPC). Because the MPC is constant in this example at 0.80, the consumption function is a straight line. Panel (b) shows the associated saving
function by households. Because Yd = C + S, therefore S = Yd − C = Yd − (100 + 0.80Yd) = −100 + 0.20Yd. This function is a straight line with a
slope of 0.20, which is the marginal propensity to save (MPS).
Disposable income (Yd)
Consumption
(C)
100
Saving
(S)
(a) (b)
S = –1 00 + 0.20Yd
0
–100
0
Disposable income (Yd)
0.20
C = 100 + 0.80Yd
0.80
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Government spending on goods and services in the simple Keynesian open-economy
model (G) is also assumed to be independent of current income. This means that G is
treated as being dependent on government priorities with respect to items such as national
defense, highways, and education and on policy measures, and not on the level of national
income. This is also a simplification:
G = G [10]
In terms of our numerical example, assume that G = 600. This autonomous government
spending on goods and services is represented by the G = 600 line in Figure 2.
Along with government spending, of course, we must also introduce taxes. In the sim-
plest tax case, we assume that taxes are independent of income; that is,
T = T [11]
In this formulation, taxes are autonomous and are, for example, levied on something other
than current income such as wealth or property. Clearly, it is unrealistic to assume that
taxes are not a function of income in the economy. However, in the body of this chapter,
we will utilize that assumption both because it makes the analysis simpler and because the
focus of the chapter is on the foreign sector’s interactions with national income and not
on the government sector’s interactions with national income. (A Keynesian model where
taxes depend on income is presented in Appendix A of this chapter.) For our continuing
numerical example, we hence assume T = 500, and this fixed amount of taxes is indicated
in Figure 2. (Note in the figure that government spending does not have to equal taxes in
any given year, and this is obviously realistic!)
Finally, turning to the external sector of the Keynesian open-economy income model,
exports are also specified as being autonomous or independent of the country’s current
level of national income. The export equation is thus
X = X [12]
FIGURE 2 Autonomous Investment, Government Spending, Tax, and Export Schedules
Investment, government spending on goods and services, taxes, and exports are all assumed to be autonomous or
independent of current income in the simple Keynesian model (i.e., they depend on factors other than income).
Thus, in our numerical example, I = 180, G = 600, T = 500, and X = 140 no matter what the level of national
income.
Income (Y )0
I = 180180
G = 600
X = 140140
600
T = 500500
Investment (I ),
government spending on
goods and services (G),
exports (X )
taxes (T ),
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where X indicates the autonomous exports. To continue our numerical example, let us say that
X = 140
Exports are constant at $140. This is also represented graphically in Figure 2. Home-
country exports are more likely to depend on other countries’ incomes than upon home
income, because domestic exports are dependent on the buying power of other countries
as determined by their incomes. In addition, home exports depend on nonincome factors
such as relative prices of domestic goods compared with foreign goods, the exchange rate
(assumed to be fixed in the Keynesian model), innovation in home export industries, and
foreign tastes and preferences. If any of these factors change so that more domestic exports
are demanded, then the export function will shift vertically upward in parallel fashion;
if other countries decreased their demand for the home country’s goods, the export line
would shift vertically downward in a parallel manner.
In the simple Keynesian macro model, imports (M) are generally made to depend on
only one variable—the level of home-country income. The relationship between imports
and national income is expressed by the import function. Its general form is
M = f (Y ) [13]
A specific form is
M = M + mY [14]
Here, M represents autonomous imports, the amount of spending on imports that is inde-
pendent of income. This spending on imports depends on factors such as tastes and prefer-
ences for foreign goods as opposed to home goods, and relative prices of foreign goods
compared with home goods. The term mY refers to induced imports, the spending on
foreign goods that is dependent on the level of income. As the income of a country rises,
more spending occurs on goods and services, and some of this additional spending is on
imported goods and services. If imports consisted only of consumption goods and services,
disposable income (Yd) would appear in expression [14] rather than national income (Y).
However, we assume here (and it is true in practice) that imports contain not only con-
sumption goods and services but also inputs into the domestic production process (which
depend on total income). Hence, we use Y in the import equation rather than Yd. Continuing
with our numerical example, suppose
M = 20 + 0.10Y
This equation states the value of autonomous imports as $20 and the value of induced
imports as 0.10 times the income level. The figure 0.10 (or the letter m in expression [14])
is the marginal propensity to import, or MPM. This concept is defined as the change in
imports divided by the change in income:
MPM = ΔM∕ΔY [15]
If income rises by $100 and the MPM is 0.10, an additional $10 will be spent on imports.
The MPM is to be distinguished from the average propensity to import, or APM, which
is the total spending on imports divided by total income:
APM = M∕Y [16]
Another term emerges from this analysis: the income elasticity of demand for imports,
or YEM, which is the percentage change in the demand for imports divided by the percent-
age change in income and was also noted in Chapter 11. The term has useful applications
because it indicates the percentage growth in imports that will occur as a country’s national
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income grows over time. It can be shown that the YEM is related in simple fashion to the
APM and the MPM:
YEM = (%ΔM)∕(%ΔY) [17]
= (ΔM∕M)∕(ΔY/Y)
= (ΔM∕ΔY)∕(M/Y)
= MPM∕APM
Thus, if a country’s MPM exceeds its APM, imports relative to income will rise as the
country’s income grows (YEM is elastic). If MPM is less than APM, the YEM is inelastic
and imports will fall as a fraction of income as income rises. Finally, if MPM equals APM,
the YEM is unit elastic and imports as a fraction of national income stay the same as income
rises. In the past several decades, trade as a fraction of national income in the United States
has been rising, indicating the MPM of the United States is larger than the APM.
The import function is shown in Figure 3, plotting the specific function given earlier,
namely, M = 20 + 0.10Y. The intercept of the import function is located at the value of
autonomous imports, M. The slope of the (straight-line) import function is the MPM, or
0.10 in our example.
The next step in the analysis involves the actual determination of the equilibrium level of
national income in this type of model. The equilibrium income level is the level at which
there is no tendency for the income level to rise or to fall (i.e., the economy is “at rest”). This
level of income occurs when desired spending exactly matches the production level of the
economy. If such is the case, then there is no net tendency for economic activity to change.
However, if spending exceeds production (which equals income), then firms have not pro-
duced enough output to meet demand and their inventories of goods will fall. Output will
consequently rise in order to prevent this unintended depletion of inventories. On the other
hand, if production exceeds spending, there will be unintended inventory accumulation.
This accumulation will be a signal to producers to reduce their output, and production will
decline until it equals the level of demand. Thus, at income levels both above and below the
equilibrium level, forces are at work to return the economy to the equilibrium income level.
Determining the
Equilibrium Level
of National Income
FIGURE 3 A Keynesian Import Function
The autonomous component of imports (20) reflects imports purchased independently of income. The induced
component of imports is 0.10 times the income level, with 0.10 indicating the marginal propensity to import
(MPM). With a constant MPM, the import function is a straight line.
Imports
(M)
Income (Y)0
0.10
20
M = 20 + 0.10Y
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IN THE REAL WORLD:
AVERAGE PROPENSITIES TO IMPORT, SELECTED COUNTRIES
Table 1 presents the average propensities to import for five major
industrialized countries from 1973 through 2013. As can be
seen, there has been a major increase in openness for the United
States. In addition, there has been some increase in the APM
for Canada and for France. For the United Kingdom, inspection
of the data suggests little change for most of the period. Japan’s
average propensity to import declined and then rose, with
perhaps a slight overall increase and a definite increase from
2000–2013. It appears to have followed the price of imported
oil (very important for the Japanese economy) in a general way.
The results for Canada, Japan, and the United States are broadly
consistent with careful estimates of long-run income elasticities
of demand made by Peter Hooper, Karen Johnson, and Jaime
Marquez,* who estimated the YEM to be 1.4 for Canada, 1.6 for
France, and 1.8 for the United States. The YEM for the United
Kingdom was estimated to be 2.2, which seems large, given
the behavior of the United Kingdom’s APM data in Table 1.
Clearly, examination of APMs such as in Table 1 can offer tenta-
tive suggestions, but more detailed work is necessary for precise
conclusions regarding the trend in the openness of a country.
*Peter Hooper, Karen Johnson, and Jaime Marquez, “Trade
Elasticities for G-7 Countries,” Board of Governors of the Federal
Reserve System, International Finance Discussion Papers no. 609,
April 1998, p. 7, obtained from www.federalreserve.gov.
(continued)
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The determination of the equilibrium level of income is shown graphically in Figure 4,
utilizing our numerical example. Remembering that, in our example,
C = 100 + 0.8Yd G = 600
Yd = Y − T X = 140
T = 500 M = 20 + 0.1Y
I = 180
FIGURE 4 The Equilibrium Level of Income
Total desired spending on domestic goods in relation to income is indicated by the C + I + G + X − M line,
with a slope of (MPC − MPM). Equilibrium income level 0Ye (or 2,000 in our example) occurs where desired
spending equals production. At lower income level 0Y1 (or 1,900), desired spending (= Y1F) is greater than
production (= 0Y1 = Y1H), so inventories are being depleted and production expands to 0Ye. At income level 0Y2
(or 2,100) above 0Ye, desired spending (=Y2 A) is less than production (= 0Y2 = Y2 B), so inventories are accu-
mulating and production contracts to 0Ye (2,000).
Desired
spending
(C + I + G + X – M )
Income or production (Y)
0
B
A
F
H
q
45°
600 (= a – bT + I + G + X – M )
– – – – –
0.7 (= MPC – MPM)
1,900 2,000 2,1 00
(Y1) (Ye) (Y2)
C + I + G + X – M = E
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IN THE REAL WORLD:
TABLE 1 Average Propensities to Import, Selected Countries, 1973–2013
Year Canada France Japan United Kingdom United States
1973 .220 .167 .100 .254 .066
1974 .246 .217 .143 .322 .085
1975 .241 .179 .128 .271 .075
1976 .229 .203 .128 .291 .083
1977 .235 .204 .115 .290 .090
1978 .249 .191 .094 .269 .092
1979 .265 .206 .125 .274 .098
1980 .264 .228 .144 .249 .105
1981 .261 .238 .138 .238 .101
1982 .221 .240 .136 .244 .093
1983 .221 .228 .120 .256 .093
1984 .249 .239 .121 .286 .103
1985 .258 .239 .108 .278 .099
1986 .264 .206 .073 .265 .102
1987 .255 .207 .072 .266 .107
1988 .258 .212 .077 .266 .108
1989 .255 .226 .088 .278 .107
1990 .256 .223 .094 .266 .108
1991 .256 .219 .083 .242 .104
1992 .272 .209 .077 .248 .105
1993 .301 .192 .069 .265 .108
1994 .328 .210 .071 .272 .115
1995 .341 .216 .078 .288 .122
1996 .344 .217 .094 .298 .123
1997 .375 .228 .098 .286 .127
1998 .394 .237 .090 .273 .127
1999 .393 .240 .087 .276 .134
2000 .399 .277 .095 .295 .148
2001 .378 .270 .099 .294 .136
2002 .367 .260 .099 .286 .130
2003 .338 .251 .102 .278 .134
2004 .340 .257 .113 .279 .146
2005 .339 .269 .129 .294 .155
2006 .339 .281 .149 .313 .162
2007 .329 .284 .161 .292 .164
2008 .333 .290 .175 .316 .174
2009 .304 .252 .123 .300 .137
2010 .313 .277 .140 .323 .158
2011 .324 .298 .160 .336 .172
2012 .320 .296 .167 .337 .169
2013 .318 .292 .190 .327 .164
Average for period .297 .236 .113 .282 .120
Note: Figures are imports of goods and services in the GDP accounts divided by GDP.
Sources: Calculated from data in International Monetary Fund (IMF), International Financial Statistics Yearbook 2002 (Washington, DC: IMF, 2002), pp. 334–35,
482–83, 608–09, 1032–33, 1040–41; IMF, International Financial Statistics Yearbook 2006 (Washington, DC: IMF, 2006), pp. 211, 301, 368, 607, 611; IMF,
International Financial Statistics Yearbook 2010 (Washington, DC: IMF, 2010), pp. 215, 331, 424, 748, 754; and IMF, International Financial Statistics Yearbook
2014 (Washington, DC: IMF, 2014), pp. 233, 357, 452, 810, 816. ●
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Then the E (desired expenditures or spending line) is
E = C + I + G + X − M
= 100 + 0.8Yd + 180 + 600 + 140 − (20 + 0.1Y )
= 100 + 0.8(Y − 500) + 180 + 600 + 140 − (20 + 0.1Y )
= 1,000 + 0.8Y − 400 − 0.1Y
= 600 + 0.7Y
This equation indicates that the intercept of the expenditures or spending line in Figure 4
is 600 [= the sum of all autonomous spending = (a − bT + I + G + X − M) ] and the
slope is 0.7 [= the marginal propensity to consume minus the marginal propensity to import
= (0.8 − 0.1) = 0.7 = (b − m)]. Another important line in the diagram is the 45-degree line.
Because a 45-degree line has the property that each point on it is equidistant from the verti-
cal axis (spending) and the horizontal axis (production), it is clear that, for the economy to
be in equilibrium, the economy must be located somewhere on this line. The equilibrium
point q occurs where the C + I + G + X − M, or spending, line intersects the 45-degree line,
and the equilibrium level of income associated with point q is income level 0Ye. Because
C + I + G + X − M shows desired spending and the 45-degree line illustrates points that
are equidistant from both axes, the intersection of the E line with the 45-degree line gives
us the single point where production equals spending.
In terms of our numerical example, the equilibrium where E = Y or spending = produc-
tion is found in straightforward fashion. We have established earlier that E = 600 + 0.7Y,
so, for equilibrium,
E = Y
600 + 0.7Y = Y
600 = Y − 0.7Y
600 = 0.3Y
Y = 600∕0.3 = 2,000
To see that 2,000 is indeed the equilibrium level, let us check the sum of the spending items
to determine if they add up to 2,000. First, look at consumption. With an income level of
2,000 and taxes of 500, this means that disposable income is 1,500 (= 2,000 − 500). Because
the consumption function is C = 100 + 0.8Yd, this means that consumption is 100 + (0.8)
(1,500) = 100 + 1,200 = 1,300. Investment is constant at 180, government spending is con-
stant at 600, and exports are constant at 140. Finally, imports, which must be subtracted, are
equal to 20 + 0.1Y = 20 + (0.1)(2,000) = 20 + 200 = 220. Thus, at the national income level
of 2,000, spending = C + I + G + X − M = 1,300 + 180 + 600 + 140 − 220 = 2,000. Thus,
at the equilibrium level of income, desired spending equals production and there is no
unintended change in inventories of firms.
Let us consider briefly what happens if national income is not at the equilibrium level
0Ye or 2,000. In Figure 4, consider the lower income level 0Y1 or 1,900. At 0Y1, spend-
ing is indicated by the height of the E line (distance Y1F) and production is 0Y1, which
because of the nature of the 45-degree line, is equal to distance Y1 H. In numbers, spend-
ing (E or distance Y1F) is 600  +  (0.7)(1,900)  =  600  +  1,330  =  1,930 and production
(Y or Y1H) is 1,900. Because spending of 1,930 is thus greater than production of 1,900 at
income level 0Y1 by 30 (or distance HF), inventories of firms will decline; as firms then
step up their production to eliminate this inventory depletion, income in the economy will
rise until 0Ye is reached and spending equals production. A similar analysis applies to
income level 0Y2 (or 2,100), which is above the equilibrium level of income. At 0Y2, house-
holds and firms want to spend the amount Y2A, which in numbers is equal to 600 + (0.7)
(2,100) = 600 + 1,470 = 2,070. However, production equals distance Y2B (= 0Y2 by the
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construction of the 45-degree line) or 2,100. Hence, production exceeds spending (by AB
or 30), and unintended inventory accumulation will lead to cutbacks in production. The
cutbacks will continue until the income level reaches 0Ye or 2,000.
An alternative method of determining the equilibrium level of income is to represent the
equilibrium income level as that level that equates desired or planned saving, imports, and
taxes with desired investment, government spending, and exports. In this approach, saving,
imports, and taxes are thought of as leakages from the spending stream, in that they repre-
sent actions that reduce spending on domestic products. Investment, government spending,
and exports are injections into the spending stream and therefore lead to home production.
If the leakages exceed the injections, then there is downward pressure on spending and
hence on income. If the injections exceed the leakages, there is pressure for expansion in
the economy.
This approach is illustrated in Figure 5, panel (a), which shows the saving, tax, and
import functions combined into an S + T + M function and the autonomous investment,
government spending, and export schedules combined into an I + G + X schedule. The
equilibrium level of income is situated immediately below point q where the two sched-
ules intersect, at income level 0Ye. This 0Ye is the same 0Ye as in Figure 4 because the two
figures employ the same basic information but in a different form.2 That the equilibrium
Leakages and
Injections
FIGURE 5 Alternative Representations of the Equilibrium Level of Income
In panel (a), the equilibrium level of income 0Ye occurs where the leakages from the domestic spending stream (S + T + M) are equal to the
injections into the spending stream (I + G + X). At income levels below (above) 0Ye, injections are greater (less) than leakages, so there is pres-
sure to expand (contract) income. Panel (b) shows an alternative representation using the relationship that, since S + T + M = I + G + X, then
S + (T − G) − I = X − M. In this graph, equilibrium income level 0Ye occurs simultaneously with a current account deficit (that is, X − M < 0). Y 0 q S + T + M YeY1 Y2 I + G + X S + T + M, I + G + X S + (T – G) – I, X – M S + (T – G) – I X – M 0 Y q Ye (b)(a) 2In the equilibrium expression Y = C + I + G + X − M, the right-hand side consists of expenditures that generate income, or it can be thought of as sources of income. Now consider the expression Y = C + S + T. The right-hand side of this equation indicates the uses of the income generated in the economy (for consumption, for saving, and for taxes). Because uses of income must equal sources of income, C + S + T = C + I + G + X − M S + T = I + G + X − M S + T + M = I + G + X [18] Expression [18] is another way of writing the equilibrium condition, and the intersection of the two schedules in panel (a) of Figure 5 thus also yields the equilibrium level of income. Final PDF to printer 602 PART 5 FUNDAMENTALS OF INTERNATIONAL MONETARY ECONOMICS app9062x_ch24_590-618 602 06/13/16 07:14 AM level is the same as previously in terms of our numerical example can be shown by cal- culating the leakages at the income level 2,000 and then comparing their sum with the injections. Because consumption in our example was 100  +  0.8Yd, and because sav- ing  =  disposable income minus consumption, saving equals  =  Yd  −  (100  +  0.8Yd)  =  −100 + (1 − 0.8)Yd = −100 + 0.2Yd. With income of 2,000 and taxes of 500, Yd = 1,500 and saving  =  −100  +  (0.2)(1,500)  =  −100  +  300  =  200. The import leakage is M = 20 + 0.1Y = 20 + (0.1)(2,000) = 20 + 200 = 220. Hence, with S = 200, T = 500, and M = 220, total leakages are 200 + 500 + 220 = 920. Injections in our example were I = 180, G = 600, and X = 140, for total injections of 180 + 600 + 140 = 920. Clearly, at the income level of 2,000, leakages equal injections. Again, if the economy is at an income level below 0Ye or 2,000, the economy will expand because injections into the spending stream exceed leakages or withdrawals from that stream. For example, if 0Y1 in Figure 5(a) is 1,900, with T = 500, then S = −100 + (0.2) (1,900 − 500) = −100 + (0.2)(1,400) = −100 + 280 = 180. At the income level of 1,900, M  =  20  +  (0.1)(1,900)  =  20  +  190  =  210. Hence, while injections have remained at 920, total leakages are now 180 + 500 + 210 = 890 and are 30 short of the injections. Inventories decline by 30 and income rises toward the equilibrium level of 2,000 or 0Ye. At income level 0Y2 (say, 2,100), the opposite is the case. Leakages will exceed injections (by 30 in our example), inventories will accumulate (by 30), and production will be cut back (to 2,000). A second alternative representation of equilibrium focuses on the current account balance for the economy. [In our model, X − M embraces exports and imports of all goods and services (including primary and secondary income payments and receipts) and thus is the current account balance.] In this approach, we take the equilibrium condition of S + T + M = I + G + X and rearrange it to obtain S + (T − G) − I = X − M [19] In expression [19], S is private saving and (T − G) is government saving (which can be neg- ative). Thus, the expression makes the important point that, in an open economy, the differ- ence between a country’s total saving (private + government) and the country’s investment equals the current account balance. If X < M, the country is saving domestically less in total than it is investing; the shortfall is being made up by a net inflow of foreign saving. This has been the case for the United States for most of the past 35 years. If X > M, the coun-
try is saving more than it is investing domestically (and hence it is investing abroad via
a financial outflow, with the financial account outflow being equal to the current account
surplus). The expression also helps us understand Catherine Mann’s point at the start of
this chapter that an increase in U.S. household saving rates could reduce the U.S. trade and
current account deficits.
Utilizing expression [19], we can then plot two new schedules as in Figure 5, panel (b).
The upward-sloping S + (T − G) − I line subtracts the fixed autonomous amount of invest-
ment and the fixed autonomous amount of government spending from private saving and
taxes. Because S depends positively on Y, the line is clearly upward sloping. The X − M
line slopes downward because, at higher levels of Y, rising amounts of imports are being
subtracted from a fixed amount of autonomous exports. As should be evident, the intersec-
tion of these two lines (at q) will also yield the equilibrium level of income 0Ye.
The virtue of this approach is that the state of the current account balance that exists at
the equilibrium level of income can be observed. (In our numerical example, X = 140 and
Income Equilibrium
and the Current
Account Balance
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M = 220 at equilibrium, so the current account is in deficit by 80.) Further, an important
point that emerges from this discussion is that, even though the economy is in income
equilibrium, it is not necessary that the current account balance be zero. In Figure 5(b), the
existence of the current account deficit when the economy is at its equilibrium income is
reflected in the fact that the equilibrium position q is below the horizontal axis. If q occurs
at a point above the horizontal axis, there would be a current account surplus; if q lies on
the horizontal axis, X = M, which indicates balance in the current account.
CONCEPT CHECK 1. Explain why an income level below the equi-
librium level of income cannot persist.
2. Suppose that imports are entirely induced,
that is, that the import function is M  =  mY
(with m being the marginal propensity to
import). What is the APM in this case? What
is the value of the YEM?
3. If the economy is at its equilibrium level of
income and has a current account deficit,
what must be true of the total amount of sav-
ing (private plus government) in the economy
relative to the amount of investment? How is
the excess of investment over saving being
financed?
THE MULTIPLIER PROCESS
A familiar concept contained in Keynesian income models is the autonomous spending
multiplier. The autonomous spending multiplier is used to answer the following ques-
tion: If autonomous spending on C, I, G, or X is changed, by how much will equilib-
rium income be changed? Graphically, as in Figure 4 earlier, this question is simply, if
(C  +  I  +  G  +  X  −  M) shifts in parallel fashion, what will be the ΔY as the economy
responds to the change in autonomous spending?
To answer this question, suppose that autonomous investment in our numerical example
rises to 210 from its original level of 180. (This could be to $210 billion from $180 billion,
for example.) The best way to think of the multiplier concept is in terms of rounds of
spending in the multiplier process. The autonomous increase of 30 in investment
(assumed to be spent on domestic goods) generates production (and income) of 30 as firms
produce the new machinery, for example, that is now in demand. The workers and owners
of the firms producing the machinery receive 30 in income. Because taxes do not depend
on income in this simplified model with which we are working, the 30 of new income will
translate into 30 of new disposable income.3 But what happens to this 30 of new disposable
income? Some of it will be spent as indicated by the MPC. So a second round of spending
will occur; in our example with MPC = 0.8, 24 will be spent [= (0.8)(30)]. However, some
of this new spending will be on imports and will not lead to increased domestic production.
In addition, remember that in our model, imports are a function of total income and not
just disposable income because, besides consumption goods, some imports are also inputs
for the new production being generated in this round. With our MPM of 0.1, imports go up
by the MPM times the change in total income, or 3 [= (0.1)(30)]. This 3 amount must be
subtracted from the 24 of second-round spending because the 3 does not generate domestic
production and income, resulting in a net effect of 21 (= 24 − 3) in this second round of
the multiplier process. In sum, the 30 of production in the first round has led to 21 of new
domestic spending and income in the second round; 70 percent gets “re-spent.”
The Autonomous
Spending Multiplier
Changes in Autonomous
Consumption,
Investment, Government
Spending, and Exports
3For a model that has taxes that depend on income, see Appendix A of this chapter.
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The process continues into a third round. The 21 of spending from the second round
leads to 21 of new income for the workers and firms producing the goods purchased in
that second round. Of the 21 of new income (and new disposable income) thus generated,
with the MPC of 0.8, 16.8 [= (0.8)(21)] will be spent. However, spending on imports
will increase by the MPM times the 21 change in total income, and this 2.1 of imports
[= (0.1)(21)], when subtracted from the 16.8 of spending, leaves a net increase in spend-
ing on domestic goods in the third round of 14.7. Thus, 70 percent of the second-round
amount of 21 has been re-spent in the third round. This 14.7 of spending leads to new
income, and a fourth round is started. Theoretically, this process goes on through an
infinite number of rounds, although the amount of new income generated in each cycle
rapidly gets smaller.
What is the ultimate change in income occurring because of the original 30 of new
investment? The total change in income after all the rounds have been completed equals
the sum of the following geometric series:
ΔY = 30 + 21 + 14.7 + . . .
= 30 + (0.7)(30) + (0.7)2(30) + . . .
which, mathematically, can be shown to be
ΔY = [1∕(1 − fraction re-spent in each round)](initial ΔI )
= [1∕(1 − 0.7)](30)
= (1∕0.3)(30) = (3 1∕3)(30) = 100
The 0.7 in the (1 − 0.7) denominator term derives from the 70 percent re-spent in each
round; in symbols, this 70 percent is [MPC − MPM] or (0.8 − 0.1) = 0.7. Thus, the initial
increase in autonomous investment spending of 30 has led to a total change in income of
100. An initial change in autonomous consumption spending4 or in autonomous govern-
ment or export spending of 30 would have had the same 100 impact on income as the 30
change in autonomous investment. The “multiplier” is simply the total change in income
divided by the initial change in autonomous spending, or $100/$30 = 3⅓. The formula for
calculating the autonomous spending multiplier in the open economy (ko) is
ko =
1
1 − (MPC − MPM)
= 1
MPS + MPM
[20]
or, in our example,
ko =
1
1 − 0.8 + 0.1
= 1
0.2 + 0.1
= 3⅓
Expression [20] is the basic open-economy multiplier. If the economy were a closed
economy, there would be no imports (or exports). Hence, the MPM would be zero and the
closed economy multiplier would be 1/(1 − MPC). This multiplier would be larger than the
open economy multiplier (for any given MPC) because there is no leakage of spending out
of the domestic economy into imports.
A further multiplier exists in the open economy. We have dealt previously with autonomous
increases in consumption, investment, government spending on goods and services, and
exports. But autonomous imports M constitute another type of autonomous spending in the
Changes in
Autonomous Imports
4It is assumed in all cases that the first round of spending is entirely on domestic goods.
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IN THE REAL WORLD:
MULTIPLIER ESTIMATES FOR INDIA
There have been many, many estimates of open-economy
multipliers for different countries over different time peri-
ods, usually for high-income or developed countries.
However, attempts have also been made to estimate the
multiplier for some developing countries, especially as com-
prehensive and more reliable data have become available.
For example, in 1994, D. P. Bhatia published calculations of
various multipliers for the Indian economy.* He approached
the estimations from two perspectives—at the aggregate
level directly (such as we have done in this chapter) and at
the sectoral level, whereby multipliers were estimated for
each sector of the economy and then aggregated to get an
economywide figure. The direct aggregate-level estimates
are most relevant for this chapter, and he obtained the fol-
lowing results with this procedure (given on his p. 46):†
1973–1974: marginal propensity to save = 0.30967
marginal propensity to import = 0.05449
multiplier  = 1/(0.30967 + 0.05449) = 1/(0.36416) 
= 2.74605
1978–1979: marginal propensity to save = 0.42487
marginal propensity to import = 0.06206
multiplier  = 1/(0.42487 + 0.06206) = 1/(0.48693)
= 2.05368
1983–1984: marginal propensity to save = 0.18092
marginal propensity to import = 0.14323
multiplier  = 1/(0.18092 + 0.14323) = 1/(0.32415)
= 3.08499
Hence, during the period from 1973–1974 through 1983–
1984, the multiplier fell and then rose. Bhatia notes (and this is
evident from the numbers given) that the marginal propensity
to save (MPS) and the marginal propensity to import (MPM)
both increased between 1973–1974 and 1978–1979. Clearly
these increases would cause a drop in the value of the multi-
plier as the leakages from the spending stream increased, and
the multiplier decreased from its 1973–1974 value of 2.75
to a value of 2.05 in 1978–1979. Between 1978–1979 and
1983–1984, the MPS fell dramatically, which would increase
the size of the multiplier, and the MPM rose sharply (partly
reflecting greater spending on imports due to increases in oil
prices), which would decrease the multiplier. On balance, the
multiplier rose to 3.08 in 1983–1984.
With any estimates of this sort, though, it is useful to
keep in mind that data problems do exist and that there are
numerous different estimating techniques. (Bhatia’s esti-
mates from his sectoral procedure yielded higher multipli-
ers than those given here, although the pattern of a decrease
from 1973–1974 to 1978–1979 and then an increase to
1983–1984 remained intact.) In addition, we must always
ask ourselves whether there are economic explanations that
are consistent with the statistical results (such as the large
increase in the Indian MPS from 1973–1974 to 1978–1979).
Bhatia’s paper does not pursue such explanations.
In retrospect these Bhatia estimates seem high. Current
general information suggests that developing countries actu-
ally have smaller multipliers than developed countries.
*D. P. Bhatia, “Estimates of Income Multipliers in the Indian
Economy,” Indian Economic Journal 42, no. 1 (July–September
1994), pp. 39–56.
† The Indian fiscal year ends in March; hence, 1973–1974, for
example, runs from April 1973 through March 1974. ●
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open economy. What happens if M increases? This one is tricky. If the demand for imports
increases autonomously, this is equivalent to an autonomous decrease in the demand for
domestic goods. Therefore, in national income models, an autonomous increase in imports
will lead to a decrease in the level of income. The autonomous increase in imports reflects
a decrease in spending on domestic goods, which leads to lower income. Because the mul-
tiplier process for an autonomous increase in imports operates in a downward direction, the
multiplier for a change in autonomous imports is equal to minus ko; that is,
ΔY∕ΔM = −ko
= −
1
1 − MPC + MPM
[21]
There is no conflict between this negative effect of an increase in imports in macro mod-
els and the positive effect of imports on national well-being in international trade theory.
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Trade theory assumes that the country is always at full employment and on its production-
possibilities frontier both before and after the change in imports. In the macro models, we
are making no such assumption that the economy is always at its maximum output.
With this import multiplier in mind, what will happen if exports and imports both
increase autonomously by the same amount? The net effect of an autonomous balanced
change in the size of the foreign trade sector (i.e., an equal autonomous change in exports
and imports) is zero. This occurs because the export change has a multiplier of ko while the
autonomous import change has a multiplier of minus ko. The two changes cancel each other
out with respect to their impact on national income.
Having examined the multiplier in the Keynesian income model, let us now look at rela-
tionships between national income, the current account balance, and the multiplier. First,
recall the earlier point that national income equilibrium can coexist with a deficit in the cur-
rent account. Suppose that, as a policy objective, we wish to eliminate the current account
deficit by reducing imports, with the reduction in imports to be accomplished by reduc-
ing national income (through contractionary macroeconomic policy). By how much would
national income have to be reduced to eliminate the current account deficit? The answer
is easy to obtain. For instance, in our earlier numerical example, there was a deficit of
80 (X was 140, M was 220); we must contract income enough so that imports fall by 80.
Remembering the MPM, this means that income must fall enough so that the change in
income multiplied by the MPM equals −80. Thus, if the ΔM target is −80,
ΔM = MPM × ΔY
−80 = 0.10 × ΔY
ΔY = −800
The level of income must fall by 800 to reduce imports by an amount that will restore bal-
ance in the current account. If the economy is at less than full employment, this might be
a large contraction in income that would not be welcomed. There is a conflict between an
“internal” target for the economy, such as full employment, and an “external” target, such
as balance in the current account.
Second, suppose that we want to take policy measures to expand exports (e.g., by
depreciating the value of our currency relative to other currencies and assuming that the
Marshall-Lerner condition holds) as a way of eliminating the current account deficit.
If exports increase by 80, will this eliminate the current account deficit? The answer is
no. If exports increase by 80, then the open-economy multiplier of 3⅓ is applied to this
autonomous increase in exports. The level of Y will rise by (80)(3⅓), or 266.67, to 2,266.67
from the original 2,000. But because Y has risen by 266.67, there will be induced imports
of the MPM (= 0.10) times 266.67, or 26.67. The expansion of exports (by 80) has cut
the deficit by 53.33 (= 80 − 26.67) but has not eliminated it. It can also be noted that this
analytical result of the export increase leading to a reduction in the deficit is what lies
behind Catherine Mann’s indication in the statement at the beginning of this chapter that
faster global growth would reduce the U.S. trade and current account deficits. The reduc-
tions would occur because faster income growth in other countries would lead to increased
exports from the United States because other countries have a positive marginal propensity
to import from the United States.
This relationship between an increase in exports and the resulting increase in imports,
though a smaller import increase than the initial increase in exports, is an important one.
It is important because it shows that, given a disturbance in the foreign sector of the econ-
omy such as a rise in exports (it could also be a fall in exports or an autonomous rise or
fall in imports), forces are set in motion to dampen the effect of that disturbance on the
The Current Account
and the Multiplier
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IN THE REAL WORLD:
THE GOVERNMENT SPENDING MULTIPLIER IN DEVELOPED
AND DEVELOPING COUNTRIES
Two recent papers that have calculated estimates of the size
of the autonomous spending multiplier in many countries are
those by Aart Kraay (2014) and Ethan Ilzetzki, Enrique G.
Mendoza, and Carlos A Végh (2013). These studies are seek-
ing statistical association (multiplier) between a change in gov-
ernment spending and the change in GDP. In both papers, their
estimated impacts of the change in spending are well below
what simple Keynesian multiplier analysis would suggest.
Kraay employs a novel approach in his estimations,
which concentrates exclusively on developing countries. A
problem when attempting to measure the government spend-
ing multiplier is that changes in government spending may
occur because of developments in the economy itself due, for
example, to a decrease in government tax revenues during a
recession. Thus the attempt to sort out the causal impact of
government spending per se on the economy must not mix
in the reverse impact of changes in the economy on govern-
ment spending. Kraay gets around this problem by looking
at situations where the developing countries specifically took
out loans from multilateral institutions such as the World
Bank and from particular country governments (bilateral
loans). These loans are additional to other developments in
the recipient economies and are generally subsequently asso-
ciated with specific spending projects such as infrastructure.
Using data pertaining to about 60,000 loans to a large
set of developing countries (102 countries in one estima-
tion) over the period 1970–2010, Kraay estimates short-run
(one-year) government spending multipliers. His various
estimates center around the result of a multiplier of 0.4,
meaning that one dollar of increased government spending
increases GDP in the first year by about 40 cents. He made
an attempt to look at longer periods than a year and sug-
gested a cumulative impact multiplier of 0.56 after two years
but concluded that his work on years beyond the first year
was “. . . not very informative about the long-run effects of
government spending on output . . .” (p. 200). Regarding the
short-run estimates, however, he concluded that multipliers
are larger in recessions than in boom times, are larger for rel-
atively closed economies than for relatively open economies
(consistent with the analysis of this chapter), and are larger
for developing countries with relatively flexible exchange
rates than for developing countries with relatively fixed
exchange rates. (The relationship of government spending
to GDP under different exchange rate regimes is discussed
in Chapter 26 of this text.)
In the Ilzetzki, Mendoza, and Végh paper, the authors
assembled quarterly data for 44 countries, with 20 of them
being high-income countries and 24 being developing coun-
tries. The years of coverage varied for the countries but were
all within the 1960–2007 period. Ilzetzki, Mendoza, and
Végh were principally examining both short-run (impact)
effects and long-run (cumulative) effects of an increase in
government consumption spending (as distinct from govern-
ment investment spending) on GDP. The long-run effects
are of more interest and will be our focus here. The authors
concluded that, for the developed countries, the value of the
long-run multiplier was 0.66; for the developing countries,
the surprising result was that the effect of increased govern-
ment consumption spending on output was not statistically
significantly different from zero. However, when looking at
government investment spending in the developing coun-
tries rather than government consumption spending, they
concluded that the investment spending had a multiplier of
1.0 in the long run. Other results were that relatively closed
economies (low ratio of trade to GDP) had a multiplier of
1.1 in the long run while relatively open economies had a
multiplier that was not statistically significantly different
from zero. Finally, unlike the result of the Kraay study, in
the Ilzetzki, Mendoza, and Végh paper, countries with rela-
tively fixed exchange rates had a larger multiplier than coun-
tries with relatively flexible exchange rates.
As noted earlier, the estimated impacts obtained in these
two studies are smaller than one would expect from the
simple Keynesian model. Reasons for the smaller multi-
pliers include the behavior of interest rates and “crowding
out” as well as the impacts of international capital flows and
the exchange rate. These phenomena will be discussed in
later chapters. Also, for developing countries, their inter-
nal economic structures may be more rigid—for example,
an inability to increase agricultural output quickly or to
transport goods immediately. These rigidities may keep any
expenditure from going through the “rounds” of the multi-
plier process.
Sources: Aart Kraay, “Government Spending Multipliers in
Developing Countries: Evidence from Lending by Official
Creditors,” American Economic Journal: Macroeconomics 6, no. 4
(October 2014), pp. 170–208; Ethan Ilzetzki, Enrique G. Mendoza,
and Carlos A. Végh, “How Big (Small?) Are Fiscal Multipliers?”
Journal of Monetary Economics 60, no. 2 (March 2013),
pp. 239–54. ●
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current account balance. Thus, in our example, when exports increased by 80, the current
account balance didn’t improve by the full 80 because imports increased by 26.67. The
current account balance did improve, but by less than the initial disturbance. Because the
initial export increase was partly offset by induced imports, there was at least some adjust-
ment to the initial disturbance, but there was not full adjustment because imports did not
rise by 80 and eliminate the effect of the export increase on the current account balance.
This phenomenon of a current-account disturbance not leading to a full offset of the distur-
bance is called partial current account adjustment to any initial disturbance.
A final matter to consider in our treatment of Keynesian income models is foreign
repercussions. In the real world, when spending and income change in a home country,
changes are transmitted to other countries through changes in imports of the home country.
As reactions to the changes in trade occur in the other countries, there will be feedback
upon the original home country. While full-scale econometric models of the world econ-
omy with hundreds of equations have been used to trace through foreign repercussions, we
are less ambitious in this chapter. We give one limited example of how such repercussions
can be taken account of in relatively simple macroeconomic models. This example con-
cerns the multiplier process.
In the traditional (no-repercussions) open-economy multiplier process, an autonomous
investment increase in the United States, for example, will cause a rise in U.S. income by
the change in investment times the standard open-economy multiplier. This multiplied
change in income will generate an induced rise in imports (by the MPM times the change
in income). Thus, in the following schematic diagram:
↑ IUS ⟶ ↑ YUS ⟶ ↑ MUS
The process stops here in the model we have been using so far. However, when foreign
repercussions are permitted in the model, the process continues. The rise in imports into
the United States constitutes a rise in exports of the rest of the world (ROW). When exports
in ROW increase, this initiates a multiplier process in ROW and a rise in ROW income.
This rise in income causes ROW to import more goods based on its marginal propensity
to import. Finally, at least some of the increased imports into ROW will be exports of the
United States! These increased exports will then set in motion additional spending and
income generation in the United States. Further, this additional U.S. income will cause
more U.S. imports, and so on. The process continues in ever-diminishing amounts. The
multiplier mechanism when foreign repercussions exist can be represented by the follow-
ing flow diagram:
↑ IUS → ↑YUS → ↑MUS = ↑XROW → ↑YROW → ↑MROW → ↑XUS
↑ ↓
← ← ← ← ← ← ← ← ← ← ← ← ← ←
As you can see, we continue going through the loop until the marginal changes in income
approach zero.
When all of these repercussions have occurred, the total change in income in the United
States that results from the initial increase in investment will be larger than was the case
when repercussions were not considered because of the additional feedback on U.S.
income from the rest of the world. The expression for this repercussions multiplier, the
open-economy multiplier with foreign repercussions, is complicated and is explored
further in Appendix B of this chapter.
The “foreign repercussions process” emphasizes that countries of the world are interde-
pendent with respect to macroeconomic activity, as was observed in the world economic
Foreign Repercussions
and the Multiplier
Process
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recession that began in 2007–2008. When a boom (or recession) occurs in one country,
it will be transmitted to other countries and will then feed back upon the originating
country. We can therefore graph one country’s income level as being positively related
to other countries’ income levels, and likewise can graph other countries’ income levels
as being positively related to the first country’s income level, as in Figure 6. This graph
demonstrates the simultaneous determination of equilibrium income in the two countries.
Consequently, both levels of income are altered whenever autonomous spending in any
one country changes (which would be a shift in one of the income lines) and macroeco-
nomic variables can move together across countries.
Not surprisingly, it is difficult to measure the repercussions effect. An empirical
attempt to do so was made in 2001 by OECD (Organization for Economic Cooperation
and Development) researchers (Dalsgaard, André, and Richardson, 2001) with data for the
United States, Japan, the European-area countries, and a group of “rest of world” countries,
using the OECD multi-country INTERLINK model. The results generally suggested that
the responsiveness of an increase in government consumption incorporating trading part-
ner repercussions on GDP was positive, although moderately small and notably different
between countries. The total impact including repercussions for the initial year averaged
only about 7.3 percent larger than the estimate excluding repercussions for seven major
countries (United States, Japan, Germany, France, Italy, United Kingdom, and Canada).
For a longer five-year period, the cumulative effect for these same countries incorporating
repercussions averaged about an 18 percent larger impact on GDP compared to the non-
trade-linked estimate, although again there was considerable difference between countries
(ranging from 0 to 50 percent).5
FIGURE 6 Income Interdependence between Countries
Because imports of one country are exports of the other country, a rise in income in one country will stimulate
exports and therefore income in the other country. Thus, income in the foreign country (Y*) is dependent on
income in the home country (Y), and vice versa. There is simultaneous national income equilibrium in the two
countries where the two lines intersect (i.e., at Ye and Ye*).
q
Y = g(Y *)
Ye
Income in
foreign
country (Y *)
Y* = f (Y )
Income in home country (Y)0
Y e*
5It must be noted, however, that the INTERLINK model incorporates changes in other important variables in
the macro economy that can affect the impact of incorporating the trade links between countries. Such variables
include prices, wages, interest rates, consumption, and supply effects, whose inclusion can result in smaller
multiplier estimates.
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IN THE REAL WORLD:
HISTORICAL CORRELATION OVER TIME OF COUNTRIES’ GDP
An attempt to determine the extent to which countries’ eco-
nomic cycles have been correlated or synchronized over
time was undertaken by Michael D. Bordo and Thomas
F. Helbling (2011) in order to see if any trends could be
ascertained. They examined data for 16 industrial countries
to determine the correlations between real GDPs over the
long era ranging from the 1880–1913 period to the 1973–
2008 period. These two beginning and ending periods were
dubbed the “Gold Standard” period (an era where exchange
rates were fixed by participating countries) and the “Modern
Floating Era” (basically the current period, where there is
considerable flexibility in exchange rates), respectively. The
two other periods examined were the “Interwar” period of
1926–1938 and the “Bretton Woods” period of 1952–1972.
(The Bretton Woods system is covered in detail in Chapter
29 of this book.)
The technique used by Bordo and Helbling was to deter-
mine the extent of positive (or negative) correlation of output
(real GDP) bilaterally—that is, of each country individu-
ally with each other country. Their overall conclusion was
that the degree of synchronization of activity across coun-
tries increased noticeably over the long time from 1880 to
2008. For example, during the Gold Standard period, about
50  percent of the bilateral correlations were negative, and
the average correlation coefficient was zero. (Two perfectly
correlated series would have a correlation coefficient of
+1.0; two perfectly opposite series would have a correlation
coefficient of −1.0.) Then in the Interwar period the num-
ber of negative correlations decreased to about 30 percent of
the correlations, and the average coefficient rose to +0.15.
Next, there was a slight move away from synchronization
during the Bretton Woods period, but the average correlation
was still higher than during the Gold Standard. Finally, for
1973–2008, the average correlation was about +0.33 and the
number of negative correlations fell to less than 10 percent.
The authors also tested a suggestion by some observers that,
within the last period, there had been some movement away
from synchronization during 1986–2006, but Bordo and
Helbling did not find supporting evidence for that claim.
Overall, they reached the conclusion that there had indeed
been an increase in the extent of co-movement of countries’
GDPs over the long period from 1880–2008. Of course, the
correlations do not indicate extremely close correlation, but
the increase in synchronization is clearly evident.
Other noteworthy findings in the Bordo-Helbling paper
were that, over time and as a general rule, there has been
a tendency for business cycles to become less volatile and
less frequent, and they now have the characteristic that
recessions are of shorter length than recoveries. Further,
shocks to economies tend to be global in nature rather
than country-specific. In addition, the increased presence
of regional grouping, as in Europe and in North America,
has played a role in the increased synchronization of GDP
movements across countries. Finally, the authors had a
strong feeling that financial factors are critical in generating
global shocks, but they were unable to generate a measure of
financial conditions that they deemed satisfactory for testing
this proposition.
Source: Michael D. Bordo and Thomas F. Helbling, “International
Business Cycle Synchronization in Historical Perspective,” The
Manchester School 79, no. 2 (March 2011), pp. 208–38. ●
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CONCEPT CHECK 1. What happens to the size of the open-economy
multiplier (without foreign repercussions) if,
other things being equal, the marginal pro-
pensity to import increases? Explain in eco-
nomic terms, not just in algebraic terms.
2. Explain why an autonomous increase in invest-
ment spending in a country will lead to a greater
increase in national income in that country if
foreign repercussions are important than it
would if foreign repercussions are unimportant.
AN OVERVIEW OF PRICE AND INCOME ADJUSTMENTS
AND SIMULTANEOUS EXTERNAL AND INTERNAL BALANCE
This and the preceding chapter have been concerned with how the exchange rate and the
state of the external sector lead to effects on the current account and the internal sector
of the economy. In the previous chapter, we examined the manner by which a change
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IN THE REAL WORLD:
RECENT SYNCHRONIZATION OF GDP MOVEMENTS
OF COUNTRIES
A recent study by Ananth Ramanarayanan of the Federal
Reserve Bank of Dallas (2009) focuses on the synchroniza-
tion of international business cycles—that is, the correla-
tion of macro fluctuations in terms of timing and magnitude,
drawing in part on work by Heathcote and Perri (2004). Data
on fluctuations in growth rates of GDP suggest that these cor-
relations tend to rise as countries’ bilateral imports as a share
of GDP increase. Not surprisingly, U.S. GDP growth rates
appear to be much more highly correlated with Canada than
with Germany. Further, the synchronization of U.S. GDP
growth with its North American trading partners has remained
strong for the past 20 years, while showing some decline with
Europe and Japan over the same period. Recent work sug-
gests that the synchronization appears to be stronger when
trade incorporates intermediate goods more intensively. For
example, in the case of the United States and Canada, the use
of rubber and plastic imports from Canada by the U.S. auto
industry provides a strong linkage between the two countries
and strengthens the synchronization of their growth rates.
Heathcote and Perri (2004) provided specifics on such
relationships. They calculated correlation coefficients of
the co-movement of U.S. GDP with the GDPs of Europe,
Japan, and Canada. Their results verify the strong rela-
tionship between U.S. and Canadian GDPs: for the period
1972–1986, the coefficient for the two GDPs was 0.76, and
it increased to 0.84 for the period 1986–2000. On the other
hand, the coefficient for U.S. GDP and European GDP was
0.71 for the 1972–1986 period, and it decreased to 0.31 for
1986–2000. The relationship with Japan became noticeably
less closely linked—the co-movement coefficient for U.S.
GDP with Japanese GDP was 0.61 for 1972–1986 but then
became a negative 0.05 for 1986–2000.
Studies of synchronization during very recent years
are of interest. Data indicate that there is strong evidence
of increased linkages taking place during the recessionary
period that began in 2007; one paper (Imbs, 2010, p. 327)
stated that the “degree of international correlation in national
business cycles since the end of 2008 is unprecedented in
three decades.” The enhanced synchronization has been
traced to financial integration and contagion for the indus-
trialized countries, with trade itself playing only a minor
role. However, for developing countries, whose degree of
synchronization has been more modest, the increased trade
linkages appeared to be the dominant factor.
Sources: Jonathan Heathcote and Fabrizio Perri, “Financial
Globalization and Real Regionalization,” Journal of Economic Theory
119, no. 1 (November 2004), pp. 207–43; Ananth Ramanarayanan,
“Ties that Bind: Bilateral Trade’s Role in Synchronizing Business
Cycles,” Federal Reserve Bank of Dallas Economic Letter 4, no. 1
(January 2009), pp. 1–8; Jean Imbs, “The First Global Recession in
Decades,” IMF Economic Review 58, no. 2 (June 2010), pp. 327–54;
Nikolaos Antonakakis and Johann Scharler, “The Synchronization
of GDP Growth and the G7 during U.S. Recessions: Is This Time
Different?” Applied Economics Letters 19, no. 1 (2012), obtained
from http://epub.wu.ac.at/3468. ●
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in the exchange rate affects export receipts and import outlays and the current account
balance through altering the relative prices of home and foreign goods. In a context of
fixed exchange rates, we discussed how a disequilibrium in the balance of payments (a
deficit or surplus) sets into motion money supply changes and internal price changes so
as to improve (deteriorate) the current account in the case of a BOP deficit (surplus).
In this chapter, we noted that a disturbance in the current account (such as an autono-
mous increase in exports) leads to national income changes, which in turn partly (but
not completely) offset the initial current account disturbance through induced changes
in imports.
An important feature of the interrelationships between the current account and the inter-
nal economy, and one that will be examined in more detail in subsequent chapters, is
the possible conflict between the macroeconomic goals of “external balance” and “inter-
nal balance.” External balance in this context refers to balance in the current account
(X = M ), while internal balance refers to the desirable state of the economy where there is
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a low level of unemployment together with reasonable price stability. There are clearly four
possible combinations of departures from external and internal balance:
Case I: Deficit in the current account; unacceptably rapid inflation.
Case II: Surplus in the current account; unacceptably high unemployment.6
Case III: Deficit in the current account; unacceptably high unemployment.
Case IV: Surplus in the current account; unacceptably rapid inflation.
If policymakers are confronted with any one of these four combinations in a situation of
fixed exchange rates, what should the macroeconomic policy stance be?
In this case, restrictive or contractionary aggregate demand-oriented monetary and fis-
cal policy (i.e., a reduction in the money supply, a decrease in government spending, an
increase in taxes) is in order. With the adoption of such policies, the price level and the
level of national income will fall. The falling prices—or at least prices that are rising less
rapidly than prices in other countries—will expand exports and reduce imports, and the fall
in income will also reduce imports via the MPM. Thus the restrictive policies will improve
the current account and move the economy toward external balance, as well as dampen the
inflation and move the economy toward internal balance. However, the degree of restric-
tion needed to attain external balance may differ from the degree of restriction needed to
attain internal balance, and thus policymakers may not be able to attain both targets simul-
taneously. Nevertheless, the direction of policy will be correct.
In this case, of course, policy is moving in the opposite direction from case I. Expansionary
monetary and fiscal policy—an increase in the money supply, an increase in government
spending, a reduction in taxes—will stimulate national income and also induce more
imports. In addition, any price pressures generated by the expansion will reduce exports
and increase imports. Thus, the direction of policy works to reduce the current account
surplus and to reduce the amount of unemployment, although of course the degree of nec-
essary expansion may differ with respect to attainment of each particular goal.
In this case, even the direction of the appropriate policy stance is unclear. Expansionary
monetary and fiscal policy to decrease unemployment will worsen the current account
through induced imports by the MPM times the rise in income. In addition, if the price
level rises due to the expansionary policy, exports will fall and imports will rise even more,
thus worsening the already existing current account deficit. On the other hand, contrac-
tionary policy to reduce the current account deficit will drive national income downward
and worsen the unemployment situation.
In this case, expansionary policy will reduce the current account surplus but worsen the
inflation. However, contractionary policy to alleviate the inflation will enlarge the current
account surplus.
Case I: Current
Account Deficit and
Inflation
Case II: Current
Account Surplus and
Unemployment
Case III: Current
Account Deficit and
Unemployment
Case IV: Current
Account Surplus and
Inflation
6Of course, as the experience of the 1970s particularly indicated, it is also possible to have unacceptably high
unemployment and unacceptably rapid inflation at the same time. We deal here only with the traditional macro-
economic analysis that treats the economy as having one of these internal problems but not the other simultane-
ously. The “stagflation” situation of high unemployment and rapid inflation at the same time is discussed more
thoroughly in Chapter 27.
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SUMMARY
This chapter considered the interrelationships between the cur-
rent account and national income in the context of an open-
economy Keynesian model. The equilibrium level of income
occurs when desired aggregate expenditures equal produc-
tion or, alternatively, when desired S + T + M equals desired
I + G + X or S + (T − G) − I equals the current account bal-
ance. In this model, increases in autonomous spending on con-
sumption, investment, government spending, or exports lead to
multiplied increases in national income through the multiplier
of 1/(1  −  MPC  +  MPM) or 1/(MPS  +  MPM). The presence
of “foreign repercussions” introduces additional features into
the multiplier process, with these repercussions embodying the
role of interdependence among economies in national income
determination. In Keynesian income models in general, if the
current account is in equilibrium, a disturbance to that equilib-
rium will set forces in motion to restore current account balance.
However, only partial adjustment rather than a full restoration
of current account balance will occur.
An important point emerging from the Keynesian income
model is that, with a fixed exchange rate, equilibrium in
national income need not occur with simultaneous equilibrium
in the current account. Policymakers confront targets of both
external and internal balance, and it may be difficult to attain
both targets even if explicit changes in the exchange rate are
permitted. Further policy considerations are explored in the
next three chapters.
KEY TERMS
autonomous consumption spending
autonomous imports
autonomous spending multiplier
average propensity to import (APM)
consumption function
desired aggregate expenditures
equilibrium level of national income
external balance
foreign repercussions
import function
income elasticity of demand for
imports (YEM)
induced consumption spending
induced imports
injections
internal balance
Keynesian income model
leakages
marginal propensity to
consume (MPC)
marginal propensity to
import (MPM)
marginal propensity to save (MPS)
open-economy multiplier
open-economy multiplier with for-
eign repercussions
partial current account adjustment
rounds of spending in the multiplier
process
saving function
Hence, the attainment of one “balance” in either of these last two cases will worsen the
situation with respect to the other “balance.” There is thus a conflict between the attain-
ment of external balance and internal balance in these two cases. The policymakers may
have to decide which goal is more important.
In the conflict cases, however, as well as in cases I and II, where the degree of needed
policy restriction or expansion was in doubt, it is possible to have the relative price effects
and the income effects work together to attain both goals simultaneously. This can be
accomplished by using a change in the exchange rate as an instrument of policy. This
change in the exchange rate can be interpreted as a change in the official parity rate in a
fixed-but-adjustable-rate system (for example, the Bretton Woods system from 1947 to
1971, discussed in the last chapter of the book) or as government intervention to influence
the exchange rate in a more flexible exchange rate system, such as currently exists for
many countries. Hence, in a model such as that of Swan (1963), a country with unemploy-
ment and a current account deficit could devalue (depreciate) its currency in order to alle-
viate the current account problem as well as to provide economic stimulus from enhanced
exports and reduced imports. In the other previous conflict situation of inflation and a cur-
rent account surplus, an upward revaluation (appreciation) of the country’s currency would
work, through a decrease in exports and an increase in imports, to remove the surplus as
well as to dampen the inflation.
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Appendix A THE MULTIPLIER WHEN TAXES DEPEND ON INCOME
The open-economy multiplier when taxes depend on income is smaller than the open-economy mul-
tiplier when taxes are entirely autonomous or lump sum in nature (as was the case in the body of this
chapter). To illustrate, building on the numerical example in the chapter, suppose that, as before,
C = 100 + 0.8Yd G = 600
Yd = Y − T X = 140
I = 180 M = 20 + 0.1Y
However, suppose that the tax function, instead of T = 500, is now
T = 40 + 0.25Y
This expression indicates that, besides an autonomous or lump-sum component of taxes (40), there is
also a component that depends on income (0.25Y). The 0.25 in this example is the marginal tax rate,
or t in general form. The marginal tax rate is the fraction of an additional unit (dollar) of income that
must be paid in taxes—25 percent in this example. With this tax function, the equation for disposable
income becomes
Yd = Y − (40 + 0.25Y )
= −40 + 0.75Y
QUESTIONS AND PROBLEMS
1. Using the Keynesian model, explain the effect on national
income of an autonomous increase in saving.
2. Given the following simple Keynesian model:
E = C + I + G + X − M I = 150
C = 50 + 0.85Yd G = 300
Yd = Y − T X = 80
T = 400 M = 10 + 0.05Y
Y = E in equilibrium
(a) Determine the equilibrium level of income.
(b) When the equilibrium income level is attained, is there
a surplus or a deficit in the current account? Of how
much?
(c) What is the size of the autonomous spending multiplier?
3. In the model of Question 2, by how much would income
have to change in order to make X  =  M (with no change
in X)? How much change in autonomous investment would
be necessary to generate this change in income?
4. Explain why a country with a current account surplus (such
as China) can be said to be saving more than it invests.
5. Germany has consistently pursued an anti-inflationary
domestic policy that has resulted in more unemployment and
a lower rate of economic growth than would otherwise have
been the case. Why might Germany’s trading partners have
reacted adversely to such a German policy stance?
6. In trade negotiations with the Japanese over the large U.S.
trade deficit with Japan, the Clinton administration urged the
Japanese government to undertake a more expansionary fis-
cal policy. If the Japanese government did so, how might
the U.S. trade deficit with Japan be reduced? Could U.S.
imports from Japan rise because of the expansionary policy?
Explain.
7. You are given the following four-sector Keynesian income
model:
E = C + I + G + (X − M ) I = 230
C = 120 + 0.75Yd G = 560
Yd = Y − T X = 350
T = 40 + 0.20Y M = 30 + 0.10Y
Y = E in equilibrium
(a) Calculate the equilibrium income level (Ye).
(b) Calculate the amount of taxes collected when the econ-
omy is at Ye. Then indicate whether the government has
a surplus or deficit at Ye and calculate the value of the
surplus or deficit.
(c) Calculate the value of net exports when the economy is
at Ye.
(Note: To answer this question, you need to read Appendix
A of this chapter.)
8. Suppose that there are two countries in the world economy,
countries I and II. The countries possess the following mar-
ginal propensities: MPCI = 0.7; MPMI = 0.1; MPCII = 0.8;
MPMII = 0.2. There is no government sector. Using the for-
mula for the open-economy multiplier with foreign reper-
cussions, calculate the effect on country I’s income of a rise
in autonomous investment in country I of $35 billion. (Note:
To answer this question, you need to read Appendix B of
this chapter.)
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To examine the effect of this change in the tax structure on the multiplier and the rounds of spending
in the multiplier process, let us now suppose that, as in the body of the chapter, investment increases
by 30. In the first round of the multiplier process, producers of the new capital goods increase their
output by 30. (We again assume that the first round of spending is entirely on domestic goods.) This
output increase of 30 increases income of the workers in the capital goods industries by 30. How much
spending will take place in the second round of the multiplier process? The second-round spending
will be less than the MPC (0.8) times the change in income (30) because taxes now have to be paid
before any more spending takes place. With the marginal tax rate of 25 percent, the recipients of the
30 in income must pay (0.25)(30) = 7.5 in taxes. Hence, although income increased by 30, dispos-
able income increased by only 22.5 (= 30 − 7.5). Applying the MPC of 0.8 to the 22.5 increase in
disposable income, households in the second round thus spend 18 [= (0.8)(22.5)] more on goods and
services. However, remember that some of the new spending in the economy is on imports and, in our
example, this is 0.1 of the new total income (not the new disposable income). Hence, with the total
income increase of 30, imports will increase by 3 [= (0.1)(30)]. Thus, in the second round, the amount
of spending on domestic goods is 15 (= 18 − 3). This second-round result is 50 percent of the first
round spending (unlike in our earlier example where it had been 70 percent of first-round spending).
Let us trace this multiplier process through one more round. Of the new domestic production and
income of 15 generated in the second round, 25 percent must be paid in taxes—an amount of (0.25)
(15) = 3.75. Thus, disposable income rises in the third round by 11.25 (= 15 − 3.75). To the 11.25,
the MPC of 0.8 applies, and consumption increases by 9 [= (0.8)(11.25)]. With imports increasing by
1.5 (= 10 percent of the 15 total new income coming from the second round), spending on domestic
goods hence rises by 7.5 (= 9 − 1.5) or 50 percent of the second-round figure of 15.
To cut to the chase, the many rounds of spending yield a series of income changes
ΔY = 30 + 15 + 7.5 + ⋅ ⋅ ⋅
As noted earlier in the chapter, such a series sums to
ΔY = [1∕(1 − fraction re-spent in each round)](initial ΔI )
or, in this case because 50 percent is re-spent in each round,
ΔY = [1∕ (1 − 0.5)](30)
= (1∕0.5)(30) = 60
The multiplier is thus 2.0 (= 60/30 or 1/0.5). It has been reduced from the 3⅓ of the earlier example
in the chapter because taxes are now an additional leakage in each round of the spending process
after the first round.
In conceptual terms, the open-economy multiplier when taxes depend on income (k*o) is given
by the expression
k*o =
1
1 − MPC(1 − t) + MPM
[22]
or, alternatively,
=
1
1 − MPC + MPC × t + MPM
[22′]
If t = 0, we are back at the original multiplier. With the current numbers in this appendix, you can
plug in MPC = 0.8, t = 0.25, and MPM = 0.1 to verify that the multiplier = 2.0.
One final note: If, unlike in our analysis in this chapter and this appendix, imports are made to
depend on disposable income rather than on total income, the open-economy multiplier becomes
k**o =
1
1 − MPC(1 − t) + MPM(1 − t)
[23]
which is slightly smaller than the multiplier in expressions [22] and [22′].
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Appendix B DERIVATION OF THE MULTIPLIER WITH FOREIGN REPERCUSSIONS
This appendix derives the autonomous spending multiplier when foreign repercussions are taken into
account. To simplify to some extent the complicated algebra, we assume that there is no government
sector (in either country), and hence G = 0 and t = 0. Note that the standard open-economy multiplier
in this case is 1/(1 − MPC + MPM) or 1/(MPS + MPM).
In the derivation, we designate foreign country variables with a *; unstarred variables refer to the
home country. Consumption contains the usual autonomous component and induced component in
both countries, as does the import function. Investment and exports are autonomous. The equations
for the two economies are thus
E = C + I + X − M E* = C* + I* + X* − M*
C = a + bY C* = a* + b*Y*
I = I I* = I*
X = X X* = X*
M = M + mY M* = M* + m*Y*
Y = E and Y* = E* in equilibrium
The equilibrium level of income for the home country is found by substitution into the Y = C+
I + X − M equilibrium expression:
Y = a + bY + I + X − (M + mY )
Y − bY + mY = a + I + X − M
Y =
a + I + X − M
(1 − b + m)
[24]
However, in this two-country model, the exports of the home country are equal to the imports of
the foreign country, so [24] can be written as
Y =
a + I + M* + m*Y* − M
(1 − b + m)
For simplification, we substitute s (the marginal propensity to save in the home country) for
(1 − b), because b is the home country’s marginal propensity to consume:
Y =
a + I + M* + m*Y* − M
s + m
[25]
A similar procedure for obtaining equilibrium income in the foreign country yields the equation
for Y* as
Y* =
a* + I* + M + mY − M*
s* + m*
[26]
where s* is the foreign country’s marginal propensity to save.
To obtain multipliers for the home country, expression [26] is substituted into expression [25]:
Y =
a + I + M* − M + m*(
a* + I* + M + mY − M*
s* + m* )
s + m
Y =
(s* + m*)(a + I + M* − M) + m*(a* + I* + M + mY − M*)
(s* + m*)(s + m)
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(s + m)Y =(
(s* + m*) (a + I + M* − M) + m*(a* + I* + M − M*)
s* + m* )+
m*mY
s* + m*
and
(s* + m*)(s + m)Y − m*mY = (s* + m*)(a + I + M* − M) +
m*(a* + I* + M − M*)
Therefore, equilibrium income Y can be expressed as
Y = (
s* + m*
ss* + ms* + sm*) (a + I + M* − M) +
(
m*
ss* + ms* + sm*) (a* + I* + M − M*) [27]
Expression [27] can be used to obtain a variety of multipliers. The autonomous investment multi-
plier in the home country simply involves looking at the ΔY associated with a ΔI:
ΔY
ΔI
= s* + m*
ss* + ms* + sm*
or
=
1 +
m*
s*
s + m + m*(s/s*)
[28]
Inspection of this multiplier indicates that it is larger than it would be if there were no foreign
repercussions. The standard no-repercussions open-economy multiplier (i.e., expression [20] in the
chapter) is
1
1 − MPC + MPM
= 1
MPS + MPM
or, in the symbols of this appendix, 1/(s + m). Expression [28] is larger than this multiplier because
the percentage increase in the numerator in [28] from that in [20] is larger than the percentage
increase in the denominator.
The investment multiplier in [28] applies also to a change in autonomous consumption (i.e., to
a change in “a”). However, note that, unlike the case where foreign repercussions are absent, the
foreign repercussions multiplier for an autonomous change in exports of the home country will differ
from the foreign repercussions multiplier for a change in autonomous investment (or consumption).
Looking at expression [27], an autonomous change in exports for the home country is a change in
autonomous imports (M*) for the foreign country. Thus,

ΔY
ΔX
= ΔY
ΔM*
= s* + m*
ss* + ms* + sm*

m*
ss* + ms* + sm*
=
s*
ss* + ms* + sm*
=
1
s + m + m*(s/s*)
[29]
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The multiplier in [29] is smaller than the multiplier in [28] because of the absence of the m*/s*
term in the numerator of [29]. Expression [29] is also smaller than the [1/(s + m)] multiplier when
there are no foreign repercussions. The economic reason is that an autonomous increase in home
exports, while it stimulates home production and generates an expansion in home income, is also an
autonomous increase in foreign country imports. The increase in autonomous foreign imports is at
the expense of foreign consumption of goods produced in the foreign country, and it thus initiates a
downward movement of income abroad. The decrease in foreign income in turn induces a decrease in
purchases of home-country exports through the operation of the marginal propensity to import in the
foreign country, and it generates a downward movement in home-country income that partly offsets
the upward income effects of the original autonomous export increase in the home country.
Another multiplier of interest is the effect of a change in autonomous investment in the foreign
country upon home-country income. If I* is changed in expression [27], the effect upon Y is

ΔY
ΔI*
= m*
ss* + ms* + sm*
=
m*
s*
s + m + m*(s/s*)
[30]
Obviously, the introduction of foreign repercussions makes multiplier analysis more complex!
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619
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CHAPTER
LEARNING OBJECTIVES
LO1 Indicate the appropriate assignment of policy instruments to economic
targets in a fixed exchange rate system.
LO2 Explain general equilibrium in the macroeconomy using the IS/LM/BP
model.
LO3 Describe the impact of changes in fiscal policy on income, trade, and
interest rates under fixed exchange rates.
LO4 Describe the impact of changes in monetary policy on income, trade, and
interest rates under fixed exchange rates.
LO5 Demonstrate the impacts of a change in the official exchange rate on
income, trade, and interest rates.
ECONOMIC POLICY IN
THE OPEN ECONOMY
UNDER FIXED
EXCHANGE RATES
25
PART 6: Macroeconomic
Policy in the Open Economy
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INTRODUCTION
The yuan (RMB) has maintained a close tie to the U.S. dollar since 1994. As China’s trade
surpluses both with the United States and overall have grown, many have argued that its
export success has been the result of an undervalued yuan. At the same time, there has been an
ever-increasing flow of foreign investment into China, adding to the tremendous productive
capacity of the country. In an article in The International Economy,1 30 international experts
from different professional backgrounds expressed their opinions about the degree to which
the yuan is undervalued and the effect, if any, the undervaluation has had on world trade and
finance. Not surprisingly, there was a wide variety of views ranging from “China should float
the renminbi and permit it to appreciate in the currency markets” to “there is no clear evidence
that the currency is undervalued.” While not accepting the notion that the RMB is seriously
undervalued, Chinese officials nonetheless permitted it to appreciate by about 30 percent
from 2006 to 2014. In August 2015, the Chinese government undertook a 1.9 depreciation of
the RMB and announced that there would be a greater role for the market in determining the
value of the RMB in the future.
How do we go about evaluating such different positions? What does the nature of the
exchange rate system have to do with the issues of foreign investment, currency accumu-
lation, and the effect on the domestic money supply? How do we take into account the
many aspects of this difficult domestic and international issue? In this chapter we develop
a framework for analysis of macroeconomic issues and policy that will provide a basis for
analyzing these important questions. More specifically, we focus on the situation when-
ever a country has chosen to fix the exchange rate and not let it float on a regular basis.
Of particular interest is the manner in which discretionary economic policy influences the
macroeconomy under fixed exchange rates. Because the effects of discretionary policy are
different under a flexible exchange rate system compared with a fixed-rate system, we then
consider economic policy under flexible exchange rates in the following chapter. Although
the major industrial countries tend to have flexible-rate systems today, many countries still
peg their currencies and thus have to contend with the effects of fixed rates when carrying
out macroeconomic policy. This is true to an extreme for the 19 European countries that
have adopted a common currency, the euro, although the euro is flexible against most other
currencies of the world.
Prior to current monetary arrangements (discussed in detail in the last chapter in
the book), the international monetary system was characterized by relatively fixed
exchange rates, and there is continual pressure on the part of many individuals to return
to some sort of fixed standard. In our consideration of economic policy under fixed
rates, we first examine a fixed-rate model that separates monetary policy from fiscal
policy and that provides some guidance in the selection of appropriate policy instru-
ments. We then introduce a macroeconomic framework that specifically incorporates
the money markets, the real sector, and the foreign sector (the IS/LM/BP model), which
we use to examine the effects of alternative policy actions under fixed exchange rates
(in this chapter) and under flexible exchange rates (in the next chapter). Consideration
of possible price effects accompanying these policy actions will be discussed in
Chapter 27.
The Case of the
Chinese Renminbi
Yuan
1“Is the Chinese Currency, the Renminbi, Dangerously Undervalued and a Threat to the Global Economy?
(A Symposium of Views),” The International Economy 17, no. 2 (Spring 2003), pp. 25–39.
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TARGETS, INSTRUMENTS, AND ECONOMIC POLICY IN A TWO-INSTRUMENT,
TWO-TARGET MODEL
As an introduction to policy analysis in the open economy, we begin by developing a very
basic framework that will allow us to examine the interaction between policies aimed at
attaining external balance and those aimed at other domestic targets such as full employment
and price stability. One of the early models that differentiated the effects of monetary and
fiscal policy on the open economy was developed by Robert Mundell (1962). The separation
of monetary and fiscal policy was accomplished by extending the current account analysis
of that time to include capital flows as well. “External balance,” or “balance-of-payments
equilibrium,” was thus defined by Mundell to mean a zero balance in the official reserve
transactions balance.2 The attainment of the external balance target is influenced by both
TITANS OF INTERNATIONAL ECONOMICS:
ROBERT A. MUNDELL (BORN 1932)
Robert A. Mundell was born on October 24, 1932, in Kingston,
Ontario, Canada. He received his B.A. from the University
of British Columbia in 1953, did postgraduate work at
the University of Washington and the London School of
Economics and Political Science, and earned his Ph.D. (very
rapidly!) from the Massachusetts Institute of Technology in
1956. He has taught at the University of British Columbia,
Stanford University, the Johns Hopkins University Center in
Bologna, Italy, McGill University, the University of Waterloo,
and the University of Chicago. He is currently a professor at
Columbia University. He has also been very active as a con-
sultant and adviser, having worked with the U.S. Department
of the Treasury, the Inter-American Development Bank, the
World Bank, and the European Economic Community. He
also is greatly envied because, despite his professional com-
mitments, he finds time to be with his family in their palazzo
near Siena, Italy.
Professor Mundell’s work has been diverse and extremely
influential. He has published articles in many economics
journals, as well as important books such as The International
Monetary System—Conflict and Reform (1965), International
Economics (1968), and Monetary Theory—Interest, Inflation,
and Growth in the World Economy (1971). He made a semi-
nal contribution to the theory of optimum currency areas
(discussed in Chapter 28). His work on monetary and fiscal
policy under fixed and flexible exchange rates (discussed
in this and the succeeding chapter) has been widely used,
and it has had influence on actual policy. In addition, he
did creative work on factor mobility in the context of inter-
national trade theory (discussed in Chapter 8), and he dem-
onstrated how movements of factors of production can be
substitutes for movements of goods in terms of impacts on
relative factor prices. Further, he is regarded as a founder
of the monetary approach to the balance of payments (dis-
cussed in Chapter 22) and as a father (if not the father) of
supply-side economics. Indeed, Mundell’s work in supply-
side economics was of such import that fellow supply-sider
Arthur Laffer has written (1999, p. A16) that “Mr. Mundell
has been as influential as John Maynard Keynes, the dif-
ference being that Mr. Mundell was right.” While not all
economists would share that view, the consensus is that this
brilliant man has made enduring contributions to the subject
of economics.
Professor Mundell has played a major role in stimulating
macroeconomists in particular to “think internationally,” and
international economics would be much different if Mundell
had not devoted his energies to the area. The culmination of
his career (at least to date!) was the awarding to him of the
Nobel Prize in economic science in 1999.
Sources: Arthur B. Laffer, “Economist of the Century,” The Wall
Street Journal, October 15, 1999, p. A16; “Man of the Hour,”
The Economist, October 16, 1999, p. 82; David Warsh, Economic
Principals: Masters and Mavericks of Modern Economics
(New York: The Free Press, 1993), pp. 192–96; Who’s Who in the
World: 2000 Millennium Edition (New Providence, NJ: Marquis
Who’s Who, 1999), p. 1514. ●
2Note that this definition of external balance differs from the definition given at the end of the preceding chapter,
where the term referred to balance in the current account.
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3In this Mundell model, it is assumed that expansionary fiscal policy worsens the balance of payments. As we see
later, expansionary fiscal policy can improve the balance of payments under certain circumstances.
monetary policy and fiscal policy. For example, an increase in the money supply will reduce
interest rates, leading to a reduction in short-term financial capital inflows or an increase in
short-term financial capital outflows and to a BOP deficit. Expanding government spending
will lead to increased income and an increase in imports and also to a BOP deficit.3 Because
expansionary monetary policy and fiscal policy are assumed to affect the balance of pay-
ments in a similar fashion, we can conclude that maintaining balance-of-payments equilib-
rium for a given exchange rate requires an opposite use of monetary and fiscal policy in this
model; that is, expansionary fiscal policy must be accompanied by contractionary monetary
policy and vice versa.
There is a similar policy relationship with respect to the internal balance target. Increases
in the money supply tend to lower the interest rate and thus to stimulate real investment. If
this is not to be expansionary and/or inflationary, the increase in investment must be offset
by a decrease in government spending or by an increase in taxes that will reduce consump-
tion spending. Similarly, maintenance of a given domestic internal balance target indicates
that any increase in government spending (or any increase in consumption spending via a
decrease in taxes) must be offset by some decrease in domestic investment through mon-
etary policy actions if inflationary pressures are not to ensue.
The policy problem in this instance is demonstrated graphically in Figure 1. The
effects of monetary policy are captured through the use of different rates of interest
i
(G – T )*0
I
c
d
b
IB
EB
IV
II
III
(G – T )
a
FIGURE 1 Internal Balance, External Balance, and Policy Instrument Assignment
The IB curve reflects all combinations of interest rates i (monetary policy) and net government spending (G − T )
that lead to the attainment of domestic targets, that is, internal balance. Similarly, the flatter EB curve reflects all
combinations of i and (G − T ) that generate equilibrium in the balance of payments for a given exchange rate.
Points above the IB curve reflect unacceptably high unemployment, and points below reflect unacceptably rapid
inflation. Similarly, points above the EB curve represent a surplus in the balance of payments, and points below
represent a deficit. It is clear that internal balance and external balance are obtained simultaneously only at i*
and (G − T )*. Finally, if the economy is not at i* and (G − T )*, monetary policy should be pursued to reach
external balance and fiscal policy to reach internal balance.
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on the vertical axis. Fiscal policy is represented through the levels of net government
spending (G − T ) plotted on the horizontal axis. The inverse relationship between the
two policy instruments is shown by upward-sloping curves, because higher interest rates
reflect, ceteris paribus, a smaller money supply. Internal balance is represented by the
IB curve and external balance by the EB curve. In this case, each curve shows combina-
tions of monetary and fiscal policy [i and (G − T )] that bring about internal and external
balance, respectively.
Although both curves slope upward for the reasons given earlier, the EB curve is drawn
flatter than the IB curve because changes in the money supply (and hence the interest rate)
are assumed to have a greater relative effect on external balance than on internal balance.
This is generally thought to be the case because changes in the interest rate affect the bal-
ance of payments through both the capital and the current accounts. A rise in the interest
rate causes not only an increase in net short-term capital inflows but also reduced domestic
real investment and income, which acts to reduce imports. Changes in the interest rate thus
exert both a direct and an indirect effect on the balance of payments, whereas they affect
the internal balance target only through the direct effect on real investment. This assump-
tion allows us to reach a conclusion about the appropriate assignment of policy instruments
to the IB and EB targets (i.e., effective policy classification).
In Figure 1, it is clear that only one combination of monetary policy and fiscal policy
will allow the simultaneous attainment of both targets, that of i* and (G − T )*. Any other
combination will lead to one or both of the targets not being met. All points to the left
of or above the IB curve reflect combinations of the two instruments where the interest
rate is too high given the fiscal policy stance, resulting in low investment, low income,
and unemployment. Similarly, all points to the right of or below the IB curve lead to real
investment levels that are too high, contributing to inflation. Points to the left of or above
the EB curve reflect interest rates that are higher than necessary to bring the balance of
payments into equilibrium at the given exchange rate, and hence generate a surplus in the
balance of payments due to capital inflows. Points to the right of or below the EB curve
reflect a balance-of-payments deficit because the low interest rate leads to financial capital
outflows. The graph can thus be divided into four quadrants, each reflecting a different
combination of missed targets:
I. Unacceptably high unemployment; balance-of-payments surplus.
II. Unacceptably rapid inflation; balance-of-payments surplus.
III. Unacceptably rapid inflation; balance-of-payments deficit.
IV. Unacceptably high unemployment; balance-of-payments deficit.
Again we see that the simultaneous attainment of the two targets can take place only by
careful choice of the two instruments involved. For example, if the economy is at point
a, altering one instrument will permit the attainment of one target but not both. To reach
equilibrium, both instruments must be utilized.
A further important point needs to be made relating to the assignment of instruments to
targets. Given the nature of the IB and EB functions, it will be more efficient to assign the
monetary policy instrument to pursue EB and fiscal policy instruments to pursue IB targets.
This becomes obvious when we consider the possible sequence of policy decisions that
could take place at point a. If monetary policy is directed toward the IB target, a decrease
in the money supply (an increase in the interest rate) is required. If the fiscal policy instru-
ment is then directed toward the EB target, expansionary fiscal action is required. These
steps (shown by the dashed arrow in region II of Figure 1) would move the economy even
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farther away from i* and (G  −  T )*, not closer. On the other hand, devoting monetary
policy to the EB target and fiscal policy to the IB target4 leads to a sequence of policy
steps that drives the economy closer to the desired levels of i* and (G − T )* (indicated
by the solid arrows in region II). A similar conclusion would be reached for points b, c, or d.
This model thus suggests that effective policy classification of policy instruments and tar-
gets is an important element in the successful administration of economic policy in the
open economy under fixed exchange rates.
4The reader may recall from other courses that fiscal policy has an effect on interest rates, because an expansionary
policy, for example, will raise income, raise money demand, and therefore raise interest rates (given a fixed money
supply). In the Mundell model, the monetary authorities are assumed to recognize this effect when implementing
policy to meet any interest rate target.
5See expressions [1], [2], and [5] in that chapter.
CONCEPT CHECK 1. What is the difference between internal bal-
ance and external balance?
2. If the economy is operating at c in Figure 1,
what policy actions should be carried out to
reach the internal balance target? Why?
3. Which policy tool should be used to attain
external balance in Figure 1? Why?
GENERAL EQUILIBRIUM IN THE OPEN ECONOMY: THE IS/LM/BP MODEL
Building on the introduction to policymaking in the open economy provided by the pre-
vious analysis, we now turn to a broader general equilibrium construct that specifically
incorporates the money market relationships developed in Chapter 22 and the real sector
or income effects discussed in Chapter 24. In addition, the model specifically incorporates
the effects of international trade and international capital flows on equilibrium in the open-
economy model. The approach is commonly referred to as the Mundell-Fleming model.
(Marcus Fleming was a long-time official at the International Monetary Fund.)
Equilibrium in the money market occurs when the supply of money is equal to the demand
for money. In Chapter 22, we covered both the supply of and the demand for money in
considerable detail, and we presented the concept of money market equilibrium conceptu-
ally and algebraically in the following general manner:5
Ms = L
or
+ − + + − ?
a(DR + IR) = a(BR + C ) = f [Y, i, P, W, E ( p), O]
where: Ms = money supply
L = money demand
a = money multiplier
DR = domestic reserves held by the central bank
IR = international reserves held by the central bank
BR = reserves of commercial banks and other depository institutions
C = currency held by the nonbank public
Y = level of real income in the economy
i = domestic interest rate
P = price level
General Equilibrium
in the Money Market:
The LM Curve
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W = level of real wealth
E(p) = expected percentage change in the price level
O =  all other variables that can influence the amount of money balances the
country’s citizens wish to hold (e.g., the foreign interest rate, expected
changes in the exchange rate if the exchange rate is not fixed, risk pre-
mium for holding foreign assets)
The nature of the effect of changes in the principal independent variables on money demand
is indicated above each demand variable in equation [1]. Because the income level and the
interest rate are thought to be the two major influences on the demand for money, we focus
our attention on these two variables with regard to money market equilibrium. Holding the
variables other than Y and i constant, there will be a transactions demand for money fixed
by a given level of income and an asset demand for money determined by the domestic
interest rate (given the foreign interest rate, the foreign risk premium, and other financial
considerations). Further, for any given income level, a graph of the demand for money can
be portrayed as the downward-sloping L curve in Figure 2. This graph enables us to focus
on the inverse relationship between the interest rate and the demand for money, holding
other things constant. You will recall the various explanations for the inverse relationship;
for example, a higher interest rate means an increase in the opportunity cost of holding
non-interest-bearing money assets and reduces the amount of money that people wish to
hold. If any of the “other things” besides the interest rate change, the L curve will shift
(e.g., a rise in income shifts the L curve to the right because greater transactions demand
for money would exist at each interest rate).
Having looked at the demand for money, let us comment briefly on the supply of money.
For the time being, we assume that the supply of money at any given point in time is fixed.
The money supply is presumed to be under the control of the monetary authorities (such as
L = f(i)
Interest
rate (i )
Money0
i1
i2
ie
A
A’
B’
B
q
Ms
The fixed money supply is indicated by the vertical line Ms. The demand for money is represented by the
L curve, and the equilibrium interest rate is ie. Above ie at interest rate i1, the demand for money is equal to
horizontal distance i1A, which is less than the supply of money i1B. With an excess supply of money, people
purchase bonds, which drives up bond prices and reduces the interest rate—a process that continues until ie is
reached. Below ie, there is an excess demand for money. People sell bonds to obtain money, bond prices fall,
and the interest rate rises until ie is attained.
FIGURE 2 Equilibrium in the Money Market
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the Board of Governors of the Federal Reserve System in the United States). The specifica-
tion of a fixed money supply (call it amount Ms) is represented by the vertical line in Figure 2.
Increases (decreases) in the supply of money shift this line to the right (left). The demand
and supply of money jointly determine the equilibrium interest rate, at rate ie.
Interest rate ie is the equilibrium rate because, at any other rate, there is either an excess
supply of or an excess demand for money. For example, at interest rate i1, the amount of
money demanded (represented by the horizontal distance i1A) is less than the money sup-
ply (represented by the distance i1B). The excess supply of money AB indicates that people
hold more of their wealth in the form of money (distance i1B) than they wish to hold (dis-
tance i1A) at this relatively high interest rate. In response, the money holders will purchase
other assets such as bonds with their excess cash balances. These asset purchases drive up
the price of bonds and drive down the interest rate. (Remember the inverse relationship
between bond prices and interest rates.) This process continues until the interest rate falls
to the level at which the existing money supply is willingly held (at interest rate ie). In the
opposite situation, at low interest rate i2, there is an excess demand for money of B′A′.
People sell bonds and other assets to build up their money balances, and this action drives
down the price of bonds and other assets and drives up the interest rate until the equilibrium
rate is reached.
In light of Figure 2, consider what will happen when there are changes in the demand
and supply of money. If the monetary authorities increase the supply of money, then line
Ms shifts to the right (not shown). The resulting excess supply of money at old equilibrium
interest rate ie causes the interest rate to fall to the level corresponding to the intersection
of demand curve L with the new money supply line. Going in the other direction from Ms
a decrease in the supply of money shifts Ms to the left. Excess demand for money at old
interest rate ie causes the interest rate to rise to a new equilibrium level. Considering shifts
in the demand curve, an increase (decrease) in the demand for money would shift the L
curve to the right (left) and generate an excess demand for (supply of) money, given the
money supply Ms; the interest rate will rise (fall).
To this point, we have focused on the interest rate and equilibrium between the demand
for and supply of money. But this is only a partial analysis because it has neglected the
other main determinant of the demand for money—the level of income in the economy. We
now introduce the role of income in money market equilibrium.
When we obtained the equilibrium interest rate in Figure 2, the interest rate was the
only explicit determinant of the demand for money. Suppose that this is not so and that
the level of Y in the economy goes up. Remembering expression [1], the level of income
is positively associated with the demand for money. Consider Figure 3, panel (a). The L
curve is the one we have been using, and we indicate by the parenthetical expression that
this L curve is associated with income level Y0. If income rises to Y1, then we generate a
new L curve indicated by L′ and by the Y1 in parentheses. More money is demanded at this
higher income level, and the equilibrium interest rate rises from i0 to i1. Similarly, a fall in
income from Y0 to Y2 leads to a fall in the demand for money curve to L″, with the lower
level of income Y2 indicated in parentheses. The decrease in the income level has thus led
to a lower equilibrium interest rate (i2).
This discussion of the relationship between the income level, the interest rate, and money mar-
ket equilibrium leads us to a graphical construct, the LM curve. The LM curve shows the various
combinations of income and the interest rate that produce equilibrium in the money market.6
6Note that all variables (and especially the price level) influencing the demand for money other than the interest
rate and income are being held constant along any given LM curve. The relationship of the price level to the LM
curve is developed in detail in Chapter 27.
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Such a curve is illustrated in Figure 3, panel (b). At each point on this curve, for the particular
income level on the horizontal axis, the associated interest rate on the vertical axis is the inter-
est rate that makes the demand for money equal to the fixed supply of money. Thus, at point
R0, the income level Y0 and the interest rate i0 together give equilibrium in the money market
when the money supply is Ms.
Why does the LM curve slope upward? Suppose that the level of income rises from Y0 to
Y1. As indicated, the increase in income will generate an increase in the demand for money
as L in Figure 3(a) shifts to L′; the interest rate thus rises from i0 to i1. Once the interest rate
has risen to i1, the excess demand for money has been eliminated and the money market is
again in equilibrium. Similarly, if income falls from Y0 to Y2, the decrease in the demand for
money to L″ lowers the equilibrium interest rate to i2. From this discussion, we can see that
any point to the right of the LM curve, such as point T, is associated with an excess demand
for money. At point T, the interest rate is too low for the income level; equilibrium in the
money market requires a higher i. (Alternatively, the income level is too high for the given
interest rate; equilibrium requires a lower income and thus a lower demand for money in
order to be at the interest rate associated with T.) Similarly, any point to the left of the LM
curve, such as point V, involves an excess supply of money. For the income level associated
with V, the interest rate needs to be lower in order to have equilibrium in the money market
(or the income level needs to be higher for the interest rate associated with V ).
A final point to make at this juncture is that increases in the demand for money (due
to other things besides a rise in income) or decreases in the supply of money will shift the
LM curve to the left. In either situation, the interest rate rises for any given income level,
which is analogous to saying that the income level must fall to maintain the same interest
rate. Thus, each interest rate is plotted against a lower income level than before the increase
in the demand for money or the decrease in the supply of money. By reverse reasoning,
Money0 0
i1
L’ (Y1)
L” (Y2)
M s
Interest
rate (i )
L (Y0)
LM
V
T
Y2 Y0 Y1
i1
Interest
rate (i )
Income (Y )
(a) (b)
i0
i2
i0
i2
Ro
In panel (a), an increase in income from Y0 to Y1 increases the demand for money from L to L′ and results in a rise in the interest rate from i0 to i1.
A decrease in income from Y0 to Y2 decreases the demand for money from L to L″ and leads to a fall in the interest rate from i0 to i2. This positive
relationship between Y and i is portrayed by the LM curve in panel (b), which shows the various combinations of income and the interest rate that
yield equilibrium in the money market. To the right of the LM curve, such as at point T, there is an excess demand for money; to the left of the
LM curve, such as at point V, there is an excess supply of money. In either case, movement will take place to the LM curve.
FIGURE 3 Income and the Interest Rate: The LM Curve
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decreases in the demand for money (due to other things besides a fall in income) and
increases in the supply of money will shift the LM curve to the right. With either a decrease
in the demand for money or an increase in the supply of money, the interest rate is lower
for each given income level or, expressed differently, a lower income level is associated
with each given interest rate.
CONCEPT CHECK 1. What effect will an increase in income have
on the demand for money? The LM curve?
Why?
2. Explain why the LM curve slopes upward.
3. If bank reserves increase, what happens to the
supply of money? The LM curve? Why?
In the preceding chapter, we examined the goods and services markets, or the real sec-
tor of the economy. We indicated that, in income equilibrium, the “leakages” of saving,
imports, and taxes were equal to the “injections” of investment, exports, and government
spending on goods and services. However, a key feature was that the monetary sector was
neglected in that real-sector analysis, meaning that we were assuming that the interest rate
was constant. It is now time to relax that assumption! In Figure 4(a), the i0 in parentheses
indicates that the interest rate is held constant at some interest rate i0 when we consider the
I(i0) + X + G line. With this interest rate, the equilibrium level of income is Y0. What if
we reduce the interest rate from i0 to i1? Investors will want to undertake greater amounts
of investment because borrowing costs have been lowered, and some investment projects
General Equilibrium
in the Real Sector:
The IS Curve
IS
U
R
Y2 Y0 Y1
i2
i
Y
(b)
i0
i1
S + M + T,
I + X + G
I” (i2) + X + G
(a)
0
0Y2
R’
Y0 Y1 Y
I (i0) + X + G
I’ (i1) + X + G
S + M +T
In panel (a), with interest rate i0, equilibrium income is at level Y0 because leakages equal injections at that income level. However, a lower inter-
est rate i1 will increase investment spending and shift I(i0) + X + G to I′(i1) + X + G; income will rise from Y0 to Y1. Similarly, a higher interest
rate i2 will cause I(i0) + X + G to shift downward to I ″(i2) + X + G, resulting in a lower income level Y2. The inverse relationship between the
interest rate and income is plotted on the IS curve in panel (b), which shows the various combinations of i and Y that produce equilibrium in the
real sector. To the right of the IS curve, such as at point R, (S + M + T ) > (I + X + G), and there is downward pressure on the income level. To
the left of the IS curve, such as at point U, (I + X + G) > (S + M + T ), and there is upward pressure on the income level. Points off the IS curve
thus generate movement to the IS curve.
FIGURE 4 Income and the Interest Rate: The IS Curve
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that were previously unprofitable because their return was less than the borrowing costs
are now profitable. (Remember that investment in the real sector refers to plant and equip-
ment spending by firms, residential construction, and changes in inventories, not to the
purchase of financial assets.) Empirical studies have indeed shown that residential con-
struction spending is particularly sensitive to the rate of interest, but plant and equipment
also responds to the interest rate (albeit to a smaller degree).7
Because of the responsiveness of investment to the interest rate, the lower interest rate
i1 is associated with an investment line (and therefore I + X + G line) that is higher. The
line I(i0) + X + G shifts upward to I′(i1) + X + G, and the result is an intersection with the
S + M + T line at a higher equilibrium level of income Y1. Similarly, a rise in the interest
rate from i0 to i2 causes the I(i0) + X + G line to shift vertically downward to I ″(i2) + X + G.
Thus, i2 is associated with a lower level of income Y2.
This relationship between the interest rate (reflecting the importance of monetary vari-
ables), investment, and the resulting equilibrium level of income gives us the information
needed to generate the IS curve. The IS curve shows the various combinations of income
and the interest rate that produce equilibrium in the real sector of the economy. In our
model, this is equivalent to saying that the IS curve shows the combinations of income and
the interest rate that make investment plus exports plus government spending equal to saving
plus imports plus taxes. Thus, in Figure 4, panel (b), interest rate i0 is plotted against income
level Y0, because this is one combination of the interest rate and income that generates equal-
ity between (S + M + T ) and (I + X + G). The lower interest rate i1 is plotted against the
higher income level Y1; in the opposite direction, the higher interest rate i2 is associated with
the lower income level Y2. Note that the slope of the IS curve reflects both the elasticity of
investment to changes in the interest rate and the size of the domestic multiplier in the simple
macro model of Chapter 24. The greater the responsiveness of investment to changes in the
interest rate and the larger the autonomous spending multiplier, the flatter the IS curve.
If the economy is situated to the right of the IS curve, such as at point R in panel (b),
then disequilibrium exists because saving plus imports plus taxes exceeds investment
plus exports plus government spending. The income level is “too high” for the associ-
ated interest rate, and the high income level gives “too much” saving, taxes, and imports.
Alternatively, for the income level at R, the interest rate is “too high” and is thus choking
off investment. [Point R in Figure 4(b) is analogous to point R′ in Figure 4(a).] Income falls
until the IS curve is reached through cutbacks of production because of unintended inven-
tory accumulation at the higher levels of income. To the left of the IS curve, investment
plus exports plus government spending exceeds saving plus imports plus taxes, and there is
expansionary pressure due to unintended inventory depletion. For the given interest rate at
point U, income is too low to generate enough saving, taxes, and imports to match invest-
ment, exports, and government spending. [Alternatively, for a given income level, the “too
low” interest rate makes desired (I + X + G) exceed desired (S + M + T ).]
What causes shifts in the IS curve? Clearly any change in autonomous investment, exports,
government spending, saving, taxes, or imports will do so. An increase in autonomous invest-
ment (due to something other than a fall in the interest rate), autonomous exports, and gov-
ernment spending or an autonomous decrease in saving, taxes, and imports will shift the IS
curve to the right. Hence, for example, an autonomous decrease in saving in Figure 4(a) could
shift the (S + M + T ) line to the right and through point R′, and this would shift the IS curve
in Figure 4(b) to the right and through point R. On the other hand, an autonomous decrease in
I, X, or G or an autonomous increase in S, M, and T will shift the IS curve to the left.
7It is also possible that exports may increase with a lower interest rate if financing is thus easier.
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The simultaneous determination of income and the interest rate when both sectors of the
economy are considered involves plotting the IS curve and the LM curve on the same dia-
gram, as in Figure 5. Equilibrium occurs where the two curves intersect at point q, giving
the income level Ye and the interest rate ie. This is the only combination of income and the
interest rate that simultaneously gives equilibrium in both sectors of the economy.
If the economy has not settled at Ye and ie, forces are set in motion to move to this
equilibrium position. For example, suppose that the economy is at point F. Because we
are to the right of the IS curve, then (S + M + T ) is greater than (I + X + G), so there is
contractionary pressure on the level of income. But, because we are also to the right of the
LM curve, the demand for money exceeds the supply of money and therefore the interest
rate rises. These forces eventually move the economy to point q. However, various paths of
adjustment might actually be taken, depending on the speed of adjustment in each sector.
For example, from point F, the economy might first move vertically to a position on the LM
curve; the monetary sector would then be in equilibrium but the real sector would not. We
could then move horizontally to the IS curve where real sector equilibrium is attained, but
then the economy would be to the left of the LM curve and would have an excess supply of
money. This would drive interest rates downward and move us vertically to the LM curve.
However, we would now be below the IS curve. The process of adjustment would continue.
We need to introduce a further construct to describe the balance of payments in an open
economy. This analytical device, the BP curve, shows the various combinations of income
and the interest rate that produce equilibrium in the balance of payments. In this context,
we are including both the current account and international financial capital flows in the
balance of payments. In terms of the balance-of-payments accounting categories, not only
category I (the current account) but also category II (financial flows except for official
reserve flows) is considered (see Chapter 19). We are not dealing with category III (official
reserve flows). The focus is on all items in the balance of payments with the exception of
Simultaneous
Equilibrium in the
Monetary and Real
Sectors
Equilibrium in the
Balance of Payments:
The BP Curve
Income (Y )0
Interest
rate (i )
q
Ye
LM
F
ie
IS
Only at point q is there equilibrium in both the real and monetary sectors of the economy. If the economy is sit-
uated away from q at point F, saving plus imports plus taxes exceeds investment plus exports plus government
spending; in addition, there is an excess demand for money. Movement occurs (by any of a number of different
paths) to point q. Any other point away from point q also sets forces in motion to move the economy to point q.
FIGURE 5 Simultaneous Equilibrium in the Real and Monetary Sectors
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government official reserve changes. Balance-of-payments equilibrium in this sense means
a zero balance in the official reserve transactions balance.
For the purpose of obtaining the BP curve, we consider how the income level and the
interest rate affect a country’s balance of payments. It is important to note that a given BP
curve is constructed under the assumption of a fixed exchange rate. In addition, a number
of other variables such as the foreign interest rate, foreign price level, expected exchange
rate, and foreign wealth are assumed to be constant. Income in this analysis is presumed
primarily to influence the current account through the effect of income on imports. Other
things being equal, a rise in income induces more imports (by the marginal propensity
to import times the change in income). With exports independent of income, this rise in
imports means that the current account tends to deteriorate (move toward deficit) by the
amount of the rise in imports. These changes would be reversed for a decline in income.
On the other hand, the interest rate is assumed to have its primary influence on the financial
account, and particularly on short-term private financial capital flows. If the interest rate
rises, liquid short-term financial capital from abroad comes into the home country to earn
the higher interest rate, and some domestic short-term capital will “stay home” rather than
be sent abroad. The inflow of foreign short-term capital and the reduced outflow of home
capital move the financial account toward a surplus. If the interest rate declines, these
responses are in the opposite direction.
With this background, examine the BP curve in Figure 6. Because the curve shows the
various combinations of income and the interest rate that produce balance-of-payments
(BOP) equilibrium, point Q0 is one such point. The income level associated with this point
is Y0 and the interest rate is i0. Why does the BP curve slope upward? Consider a starting
point of Q0 and introduce a rise in income. This rise in income (with no change in the
Income (Y )0
Interest
rate (i )
Q2
N
N’
BP
Y2 Y0 Y1
i2
i0
i1
Q0
Q1
The BP curve shows the various combinations of income and the interest rate that yield equilibrium in the
balance of payments. The curve slopes upward because a higher income level induces more imports and
worsens the current account; a rise in the interest rate is then necessary to increase short-term capital inflows
(and to reduce short-term capital outflows), which in turn improve the capital account and offset the worsening
of the current account. A movement from point Q0 to point N worsens the current account and must be offset
by a rise in the interest rate from i0 to i1 to improve the capital account sufficiently to move the economy back
to BOP equilibrium. Points to the right of the BP curve are associated with a BOP deficit; points to the left of
the curve are associated with a BOP surplus.
FIGURE 6 Income and the Interest Rate: The BP Curve
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interest rate) will move us horizontally to the right of Q0, say, to point N. The balance
of payments will move into deficit because the higher income level will have generated
more imports. If the interest rate is then increased from i0 to i1, this will eliminate the
BOP deficit. Why? Because the rise in the interest rate will generate net short-term capital
inflows that will have a positive effect on the BOP and will completely offset the negative
effect in the current account when we reach point Q1. The current account deterioration is
offset by the financial account improvement, because Q1 has a zero BOP deficit or surplus
by definition. Thus, point Q1 illustrates that income level Y1 and interest rate i1 also com-
bine to produce BOP equilibrium.
It is clear that point Q2 with an income level (Y2) lower than Y0 and an interest rate i2
lower than i0 shows another combination of Y and i that yields BOP equilibrium. If income
falls from Y0 to Y2, this means reduced imports, a movement to point N′, an improvement
in the current account, and a BOP surplus. However, a reduction in the interest rate from
i0 to i2 will cause the short-term financial account to deteriorate by enough to offset the
improvement in the current account. The financial account deteriorates because short-term
funds seeking a higher rate of interest now leave the country and fewer foreign funds come
into the country. With this reduction in the interest rate, movement takes place from point
N′ to point Q2, another point on the BP schedule.
If the economy is located to the right of the BP curve, then there is a BOP deficit
because, for any given interest rate, the income level is leading to an “excessive” amount
of imports, and the interest rate is “too low” to attract a capital inflow sufficient to match
the current account’s movement toward deficit. The result is that the balance of payments
as a whole (official reserve transactions balance) is in deficit. For the reverse reasons, if the
economy is located to the left of the BP curve, there is a BOP surplus. Later in the chapter,
we discuss the process by which an economy that is not located on its BP curve adjusts in
order to attain balance-of-payments equilibrium.8
An additional point about the BP schedule is that the precise value of the upward slope
of the BP curve importantly depends on the degree of responsiveness of the short-term
private capital account to changes in the interest rate. To demonstrate this point, consider
the horizontal movement from point Q0 to point N in Figure 6. This movement generated a
movement toward current account deficit, and a return to BOP equilibrium required a rise
in the interest rate. Other things being equal, if short-term capital flows are very responsive
to changes in i, then a small rise from i0 to i1 will generate the requisite capital inflow.
However, if capital flows are not very responsive to changes in the interest rate, a much
larger rise in i0 will be needed to return the economy to BOP equilibrium. The conclusion
is that the less (more) responsive short-term capital flows are to the interest rate, the steeper
(flatter) the BP curve will be.9
Although up to now it has been assumed that equilibrium in the foreign sector is described
by an upward-sloping BP curve, this is not always the case. The upward-sloping relation-
ship between i and Y in the open economy results whenever there are some impediments
8It is common to refer to the official reserve transactions surplus as a balance-of-payments surplus and to an
official reserve transactions deficit as a balance-of-payments deficit. Remember from Chapter 19, though, that
balance-of-payments surplus and balance-of-payments deficit are not strictly correct terms because, if all items
in the BOP accounts are included, the “balance” is zero. The concept of concern in this and succeeding chapters,
unless otherwise indicated, is the net result of all transactions other than official government intervention in the
foreign exchange market—this is the official reserve transactions balance.
9The slope of the BP curve also depends on the extent to which changes in the interest rate affect real invest-
ment (plant and equipment, residential construction, changes in inventories) and, in turn, by the extent to which
such real investment responses affect income and imports. However, the international short-term capital-flow
responses are the most crucial in practice.
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to the flow of short-term capital between countries (or the country is financially a “large
country,” able to influence the international level of interest rates; that is, the country is
not a price taker with respect to the interest rate). Thus, the case where the BP curve slopes
upward is referred to as the case of imperfect capital mobility. It is assumed that short-
term capital is not completely restricted from moving between countries in response to
changes in the interest rate but that the movement of short-term capital is not so complete
as to remove all differences between the domestic interest rate and the international interest
rate [see Figure 7, panel (a)]. This result also occurs in the context of a portfolio balance
model, even with uncovered interest parity. As you will recall, the imperfect substitut-
ability between foreign and domestic assets means that there is a risk premium associated
with holding assets other than those of an investor’s own country. Thus, in this case, the
domestic interest rate will be above the foreign interest rate because the net capital inflow
means that foreign investors’ risk premium has increased since they are now holding rela-
tively more home country assets.
The upward-sloping BP curve can be contrasted with the case of perfect capital
mobility, where the BP curve is fixed horizontally at the level of the world interest rate, iw
[panel (b) of Figure 7]. In this case, any slight deviation of the domestic interest rate away
from the international rate leads to a movement of short-term capital sufficient to return the
domestic rate to the level of the international rate. For example, suppose that an increase
in the domestic money supply leads to a reduction in the domestic interest rate. This action
causes financial investors to immediately move their short-term capital out of the country
as they adjust their portfolios to include more foreign assets. This outward capital flight and
resultant BOP deficit will reduce the holdings of international reserves (as such reserves
are used to purchase domestic currency to maintain the fixed exchange rate) and hence
the money supply, and it will continue until the domestic interest rate is once again at the
international level. An increase in the domestic interest rate above the international level
would trigger an inflow of short-term capital and a BOP surplus, which would increase the
i
BP
Y0Y0 0 0
BP
BPi
iw
i
Y Y” Y’ Y
(a) (b) (c)
In panel (a), the upward-sloping BP curve indicates that capital is imperfectly mobile. In this case, capital moves between countries in response
to changes in relative interest rates, but not so easily that domestic interest rates become identical to world interest rates. In panel (b), the hori-
zontal BP curve reflects perfect capital mobility, and the domestic interest rate is always equal to the world interest rate. Any slight changes in
the domestic interest rate will lead to sufficiently large movements of short-term capital so that the domestic rate will become equal again to
the world rate. In panel (c), the BP curve is vertical, indicating that the barriers to capital movements are such that there is no short-term capital
response to changes in the domestic interest rate; that is, there is perfect capital immobility. In this case, there is only one level of income (and
imports) consistent with the level of exports and the controlled net capital inflows.
FIGURE 7 The BP Curve under Different Capital Mobility Assumptions
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international reserves of the country and the money supply. This would take place until the
domestic rate was once again at the level of the international rate. In this situation, there is
perfect substitutability between foreign and domestic financial assets, and any interest rate
differences are instantaneously removed by international capital flows.
Because the interest rate does not change with perfect capital mobility, what effect
do changes in other economic variables have on the foreign sector? Remember that the
BOP is influenced by variables such as the exchange rate, relative prices of traded goods,
expected prices, and the expected profit rate in both countries as well as the level of Y and
i. Suppose that there is an increase in the expected domestic profit rate that stimulates an
inflow of long-term real investment (improvement in the financial account), which in turn
stimulates income. To maintain the pegged exchange rate e, the central bank will purchase
foreign exchange with domestic currency, thereby increasing the domestic money supply
and facilitating the expansion of income. The increase in domestic income will stimulate
an increase in imports, causing a deterioration in the current account that exactly offsets the
improvement in the capital account.
Changes in exogenous economic factors thus ultimately stimulate changes in the domes-
tic money supply until the economy is once again in equilibrium. As this adjustment takes
place, it can lead to a different composition in the balance of payments. More specifically,
holding everything but domestic income constant, movements from left to right along the
BP curve reflect a transition in the composition of the balance of payments from one of sur-
plus in the current account (on the left) to one of deficit in the current account (on the right).
In similar fashion, the capital/financial account is changing from that of deficit (on the left)
to a position of surplus (on the right) over the same income range. It must be emphasized
that when there is perfect mobility in the capital markets in the open economy, the horizon-
tal BP curve remains fixed at the level of the international interest rate. Changes in exoge-
nous factors simply bring about movement in the domestic equilibrium along the BP curve
concomitant with appropriate changes in the composition of the balance of payments. The
country wishing to attain current account balance is thus forced to accept the level of
income that is consistent with that particular composition in the balance of payments.
It is not uncommon to find countries with a pegged exchange rate strictly controlling
the foreign sector both in the commodity markets and in the capital markets. This is not
unusual in developing countries and can be the result of having an overvalued exchange
rate, which the governments ultimately maintain by strict foreign exchange control. In
this case, the BP relationship is characterized by perfect capital immobility [Figure 7(c)
on page 633]. When short-term capital flows are strictly controlled and not permitted to
respond to changes in the interest rate, the BP curve is vertical at the level of income that
is consistent with the controlled use of foreign exchange pursued by government poli-
cymakers. Given the control on the capital/financial accounts, only one level of income
(and hence imports) is consistent with the given exchange rate. Should income rise, for
example, from Y0 to Y′, the level of imports induced by the higher income would be too
high and there would be a BOP deficit, putting upward pressure on the exchange rate (pres-
sure toward depreciation of the domestic currency). To maintain the value of the domestic
currency, the government would have to purchase it in the exchange market with foreign
exchange reserves. In so doing, the domestic money supply would decline, raising domes-
tic interest rates and reducing domestic investment and income until the domestic economy
was once again back in equilibrium on the BP curve. Similarly, a fall in income from Y0 to
Y ″ would lead to reduced demand for foreign exchange, government purchases of foreign
exchange to maintain the exchange rate, and hence an expansion of the money supply until
the economy was once again in equilibrium on the BP curve. The requisite changes in the
money supply will thus automatically keep the economy on the BP curve.
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IN THE REAL WORLD:
THE PRESENCE OF EXCHANGE CONTROLS IN THE
CURRENT FINANCIAL SYSTEM
Although few countries exercise complete exchange con-
trol, a surprising number of restrictions are in place around
the world on access to foreign exchange and the uses to
which it can be applied. Table 1 summarizes the degree to
which various foreign exchange controls are in place within
the membership of the International Monetary Fund. A cur-
sory examination seems to suggest that capital is indeed
somewhat, if not perfectly, immobile for many countries of
the world. Relatively mobile capital conditions mostly exist
only for the major trading countries of the world whose
financial markets have become increasingly integrated in
recent years. Even in those cases, however, many differ-
ent circumstances cause financial capital not to be perfectly
mobile.
TABLE 1 Foreign Exchange Restrictions in 191 IMF Countries, 2014*
Type of Restriction Number of Countries Percentage of Countries
Exchange rate structure:
Dual exchange rates 16 8.4%
Multiple exchange rates 6 3.1
Controls on payments for invisible transactions and current transfers 102 53.4
Proceeds from exports and/or invisible transactions
Repatriation requirements 87 45.5
Surrender requirements 61 31.9
Capital transactions:
Controls on:
Capital market securities 153 80.1
Money market instruments 129 67.5
Collective investment securities 129 67.5
Derivatives and other instruments 104 54.5
Commercial credits 87 45.5
Financial credits 117 61.3
Guarantees, sureties, and financial backup facilities 80 41.9
Direct investment 153 80.1
Liquidation of direct investment 44 23.0
Real estate transactions 146 76.4
Personal capital transactions 96 50.3
Provisions specific to:
Commercial banks and other credit institutions 173 90.6
Institutional investors 146 76.4
*Restrictions in place generally as of December 31, 2013.
Note: There were 188 IMF member countries, in 2014 but Aruba, Hong Kong, and Curacao & Sint Maarten (not separate countries) had their own
particular arrangements and were listed separately by the IMF. They are included in this listing.
Source: International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions 2014 (Washington, DC: IMF, 2014),
pp. 80–88. ●
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In sum, the slope of the BP curve reflects the nature of capital mobility in the country
under analysis. The more capital flows are restricted and short-term capital movements are
not permitted to respond to changes in the domestic interest rate, the steeper the slope of the
BP curve. Similarly, the less restricted are movements of capital and the more the country
in question is financially a small country, the flatter the BP curve will be.
Finally, remember that the BP curve is drawn for a specific exchange rate. If the home
country is the United States, for example, and if the exchange rate between the dollar and
other currencies changes, then a different BP curve emerges. The simple rule is this: A
depreciation of the home currency against foreign currencies shifts the BP curve to the
right, and an appreciation of the home currency against foreign currencies shifts the BP
curve to the left. To grasp this rule, consider an existing BP curve such as that shown in
Figure 6 on page 631. If the home currency depreciates, then the home country’s current
account balance will improve, assuming that the Marshall-Lerner condition is met. For any
given interest rate on the “old” BP curve, there is now a surplus in the balance of payments.
Hence, a larger level of Y is needed for each i to have BOP equilibrium, because the larger
Y will induce more imports and eliminate the BOP surplus. Each interest rate must now be
plotted against a higher level of income to show the combinations of the interest rate and
the income level that produce BOP equilibrium. This means that the “new” BP curve (not
shown) will be to the right of the “old” BP curve.10
In addition, changes in a number of other variables will also shift the BP curve. Because
changes in these factors can influence equilibrium in the open economy, it is useful to
mention several of them before proceeding further. For example, an autonomous increase
in exports will cause the BP curve to shift to the right or downward because a lower rate
of interest will now be sufficient to maintain BOP equilibrium with the stronger balance
on current account. This would also be the case with an autonomous decrease in home-
country imports. Such a downward shift could also result from changes in monetary vari-
ables such as a fall in the foreign interest rate. Also, changes in expectations can influence
equilibrium in the foreign sector and hence the BP curve. Further discussion of these and
other factors and their effect on the BP curve is presented in the next chapter.
As a final step for preparing for the discussion of economic policy in the open economy, we
bring together the LM, IS, and BP curves in Figure 8. There is simultaneous equilibrium in
the money market, the real sector, and the balance of payments at point E, where all three
schedules intersect. The income level associated with this three-way equilibrium is YE and
the interest rate is iE. However, this equilibrium position may not be optimal in terms of a
country’s economic objectives. In such cases, there is a role for macroeconomic policy in
order to attain the objectives.
Having established general equilibrium in the IS/LM/BP framework, we now turn to
a discussion of the nature of this equilibrium and the adjustment processes that move the
system to that point.11 To begin our analysis, we first examine the automatic BOP adjust-
ment mechanism under a fixed-rate system. To do this, we begin with the economy in
equilibrium at point E (Y*, i*) in Figure 9 and examine what happens when a shock to the
system takes place. For example, suppose that there is an increase in foreign income, which
increases the level of exports in the home economy. This exogenous change in exports
Equilibrium in the
Open Economy: The
Simultaneous Use of
the LM, IS, and BP
Curves
10In the case of perfect capital mobility, changes in the exchange rate simply lead to movements along the BP
curve, because the height of the horizontal BP curve is determined by the international rate of interest.
11Remember that the basic IS/LM/BP framework assumes that the price level remains fixed. This assumption will
be dropped in Chapter 27.
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Income (Y )0
Interest
rate (i )
E
YE
LM
iE
IS
BP
Only at point E is there equilibrium between saving plus imports plus taxes and investment plus exports plus
government spending, between the demand and supply of money, and in the balance of payments. With the
schedules as drawn, YE and iE are thus the economywide equilibrium levels of income and the interest rate.
Any other combination of Y and i is associated with disequilibrium in at least one part of the economy.
FIGURE 8 Simultaneous Equilibrium in the Real and Monetary Sectors and in the
Balance of Payments
Starting with the economy in equilibrium at i* and Y*, an increase in foreign income leads to an autonomous
increase in exports, causing the IS curve to shift to the right and the BP curve to shift to the right. An inflow
of foreign reserves now occurs due to both the increase in exports (which improves the current account) and
the higher domestic interest rate i′ (which improves the financial account). Assuming that the government does
not intervene to sterilize the effects on the money supply, this ORT surplus leads to an expansion in the money
supply, causing the LM curve to shift to the right. The surplus and the expansion of the money supply continue
(the LM curve continues to shift to the right) until a new equilibrium is reached at Y ″ and i ″.
i
i’
i”
E
E’
E”
BP’
LM
LM’
BP
IS
IS’
i*
Y* Y’ Y” Y0
FIGURE 9 Automatic Adjustment under Fixed Exchange Rates
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shifts the BP curve to the right to BP′ because any given level of the interest rate can
now be associated with a higher income level and still have BOP equilibrium. An official
reserve transactions surplus will now occur as long as the domestic economy remains at
the initial equilibrium at point E. However, the domestic equilibrium will no longer remain
at Y* and i* because the expansion of exports causes the IS curve to shift outward to IS′,
raising the level of income and the interest rate to E′(Y′, i′).
Given the official reserve transactions or ORT surplus that will occur at E′, the econ-
omy will not remain at this point. Because the country is operating under a fixed-rate
system, it has committed itself to keep constant the value of its currency. Under such
a system, the central bank must stand ready to purchase the surplus foreign currency in the
exchange market to prevent the appreciation of the domestic currency. Because the foreign
exchange is purchased by the central bank with domestic currency, there is expansion of
the domestic money supply. In our IS/LM/BP analysis, this has the effect of shifting the
LM curve to the right. This automatic monetary adjustment will continue until there is
no longer an inflow of foreign exchange reserves. This will occur when the IS, LM, and
BP curves again intersect at a common point E ″(Y ″, i″ ) consistent with the new higher
level of exports.
An official reserve transactions deficit would produce automatic reactions opposite to
these just described for a surplus. The deficit would cause the domestic central bank to sell
foreign exchange in return for domestic currency so as to keep foreign currencies from
appreciating (i.e., buy home currency with foreign exchange so as to keep the home cur-
rency from depreciating), which would reduce the home money supply in private hands.
This would shift the LM curve to the left. In this deficit case, the reverse of Figure 9’s
surplus case, the deficit means that the IS and BP curves would be intersecting to the left
of the LM curve. The reduction in the money supply and the leftward shift of the LM curve
would continue to take place until the LM curve moved far enough to the left to yield again
a threeway equilibrium intersection of the IS, LM, and BP curves.
Under a fixed exchange rate, the automatic adjustment mechanism is the change in
the domestic supply of money brought about by an underlying surplus or deficit in the
balance of payments at the pegged exchange rate. Because the exchange rate cannot be
changed under a pegged rate system, equilibrium combinations of i and Y (where IS and
LM intersect) must necessarily lie on the BP curve dictated by underlying international
economic considerations. As long as the exchange rate remains fixed, domestic policy-
makers may be faced with choosing between hitting a target interest rate (e.g., to reach a
particular growth target) and a target level of income (and hence employment). It should
be emphasized, however, that the economy will automatically adjust to the new equi-
librium levels as long as the central bank does nothing to interfere with the adjustment
process by sterilization, or the offsetting of the effects of maintaining the fixed value
of the currency in the foreign exchange market. Sterilization would be accomplished in
Figure 9 by the central bank selling government securities in the open market, causing a
shift from LM′ back to LM. Such sterilization, however, will perpetuate the balance- of-
payments disequilibrium. Further, given the huge volume of capital flows across coun-
try borders in today’s world, the question arises as to whether foreign central banks
have enough international reserves to permit the continual acquisition of them by the
domestic central bank for any length of time and in sufficient size to offset the intense
exchange rate pressure.
Finally, it should be noted that nothing yet has been said about changes in prices.
The above automatic adjustment process relies solely on monetary and income effects. The
incorporation of price effects that might accompany this kind of adjustment is presented
in Chapter 27.
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CONCEPT CHECK 1. Ignoring the LM curve, suppose that the econ-
omy is located at a point to the left (right) of
the IS curve. Why is there pressure for the
economy to expand (contract)?
2. In Figure 5, suppose that the economy is
located to the left of the IS curve and also
to the left of the LM curve. Is (S + M + T )
greater or less than (I + X + G )? Is there an
excess demand or excess supply of money?
What will happen to income and why?
3. Explain the rationale for an upward-sloping
BP curve.
4. Explain how the degree of capital mobility
affects the degree of slope of the BP curve.
THE EFFECTS OF FISCAL POLICY UNDER FIXED EXCHANGE RATES
The effect of expansionary fiscal policy under various international capital mobility
assumptions is presented in Figure 10. First, consider the effect of fiscal policy under
conditions of perfect capital immobility, as shown in panel (a). Beginning at Y0 and i0,
an increase in government spending or a decrease in taxes shifts the IS curve to the right,
putting upward pressure on domestic income and interest rates. As the economy begins
to expand, there is an increase in desired imports and an increase in demand for for-
eign exchange. To maintain the exchange rate, the central bank sells foreign exchange
for home currency, thus reducing the money supply. This leads to a leftward shift in the
LM curve, which continues until the domestic interest rate has risen sufficiently to bring
about a decrease in domestic investment, exactly offsetting the increase in government
spending. The only effect of increased government spending under conditions of perfectly
immobile capital is a crowding out of an equivalent amount of domestic investment; that
is, the increased G has raised i and has decreased I by the same amount that G increased.
Income and employment remain at their initial equilibrium levels. Fiscal policy is thus
ineffective in stimulating income and employment in the case of perfectly immobile capi-
tal. In the context of the multiplier analysis of Chapter 24, this result in effect means that
the multiplier for the increased government spending would be zero. It is important to note
that, if increased government spending leads to an increase in the interest rate, there will
be a decline in investment spending that at least partly offsets the increase in government
spending.
Figure 10, panel (b), reflects a situation with some degree of capital mobility, but where
international capital flows are fairly unresponsive to changes in the interest rate so that the
BP curve is steeper than the LM curve. We designate this situation as one of relative capital
immobility. Starting from Y0 and i0, an increase in net government spending leads to a new
domestic equilibrium at Y1 and i1. However, because this new equilibrium is below the BP
curve, there is an official reserve transactions deficit. With the exchange rate fixed, the
government must provide the necessary foreign exchange to meet the deficit and to main-
tain the value of the domestic currency. When this happens, the money supply declines
and the LM curve shifts to the left until levels of income and the interest rate are reached
that are consistent with BOP equilibrium. This new equilibrium is represented by Y2 and
i2. We see that fiscal policy is somewhat effective in expanding income and employment
in this case, although some of the expansionary effect has been offset by crowding out of
domestic investment because of the new, higher equilibrium interest rate. In this model and
in practice, taking into account such secondary effects as crowding out can reduce consid-
erably the size of the government spending multiplier below that discussed in Chapter 24.
Clearly, the less mobile capital is (and hence the steeper the BP curve), the less effective
fiscal policy is in altering the level of income.
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Figure 10, panel (c), demonstrates a case in which financial capital shows some degree
of immobility because the BP curve is upward sloping, but where the balance of payments
is more responsive to changes in the interest rate than is the domestic money market (the
LM curve). This is a situation of relative capital mobility. From Y0 and i0, an expan-
sionary fiscal policy causes the domestic economy to seek a new equilibrium at Y1 and
i1, which produces a surplus in the balance of payments. This comes about because the
increase in the inflow of short-term capital more than offsets the increase in imports at
the higher levels of Y and i. With a BOP surplus, the central bank is forced to purchase the
surplus foreign exchange to maintain the exchange rate, which causes the money supply to
expand and the LM curve to shift to the right. The expanding money supply causes a further
i2
i
LM
LM’
LM’
LM’
LM’
BP
IS
IS’
IS’
IS’
i1
i0
i2
i1
i0
i2
i1
i0
Y00 0
0 0
Y1 Y
i LM
BP
IS
Y0 Y1 YY2
i
LM
BP
IS’IS
Y0 Y1 Y
i
LM
BP
IS
i0
Y0 Y1 Y
Y2
(a) (b)
(c) (d)
With perfect capital immobility [panel (a)], an increase in government spending (or a decrease in autonomous taxes) shifts the IS curve right,
leading to increased income and imports. Because there is no short-term capital movement, an official reserve transactions deficit occurs. This
leads to a fall in the domestic money supply, shifting the LM curve left and increasing i until there is once again equilibrium at Y0. The increase
in G has led to an equivalent crowding out of domestic investment. A similar result takes place in panel (b), with relative capital immobility,
although the presence of some responsiveness of short-term capital to changes in the interest rate means that the crowding out of investment is not
complete and there is a slight expansion of income. With relative capital mobility [panel (c)], the expansionary fiscal policy and the accompany-
ing increase in domestic interest rates lead to a BOP surplus and an expansion of the money supply, causing income to increase even more to Y2
because the crowding out of domestic investment is considerably reduced. Finally, with perfectly mobile capital there is no change in the interest
rate with the expansionary policy, because there is a sufficient inflow of short-term capital (and increase in the domestic money supply) to finance
the increase in net G without reducing domestic investment.
FIGURE 10 Fiscal Policy with Fixed Rates under Different Capital Mobility Assumptions
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expansion of the economy to Y2 and i2.12 In this case, fiscal policy is complemented by the
monetary effects associated with the automatic adjustments under a fixed exchange rate
system, although there is still some crowding out.
We now turn to the final case, that of perfectly mobile capital, which is illustrated in
Figure 10, panel (d). This case is similar to the previous case except for the fact that there is
no crowding out of domestic investment because the interest rate remains fixed at the inter-
national level. This results from the fact that short-term capital movements instantaneously
respond in large-scale fashion to the slightest movement of the interest rate on either side of
the international rate because domestic and foreign financial assets are perfect substitutes.
With an increase in net government spending, there is immediate upward pressure on the
domestic interest rate, which stimulates an inflow of short-term capital and a surplus on
all transactions other than governmental intervention. To keep the domestic currency at
the pegged rate, the central bank purchases the surplus foreign currency in exchange for
domestic currency. This expands the money supply, and this expansion continues until the
interest rate effects due to the increase in government spending have been exactly offset
by the inflow of short-term capital and the concomitant increase in the domestic money
supply. This adjustment is shown by the rightward shift in the LM curve until it intersects
the new IS′ at a point on the horizontal BP curve. Expansionary fiscal policy is thus totally
effective in the case of perfectly mobile capital, in that the economy suffers no offsetting
crowding-out effects through increases in the interest rate. With perfectly mobile capital,
the full expansion of income is facilitated by the inflow of short-term capital.
This analysis of fiscal policy under fixed rates leads to the conclusion that, to vary-
ing degrees, fiscal policy is effective in influencing income under fixed exchange rates
except when capital is perfectly immobile. The greater the mobility of capital, the greater
the effectiveness of fiscal policy. Although our discussion focused only on expansionary
policy, the arguments are symmetric in nature; thus, a reduction in government spending or
an increase in taxes will move the IS curve to the left and will generate the opposite effects
in terms of ultimate changes of the money supply in response to capital flows resulting
from the pressures on the interest rate.
This discussion of fiscal policy can help to illustrate the “crisis” situation that has
recently existed with respect to indebted members of the euro common-currency zone [the
Economic and Monetary Union (EMU) in Europe]. Consider in theory the case of Greece,
for example. In the IS/LM/BP analysis (see Figure 11), the situation in this common-
currency scenario is that Greece possesses a fixed LM curve because the money supply
(the euro) is set from the outside by the European Central Bank, which controls the money
supply for the 19 members of the euro zone. Because of the considerable capital mobility
that exists within the EMU, one would expect that the BP curve would be relatively or even
perfectly elastic or flat. However, if investing funds in Greece is regarded as risky because
of Greece’s fiscal deficits and debt, there will be a risk premium, so that Greece’s BP curve
will be upward-sloping. If the risk is considerable, the BP curve could even be steeper than
the LM curve.
Consider, in Figure 11, the implications of the case where the BP curve is steeper than
the LM curve, analogous to the situation in Figure 10, panel (b). Suppose that the initial
equilibrium point in Figure 11 is at i0 and Y0, the three-way intersection of IS0, BP0, and
LM0. If Greece, in pursuing expansionary fiscal policy, shifts IS0 to the right to IS1, the new
12Portfolio balance considerations would suggest that this may not be the final equilibrium. If the capital inflow
was part of a portfolio stock adjustment shift, the capital flows would fall off after completion of the stock adjust-
ment. This would shift the BP curve to the left, setting off further changes. See Willett and Forte (1969).
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internal interest rate and income position is at i1 and Y1. However, note that there is a BOP
deficit for Greece at this position, because IS1 and LM0 intersect below the BP0 curve. If the
exchange rate were free to move (which it would be if Greece had its own currency), BP0
would begin to shift to the right because of the BOP deficit. After various subsequent adjust-
ments described in Chapter 26, where fiscal policy under flexible rates is discussed, there
would be a new equilibrium position with higher income than Y0, a depreciated currency,
and a somewhat higher interest rate than originally. But if Greece cannot change its currency
value (as long as it remains in the euro system), then it is stuck with a BOP deficit at a higher
income level, and it must borrow from other members of the EMU to finance its BOP deficit
(and in effect its increase in government spending). This borrowing will increase Greece’s
external indebtedness, which might well make it even riskier to lend to Greece in the future
(which could make Greece’s BP0 curve even steeper). Greece has no automatic way out of
its difficulties, given the common currency, and it may well have to cut back on its govern-
ment spending and/or raise taxes (i.e., implement an austerity program). Additionally, the
economic situation in Greece could be further worsened if the increase in government spend-
ing results in an increase in the Greek government’s internal debt as well.
THE EFFECTS OF MONETARY POLICY UNDER FIXED EXCHANGE RATES
The effects of expansionary monetary policy under the different assumptions of capital
mobility are demonstrated in Figure 12. Beginning with the system in equilibrium at Y0 and
i0, we examine the effects of rightward shifts in the LM curve brought about by increases in
i 0
Y1
IS0
IS1
Y
LM0
i
i 1
Y00
BP0
From the initial equilibrium position at Y0 and i0, an increase in government spending shifts IS0 rightward to IS1.
This leads to an increase in income from Y0 to Y1 but also to a balance-of-payments deficit, because with the
common-currency, fixed exchange rate, and the country’s lack of control over the money supply, neither BP0
nor LM0 can shift. To finance the BOP deficit, the country will need to borrow from other members of the
monetary union or engage in an austerity program to shift IS1 back to IS0.
FIGURE 11 Illustrative Fiscal Expansion in a Monetary Union Member with High
Country Risk
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the money supply. Figure 12, panel (a), describes the situation with perfect capital immo-
bility, with each successive graph demonstrating cases of greater and greater international
capital mobility.
An increase in the money supply shifts the LM curve to the right. In every instance, there
is a new intersection of the IS and LM curves at a combination of i and Y that lies below
or to the right of the BP curve and thus is associated with a BOP deficit and downward
pressure on the value of home currency or potential appreciation of foreign currency. The
result is, of course, a loss of international reserves, as the central bank intervenes to provide
the needed foreign currency to prevent the foreign exchange appreciation. In the process
i
LM
LM’
LM’ LM’
LM’
BP
IS
i0
Y00 0
0 0
Y
i
i0
Y0 Y
LM
IS
BP
i
LM
BP
IS
i0
Y0 Y
i
i0
Y0 Y
LM
IS
BP
(a) (b)
(c) (d)
Starting with the economy in equilibrium at Y0 and i0, expansionary monetary policy leads to a rightward shift in the LM curve, lowering domestic
interest rates and stimulating income. When capital is perfectly immobile [panel (a)], the increase in income stimulates imports and creates an
official reserve transactions deficit. As the central bank sells foreign exchange to maintain the pegged rate, the money supply declines, causing
the LM curve to shift leftward until the initial equilibrium point is again attained. When capital is imperfectly mobile [panels (b) and (c)], the
increase in the money supply leads to a deficit as imports increase and net short-term capital inflows decline or become negative. As before,
attempts by the central bank to maintain the fixed exchange rate lead to a decline in the money supply, bringing the economy again to Y0 and i0.
Finally, in the case of perfectly mobile capital [panel (d)], the slightest drop in domestic interest rate i instantaneously leads to a large-scale out-
flow of short-term capital. Again, the central bank must provide the desired foreign exchange to support the exchange rate, and the money supply
declines. This continues until there is no further downward pressure on i, that is, at Y0.
FIGURE 12 Monetary Policy with Fixed Rates under Different Capital Mobility Assumptions
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of selling the desired foreign exchange, home currency is acquired by the central bank and
the money supply falls. The effect is exactly analogous to that of selling short-term gov-
ernment bonds under open-market operations. The reduction in the money supply has the
effect of shifting the LM curve back to the left. Because this will continue until IS and LM
again intersect on the BP curve, we can immediately see that monetary policy is completely
ineffective for influencing income under a system of fixed exchange rates, regardless of the
degree of capital mobility. This is demonstrated in Figure 12 by the pair of arrows in each
figure, which indicate that the LM curve first shifts to the right and then shifts back to the
original position due to the automatic adjustment mechanism under fixed rates. It should be
noted that the shift back to the original position can be delayed if the monetary authorities
undertake open-market purchases of domestic securities, that is, sterilization operations to
maintain the domestic money supply. This postponement cannot be sustained indefinitely,
however, because the country may soon decrease its stock of foreign exchange reserves
below a target level. Thus, in the end under a fixed-rate system, a country loses the use of
discretionary monetary policy to pursue economic targets. Alternatively, the country may
weaken its commitment to the fixed-rate system.
The fact that monetary policy has minimal impact on national income in this setting
of a fixed exchange rate and short-term capital flows between countries has led to the
concept in economics literature of the impossible trinity. This concept states that for a
country, it is not possible to meet or have in place, at the same time, all three of the fol-
lowing objectives: (1) an independent monetary policy, (2) free capital mobility across
the country’s borders, and (3) a fixed exchange rate. Only two of the three can co-exist
simultaneously, not all three. We have just seen that with capital mobility and a fixed
rate, the country has lost control of its money supply and hence cannot have an indepen-
dent monetary policy—thus, (2) and (3) co-exist but (1) is lost. Alternatively, consider a
country that wishes to have a fixed exchange rate and also to have an independent mon-
etary policy: it can do so only by restricting short-term capital movements into and out
of the country because, otherwise, those flows would put pressure on the exchange rate
(depreciation or appreciation, depending on whether the monetary policy was expansion-
ary or contractionary) that would necessitate counteracting changes in the money supply
in order to keep the exchange rate fixed. In this case, with the restrictions on capital flows,
(1) and (3) co-exist but (2) cannot be permitted. Finally, if a country wishes to permit
free capital flows along with independent monetary policy, it must permit the exchange
rate to depreciate or appreciate in response to the capital flows induced by the changes in
the interest rates and the money supply; if it fixes the exchange rate, the money supply
will not be able to be independently changed. Hence, (1) and (2) co-exist but (3) cannot be
allowed. The analysis of monetary policy with a flexible exchange rate is discussed further
in Chapter 26.
THE EFFECTS OF OFFICIAL CHANGES IN THE EXCHANGE RATE
Although changing the exchange rate cannot be an active tool of discretionary policy under
a fixed-rate system, it is useful to examine briefly the macroeconomic effects of an offi-
cial decision to change the pegged value of the home currency under the various capital
mobility scenarios above. Because structural changes may at times require the devaluation/
upward revaluation of a currency, it is important to understand how such changes would
affect the economy. We proceed in the same manner as above. The four different market
conditions are described in Figure 13.
Changes in the exchange rate lead to expenditure switching between foreign and domes-
tic goods and hence will affect both the IS curve and the BP curve. For example, as the
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currency is devalued or depreciates,13 imports become more expensive to domestic residents
and exports become cheaper to trading partners. Consequently, depreciation will generate
an expansion of exports and a contraction of imports, leading to a rightward shift in the IS
curve.14 An appreciation of the currency would do the opposite. The effect of changing the
exchange rate on the BP curve will depend on the nature of international capital mobility.
i
LM
LM’
IS’
LM’
IS’
BP BP’
LM’
IS’
BP’
LM’
IS’
BP’
BP’
IS
i0
Y0 Y
(a)
i2
i1 i0i2
i1
i0 i0i2
i1
Y1 Y2
Y0 Y1 Y2 Y0 Y2
Y0 Y1 Y2
i
LM
BP
IS
Y
i LM
BP
IS
Y
i
LM
IS
Y
(b)
(c) (d)
BP,
0 0
0 0
Starting at equilibrium at Y0 and i0, a depreciation of the currency leads to increased exports and decreased imports, shifting both the IS
and the BP curves to the right and raising the level of income and the interest rate. With imperfect capital mobility [panels (b) and (c)],
the improvement in the current account balance coupled with the higher relative domestic interest rate produces a surplus in the balance
of payments. There is then an expansion in the money supply (rightward shift of the LM curve) as the central bank buys foreign exchange
to maintain the pegged exchange rate, and a further increase in income to Y2. A similar but less strong expansion in income occurs in panel
(a) when capital is perfectly immobile, because there are no short-term capital movements taking place as the domestic interest rate rises.
However, under perfect capital mobility [panel (d)], the upward pressure on the interest rate generates very large inflows of short-term
capital. As the central bank purchases foreign exchange to maintain the new exchange rate, the money supply expands until there is no
longer any upward pressure on the interest rate (at Y2).
FIGURE 13 Expenditure Switching with a Pegged-Rate Change under Different Capital Mobility Assumptions
13Changes in an official pegged exchange rate are usually called devaluations (for a rise in e) or upward revalu-
ations (for a fall in e). The terms depreciation or appreciation represent the actual market rate movements of the
currency’s value.
14Again we are assuming that the Marshall-Lerner condition is satisfied.
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IN THE REAL WORLD:
THE HISTORICAL RISE AND FALL OF A CURRENCY BOARD—
THE CASE OF ARGENTINA
As noted in the text, a country’s monetary policy loses effec-
tiveness in influencing national income under a system of
fixed exchange rates. An example of fixed exchange rates in
practice that is currently used by 11 countries is the concept
of a currency board. In this arrangement, a fixed rate is
established between a home country’s currency and some
internationally accepted, stable major currency. Further, the
money supply of the home country is tied to the country’s
holdings of the internationally accepted currency. Thus, the
money supply can increase only if there is an inflow of the
international currency (say, the dollar) because of an official
reserve transactions surplus, which in turn is due to an export
surplus, a private capital inflow, or both. Analogously, with
an official reserve transactions deficit, the country’s reserves
of the dollar flow out and the money supply is contracted.
Hence, if there is rapid inflation, for example, the automatic
adjustment mechanism characteristic of fixed exchange rate
regimes is activated and the inflation is severely weakened
because of the currency board’s tie of the home currency’s
value to the international asset.
Argentina is a prominent example of a country that
enacted a fixed exchange rate through a currency board. In
the 1980s, the country had substantial inflation. For example,
the June 1989 consumer price index (CPI) was 1,471 percent
above the CPI level of a year earlier. Further, by March
1990, the CPI had risen 20,266 percent above that of March
1989. Real GDP fell by 23 percent over the 1980s decade as
a whole.
(continued)
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Consider first the case of perfectly immobile capital in panel (a) of Figure 13. Beginning
at Y0 and i0, depreciation of the currency shifts the BP curve to the right (BP′). Exports
increase and imports decrease because of the depreciation, causing the IS curve to shift to the
right (IS′). Once the real expenditure changes have taken effect, any additional adjustment
required will take place through automatic changes in the money supply (in the absence of
sterilization). For example, if the IS shift moves the domestic economy to Y1 and i1, domestic
equilibrium (the intersection of LM and IS′) is to the left of the BP′ curve, indicating an ORT
surplus. This surplus will cause the central bank to purchase the foreign exchange necessary
to hold the new value of the currency, and, in the process, increase the money supply. The
increase in the money supply will show up as a rightward shift in the LM curve and continue
until the LM′ and IS′ curves intersect at a point on the new BP′ curve at Y2. Under perfect
capital immobility, expenditure switching does have an effect on income (and prices).
Under imperfect capital mobility [panels (b) and (c)], depreciation again leads to a right-
ward shift in both the BP and the IS curves. The expansionary effects associated with
expenditure switching lead to higher levels of income and the interest rate and again to a
BOP surplus. Central bank intervention to peg the new value of the currency leads to an
expansion of central bank holdings of international reserves and, consequently, an expan-
sion of the money supply. The increase in the money supply leads to a rightward shift in
the LM curve, which continues until the economy is again in equilibrium at the level of
Y2 and i2 where the three new curves intersect. Devaluation has altered the locus of points
that produce equilibrium in the balance of payments, and the economy has found levels
of income and the interest rate compatible with the new exchange rate. From a policy per-
spective, we again see that devaluation has had an expansionary effect on the economy.
An upward revaluation of the domestic currency would have the opposite effect because
it would stimulate imports and reduce exports, leading to a lower level of income. For a
demonstration of the direct link between equilibrium income and the exchange rate under
a situation of imperfectly mobile capital, see the appendix to this chapter.
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Given this disastrous economic performance, Argentina
instituted a variety of reforms, including trade liberalization,
more restrictive fiscal policy, and privatization. However,
most important was the 1991 Convertibility Law, which
aimed to divorce money creation from the political arena by
fixing a one-for-one exchange rate between the Argentine
peso and the U.S. dollar. Subsequently, by 1998 the inflation
rate had fallen to 1 percent, and real output per person grew at
an annual average rate of 4.6 percent from 1992 to 1998. This
economic success did come at the cost of forgoing an inde-
pendent role for monetary policy, but clearly this may not
have been a bad thing. However, a currency board arrange-
ment in general does mean that, should an unexpected shock
such as an export shortfall occur, the economy would shrink
because the money supply would contract and there is no pos-
sibility of offsetting the contraction within a currency board
framework. Further, the currency board arrangement may
not be completely insulated from speculative attacks on the
currency if doubts exist about the permanent viability of the
arrangement. In fact, Argentina at times experienced interest
rates above dollar interest rates as investors demanded a risk
premium to keep capital from leaving the country.
Unfortunately for Argentina, several of the aforemen-
tioned problems did arise, spelling doom for the currency
board arrangement. Problems began to arise in 1998, when
the government had to reduce its budget deficit because of
the increase in the external debt load from 29 percent of GDP
in 1993 to 41 percent in 1998. A concomitant financial cri-
sis in Brazil and accompanying currency devaluation further
contributed to Argentine problems, and a recession subse-
quently ensued in late 1998 and 1999 that resulted in fall-
ing tax revenues and a further widening of the government
deficit. This raised further concern about the ability of the
government to service its debts, which depressed the finan-
cial markets and further deepened the recession. A series of
tax hikes ensued in 2000, which were expected to reduce
the deficit, lower interest rates, and pull the country out of
recession. However, things only got worse as rising criticism
of the tie to the dollar and its role in bringing about the reces-
sion stimulated concern that a devaluation of the peso was
in the offing. Various attempts were made to obtain an infu-
sion of dollars into the country, ranging from seeking more
international bank lending to new IMF loans to a debt swap
arrangement proposed by Finance Minister Cavallo. When
these arrangements failed in late 2001, economic meltdown
ensued, as increases in bank account withdrawals triggered
fears of a potential bank run, leading to a freeze on bank
deposits that was followed soon after by a default on foreign
debt. During this turbulent period there was great political
instability as President Saa, Economic Minister Cavallo,
and all the ministers eventually resigned. On December 30,
2001, the legislative assembly chose Eduardo Duhalde as the
new president, and on January 2, 2002, he assumed power
and officially ended the currency board.
Economists point out several key lessons to be learned
about the adoption of a hard currency peg and the use of
currency boards. First, Argentina failed to meet many of the
key requirements for success—it is subject to very different
shocks than the United States, resource and product markets
are not very flexible, its structure of foreign trade is very dif-
ferent from the United States, and it is relatively closed. Thus,
as the U.S. dollar strengthened in the 1990s, Argentine goods
faced increasing price pressure in the world, and a resulting
weaker current account added to recession forces. Thus, in
retrospect, it appears that increased flexibility in domestic
markets coupled with a greater opening to trade would have
been useful. It has been argued that much of the crisis could
possibly have been avoided by either using the dollar as a
circulating currency (dollarization) or by floating the peso
in 1999. However, currency board arrangements often tend
to lack clear transition or exit rules as warranted by changes
in the economic environment. Also, such moves are often
not feasible politically. Since the abandonment of the cur-
rency board, Argentina has continued to have difficulties. For
example, devaluations of the peso have occurred and a default
on international debt obligations took place in early 2014.
Sources: David E. Altig and Owen F. Humpage, “Dollarization
and Monetary Sovereignty: The Case of Argentina,” Federal
Reserve Bank of Cleveland Economic Commentary, September 15,
1999; Andrew Berg and Eduardo Borensztein, “The Dollarization
Debate,” Finance and Development, March 2000, pp. 38–41; Steve
H. Hanke, “How to Make the Dollar Argentina’s Currency,” The
Wall Street Journal, February 19, 1999, p. A19; “No More Peso?”
The Economist, January 23, 1999, p. 69; Augosto de la Torre,
Eduardo Levy Yeyati, and Sergio L. Schmukler, Living and Dying
with Hard Pegs: The Rise and Fall of Argentina’s Currency Board,
World Bank, March 2003; Guillermo Perry and Luis Serven, The
Anatomy of a Multiple Crisis: Why Was Argentina Special and
What Can We Learn from It? World Bank, June 2003; Paul Blustein,
“Argentina Didn’t Fall on Its Own,” The Washington Post, August 3,
2003, p. A01; Mary Anastasia O’Grady, “Take Argentina Off Life
Support,” The Wall Street Journal, August 15, 2003, p. A9; Mary
Anastasia O’Grady, “Mi Amor, I Shrunk the Peso,” The Wall Street
Journal, February 3, 2014, p. A13. ●
IN THE REAL WORLD: (continued)
THE HISTORICAL RISE AND FALL OF A CURRENCY BOARD—
THE CASE OF ARGENTINA
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The final case [panel (d)], that of perfect capital mobility, is slightly different in that
altering the value of the currency does not change the position of the BP curve. With per-
fectly mobile capital, BP remains fixed at the level of the international interest rate. What
does take place, as indicated earlier in this chapter, is that altering the value of the currency
leads to a movement along the BP curve. For example, a devaluation (depreciation) of the
currency again leads to a rightward shift in the IS curve due to the expansion of exports and
the contraction of imports that will accompany it. As the economy expands in response to
the increase in demand for domestic goods, the rise in the domestic interest rate will pre-
cipitate an inflow of short-term capital, putting upward pressure on the home currency. As
the central bank purchases the excess foreign exchange (at the new pegged rate), the money
supply increases, shifting LM to the right. The net short-term capital position will continue
to improve (and the money supply to expand) until the IS and the LM curves again inter-
sect on the BP line. This new equilibrium will necessarily be at a higher level of income.15
Thus, we conclude that changing the exchange rate under a fixed-rate regime will influence
the level of economic activity, regardless of the mobility of capital. As with fiscal policy,
the effect will be the greatest under conditions of perfect capital mobility where there are
no crowding-out effects to offset the expansion in demand for domestic goods and services
brought about by the change in value of the currency.
15Remember that prices are held constant in this analysis and that income is not necessarily at the full employ-
ment level. We also assume that the foreign countries do not match the initial devaluation with devaluation of
their own currencies.
CONCEPT CHECK 1. What will be the situation in the balance of
payments if the IS-LM intersection is below
the BP curve? What then takes place in the
economy under fixed exchange rates? Why?
2. Is monetary or fiscal policy more effective
under fixed rates? Why?
SUMMARY
This chapter examined macroeconomic policy under a system
of fixed exchange rates. With prices and exchange rates fixed,
it became evident very early that there was no guarantee that
internal balance targets and external balance targets would nec-
essarily be reached simultaneously. We then introduced a model
incorporating the monetary sector, real sector, and the balance of
payments (the IS/LM/BP model). The effectiveness of domestic
monetary and fiscal policy under fixed exchange rates was then
analyzed under different international capital mobility assump-
tions. Monetary policy was generally ineffective in influencing
income, whereas fiscal policy had varying degrees of effective-
ness depending on the degree of capital mobility. Only when
capital was perfectly immobile was fiscal policy totally ineffec-
tive in stimulating output and employment. Official changes in
the exchange rate (to the extent permitted) were also effective
in stimulating economic activity. However, because changing
the exchange rate is often difficult under a pegged-rate sys-
tem, countries may find themselves with an incorrectly valued
exchange rate and therefore unable to meet their internal and
external balance targets.
KEY TERMS
automatic monetary adjustment
BP curve
crowding out
currency board
equilibrium interest rate
imperfect capital mobility
impossible trinity
IS curve
LM curve
perfect capital immobility
perfect capital mobility
relative capital immobility
relative capital mobility
sterilization
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QUESTIONS AND PROBLEMS
1. Explain carefully why a country settles in equilibrium at
the intersection of the IS, LM, and BP curves.
2. Why is domestic monetary policy ineffective in an open
economy under a fixed exchange rate regime?
3. What will happen to the relative holdings of foreign and
domestic assets by the home country if there is an increase
in the money supply and capital is perfectly mobile? Why?
4. Explain why a developing country with a fixed exchange
rate and foreign exchange controls in place (perfectly immo-
bile capital) may find itself dependent on growth in exports,
foreign investment, or foreign aid to attain economic growth.
5. Under what capital flow conditions is fiscal policy least
effective in a fixed-rate regime? Most effective? Why?
6. Why does devaluing the domestic currency have an expan-
sionary effect on the economy? Does this expansionary effect
take place if capital is perfectly immobile? Why or why not?
7. Suppose you were instructed to construct a BP curve of
one state in the United States with another, such as New
York’s BP curve with Illinois. What general slope would
you expect for this curve and why?
8. Why must countries, especially those prone to official reserve
transactions deficits, maintain relatively large holdings of
foreign exchange reserves in a fixed exchange rate system?
9. Japan has run huge current account surpluses in the last
decade. Because of concern over this surplus (and over the
associated U.S. current account deficit with Japan), U.S.
government officials for several years urged the Japanese
government to adopt a more expansionary fiscal policy
stance. Using an IS/LM/BP diagram (assuming that the
BP curve is flatter than the LM curve) and starting from a
position of equilibrium, explain how the adoption of such a
policy stance would affect Japan’s national income, current
account, capital account, and money supply. Would your
conclusions be different if the BP curve were steeper than
the LM curve? Why or why not? (Note: Assume throughout
your answer that Japan does not allow the value of the yen
to change.)
10. If financial capital is relatively mobile between countries,
what difficulties emerge if the various countries have dif-
ferent interest rate targets for attaining domestic inflation
and/or growth objectives? (Assume fixed exchange rates.)
11. Explain why a country that wishes to have an indepen-
dent monetary policy as well as a fixed exchange rate
would have to institute controls on capital flows into
and out of the country in order to accomplish these two
objectives.
Appendix THE RELATIONSHIP BETWEEN THE EXCHANGE RATE
AND INCOME IN EQUILIBRIUM
The direct relationship between the exchange rate and open-economy macroeconomic equilibrium
under fixed exchange rates can be demonstrated by selecting different exchange rates and noting
the resulting equilibrium income. Plotting all combinations of the exchange rate and income that
generate macroeconomic equilibrium, while holding all other variables constant except the exchange
rate, income, and the interest rate, will produce a locus of points demonstrating that there is a direct
relationship between a higher (depreciated) exchange rate and the level of income. Connecting these
points will produce a curve like that demonstrated in the EYE (exchange rate–income equilibrium)
curve shown in Figure 14, panels (b) and (d). Because depreciating the currency will lead to a more
positive trade balance, it will necessarily produce a higher income. Stated in a different way, a higher
level of income will be associated with a depreciated currency, ceteris paribus.
Using Figure 14, panels (a) and (b), we can demonstrate the simultaneous impact of fiscal policy
on income and the exchange rate, ceteris paribus. We are focusing on the case of relatively mobile
short-term international capital—that is, the situation where the BP curve is flatter than the LM curve.
Expansionary fiscal policy leads to a rightward shift of the ISG0 curve to ISG1. The impact of the expan-
sionary policy leads to upward pressure on the interest rate given the accompanying increased trans-
actions demand for money and the fixed supply of money. With the increased interest rate, there is
now an official reserve transactions surplus and the money supply begins to increase, shifting the LM
curve to the right and leading to a fall in the interest rate and an expansion of investment along the IS
curve. Eventually, the economy comes to rest at a new higher equilibrium level of income along BP
because the initial fiscal policy action has been enhanced by a growth in the money supply. This endog-
enous response in the money markets results in an unambiguously higher equilibrium rate of interest.
Deriving the EYE curve with the new level of money supply will lead to a new EYE curve (EYEMS1)
which lies to the right of the original EYE curve (EYEMS0) for all possible exchange rates and reflects
the policy action’s impact on income under a fixed exchange rate, e0. Hence, the fixed exchange rate e0,
which was originally associated with income level Y0, is now associated with the new level of income Y1.
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The upward sloping EYE curves in panels (b) and (d) indicate that, as the home currency depreciates, the resulting increased net exports are asso-
ciated with higher equilibrium income. In panel (a), expansionary fiscal policy leads to a BOP surplus, a consequent increase in the money supply
under fixed exchange rates, and a shift of EYEMS0 to EYEMS1 in panel (b) as the fixed rate is now compatible with a higher level of equilibrium
income. Expansionary monetary policy in panel (c) leads to a BOP deficit and downward pressure on the value of the home currency in panel (d).
Central bank intervention to maintain the fixed rate results in a reduction of the money supply and a return of income to its original level.
FIGURE 14 Macro Policy, National Income, and the Exchange Rate
EYEMS0
EYEMS1
e0
e
Y Y0
(b)
Y10
EYE
e0
e1
e
Y
(d)
Y0Y10
BP
LMMS0
LMMS1
i
IS
Y
i1
i0
Y0Y1
(c)
0
(a)
i
LMMS0
LMMS1
BPe0
ISG0
Y0 Y1 Y
i1
i0
ISG1
0
The impact of expansionary monetary policy is analyzed in Figure 14, panels (c) and (d). Given
an initial level of income Y0, an increase in the money supply shifts the LM curve to the right, from
LMMS0 to LMMS1, thereby lowering the rate of interest and increasing investment and income along
the IS curve. The downward pressure on the interest rate generates an official reserve transactions
deficit, which leads to a reduction in foreign exchange reserves due to the central bank’s need to
maintain the pegged exchange rate. This purchase of the domestic currency to support the fixed
rate leads to a decrease in the domestic money supply, shifting the LM curve to the left. This shift
continues until the equilibrium interest rate is again on the BP curve—that is, at the original level of
income. This series of events can be viewed as an initial movement to the right along the EYE curve
and then a return to the left as the money supply subsequently declines and the economy returns to
the initial equilibrium point. Because the exchange rate cannot adjust to the changing financial condi-
tions, the initial increase in the money supply is offset by the resulting loss in foreign reserves that
takes place until the initial equilibrium condition is reached.
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LEARNING OBJECTIVES
LO1 Analyze the impact of fiscal policy on income, trade, and exchange rates
under flexible exchange rates.
LO2 Analyze the impact of monetary policy on income, trade, and exchange
rates under flexible exchange rates.
LO3 Show how external economic shocks affect the domestic economy under
flexible exchange rates.
CHAPTER
26ECONOMIC POLICY IN THE OPEN ECONOMY UNDER FLEXIBLE
EXCHANGE RATES
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INTRODUCTION
In recent decades, many of the developing economies throughout the world—from Latin
America to Southeast Asia to North Africa—that had fixed exchange rates experienced financial
crises. They were increasingly advised to move away from pegged exchange rates or intermedi-
ate, less rigid, fixed rates and to adopt flexible exchange rates. Generally the advice urges them
to adopt a flexible-rate regime and devote their monetary policy to other domestic targets such
as inflation. A number of Latin American countries have moved away from a variety of fixed-
rate regimes and adopted either flexible rates or a hard peg via currency boards or dollarization.
Chile, Brazil, Mexico, and Venezuela are examples of countries that moved to flexible rates,
while Argentina chose to use a currency board and Ecuador and El Salvador adopted the U.S.
dollar as legal tender (dollarized). As noted in the previous chapter, Argentina was forced to
abandon the currency board and has moved to a more flexible arrangement. The proponents of
flexible exchange rate regimes argue that flexible exchange rates would help the developing
economies deal with external shocks better, improve financial stability, and reduce the risk of
a resulting banking crisis. In addition, adoption of floating rates might make for more effective
monetary policy. What are the bases for this viewpoint? Has the presence of flexible rates helped
or hurt these economies and their policy effectiveness in comparison with what would otherwise
have been the case?
If the exchange rate continuously adjusts to maintain equilibrium in the foreign exchange
market, there is no longer a need for central banks to intervene to remove any excess sup-
plies or demands for foreign exchange. Consequently, the monetary authorities have con-
trol over the money supply and can use it to pursue domestic targets. A system of flexible
rates thus significantly affects the policy environment and the effects of policy actions. In
this chapter we examine the effects of monetary policy and fiscal policy under a flexible-
rate regime, comparing and contrasting the effects of policy actions under different capital
mobility assumptions. We also evaluate the way a flexible-rate regime responds to external
economic shocks. The main point to be made is that monetary policy and fiscal policy
differ markedly in their ability to influence national income under flexible exchange rates
when compared to a fixed-rate system. Note that the price level is being held constant in
the analysis of this chapter; prices are allowed to vary in the next chapter.
THE EFFECTS OF FISCAL POLICY UNDER FLEXIBLE EXCHANGE RATES WITH DIFFERENT
CAPITAL MOBILITY ASSUMPTIONS
In this section, we examine the effects of economic policy under flexible rates using the
IS/LM/BP (Mundell-Fleming) model employed in the last chapter. The distinct feature
of the analysis in this chapter is that domestic responses to combinations of income and
interest rates that lie off the BP curve will produce disequilibrium situations in the foreign
exchange market, which will lead to an adjustment in the exchange rate that brings the
foreign exchange market back into equilibrium. As this happens, the BP curve will shift,
reflecting the new equilibrium exchange rate. Consider, for example, the BP curves in
Figure 1. Because the exchange rate is now subject to change, we denote a specific BP
equilibrium by an exchange rate subscript, for example, BP0 for initial exchange rate e0.
Suppose that the domestic economy moves to a point below the BP0 curve. At this point,
the domestic interest rate is too low to attain equilibrium in the balance of payments for any
level of income in question, and the economy begins experiencing a balance-of- payments
deficit (official reserve transactions deficit) under the exchange rate e0. However, because
we have a flexible-rate system, as the economy begins to experience the deficit pressure,
the home currency depreciates. Consequently, the country never experiences the deficit
but, rather, observes a depreciation of the currency instead.
Movements to Flexible
Rates
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The initial disequilibrium in the foreign sector at point a, brought about by the new level
of income and interest rate, is often referred to as an incipient BOP deficit, because it is not
observed as a deficit per se but triggers a depreciation of the currency and a shift in the BP
curve to BP1. The lower BP curve reflects the fact that at the new, depreciated value of the
home currency, any given income level (with its now more favorable current account position
due to the enhanced exports and reduced imports caused by the depreciation) is associated
with a lower interest rate (which worsens the capital/financial account through additional net
capital outflows that exactly offset the more favorable current account). Alternatively, any
given interest rate is, in BOP equilibrium with the now-depreciated home currency, consis-
tent with a higher level of income on BP1 than on the original BP0. Analogously, a combina-
tion of domestic income and the interest rate at point b, which lies above the initial BP curve,
will trigger an incipient BOP surplus that causes the exchange rate to appreciate and shifts
the BP curve to BP2. It is important to emphasize the difference between the adjustment
mechanisms under flexible and fixed rates. Under flexible rates, any disequilibrium leads to
a change in the exchange rate and a shift in the BP curve. Under fixed rates, a disequilibrium
in the foreign sector leads to a change in the money supply and a shift in the LM curve.
Finally, it must be noted that a number of different factors influence the position of the
BP curve in addition to the exchange rate. These factors are assumed to be unchanged in our
analysis, but they can, and often do, change. Changes in any one of these factors can cause the
BP curve to shift, triggering a macroeconomic response. For a brief overview of several of the
more important factors and the manner in which they affect the BP curve, see Concept Box 1.
Now we can turn to consideration of the effects of fiscal policy under the various inter-
national financial capital mobility assumptions. Expansionary fiscal policy is represented by
FIGURE 1 The Effects of Changes in the Exchange Rate on the BP Curve
i
b
BP2
a
Appreciation
Depreciation
BP0
BP1
Y
Initial balance-of-payments equilibrium at the exchange rate e0 is depicted by the BP0 curve. A depreciation of
the currency leads to an expansion of exports and a contraction of imports. Thus, for any given level of income, a
larger amount of net capital outflows (or smaller net capital inflows), and thus a lower rate of interest, is required
to balance the balance of payments. The BP curve thus shifts down (to the right) with currency depreciation to
BP1. In analogous fashion, an appreciation of the currency leads to greater imports and fewer exports, thus requir-
ing a smaller amount of net capital outflows (or larger net capital inflows) to obtain external balance. A higher
interest rate is therefore required at all levels of income, causing the BP curve to shift up (or leftward) to BP2.
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a rightward shift in the IS curve, and its impacts are shown in Figure 2. Each of the four
diagrams again reflects a different assumption about capital mobility. In each case, we begin
with the economy in equilibrium at Y0 and i0 and then examine the effect of an increase in gov-
ernment spending (or a decrease in taxes), which is captured by a shift in the IS curve to IS′.
Beginning with panel (a), an increase in government spending increases domestic
demand for goods and services (IS′), leading to higher equilibrium income and a higher
interest rate. Because capital is perfectly immobile, the increase in income creates an incip-
ient deficit and causes the currency to depreciate. With depreciation of the currency, BP0
shifts to the right to BP1. At the same time, the depreciation of the currency causes exports
to increase and imports to decrease, resulting in a further rightward shift of the IS curve to
IS″. These adjustments stop when the IS, LM, and BP curves again intersect at a common
point (Y2, i2). In the case of perfectly immobile capital, the adjustment in the foreign sector
CONCEPT BOX 1
REAL AND FINANCIAL FACTORS THAT INFLUENCE THE BP CURVE
A number of different factors influence the nature of the
current account and the capital/financial account in the bal-
ance of payments in addition to the domestic level of income,
the domestic interest rate, and the current (spot) exchange
rate. The level of exports is influenced by domestic and for-
eign price levels, the level of income in the rest of the world,
and foreign tastes and preferences. Home-country imports are
also influenced by the level of foreign and domestic prices as
well as by tastes and preferences. Capital flows depend on
foreign interest rates, expected profit rates in both the home
and foreign countries, expected future exchange rates, and the
perceived risk associated with the investment alternatives.
All of these additional considerations are being held
constant for a specific external balance (BP) curve. Should
any of the factors change, the BP curve will shift to offset
the effects of the changing condition and thus continue to
reflect external balance. For example, an increase in foreign
income will increase home-country exports, thus permit-
ting a higher level of domestic income to obtain balance-of-
payments equilibrium for every interest rate. The BP curve
will therefore shift to the right. A decrease in the foreign
price level would have the opposite effect, leading to an
increase in home-country imports, a higher necessary rate
of interest to balance the balance of payments, and hence a
leftward shift in the BP curve.
Changes in financial variables will also shift the BP
curve. For example, an increase in the foreign interest rate
will stimulate an increase in short-term financial capital out-
flows from the home country. A higher domestic interest rate
will therefore be required to balance the balance of payments
for every given level of income, and the BP curve shifts to the
left. A similar adjustment would take place for an increase in
the expected profit rate abroad or a decrease in the expected
profit rate at home. Finally, if investors’ expectations regard-
ing the future value of the exchange rate change—for exam-
ple, there is an increase in the expected appreciation of the
home currency—this would lead to a shift in the BP curve.
An increase in the expected appreciation of the home cur-
rency leads to an inflow of short-term capital and hence to a
rightward shift in the BP curve, because it now takes a lower
rate of interest for each level of income to maintain external
balance. These effects are summarized in Table 1.
TABLE 1 Exogenous Factors and Shifts in the BP Curve
Increase in foreign income BP curve shifts right (down)
Increase in foreign prices BP curve shifts right
Increase in domestic prices BP curve shifts left (up)
Increase in the expected profit rate:
Foreign BP curve shifts left
Domestic BP curve shifts right
Increase in the foreign interest rate BP curve shifts left
Increase in expected home-currency appreciation (depreciation) BP curve shifts right (left)
Perceived increase in country risk abroad BP curve shifts right ●
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produces a secondary expansionary impulse through the increase in net exports. Note that
because the adjustment in the foreign sector is taking place through the exchange rate, there
is no change in the money supply and hence no change in the LM curve.
Figure 2, panel (b), illustrates the situation of relative capital immobility, where inter-
national short-term capital movements are less responsive to changes in the interest rate
than are the domestic financial markets. In this case, the BP curve is steeper than the LM
curve. Increases in government spending again have an expansionary effect on the econ-
omy, leading to an incipient deficit in the balance of payments. The deficit pressure is less
than it was when capital was perfectly immobile, because there is some degree of short-
term capital response to changes in the domestic interest rate. An incipient deficit arises
because induced imports from the higher Y outweigh the increased net capital inflow, and
the resulting depreciation of the currency leads to a rightward shift of the BP curve to BP1.
An additional rightward shift of the IS curve to IS″ occurs as net exports increase with
the depreciating currency. While the effects are smaller than those under perfect capital
FIGURE 2 Fiscal Policy in the Open Economy with Flexible Exchange Rates under Alternative Capital Mobility
Assumptions
i BP0 BP1
BP0
BP1
BP0 BP1
LM
IS
IS’
IS”
IS’
IS’IS”
IS’
IS”
i 2
i 0
Y2Y0 Y0 0
0 0
i LM
IS
Y
i
LM
IS
Y
i LM
IS
i 0
Y
(a) (b)
(c) (d)
BP
i 1
i 1
i 2
i 0
i 1
i 2
i 0
i 1
Y1
Y2Y0 Y0Y1 Y1
Y2Y0 Y1
Starting at equilibrium Y0 and i0, an expansionary fiscal policy shifts the IS curve right (IS′). This causes income and imports to rise, leading to
an incipient deficit when capital is perfectly immobile [panel (a)] or relatively immobile [panel (b)], and a depreciation of the home currency.
Currency depreciation shifts the BP curve right (BP1), and increases exports and decreases imports, which generates an additional shift in the IS
curve (IS″). A new, higher equilibrium, Y2 and i2, results. However, when capital is relatively mobile [panel (c)], the effectiveness of fiscal policy
is reduced. In this case, expansionary fiscal policy (IS′) produces an incipient surplus and currency appreciation. The BP curve thus shifts up and
the IS curve shifts left as imports increase and exports decrease. The trade adjustment offsets some of the expansionary effect of the fiscal policy,
and the expansionary effect on income is reduced, not enhanced as it was when capital was immobile or relatively immobile. Finally, note that
with perfectly mobile capital [panel (d)], fiscal expansion sets in motion a currency appreciation that continues until the current account effect
(−ΔX, + ΔM) completely offsets the initial fiscal policy, leaving income at Y0.
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immobility, fiscal policy is still effective in expanding national income, and the adjustment
of the foreign sector supplements the initial effect of the increase in government spending.
In panel (c), we have the case of relative mobility of international short-term financial
capital, where the BP curve is flatter than the LM curve. While there is still imperfect mobility
of capital in this instance, the foreign sector is seen to be more responsive to changes in the
interest rate than the domestic money markets. An increase in government spending leads to
an incipient surplus in the balance of payments due to net capital inflows more than offsetting
the current account deficit and, hence, appreciation of the currency. With the currency appre-
ciation, the BP curve moves to the left. The deterioration in the current account has an impact
on aggregate demand as well, shifting the IS curve to the left. Consequently, the system comes
to rest at a level of income Y2 instead of Y1. This takes place because part of the expansion-
ary effect of the increase in government spending is offset by the deterioration in the current
account that accompanies the appreciation of the currency. In this case, the foreign sector
adjustment dampens the initial expansionary effect of the increase in government spending.
In the final scenario in panel (d), that of perfect capital mobility, we see that the shift
in the IS curve to IS′ due to the increase in government spending again causes an incipient
surplus in the balance of payments (Y1, i1). This triggers an appreciation of the home cur-
rency (due to large-scale capital inflows), which continues until the current account bal-
ance deteriorates sufficiently to offset exactly the initial increase in government spending.
The IS curve will settle in the same position as before the increase in G. Thus, the principal
real result of the increase in G is that it leads to a reduction in exports and an increase
in imports, that is, to a change in the composition of GDP and the balance of payments.
Because income has not expanded, the increase in government spending has essentially
been facilitated by an increase in imports and a decrease in exports. Thus, exports have
been “crowded out” and the imported goods have been “crowded in” by increased gov-
ernment spending. Note, however, that there has been no crowding out of real investment
because, with perfectly mobile capital, the interest rate remains fixed at the international
rate. The autonomous spending multiplier for this increase in G is thus zero.
As you will have noted, in the circumstance where capital is neither perfectly mobile nor
perfectly immobile, the effect of expansionary fiscal policy on the exchange rate is indeter-
minate without knowledge of the relative slopes of the BP and LM curves. If the BP curve
is steeper than the LM curve (relative capital immobility), the home currency depreciates; if
BP is flatter than LM (relative capital mobility), the home currency appreciates. Likewise,
from a portfolio balance perspective, there is indeterminacy regarding the effect of the expan-
sionary fiscal policy on the exchange rate. For example, if the expansionary policy involves
a government budget deficit and the consequent issuance of new government bonds, then
home-country bonds may become more risky to foreign portfolio owners because there is
now a greater supply of the home bonds. A depreciation of the domestic currency would then
occur to induce foreign bondholders to buy the new bonds. This increase in riskiness is tanta-
mount to making the BP curve steeper, approaching or becoming steeper than the LM curve
(i.e., becoming the relative capital immobility case). On the other hand, if the expansionary
fiscal policy did not involve issuing new bonds (i.e., there is no government budget deficit),
the home currency would appreciate because of the short-term capital inflow response to
the higher domestic interest rate. Finally, if deficit spending occurred but the deficit was
financed by printing money rather than by issuing government bonds, the money supply
increase would cause the home currency to depreciate. (As we see in the next section, increas-
ing the money supply leads to depreciation.) Hence, portfolio balance considerations also
yield uncertainty regarding the impact of the expansionary fiscal policy on the exchange rate.
An overview of the effects of fiscal policy under flexible rates thus indicates that the
effectiveness of fiscal policy depends strongly on the degree of international mobility of
capital. When capital is completely or relatively immobile, fiscal policy is effective in
moving the economy to income and employment targets, and more so than under fixed
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exchange rates because of the extra income stimulus provided by the currency deprecia-
tion. On the other hand, as capital becomes more and more mobile, fiscal policy becomes
less and less effective. In the case where capital is relatively mobile (LM steeper than
BP), fiscal policy is less effective under flexible rates than under fixed rates because of
the income-depressing effect of the currency appreciation. For the extreme case of perfect
capital mobility, fiscal policy is totally ineffective. As financial capital becomes more and
more mobile in our shrinking world, fiscal policy will become less and less effective for
influencing the level of income and employment. While a flexible-rate system thus severely
weakens the fiscal instrument in a world of mobile capital (because the adjustments in the
foreign exchange markets can severely offset the effects of discretionary fiscal policy), it
does free up the monetary policy instrument, as will be seen in the following section.1
THE EFFECTS OF MONETARY POLICY UNDER FLEXIBLE EXCHANGE RATES WITH
DIFFERENT CAPITAL MOBILITY ASSUMPTIONS
The economic response to increases in the money supply is straightforward and consistent
across the different capital mobility scenarios (see Figure 3). Increases in the money supply shift
the LM curve to the right and in all four cases expand domestic income from the initial Y0, put
downward pressure on the domestic interest rate from the initial i0, and produce an incipient def-
icit in the balance of payments. Under a system of flexible rates, expansionary monetary policy
leads to a depreciation of the domestic currency, accompanied by an increase in exports and a
decrease in imports. With the depreciation, both the BP curve and the IS curve shift to the right.
The end result is an increase in equilibrium income and a strengthening of the trade balance.
Looking more closely at each case, in the situation of perfectly immobile capital
[panel (a)], the incipient deficit is caused by the increase in imports that accompanies
the higher level of domestic income. Because capital flows are completely insensitive
to changes in the interest rate, there is no capital-flow response to the monetary policy
action. Consequently, the currency needs to depreciate only enough to offset the income
effect on imports. As the currency depreciates, the BP curve shifts to the right from
BP0 to BP1 and the increase in net exports also shifts the IS curve to the right to IS′.
The system will eventually come to rest at a new equilibrium with a higher level of
income Y2, a depreciated currency, and a lower interest rate.2 Note that the expenditure
1For a demonstration of the link between equilibrium income and the exchange rate under fiscal policy scenarios,
see the appendix to this chapter.
2The interest rate falls unambiguously because the BP curve shifts to the right to a greater extent than does the IS
curve at any given interest rate. Remembering the autonomous spending multiplier from Chapter 24, the change
in income at each interest rate is the depreciation-induced improvement in the trade balance (the net addition to
spending in the economy at each interest rate) times the multiplier. This income change (in the Keynesian model
with taxes that depend on income) equals the size of the horizontal shift in the IS curve; that is,
ΔYIS = Δ (X − M) × (1/ [1 − MPC (1 − t) + MPM]) [1]
On the other hand, the BP curve shifts to the right at any given interest rate by the amount of increase in income
needed to generate sufficient imports to restore balanced trade after the currency depreciation. In other words,
imports must rise by the amount necessary to match the initial improvement in the trade balance; that is, imports
must change by MPM × ΔY. Hence,
ΔM = MPM × ΔY [2]
or the necessary rightward shift in the BP curve at each given interest rate is
ΔYBP = ΔM/MPM [3]
Because trade balance is restored after the BP shift, this means that ΔM associated with the BP shift is equal
to Δ(X − M) associated with the IS shift. Letting ΔM = Δ(X − M) = a in expressions [3] and [1], we see that
ΔYBP = a/MPM and ΔYIS = a/[1 − MPC(1 − t) + MPM]. Because [1 − MPC(1 − t)] is a positive number, the
denominator in the ΔYIS expression is larger than the denominator in the ΔYBP expression, and hence with an
identical numerator, ΔYBP is greater than ΔYIS. In other words, the BP curve shifts farther to the right than does
the IS curve at any given interest rate.
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effects associated with the depreciation further enhance the initial effects of the mon-
etary expansion.
The expansion of the money supply under imperfect capital mobility [panels (b) and (c)]
leads to a fall in the domestic interest rate and in turn stimulates a short-term capital out-
flow, worsening the short-term financial account. Thus, both short-term capital movements
and the increase in domestic income put downward pressure on the value of the home cur-
rency. The more responsive international capital flows are to changes in the domestic inter-
est rate (the flatter the BP curve), the greater the additional pressure will be. Consequently,
the more interest-elastic the BP curve is, the greater the depreciation that will take place to
FIGURE 3 Monetary Policy in the Open Economy with Flexible Exchange Rates under Alternative Capital Mobility
Assumptions
i BP0 BP1
LM
LM’
IS IS’
i 1
i 2
i 0
i 1
i 2
i 0
i 1
i 2
i 0
Y1Y0 Y
(a)
Y2
Y1Y0 Y2 Y1Y0 Y2
Y1Y0 Y2
Y
(c)
i
i BP0
BP1
LM
LM’
IS
IS’
Y
(b)
Y
(d)
i 0
i
BP0
BP1
LM
LM’
IS IS’
LM’
IS’
BP
LM
IS
0 0
0 0
Starting at equilibrium at Y0 and i0, expansionary monetary policy shifts the LM curve to the right (LM′), lowering the interest rate and increasing
income (Y1, i1). The lower interest rate reduces a net capital inflow or worsens a net capital outflow [except in case (a)], and the higher income
level increases imports. Consequently, there is an incipient deficit in the balance of payments, resulting in a depreciation of the home currency
and a rightward shift in the BP curve (BP1). However, depreciation increases exports and decreases imports, causing a rightward shift of the IS
curve (IS′). Depreciation (rightward shift of the BP curve) and improvements in the trade balance (rightward shift of the IS curve) continue until
all three curves again intersect at a common point and equilibrium is obtained (Y2 and i2). In the case of perfect capital mobility [panel (d)], all the
adjustments take place along the BP curve, because it remains horizontal at the world rate of interest. With flexible exchange rates, expansionary
monetary policy is effective in influencing income regardless of the degree of capital mobility, and the current account effects complement the
monetary policy in all cases.
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maintain equilibrium in the balance of payments. Because the expansion in net exports is
greater with a greater depreciation, the overall expansionary effects of monetary policy are
larger the more mobile international capital is. This is verified in the last case, panel (d),
where capital is perfectly mobile and the BP curve is horizontal. Because capital is very
responsive to the slightest change in the domestic interest rate, expansion of the money
supply generates a very large capital outflow and a depreciation of the home currency.
This depreciation leads to a large expansion of net exports (exactly offsetting the capital
outflow), which in turn stimulates national income.
The more mobile international capital is, the more effective monetary policy is.
However, the more mobile international capital is, the greater the degree to which expan-
sionary monetary policy depends on the adjustment in the foreign trade sector to bring
about the increase in income and employment. If the interest rate does not initially change,
or changes very little with respect to changes in the money supply, then investment may
not respond and the income expansion must come about through shifts in the IS function
via changes in exports and imports. With all mobility assumptions, however, the subse-
quent adjustments in the foreign trade sector strengthen the initial impact of the growth in
the money supply. It can be concluded, therefore, that, in general, monetary policy is more
effective under flexible exchange rates than under fixed exchange rates.3
A general conclusion reached in the preceding analysis of fiscal and monetary policy is that
monetary policy is consistently effective in influencing national income under flexible rates
and that it is stronger the more mobile is international short-term capital. Fiscal policy is less
effective under flexible rates than under fixed rates when capital is relatively or perfectly
mobile. This results from the fact that the expenditure-switching effects can work against fis-
cal policy, whereas they complement monetary policy. It is not surprising, then, that policy-
makers may find it desirable to use both instruments in a coordinated fashion to achieve
domestic targets. Monetary policy–fiscal policy coordination will permit policymakers
to strive for other targets besides income, such as an interest rate target, stability of the for-
eign exchange rate, or a desired combination of government spending, export production/
employment, and output/employment in the import-competing sector. Joint use of monetary
and fiscal policies will allow the policymaker some control over the nature of the structural
adjustment and over the distribution of the economic effects of the policies adopted.
This point can be seen in Figure 4. Let us start with the economy initially in equilibrium
at Y0 and i0. Suppose that policymakers set a joint target of Y* and i* that is consistent with
the existing exchange rate. Turning first to panel (b), let us examine how attempts to reach
that point using monetary policy alone will fare. Expanding the money supply alone (LM′)
leads to depreciation of the domestic currency (a rightward shift of BP) and an expansion
of net trade in the foreign sector (a rightward shift of IS). Because the new equilibrium
must lie on LM′ with a depreciated currency (a lower BP), the equilibrium rate of interest
will be less than i*. Such an equilibrium interest rate is illustrated by i′, occurring at the
intersection of IS′, LM′ and BP1. In this instance, both targets would be missed because Y′
is less than Y* and i′ is less than i*. In addition, exporters and import competitors would
be rewarded and the nontraded sector would be harmed by the change in relative prices
brought about by the change in the exchange rate.
If, on the other hand, government officials attempted to attain Y* using only fiscal pol-
icy and they were successful, interest rates would be driven up to iy*, as demonstrated in
panel (a), clearly missing the target i*. In all likelihood, it would prove difficult to attain
Policy Coordination
under Flexible
Exchange Rates
3The appendix to this chapter describes in more detail the link between equilibrium income and the exchange rate
when monetary policy is employed to alter an existing equilibrium.
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Y* with only fiscal policy, because expansionary fiscal policy (i.e., a rightward shift in the
IS curve to ISFP) will create an incipient surplus, causing the currency to appreciate (a left-
ward shift of the BP curve). With the currency appreciating, exports decrease and imports
increase, and the IS curve shifts back leftward to IS′FP. The system thus moves to a new
equilibrium on the LM curve, for example, the intersection of IS′FP and BPFP, which misses
both targets. The use of fiscal policy alone will lead to an interest rate that is too high and in
FIGURE 4 Monetary Policy–Fiscal Policy Coordination under Flexible Exchange Rates
i
BP0
BPFP
IS IS’FP
i0
YFPY0
(a)
Y*
ISFP
LM
i*
iFP
iy*
Y
i
BP0
IS IS’
i0
Y0 Y’
(b)
Y*
LM
LM’
i*
Y
i’
BP1
i0
i*
Y0 Y*
BP0
IS
IS’
Y
LM
LM’i
(c)
0 0
0
With the economy in equilibrium at Y0 and i0, policymakers decide that it would be desirable to be at Y* and i*. However, it is possible to reach
this combination only by the coordinated use of monetary and fiscal policies as shown in panel (c). Turning to panel (a), attempts to use only fiscal
policy (a rightward shift in the IS curve to ISFP) will lead to an incipient surplus and appreciation of the home currency. Consequently, the BP curve
starts shifting left, and at the same time exports decrease and imports increase, causing the IS curve to shift left. The new equilibrium that must be
on the LM curve will either miss the interest rate target at Y* (i.e., iy* will exist instead of i*) or miss both targets such as at YFP and iFP(IS′FP, BPFP,
LM). Attempts to use only monetary policy (a rightward shift in the LM curve to LM′), as demonstrated in panel (b), will lead to an incipient deficit
and depreciation of the currency. Consequently, the BP curve will start shifting right (toward BP1) and, as exports increase and imports decrease, the
IS curve will also start shifting to the right. The new equilibrium will occur on LM′, but with a depreciated currency and hence with the IS′ and BP1
curves. Consequently, attempts to attain Y* will lead to an interest rate less than i*, or to a new equilibrium at i′ and Y′, which misses both targets.
Hence, as shown in panel (c), the only way to attain the two targets simultaneously is with coordinated use of the two instruments.
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all likelihood a level of income below Y*. Attempts to reach Y* by additional government
spending will simply drive the interest rate higher. Further, in this process, exporters and
producers of import substitutes would be hurt and the nontraded sector would gain.
The only way to obtain the two targets in question without causing exchange rate
changes and affecting relative prices—and therefore, the structure of the economy—is
to rely on both of the instruments. In Figure 4(c), Y* and i* are obtained by the joint use
of monetary and fiscal policies (IS′ and LM′), which allows the economy to expand to Y*
without stimulating any expenditure-switching effects. For similar reasons, policymakers
will likely find it effective to use both policy instruments to respond to exogenous shocks
should they feel that a policy response is appropriate.
The attempts to deal with the recessionary conditions of 2007–2009 can be interpreted in
the context of the coordination of monetary and fiscal policy. U.S. national income declined
as the IS curve shifted to the left because of significant decreases in investment and con-
sumption due to financing difficulties and loss of confidence, as well as because of a decline
in exports as the rest of the world went into an economic slump. The U.S. federal govern-
ment’s stimulus policy can be regarded as an attempt to shift the IS curve to the right. The
Federal Reserve attempted to coordinate with the federal government by increasing the
money supply and lowering interest rates, thus shifting the LM curve to the right. A compli-
cating factor for monetary policy was that the financial crisis made it difficult for firms and
consumers to obtain loans and hence made the IS curve steeper. The economic uncertainty
associated with the crises in the financial sector reduced the willingness of banks to lend
and resulted in the accumulation of excess reserves and very low interest rates (and also
made the LM curve flatter). In effect, this meant that any new money introduced by the
Federal Reserve would have little or no impact on the level of income.
4For simplicity, we are ignoring any effect on domestic prices of the foreign price change. Such effects would not
change the central conclusion of the analysis.
CONCEPT CHECK 1. Under what capital mobility conditions is
fiscal policy effective in pursuing an income
target in a flexible exchange rate system?
When is it totally ineffective? Why?
2. Why is it said that the effectiveness of mon-
etary policy in altering income is enhanced
by induced changes in the foreign sector in a
flexible exchange rate system?
THE EFFECTS OF EXOGENOUS SHOCKS IN THE IS/LM/BP MODEL WITH IMPERFECT
MOBILITY OF CAPITAL
The analysis to this point has focused on the effects of monetary and fiscal policy, hold-
ing a number of important variables constant. These include such variables as the level
of prices at home, the level of prices abroad, and the interest rate abroad, as well as the
expected profit rates at home and abroad, the expected exchange rates, and the trade poli-
cies and economic institutions at home and abroad. Because these variables can, and often
do, change abruptly or unexpectedly, it is useful to examine briefly the effects of changes in
selected variables through comparative statics to get some idea of how economic “shocks”
are transmitted in an interdependent world under flexible exchange rates.
Suppose that there is a sudden increase in the level of foreign prices, that is, a foreign
price shock (see Figure 5).4 There will be an expansionary effect (a shift of the IS curve to
the right) on the home economy as exports increase and imports decrease in response to the
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FIGURE 5 Foreign Price Shocks and Macroeconomic Adjustment in the Open Economy
i0
Y00
IS
IS’
Y
LMi
BP0 = BP1
BP’0
An increase in foreign prices causes the BP curve to shift out to BP′0 and exports to rise and imports to fall.
The improved current account shifts IS right to IS′, putting upward pressure on income and the interest rate.
The improved current account and the higher domestic rate of interest produce an incipient balance-of-payments
surplus, and the home currency begins to appreciate. With currency appreciation, the BP curve moves upward
and the IS curve moves leftward. Equilibrium is again reached at Y0 and i0 as the appreciating currency offsets
the foreign price shock.
IN THE REAL WORLD:
COMMODITY PRICES AND U.S. REAL GDP, 1972–2014
Price shocks can originate in a number of ways, for example,
increases in the money supply, fiscal expansion, simultane-
ous expansion of several key industrial countries, sudden
increases in wages, and changes in real commodity prices.
Figure 6 focuses on commodity price changes and portrays
the movement of world wholesale prices of food, agricul-
tural raw materials, metals, and petroleum over the period
1972–2014. Oil prices quadrupled from 1972 to 1974 and
then almost tripled from 1978 to 1980, before falling about
60 percent from 1980 to 1986. Oil prices subsequently
leveled off somewhat through 1996, after which there was
a steep climb, with some fluctuation, to a high in 2012.
The 2012 price was eight times the 1996 price. A decline
in oil prices then took place. (The 2015 index figure was
not available at the time of this writing.) There was also
price variability during the 1972–2014 period in the other,
broader commodity categories as well. All these other prices
rose substantially in recent years through 2011, after which
declines occurred.
However, despite these major price shocks, real GDP
in the United States demonstrated relatively steady growth
over these 42 years. Because major countries’ exchange
rates became more flexible in 1973, this relative stabil-
ity of GDP is consistent with the notion that flexible rates
tend to insulate an economy from external price shocks.
Nevertheless, we do not wish to minimize the impact of
the shocks, because unemployment and inflation in indus-
trial countries were affected in particular by the OPEC
price hikes in 1973–1974 and recovery from the 2007–2009
recession appears to have been hampered by high oil prices.
The insulation from exogenous forces that was expected to
accompany flexible exchange rates has not been complete
(although exchange rates were and still are not completely
flexible).
Source: International Monetary Fund (IMF), information obtained
from elibrary at data.imf.org.
(continued)
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IN THE REAL WORLD: (continued)
FIGURE 6 Commodity Prices and U.S. Real GDP, 1972–2014
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150
160
170
180
190
200
210
220
230
240
250
Real GDP
Agricultural raw materials
Food
Metals
Petroleum
72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Year
World commodity price indexes
and index of U.S. real GDP
(2005 = 100)
U.S. real GDP grew relatively steadily during the 1972–2014 period, despite substantial price fluctuations in major commodities. The flexible
exchange rate of the dollar during this period appears to have provided some insulation of the economy from the external shocks.
price change in question. In addition, there will be a rightward shift in the BP curve (from
BP0 to BP′0) because the expenditure-switching effect of the increase in foreign prices means
that a higher level of domestic income is consistent with BOP equilibrium for each given

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home interest rate. With the increased spending (IS′) on the country’s products, income and
the interest rate begin to rise. The rise in the domestic interest rate generates upward pres-
sure on the value of the home currency (appreciation) because of short-term capital inflows,
as has the improvement in the current account, and the BP curve will begin to shift back up.
As the currency continues to appreciate, exports fall and imports rise, shifting the IS curve
back toward its initial position. The final result is a return to the original Y0, i0 equilibrium
position. Thus, we see that under (completely) flexible rates the economy is insulated from
price shocks originating outside the country. This case is relevant to the period since 1972,
when considerable price variability occurred in major commodity groups.
Suppose on the other hand that there is a sudden increase in domestic prices, that is, a
domestic price shock (see Figure 7). In this case, equilibrium in all three sectors will be
affected. An increase in domestic prices will increase the demand for money and reduce the
real money supply, shifting the LM curve to the left. At the same time, increased domestic
prices will reduce the competitiveness of home exports and make imports more attractive
to domestic consumers. Consequently, the IS curve will shift to the left. Finally, these same
trade effects will lead to an upward shift of the BP curve, because it will now take a higher
interest rate to attract sufficient short-term capital to bring the balance of payments into
balance at every level of income. These adjustments are shown in Figure 7 by LM′, IS′, and
BP1. The new equilibrium will lie along LM′ at a higher interest rate (i1) and a lower level
of income (Y1) than the initial equilibrium (i0, Y0), although i1 could be less than i0. Should
the initial shifts in the IS and BP curves not lead to a simultaneous equilibrium point with
LM′, a change in the exchange rate will occur, because an IS/LM equilibrium point that
does not lie on the BP curve will bring about the requisite exchange rate adjustment.
Next, from an initial i0, Y0, suppose that there is an increase in the foreign interest
rate, that is, a foreign interest rate shock (see Figure 8). Because this will make foreign
short-term investments more attractive and cause portfolio adjustments, we would expect
FIGURE 7 Open-Economy Adjustment to Domestic Price Shocks in a Flexible-Rate Regime
i 0
Y0
BP0
ISIS’
Y
LMLM’i
BP1
i 1
Y10
Assume that the economy is in equilibrium at Y0 and i0. An increase in the domestic price level will affect
equilibrium in all three sectors. The LM curve will shift to the left to LM′ as the real supply of money falls.
The IS curve will shift to the left as exports fall and imports rise. Finally, the BP curve will shift upward as the
deteriorating trade balance requires a higher rate of interest for every level of income to balance the balance of
payments. Equilibrium will occur on LM′ at a lower level of income (Y1) and a new rate of interest (i1).
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an increased outflow (or decreased inflow) of short-term capital. With the new, higher
interest rate abroad and the same exchange rate, a higher domestic interest rate is now
required to balance the balance of payments at all income levels. Consequently, there is an
upward shift in the BP curve from BP0, if0 to BP0, if1. With the new BP curve, the previous
equilibrium level of interest (i0) is too low for attaining domestic balance-of-payments
equilibrium, and an incipient deficit appears. The domestic currency depreciates (shifting
BP0, if1 to BP1, if1), and this depreciation stimulates exports and decreases imports. This
current account effect (driven by the capital/financial account developments) leads to a
rightward shift in the IS curve to IS′. Eventually, a new equilibrium is reached on the LM
curve with the new BP and IS curves. Both the interest rate (i1) and the income level (Y1)
have increased. Thus, the initial rise in the foreign interest rate has led to an increase in the
domestic interest rate as well as to a depreciation of the home currency.
An additional consideration relates to portfolio adjustments. Because the foreign inter-
est rate has risen, home-country asset holders will also reduce their demand for domestic
money as they rearrange their portfolios to take advantage of the higher foreign interest
rate. With a decrease in home money demand, the LM curve of Figure 8 will shift to the
right. The initial incipient BOP deficit will be even larger than discussed in the previous
paragraph, and the depreciation of the home currency will be even greater. The simultane-
ous intersection of the final BP, LM, and IS curves will, as before, be at a higher income
level than Y1. While there is no a priori way to discern whether the domestic adjustment to
foreign interest rate shocks occurs relatively more via the exchange rate rather than via the
domestic interest rate, some empirical evidence suggests that the exchange rate in practice
carries the bulk of the adjustment between the United States and its major trading partners.
FIGURE 8 Foreign Interest Rate Shocks and Macroeconomic Adjustment in a Flexible-
Rate Regime
i 0
Y1
BP0, if 1
BP1, if 1
BP0, if 0
IS
IS’
Y
LM
i
i 1
Y00
From the starting point of Y0 and i0, the increase in the foreign interest rate makes short-term foreign invest-
ments more attractive. It therefore takes a higher domestic rate of interest to maintain external balance for all
levels of income, and the BP curve shifts up to BP0, if1. As domestic investors increase their short-term financial
investments abroad, there is an incipient deficit and the home currency depreciates (the BP curve moves down-
ward). Depreciation stimulates exports and discourages imports, causing the IS curve to shift to the right. A
new equilibrium results at a higher level of income (Y1) and interest rate (i1) at the intersection of LM, IS′, and
BP1, if1. In addition, if the higher foreign interest rate reduces the home demand for money, LM will shift farther
to the right and income will rise even further.
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IN THE REAL WORLD:
EUROPEAN INSTABILITY AND U.S. GDP
An event of recent interest that can be analyzed in the
IS/LM/BP framework is associated with the deficits/debt/insta-
bility situation in the euro zone. To illustrate, consider Figure 9.
This figure portrays the situation in the United States. The ini-
tial equilibrium of the U.S. economy is at income level Y0 and
interest rate i0; the economy is in equilibrium at the three-way
intersection of IS0, LM0, and BP0. Now suppose that, with new
fears and pessimism about the European situation, financial
investors become worried about the future of the euro and thus
undertake a “flight toward safety” by changing their portfolios
so that they are holding a greater volume of dollar assets and a
smaller volume of the now-more-risky euro assets.
What are the consequences of this search for greater
stability through sending funds to the United States? First,
because a lower interest rate at any given income level is
required to yield balance-of-payments equilibrium for the
United States, BP0 shifts downward (or to the right) to BP1.
(For ease of exposition, we ignore any possible change in the
slope of the BP curve that may occur due to the greater riski-
ness abroad.) Given this shift, the old IS-LM equilibrium
position is now associated with an incipient BOP surplus.
In a floating-rate system, this incipient BOP surplus leads
to an appreciation of the dollar. (In fact, in recent years with
debt and deficit problems in some member countries of the
euro zone, the dollar has appreciated considerably rela-
tive to the euro. See the “In the Real World” box on page
667.) Hence, BP1 begins to shift back upward (to the left).
The appreciation of the dollar also leads to a shift leftward
(or downward) of IS0 because, with the appreciation, U.S.
exports are now more expensive to foreign buyers than pre-
viously and imports are now cheaper to U.S. buyers. The
end result of the process, after all adjustments have been
completed, is that the U.S. economy is operating at a lower
equilibrium income level Y1 than the previous equilibrium
income level Y0. Further, the United States has a lower inter-
est rate (i1) at the new three-way intersection of BP2, IS1, and
LM0 than it had prior to the financial inflow (when the inter-
est rate was i0). Overall, fears and uncertainty about Europe
have thus lowered economic activity in the United States. If
U.S. policymakers wished to offset the decline in income,
they could attempt to undertake expansionary monetary and/
or fiscal policy.
i 1
Y0
BP0
BP2
BP1
Y
LM0
i
i 0
Y10
IS1
IS0
The initial equilibrium position for the United States is at Y0 and i0. With an increase in perceived risk in the euro zone, investors switch
their portfolios toward holding relatively more dollar assets, and the BP0 curve thus shifts downward to BP1. There is now an incipient
BOP surplus for the United States; with flexible exchange rates, the resulting appreciation of the dollar leads to an upward (or leftward)
shift of the BP curve and a downward (or leftward) shift of the IS curve. The new equilibrium position for the United States is at the
intersection of IS1, LM0, and BP2, and there has been a fall in the interest rate to i1 and a fall in the income level to Y1.
FIGURE 9 Effects of Perceived Increased Foreign Country Risk

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IN THE REAL WORLD:
POLICY FRICTIONS IN AN INTERDEPENDENT WORLD
The effect of international economic interdependence on
policy decisions is clearly in evidence as the United States,
Europe, and Japan in recent years have been faced with
widely different economic problems and circumstances.
After the European Union adopted a new currency, the euro
(discussed in Chapter 29), its value declined by 25 percent
in the first 16 months after its launch in January 1999. With
relatively high unemployment and low inflation in Europe,
the European Central Bank and national central banks hesi-
tated to raise interest rates to halt the downward spiral of
the euro. At the same time, the United States faced infla-
tionary pressures that the Federal Reserve attempted to
keep under wraps by a succession of interest rate increases,
coupled with increasing current account deficits. The higher
U.S. interest rates put further pressure on the euro, as short-
term financial capital was attracted to the United States.
Meanwhile, Japan found itself in economic recession, along
with a growing current account surplus. Japan thus had little
incentive to raise domestic interest rates. As the U.S. inter-
est rates increased, interest rate differentials with Japan and
Europe became larger, leading to continued financial invest-
ment flows to the United States and further pressure on the
euro, the yen, and interest rates outside the United States.
The strong dollar also contributed to continued and expand-
ing U.S. current account deficits. However, the situation
began to change in 2001 as the United States began to slide
into recession. This led to a succession of interest rate reduc-
tions by the Federal Reserve, which, by 2003, resulted in
the lowest interest rates in many years. Not surprisingly, the
dollar began to depreciate in late 2002 and 2003, especially
against the euro. From 2003 onward, the euro continued to
strengthen against the U.S. dollar and reached a value over
$1.58 in June 2008. This rise occurred as European growth
rates increased and as doubts arose concerning the huge U.S.
federal government and current account deficits. The large
and growing U.S. trade deficit with China, thought by many
to be the result of the deliberately undervalued renminbi
yuan, generated congressional concern and led to political
tensions between the two countries.
With the subsequent recession in the world economy
and its accompanying uncertainties, many investors sought
to reduce risk and moved into dollar assets, with the result
that the exchange rate fell to $1.26/euro in early 2009 before
recovering somewhat by mid-summer. The recession also
generated pressures toward economic nationalism and led
to adoption of a number of new protectionist devices in an
attempt to stimulate employment in domestic economies by
turning inward. Within Europe, the growing debt “crisis” of
euro-zone countries such as Greece, Spain, Ireland, and Italy
caused uncertainty as to the future of the euro area and the
euro itself. The leading euro-area countries, Germany and
France in particular, urged the adoption of austerity policies
by the high deficit/debt countries, making such policies a
precondition for loans to ease the financial problems. As
might be expected, attempts to adopt such policies resulted
in a slowdown of European growth. The euro fears and the
economic slowdown caused some capital flight toward
the safety of the U.S. dollar, and the euro fell to $1.29 by the
end of 2011. The U.S. administration and Federal Reserve,
in the meantime, did not share the austerity objective, and
were seeking to speed up the recovery from the 2009 reces-
sion. The austerity push in Europe in conjunction with bet-
ter (though not especially good) prospects in the United
States by early 2012 had led to a strengthening of the dollar
against the euro. By July the euro had fallen to $1.23/euro.
However, the downward trend reversed itself in 2013 such
that by March 2014 the rate had risen to $1.38/euro as stron-
ger growth in the United States contributed to an increase
in the U.S. demand for European goods. The sub sequent
resumption of the debt crisis and austerity pressures in
Europe, especially in Greece, resulted in a precipitous fall in
the value of the euro to $1.07 by November 2015.*
*For discussion of the need for coordination of policy among the
United States, Europe, and Japan in the context of a plea for greater
exchange rate stability, see George Melloan, “U.S. Inflation Will
Complicate the Euro-Quandary,” The Wall Street Journal, May 2,
2000, p. A27; “Will the Fallen Dollar Set the Stage for a Global
Economic Boom a Year or Two from Now?” The International
Economy, Summer 2003, pp. 30–44. For a look at protectionist
tendencies, see “The Return of Economic Nationalism,” The
Economist, February 7, 2009, pp. 9–10; John W. Miller, “Nations
Rush to Establish New Barriers to Trade,” The Wall Street Journal,
February 16, 2009, pp. A1, A6; Federal Reserve Economic Data
(FRED), available at https://research.stlouisfed.org. ●
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As a last example of a shock, consider the case of a shock to the expected exchange
rate. Suppose that because of some exogenous event (such as the election of a foreign gov-
ernment that is expected to stabilize its country economically), there is now an expected
greater appreciation of the foreign currency (or, alternatively, an expected greater depre-
ciation of the home currency). Recall the uncovered interest parity (UIP) expression from
earlier chapters (and ignore any risk premium):
id = if + xa
where id = the domestic interest rate, if = the foreign interest rate, and xa = the expected
percentage appreciation of the foreign currency. From an initial UIP equilibrium, the rise
in xa will now make the term (if + xa) greater than id and there will thus be a short-term
capital outflow from the home country to the foreign country. This change in the expected
exchange rate has the same effects in the IS/LM/BP diagram as did the foreign interest rate
shock considered earlier, and Figure 8 (page 665) can also be used to interpret this case. In
terms of the figure, the rise in xa shifts the BP curve upward (to the left) because a higher
domestic interest rate is now needed for home-country BOP equilibrium at each income
level. There is an incipient deficit at the old equilibrium income level Y0, and depreciation
of the domestic currency thus takes place, moving the IS curve to the right and also causing
the BP curve to move back to the right. The end result (as at Y1 and i1) is a higher income
level and, as the UIP expression also suggests, a higher domestic interest rate.
In overview of external shocks, it is important to note that the greater the economic
interdependence among countries, the greater the general likelihood that foreign shocks
(other things equal) will have an effect on domestic interest rates and/or the exchange rate.
Domestic policymakers are forced to make decisions that take into account both domestic
variables and foreign economic variables, so policymaking becomes more difficult.
For example, in the foreign interest rate shock case, a rise in the foreign rate led to an
increase in the domestic interest rate. However, the domestic economy may be in such a
state that domestic authorities do not wish to have a higher domestic interest rate. To offset
the rise in the domestic rate, suppose the monetary authorities increase the money supply
(to sterilize the interest rate effects). From i1, Y1 in Figure 8, this shifts LM to the right (not
shown) and generates an incipient deficit. The BP curve shifts to the right, as will the IS
curve due to the currency depreciation. The income level rises above Y1 and the interest rate
falls below i1, perhaps all the way to i0. The country has thus negated to at least some extent
the original effects of the foreign interest rate increase, but it has also generated deprecia-
tion of the home currency. The foreign country in turn has now experienced an appreciation
of its currency to a greater extent than it originally expected. Consequently, its income level
may fall, and it may consider taking appropriate policy actions to counter these effects.
Note, of course, that changes in the exchange rate are important actors in this scenario.
To reduce the degree of instability in exchange rates and domestic variables caused by
this kind of sequence of policy reactions, a case can be made that there should be greater
international macroeconomic policy coordination in a regime of flexible exchange
rates. Such coordination of macro policy is currently being fostered. The most obvious
examples of such joint consultations in practice consist of the economic summits held by
leaders of the Group of 7 or G-7 countries, Group of 8 or G-8 countries, and Group of 20
or G-20 countries.
CONCEPT CHECK 1. Explain the effect that a decrease in foreign
prices has on the open economy under a flex-
ible exchange rate system.
2. Using the IS/LM/BP framework, explain how
an increase in the foreign interest rate influ-
ences the home-country interest rate in the
open economy under flexible exchange rates.
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IN THE REAL WORLD:
MACROECONOMIC POLICY COORDINATION: THE IMF, THE 
G-7/G-8, AND THE G-20
As long ago as in a 1991 IMF task force report, it was stated
that “Improving international coordination of national eco-
nomic policies should be a major objective of industrial
countries.”a The director of the task force, Robert Solomon,
pointed out that, because the world had become increasingly
integrated both with respect to trade and capital mobility,
policymakers must take into account that their policy actions
have spillover effects in other countries:
The failure to coordinate policies can be “dramatic,”
Solomon argued. He suggested that economic policy
coordination among the major industrial countries could
have averted at least some of the very sharp runup in
inflation that followed the adoption of expansionary
fiscal and monetary policies in 1972–73. Similarly,
he observed, the 1981–82 downturn might have been
less severe.
Policy coordination among industrial countries,
Solomon contended, should aim to harmonize targets.
Industrial countries should also seek to maintain consis-
tency in the goals and targets that they pursue and in the
instruments that they utilize. The Group of 7 generally
aims for high levels of employment and growth and for
relative price stability. Its instruments are primarily mon-
etary and fiscal policy.b
Because of the increased interdependency, the task force
urged that governments become more flexible in their fiscal
policy and that fiscal policy be focused more on medium-
term targets instead of on short-term fine-tuning exercises.
In keeping with the greater focus on international coordi-
nation, the G-7 countries (Canada, France, Germany, Italy,
Japan, the United Kingdom, and the United States) com-
municated the following after their January meeting in New
York in 1991:
∙ Reaffirmed their support for economic policy
coordination.
∙ [Urged] Implementation of sound fiscal policies, com-
bined with stability-oriented monetary policies [which]
should create conditions favorable to lower global inter-
est rates and a stronger world economy.
∙ Stressed the importance of a timely and successful
conclusion of the Uruguay Round.
∙ Agreed to strengthen cooperation and to monitor
developments in exchange markets.
∙ [Agreed] to respond as appropriate to maintain stabil-
ity in international financial markets.c
This emphasis on policy coordination has become a per-
manent feature of the world policymaking environment and
G-7 summits. For example:
∙ In July 1992 the G-7 leaders pledged to continue to
promote monetary and fiscal policies that would sup-
port economic recovery without reigniting inflation
and that would permit lower interest rates by reducing
members’ budgets and government spending.d
∙ In July 1993 the G-7 encouraged Japan to implement
macroeconomic policies that would reduce Japan’s
trade surplus and praised President Bill Clinton’s
efforts to reduce the U.S. federal government deficit.
In addition the Group committed $3 billion of finan-
cial aid to Russia for assistance in the privatization of
government enterprises.e
∙ In June 1995 measures were introduced to reduce the
likelihood of future crises, similar to that of Mexico in
late 1994 and early 1995. In addition they agreed to
increase aid to poor countries by 2010, half of which
was to go to Africa.f
∙ In May 1998, with Russia participating, the organi-
zation became known as the G-8 and took on a more
worldwide view. A general statement was issued that
multilateral cooperation was needed to ensure that all
countries, especially low-income countries, benefit
from growing globalization.g
In more recent years the G-8 has, for example, agreed
on policy steps regarding forgiveness of part of the external
debt of developing countries. A useful overview of the G-7’s
evolution was provided by Japan’s former vice finance min-
ister, Tomomitsu Oba.h He noted that the character of the
group has changed significantly as Russia and then China
have been invited to the meetings. Brazil, India, South
Africa, and Mexico also attended meetings, and, at the time
of this writing, policy coordination discussions are also now
being conducted under the framework of the Group of 20
(G-20). The G-20 is composed of finance ministers and
central bankers from 19 countries (the G-8 plus Argentina,
Australia, Brazil, China, India, Indonesia, Republic of
Korea, Mexico, Saudi Arabia, South Africa, and Turkey) and
a representative of the European Union. Formed in 1999, it
has no formal power but has regular summits to discuss sig-
nificant world economic developments and offer collective
opinions for action steps.i In April 2009, the G-20 endorsed
additional lending by the IMF to developing countries and
(continued)
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IN THE REAL WORLD: (continued)
agreed on some tightening of regulations pertaining to finan-
cial markets.j In May 2012 the G-8 at their summit commit-
ted “to promote growth and jobs  .  .  .  to take all necessary
steps to strengthen and reinvigorate our economies and
combat financial stresses.”k It is important to note that all
agreed to keep the euro zone intact and Greece as a member.
However, the observation was made that for recommending
correct policy measures, such as austerity versus stimulus,
there was considerable disagreement.l Finally, the G-20 has
lately received more attention than the G-7/G-8, reflecting a
conscious movement toward including developing countries
in official multilateral endorsements of policy. In 2013, the
G-20 agreed that the focus of monetary policy should be on
price stability and growth rather than on depreciating curren-
cies to stimulate growth. However, in 2015 the G-20 stated
that currency depreciation could be a means of promoting
growth. A problem with obtaining agreement within the
G-20 is that the desired focus of the G-20 differs between the
emerging/developing countries and the industrialized coun-
tries. The former wish to focus on external imbalances while
the latter are more concerned with internal balance issues.m
a“Task Force Backs Macroeconomic Policy Coordination,” IMF
Survey, February 4, 1991, p. 33.
bIbid., p. 41.
cIbid.
d“G-7 Leaders Urge Strong IMF-Supported Policies in States of
Former U.S.S.R.,” IMF Survey, July 20, 1992, p. 226.
eDavid Wessel and Jeffrey Birnbaum, “U.S. Lines Up Aid for Russia
at G-7 Meeting,” The Wall Street Journal, July 9, 1993, pp. A3–A4.
fSee “G-7 Offers Proposals to Strengthen Bretton Woods
Institutions,” IMF Survey, July 3, 1995, pp. 201–05.
g“Group of Eight Leaders Focus on Asian Crisis, Monetary
Cooperation, Debt Relief Issues,” IMF Survey, May 25, 1998, 
pp. 157–58.
hTomomitsu Oba, “G7 Reflections,” The International Economy,
Spring 2007, p. 62.
iG20 Information Centre, University of Toronto, at www.g20
.utoronto.ca.
jStephen Fidler, Bob Davis, and Carrick Mollenkamp, “World
Leaders Agree on Global Response,” The Wall Street Journal, April
3, 2009, p. A7.
kG8 Information Centre, University of Toronto, at www.g8
.utoronto.ca.
lIbid.
mCostas Paris, Andrey Ostroukh, and Harriet Torry, “G-20 to Pledge
Not to Target Currencies, “The Wall Street Journal, February 16-17,
2013, p.A8; Ian Talley and Brian Blackstone,” Currency Warriors
Get Boost at G-20,”
The Wall Street Journal. February 11, 2015, pp. A1, A8; Stephen
Grenville, “G20 and International Economic Policy Coordination,”
Asia Pathways, February 21, 2014, available at asia_pathways@
adbi.org. ●
MACROECONOMIC POLICY COORDINATION: THE IMF, THE 
G-7/G-8, AND THE G-20
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SUMMARY
This chapter examined the automatic adjustment process under
flexible exchange rates and the effects of discretionary eco-
nomic policy under different capital mobility assumptions.
It was found that monetary policy is effective in influencing
income under flexible exchange rates, whereas it was inef-
fective under fixed rates. Further, the degree of effectiveness
under flexible rates increases with the degree of capital mobil-
ity. Fiscal policy, on the other hand, was found to be much
less effective under flexible rates than under fixed rates as
capital becomes very mobile internationally, since expenditure-
switching effects dampen the initial effects. The effects of
fiscal policy on national income are the strongest when capital
is immobile. The flexible-rate system does, however, give the
country more policy options than a fixed-rate system because
the external sector is always in balance. If a country wishes to
attain several domestic targets, the coordinated use of monetary
and fiscal policies can be helpful. The chapter concluded with a
discussion of automatic adjustment to exogenous shocks under
a flexible-rate system. The realization that a number of these
shocks are often taking place simultaneously makes one keenly
aware of the difficulties surrounding effective policymaking in
a system of flexible rates.
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KEY TERMS
domestic price shock
foreign interest rate shock
foreign price shock
G-7 countries
G-8 countries
G-20 countries
incipient BOP deficit
incipient BOP surplus
international macroeconomic
policy coordination
monetary policy–fiscal policy
coordination
shock to the expected exchange rate
QUESTIONS AND PROBLEMS
1. What will happen under flexible rates if the intersection of
the IS and LM curves is below (or to the right) of the BP
curve? Why?
2. What exogenous real and financial factors influence the
position of the BP curve?
3. Under what capital mobility conditions is fiscal policy
totally ineffective in influencing income? Explain why this
result occurs.
4. One strong argument for a flexible exchange rate system is
that it frees up monetary policy for use in pursuing domestic
targets. Explain why this is so.
5. Why does monetary policy get a boost from the external
sector under a flexible-rate system?
6. Suppose that policymakers decide to expand the economy by
increasing the money supply. Based on the trade effects, who
do you expect to favor such a policy? Who is likely to be
against this policy? Why?
7. If short-term capital is neither perfectly immobile nor per-
fectly mobile internationally, why is the predicted impact of
expansionary fiscal policy on the exchange rate ambiguous?
8. Explain, using the IS/LM/BP model, how a rise in the
expected appreciation of the foreign currency can lead to
an increase in domestic interest rates.
9. Why might it be argued that recent changes in international
prices of food and energy have had a smaller impact on the
U.S. economy than would have been the case under the pre-
1973 pegged-rate system?
10. “A sudden increase in interest rates in the European Union
would likely lead to both depreciation of the U.S. dollar
and upward pressure on U.S. interest rates.” Agree?
Disagree? Why?
Appendix POLICY EFFECTS, OPEN-ECONOMY EQUILIBRIUM,
AND THE EXCHANGE RATE UNDER FLEXIBLE RATES
The impact of monetary and fiscal policy on macroeconomic equilibrium and the exchange rate
can be demonstrated in a manner similar to that used in the appendix in Chapter 25. Again we are
focusing on the case where capital is relatively mobile. The simultaneous effect of expansionary
fiscal policy on income and the exchange rate is demonstrated in Figure 10, panels (a) and (b).
Expansionary fiscal policy shifts the IS curve to the right (from ISG0,e0 to ISG1,e0), leading to an
increase in income and an upward pressure on interest rates. The increase in interest rates leads to
an incipient surplus in the official reserve transactions balance. However, rather than seeing a BOP
surplus, the increased demand for the domestic currency by foreigners leads to an appreciation of the
currency and an upward shift in the BP curve as exports decline and imports increase. This apprecia-
tion leads to a leftward shift in the IS curve, and the economy settles at a new equilibrium at the inter-
section of BP2, LM, and ISG1,e1. The result of the policy action is a much smaller increase in income
than suggested by the initial fiscal expansion because part of the expansionary effort is counteracted
by the appreciation of the domestic currency as the exchange rate adjusts to maintain equilibrium in
the balance of payments. The exogenous increase in government spending leads to a new EYE curve
(EYEG1), which is to the right of the initial EYE curve (EYEG0)—that is, the equilibrium exchange rate
is lower (home currency is appreciated) for every level of income.
Turning to an expansionary monetary policy action [panels (c) and (d)], we again see that expand-
ing the money supply shifts the LM curve to the right (from LMMS1 to LMMS2), putting downward
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pressure on the interest rate. A falling interest rate will result in a worsening capital account (an
incipient deficit), which is observed as a depreciation of the currency. As the currency depreciates,
the BP curve shifts to the right (from BP1 to BP2) and the IS curve simultaneously shifts out (from
IS1 to IS2). The economy adjusts to a new equilibrium income and interest rate on the new LMMS2
curve where BP2 and IS2 simultaneously intersect LMMS2. The final effect of the monetary policy
action is thus greater than the initial response to the interest rate change because the monetary effect
is complemented by an expansionary effect due to the ensuing depreciation of the currency. The
direct link between the exchange rate and the new equilibrium level of income can be viewed as a
movement along the EYE curve, where the new level of higher income is seen as occurring with a
depreciated currency. Or, stated differently, higher levels of income brought about by the expanded
money supply will necessarily be accompanied by a depreciation of the currency to offset the dete-
rioration in the capital account.
FIGURE 10 Macro Policy and Exchange Rate Changes
i
LM
BP2
BP2
i0
Y0 Y
(a)
i2
i1
Y1 Y2
Y0 Y1
BP1
BP1
i
LMMS1
LMMS2
Y
e
Y0 YY1
(c)
(b)
0
0
0
ISG0,e0
ISG1,e1
ISG1,e0
i1
i0
e1
e0
IS1
IS2
EYEG0
EYEG1
e
Y0 YY1
(d)
0
e1
e0
EYE
Expansionary fiscal policy in panel (a) shifts ISG0,e0 to ISG1,e0, leading to a higher income level, a higher interest rate, and an incipient BOP
surplus; the resulting appreciation of the home currency shifts BP1 to BP2 and ISG1,e0 to ISG1,e1. In panel (b), each level of equilibrium income
is now associated with a lower e along the new EYEG1 schedule. Expansionary monetary policy in panel (c) generates a lower interest rate and
higher income, which in turn lead to a depreciation of the home currency and a consequent shift of BP1 to BP2 and of IS1 to IS2. In panel (d), the
increase in income from Y0 to Y1 has been accompanied by a rise in e.
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673
app9062x_ch27_673-700.indd 673 06/23/16 10:22 AM
CHAPTER
LEARNING OBJECTIVES
LO1 Explain the concepts and interaction of aggregate demand and aggregate
supply in the closed economy.
LO2 Explain the concepts and interaction of aggregate demand and aggregate
supply in the open economy.
LO3 Distinguish between short-run and long-run effects of macro policies on
output and prices under fixed and flexible exchange rates.
LO4 Demonstrate how economic shocks and policies affect prices and output.
PRICES AND OUTPUT
IN THE OPEN
ECONOMY
Aggregate Supply and Demand
27
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INTRODUCTION
The Argentine economy suffered a severe economic crisis during 2001 and 2002. Research by
Murphy, Artana, and Navajas1 indicates that poverty stretched to one in every three homesteads
in the suburbs of Buenos Aires. In addition, the combination of a traumatic departure from con-
vertibility of the peso into dollars, a financial crisis, and public debt default undermined local
and foreign investor confidence. Murphy, Artana, and Navajas believe that the crisis owed its
existence to four main causes:
1. Inappropriate fiscal policy.
2. Wage and price rigidities inconsistent with a fixed exchange rate.
3. A considerable, adverse external shock.
4. Political turmoil.
The Argentine situation had parallels in the recent 2007–2009 worldwide recession’s
impacts on developing countries. The crisis hit some of the world’s least developed countries
hard and offset some of the income gains they had recently attained. Dominique Strauss-Kahn,
managing director of the International Monetary Fund at the time, indicated in early 2009 that
the financial difficulties in developed countries had triggered recessions that reduced demand
for imports from low-income countries and that many low-income countries would see stagna-
tion or even decline in their per capita incomes. The external shocks were also creating budget-
ary crises and could produce large humanitarian costs that might well lead to political unrest
and conflict.2
This chapter focuses on the framework necessary to examine the effect of policy actions
and external shocks (like those in Argentina) on prices and output in both fixed and flexible
exchange rate systems. The analysis of the open economy up to this point has proceeded
under the assumption that expansion and contraction of the macroeconomy would take
place without affecting the level of prices. Although the comparative statics of a change in
prices were examined in terms of the macroeconomic adjustment that would accompany
such an exogenous shock in the previous chapter, no attempt was made to incorporate price
changes endogenously into the analysis. Because changes in prices are a very important
aspect of economic activity in the open economy, it is imperative to consider the interac-
tion between the foreign sector and the domestic price level in the open macroeconomy.
We will pursue this line of analysis using an aggregate demand and supply framework that
incorporates the effects of trade and financial flows. The presentation begins by reviewing
the concepts of aggregate demand and supply in the closed economy, taking into account
differences between short-run and long-run effects. We then open the economy and exam-
ine the effects of international transactions on the aggregate demand and supply curves
under fixed exchange rates and flexible exchange rates. The chapter concludes with a dis-
cussion of monetary and fiscal policy in the open-economy demand and supply framework
and of the responsiveness of the economy to various shocks. Consideration of the price
level complicates policy problems and, consequently, the design of effective macroeco-
nomic policy. In the long run, measures that increase aggregate supply are paramount for
increasing national income.
Crisis in Argentina
1This discussion is drawn from Ricardo Lopez Murphy, Daniel Artana, and Fernando Navajas, “The Argentine
Economic Crisis,” Cato Journal 23, no. 1 (Spring/Summer 2003), pp. 23–28.
2“Economic Crisis Starts to Hit World’s Poorest Countries,” IMF Survey Magazine, March 3, 2009, obtained
from www.imf.org.
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CHAPTER 27 PRICES AND OUTPUT IN THE OPEN ECONOMY 675
app9062x_ch27_673-700.indd 675 06/23/16 10:22 AM
FIGURE 1 Derivation of the Aggregate Demand Curve in the Closed Economy
Y3Y2Y1 Y0
i
i0
Y3Y2Y1Y0 Y
P
(b)(a)
i1
i2
i3
P0
P1
P2
P3
LM0 (P0)
LM1 (P1)
LM2 (P2)
LM3 (P3)
IS
AD
Y 0 0
Starting at Y0 and i0 in panel (a), increases in the price level reduce the real money supply, shifting the LM curve to the left. Therefore, a particular
LM curve is associated with each higher price level (e.g., LM1 for P1, LM2 for P2). With each new, higher price level, Pi, there is a new, lower
equilibrium level of income Yi determined by the intersection of the LMi and the IS curve (e.g., for P0, Y0; for P2, Y2; and so on). These pairs of
price levels and equilibrium income levels are now plotted on a different graph in panel (b), with price levels measured on the vertical axis and
real income levels represented on the horizontal axis. Because successively lower equilibrium levels of income are associated with successively
higher price levels, a normal downward-sloping aggregate demand curve results.
AGGREGATE DEMAND AND SUPPLY IN THE CLOSED ECONOMY
We begin by reviewing the link between aggregate demand and prices in the closed mac-
roeconomy. In Chapter 25 income and interest rate equilibrium was described using the IS
and LM curves to portray equilibrium in the real sector and the money market, assuming that
prices were constant. From the demand perspective, macroeconomic equilibrium takes place
at the level of income and the interest rate determined by the intersection of the IS and LM
curves. What happens to equilibrium in this model when prices change? Because equilib-
rium in the goods sector is measured in real terms, price changes do not directly affect the
IS curve. Changes in price do, however, affect the size of the real money supply, Ms/P. As the
price level rises, the demand for money increases and the real money supply declines, which
will have the effect of shifting the LM curve to the left. Such a shift is shown in Figure 1(a)
by four LM curves (LM0, LM1, LM2, LM3) associated with four different price levels, where
P0 < P1 < P2 < P3. Associated with each price level is an equilibrium level of income, Y0, Y1, Y2, and Y3. The higher the price level, the lower the equilibrium level of income. The level of prices and the corresponding equilibrium level of income can be used to generate an aggregate demand curve in panel (b). Note that the vertical axis measures the price level and not the interest rate, while the level of real income is still measured on the horizontal axis. When the price level–equilibrium income coordinates are plotted, they produce a normal downward-sloping aggregate demand curve (AD), which shows the level of real output demanded at each price level. The slope of the AD curve is determined jointly by the slopes of the IS and the LM curves. The more elastic these curves are, the more elastic the AD curve is. Any change in the slope of either the IS or the LM curve will lead to a similar change in slope of the AD curve. Aggregate Demand in the Closed Economy Final PDF to printer 676 PART 6 MACROECONOMIC POLICY IN THE OPEN ECONOMY app9062x_ch27_673-700.indd 676 06/23/16 10:22 AM Condition Outcome Possible Cause Slope of Aggregate Demand: Flatter IS or LM More elastic AD Decrease in tax rate, increase in elasticity of demand for money Steeper IS or LM Less elastic AD Decrease in responsiveness of investment to the interest rate Position of Aggregate Demand: IS shifts right Rightward shift in AD Increase in government spending IS shifts left Leftward shift in AD Decrease in autonomous investment LM shifts right Rightward shift in AD Expansionary monetary policy LM shifts left Leftward shift in AD Contractionary monetary policy TABLE 1 Factors Affecting Aggregate Demand Similarly, the position of the AD curve is determined by the positions of the IS and LM curves. If the IS curve shifts to the right, it will lead to higher equilibrium levels of income for each respective price level. Consequently, a rightward (leftward) shift in the IS curve will lead to a rightward (leftward) shift in the AD curve. For example, an increase in gov- ernment spending or domestic investment will lead to a rightward shift in the IS curve and hence in the AD curve. An increase in the tax rate would make the IS curve steeper and hence the AD curve steeper. Because it is changes in the nominal money supply (for given price levels) that shift the LM curve, an increase in the money supply shifts the LM curve to the right and, ceteris paribus, leads to higher equilibrium income and hence a rightward shift in the AD curve. Contractionary monetary policy would, on the other hand, lead to a leftward shift in the AD curve. These results are summarized in Table 1. Finally, any change in the transactions demand for money or in the asset demand for money would lead to a change in slope and/or position of the LM curve and therefore a change in slope and/or position of the AD curve, the details of which are not critical for this chapter. Aggregate domestic supply is determined by the level of technology, the relative quantity of available resources, the level of employment of those resources, and the efficiency with which they are used. In the short run, factors such as the level of capital, natural resources, and technology are assumed to be fixed. This leaves labor as the principal variable input that firms hire to maximize expected profits. In this situation, the representative firm will maximize profits where marginal cost equals marginal revenue. In the case of labor, this means hiring labor up to the point where the marginal factor cost (which equals the nominal wage rate with competitive labor markets) is equal (with competitive product markets) to the marginal product of labor times the price of the output (marginal revenue product). The nominal value of the additional worker is thus determined by the productivity of labor and the price level. The relationship between labor and output can be represented by an aggregate production function such as that in panel (a) of Figure 2. Real output is shown to vary positively with labor employed, given the level of technology and the fixed avail- ability of other inputs such as level of capital stock. The shape of the curve indicates that the marginal productivity of labor declines with additional employment of the labor input, because each successive unit of labor contributes less to output than the unit preceding it. The slope of the production function is the marginal physical pro- ductivity of labor (MPPN), which is plotted in panel (b). The decreasing productivity of labor causes the MPPN schedule to have a downward slope. Multiplying MPPN by Aggregate Supply in the Closed Economy Final PDF to printer CHAPTER 27 PRICES AND OUTPUT IN THE OPEN ECONOMY 677 app9062x_ch27_673-700.indd 677 06/23/16 10:22 AM different levels of prices produces different marginal revenue product curves of labor (MRPN0, MRPN1, MRPN2). Inasmuch as these MRPN curves show the value of labor to producers at different levels of employment and prices, they can each be viewed as an aggregate demand curve for labor. Given a particular wage rate, one can immediately see the level of employment that will lead to a maximization of profits, ceteris paribus. For example, if the wage rate is W0 and the price level is P0, the desired level of employment is N0. It is also apparent that if the price level changes, the MRPN curve will change. An increase in prices will cause the MRPN to shift to the right, and a decrease in prices will cause it to shift to the left. Thus, for a fixed wage rate, W0, an increase in the price level leads to a rightward shift in the MRPN curve and hence to a higher level of employment and output. A reduction in the price level leads to a leftward shift in the MRPN curve and to a reduction in the optimal level of employment and output. If we now plot these combinations of different price levels and equilibrium output at the wage W0, we obtain the upward-sloping short-run aggregate supply curve (see Figure 3). It needs to be noted that the marginal revenue product can also be altered by changes in the factors normally held constant, for example, changes in technology, changes in the level of capital stock, or changes in managerial efficiency. These changes are commonly viewed as long-run changes, as opposed to the short-run change brought about by the change in price level. The aggregate supply curve in Figure 3 was derived assuming that firms could hire all the labor they wished, up to full employment, at the fixed wage W0. However, microeconomic FIGURE 2 Aggregate Production and the Demand for Labor Y2 N (b)(a) W, MPPN MRPN2 MRPN0 MRPN1 MPPN W0 Y0 Y1 Y N2 N0 N1 N2 N0 N1 MRPN N 0 0 Y= f (N) The aggregate production function is represented in panel (a). Given the level of technology and a fixed amount of other inputs, aggregate output is determined by the level of employment of labor, N. The decreasing slope of the production function indicates that the marginal product of each successive worker is getting smaller. The marginal physical product of labor (MPPN) is then plotted against level of employment N in panel (b). If the MPPN is multiplied by the price level P, the resulting marginal revenue product (MRPN) indicates the value of using that particular unit of labor in production and is, therefore, the derived demand curve for labor. To maximize profits, producers should employ labor up to N0, where the wage rate W0 is equal to the MRPN0 when prices are P0, N1 when prices are P1, etc. Note that an increase in the price level to P1 (decrease to P2) leads to a higher (lower) MRP of labor and hence to greater (less) employment and output. Final PDF to printer 678 PART 6 MACROECONOMIC POLICY IN THE OPEN ECONOMY app9062x_ch27_673-700.indd 678 06/23/16 10:22 AM theory and practical experience indicate that while that assumption may hold in labor sur- plus economies, in industrialized economies with relatively high levels of employment, an increase in the quantity of labor supplied can be obtained in the short run only by increas- ing the wage rate. This line of thinking sees the labor supply curve as an upward-sloping curve, and not as a horizontal line as at W0 in Figure 2(b). Its slope and position are influ- enced by such factors as the value of leisure, institutional factors, the characteristics of the labor force, and expectations regarding prices. Labor market equilibrium with an upward-sloping aggregate supply curve of labor is shown in Figure 4(a), with an initial equilibrium at W0 and N0. If we again increase the price level, output increases, but not as greatly as it did when the labor supply curve was hori- zontal. Thus, we again get an upward-sloping aggregate supply curve of output [panel (b)], but it is now steeper than it was with the horizontal labor supply curve. In general, the greater the increase in wages necessary to attract the additional labor, the steeper the short- run aggregate supply curve of labor in Figure 4(a) will be. It is generally accepted in the macroeconomics and labor economics literature that the quantity of labor supplied depends ultimately on the real wage received, and not on the money wage. Because the aggregate supply curve of labor is drawn under a given level of price expectations, changes in the price level that affect price expectations will cause the labor supply curve to shift—once workers realize that prices have changed. The realiza- tion that prices are higher than expected will lead labor to demand a higher nominal wage so that the same amount of labor is being provided at the same real wage. In other words, nominal wage increases eventually offset the increase in prices as workers adjust their wages to the new level of expected prices. The worker adjustment to higher prices is shown in Figure 5. An increase in price leads to a new MRP′N and a higher level of employment and income. However, once workers realize that prices are higher than expected, they increase their wage demands, shifting the short-run supply curve of labor to the left (S′N) until it intersects MRP′N at the original equi- librium level of employment. Thus, if labor is given sufficient time to respond, an increase FIGURE 3 The Aggregate Supply Curve with a Fixed Wage P2 Y AS P0 P1 P Y20 Y0 Y1 In panel (b) of Figure 2, higher price levels lead to increased demand for labor as producers hire labor so as to maximize profits for a given wage rate W0. Higher levels of employment, such as N1, lead to a higher level of output Y1 [in Figure 2(a)]. If we now plot the level of prices against the resulting level of income at the level of employment that maximizes profits (e.g., Y1, P1; Y0, P0), an upward-sloping aggregate supply curve results. Final PDF to printer CHAPTER 27 PRICES AND OUTPUT IN THE OPEN ECONOMY 679 app9062x_ch27_673-700.indd 679 06/23/16 10:22 AM FIGURE 4 Variable Wages and the Aggregate Supply Curve W2 N (b)(a) W, MRP SN Y 0 0 MRP1 MRP0 AS P2 W0 W1 N2 N0 N1 Y2 Y0 Y1 P0 P1 P MRP2 In panel (a), the labor market is characterized by a more typical upward-sloping supply curve of labor, instead of the infinitely elastic supply curve used in Figure 2(b). As a result, the increases in the MRPN brought about by the increases in the price level lead to smaller increases in output compared with the previous case. Hence, the aggregate supply curve presented in panel (b) above will be steeper than the AS curve in Figure 3. The greater the wage increase required to increase the quantity supplied of labor, the steeper the AS curve. FIGURE 5 Labor Market Adjustment to Higher Prices W0 N0 W, MRP SN W1 W2 N0 N1 S'N MRPN MRP'N An initial increase in prices increases the MRP of labor to MRP′N, stimulating a short-run increase in employment (from N0 to N1), income, and wages (from W0 to W1). However, because the labor supply is determined by the real wage and not the money wage, once workers realize that prices have risen, they alter their wage demands (shift the labor supply curve vertically upward) until they again are offering the same amount of labor at the same real wage as previously, that is, N0 at W2 given the new price level. After sufficient time has passed for labor to adjust to the new price level, the labor market is again in equilibrium at the initial level of employment N0. Final PDF to printer 680 PART 6 MACROECONOMIC POLICY IN THE OPEN ECONOMY app9062x_ch27_673-700.indd 680 06/23/16 10:22 AM in the price level simply leads to an offsetting increase in nominal wages and no real effect on employment and output. The longer labor takes to adjust its wage demands (the stick- ier wage movements are), the greater the short-run effect of price changes on output and employment. However, if wage demands change as quickly as prices (which takes place under the rational expectations assumption, where price changes are fully anticipated), then a price increase produces no change in real output or employment. The employment of labor is constant, and the aggregate supply curve is vertical both in the short run and in the long run at the initial equilibrium level— sometimes referred to as the natural level of employment (i.e., the level of employment at which the actual price level equals the expected price level by workers). Note that the natural level of employment need not cor- respond with some society-defined level of full employment (e.g., 95 percent employment or 5 percent unemployment). The equilibrium level of income associated with the natural level of employment is designated the natural level of income. There is considerable debate among macroeconomic theorists about whether wages are in fact sticky and about the length of the possible adjustment lag in the labor mar- kets. Keynesians postulate a longer adjustment period due to various rigidities and market imperfections than do the Monetarists, and therefore a greater role for discretionary policy. The New Classical writers, a school of writers that emerged in the 1970s, generally adopt a rational expectations assumption, which leads to nominal wages rising as fast as prices. In this framework, workers immediately perceive the impact on real wages of any event that was anticipated and immediately act to maintain the same real wage. Consequently, a vertical short-run–long-run aggregate supply curve results. Hence, while most concur that the long-run aggregate supply curve of output is vertical at the natural level of income, there is a difference of opinion about the existence of a nonvertical short-run aggregate supply curve and the extent to which there is a short-run response of output to prices. Finally, increases in the natural level of employment and output are stimulated by changes in technology, increased quantities of capital, more efficient management, and growth in the supply and quality of the labor force. Given the aggregate demand and the short-run and long-run aggregate supply curves, we can now examine equilibrium in the closed economy. Aggregate supply–aggregate demand equilibrium occurs where all three curves (ASLR, ASSR0, AD0) intersect, for exam- ple, P0 and Y0 in Figure 6. Suppose that from this position there is an increase in aggregate demand due to an increase in government spending or an increase in the money supply. This will cause the aggregate demand curve to shift to the right. As this takes place, there will be an increase in the level of prices and a short-run increase in income as the economy moves to the new short-run equilibrium P1, Y1. This, of course, assumes that labor does not demand an instant adjustment in the nominal wage. Once labor alters its expectation about the level of prices, wages begin to rise as the short-run supply curve shifts vertically upward. This will continue until the new aggregate demand curve (AD1), the long-run supply curve (ASLR), and the new short-run supply curve (ASSR1) all intersect at a common point (P2, Y0). At that price level, actual prices are equal to the expected prices on which the short-run supply curve is based. Although this new aggregate supply–aggregate demand equilibrium will be at the same natural level of output Y0 (and employment), the increase in demand will have generated a higher level of prices P2 and will have had only a temporary effect on aggregate output. The adjustment of output from Y0 to Y1 and back to Y0 is indi- cated by an arrow in Figure 6. The only way that a permanent change in the natural rate of output and employment can occur is if there is a change in basic underlying variables such as technology or the level of capital stock. For expansionary economic policy to have any permanent effect on income and output rather than only to increase prices, it must change one or more of these underlying variables. Equilibrium in the Closed Economy Final PDF to printer CHAPTER 27 PRICES AND OUTPUT IN THE OPEN ECONOMY 681 app9062x_ch27_673-700.indd 681 06/23/16 10:22 AM FIGURE 6 Equilibrium in the Closed Economy P0 Y0 P P1 P2 Y0 Y1 ASLR AD1 AD0 ASSR 1 ASSR 0 The initial equilibrium occurs at the point where AD0, ASLR, and ASSR0 intersect at Y0, P0. Expansionary forces in the economy shift the AD curve rightward to AD1, increasing prices to P1 and income to Y1 (assuming that wage increases lag behind price increases). When workers realize that the price level has risen, altering their price expectations, wages begin to rise as the short-run aggregate supply curve shifts up. This will continue until the actual price level again equals the expected price level, which now occurs at P2, Y0 (the intersection between ASLR, ASSR1, and AD1). The only way to increase income in the long run is to shift ASLR to the right through accumulation of capital, changes in technology, and so on. IN THE REAL WORLD: U.S. ACTUAL AND NATURAL INCOME AND UNEMPLOYMENT Table 2 contains 1970–2014 figures for U.S. actual real GDP, estimates of the natural levels of GDP, and the actual and estimated natural unemployment rates. The data come from the Federal Reserve Economic Data (FRED) source at the Federal Reserve Bank of St. Louis, and the natural estimates are those of the Congressional Budget Office (CBO). The estimates of the natural level of GDP (called “potential GDP” by the CBO) are based on the natural rate of unemployment, and the CBO defines the natural rate of unemployment as the unemployment rate that results from all sources except for fluctuations in aggregate demand. The actual levels of income were below the natural or potential levels in 1970 and 1971, from 1974 through 1977, and from 1980 through 1987. They were above the natu- ral levels in 1978 and 1979 and from 1998 through 1990. A recession occurred in 1991, and the actual levels were below the natural levels of output from 1991 through 1997. Expansion in the economy drove the actual GDP above potential GDP in 1998–2000; it then dipped below the natu- ral GDP level from 2001 to 2004 and rose slightly above the natural level in 2005 and 2006. The financial crisis that began in 2007 resulted in the actual output level falling below the natural output level from 2007 onward, even dur- ing the recovery after 2009. The actual/natural unemployment rate relationship did not precisely mesh with the actual/natural GDP  relationship— the years when the actual unemployment rate was above the natural unemployment rate were not the same as the years when actual GDP was below natural/potential GDP. The actual unemployment rate exceeded the natural rate in 1971, 1975–1977, 1980–1987, 1991–1996, 2002–2005, and 2008 and later. In 1997–2001, the actual unemployment rate was below the natural rate of unemployment, sometimes sub- stantially so. (continued) Final PDF to printer IN THE REAL WORLD: (continued) U.S. ACTUAL AND NATURAL INCOME AND UNEMPLOYMENT Real GDP* Unemployment Rates Real GDP* Unemployment Rates Year Actual Natural Actual Natural Year Actual Natural Actual Natural 1970 $4,722.0 $4,750.0 5.0% 5.9% 1993 $ 9,521.0 $ 9,751.8 6.9% 5.5% 1971 4,877.6 4,905.6 6.0 5.9 1994 9,905.4 10,051.8 6.1 5.4 1972 5,134.3 5,062.0 5.6 6.0 1995 10,174.8 10,383.5 5.6 5.3 1973 5,424.1 5,234.2 4.9 6.1 1996 10,561.0 10,729.9 5.4 5.2 1974 5,396.0 5,427.4 5.6 6.2 1997 11,034.9 11,089.9 4.9 5.1 1975 5,385.4 5,623.9 8.5 6.2 1998 11,525.9 11,471.4 4.5 5.1 1976 5,675.4 5,810.7 7.7 6.2 1999 12,065.9 11,869.1 4.2 5.0 1977 5,937.0 6,006.8 7.1 6.2 2000 12,559.7 12,288.6 4.0 5.0 1978 6,267.2 6,225.5 6.1 6.3 2001 12,682.2 12,740.9 4.7 5.0 1979 6,466.2 6,446.8 5.9 6.3 2002 12,908.8 13,171.9 5.8 5.0 1980 6,450.4 6,616.7 7.2 6.2 2003 13,271.1 13,559.4 6.0 5.0 1981 6,617.7 6,762.6 7.6 6.2 2004 13,773.5 13,901.1 5.5 5.0 1982 6,491.3 6,952.5 9.7 6.1 2005 14,234.2 14,234.0 5.1 5.0 1983 6,792.0 7,159.8 9.6 6.1 2006 14,613.8 14,585.0 4.6 5.0 1984 7,285.0 7,382.4 7.5 6.0 2007 14,873.7 14,930.0 4.6 5.0 1985 7,593.8 7,632.5 7.2 6.0 2008 14,830.4 15,244.7 5.8 5.0 1986 7,860.5 7,890.4 7.0 6.0 2009 14,418.7 15,504.1 9.3 5.1 1987 8,132.6 8,147.4 6.2 6.0 2010 14,783.8 15,691.9 9.6 5.2 1988 8,474.5 8,406.5 5.5 5.9 2011 15,020.6 15,898.4 8.9 5.3 1989 8,786.4 8,669.9 5.3 5.9 2012 15,354.6 16,130.1 8.1 5.3 1990 8,955.0 8,938.8 5.6 5.9 2013 15,583.3 16,368.5 7.4 5.2 1991 8,948.4 9,210.1 6.9 5.8 2014 15,961.7 16,614.6 6.2 5.1 1992 9,266.6 9,478.2 7.5 5.7 TABLE 2 Actual and Natural Income and Unemployment in the United States, 1970–2014 *Billions of 2009 chained dollars. Source: Federal Reserve Economic Data (FRED), available at https://research.stlouisfed.org. ● 682 PART 6 MACROECONOMIC POLICY IN THE OPEN ECONOMY app9062x_ch27_673-700.indd 682 06/23/16 10:22 AM CONCEPT CHECK 1. Why does an increase in the price level lead to a lower equilibrium income in the IS-LM framework? What determines the slope of the resulting aggregate demand curve? 2. Why does an increase in the price level lead to both an increase in the demand for labor and a decrease (vertically upward shift) in the supply curve of labor? Do these shifts take place simultaneously? 3. What is meant by the natural level of income and employment? AGGREGATE DEMAND AND SUPPLY IN THE OPEN ECONOMY Opening the economy clearly affects the aggregate demand curve. Although there are pos- sible long-run supply effects through international investment flows, technological innova- tions, and improved management techniques, from a policy standpoint the opening of the Final PDF to printer CHAPTER 27 PRICES AND OUTPUT IN THE OPEN ECONOMY 683 app9062x_ch27_673-700.indd 683 06/23/16 10:22 AM economy has considerably greater implications for short-term and medium-term aggre- gate demand. Consequently, we will focus on the nature of aggregate demand in the open economy under fixed and flexible exchange rates.3 In this exercise, it will be assumed that capital is relatively mobile internationally (but not perfectly mobile) for the country in question; that is, the BP curve is upward sloping and flatter than the LM curve. When the economy is opened, the discussion of aggregate demand must consider not only domestic equilibrium in the goods market (the IS curve) and the money market (the LM curve) but also equilibrium in the foreign sector (the BP curve). Such an initial equilibrium (i0, Y0) is shown in Figure 7(a).To obtain the domestic aggregate demand curve under fixed exchange rates [panel (b)], suppose prices increase. The increase reduces the real money supply and causes the LM curve to shift to the left. In addition, however, the increase in the domestic price level alters relative prices with trading partners as exports become more expensive and imports become relatively cheaper. The increase in the domestic price level thus leads to an expansion of imports and a contraction of exports. The change in relative prices causes the BP curve to shift to the left, because it now will take a higher level of the interest rate to gen- erate the needed net short-term capital inflow to offset the deteriorating trade balance. The deterioration in the trade balance—that is, the expansion of imports and the contraction of Aggregate Demand in the Open Economy under Fixed Rates 3When a country imports intermediate inputs, the aggregate supply curve in the open economy also depends on the exchange rate. A depreciation of the home currency would shift aggregate supply curves leftward due to the higher domestic prices of imported intermediate inputs, and an appreciation would shift them to the right for the opposite reason. FIGURE 7 Aggregate Demand in the Open Economy under Fixed Rates i i0 Y0 0 P (b)(a) Y1 Y0 Y1 Y0 i1 P0 P1 LMP1 AD Y BPP1 BPP0 ISP1 IS P0 LMP0 With the initial price level P0, equilibrium occurs at i0 and Y0. An increase in the price level to P1 causes (1) the LM curve to shift to LMP1 due to the decline in the real money supply; (2) the BP curve to shift up to BPP1, as foreign goods become relatively cheaper and domestic exports become relatively more costly; and (3) the IS curve to shift left to ISP1, as the current account deteriorates. The new equilibrium will occur at the intersection of ISP1, LMP1, and BPP1 at Y1 and i1. Should the intersection of ISP1 and LMP1 initially be above or below BPP1, the balance of pay- ments will not be in balance and pressure on the exchange rate occurs. As the central bank acts to maintain the exchange rate, the domestic money supply changes, shifting the LM curve into equilibrium at i1 and Y1. When the two price levels P0 and P1 are plotted against the two equilibrium levels of income Y0 and Y1 in panel (b), a downward-sloping aggregate demand curve AD results. Final PDF to printer 684 PART 6 MACROECONOMIC POLICY IN THE OPEN ECONOMY app9062x_ch27_673-700.indd 684 06/23/16 10:22 AM exports—will also cause the IS curve to shift to the left. In sum, increasing the level of prices causes the LM curve to shift left (LMP1), the BP curve to shift left (BPP1), and the IS curve to shift left (ISP1). Price increases thus lead not only to a decrease in the real money supply but also to changes in relative prices and hence in the demand for real domestic output. With all three markets adjusting to the change in the level of prices, what will guaran- tee that a new equilibrium will result? How can we be certain that the three curves will again intersect at a common point? The change in relative prices will lead to new IS and BP curves, consistent with the new price level. If the intersection between the ISP1 and the LMP1 is not on the BPP1 curve, then there will be disequilibrium in the balance of pay- ments (official reserve transactions balance). If they intersect above the BPP1 curve, then a balance-of-payments surplus will result. Under fixed rates, a surplus will lead to an expan- sion in the money supply (assuming no sterilization) as the central bank purchases foreign exchange with domestic currency to maintain the pegged exchange rate. Consequently, the LM curve will shift right until there is no longer a surplus in the balance of payments and the economy is once again in equilibrium. Similarly, should ISP1 and LMP1 intersect at a point below the BPP1 curve, a balance-of-payments deficit will occur. As the central bank seeks to maintain the pegged value of the currency by selling foreign exchange for domes- tic currency, the money supply declines (with no sterilization), shifting the LM curve even further to the left. This continues until ISP1, LMP1, and BPP1 intersect at a common point. Central bank intervention to maintain the value of the currency thus will automatically cause the LM curve to move to the new equilibrium point, which must lie on BPP1. The aggregate demand curve in the open economy under a flexible-rate system is obtained in the same manner. Increases in the domestic price level lead to leftward shifts in the LM, IS, and BP curves, just as in the case of fixed exchange rates.4 The principal difference between fixed and flexible rates lies in the adjustment process once the change in domestic prices has affected the three markets. If the leftward shifts in the three curves do not initially produce a new equilibrium—that is, the intersection of ISP1 and LMP1 is not on the BPP1 curve—the balance of payments will not be in equilibrium. If this occurs, there will either be an incipient BOP surplus (if the new IS-LM equilibrium is above the new BP curve) or an incipient BOP deficit (if the IS-LM equilibrium is below the new BP curve). In the case of an incipient surplus, the exchange rate will appreciate, shifting both the BP curve and the IS curve even further left. This adjustment will continue until simultaneous equilibrium is once again attained in all three markets. This adjustment process and the resulting new equilibrium are shown in Figure 8(a). Note that under flexible rates, any needed adjustment to the LM shift takes place in the foreign sector and the goods markets. If the price increase had produced an incipient deficit instead, then the currency would have depreciated, lead- ing to rightward shifts in the IS and BP curves until equilibrium is once again attained. Regardless of the adjustment process, an increase in prices leads to a decline in equilib- rium income, producing the normal downward-sloping aggregate demand curve [panel (b) of Figure 8]. Because of the nature of the further BP shift and its repercussions on IS after the initial shifts in these curves under flexible exchange rates (in contrast to the LM shifts under fixed rates), the aggregate demand curve in the open economy under flexible exchange rates might well have a different degree of negative slope than under a fixed-rate system. Aggregate Demand in the Open Economy under Flexible Rates 4The determination of the precise effect of price-level changes on the LM curve is considerably more complicated with flexible rates than with fixed rates. The reason is that, as the exchange rate changes, this will alter the domes- tic prices of imported goods, and these prices are part of the domestic price level. Thus changes in the exchange rate itself can affect the position of the LM curve. However, this factor does not alter the normal direction of shift of LM in response to price-level changes. Final PDF to printer CHAPTER 27 PRICES AND OUTPUT IN THE OPEN ECONOMY 685 app9062x_ch27_673-700.indd 685 06/23/16 10:22 AM THE NATURE OF ECONOMIC ADJUSTMENT AND MACROECONOMIC POLICY IN THE OPEN-ECONOMY AGGREGATE SUPPLY AND DEMAND FRAMEWORK In the open economy, any factor that affects the IS curve, the LM curve, or the BP curve can potentially influence the aggregate demand curve. The way it influences the AD curve depends, however, on whether there are fixed or flexible rates. For example, an increase in the foreign price level will stimulate domestic exports and reduce domestic imports. This has the effect of stimulating income as the BP curve and the IS curve both shift to the right due to the improvement in the current account. Under a fixed-rate system, this would pro- duce a balance-of-payments surplus, which will lead to an expansion of the money supply and a further expansion in the economy. The end result, then, would be a rightward shift of the AD curve. Under flexible rates, however, the incipient surplus that accompanies the improvement in relative prices will lead to an appreciation of the home currency. This change in the exchange rate neutralizes the initial increase in foreign prices. As the appre- ciation takes place, the BP and IS curves shift back to the initial equilibrium. There is thus no lasting effect of the initial change in relative prices under a flexible-rate system and no permanent change in the AD curve. We can generalize from this example and see that any shock originating in the foreign trade sector or current account will have an effect on the AD curve under fixed rates but not under completely flexible rates. A shock originating in the foreign financial sector or capital/financial account has a dif- ferent effect in this model. Suppose there is an increase in the foreign interest rate. This will Shifts in the Aggregate Demand Curve under Fixed and Flexible Rates FIGURE 8 Aggregate Demand in the Open Economy under Flexible Rates LMP1 LMP0 BPe1, P1 BPe0, P1 BPe0, P0 ISe0, P0 ISe0, P1 ISe1, P1 Y1 Y0 Y i0 i1 i Y1 Y0 P P1 P0 Y0 0 AD (b)(a) Starting from equilibrium at Y0 and i0 in panel (a), an increase in the price level from P0 to P1 reduces the real money supply, shifting the LM curve to LMP1. It also raises the relative price of domestic products, leading to an upward shift in the BPe0, P0 curve to BPe0, P1 and a leftward shift in the ISe0, P0 curve to ISe0, P1 as the current account deteriorates. Should the new IS and LM curves not intersect on BPe0, P1, there will be either an incipient surplus or an incipient deficit and the exchange rate will adjust (causing the IS and the BP curves to further adjust) until the system is in equilibrium at Y1 and i1 (in the case of ISe1, P1, LMP1, and BPe1, P1). When the old and the new levels of equilibrium income corresponding to the two price levels are plotted [panel (b)] against the two price levels, the downward-sloping aggregate demand curve AD is obtained. Final PDF to printer 686 PART 6 MACROECONOMIC POLICY IN THE OPEN ECONOMY app9062x_ch27_673-700.indd 686 06/23/16 10:22 AM stimulate an outflow of short-term capital from the home country, producing either a defi- cit under fixed rates or an incipient deficit under flexible rates. In the fixed-rate case, the financial shock will cause the BP curve to shift to the left and the LM curve to shift to the left as the central bank responds to the new deficit pressure. Hence the AD curve will shift to the left. In the case of flexible rates, the shift in the BP curve will produce an incipient deficit, which will cause the home currency to depreciate. As the depreciation takes place, it will stimulate exports and reduce imports, leading to a rightward shift in both the IS func- tion and the BP curve along the fixed LM curve. As a result, the AD curve will shift to the right. The AD curve shifts under either system, but in opposite directions due to the differ- ent nature of the adjustment in each case. Of course, remembering portfolio balance con- siderations, the increase in the foreign interest rate would also reduce the domestic demand for money, causing the LM curve to shift to the right. This would lead to an even greater rightward shift of the AD curve under flexible rates and an even greater leftward shift of the AD curve under fixed rates (as the BOP deficit to be adjusted to would be even greater). Now consider the effect of domestic shocks originating in the real sector. A change in a variable that affects the real sector and the current account will cause a change in aggre- gate demand under fixed rates but will have little effect under flexible rates. For example, suppose that there is a shift in tastes and preferences of home consumers away from for- eign automobiles toward domestically produced automobiles. This change in the “state of nature” would cause the IS curve to shift out (due to the decline in autonomous imports) and cause the BP curve to shift to the right as well. Under fixed rates, this will create a surplus in the balance of payments, leading to an expansion in the money supply and a rightward shift in the LM curve. This adjustment will take place until all three sectors are again in equilibrium at a higher level of income and will result in a rightward shift in the AD curve. Under flexible rates, however, the incipient surplus resulting from the change in tastes and preferences will lead to appreciation of the home currency. As the currency appreciates, the BP curve and the IS curve will both shift back to the left as the appreciation of the currency adjusts for the change in tastes and preferences. Consequently, there will be less overall change in aggregate demand once the expenditure-switching adjustment has taken place under flexible rates relative to fixed rates. Changes in a domestic financial variable also generate different effects under the two systems. Suppose there is an exogenous shift of preferences in desired portfolio composi- tion by domestic citizens toward domestic short-term investments and away from foreign short-term investments. The immediate effect of this change will be a rightward shift in the BP curve, due to the reduced outflow of short-term capital, creating a surplus in the bal- ance of payments under fixed rates and an incipient surplus under flexible rates. This will prove to be expansionary under fixed rates, because the LM curve shifts out as the central bank responds to the surplus in the balance of payments. Under flexible rates, however, an appreciation of the currency results, leading to a worsening of the current account and a leftward shift in the IS curve and the new BP curve. The end result is a fall in income and hence in aggregate demand. As discussed in the preceding chapters, monetary policy and fiscal policy have different effects under the two different exchange rate regimes. Turning first to the case of fixed exchange rates, it was observed that monetary policy is ineffective for influencing income in a fixed exchange rate system under the various mobility assumptions. On the other hand, fiscal policy was found to be effective in all cases except when capital was perfectly immo- bile internationally. If we continue to restrict our analysis to the case of relatively mobile capital (BP curve flatter than LM curve) for ease of discussion, we can generalize and say that expansionary fiscal policy will shift the AD curve to the right and contractionary The Effect of Monetary and Fiscal Policy on the Aggregate Demand Curve under Fixed and Flexible Rates Final PDF to printer CHAPTER 27 PRICES AND OUTPUT IN THE OPEN ECONOMY 687 app9062x_ch27_673-700.indd 687 06/23/16 10:22 AM fiscal policy will shift it to the left. In contrast, altering the money supply will have no effect on the AD curve in a fixed-rate system unless the central bank continually sterilizes the balance-of-payments effect on the money supply (i.e., replaces the change in foreign exchange reserves by open market purchases or sales of domestic bonds). Under a flexible-rate system, monetary policy was always shown to be effective regard- less of the mobility assumption. The greater the mobility of capital, the more effective is dis- cretionary monetary policy in influencing income. Fiscal policy, however, was less effective under flexible rates than under fixed rates when the BP curve was flatter than the LM curve, and more effective when the BP curve was steeper than the LM curve. The more mobile is capital, the less effective is fiscal policy, as short-term capital flows offset much of the effect of the discretionary policy. In the extreme case, when capital is perfectly mobile, fiscal policy is totally ineffective. Consequently, fiscal policy will have a weak effect on the AD curve under the relatively mobile capital assumption we have adopted for this discussion. Thus, fiscal policy under flexible rates will generally be relatively ineffective in shifting the AD curve compared with fixed rates,5 whereas expansionary (contractionary) monetary policy will shift the AD curve to the right (left) under a system of flexible exchange rates and monetary policy has no effect on AD under fixed rates (without sterilization). Before moving on to an examination of how domestic and foreign policies and other selected economic variables affect prices and output in the open economy, let us take a moment to summarize how the AD curve is affected by changes in variables under fixed and flexible rates. We continue to assume that the mobility of capital is such that the BP curve is upward sloping and flatter than the LM curve. These results are summarized in Table 3. Because the effects on the AD curve of changes in these variables are symmetrical, the results in Table 3 have been limited to one example per type of influence. Test your Summary 5A paper bearing out this expectation in the Mundell-Fleming IS/LM/BP framework is Georgios Karras, “Exchange-Rate Regimes and the Effectiveness of Fiscal Policy,” Journal of Economic Integration 26, no. 1 (March 2011), pp. 29–44. Using data for 62 countries over the period 1951–2007, Karras found that, on average, the multiplier for an increase in government expenditures was 30–45 percent larger with fixed exchange rates than with flexible exchange rates. For useful insights pertaining to the output response to various fiscal policy instru- ments (e.g., tax reductions, different types of government expenditure), see the collection of papers in American Economic Journal: Economic Policy 4, no. 2 (May 2012). Fixed Rates Flexible Rates Change in partner-country variable that increases home-country exports Shifts AD right No effect on AD Change in partner-country variable that alters short-term capital flows in partner-country favor Shifts AD left Shifts AD right Change in home-country variable that reduces home-country exports Shifts AD left No effect on AD Change in home-country variable that stimulates short-term capital inflow Shifts AD right Shifts AD left Expansionary monetary policy No effect on AD (without sterilization) Shifts AD right Expansionary fiscal policy Shifts AD right Little effect on AD (slight rightward shift) TABLE 3 Influences on Aggregate Demand under Fixed and Flexible Exchange Rates Final PDF to printer 688 PART 6 MACROECONOMIC POLICY IN THE OPEN ECONOMY app9062x_ch27_673-700.indd 688 06/23/16 10:22 AM understanding of the adjustment process under fixed and flexible rates by examining both positive and negative changes in an important economic variable to verify the symmetry of the AD adjustment. Having looked at the nature of aggregate supply and aggregate demand and the factors that influence them, we are now ready to examine the effect of discretionary economic policy in the open economy when prices are not fixed. Because the short-run–long-run distinction is important with regard to supply response, we pay close attention to the time frame under consideration when discussing the likely economic effects of a policy action. As has been emphasized, the effect of monetary policy on the domestic economy depends on the type of exchange system under consideration. Because monetary policy has a lim- ited effect on aggregate demand under a fixed exchange rate system, that case can be ignored. However, monetary policy was found to be an effective policy instrument under flexible rates. In that case, expansionary monetary policy has the effect of shifting the AD curve to the right. The economic implications of that policy are examined in Figure 9. We begin with the economy in equilibrium at Y0 and P0 (point E), the intersection of the long- run supply curve (ASLR), the short-run supply curve (ASSR0), and the aggregate demand Monetary Policy in the Open Economy with Flexible Prices FIGURE 9 The Effect of Monetary Policy in the Aggregate Supply–Aggregate Demand Framework under Flexible Rates Y1Y0 P P2 P0 Y0 P1 E F G ASLR ASSR1 ASSR0 ADM1 ADM0 Beginning in equilibrium at point E, expanding the money supply causes the AD curve to shift right to ADM1, putting upward pressure on income and prices in the short run. A new short-run equilibrium is established at F on the short-run supply curve ASSR0 at (Y1, P1). However, once workers realize that prices have risen and that their real wages have fallen, they will demand higher wages so that the same labor will be supplied at the same real wage as initially. The increase in nominal wages causes the short-run supply curve to shift upward along ADM1, leading to a further increase in prices. A new equilibrium is reached at G, where ASLR, ASSR1, and ADM1 intersect. At this point, the actual price level P2 equals the expected price level and the economy is again in equilibrium. The short-run expansionary effect on income is offset by the ultimate increase in the wage rate, leaving the economy again at Y0 but at the higher price level P2. Final PDF to printer CHAPTER 27 PRICES AND OUTPUT IN THE OPEN ECONOMY 689 app9062x_ch27_673-700.indd 689 06/23/16 10:22 AM curve (ADM0). Remember, at that point, actual prices equal expected prices. The expansion of the money supply leads to a rightward shift in the AD curve to ADM1, creating a disequi- librium condition. Assuming that there is a lag between the change in the price level and workers’ demands for higher wages, the economy will respond to the increase in demand. As output increases, prices begin to increase and the economy moves to a new short-run equilibrium at F. However, once labor realizes that the actual price level is higher than the expected price level and has time to respond, workers will raise their wage demands commensurate with the increase in prices so that the same amount of labor is being supplied at the same real wage. This will cause the short-run aggregate supply curve to shift left until the expected price level is again equal to the actual price level, given the new larger supply of money. This equilibrium is point G, where ASSR1, ASLR, and ADM1 intersect at (Y0, P2). After all adjustments have taken place, the economy is again at the natural or potential level of income Y0 but at a higher price level P2. Expansionary monetary policy can produce a short-run increase in income and employment, but it will last only until workers adjust their wage demands to the new higher level of prices.6 Given the change in the price level or rate of inflation as a result of the expansion in the money supply, what if anything can be said about the accompanying changes in the other key monetary variables, specifically the nominal rate of interest and the exchange rate? If we adopt the monetary approach perspective developed in Chapter 22, several clear con- clusions can be reached. Following the relative purchasing power parity view, in the long run the exchange rate will rise (the home currency will depreciate) proportionally with the rise in the price level in the home country relative to that in the trading partners. In addition, it is generally agreed that the real rate of interest is what concerns investors (i.e., the rate at which purchasing power is increased over the investment period because of the sacrifice of current consumption). From this perspective, the nominal interest rate (what we have been calling the “interest rate” under the earlier fixed-price assumption) consists of two components: the real interest rate or rate of time preference, and a payment for expected inflation. Therefore, i = ir + E(p ⋅ ), [or ir = i − E(p ⋅ )], where i is the nominal rate of interest, ir is the real interest rate, and E(p ⋅ ) is the expected inflation rate. If real rates of interest are equalized (or differ by a more or less constant amount due to imperfect capital mobility) between any two countries through interest arbitrage, it follows that any difference in the nominal rates of interest must be attributable to differences in the expected inflation rate in the two countries.7 Therefore, an increase in the domestic inflation rate (with the expectation that it would continue), ceteris paribus, should lead to a comparable relative increase in the domestic nominal interest rate. For example, if the U.S. rate of inflation were to rise from 4 to 6 percent and the U.K. inflation rate and rate of interest remain constant, nominal interest rates in the United States should rise by 2 percentage points. Finally, because the change in relative prices is driving both a change in the nomi- nal exchange rate and a change in the nominal interest rate, the percentage change in the 6Another factor involved is that, to the extent that there are intermediate goods imports, the depreciation of the home currency from the expansionary monetary policy will raise the costs of production of domestic firms. This also will shift the short-run aggregate supply curve (as well as the long-run aggregate supply curve) to the left. We generally ignore this repercussion but refer to it in occasional cases later in this chapter. 7In a U.S.–U.K. example, iUS − iUK = E(p ⋅ )US − E(p ⋅ )UK, where i refers to the nominal interest rate and E(p ⋅ ) to the expected inflation rate in each country as indicated by the subscript. This general relationship between relative nominal interest rates and relative inflation rates is referred to as the Fisher effect (after the early-20th-century American economist Irving Fisher). Final PDF to printer 690 PART 6 MACROECONOMIC POLICY IN THE OPEN ECONOMY app9062x_ch27_673-700.indd 690 06/23/16 10:22 AM relative nominal interest rates between two countries should equal the expected percent- age change in the exchange rate. This is, of course, another way of stating the uncovered interest parity condition discussed in previous chapters.8 Basically, this can be thought of as extending the application of the law of one price to the financial markets (investors are receiving the same expected real rate of return in both countries when those rates are expressed in a single currency). In sum, after the long-run adjustments to the increased domestic money supply have been completed, there will be, in the domestic country, no change in income, an increase in the price level, an increase in the nominal interest rate, and an increase in the exchange rate (depreciation of the home currency). Next, however, suppose that we begin with the economy in disequilibrium at a level of income Y0 that is less than the natural level of income, YN (i.e., point H in Figure 10). Is there perhaps a stronger rationale for using expansionary monetary policy in this instance? 8Recall that the uncovered interest parity condition was, in an example case of the United States and the United Kingdom, iUS = iUK + xa or iUS − iUK = xa where xa was the expected rate of appreciation of the pound against the dollar, ignoring any risk premium. The term xa in turn is equal to [E(e) − e]/e, where E(e) is the expected future exchange rate and e is the current spot rate (both in $/£). FIGURE 10 The Role of Expansionary Monetary Policy When the Open Economy Is in Recession YNY0 P P2 P0 Y 0 P1 ASLR ASSR 1 ASSR0 ADM1 ADM0 K H M With the economy in equilibrium below YN at H, expanding the money supply causes the aggregate demand curve to shift right to ADM1, and it then intersects ASLR and ASSR0 at K. At that point, expected prices equal actual prices and aggregate demand equals both long- and short-run aggregate supply, so there will be no further adjustment. The economy is now at the natural level of income, but at a higher price level, P1. If policymakers do nothing at H, and wages and prices are flexible downward, labor will eventually realize that the actual level of prices, P0, is less than the expected level, P1, and the wage rate will fall to increase the level of employment. This will cause the short-run aggregate supply curve to begin to drift down (along with prices) until long-run and short-run aggregate supply and aggregate demand are in equilibrium at M and the actual level of prices equals the expected level of prices, P2. Final PDF to printer CHAPTER 27 PRICES AND OUTPUT IN THE OPEN ECONOMY 691 app9062x_ch27_673-700.indd 691 06/23/16 10:22 AM Expanding the money supply will cause the AD curve to shift up to a new long-run equilib- rium, at P1 and YN (point K). Domestic income will have increased, but again at the expense of an increase in the price level. On the other hand, because P1 is consistent with the expected level of prices on ASSR0, there will be no pressure on the part of labor to increase wages (and hence prices) further. Suppose instead that there had been no policy reaction to the recession reflected by Y0 and P0. If wages and prices are flexible downward, once it is recognized that the actual level of prices, P0, is less than the expected level of prices, P1, the recession and unemploy- ment should produce a fall in expected prices and consequently in the nominal wage rate. As expected prices decline, the short-run aggregate supply curve begins to shift downward to ASSR1 from ASSR0. As actual prices begin to fall, movement occurs along ADM0, exports increase, and imports decrease. These adjustments continue until the economy is once again in equilibrium at YN, but now at price level P2 (point M). In the situation where Y0 is less than YN, there are thus two adjustment processes lead- ing to long-run equilibrium at YN. One process relies on discretionary monetary policy and the other on the natural market mechanism, assuming that wages and prices are flexible in both the upward and downward direction. Critics of the policy action point to the inflation- ary pressures stimulated by the expanding money supply, arguing that these pressures will contribute to further expectations regarding discretionary government policy and further price increases. Economists in favor of policy argue that, in reality, wages are not very flexible in the downward direction and that market adjustments take a long time to work themselves out. Thus, in this view, while the automatic adjustment may work to some degree, the adjustment cost of the recession in terms of lost output, unemployment, and social programs is far too high to leave to uncertain market forces. In a recent context, suppose that the Y0, P0 equilibrium in Figure 10 has been reached because the aggregate demand curve has shifted leftward due to a financial crisis that increased risk, made banks less willing to lend, and led to a decrease in investment (as happened in the United States in 2007–2009). In such an instance, the capital stock in the economy will decline if depreciation of existing stock exceeds new investment. Hence, both the long-run and the short-run aggregate supply curves will shift leftward. As time passes and wages even- tually fall, the short-run aggregate supply curve will shift to the right, but the new long-run equilibrium will occur at a lower GDP level than would otherwise have been the case. In sum, monetary policy under flexible rates can cause short-run increases in income above the natural level of income as long as wage adjustments lag behind price increases. Eventually, however, the income gains will be lost as labor adjusts its wage demands to the new, higher level of prices. The increase in output and employment is thus temporary and ultimately leads only to higher prices and wages. Monetary policy can be effective in stimulating the economy when the economy is below the natural rate of employment, but again at the expense of higher prices. However, relying on the market mechanism and not on monetary policy may entail a long adjustment period and may be ineffective if wages are rigid downward.9 9It must be noted that the understanding of the effects of monetary policy on the economy has evolved greatly in recent years because of the use of increasingly sophisticated econometric techniques. According to Christopher Sims of Princeton University, the newer econometric models have yielded general consensus that changes in the interest rate induced by changes in the money supply do substantially affect output in the short run and the price level over longer periods. However, he also suggests that erratic changes in monetary policy are not the principal cause of economic cycles. In addition, changes in the quantity of money alone are not a good measure of the direction of monetary policy that is being pursued. For these points and an excellent review of the evolution of modeling policy activity, see Christopher A. Sims, “Statistical Modeling of Monetary Policy and Its Effects,” American Economic Review 102, no. 4 (June 2012), pp. 1187–205. Final PDF to printer 692 PART 6 MACROECONOMIC POLICY IN THE OPEN ECONOMY app9062x_ch27_673-700.indd 692 06/23/16 10:22 AM Aided by Figures 9 and 10, we can also briefly discuss another policy that is in the pur- view of the monetary authorities. Suppose that an economy is operating under a pegged exchange rate but that it now undertakes an official devaluation of its currency. In the context of an IS/LM/BP diagram, such a policy shifts BP to the right and also shifts IS to the right through the net export stimulus. There will be a BOP surplus and expansion of the money supply as the new exchange rate is pegged. The result is a shift of AD to the right as in Figure 9 (but for the reason that BP, IS, and LM have all shifted to the right). There is a temporary expansion of income as in Figure 9 until workers adjust their nominal wage, but the end result is then only inflation. Even worse, however, if intermediate imports are important as in many developing countries, ASSR1 and ASLR will shift to the left because of the devaluation, leading to what has been called contractionary devaluation because out- put has fallen. This issue has been debated for developing countries, but for those countries it is possible that point H in Figure 10 is a more likely starting point and ASSR0 also may be flatter. In that case, no contraction of output (and some expansion) and only mild inflation may follow the devaluation. Work by Ramanarayanan (2009) suggests that trade in inter- mediate goods not only affects currency adjustments but is also an important influence on the transmission of business cycles across countries. As noted in the previous chapter, fiscal policy is relatively ineffective in increasing the level of national income under flexible rates if short-term capital is relatively mobile (BP curve flatter than LM) or perfectly mobile (horizontal BP curve). To the extent that there is any effect on AD, the price and output effects are qualitatively similar to monetary policy, except that the home currency will appreciate due to the relatively higher domestic interest rate.10 If capital is relatively immobile (BP curve steeper than the LM curve) or perfectly immobile (vertical BP curve), the price and output effects are larger as the AD curve shifts to a greater extent. In these situations, the home currency depreciates. In the fixed-rate case, expansionary fiscal policy will shift AD to the right, just as expansionary monetary policy did under flexible rates (see Figure 11). Assuming there is a lag between price increases and wage adjustments, the economy will expand in the short run from Y0 and P0 (point E) to Y1 and P1 (point F). At that point, the actual level of prices (P1) will be higher than the initial expected level (P0). Once the nominal wage of labor begins adjusting to the rising price level, the short-run supply curve will shift upward. This will continue until ASSR1, ASLR, and ADG1 intersect at a common point (Y0, P2). Expansionary fiscal policy can thus stimulate income and employment in the short run under fixed rates, but only tem- porarily. Once labor adjusts its wage demands, the economy returns to the natural level of income and employment. Should this happen very quickly, fiscal policy will only generate inflation, even in the short run. The implications of the recession situation for fiscal policy under fixed rates are analo- gous to those of monetary policy under flexible rates. Recall that with the economy in reces- sion as in Figure 10, there is greater unemployment than is the case when the natural rate is attained. The movement back to the natural level of income can take place through fiscal stimulus or through reliance on the market adjustment of wages and prices. Use of the fiscal instrument will lead to an increase in the price level, whereas the market adjustment will lead to lower wages and prices. The issues that once again emerge are the degree to which prices and wages are downwardly flexible and the length of time of the market adjustment process. Keynesian theorists tend to lean toward more policy intervention, whereas the Monetarists and the New Classical theorists place primary emphasis on the market solution. Currency Adjustments under Fixed Rates Fiscal Policy in the Open Economy with Flexible Prices 10If intermediate goods imports are significant, the short-run and long-run aggregate supply curves will also shift to the right because of the appreciation. Final PDF to printer CHAPTER 27 PRICES AND OUTPUT IN THE OPEN ECONOMY 693 app9062x_ch27_673-700.indd 693 06/23/16 10:22 AM The analysis up to now has focused on the effect of monetary and fiscal policy on aggre- gate demand. At this point, it is important to indicate that economic policy can also have an effect on aggregate supply. If discretionary economic policy is to have any lasting effect other than to increase prices, it must contribute to a growing production capacity, that is, a rightward shift in the long-run aggregate supply curve. For example, the Obama administration’s 2009 economic stimulus package to deal with the U.S. recession was primarily viewed as affecting aggregate demand. However, some elements of the pack- age were aimed at supply considerations. Indeed, it is important to emphasize that for a more permanent effect and for avoidance of long-run inflation, measures that affect aggre- gate supply such as retraining programs for displaced workers (e.g., auto workers), tax cuts for research and development, or capacity-building infrastructure projects are nec- essary. Monetary and fiscal policies that encourage improvements in technology (either directly or indirectly through such programs as the space program), improve the quality and mobility of the labor force, or stimulate private accumulation of capital can have a lasting effect on income and employment. These kinds of policies would, in the long run, make the United States’ production pattern more consistent with comparative advantage and with the changes that are taking place in the world economy. The effect of such policies is demonstrated in Figure 12. Expansionary discretionary policy (e.g., a tax cut) again causes the AD curve to shift to the right to AD′, producing some income and employment gains in the short run along with the increase in prices. Economic Policy and Supply Considerations Y1Y0 P P2 P0 Y0 P1 ASLR ASSR1 ASSR0 ADG1 ADG0 F E G With the economy in equilibrium at Y0 and P0, expansionary fiscal policy shifts the aggregate demand curve rightward from ADG0 to ADG1. The expansion in demand causes the price level to rise to P1 and output to expand to Y1, assuming that there is a lag in the wage adjustment to the increase in prices. Once workers real- ize that the actual price level is now above the expected price level P0, they demand higher wages, shifting the short-run aggregate supply curve to the left. This results in a decline in employment and income that will continue until the economy is back in equilibrium, that is, where ASSR1, ASLR, and ADG1 intersect at a common point. This occurs at P2 and Y0. Because supply now equals demand and actual prices P2 equal expected prices P2, no further adjustments will take place. FIGURE 11 The Effect of Fiscal Policy in the Aggregate Supply–Aggregate Demand Framework under Fixed Exchange Rates Final PDF to printer 694 PART 6 MACROECONOMIC POLICY IN THE OPEN ECONOMY app9062x_ch27_673-700.indd 694 06/23/16 10:22 AM Suppose, however, it also leads to a rightward shift in the long-run supply curve to AS′LR. After all the adjustments have taken place, the economy now finds itself at a higher natural level of employment and income (Y1), and economic growth has occurred. The new price level could be higher, lower, or about the same as the equilibrium price level prior to the policy undertaking, depending on the relative shifts in all three curves. If tax policy stimu- lates a large supply response and little AD response under flexible rates, the end result can be higher income and employment, a lower price level, and an appreciated currency. What is critical here is that the ultimate effect on the level of income and employment depends on the degree to which there is a demand response and a long-run supply response. To be effective, government policy must be aware of the implications of its policy actions on long-run supply conditions. This effect on income and employment is particularly important if we recall from ear- lier in the chapter that some unemployment (the natural level) exists at the natural level of income Y0. The implication of the preceding paragraph is that policy actions that shift AD to the right, as well as shift ASLR to the right, are considerably more likely to result in a reduction of unemployment than are actions that affect AD only. FIGURE 12 Economic Policy and Shifts in the Long-Run Aggregate Supply Curve Y1Y0 P P0 Y 0 ASLR AS'LR AS'SR ASSR AD AD' ? ? Starting with the economy in equilibrium at Y0 and P0, suppose that discretionary monetary and/or fiscal policy is undertaken that has an effect on domestic long-run supply conditions. The expansionary effect increases income and prices in the short run but eventually shifts the long-run and short-run supply curves to the right. A new equilibrium will result at Y1, where AS′LR, AS′SR, and AD′ intersect. Because the new price level will depend on the relative movements of the curves, the exact position of the new equilibrium is uncertain. CONCEPT CHECK 1. Why could the AD curve in the open economy have a different degree of downward slope than the AD curve in the closed economy? 2. Under what conditions will expansionary policy increase income in the short run? In the long run? 3. What effect will an increase in exports have on the economy under flexible rates? Under fixed rates? Final PDF to printer IN THE REAL WORLD: ECONOMIC PROGRESS IN SUB-SAHARAN AFRICA The countries in which growth is finally beginning to emerge and in which supply-type policy factors seem to be playing a role include many of the 45 nations in sub-Saharan Africa. A number of these countries, after stagnation for decades, have instituted, at the behest of and with assistance from the World Bank and the International Monetary Fund, structural reforms. These reforms embody measures such as removal of price controls, liberalization of imports, improved agri- cultural marketing systems, privatization of public enter- prises, and more efficient tax systems. The reforms can be thought of as having increased productive capabilities by changing institutions, and they shift aggregate supply curves to the right. At the same time, measures such as the introduc- tion of new monetary policy instruments and the reduction in government budget deficits as a percentage of GDP have led to slower increases in aggregate demand (smaller right- ward shifts in the AD curve). Overall, the result has been an improvement in the rate of growth of real GDP as well as a decrease in inflation rates in the 2000s. The overall experi- ence is captured in Table 4. The first row for each indicator pertains to the Sub-Saharan region as a whole; the second and third rows give the experience for Sub-Saharan Africa’s two largest countries (by a very considerable margin) in terms of GDP. The Nigerian and especially the South African experi- ence have clearly been different from the growth/inflation developments in the remainder of the region. Overall, the 1998 per capita GDP for Sub-Saharan Africa was only $510 ($1,440 in purchasing-power parity terms) and by 2014 had risen to $1,654 ($3,332 in PPP terms). Three countries with notably impressive recent growth have been Côte d’Ivoire, Ethiopia, and Tanzania. This optimistic picture has very recently been somewhat tempered, however. In late 2014 and in 2015, commodity prices worldwide, and especially oil prices, fell dramatically. Because Sub-Saharan African countries have tended to spe- cialize in commodities/primary products (and Angola and Nigeria in oil in particular), these price declines led to fore- casts of slower growth in the immediate future. Declines in exports and fiscal adjustments due to decreasing government revenues shifted aggregate demand curves to the left. The sit- uation was intensified because, among emerging/developing countries, Sub-Saharan African countries have had a smaller manufacturing sector than is common. Clearly, in this situa- tion, policies to shift the aggregate supply curves to the right could help to offset the slower growth of the countries. Sources: Alassane D. Outtara, “Africa: An Agenda for the 21st Century,” Finance and Development, March 1999, pp. 2–5; Evangelos A. Calamitsis, “Adjustment and Growth in Sub-Saharan Africa: The Unfinished Agenda,” Finance and Development, March 1999, pp. 6–9; Ernesto Hernández-Catá, “Sub-Saharan Africa: Economic Policy and Outlook for Growth,” Finance and Development, March 1999, pp. 10–12; World Bank, World Development Indicators 2000 (Washington, DC: World Bank, 2000), p. 12; World Development Report 2012 (Washington, DC: World Bank, 2012), p. 393; “Sub- Saharan Africa Faces Slowest Growth Since 2009,” IMF Survey, October 9,2015: “More a Marathon than a Sprint,” The Economist, November 7, 2015, pp. 41–42. TABLE 4 Inflation and Real GDP Growth in the Sub-Saharan Africa Region, 1997–2014 ● 1997–2006 2007 2008 2009 2010 2011 2012 2013 2014 Growth in real GDP 5.0% 7.6% 6.0% 4.1% 6.6% 5.0% 4.3% 5.2% 5.0% Nigeria 7.2 9.1 8.0 9.0 10.0 4.9 4.3 5.4 6.3 South Africa 3.4 5.4 3.2 –1.5 3.0 3.2 2.2 2.2 1.5 Percentage change in consumer price index 11.2 5.5 13.0 9.8 8.2 9.5 9.4 6.6 6.4 Nigeria 11.8 5.4 11.6 12.5 13.7 10.8 12.2 8.5 8.1 South Africa 5.6 7.1 11.5 7.1 4.3 5.0 5.7 5.8 6.1 Source: International Monetary Fund, World Economic Outlook, October 2015, pp. 174, 179, obtained from www.imf.org. CHAPTER 27 PRICES AND OUTPUT IN THE OPEN ECONOMY 695 app9062x_ch27_673-700.indd 695 06/23/16 10:22 AM Final PDF to printer 696 PART 6 MACROECONOMIC POLICY IN THE OPEN ECONOMY app9062x_ch27_673-700.indd 696 06/23/16 10:22 AM EXTERNAL SHOCKS AND THE OPEN ECONOMY To conclude this chapter on the open economy with flexible prices, let us concentrate more specifically on the effects of some external shocks to the economy. Suppose that there is an increase in the world price of a critical imported intermediate input for which domes- tic demand is relatively inelastic. With a flexible-rate system, this causes depreciation of the home currency and an expansion of domestic aggregate demand in response to the expenditure-switching effects of the depreciation. At the same time, the higher world price of the critical intermediate good leads in Figure 13 to a leftward shift in both the short-run supply curve (from ASSR0 to ASSR1) and the long-run supply curve (from ASLR0 to ASLR1). As you can see in the figure, both effects put upward pressure on the price level. If the price shock is sufficiently large, it could alter domestic supply conditions so much that the new equilibrium income is at Y2 (i.e., less than Y1). Declining income coupled with rising inflation is often referred to as stagflation. The United States has, in fact, experienced two periods of stagflation in recent decades, both associated with sharp increases in petroleum prices. Attempts in the short run to ease the stagflation at point E′ by expansionary mone- tary policy will lead to even higher prices. Attempts by labor to raise the nominal wage to offset the initial price shock would shift the short-run aggregate supply curve even further to the left, making the stagflation even worse. However, if wages were flexible downward at E′, a fall in the nominal wage rate would shift the short-run aggregate supply curve to FIGURE 13 The Effect of a Price Shock of an Imported Input in the Open Economy Y1 Y0 P P0 Y 0 ASLR1 ASSR1 ASSR0 E' E'' AD AD' ASLR0 P1 Y2 E With the economy in equilibrium at E, a sudden increase in the price of a critical imported intermediate good for which demand is inelastic leads to depreciation of the currency and to a rightward shift in the aggregate demand curve to AD′. At the same time, it causes both the short-run and the long-run aggregate supply curves to shift left as production costs rise. The economy contracts to E′, with a higher price level P1 and a new short-run equilib- rium income Y2 (i.e., the economy is experiencing stagflation). Attempts on the part of labor to increase nominal wages would lead to more inflation and unemployment (not shown). Attempts to use expansionary monetary pol- icy to increase income in this instance also would lead to further price increases (not shown). If wages were flex- ible downward, a fall in the nominal wage could move the economy into equilibrium at E″ and Y1 (but not Y0). Final PDF to printer CHAPTER 27 PRICES AND OUTPUT IN THE OPEN ECONOMY 697 app9062x_ch27_673-700.indd 697 06/23/16 10:22 AM IN THE REAL WORLD: INFLATION AND UNEMPLOYMENT IN THE UNITED STATES, 1970–2014 Figure 14 indicates inflation (GDP deflator) and unemploy- ment rates in the United States in recent decades. The two time-series seem to move together rather consistently over most of the time period. However, two periods clearly stand out. During both the 1973–1975 period and the 1979–1981 period, the economy was experiencing high and increasing inflation rates and rising unemployment rates. Both of these periods followed upon sizable increases in petroleum prices. The increases in petroleum prices shifted the aggregate sup- ply curves leftward, raising the actual unemployment rate. In contrast, oil price increases due to the 1990 Iraqi invasion of Kuwait and the subsequent embargo on trade with Iraq do not appear to be associated with a rise in the U.S. inflation rate. Further, the more typical movement of inflation and unemployment associated with the business cycle appears in the 1986–1989 period, the 1990–1992 period, and from 2003 to 2005. In the early to late 1980s, from 1993 to 1998, and in 2006, unemployment and inflation rates simultane- ously fell. This suggests that there was important movement of the aggregate supply curves to the right in those years. From 2007 to 2010, inflation declined and hit a low level while unemployment was rising and high. The experience of these years suggests that the main factor at work was a shift of the aggregate demand curve to the left as the severe reces- sion took hold. After 2010, unemployment dropped while inflation stayed low. This combination would be consistent with aggregate demand and aggregate supply both shifting to the right. FIGURE 14 U.S. Inflation and Unemployment Rates, 1970–2014 0 1970 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 100907050301999795939189878583817977757371 11 12 13 14 2 4 6 5 3 1 8 7 10 % 9 Unemployment rate Inflation rate Year Source: Federal Reserve Economic Data (FRED) obtained from https://research.stlouisfed.org. ● Final PDF to printer 698 PART 6 MACROECONOMIC POLICY IN THE OPEN ECONOMY app9062x_ch27_673-700.indd 698 06/23/16 10:22 AM the right, increasing income and employment until it reached E′′ and Y1 (not, however, E and Y0). Thus, external shocks that affect both supply and demand conditions create special problems for macro policy, for there may be little that can be done in the short run (absent effective and quick supply-side tax policies) to facilitate the needed structural adjustment without generating further inflation. Consider as a second external shock a foreign financial shock that triggers an inflow of short-term capital into the home country. Under flexible rates this will cause the AD curve to shift to the left as the home currency appreciates in value. As indicated in Figure 15, this will lead to lower income and prices in the short run as the expenditure-switching effects come into play (a movement from E to E′). In this case, expansionary monetary policy could be used to offset the initial short-term capital inflow, moving the economy back to the natural level of income and to the initial prices. This would, of course, then lead to a decline in the value of the home currency in the short run as the interest rate fell in response to the monetary action. The movement back to macro equilibrium could also take place through a downward or rightward shift in the short-run supply curve (not shown), once labor adjusts its price expectations to the new, lower price level. In either case, the adjustment process is not complicated by an initial supply effect as it was in the previous example. The adjust- ments following this shock would also occur if the initial event were a change in expecta- tions regarding the exchange rate such that the home currency was expected to rise in value. As a final example (can you put up with one more example?!), let us examine the effect of an improvement in aggregate productivity, as especially occurred in the 1990s and the early 2000s with the new information technology. To see how productivity growth affects FIGURE 15 A Foreign Financial Shock and Adjustment in the Open Economy Y1 Y0 P P0 Y0 ASSR AD ASLR P1 E' AD' E In this case, a foreign financial shock triggers an inflow of short-term capital into the home country, appreciating the currency and reducing aggregate demand to AD′. As a result, the economy will move to E′, experiencing a lower level of income, employment, and prices in the short run. In this instance, expansionary monetary policy could increase aggregate demand and move the economy back to Y0. The movement to Y0 could also take place through a reduction in the nominal wage as labor realizes that the actual price level is below the expected price level P0. This would cause ASSR to shift to the right until equilibrium (not shown) is once again attained at Y0. Final PDF to printer CHAPTER 27 PRICES AND OUTPUT IN THE OPEN ECONOMY 699 app9062x_ch27_673-700.indd 699 06/23/16 10:22 AM the open economy, consider an improvement in technology that shifts the supply curves ASLR0 and ASSR0 to the right (see Figure 16). If aggregate demand does not change from ADM0, the new equilibrium level of income will lie to the left (at point E1) of the new long- run supply curve (ASLR1). For the economy to take further advantage of the new productiv- ity gains, there must either be an increase in aggregate demand or a further downward shift in the short-run supply curve (by the labor market adjustment process). Proper growth in the money supply would lead to growth in aggregate demand that causes the economy to move to the new, higher level of income made possible by the productivity change without any major impact on prices from the original price level (point E2). On the other hand, the lower level of prices in place at Y1 could eventually stimulate a fall in the expected level of prices on the part of labor, a consequent fall in wages from W0 to W1, and a rightward shift in the short-run supply curve. This adjustment continues to take place until the three curves intersect at the new level of income that reflects the new, higher level of technology (point E3). This latter wage adjustment process relies on the assumption that prices and wages are downwardly flexible. On the other hand, the first situation of reliance on monetary policy requires that the monetary authorities correctly gauge the increase in the money supply necessary to move to the new natural level of income, and not beyond. Overestimating the FIGURE 16 Technological Change and Adjustment in the Open Economy P P0 P1 P2 ASSR0-W0 ASLR0 ASLR1 ASSR1-W0 ASSR11-W Y0 Y0 Y1 Y2 E0 ADM1 ADM0 E1 E3 E2 The improvement in technology shifts the aggregate supply curves to the right from ASLR0 to ASLR1, and ASSR0-W0 to ASSR1-W0. With no change in aggregate demand, equilibrium moves to E1 at a higher level of income Y1 and a lower level of prices P1. Because Y1 < Y2, the economy is operating below the natural level of income and employment. In this instance, the economy can move to Y2 (the natural level) through the use of expansionary monetary policy, which would shift the aggregate demand curve to the right (ADM1 at E2), or wait for a fall in nominal wages, which would shift the short-run aggregate supply curve to the right until it reached Y2 at E3. Expansionary policy would cause the price level to drift back up from P1, whereas the reduction in the nominal wage would lead to further deflation to P2. Final PDF to printer 700 PART 6 MACROECONOMIC POLICY IN THE OPEN ECONOMY app9062x_ch27_673-700.indd 700 06/23/16 10:22 AM SUMMARY This chapter focused on the open economy when prices are flex- ible. This was accomplished by deriving an aggregate demand curve for the open economy and combining it with aggregate supply curves. Both a short-run aggregate supply curve and a long-run aggregate supply curve were employed in the analysis. The aggregate demand–aggregate supply framework was then used to examine the effects of changes in policy variables and in exogenous variables. This was done for both a flexible-rate sys- tem and a fixed-rate system. The analysis demonstrated the auto- matic adjustment mechanism present when prices and wages are flexible. In addition, it pointed out the difference in the adjust- ment mechanism under fixed rates compared with that under flex- ible rates. Attempts to increase income and employment beyond the natural level by increasing aggregate demand ultimately lead only to increases in prices under either exchange rate regime. In the case when the economy is operating at a level below the natural level of employment, discretionary policy is effective in moving the economy back to the natural level, but only by increasing prices. Given sufficient time with actual employment below the natural level, the economy automatically moves back to the natural level through a fall in prices. The uncertainty sur- rounding the downward flexibility in prices and wages and the time required for such an adjustment underlie the view by many that the preferable adjustment mechanism is discretionary mon- etary policy under flexible-rate regimes and discretionary fiscal policy under fixed-rate regimes. The chapter concluded with a discussion of the effect of several exogenous shocks to the open economy operating under a flexible-rate system. KEY TERMS aggregate demand curve aggregate demand curve for labor aggregate production function aggregate supply–aggregate demand equilibrium contractionary devaluation long-run aggregate supply curve natural level of employment natural level of income short-run aggregate supply curve stagflation QUESTIONS AND PROBLEMS 1. What is meant by the natural level of income and employ- ment? Why is the long-run aggregate supply curve vertical at the natural level? 2. What is the difference between the short-run aggregate sup- ply curve and the long-run aggregate supply curve? Are they ever the same? 3. Is it possible that increased international economic transactions could affect the aggregate supply curves? Why or why not? 4. In the 1990s Germany attempted to control inflation through a restrictive monetary policy and high interest rates. Explain how this might have influenced income and prices in the United States. 5. Explain how appreciation of a country’s currency could affect its aggregate supply curves when imported intermedi- ate inputs are sizeable. 6. If discretionary economic policy is to have more than a short-run effect on income and employment, what needs to take place? 7. If a country finds itself experiencing stagflation under a flexible-rate system, why is expansionary monetary pol- icy unlikely to cure the problem? Why are technological improvements or general productivity improvements so critical in this situation? 8. Suppose that a home country’s currency is expected to depreciate in a flexible-rate system. Trace through the effects on home country AD, AS, prices, and income (output). 9. Suppose the economy is operating below its natural level of income (e.g., at point H in Figure 10). Would you recom- mend the use of expansionary policy in this instance? Why or why not? growth in income capacity of course would lead to an overexpansion of the money supply and thus of aggregate demand, a response that would trigger an increase in the price level and expected prices and lead to continued inflation. Finally, with the productivity increase, if the price level does fall to a value such as P2 in Figure 16, this can have an effect on the nominal interest rate and the expected exchange rate. If the lower price level reduces inflationary expectations, then the nominal interest rate in the country will fall. With the reduced inflationary expectations, there may also occur a lower expected percentage depreciation (or an expected appreciation) of the home currency. Final PDF to printer 701 app9062x_ch28_701-727.indd 701 06/22/16 01:56 PM CHAPTER LEARNING OBJECTIVES LO1 Discuss the central points of debate between proponents of fixed exchange rates and proponents of flexible exchange rates. LO2 Explain the advantages and disadvantages of a currency board. LO3 Describe the economic characteristics necessary for the formation of an optimal currency area. LO4 Compare and contrast the strengths and weaknesses of exchange rate systems that combine elements of both fixed and flexible exchange rates. FIXED OR FLEXIBLE EXCHANGE RATES? 28 PART 7: Issues in World Monetary Arrangements Final PDF to printer 702 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch28_701-727.indd 702 06/22/16 01:56 PM INTRODUCTION In 2014 and 2015, as commodity prices fell worldwide, exporters of natural resource products were obviously hurt. Such exporters who had exchange rates that could vary with demand and supply experienced a fall in their currencies’ value. As The Economist noted, “Sinking might be a better description than floating when it comes to many of the world’s currencies.”1 The use of a fixed exchange rate has recently proved to be problematic for Egypt as growth in demand for foreign exchange has exceeded growth in supply, leading to a substantial loss of the country’s holdings of foreign reserves. Years of political turmoil have had a negative effect on tourism and foreign direct investment. In response to the continuing loss of reserves, the govern- ment devalued the Egyptian pound in 2015.2 A prominent issue in any consideration of the effective use of economic policy in the open economy, as well as in discussions of the desirable nature of the international monetary system, is the degree of exchange rate flexibility that should be permitted. We have dealt with this issue in preceding chapters, and in the next chapter we deal with it again in the recent historical context. However, it is useful at this point to bring together a variety of relevant arguments. The first section of this chapter does so by examining the arguments for fixed or flexible rates in the context of major substantive issues. In this discussion the term fixed exchange rates refers to a system that permits only very small, if any, deviations from officially declared currency values. By flexible exchange rates we mean rates that are completely free to vary or float; that is, the foreign exchange market is cleared at all times by changes in the exchange rate and not by any buying and selling of currencies by the monetary authorities. We then examine the controversy in the contexts of currency boards the theory of optimum currency areas. Finally, we look at cases of exchange rate flexibility located between the two extremes. “Middle-ground” solutions are possible as well as the two extremes of fixed rates and completely flexible rates. CENTRAL ISSUES IN THE FIXED–FLEXIBLE EXCHANGE RATE DEBATE A point made in favor of fixed exchange rates is that such a system provides for the “dis- cipline” needed in economic policy to prevent continuing inflation. That is, in a fixed-rate system, there should be no tendency for greater inflation to occur in one country than in the world as a whole. Consider a country with a balance-of-payments (BOP) deficit (official reserve transactions deficit). If the cause of the deficit is a more rapid inflation than that in trading partners, then the country’s authorities will need to apply anti-inflationary policy to protect the country’s international reserve position. The fixed-rate system virtually forces this type of policy action, because failure to do so will lead to an eventual elimination of the coun- try’s international reserves if the automatic adjustment mechanism takes considerable time. What about the situation in a BOP surplus country? Given the objective of a fixed exchange rate, the forces working in the opposite direction from that for a deficit country are set into motion. Accumulation of foreign exchange reserves (which may be difficult to sterilize) will expand the money supply. This enhancement of the money supply will drive the interest rate downward, increase aggregate demand and prices, increase private purchases of goods and foreign financial assets, and thus eliminate the surplus. Exchange Rate Experiences Do Fixed or Flexible Exchange Rates Provide for Greater “Discipline” on the Part of Policymakers? 1“Pegs under Pressure,” The Economist, October 17, 2015, pp. 77–78. 2“Dwindling Dollars,” The Economist, October 24, 2015, pp. 68–69. Final PDF to printer CHAPTER 28 FIXED OR FLEXIBLE EXCHANGE RATES? 703 app9062x_ch28_701-727.indd 703 06/22/16 01:56 PM Note that the result in the preceding discussion is a tendency for deflation in the deficit country and inflation in the surplus country. Therefore, if prices are flexible in both direc- tions, it is likely that prices will be relatively stable in the world as a whole. In practice, the world could have some inflation if prices are less flexible downward than upward. However, the inflation will probably not be as rapid as it would be if the discipline of the fixed rates did not exist. In addition to this emphasis on the discipline of fixed exchange rates, proponents of such a system stress that flexible rates could actually aggravate inflationary tendencies in a coun- try. The point is made that, under flexible or floating rates, inflation in a country becomes self-perpetuating; this argument is sometimes called the vicious circle hypothesis. Suppose that a country is undergoing rapid inflation because of an excess supply of money and excess demand in the economy. The inflation will cause the country’s currency to depreciate in the exchange markets, which will add to aggregate demand in the economy and generate fur- ther inflationary pressure. In addition, the rise in prices will lead to correspondingly higher money wages, which also induces more inflation (see the preceding chapter). Thus, inflation will cause depreciation, but the depreciation itself will cause further inflation. This sequence of events continues until the monetary authorities put a stop to the monetary expansion. Two major replies can be made to these points. First, with respect to the vicious circle hypothesis, flexible-rate advocates think that the depreciation that was a response to the inflation and that is alleged to cause further inflation can actually be a clear signal to the authorities that monetary restraint is needed. This signal can therefore lead to the quick instigation of anti-inflationary policies. Thus, in this view, the danger of inflation is no greater under flexible than under fixed rates. In response to the alleged discipline provided by the fixed-rate system, it can be ques- tioned whether such discipline is necessarily always desirable. Countries also have other domestic goals besides maintenance of the fixed exchange rate and price stability, such as the generation of high levels of employment and of reasonably rapid economic growth. A BOP deficit implies that whether the adjustment is accomplished through the automatic reduction of the money supply or through contractionary discretionary macroeconomic policies, the attainment of these other domestic goals may have to be sacrificed or at least pursued in a less determined fashion. If the deficit country is already in a state of high unem- ployment and slow economic growth, the contractionary tendencies will serve to worsen the internal situation. The United States faced this dilemma in a number of years in the 1960s. On the other hand, if a country has a BOP surplus, there is upward pressure on the price level because of the expanding money supply. While this could potentially be helpful from the standpoint of employment and growth, it will aggravate internal performance with respect to the goal of price stability. For example, Germany has often had a BOP surplus but at the same time did not want its inflation rate to rise. Thus, whether a country is in BOP deficit or surplus, the attainment of some internal goal will be frustrated because of the fixed-rate system. The resolution of the question of whether discipline and hence price stability is more prevalent with fixed rates than with flexible rates requires extensive empirical research. It can be noted that world inflation was more rapid in the floating-rate period of the 1970s than in the pegged rate period of the 1960s, but events occurring independently of the exchange rate system—such as the behavior of OPEC—undoubtedly played a role in gen- erating this difference in world inflation. Empirically, Joseph Gagnon (2013) examined evidence pertaining to the recent global financial crisis and its aftermath in small- and medium-sized countries. He concluded that countries with flexible rates as well as specific inflation targets performed better than countries with fixed exchange rates with regard to both inflation and unemployment. Final PDF to printer 704 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch28_701-727.indd 704 06/22/16 01:56 PM A long-standing point made by proponents of fixed rates is that flexible rates are less con- ducive to the expansion of world trade and foreign direct investment than are fixed rates. In particular, a flexible exchange rate system is judged to bring with it a considerable amount of risk and uncertainty. Suppose that a U.S. exporter is considering a sale of goods to a Mexican buyer for future delivery in 30 days and that the exporter requires a price of $1,000 per unit to be willing to make the sale. If the Mexican buyer is willing to pay 15,000 pesos per unit and if the expected exchange rate in 30 days is 15 pesos = $1, then there is a basis for a contract and the sale will be made. However, if the exchange rate changes to 16 pesos = $1 by the end of the 30 days, then the U.S. firm will have made an unwise decision, because only $937.50 (= 15,000 pesos ÷ 16 pesos/$) rather than $1,000 will be received. In the context of this example, the case for fixed rates is that current decisions can be more certain as to their prospective future outcomes because the risk of a change in the value of the foreign currency (a depreciation in this case) is relatively small. With a flexible rate instead of a fixed rate and with the natural characteristic of risk aversion of most firms and individu- als, the exporting firm will require some insurance against the exchange rate change. This insurance can take the form of holding out for a slightly higher expected price than $1,000 or of hedging in the forward market (which incurs the transaction cost of hedging), although active forward markets exist only for major currencies. Further, it should be noted that the rapid increase in international financial derivatives (discussed in Chapter 21) now provides a wide variety of instruments for hedging the risks associated with international financial transactions. In any event, there is a cost, which means that, other things equal, a smaller volume of trade will occur under flexible rates than under fixed rates. With a reduced volume of international trade, there is less international specialization and lower world welfare. Aside from focusing on the potential reduction in the volume of trade, proponents of fixed rates also judge that the amount of long-term foreign direct investment will be less under flexible rates than under fixed rates. Any firm contemplating the building of a plant abroad, for example, will be concerned about the size of the return flow of repatriated profits in the future. If the exchange rate varies, then the real value of the return flow when converted into home currency may be less than anticipated when the original investment was made (if prices in the two countries have not moved proportionately with the exchange rate). In view of this prospect, firms will be more timid about investing overseas, and con- sequently capital may not flow to areas where the “true” rate of return is greatest. World resource allocation will hence be less efficient under flexible rates, and a fixed-rate system can prevent this reduced efficiency. The risk and uncertainty argument is thought to be stronger in the case of long-term investment than in the case of international trade because long-term forward currency contracts and other instruments for hedging are more difficult to acquire and more costly than short-term contracts to cover trade risk. However, with respect to this alleged adverse effect of flexible rates on foreign invest- ment, a directly opposite case can also be made. (See McCulloch, 1983, pp. 9–10.) Given overseas profit and price volatility in terms of domestic currency due to a floating exchange rate, firms may decide to reduce risk and uncertainty by producing in the foreign country itself. The foreign market will then be supplied from the foreign plant. In this interpreta- tion, the existence of floating rates in recent decades might actually have increased the amount of foreign direct investment. Indeed, foreign direct investment, especially into the United States, has grown during the floating-rate period, but of course we do not know what that investment would have been under fixed rates. In further reply to the arguments concerning the volume of trade and investment, propo- nents of flexible rates note that governments under fixed rates have often been unwilling to undergo the internal macroeconomic adjustments necessary for dealing with BOP deficits. The deficit situation eventually requires contraction of national income, yet a country with Would Fixed or Flexible Exchange Rates Provide for Greater Growth in International Trade and Investment? Final PDF to printer CHAPTER 28 FIXED OR FLEXIBLE EXCHANGE RATES? 705 app9062x_ch28_701-727.indd 705 06/22/16 01:56 PM unemployment and slow economic growth may seek to postpone such income adjustment by using expansionary policy to sterilize the effect of the BOP deficit on the domestic money supply. However, as reserves continue to decline, countries have resorted to import restric- tions and controls on capital outflows as devices for reducing BOP deficits. It is debatable whether such trade and investment restrictions have been successful in accomplishing their BOP objective, but they clearly interfere with efficient resource allocation and reduce welfare. In view of this behavior under fixed exchange rates, the argument is made that restric- tions on trade and capital movements for BOP purposes are unnecessary in a flexible-rate system. Movements in the exchange rate will eliminate the BOP deficit, thus undermining the rationale for the restrictions. Trade can then take place in accordance with compara- tive advantage and capital can flow to locations where its marginal productivity is highest. Nevertheless, if the rationale for the restrictions under fixed rates is protectionism and the BOP objective is only being used as a cover for this rationale, the adoption of floating rates may not lead to a removal of the restrictions. The question of whether or not flexible rates reduce the volume of international trade and investment in comparison with a fixed-rate system is difficult to answer, because the economist cannot take a country into a laboratory and conduct a test with all other condi- tions held constant. Nevertheless, the literature has tried to evaluate the argument, espe- cially with respect to the volume of trade. IN THE REAL WORLD: EXCHANGE RISK AND INTERNATIONAL TRADE Economists disagree over whether fluctuations in exchange rates and their associated risks reduce the amount of inter- national trade below what it would otherwise be. Peter Hooper and Steven Kohlhagen’s frequently cited article (1978) indicated that exchange rate variability had no sig- nificant effects on trade. More recent work has disputed this conclusion. A paper by Jerry Thursby and Marie Thursby (1987) suggested that trade is inhibited by exchange rate volatil- ity. This paper was of broad scope, focusing on the deter- minants of trade, including the role of exchange rate risk, of 17 industrialized countries over the period 1974–1982. The model tested was one of bilateral trade, where equa- tions were developed for each country’s trade with each of the other 16 countries. The Thursbys found that 15 of the 17 countries had negative relationships between size of trade and nominal rate variability, with the results for 10 of the 15 countries being statistically significant. The results using the real exchange rate were virtually identical to those using the nominal rate. Thursby and Thursby concluded that there was “strong support for the hypothesis that exchange risk affects the value of bilateral trade” (p. 494). Another test of the effect of exchange risk on trade was conducted by David Cushman (1988). He examined U.S. bilateral exports and imports with six trading partners from 1974 to 1983. Five different measures of risk involving the real exchange rate were used, with each measure incorpo- rating different assumptions about expectations patterns of traders (e.g., expectations based on recent spot rate vari- ability, forward rate behavior in relation to the spot rate) and time horizons. Allowance for the influence on trade of other factors such as real income, capacity utilization, and unit labor costs was made. Of the 12 U.S. bilateral flows, 10 showed negative effects of exchange rate risk on trade, with 7 of the 10 having statistical significance. Cushman concluded (p. 328) that “in the absence of risk, U.S. imports would have been about 9% higher, and U.S. exports about 3% higher on average during the period.” Nevertheless, debate has continued. For example, Joseph Gagnon (1993) argued from a theoretical model with numer- ical analysis that the variability in exchange rates of indus- trial countries could have had no significant effect on the volume of trade. However, a 1996 IMF study (Ito, Isard, Symanski, and Bayoumi, 1996) examined exchange rate (continued) Final PDF to printer 706 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch28_701-727.indd 706 06/22/16 01:56 PM IN THE REAL WORLD: (continued) EXCHANGE RISK AND INTERNATIONAL TRADE conclusion), other work has buttressed the case that vari- able exchange rates do inhibit trade. Michael Klein and Jay Shambaugh (2006) studied bilateral trade, with their focus on situations where any given currency was pegged in some form to at least one other currency—for example, the Saudi Arabian riyal to the U.S. dollar. They examined 181  countries over the period 1973–1999. Their overall conclusion was that a peg or fixity in an exchange rate can increase trade by up to 35 percent. Mohsen Bahmani-Oskooee and Scott Hegerty (2009) investigated the impact of exchange rate fluctuations on Mexican trade with the United States. They examined trade behavior in 102 industries for the period 1962–2004. Important results were that most effects were negative, meaning that an increase in volatility decreased the amount of trade, especially in agricultural goods and textiles. In addition, Bahmani-Oskooe, Hegerty, and Amr Hosny (2015) studied trade between Egypt and the European Union in 59 Egyptian industries. The period examined was 1994– 2007. They found relatively little impact of exchange-rate volatility on the volume of trade in the short run. In the long run, however, while a few industries showed an increase in trade with increased volatility, a much larger number dem- onstrated negative effects, that is, increased volatility of the exchange rate was associated with a decrease in the volume of trade. Thus the debate continues! ● variability and trade among the then-18 member countries of the Asia-Pacific Economic Cooperation Forum (APEC) and concluded that there was very strong evidence that medium-term exchange rate volatility does affect trade and can definitely cause complications for the economies of the countries. In other empirical work, Wang and Barrett (2002),using sector- and market-specific monthly data on trade between Taiwan and the United States (1989–1998), examined the impact of expected exchange rate risk on Taiwanese exports. In seven of eight sectors, exchange rate volatility proved to be statistically insignificant. The only exception was agricul- ture, which appeared to respond negatively and significantly to expected exchange rate volatility. Along the same line of finding no important role for exchange rate changes in influencing international trade, Mustafa Caglayan and Jing Di (2010) investigated the effect of real exchange rate vola- tility on the amount of trade between the United States and 13 leading trading partners at the micro level of sectors of the economy. They examined the period from January 1996 to September 2007. They concluded, after their econometric work with monthly data, that real exchange rate volatility had little impact on sectoral U.S. trade. Of course, as might be expected (a joke is that, if you laid all economists end-to-end, you would never reach a Another argument put forward for fixed exchange rates is that the wasteful resource movements associated with flexible exchange rates are avoided. This argument states that, with a system where exchange rates can vary substantially, there can be constantly changing incentives for the tradeable goods sectors. If the country’s currency depreci- ates in the exchange markets, then factors of production will be induced to move into the tradeable goods sectors and out of the nontradeable goods sectors because the production of exports and import substitutes is now more profitable. However, if the currency then appreciates, the incentives reverse themselves and resources move out of tradeables and into nontradeables. Therefore, if fluctuations in the exchange rate occur, there will be constant movement of factors between the sectors and this movement involves economic waste because factors are temporarily displaced, labor may need to be retrained, and so forth. Further, if resources are unwilling to undergo continuous movement, there is a more permanent misallocation and inefficiency. These various reductions in efficiency and welfare could be avoided if the exchange rate were not allowed to change in the first place. However, in response, proponents of flexible rates attack a fixed-rate system because of its key characteristic that it fixes the most important price in any economy, the exchange rate. Would Fixed or Flexible Exchange Rates Provide for Greater Efficiency in Resource Allocation? Final PDF to printer CHAPTER 28 FIXED OR FLEXIBLE EXCHANGE RATES? 707 app9062x_ch28_701-727.indd 707 06/22/16 01:56 PM The main point is that, from microeconomic theory, the fixing of any price interferes with efficient resource allocation because optimum resource use is attained when prices are free to reflect true scarcity values. The absence of a flexible price for foreign exchange in a fixed-rate system generates widespread price distortions and gives misleading signals and therefore inhibits efficient resource allocation. (Such a situation is common in developing countries, where fixed exchange rates have often been chosen over flexible rates.) The interference with efficiency can be best seen in the situation where a country’s currency is overvalued but the fixed-rate system does not permit a devaluation. In this instance, export industries are penalized because of the arbitrary level of the exchange rate, and yet comparative advantage theory tells us that the export sector contains the relatively most efficient industries in the economy. This argument is given further strength by noting that comparative advantage is not a static phenomenon. Rather, any country’s comparative advantage industries are changing over time as new resources, new technology, and new skills emerge. Such dynamic changes lead to and are caused by variations in relative prices. If the exchange rate is fixed, then the resource-allocating role of changing relative prices is prevented from generating its maximum benefits. In addition, a second efficiency objection to a fixed-rate system is that resources need to be tied up in the form of international reserves. The successful operation of a fixed exchange rate system requires that countries maintain working balances of reserves to finance defi- cits in the balance of payments. Even if a deficit is temporary (perhaps because of seasonal factors in the trade pattern) and will reverse itself, reserve assets are needed to meet the temporary excess demand for foreign exchange so as to maintain the pegged exchange rate. In addition to these working balances, which reflect the transactions demand for international reserves, countries may also wish to hold extra reserves to guard against any unexpected negative developments in the balance of payments. Hence, there is also a precautionary demand for international reserves. In this context, economic behavior by governments dictates that calculations be made of the costs versus benefits of holding reserves (the benefits being that macroeconomic adjust- ments such as a reduction in national income do not have to take place because temporary sterilization can be accomplished). The costs are the opportunity costs of holding part of the country’s wealth in the form of reserves rather than in the form of productive capital stock. The forgone capital stock would have earned the marginal productivity of capital in the country, and this lost output is a measure of the cost of holding international reserves to defend a pegged exchange rate. Quantitative assessments can be made of these benefits and costs, and the country will be holding its optimal size of international reserves when the marginal benefit is equal to the marginal cost. The marginal cost will not be zero, however, so the fixed-rate system implies a burden in terms of forgone output. In this framework, the argument in favor of flexible rates is that such a system elimi- nates the need for central banks to hold international reserves. If the exchange rate clears the market, resources are therefore freed to be used more productively elsewhere in the economy. Hence, the forgone capital stock and the forgone output which that capital would have produced do not have to be sacrificed. Another argument made in favor of fixed rates is that fiscal policy is more effective in influencing the level of national income under fixed rates than under flexible rates. The basic point is that expansionary fiscal policy, for example, shifts the IS curve to the right in the IS/LM/BP diagram. With relatively mobile capital internationally (BP curve flat- ter than the LM curve), the policy generates a BOP surplus under fixed rates because of the rise in the interest rate and the subsequent net inflow of short-term capital, which expands the money supply and aids in the effort to expand national income. With a flexible Is Macroeconomic Policy More Effective in Influencing National Income under Fixed or Flexible Exchange Rates? Final PDF to printer 708 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch28_701-727.indd 708 06/22/16 01:56 PM exchange rate, the appreciation caused by the capital flow would work to return national income toward its original level. If international capital is relatively immobile, a BOP deficit occurs under fixed rates, weakening the income effect of the expansionary fiscal policy; with flexible rates, a depreciation of the home currency adds stimulus to income. Ultimately, of course, the outcome depends on the degree of mobility of short-term capital. At least among the industrialized countries, such capital is very mobile, and so the superior effectiveness of fiscal policy under fixed rates seems to be a valid argument. However, whatever the degree of international capital mobility, monetary policy is more effective for influencing the level of national income in a flexible-rate system than in a fixed-rate system. This point was examined extensively in the previous two chapters. An expansion of the money supply to increase national income generates a depreciation of the home currency, and this will act to reinforce the income-increasing impact of the mon- etary expansion. A similar reinforcement mechanism applies in the case of contractionary monetary policy. Hence, to an important extent, the comparative effectiveness of macro policy is a debat- able issue only if fiscal policy is preferred to monetary policy as the instrument of choice. This decision on fiscal policy vis-à-vis monetary policy involves various other consider- ations with respect to direct versus indirect government influence on the economy and the proper role of government. The preference will vary from country to country. Another argument that has been made for flexible rates is that such a system permits monetary and fiscal policies to be directed solely toward the attainment of internal eco- nomic goals. The point was made earlier that under fixed rates, policy authorities might have to sacrifice the attainment of internal objectives (e.g., full employment) to satisfy the external objective of BOP equilibrium. On the other hand, if the exchange rate is flexible, the exchange rate itself will take care of any BOP problems: a deficit (surplus) situation will promptly set a depreciation (appreciation) of the home currency into operation, and this depreciation (appreciation) will remove the deficit (surplus). Hence, there is no need to use monetary and fiscal policies to deal with imbalances in the BOP, and these instru- ments can be directly used to deal with internal problems (i.e., the “balance-of-payments constraint” on policy has been removed). Proponents of this argument point to the fact that effective policymaking requires that the number of instruments match the number of targets. The virtue of the floating- rate system is that an additional (automatic) instrument—the exchange rate—has been added. Thus, if the three targets are BOP equilibrium, full employment, and price sta- bility, the three instruments are the exchange rate, fiscal policy, and monetary policy. Because the exchange rate is now handling BOP problems, fiscal policy can be directed toward raising the level of employment and monetary policy can be directed toward achieving price stability. Hence, the arsenal of instruments is enhanced under a floating- rate system. In assessing this argument, note that a conflict will not necessarily arise between the policies needed for attaining BOP equilibrium and those needed for reaching internal tar- gets. For example, a country with a BOP deficit and rapid inflation will require a con- tractionary policy stance for reaching both the external target and the internal target of price stability, although the degree of contraction necessary for reaching each respective target may differ. Similarly, a country with a BOP surplus and excessive unemployment will find that expansionary policies will work to remove the surplus as well as the unem- ployment, although again the extent of policy action may differ for each respective target. In the other cases—BOP deficit together with unemployment and BOP surplus together with inflation—the fixed-rate system imposes a constraint on the conduct of policy for the attainment of the internal target. Imaginative devices such as the use of monetary policy Final PDF to printer IN THE REAL WORLD: RESERVE HOLDINGS UNDER FIXED AND FLEXIBLE EXCHANGE RATES As noted in the text, the elimination of the need to hold international reserves and therefore of the opportunity costs of holding reserves is an advantage of a flexible-rate sys- tem over a fixed-rate system. It is therefore instructive to examine the comparative size of international reserves in a regime of fixed exchange rates and in a regime where exchange rates can vary considerably. Table 1, column (2), lists international reserves held by central banks during the 1948–1972 years of the Bretton Woods pegged exchange rate system in the world economy (see the next chapter) and since 1973, when currencies began floating subsequent to the breakdown of Bretton Woods. For relative compari- son purposes, total world merchandise imports are also given in column (3), as is the ratio of reserves to imports in column (4). This reserves/imports ratio is often used as a rough indicator of the ability of countries to finance BOP deficits under a fixed-rate system. With the advent of flexible rates in 1973, you would expect that the reserve ratios would have declined dramatically, because a flexible-rate system in theory requires no reserves. However, the table indicates that, in absolute size, reserves increased dramatically in the 1973–2014 period, rising from $191.5 billion at the end of 1973 to $12,036.8 billion at the end of 2014. Nevertheless, reserve holdings relative to imports have been somewhat lower in the floating-rate period (the average annual hold- ing was 35.9 percent) than in the 1948–1972 fixed-rate period (average annual holding of 57.2 percent). The fall in the reserve/imports ratio suggests that at least the relative opportunity cost of holding reserves has declined. Of course, since countries still do intervene to influence exchange rates (that is, the system is not a complete flexible-rate system, especially with respect to developing countries), it would not be expected that reserve holdings would disappear. Nevertheless, it is noteworthy that from 2009 to 2014, in the midst of worldwide financial upheaval, the reserves held by central banks and the ratio of reserves to imports were substantially larger than in previous years. (continued) CHAPTER 28 FIXED OR FLEXIBLE EXCHANGE RATES? 709 app9062x_ch28_701-727.indd 709 06/22/16 01:56 PM CONCEPT CHECK 1. What is meant by “discipline” in the world economy, and how might fixed exchange rates work to promote such discipline? 2. Why might a fixed-rate system potentially enhance the growth of foreign trade and investment in the world economy? 3. How can the existence of the transactions and precautionary demands for international reserves reduce world output over what would otherwise be the case? 4. Explain why it can be uncertain whether fis- cal policy is more effective for influencing national income under fixed exchange rates than under flexible exchange rates. A major concern expressed by some economists is that a system of flexible exchange rates will be characterized by destabilizing speculation. This argument stresses that the normal fluctuations that occur with flexible rates are augmented by the behavior of speculators attempting to make profits on the basis of their anticipations of future exchange rates. If a currency depreciates (appreciates), speculators will project forward the depreciation (appreciation) and will conclude that their optimal strategy is to sell (buy) the currency. These sales (purchases) will worsen the depreciation (appreciation). The result of this spec- ulative behavior is that cyclical fluctuations in exchange rates will have greater amplitude than otherwise would be the case. Will Destabilizing Speculation in Exchange Markets Be Greater under Fixed or Flexible Exchange Rates? to attain the external target and of fiscal policy to attain the internal target (the Mundell prescription in Chapter 25) may be tried in these conflict situations, but they may also not be very successful. Final PDF to printer 710 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch28_701-727.indd 710 06/22/16 01:56 PM IN THE REAL WORLD: (continued) RESERVE HOLDINGS UNDER FIXED AND FLEXIBLE EXCHANGE RATES TABLE 1 Absolute and Relative Reserves of Central Banks, 1948–2014 *In billions of dollars. Reserves consist of gold, foreign exchange holdings, reserve position in the International Monetary Fund (IMF), and holdings of special drawing rights (SDRs). The reserve components are explained in more detail in the next chapter. †In billions of dollars, valued c.i.f. Source: Data from elibrary, obtained from data.imf.org. (1) (2) (3) (4) Year World Reserves* World Imports† Ratio 1948 $ 49.2 $ 56.7 86.8% 1949 47.1 52.4 89.9 1950 50.0 51.8 96.5 1951 50.4 72.3 69.7 1952 51.3 72.7 70.6 1953 53.3 70.0 76.1 1954 55.0 72.5 75.9 1955 55.9 88.3 63.3 1956 57.9 98.0 59.1 1957 57.8 107.4 53.8 1958 58.9 91.6 64.3 1959 59.4 98.2 60.5 1960 62.5 113.4 55.1 1961 64.3 119.1 54.0 1962 65.1 125.2 52.0 1963 68.9 137.3 50.2 1964 71.3 155.6 45.8 1965 72.5 168.5 43.0 1966 75.1 188.0 39.9 1967 76.7 198.4 38.7 1968 79.8 224.7 35.5 1969 80.6 256.9 31.4 1970 97.6 298.4 32.7 1971 139.7 332.8 42.0 1972 166.0 392.0 42.3 Yearly average, 1948–1972 $ 70.7 $145.7 57.2% (1) (2) (3) (4) Year World Reserves* World Imports† Ratio 1973 $ 191.5 $ 546.0 35.1% 1974 227.5 795.4 28.6 1975 233.9 826.7 28.3 1976 264.3 936.7 28.2 1977 327.2 1,075.4 30.4 1978 373.0 1,246.7 29.9 1979 412.4 1,560.4 26.4 1980 461.2 1,913.1 24.1 1981 430.7 1,995.1 21.6 1982 406.0 1,858.4 21.8 1983 421.3 1,803.0 23.4 1984 438.4 1,915.1 22.9 1985 488.9 1,969.9 24.8 1986 561.4 2,141.7 26.2 1987 777.2 2,503.6 31.0 1988 784.9 2,868.4 27.4 1989 829.9 3,103.2 26.7 1990 990.0 3,509.2 28.2 1991 1,049.7 3,626.5 28.9 1992 1,046.0 3,884.5 26.9 1993 1,152.4 3,785.4 30.4 1994 1,313.0 4,310.3 30.5 1995 1,531.5 5,129.9 29.9 1996 1,703.2 5,375.5 31.7 1997 1,758.8 5,584.7 31.5 1998 1,810.7 5,515.0 32.8 1999 1,934.0 5,810.4 33.3 2000 2,070.3 6,582.2 31.5 2001 2,191.8 6,357.2 34.5 2002 2,574.0 6,601.6 39.0 2003 3,206.8 7,712.6 41.6 2004 3,921.5 9,436.7 41.6 2005 4,439.3 10,758.8 41.3 2006 5,359.0 12,360.5 43.4 2007 6,809.3 14,269.8 47.7 2008 7,466.2 16,502.3 45.2 2009 8,594.0 12,713.7 67.6 2010 9,701.4 15,331.6 63.3 2011 10,708.8 18,267.3 58.6 2012 11,461.2 18,367.7 62.4 2013 12,183.3 18,587.2 65.5 2014 12,036.8 18,767.8 64.1 Yearly average, 1973–2014 $ 2,967.7 $ 6,385.9 35.9% ● Final PDF to printer CHAPTER 28 FIXED OR FLEXIBLE EXCHANGE RATES? 711 app9062x_ch28_701-727.indd 711 06/22/16 01:56 PM This argument is illustrated in Figure 1. Line R shows regular (nonspeculative) fluctua- tions around the long-run equilibrium value of the exchange rate ē. Suppose that, from initial point A, the home currency begins to depreciate toward point B. With destabilizing speculation, speculators judge that, at a point like B, the currency will continue to depreci- ate. They sell the currency in anticipation of buying it back later at a lower price, driving e beyond the normal peak (point C). After the currency turns around and begins to appreci- ate, at point F the speculators will expect continued appreciation and will buy the home currency in anticipation of a future sale at a higher home-currency price. This action will carry the exchange rate below the normal trough of e at point G. The cycle with destabiliz- ing speculation is represented by R′ (which need not have peaks and troughs at the same time as R or the same cycle lengths). Such behavior of the exchange rate, even without destabilizing speculation, is also characteristic of the overshooting phenomenon discussed in Chapter 22. However, a contrary case can also be made for stabilizing speculation. Suppose that, after the movement from A to B, speculators think that the currency has “depreciated enough” in view of the fundamentals of the economy and that it is now time to buy the currency. Speculative purchases of the home currency at B will cause the upswing of the cyclical movement to be diminished rather than enhanced. The sale of the currency on the downswing of the cyclical movement at point F will also dampen the cycle in that direction. With stabilizing speculation, the entire cycle is represented by dotted line R″, and greater stability exists than with the normal cycle R. FIGURE 1 Destabilizing and Stabilizing Speculation Normal fluctuations in the exchange rate around its equilibrium value ē are pictured by line R. With destabiliz- ing speculation, when a depreciation of the home currency occurs between point A and point B, speculators project a further depreciation and sell the home currency. This causes the home currency to depreciate to a level beyond that associated with its “normal” low value at point C. In the downswing of e, speculators project for- ward the appreciation of the home currency and purchase it at F. These purchases lead to a home-currency value greater than its “normal” high value at point G. The resulting line R′ has greater amplitude than R. If speculation were stabilizing, speculators would purchase the home currency at B and sell it at F, generating line R″ with a smaller amplitude than R. Time R R' R'' A B C F G e (units of home currency per unit of foreign currency) e Final PDF to printer 712 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch28_701-727.indd 712 06/22/16 01:56 PM Debate on the nature of speculation has gone on for a number of years, and there is no unanimity of views. Milton Friedman, a longtime proponent of flexible rates, maintained that destabilizing speculation cannot persist indefinitely. Such speculation would imply that speculators are selling the home currency when its price is low (at point B in Figure 1) and buying the home currency when its price is high (at point F). Surely this is not the way to make a profit! Stabilizing speculation, on the other hand, involves the profitable activity of buying the currency at a low price and selling it at a high price. Thus, because specula- tion continues to exist in the real world, it must be profitable and therefore stabilizing. This conclusion on the profitability of speculation and its implication regarding stability have been disputed in more complex analyses. At issue is the nature of expectations. If a change in a variable leads to the expectation that the variable will return to (depart farther from) some “normal” level, the speculation will be of the stabilizing (destabilizing) sort. We do not know what circumstances will generate one or the other type of expectation. Recent studies have explored the question of expectations in relation to policy actions. If speculators can figure out how the monetary authorities will react to an exchange rate change, then this knowledge can be profitable. For example, if a depreciation of the dol- lar causes the Federal Reserve to buy dollars and if speculators anticipate that action, the speculators will buy dollars ahead of the Federal Reserve to profit from the forthcoming rise in the dollar’s price. The result is consistent with “stability.” Other matters, such as the degree of confidence speculators place in the Federal Reserve, are also involved. Finally, much work has been done on how expectations are formed. Are expectations “adaptive” (based on recent past behavior) or are they “rational” and forward-looking (based on all available information on how the economy works and how policy authorities react)? Because speculation may be destabilizing in a flexible-rate system, do we therefore con- clude that it is stabilizing in a fixed-rate system? Some economists think that fixed rates do indeed invite stabilizing speculation, because the floor and ceiling for a rate suggest that the rate will never go outside those limits. Hence, when a currency falls to its floor value, spec- ulators know that it will go no lower and could turn around, so they will likely buy it. This will turn the currency’s value upward. This scenario in reverse would occur at the ceiling. However, this argument rests on the assumption that central banks can indeed enforce the floor and ceiling limits. But this may not be the case. Suppose that, as in the Bretton Woods system, currencies are permitted to vary ±1 percent from their parity values. If the parity value of the British pound is $1.50 = £1, then the floor price of the pound is $1.485 and the ceiling is $1.515. In addition, suppose that because of greater inflation in Britain than in the United States, the pound starts to fall in value from parity toward the floor and that it even- tually hits the floor. At this point, the British authorities will be using some of their inter- national reserves to buy pounds to keep the pound from falling further. However, if Britain does nothing to slow down its inflation rate, speculators will sell large volumes of pounds on the exchange markets because the speculators essentially have a one-way bet. The mas- sive sales of pounds by speculators then will ensure that the prediction of a fall in the value of the pound is a self-fulfilling prophecy, because the continued sales will exhaust British reserves as the Bank of England futilely tries to purchase sufficient pounds. The speculators will have sold pounds at $1.485 and will later be able to buy them back at a lower price. This speculative behavior against weak currencies thus makes it very difficult to keep the fixed exchange rates intact. And the Bretton Woods system did indeed have a number of instances of speculative attacks on currencies and changes in parity values. Further, speculation clearly played a role in upsetting the pegged rates among some members of the European Community in 1993. In practice, the applicability of this argument against the viability of a fixed-rate system depends in large part on the degree of confidence specula- tors place in governments. If government policymakers are able to implement effective Final PDF to printer CHAPTER 28 FIXED OR FLEXIBLE EXCHANGE RATES? 713 app9062x_ch28_701-727.indd 713 06/22/16 01:56 PM TITANS OF INTERNATIONAL ECONOMICS: MILTON FRIEDMAN (1912–2006) Milton Friedman was born in Brooklyn, New York, on July 31, 1912, the son of a poor immigrant family. He earned his A.B. at Rutgers in 1932, his master’s degree at the University of Chicago in 1933, and his Ph.D. at Columbia in 1946. During the time between his master’s and his Ph.D., he worked for the National Resources Committee in Washington, the National Bureau of Economic Research in New York, the U.S. Treasury Department, and the War Research division of Columbia University, as well as per- forming short-term teaching stints at the universities of Wisconsin and Minnesota. After finishing his Ph.D., he taught at the University of Chicago from 1948 to 1982 and was the Paul Russell Snowden Distinguished Service Professor of Economics from 1962 to 1982. He became a Senior Research Fellow at the Hoover Institution at Stanford University in 1977 and remained an active scholar until his death on November 16, 2006. Milton Friedman’s contributions to economics are leg- endary and of extremely wide scope. His early work con- centrated on statistical methods, but he then ventured into other areas. Still widely discussed is his 1953 book, A Theory of the Consumption Function, in which he developed the hypothesis that consumption spending by households depended not on current income but on the longer-term notion of permanent income, an expectation of income flows over many years. In this light, short-term transitory changes in current income would have virtually no impact on current consumption. Even more well known is Friedman’s work on money and economic activity, and he is hailed as having been the driving force behind monetarism and its emphasis on monetary policy rather than on fiscal policy for influ- encing the macroeconomy. His work was both historical [e.g., Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867–1960 (1963)] and theoretical (e.g., “The Role of Monetary Policy,” American Economic Review, March 1968). It led to such familiar doctrines as the modern quantity theory of money and the automatic “rule” for monetary growth. Friedman is also widely regarded as the father of the concept of the “natural” rate of unemploy- ment, an attack on the notion of a downward-sloping Phillips curve reflecting a trade-off between inflation and unemploy- ment. In addition, he was the leading proponent of flexible exchange rates. Throughout Professor Friedman’s career, he was vitally concerned that economics be “practical.” His widely cited view was that theory should not be judged by its assump- tions but by whether it can satisfactorily predict economic behavior in the real world. In addition, he stressed continu- ally the role of individuals, the market, and laissez-faire, even suggesting in his popular 1962 book, Capitalism and Freedom, that licensing of medical practitioners should be abolished because it is a barrier to entry and thus to effi- cient resource allocation. He was constantly suspicious of government intervention and regulation, and his public television series, Free to Choose, made his views known to millions worldwide. He is also known for the absolute clar- ity of expression that helped to popularize his ideas. In the context of this chapter, for example, he made the case that the adoption of flexible exchange rates is analogous to the adoption of daylight saving time. Instead of going through the confusion and inefficiency of having everyone move all their activities one hour earlier every summer, why not just change the clock? For his many contributions, Milton Friedman was elected president of the American Economic Association for 1967 and was awarded the Nobel Prize in economics in 1976. In addition, he received honorary doctorates from many col- leges and universities. His awards were innumerable, and some of them are seldom given to ordinary academics—we note in particular such honors as “Chicagoan of the Year” and “Statesman of the Year.” Upon Friedman’s death, John L. Hennessy, the president of Stanford University, noted that the United States had lost one of its leading economists, and he lauded Friedman’s scholarship and ability to explain dif- ficult theories. He predicted that Friedman’s insights would remain influential for a very long time. There is no doubt that this last point is indeed true and that it is true with respect to an impressive number of different areas of economics. Sources: Mark Blaug, ed., Who’s Who in Economics: A Biographical Dictionary of Major Economists 1700–1986, 2nd ed. (Cambridge: MIT Press, 1986), pp. 291–93; John Burton, “Positively Milton Friedman,” in J. R. Shackleton and Gareth Locksley, eds., Twelve Contemporary Economists (London: Macmillan, 1981), pp. 53–71; Alan Walters, “Milton Friedman,” in John Eatwell, Murray Milgate, and Peter Newman, eds., The New Palgrave: A Dictionary of Economics, vol. 2 (London: Macmillan, 1987), pp. 422–27; Who’s Who in America, 46th edition 1990–1991, vol. 1 (Wilmette, IL: Marquis Who’s Who, 1990), p. 1119; Who’s Who 1997 (New York: St. Martin’s Press, 1997), p. 692; Hoover Institution, “Milton Friedman, Noted Economist, Nobel Laureate, and Hoover Senior Research Fellow, Dies at 94,” press release, November 16, 2006. ● Final PDF to printer 714 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch28_701-727.indd 714 06/22/16 01:56 PM measures for dealing with imbalances in the balance of payments, then speculators might behave in a stabilizing manner. Finally, the force of the argument also depends on the size of the speculative capital flows in relation to the size of the countries’ international reserves. Most observers feel that the volume of potential speculative capital is currently large enough to cause difficulty for any central bank. However, if the destabilizing speculation under fixed rates is an important phenomenon, it in a sense makes all previous points in the fixed-flexible debate rather moot, because the fixed-rate system may in fact not be viable with the existence of today’s potentially huge volume of speculative capital. Indeed, many economists think that the structural and policy differences among countries make it highly unlikely that a fixed-rate system can operate successfully. An emphasis in this line of reasoning is that unemployment-inflation com- binations differ across countries. In some countries (e.g., Sweden), the policy authorities aim for low levels of unemployment rather than toward the avoidance of inflation. In other countries (e.g., Germany), the preferences may be reversed. A physically small economy with a mobile labor force (e.g., Switzerland) may be able to attain a lower unemployment rate without incurring rapid inflation than can a physically large country with substantial structural unemployment (e.g., the United States). For these reasons and others (such as an ineffective tax collection system characteristic of many developing countries), some countries tend to have chronic higher inflation rates than other countries. The more rapidly inflating countries will find themselves with frequent BOP deficits, and countries with greater price stability will be running BOP surpluses. With limited international reserves, slow adjustment, and destabilizing speculation, deficit countries will ultimately have to devalue and the fixed-rate system will break down. An important argument against a fixed exchange rate system is that, in such a system, business cycles will be transmitted from one country to other countries, meaning that no country is able to insulate itself from external real shocks. If a foreign country goes into a recession, it will buy less of the home country’s exports. As a result, national income will fall in the home country. If foreign repercussions are important, the fall in income in the home country will then reduce the home country’s purchases from the foreign country, which will in turn worsen the recession abroad and eventually feed back again upon the home country. The same scenario in an upward direction also occurs, resulting in the trans- mission of inflation from one country to another. The fixed-rate system contributes to this transmission of business cycles because the exchange rate is a passive part of the process. In a flexible-rate situation, the exchange rate would take an active part in mitigating the transmission. For example, in the recession case above, the initial decline in the home country’s exports (a leftward shift of its IS and BP curves) would cause a depreciation of the home currency and would stimulate the home country’s production of exports and import substitutes. This would offset the downward thrust on income as the curves shifted back to their original positions. A similar offset would occur if an overseas boom had started the process. Thus, the flexible exchange rate serves to insulate the economy from external real sector shocks. Note, however, that we have only discussed external real sector shocks so far in this sec- tion. Suppose instead that the external sector shock is a financial sector shock, such as a rise in interest rates abroad. As noted in Chapter 26, this causes the home country’s BP curve to shift to the left, leading to an incipient deficit in the balance of payments as home coun- try short-term funds move abroad. The home currency will then depreciate, shifting the IS curve to the right and shifting the BP curve rightward toward its original position. With the LM curve unchanged, the result is a higher level of home income. On the other hand, if the exchange rate had been fixed, the initial leftward shift in the BP curve and the resulting BOP deficit would have resulted in monetary contraction and a fall in home income. Thus, there Will Countries Be Better Protected from External Shocks under a Fixed or a Flexible Exchange Rate System? Final PDF to printer IN THE REAL WORLD: “INSULATION” WITH FLEXIBLE RATES—THE CASE OF JAPAN A study to determine whether an economy is more insu- lated from outside shocks under flexible than under fixed exchange rates was carried out by Michael Hutchison and Carl E. Walsh (1992). Reacting to some 1980s literature that questioned whether flexible rates really “insulated” an economy (e.g., Dornbusch, 1983; Baxter and Stockman, 1989), Hutchison and Walsh focused specifically on Japan. For the fixed-rate regime, they examined the period from the fourth quarter of 1957 through the fourth quarter of 1972; for the flexible-rate regime, they looked at the period from the fourth quarter of 1974 through the fourth quarter of 1986. While their work indicated that the proportion of variation in Japanese real GNP due to foreign shocks was considerably larger in the flexible-rate period than in the fixed-rate period, this variation could have occurred because there were more severe external shocks in the flexible-rate period (such as the oil shocks and the recessions in the industrialized countries in the 1970s and early 1980s). Thus, Hutchison and Walsh concerned themselves with the effects of shocks after controlling for the size of the shocks. Their statistical work estimated the impacts on Japan over time of a one-unit shock in oil prices (in real terms), a one-unit shock in U.S. real GNP, and a one-unit shock in the U.S. nominal money supply (M1). What conclusions were reached? First, Hutchison and Walsh indicated that, after several quarters, a real oil price increase (by itself) caused a marked decline in the level of Japanese real GNP. However, the decline under fixed rates was significantly greater than under flexible rates. Similarly, a one-unit change in U.S. GNP was long lasting in its effect on Japan in both exchange rate systems, but the effect was greater under fixed rates. In the case of a U.S. money supply shock, the effect on Japan was the same for both exchange rate systems. Thus, the overall conclusion of Hutchison and Walsh was that, in the case of Japan, flexible rates generally pro- vided more “insulation” from external shocks than did fixed rates. Another interesting result from their model was that an initial one-unit Japanese real GNP shock (an internal shock) also had less total effect on Japan itself under flexible rates than under fixed rates. This result logically follows if the BP curve for Japan is flatter than the LM curve. ● CHAPTER 28 FIXED OR FLEXIBLE EXCHANGE RATES? 715 app9062x_ch28_701-727.indd 715 06/22/16 01:56 PM is “insulation” in neither exchange rate system, but home national income moves in opposite directions depending on the system being used. Which result is more desirable will depend on the state of the domestic economy at the time of the foreign financial shock. Empirical work by Gagnon (2013) strongly suggests that, for small- and medium- sized countries, flex- ible rates provided more insulation in the recent financial crisis than did fixed rates. Finally, although this section has been concerned with external shocks, it can be noted that, under flexible rates, internal shocks to the economy can be more destabilizing to national income than under fixed rates. A domestic monetary or financial shock (a shift in the LM curve) produces a greater income response under flexible rates than under fixed rates. The same conclusion on income response applies for an internal real sector shock if the BP curve is steeper than the LM curve (relative capital immobility). However, the real sector shock yields less income response under flexible rates than under fixed rates if the BP curve is flatter than the LM curve (relative capital mobility). Hence, to determine whether flexible or fixed rates make for greater instability with respect to internal real sec- tor shocks in practice, some determination must be made of the international responsive- ness of short-term capital to changes in interest rates. This concludes our discussion in this chapter of major issues in the fixed versus flexible exchange rate debate. In practice, the world has moved from a system of relatively fixed rates in the 1950s and 1960s to a system of considerably greater flexibility in exchange rates since 1973. As we shall see in the last section of this chapter, however, it is unnecessary to think only in terms of fixed rates versus completely flexible exchange rates. Some hybrid systems are possible, and these hybrids have also been important in practice in recent years. Final PDF to printer 716 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch28_701-727.indd 716 06/22/16 01:56 PM CURRENCY BOARDS In decisions regarding the type of exchange-rate system to employ, a relatively new arrangement that is of a fixed exchange rate nature has been chosen by several countries. This arrangement is a currency board. A currency board is a monetary authority with a mandate to issue domestic currency that can be exchanged for a foreign (reserve or anchor) currency at a fixed exchange rate. By following strict money supply rules, the currency board severely restricts the government’s monetary policy authority. The board cannot con- duct monetary policy by changing the monetary base (bank reserves plus currency in cir- culation) with the traditional tools of monetary policy such as open market operations. The monetary base increases only when the private sector sells foreign exchange to the board at a fixed rate to meet the private sector’s demand for national currency. Buying foreign cur- rency from the currency board to finance a BOP deficit reduces the monetary base. Under a currency board system, the government cannot monetize budget deficits.3 In a currency board arrangement, the commitment to exchange the local currency for the reserve (or anchor) currency at a fixed exchange rate normally does not include any quanti- tative limit. This commitment means that the monetary authority must have sufficient for- eign exchange reserves to meet demand. Countries adopting currency boards have sought to maintain at least 100 percent backing of the monetary base. The 100 percent backing of the monetary base with foreign currency means that the money supply is almost completely beyond the influence of decisions by government officials and the monetary authorities.4 A currency board combines three elements. The first is a fixed exchange rate between the country’s currency and the “anchor” currency. The second is automatic convertibility of the currency. The third is a long-term commitment to the system, in many cases made explicit by the central bank law. The main reason a country adopts a currency board is to facilitate the pursuit of an anti-inflationary policy.5 Four major advantages are usually cited when comparing a currency board arrangement with a central bank with discretionary control of the money supply. 1. A currency board ensures convertibility. The maintenance of a 100 percent reserve system makes it certain that assets are available to cover any demand for conversion into foreign currency. 2. A currency board instills macroeconomic discipline. Because the currency board is prohibited from buying domestic assets, it cannot finance a fiscal deficit. The government is forced to borrow from the public at home or abroad or maintain a balanced budget. In other words, the government cannot simply “print money” to finance a government budget deficit because the money supply is strictly tied to the quantity of foreign exchange held by the currency board. It is hence also argued that a currency board will secure discipline over inflation. The process of tying the local currency to a reserve (and presumably low inflation) currency at a fixed exchange rate enhances price stability. 3. A guaranteed payment adjustment mechanism is provided. The payment adjustment mechanism is simply the gold-standard adjustment mechanism that is actually a version Advantages of a Currency Board6 3N. B. Gultekin and K.Yilmaz, http://home.ku.edu.tr/kyilmaz/papers/parakurf . 4Iikka Korhonen, “Currency Boards in the Baltic Countries: What Have We Learned?” Bank of Finland Institute for Economies in Transition Discussion Papers No. 6 (1999). 5Anne-Marie Gulde, “The Role of the Currency Board in Bulgaria’s Stabilization,” Finance and Development 36, no. 3 (September 1999), p. 37. 6This subsection and the next one draw heavily upon John Williamson, What Role for Currency Boards? Policy Analyses in International Economics No. 40 (Washington, DC: Institute for International Economics, September 1995), Chapter 2. Final PDF to printer CHAPTER 28 FIXED OR FLEXIBLE EXCHANGE RATES? 717 app9062x_ch28_701-727.indd 717 06/22/16 01:56 PM IN THE REAL WORLD: CURRENCY BOARDS IN ESTONIA AND LITHUANIA Estonia was the first Baltic country to adopt its own currency (the kroon) after the breakup of the Soviet Union and the first to adopt a currency board system. The currency board was seen as a quick way to foster confidence in the currency. This was a key point in a newly independent country with a fragile economic and political situation. The Estonian currency board was defined and its operat- ing procedures set up in May 1992. The Estonian parliament passed the currency law, the law on backing of the Estonian kroon, and the foreign exchange law. The Estonian currency board was not the strictest possible version. The Bank of Estonia kept some authority over how much capital inflows are allowed to boost the monetary base, and a minimal reserve requirement was maintained for commercial banks. In any case, the currency board was required to keep sufficient foreign currency reserves to cover money in circulation (110 percent reserves in practice), and exporters were to surrender their export earnings in exchange for domestic currency within two months. The Estonian kroon was pegged to the German mark at a rate of 1 mark = 8 krooni at its rollout in June 1992. The exchange rate agreement was successful in bringing inflation rates down, especially compared with other former Soviet states. Additional evidence of the success of the cur- rency board system is the fact that foreign investors were deemed to have been attracted by the new macroeconomic stability. Regarding the inflation rate, the increase in con- sumer prices dropped to “only” 90 percent in 1993, and it fell to 48 percent in 1994, 29 percent in 1995, and 23 percent in 1996. Overall for 1994–2003, inflation still averaged 12.9 percent annually. It was in the 3–4 percent range from 2004 to 2006 and rose to 10.4 percent in 2008. It then was a negative 0.1 percent in 2009, a positive 2.9 percent in 2010, and a positive 5.1 percent in 2011. Turning to output, Estonia followed the other transition economies and experienced a substantial drop in real GDP in the early 1990s. Real GDP fell by 26 percent in 1992, by 8.5 percent in 1993, and by 2.7 percent in 1994. However, growth averaged a positive 5.7 percent for 1994–2003 and more than 8 percent, on average, for 2004–2007. Real GDP then fell by 3.7 percent in 2008 and by 14.3 percent in 2009  before turning to a positive 2.3 percent in 2010 and 7.6 percent in 2011. Importantly, Estonia’s currency board had been designed to lead to price stability and to allow smooth adjustment of the price level to that of European Union members. Given the apparent success of the currency board in taming infla- tion and in being associated with overall sizeable output growth, Estonia had been a member of the European Union since 2004 and then took the important monetary step of joining the Economic and Monetary Union of the EU on January 1, 2011. The kroon was then replaced by the euro. Lithuania took a more gradual approach to currency reform. Political disagreements prevented the introduc- tion of a new currency until June 1993. Prior to this intro- duction, Lithuania had a dual exchange rate system with Russian rubles remaining in circulation alongside an interim currency called talonas (coupons). The rubles began to be withdrawn from circulation, and beginning in October 1992, the use of the ruble was forbidden. Talonas were used until June 1993, when authorities announced the introduction of the new currency, the Lithuanian litas. After July 1993, the use of talonas and foreign currency was banned. These years of monetary uncertainty also resulted in rather lax monetary policy. In the first quarter of 1994, the money supply (M1) rose by 134 percent, and inflation in Lithuania was considerably higher than in Estonia. The high inflation was naturally reflected in the external value of the Lithuanian currency, which depreciated markedly against the dollar. The volatility of the exchange rate and low cred- ibility of monetary policy led to a debate about the appropri- ate exchange rate regime. In March 1994, Lithuania followed Estonia and adopted a currency board. The new arrangement became effective in April 1994 and pegged the litas to the U.S. dollar at a rate of $1 = 4 litai. Even after the establishment of the currency board, Lithuania continued to experience higher inflation than Estonia until 1996. In 2000, the inflation rate was down to 1.1 percent and in 2003, prices actually fell. In 2006, however, the infla- tion rate was 3.8 percent, followed by increases to 5.8 percent in 2007 and 11.1 percent in 2008. The inflation rate was then 4.2 percent in 2009, 1.2 percent in 2010, and 4.1 percent in 2011. Inflation then declined dramatically in the next three years, reaching 0.1 percent in 2014. The inflow of capital into Lithuania after the introduction of the currency board was as high as Estonia’s. Lithuania’s real GDP experience was also similar to Estonia’s. After falling in the early 1990s, real GDP grew by 7.0 percent in 1997, 6.7 percent in 2001, and 10.2  percent in 2003. The average growth rate was 7–8 percent in 2004–2006, 9.8 percent in 2007, and 2.9 percent in 2008. It then fell to a negative 14.8 percent in 2009 during the world recession but recovered to a positive 1.6 percent in 2010, 6.1 percent in 2011, 3.8 percent in 2012, 3.3 percent in 2013, and 2.9 percent in 2014. (continued) Final PDF to printer 718 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch28_701-727.indd 718 06/22/16 01:56 PM of David Hume’s price-specie-flow mechanism (discussed in Chapter 2). These three advantages combine to create greater confidence in the system. 4. The increased confidence leads to the promotion of higher rates of trade, investment, and growth. When comparing a currency board with control of the money supply by a central bank, eight potential disadvantages are cited: 1. The seigniorage problem. Given that the currency board earns interest on its foreign currency reserves (foreign-denominated assets), the cost of the currency board arrange- ment is the difference between the interest earned on the foreign currency and the yield on the additional investments that could have been made at home if domestic assets were to replace foreign assets in the portfolio of the monetary authority. Given the limited invest- ment options available to central banks in many countries, the difference in yield may be small or nonexistent. 2. The startup problem. This refers to the difficulty associated with gathering enough reserve currency to provide the 100 percent reserves necessary to back the monetary base. The financial feasibility of beginning a currency board must be examined on a case-by- case basis. 3. The transition problem. This refers to the danger that at the established fixed exchange rate, the local currency may quickly become overvalued when instituted in a high-inflation economy. There is little doubt that the fixed exchange rate, when adhered to long enough, will bring inflation under control. The question is how large the initial over- valuation will be and how long the transition period will last. 4. The adjustment problem. This refers to the increased cost of securing BOP adjust- ment when the exchange rate cannot be changed. The existence of a currency board pre- cludes the use of the exchange rate to help correct an overvaluation. 5. The management problem. This is the inability to use the normal tools of monetary policy such as open market operations to conduct active monetary policy. This fifth prob- lem may not actually be a problem in countries that have a history of abusing monetary Disadvantages of a Currency Board IN THE REAL WORLD: (continued) CURRENCY BOARDS IN ESTONIA AND LITHUANIA On February 2, 2002, the Lithuanian litas was repegged to the euro at 3.4528 litai/euro. In April 2004, the currency board system celebrated its 10th anniversary and, in the ensuing years, the focus turned to the changeover from the litas to the euro. Lithuania had become a member of the EU in 2004 and then joined the European Economic and Monetary Union on January 1, 2015. Sources: Iikka Korhonen, “Currency Boards in the Baltic Countries: What Have We Learned?” Bank of Finland Institute for Economies in Transition Discussion Papers No. 6 (1999); Eesti Pank, Bank of Estonia, “Estonian Monetary System,” http://www.eestipank.info/pub/ en, 2006; Lithuanian Free Market Institute, “The Currency Board— Lithuania’s Weightiest Reform—Marks the 10th Anniversary,” http:// www.freema.org/index.php/menu/newsroom/press_release, August 4, 2004; Bank of Lithuania, “The New National Changeover Plan and the Public Information on the Euro Adoption and Communication Strategy of Lithuania Have Been Approved,” http://www.euro .lt/en/news/introduction-of-the-euro-in-lithuania, April 27, 2007; International Monetary Fund, World Economic Outlook, September 2004, September 2006, April 2007, April 2012, various pages, all obtained from www.imf.org; IMF elibrary at data.imf.org. ● Final PDF to printer CHAPTER 28 FIXED OR FLEXIBLE EXCHANGE RATES? 719 app9062x_ch28_701-727.indd 719 06/22/16 01:56 PM policy. Taking the ability to increase the money supply out of the hands of the monetary authorities may be the main reason for turning to a currency board. 6. The crisis problem. The currency board can only issue domestic currency in exchange for foreign currency. The inability to issue domestic currency against domestic assets pre- vents the currency board from serving as a lender of last resort. This creates a problem if a bank is solvent but illiquid because the monetary authority cannot provide the necessary funds to prevent a crisis. On the other hand, this may actually force the financial system to be more prudent. 7. The political problem. The final two disadvantages are political in nature. The political problem is related to the question of whether fiscal policy will actually be disci- plined by the establishment of a currency board. If the country has not made the commit- ment to a balanced budget, the currency board does not prevent the financing of a deficit by borrowing at home or even abroad. The currency board seems to be a good device to reinforce a commitment to fiscal discipline, but cannot impose that discipline where is does not exist. 8. The monetary sovereignty problem. The rules of a currency board take the control of the money supply out of the hands of the domestic monetary authority and increase the influence of the “anchor” economy. OPTIMUM CURRENCY AREAS A concept that lies under the surface in the previous discussion concerning fixed versus flexible exchange rates is that of the optimum currency area. An optimum currency area is an area that, for optimal BOP adjustment reasons as well as for reasons of effectiveness of domestic macroeconomic policy, has fixed exchange rates with countries in the area but flexible exchange rates with trading partners outside the area. In other words, it may be best for the 50 states of the United States to have fixed rates among themselves (which they do to the extreme since a common currency is employed) but flexible rates vis-à-vis other countries. Similarly, 11 members of the European Union had completely fixed exchange rates among their own currencies when they adopted the new currency unit, the euro, on January 1, 1999. What determines the domain (or scope) of an optimum currency area? An answer to this question may be helpful in resolving the fixed rate–flexible rate debate. There have been two groundbreaking analyses of the necessary characteristics of an optimum currency area. Robert Mundell (1961) focused on the degree of factor mobility between countries and on economic structure. Suppose that the only two countries in the world are the United States and Canada, that a flexible exchange rate exists between them, and that variations in the exchange rate smoothly handle any BOP problems. Suppose also, however, that the eastern part of each country specializes in manufactured goods (e.g., automobiles) while the western part of each country specializes in natural resource products (e.g., lumber products). In addition, assume that factors of production do not move easily between east and west in each country and between the two types of industries. Suppose now that there is a shift in the composition of demand by consumers from auto- mobiles to lumber products. The effect of this demand shift can be to generate inflationary pressures in the western portion of each country and to cause unemployment in the eastern part. In this situation, the Federal Reserve could expand the U.S. money supply to allevi- ate the eastern U.S. unemployment, but this would aggravate the inflation in the western United States. Or the Federal Reserve could contract the money supply to alleviate the inflation in the west, but this would aggravate the unemployment in the east. The same Final PDF to printer 720 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch28_701-727.indd 720 06/22/16 01:56 PM dilemma would exist for the Bank of Canada with respect to the Canadian east and west. In this context, a smooth adjustment mechanism (the flexible exchange rate) exists between the countries but not between the regions in each country. What is the way out of the dilemma? In Mundell’s view, the problem is that the flexible exchange rate pertains to the national political units (the United States and Canada) while fixed rates exist (within the countries) between regions that are economically dissimilar and have little factor mobility between them. The situation would be much improved if the economic units of the eastern United States and eastern Canada adopted a fixed exchange rate between them, as should the western United States and western Canada. Further, the exchange rate between the East (comprising the eastern parts of both countries) and the West (comprising the western parts of both countries) should be flexible. Then, with the preceding shift of demand from automobiles to lumber products, the currency of the West would appreciate relative to the currency of the East. In addition, the monetary authorities in both countries could use contractionary policy in the West and expansionary policy in the East. The unemployment and inflation problems could both then be avoided. The point of this discussion is that there is a role to play for both fixed and flexible rates. Countries that are similar in economic structure and have factor mobility between them should have fixed exchange rates among themselves, for they comprise an optimum cur- rency area. They should also adopt flexible exchange rates relative to the rest of the world. Needless to say, an optimum currency area within which rates are fixed is not necessarily an individual country. In later work extending his ideas on optimum currency areas, Mundell (1997) distin- guished between a “true” currency area and a “pseudo” currency area. In the former, the currency area adopts a monetary system such as a gold standard that contains an automatic adjustment mechanism. This mechanism, coupled with a commitment to stability, is “in times of peace” virtually absolute. A pseudo currency area, on the other hand, does not allow an automatic adjustment mechanism to function and a certain degree of country autonomy exists with regard to changes in parities. Consequently, interest rates can diverge in response to expected changes in exchange rates, and destabilizing speculation can occur. Because Mundell judges that modern currency areas tend to be pseudo in nature, he thinks that successful functioning of these agreements requires that the countries involved have sufficiently similar political and/or economic interests and a willingness to adapt when the situation demands it. In the absence of such political commitment, in Mundell’s view, the member countries are unlikely to achieve the anticipated benefits of membership in the currency area. Another noteworthy contribution regarding the characteristics of an optimum currency area is that of Ronald McKinnon (1963). McKinnon was concerned with the choice of a flexible exchange rate versus a fixed exchange rate in the contexts of BOP adjustment and of maintaining price-level stability. His analysis involved the distinction between a rela- tively open economy and a relatively closed economy. A relatively open (closed) economy is one that has a high (low) ratio of production of tradeable goods to production of nontrade- able goods. Consider the open economy. If it has a flexible exchange rate, then a depre- ciation of its currency will raise the domestic price of imports and subsequently the price of domestic import-competing goods. Similarly, the depreciation increases the domestic price of exportable goods, because foreign demand for home exports increases with the depreciation. Because the prices of these tradeable goods are increasing, and because the tradeables comprise most of the country’s production, the depreciation results in domestic inflation, which is roughly of the same percentage as the percentage by which the currency has depreciated. For the open economy, therefore, depreciation associated with the flexible exchange rate will do little to improve a BOP deficit and do much toward contributing to domestic inflation. This country might better be advised to maintain a fixed exchange rate. Final PDF to printer IN THE REAL WORLD: THE EASTERN CARIBBEAN CURRENCY UNION AND OTHER MONETARY UNIONS Much attention has been focused recently on Europe’s Economic and Monetary Union (EMU), its current prob- lems, and the viability of the euro. Interestingly, there are currently three other monetary unions in place: ∙ The West African Economic and Monetary Union (WAEMU/UEMOA), founded in 1994 and consisting of eight members (Benin, Burkina Faso, Côte d’Ivoire, Guinea-Bissau, Mali, Niger, Senegal, and Togo). ∙ The Central African Economic and Monetary Com- munity (CEMAC), founded in 1999 and consisting of six members (Cameroon, Central African Republic, Chad, Republic of the Congo, Equatorial Guinea, and Gabon). ∙ The Eastern Caribbean Currency Union (ECCU), founded in 1983 and consisting of eight members (Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, and two territo- ries of the United Kingdom—Anguilla and Montserrat). The first three (EMU, WAEMU, and CEMAC) all are economic unions as well. The ECCU is interesting because of its historical evolution and its success in the absence of more complete economic integration. The ECCU origins go back to the establishment of the Eastern Caribbean Currency (EC) and the Eastern Caribbean Central Bank (ECCB). The establishment of the ECCB in 1983 in the Treaty of Basseterre was notable in that it focused not only on currency and financial stability, but also on the wider social concepts of development and integration, recognizing that the strength of the ECCU countries required the presence of strong interregional links, including the presence of a regional cur- rency and a strong regional central bank. Increased economic and monetary integration carries the promises of economies of scale, stronger group representation in international nego- tiations, risk sharing, and increased production efficiency with improved factor mobility and more rapid economic growth. Although the monetary union is in place, the Caribbean region has only certain parts of economic integration in place. For example, the region is a free-trade area (FTA) but contains only parts of a customs union (CU) and a common market (CM). Regarding the CU, tariffs are not fully harmonized in the coun- tries, with tariffs continuing to be a source of revenue for the individual country governments. Regarding unrestricted factor movements, capital moves freely within a well-integrated and unrestricted financial system, but unrestricted labor movements are limited to skilled labor and the informal sector labor. With respect to monetary union, the region was character- ized by large holdings of bank assets in excess of 200 percent of GDP, making it one of the world’s most monetized eco- nomic areas. Operationally, the common currency is the Eastern Caribbean dollar, which is pegged to the U.S.  dollar and supported by a quasi currency board arrangement. This contributed early on to low inflation rates and overall eco- nomic stability. The ECCB is responsible for supervising and overseeing the entire banking structure and setting mon- etary policy. The principal tasks of the ECCB are managing the common pool of reserves (including extending credit to governments and banks when needed) and maintaining the international value of the currency. Unlike other monetary unions, the utilization of a currency board limits the use of monetary policy and overall lending capacity. In spite of its early success, there are problems surrounding the integration efforts as the area moves toward more complete economic integration in the form of a Caribbean Single Market and Economy (CSME). Not surprisingly, the problems related to monetary union are similar to several currently being experi- enced in the EU. These issues have included large and perhaps unsustainable public debt, growing fiscal deficits, the need for improved coordination of fiscal policies, and improvements in the financial sector to better deal with problems like those accompanying the recent world monetary and economic crisis. The ECCU countries experienced a three-year recession that ended in 2012, followed by a slow recovery. Weak international competitiveness also appears to be a problem. The member countries are all small, open-economy countries whose economies depend on tourism, and hence on the health of the rest of the advanced economies of the world, of which the United States is by far the most important. Steps are already under way to make needed improvements, including verbal commitments from government heads in the member countries, agreeing to the establishment of a regional assembly, and adopt- ing a revised union treaty. Fiscal policy, however, still remains in the control of national governments. This is a critical weakness, as the success of the monetary union will depend on the simul- taneous solution of the member’s fiscal constraints and deficits. Sources: Alfred Schipke, “Snapshot of Another Monetary Union,” Finance and Development 49, no. 1 (March 2012), pp. 50–51; ECCB “The Story of the EC Dollar and the Eastern Caribbean Central Bank: The Coming of Age of Small Island States,” in the section on EEC Currency and the ECCB, 2004, obtained from www. eccb-centralbank.org; IMF, “Eastern Caribbean Currency Union— Selected Issues,” IMF Country Report no. 12/130, January 29, 2011, and “IMF Executive Board Concludes 2014 Discussion on Common Policies of Member Countries of the Eastern Caribbean Currency Union,” Press Release No. 14/291, June 19, 2014, both obtained from www.imf.org. ● CHAPTER 28 FIXED OR FLEXIBLE EXCHANGE RATES? 721 app9062x_ch28_701-727.indd 721 06/22/16 01:56 PM Final PDF to printer 722 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch28_701-727.indd 722 06/22/16 01:56 PM In contrast, the relatively closed economy will find that a depreciation associated with a flexible exchange rate will have less effect on the domestic price level. Although the depreciation causes a rise in the price of tradeable goods, the price of these tradeables is not a very important component of the country’s entire price level. But the rise in the price of tradeables relative to nontradeables will induce more production of tradeables, and the balance of payments will be easily improved by depreciation. Hence, for relatively closed economies, a flexible exchange rate can be very useful because it facilitates BOP adjust- ment without adding substantially to domestic inflation. In the context of the fixed rate–flexible rate debate, McKinnon’s analysis suggests that relatively open countries should consider fixed rates, while relatively closed economies should adopt floating rates with the outside world. This set of ideas can be married to Mundell’s analysis by suggesting that open economies with factor mobility between them can, given sufficient political commitment, join together to form a currency area, while relatively closed countries can “go it on their own.” In any event, these various consider- ations indicate that the optimum currency area is not the world as a whole. Obvious impli- cations for the debate concerning fixed rates versus flexible rates are (a) to form blocs of similar countries, with fixed rates among the members of each bloc (such as perhaps within the European Union or within much of East Asia) and (b) to have exchange rate flexibility between the several blocs. CONCEPT CHECK 1. Is the adoption of a fixed exchange rate sys- tem a guarantee that destabilizing speculation will not occur? Why or why not? 2. Explain how a sudden rise in the price level in foreign countries can be less inflationary for the home country in a system of flex- ible exchange rates than in a system of fixed exchange rates. 3. Explain Mundell’s point that a country may not be an optimum currency area. HYBRID SYSTEMS COMBINING FIXED AND FLEXIBLE EXCHANGE RATES Amid the continuing debate between proponents of fixed rates and proponents of flex- ible rates, several compromise or hybrid proposals have emerged. These proposals attempt to incorporate the attractive features while minimizing the unattractive features of each extreme system. We consider three such systems in this chapter; further discussion in the context of the current international monetary system is provided in the next chapter. This proposal takes as a point of comparison the Bretton Woods system, where exchange rates were permitted to vary by 1 percent on either side of parity values. The proposal for wider bands states that the permissible variations around parity should be set at some larger value, such as 10 percent around parity. Because a substantial amount of variation is permitted with this wider band, the exchange rate is able to carry out a BOP adjustment. For example, if a country has a BOP deficit, the home currency could depreciate by up to 10 percent from its parity value, and this larger depreciation could be successful in altering exports and imports in the desired direction. Because the exchange rate is handling much of the BOP adjustment, there is less need for monetary and fiscal policies to be diverted from seeking the attainment of internal economic goals. In addition, because the variation from parity is limited to 10 percent, the wider band system still preserves some of the discipline of the fixed-rate system and also means that the problem of risk interfering with trade and investment is constrained, as is the problem of wasteful resource movements due to large and reversible movements in the exchange rate. Wider Bands Final PDF to printer CHAPTER 28 FIXED OR FLEXIBLE EXCHANGE RATES? 723 app9062x_ch28_701-727.indd 723 06/22/16 01:56 PM Nevertheless, because the proposal for wider bands maintains some limitations on exchange rate variability, it does not deal with some of the objections to fixed rates. For example, if countries consistently have different inflation rates, this system may break down, just as would a fixed-rate system. If Sweden inflates more rapidly than does Switzerland because of a different unemployment-inflation preference, then sooner or later the Swedish krona/Swiss franc rate will hit the ceiling. If no corrective steps or alterations in relative preferences by policymakers occur, a change in the krona/Swiss franc parity value will be required because Sweden will deplete its international reserves. Further, when the rate first hits the ceiling, speculators will have a one-way bet against the krona, and thus speculative pressure against the krona is apt to ensure that a devaluation of the krona will occur. Finally, other objections to the wider bands proposal can be raised. Because a total change in a currency’s value of 20 percent is permitted (10 percent on either side of par- ity), there are still some additional risks introduced for international trade and investment, as well as some possibility of wasteful resource movements because of the rate changes. In addition, international reserves—with their associated opportunity costs—still need to be held, and business cycles will still be transmitted across country borders. A sophisticated extension of the wider bands proposal, known as the target zone proposal, meets some of the objections to wider bands and is discussed in the next chapter. In the system known as the crawling peg, a country specifies a parity value for its currency and permits a small variation around that parity (such as ±1 percent from parity). However, the parity rate is adjusted regularly by small amounts as dictated by the behavior of such variables as the country’s international reserve position and recent changes in the money supply or prices. (The adjustment can be accomplished by following a strict formula or by use of judgment by the policymakers.) When these variables indicate potential pressures for the country (such as when international reserves decline markedly), the currency’s par- ity value is officially devalued by a small percentage. Of course, when the parity value is thus changed, the 1 percent band now applies to the new parity. A stylized example of a crawling peg system is given in Figure 2. The solid lines indi- cate the ceiling and the floor associated with the peg, while the dotted line indicates the path of the actual exchange rate. Note that the actual rate is between the ceiling and floor until point A is reached. This ceiling rate after A can be maintained only by using up some international reserves, but continued use of the reserves eventually will trigger a change of the parity value, as reflected in the higher band (reflecting devaluation of the home cur- rency) after point B. (For simplicity, we do not show a parity value line.) A continuation of this process occurs at points C and D. Then, if the currency reverses itself and hits the floor at point F, a buildup of reserves eventually will set off an increase in the parity value at point G, so the range shifts downward. Advocates of the crawling peg concept point out that, at least in theory, the existence of the ceiling and floor can provide for some discipline on the part of the monetary authori- ties. In addition, the fact that the rate is periodically changed means that a role for the exchange rate in BOP adjustment is maintained. Finally, because each change is a small one, there is less danger of large-scale speculation against the currency. An argument against the crawling peg is that a major change in the country’s BOP position because of an internal or external shock may require a sizeable change in the exchange rate to restore BOP equilibrium. If adherence to a strict crawling peg occurs, then a sacrifice of the pursuit of internal goals may be required if a large exchange rate change is not possible. Further, if the small parity changes are frequent (and unpredict- able), there may still be some additional risks associated with international trade and investment. Finally, if experience is any guide, crawling pegs conducted in a context of Crawling Pegs Final PDF to printer 724 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch28_701-727.indd 724 06/22/16 01:56 PM unstable internal economic conditions (such as extremely rapid inflation) may amount virtually to a flexible exchange rate system. Two countries currently have crawling peg arrangements, and 15 others have a “crawl-like” arrangement as designated by the IMF. (See Chapter 29, page 747.) The final hybrid arrangement of fixed and flexible exchange rates that we consider in this chapter is designated by the broad term managed floating, the term that is generally applied to the current international monetary system (see the next chapter). In general, a managed floating regime is characterized by some interference with exchange rate move- ments, but the intervention is discretionary on the part of the monetary authorities. In other words, there are no announced guidelines or rules for intervention, no parity exchange rates or announced target rates, and no announced limits for exchange rate variations. Rather, a country may intervene when it judges that it would be well served by doing so. For exam- ple, intervention to appreciate the home currency (or to keep it from depreciating so fast) might be desirable to fight domestic inflationary pressures, or intervention to prevent an appreciation might be desirable for assisting in reaching an employment target. Sometimes the intervention by a particular country takes the form of coordinated intervention with other countries, such as when several industrialized nations (the G-7 industrialized coun- tries) agreed to drive the U.S. dollar down in value in 1985 (the Plaza Agreement) and then agreed in 1987 that the dollar had fallen far enough (the Louvre Accord). In general, a country tends to intervene to slow down a movement in the exchange rate in a particular direction, a type of intervention called leaning against the wind. If the intervention is designed to intensify the movement of the currency in the direction in which it is already moving, the intervention is called leaning with the wind. An advantage cited for managed floating is that the country is not locked into some prearranged course of action by formal rules and announcements. This greater freedom to tailor policy to existing circumstances is thought to be superior to sticking to a set of Managed Floating FIGURE 2 A Crawling Peg In this crawling peg example, the exchange rate fluctuates within its narrow band until point A is reached. The loss of reserves from A to B and any other indicators of currency weakness trigger a small devaluation of the parity value. When difficulties again occur from point C to point D, another small official devaluation takes place. This new parity value continues until a reserve buildup occurs from point F to point G, whereupon the parity value of the home currency is raised. Time e (units of home currency per unit of foreign currency) A B C D F G Final PDF to printer CHAPTER 28 FIXED OR FLEXIBLE EXCHANGE RATES? 725 app9062x_ch28_701-727.indd 725 06/22/16 01:56 PM IN THE REAL WORLD: COLOMBIA’S EXPERIENCE WITH A CRAWLING PEG A well-known case of a country that employed a crawling peg system for a number of years is Colombia. In the Colombian situation, the authorities followed “a policy of adjusting the peso in small amounts at relatively short intervals, taking into account (1) the movements of prices in Colombia rela- tive to those in its major trading partners; (2) the level of Colombia’s foreign exchange reserves; and (3) Colombia’s overall balance of payments performance.”* Despite small adjustments in each instance in a crawling peg system, how- ever, the cumulative change in currency value can be rather large over a period of a few years. Table 2 presents rele- vant information for Colombia for the period 1980–1990. Following this experience, in mid-1991 Colombia instituted a more directly market-oriented exchange rate system. As can be seen from column (2) of the table, Colombia’s peso/dollar exchange rate of 47.28 in 1980 rose to 502.26 in 1990. This was a 962 percent increase in the price of the  dollar in terms of pesos or, when the exchange rate is expressed as dollars per peso [and put into indexes as in column (3)], a decline in the peso of more than 90 percent. A prime reason for this depreciation of the peso was the 736 percent rise in Colombia’s CPI from 1980 to 1990 (not shown in the table). However, the fall in the peso relative to the dollar was unrep- resentative of the size of the overall decline in its value. The nominal effective exchange rate [column (4)] of the peso against the trade-weighted average of all trading partners fell “only” from 148.7 to 52.0 from 1980 through 1990—a 65 percent decline. When adjusted for relative internal prices via the real effective exchange rate in column (5), the peso fell from an index of 107.0 to 54.5—a fall of “only” 49 percent. Nevertheless, Colombia’s experience suggests that a crawl- ing peg may indeed crawl rapidly! *International Monetary Fund, Exchange Arrangements and Exchange Restrictions: Annual Report 1990 (Washington, DC: IMF, 1990), p. 105. (1) (2) (3) (4) (5)  Indexes of Value of Peso (1985 = 100) Year Pesos per U.S. $ Versus $ Nominal Effective Rate Real Effective Rate 1980 47.28 300.9 148.7 107.0 1981 54.49 261.0 145.8 118.1 1982 64.08 222.0 141.6 125.9 1983 78.85 180.4 134.2 125.3 1984 100.82 141.1 122.8 114.7 1985 142.31 100.0 100.0 100.0 1986 194.26 73.3 70.2 74.5 1987 242.61 58.6 58.2 66.4 1988 299.17 47.5 54.0 64.1 1989 382.57 37.1 53.8 61.7 1990 502.26 28.3 52.0 54.5 Source: International Monetary Fund, International Financial Statistics Yearbook 1993 (Washington, DC: IMF, 1993), pp. 282–83. Column (3) calculated by the authors. ● TABLE 2 Exchange Rate Behavior in Colombia, 1980–1990 rules devised in some prior period that is no longer relevant. In addition, in contrast to a fixed-rate system, the exchange rate under managed floating is allowed to play some role in external sector adjustment. Further, internal policy is not constrained to the extent that it is under a fixed-rate system. In comparison with a purely flexible-rate system, the country Final PDF to printer 726 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch28_701-727.indd 726 06/22/16 01:56 PM is able to moderate wide swings in the exchange rate that can have adverse price level risk and resource movement implications. Speculation is also more difficult because specula- tors do not know the timing of the intervention, the potential size of the intervention, or even necessarily the direction of the intervention. Working against the concept of managed floating is the possibility that, without a set of rules and guidelines for each country, various nations may be working at cross-purposes. For example, Japan may want to moderate a rise in the value of the yen in terms of dollars at the same time that the United States wants to drive the dollar down in terms of the yen. A form of economic warfare can then ensue. In addition, because exchange rates can vary substantially with a managed float, there is still a possibility that traders may be wary of full participation in international trade because of the risks of exchange rate variation. There is a danger of abuse to the free market allocation of resources according to com- parative advantage if countries use intervention to engage in what is called exchange rate protection. A contrived comparative advantage can be gained from such protection, and world resources may not be used in their most efficient manner. For example, many observers thought that Japan was intervening in the early 1980s to keep the value of the yen down in exchange markets. The advantage to Japan of this undervaluation of the yen would be that Japan’s enhanced exports and depressed imports would provide a boost to Japanese GNP. The same charge has been levied frequently in recent years with respect to China and the renminbi/dollar exchange rate, although the IMF officially classifies China as having adopted a crawl-like arrangement. When countries tend to manipulate their cur- rencies to pursue particular goals at the expense of other countries, the behavior is referred to as dirty floating. Finally, some economists have questioned the ability of a single country to meaning- fully influence its exchange rate in any event. (See Taylor, 1995, pp. 34–37.) The size of any country’s foreign exchange reserves is very small relative to the size of total foreign exchange market activity. The ability to convince foreign exchange market participants that the government is both willing and able to influence the exchange rate is critical for successful intervention. CONCEPT CHECK 1. What alleged disadvantages of a fixed-rate system are still present in the proposal for wider bands around parity? 2. Why is destabilizing speculation considered conceptually rather unlikely in a crawling peg system? SUMMARY This chapter surveyed issues in the debate over fixed versus flexible exchange rates. Those who prefer fixed rates to flex- ible or floating rates stress the monetary discipline provided by the fixed-rate system and the conducive environment supplied for growth in international trade and investment—features alleged to be absent in a flexible-rate system. In addition, flex- ible rates are thought to generate various resource allocation inefficiencies and destabilizing speculation. Flexible rates may also aggravate the impacts of internal shocks on the econ- omy. On the other hand, proponents of flexible rates point to the constraint on the attainment of internal goals inherent in a fixed-rate system, to the beneficial role of a free market in foreign exchange, and to the enhanced effectiveness of mon- etary policy for influencing national income. Further, countries with flexible exchange rates are thought to be insulated from external shocks. An example of a completely fixed exchange-rate system occurs when a country establishes a currency board and loses independent monetary policy. A country’s decision to fix or to float must reflect the economic situation as it relates to trad- ing partners and might want to consider forming an optimum currency area. Final PDF to printer CHAPTER 28 FIXED OR FLEXIBLE EXCHANGE RATES? 727 app9062x_ch28_701-727.indd 727 06/22/16 01:56 PM KEY TERMS coordinated intervention crawling peg currency board destabilizing speculation dirty floating euro exchange rate protection leaning against the wind leaning with the wind managed floating optimal size of international reserves optimum currency area precautionary demand for interna- tional reserves stabilizing speculation transactions demand for interna- tional reserves vicious circle hypothesis wider bands QUESTIONS AND PROBLEMS 1. Why does the presence of different country preferences on possible inflation-unemployment trade-offs pose a problem for a system of fixed exchange rates? 2. What case can be made that flexible exchange rates reduce the flow of long-term foreign direct investment? What case can be made that flexible rates might actually lead to more foreign direct investment? 3. In what way might the relative susceptibility of a country to external shocks rather than internal shocks condition the choice between a fixed or flexible exchange rate for that country? Explain. 4. “If you believe that free markets maximize welfare, then you should also believe that a free exchange rate is an integral part of welfare maximization.” Discuss. 5. Must the adoption of a flexible exchange rate mean that the rate will actually vary considerably over time? Why or why not? 6. Much discussion concerning floating rates stresses the risks to trade and investment involved with such a system. Is risk necessarily a bad thing? Why or why not? 7. Does a currency board seem to be a useful, practical arrange- ment for a country? What factors seem critical for a currency board’s success? 8. Under what conditions would the world as a whole be an optimum currency area? Do you think that the industrial- ized countries should be one optimum currency area and the developing countries another? Explain. 9. “The hybrid systems combining fixed and flexible exchange rates are merely ways of avoiding having to make a choice between a fixed rate and a flexible rate. These systems invariably involve the ‘worst of both worlds.’ ” Discuss. 10. In the early 1990s, the foreign exchange reserves of Chile increased dramatically as foreign investment flows into the country increased substantially because of the favorable investment climate and impressive economic growth. At the same time, Chile began intervening in foreign exchange markets to stabilize the exchange value of its peso. How might these two events be related to each other? 11. Explain Mundell’s distinction between a “true” currency area and a “pseudo” currency area. Why is this distinction important? We examined the hybrid systems of wider bands of permis- sible exchange rate variations, the crawling peg, and managed floating. These proposals satisfy to some extent the proponents of both fixed and flexible rates, but they also dissatisfy both sides in the debate because of other implications. Given this background to exchange rate arrangements, we turn in the next chapter to a discussion of exchange rate arrangements and developments in the international monetary system since the end of World War II. In addition, proposals for “reform” of the system will be examined. Final PDF to printer 728 app9062x_ch29_728-764.indd 728 06/22/16 01:26 PM CHAPTER 29THE INTERNATIONAL MONETARY SYSTEMPast, Present, and Future LEARNING OBJECTIVES LO1 Assess the postwar international monetary system known as Bretton Woods. LO2 Describe the historical evolution of the international monetary system from Bretton Woods to the present time. LO3 Differentiate among existing alternative monetary arrangements. LO4 Compare and contrast several proposals for reform of the current international monetary system. Final PDF to printer CHAPTER 29 THE INTERNATIONAL MONETARY SYSTEM 729 app9062x_ch29_728-764.indd 729 06/22/16 01:26 PM INTRODUCTION In early 2015, Switzerland surprisingly removed its self-imposed ceiling on the exchange rate of the Swiss franc with the euro, thus leading to an appreciation of the franc and an almost-immediate depreciation of the euro against the franc by 30 percent. The removal of the cap led to concerns about the stability of the euro and about deflationary pressures in the world economy.1 As the dollar rose strongly in early 2015, problems arose in Africa, which relies heavily on the United States for many imports. For example, in Uganda, the country’s shilling fell to a record low against the dollar, and Ugandan retailers were turning away customers because the stores could not come up with the increased amount of dollars needed to import desired goods.2 In 2014 Paul Volcker, former head of the Federal Reserve, delivered a speech entitled “A New Bretton Woods???” He indicated that “. . . we can agree that the absence of an official, rules- based, cooperatively managed monetary system has not been a great success” and pleaded for the development of “an international monetary and financial system worthy of our time.”3 For countries to participate effectively in the exchange of goods, services, and assets, an international monetary system is needed to facilitate economic transactions. If the ability to import goods is limited because of a scarcity of foreign exchange reserves, for example, then countries will be tempted to impose tariffs, quotas, and other trade-restricting devices to conserve on their foreign exchange. In addition, controls on the outward movement of private funds from a reserve-scarce country may be imposed, or limitations on the ability of the country’s citizens to travel abroad may be instituted. To be effective in facilitating movement in goods, services, and assets, a monetary sys- tem most importantly requires an efficient balance-of-payments adjustment mechanism so that deficits and surpluses are not prolonged but are eliminated with relative ease in a reasonably short time period. Further, unless the system is characterized by completely flexible exchange rates, (a) there must be an adequate supply of international liquidity, that is, the system must provide adequate reserves so that payment can be made by BOP deficit countries to surplus countries, and (b) the supply of international liquidity must consist of internationally acceptable reserve assets that are expected to maintain their values. Fundamental to the attainment of these objectives is the existence of strong and stable financial institutions. Historically, international monetary systems have contained widely differing charac- teristics. Among those characteristics have been differences in the degree of exchange rate flexibility. About a hundred years ago, the prevailing international monetary system was the international gold standard (1880–1914). In this system (see Chapter 23), gold constituted the international reserve asset and gold’s value was fixed by the declared par values that countries specified. This willingness to back currencies with an inter- nationally acceptable reserve asset (gold) helped contribute to relatively free trade and payments. At the same time, balance-of-payments adjustment has been judged to have been relatively smooth during the 1880–1914 period. Little gold actually appears to have flowed from one country to another because central banks were willing to alter interest Monetary System Uncertainties 1Neil MacLucas and Brian Blackstone, “Swiss Move Roils Global Markets,” The Wall Street Journal, January 16, 2015, pp. A1, A10. 2Nicholas Bariyo and Patrick McGroarty, “Dollar’s Rise Stings Africa,” The Wall Street Journal, March 25, 2015, p. C3. 3Seth Lipsky, “Paul Volcker: Back to the Woods?” The Wall Street Journal, June 12, 2014, p. A13. Final PDF to printer IN THE REAL WORLD: CONFIDENCE IN EXCHANGE RATES UNDER THE GOLD STANDARD A recent paper by Kris James Mitchener and Marc D. Weidenmier (2015) suggested that, despite the apparent success of the historical gold standard with its system of fixed exchange rates, the participating countries may not have been as integrated as traditional discussions would imply. They focused particularly on what they designated as “emerging” countries such as Argentina, Australia, Bulgaria, Chile, Russia, and the United States, in contrast to the “core” gold-standard countries such as Belgium, France, Germany, the Netherlands, and the United Kingdom. Employing extensive data for 21 emerging and core countries pertaining to the 1870–1914 period, Mitchener and Weidenmier used the short-term interest rate differen- tial of each country from the interest rate in the core coun- try of the United Kingdom as a measure of “currency risk.” Theoretically, if a country’s currency value in terms of other currencies were credible and not expected to change, then, with high international mobility of short-term capital, the interest rate in that country would tend to be similar or equal to the interest rate in the base country of the United Kingdom. If the country’s short-term interest rate were higher than the short-term interest rate in the United Kingdom, then this fact would suggest that speculators expected the currency to depreciate, and, hence, the country’s markets needed to offer a higher interest rate to attract short-term capital. (See the earlier discussions of uncovered interest parity (UIP) in Chapters 20 and 22.) The difference between the higher rate and the U.K. rate was labeled the “currency premium” by Mitchener and Weidenmier. The statistical analysis ultimately led to the conclusion that a good number of the emerging countries had non- negligible interest rate differentials/currency premia. For example, 11 countries in the sample had differentials above 100 basis points (100 basis points = 1 percentage point), and seven countries had differentials of over 300 basis points. The average non-core country had a risk premium of 285 basis points five years after joining the gold standard. Hence, in view of this study, perhaps the historical gold stan- dard did not have the high level of confidence in currency values that is often regarded as one of its features. Source: Kris James Mitchener and Marc D. Weidenmier, “Was the Classical Gold Standard Credible on the Periphery? Evidence from Currency Risk,” Journal of Economic History 75, no. 2 (June 2015), pp. 479–511. ● 730 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch29_728-764.indd 730 06/22/16 01:26 PM rates (raise them in the case of a deficit country, lower them in the case of a surplus coun- try) in response to the external payments position. These changes in money market con- ditions meant that adjustments to balance-of-payments positions were greatly facilitated by the international flows of short-term capital. (For elaboration, see Bloomfield, 1959, 1963, and Triffin, 1964.) The international gold standard broke down with the advent of World War I. In the 1920s, countries permitted a great deal of exchange rate flexibility, and there has been con- troversy over the extent to which this international monetary system was, in fact, efficient. Nevertheless, the extensive fluctuations in exchange rates did maintain a reasonably close relationship with purchasing power parity (PPP) predictions. In the middle of the decade, however, Britain (then the financial center of the world) attempted to restore the gold standard, adopting the old prewar par value of the pound. That par value greatly overval- ued the pound and caused payments difficulties for Britain. With the tremendous decline in economic activity in the 1930s, payments difficulties emerged for many countries. Extensive attempts to restore some fixity in countries’ exchange rates soon gave way to a series of competitive depreciations of currencies. Although single-country depreciation alone can stimulate employment and output in that country, when many countries depreci- ate their currencies in retaliatory fashion, the expected beneficial results are short-lived or do not occur at all. Restrictive trade policies such as the infamous Tariff Act of 1930 Final PDF to printer IN THE REAL WORLD: FLEXIBLE EXCHANGE RATES IN POST–WORLD WAR I EUROPE: THE UNITED KINGDOM, FRANCE, AND NORWAY One strong argument against a flexible exchange rate system is that it results in considerable instability of the exchange rate and the rate consequently deviates significantly from the equilibrium rate as measured, for example, by PPP. In an interesting study in the late 1950s, S. C. Tsiang (1959) examined the flexible exchange rate experience of the United Kingdom, France, and Norway during the period fol- lowing World War I. All three countries moved to flexible rates in 1919 and were floating their currencies through the mid- to late 1920s. The movements of each country’s dol- lar exchange rate, the relative PPP rate, and wholesale price levels are indicated in Figure 1. All three graphs indicate that there was considerable volatility of the exchange rates during the initial phase of the system from 1919 to 1921. This, however, is not sur- prising, given the turbulent nature of the immediate post- war years, during which there were periods of scarcity, inflation, and recession. However, with the return of rela- tive world stability in 1921, the floating exchange rates of the three countries appear to have followed PPP exchange rates very closely. What is critical here is not that there was divergence between actual exchange rates and PPP rates but that the degree of divergence did not become increasingly large or sporadic. The intriguing feature of this period is that the spot rates tended to move in a correlated fashion with PPP rates in all three countries even though monetary policy and domes- tic price experiences were different. The United Kingdom deliberately undertook contractionary monetary policy to reduce relative prices and increase the value of its currency, whereas Norway initially adopted a more expansionary policy, which increased relative prices, and then moved to a contractionary period with falling prices. France, on the other hand, chose a relatively easy money policy with greater increases in prices through the mid-1920s. Tsiang’s research suggests that the policy-induced infla- tionary environment in France contributed to greater diver- gences between the spot and PPP rates compared with those in the United Kingdom and Norway. It also increased the speculative pressures on the exchange rate, adding increas- ingly to its volatility. However, there is no evidence that the franc fell into a vicious cycle of appreciation and depre- ciation inhibiting economic activity and seriously affecting France’s foreign exchange reserves. The results in general suggest that foreign exchange instability in this period seems to have resulted from external factors and domestic policy actions, not the inherent instability of flexible rates. Such a conclusion is not inconsistent with experiences in the 1970s and 1980s, when external factors such as the oil-price shocks and the uncoordinated nature of monetary and fiscal policy in the world certainly contributed to the instability of the dollar. (continued) CHAPTER 29 THE INTERNATIONAL MONETARY SYSTEM 731 app9062x_ch29_728-764.indd 731 06/22/16 01:26 PM (Smoot-Hawley) in the United States had also been instituted. These various actions led to great reductions in the volume and value of international trade. The measures also wors- ened the Great Depression, and the low level of economic activity continued throughout most of the 1930s. Economic activity spurted upward with the advent of World War II, but involvement in the war prevented comprehensive consideration and adoption of a new system of international payments. We now begin to describe the international monetary system that was set up at the end of World War II. The chapter then focuses on changes that occurred, and examines the current system and issues concerning the type of system needed for the evolving world economy. This material provides useful background for the evaluation of policy issues pertaining to international monetary affairs. Final PDF to printer 732 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch29_728-764.indd 732 06/22/16 01:26 PM IN THE REAL WORLD: (continued) FIGURE 1 Wholesale Prices, Exchange Rate Movements, and PPP in the United Kingdom, France, and Norway in the 1920s 400 300 200 100 90 1919 1920 1921 1922 1923 1924 1925 United Kingdom Wholesale prices Exchange rate Return to gold standard Purchasing power parity France Wholesale prices Purchasing power parity Exchange rate 200 400 600 100 1919 1920 1921 1922 1923 1924 1925 1926 800 500 Norway 1919 1920 1921 1922 1923 1924 1925 1926 1927 Wholesale prices Purchasing power parity Exchange rate 400 300 200 100 Year Year Year (a) (c) (b) Index Index Index Source: S. C. Tsiang, “Fluctuating Exchange Rates in Countries with Relatively Stable Economies,” International Monetary Fund Staff Papers 7, no. 2 (October 1959), pp. 250, 257, 260. Note that a logarithmic scale is used on each vertical axis. ● THE BRETTON WOODS SYSTEM As World War II was drawing to a close, the historic United Nations Monetary and Financial Conference was held in Bretton Woods, New Hampshire, in 1944. From this conference emerged two international institutions that are still extremely prominent in Final PDF to printer CHAPTER 29 THE INTERNATIONAL MONETARY SYSTEM 733 app9062x_ch29_728-764.indd 733 06/22/16 01:26 PM the world economy—the International Monetary Fund and the International Bank for Reconstruction and Development (IBRD), now a somewhat broader institution known as the World Bank. The initial focus of the World Bank was to provide long-term loans for the rebuilding of Europe from the devastation of World War II, but since the 1950s it has been mainly concerned with providing long-term loans for projects and programs in developing countries. This institution is more properly considered in courses on economic develop- ment, so we focus on the IMF in our discussion below. The International Monetary Fund (IMF) was the key institution in the functioning of the post-World War II international monetary system known as the Bretton Woods system. In this context, the IMF had several objectives. In broad terms one important goal of the IMF was to seek stability in exchange rates. When the institution was first set up and for three decades thereafter, the IMF charter called for a system of pegged but adjustable exchange rates. As the “linchpin” of the Bretton Woods system, the dollar was defined by the United States as having a value of 1⁄35 of an ounce of gold. Other countries then defined their currency values in terms of the dollar. Thus, parity values were established by agreement, but variations of 1 percent above and below parity were permitted. These limits were to be maintained by central banks, which would buy dollars if the price of the dollar fell to the −1 percent floor or would sell dollars if the price of the dollar rose to the +1 percent ceiling. The word adjustable in the phrase “pegged but adjustable” refers to the fact that, if a country experienced prolonged BOP deficits or surpluses at the pegged exchange rate, an IMF-approved devaluation or upward revaluation of the currency’s parity value could be undertaken. In fact, as the IMF evolved, there were few changes in parity values. The desire for stable and relatively fixed rates was a reaction to the wide fluctuations, the competitive depreciations, the shrinkage in trade, and the instability of the world economy in the interwar period of the 1920s and 1930s. Another objective of the IMF was (and continues to be) the reconciliation of country adjustments to payments imbalances with national autonomy in macroeconomic policy. As you may remember, the conceptual gold standard adjustment mechanism involved, for defi- cit countries, a fall in wages and prices as gold flowed out. This mechanism, or the alterna- tive mechanism of an increase in interest rates to attract foreign short-term capital, posed the difficulty that the resulting contraction of economic activity could cause a rise in unemploy- ment and a fall in real income. In contrast, a surplus country experienced upward pressure on its wages and prices, downward adjustments in its interest rates, and the resulting threat of inflation. But, if the rules of the game were being followed, internal objectives were to be sacrificed to the objective of attaining balance-of-payments equilibrium. After the Great Depression of the 1930s, governments were unwilling to use their monetary and fiscal policy instruments solely for external balance. Conflicts arose between the external target and the internal targets of macroeconomic policy. The IMF sought to reduce this conflict. Attempts were made to alleviate the conflict through the use of loans by the IMF to deficit countries. The rationale behind these short-term loans (three to five years) was that a country’s BOP deficit might be temporary because of the stage of the business cycle in which the country was located. If a loan could provide finance to the borrower until the payments imbalance reversed itself, then there would be no need for alteration of the deficit nation’s macro policies in the direction of sacrificing internal goals. In addition, an IMF loan might reduce the likelihood that the deficit country would impose tariffs and other restrictive instruments on imports to conserve its foreign exchange reserves. Along the same line, fewer exchange controls on capital movements might be introduced. Hence, the availability of IMF loans not only could serve the purpose of giving more autonomy to domestic macro policy instruments but also contributed to a third objective of the IMF: to help preserve relatively free trade and payments in the world economy. The Goals of the IMF Final PDF to printer 734 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch29_728-764.indd 734 06/22/16 01:26 PM 4The 25 percent is now paid in internationally acceptable “hard” currencies or SDRs rather than in gold. SDRs* (millions) U.S. Dollars (millions) ($1.377940/SDR) Percent All Countries 238,182.7 328,201.5 100.00 Advanced Countries 151,141.8 208,264.3 63.46 Australia 3,236.4 4,459.6 1.36 Canada 6,369.2 8,776.4 2.67 France 10,738.5 14,797.0 4.51 Germany 14,565.5 20,070.4 6.12 Italy 7,882.3 10,861.3 3.31 Japan 15,628.5 21,535.1 6.56 Sweden 2,395.5 3,300.9 1.01 United Kingdom 10,738.5 14,797.0 4.51 United States 42,122.4 58,042.1 17.68 Emerging and Developing Countries 86,978.8 119,851.6 36.52 Africa 11,614.8 16,004.5 4.88 Algeria 1,254.7 1,728.9 0.53 Côte d’Ivoire 325.2 448.1 0.14 Kenya 271.4 374.0 0.11 Nigeria 1,753.2 2,415.8 0.74 South Africa 1,868.5 2,574.7 0.78 Zambia 489.1 674.0 0.21 Emerging and Developing Asia 24,098.2 33,205.9 10.12 China 9,525.9 13,126.1 4.00 Fiji 70.3 96.9 0.03 India 5,821.5 8,021.7 2.44 Indonesia 2,079.3 2,865.2 0.87 Pakistan 1,033.7 1,424.4 0.43 Philippines 1,019.3 1,404.5 0.43 Thailand 1,440.5 1,984.9 0.60 Commonwealth of Independent States 9,122.5 12,570.3 3.83 Kazakhstan 427.8 589.5 0.18 Russian Federation 5,945.4 8,192.4 2.50 Ukraine 1,372.0 1,890.5 0.58 TABLE 1 Selected IMF Country Quotas, November 17, 2015 What were the sources of the funds for the BOP loans? When a country joins the IMF (there are now 188 IMF member nations), it is assigned an IMF quota. This country quota is a sum of money to be paid to the IMF based on a country’s GDP, openness to trade, variability in the economy, and holdings of international reserves. (The quotas are actually denominated in Special Drawing Rights, SDRs, which are discussed later in this chapter.) Thus, for example, Kenya has a quota of $374.0 million, while the United States has a quota of $58.0 billion. (See Table 1 for the size of current IMF quotas for selected coun- tries.) Under the original rules of the IMF, each country’s quota was to be paid 25 percent in gold and 75 percent in the country’s own currency.4 When all countries subscribed their quotas, the IMF became a holder of gold and of a pool of member country currencies. (continued) Final PDF to printer CHAPTER 29 THE INTERNATIONAL MONETARY SYSTEM 735 app9062x_ch29_728-764.indd 735 06/22/16 01:26 PM SDRs* (millions) U.S. Dollars (millions) ($1.377940/SDR) Percent Emerging and Developing Europe 7,070.3 9,742.4 2.97 Bulgaria 640.2 882.2 0.27 Croatia 365.1 503.1 0.15 Poland 1,688.4 2,326.5 0.71 Turkey 1,455.8 2,006.0 0.61 Middle East 15,520.7 21,386.6 6.52 Egypt 943.7 1,300.4 0.40 Iran 1,497.2 2,063.1 0.63 Iraq 1,188.4 1,637.5 0.50 Jordan 170.5 234.9 0.07 Kuwait 1,381.1 1,903.1 0.58 Saudi Arabia 6,985.5 9,625.6 2.93 Western Hemisphere 18,233.7 25,124.9 7.66 Argentina 2,117.1 2,917.2 0.89 Brazil 4,250.5 5,856.9 1.78 Chile 856.1 1,179.7 0.36 Colombia 774.0 1,066.5 0.32 Dominica 8.2 11.3 0.003 Mexico 3,625.7 4,996.0 1.52 Peru 638.4 879.7 0.27 Venezuela 2,659.1 3,664.1 1.12 *SDRs (special drawing rights) are an international reserve asset introduced in 1970 and discussed later in this chapter, and the IMF uses the SDR as its unit of account. Note: Regional SDR quotas pertain to 2014; SDR quotas did not change from 2014 to 2015. Source: International Monetary Fund, “IMF Members’ Quotas and Voting Power, and IMF Board of Governors,” November 17, 2015, and elibrary data, obtained from data.imf.org. TABLE 1 Selected IMF Country Quotas, November 17, 2015 (continued) How do these quotas link up with balance-of-payments loans to member countries? Suppose that Kenya has a BOP deficit and that it needs, because of a foreign exchange shortage, to obtain British pounds to pay for some of its imports. Kenya can “borrow” or “draw” pounds from the IMF because the IMF has a quantity of pounds on hand from the United Kingdom quota. Initially, according to IMF rules, a country could potentially obtain loans of up to 125 percent of its quota. This figure of 125 percent was divided into five segments, officially called credit tranches with the first 25 percent called the reserve tranche. The application for the first 25 percent was automatically approved by the IMF. Other borrowing facilities from the IMF have emerged over time, such as for debt relief, and the total annual limit for borrowing by any one country is 200 percent of the country’s quota. The total cumulative limit by any one country is 600 percent of its quota, and even greater access is available under certain conditions. As a country borrows larger and larger amounts, the IMF will attach increasingly stringent conditions before approving the addi- tional loans. These conditions are designed to ensure that the borrowing country is taking action to reduce its BOP deficit. For example, the IMF may prescribe that the country adopt certain monetary and fiscal policies or may even recommend a change in the value of the borrowing country’s currency. These potential interferences by an international agency with the national policies of members have generated considerable ill will, because they are regarded by would-be borrowers as intrusions upon national sovereignty. Final PDF to printer 736 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch29_728-764.indd 736 06/22/16 01:26 PM Most economists judge the Bretton Woods system to have performed well from its imple- mentation at the end of World War II until the mid-1960s. World trade grew relatively rap- idly during this period, and the major European countries removed most of their postwar exchange restrictions. In addition, Europe and Japan recovered from the World War II dev- astation, and growth in the world economy occurred with no major setbacks or recessions. Despite this seeming success, some important problems emerged in the Bretton Woods system. Economists have pointed out problems in three principal areas, and these areas correspond to the important functions of an international monetary system with which we began this chapter.5 The Bretton Woods international monetary system was thought to be facing an adequacy of reserves problem or liquidity problem. In general terms, this problem can be stated as follows: When world trade is growing rapidly, it is likely that the size of payments imbal- ances will grow in absolute terms. Hence, there is an increased need for reserves to finance BOP deficits. The framers of the Bretton Woods agreement envisioned that gold would be the primary international reserve asset, but the supply of gold in the world economy was growing at a rate of only 1 to 1.5 percent per year while trade in the 1960s was growing at a rate of close to 7 percent per year. Hence, the fear was that reserves in the form of gold were not increasing rapidly enough to deal with larger BOP deficits. If reserves do not grow roughly apace with BOP deficits, the danger exists that countries will use trade and payments restrictions to reduce their deficits, and these policies could reduce the gains from trade and the rate of world economic growth. The second problem, the confidence problem, was related to the liquidity problem. Because the supply of gold held by central banks was growing relatively slowly, the growing international reserves consisted mostly of national currencies that were internationally accept- able and were thus being held by the central banks. The two national currencies held in largest volume were the U.S. dollar and the British pound. But, particularly with the dollar, this fact posed a danger to central banks. The dollar was the linchpin of the system because of the gold guarantee that the United States stood ready to buy and sell gold at $35 per ounce. However, the dollars held by non-U.S. central banks began to exceed by a substantial margin the size of the U.S. official gold stock. This gold stock itself was also being depleted by U.S. BOP defi- cits. If all foreign central banks attempted to convert their dollars into gold, the United States did not have enough gold to meet all demands. In addition, there were even larger amounts of dollar deposits located outside the United States in foreign private hands (eurodollar deposits). These dollars could also be a claim on the U.S. gold stock. There was thus a loss of confidence in the dollar, that is, loss of confidence in what had become the principal reserve asset of the monetary system. Further, if the United States attempted to increase its ability to meet the con- version of dollars into gold by devaluing the dollar relative to gold (e.g., by changing the price from $35 to $70 per ounce), then central banks that held dollars would suffer a reduction in the value of their reserves in terms of gold. Such a devaluation would surely have started a mas- sive “run” on gold and would have brought the Bretton Woods system to a quick termination. The third perceived problem of the Bretton Woods system was the adjustment problem. This refers to the fact that in the actual operation of the Bretton Woods system, individual countries had prolonged BOP deficits or surpluses. This was particularly true for the United States (deficits) and West Germany (surpluses). There did not seem to be an effective adjustment mechanism, because automatic forces were not removing the imbal- ances. Countries directed monetary and fiscal policies toward internal targets rather than external targets, and thus the contraction (expansion) in the money supply expected of a deficit (surplus) country did not occur (i.e., sterilization was taking place). This was The Bretton Woods System in Retrospect 5See, for more complete discussion, Fritz Machlup (1964); Machlup and Burton G. Malkiel (1964); and Robert Triffin (1960). Final PDF to printer CHAPTER 29 THE INTERNATIONAL MONETARY SYSTEM 737 app9062x_ch29_728-764.indd 737 06/22/16 01:26 PM 6For extensive discussion of the SDR concept and agreement, see Machlup (1968). especially true with respect to the U.S. BOP deficit because of U.S. concern about slow economic growth and high unemployment. (In fact, the United States could sterilize with- out worrying excessively about a loss of reserves, since its own currency was being used as reserves.) In a similar vein, Germany’s concern about inflation prevented it from adjusting to a BOP surplus by expanding its money supply. GRADUAL EVOLUTION OF A NEW INTERNATIONAL MONETARY SYSTEM Any attempt to recount the events associated with the gradual disintegration of the Bretton Woods system is bound to be arbitrary in its selection of events. With this caveat in mind, we summarize below the developments we regard as significant for the evolution of the current international monetary system. In 1967, the British pound was officially devalued from its parity exchange rate of $2.80/£1 to $2.40/£1 (a 14 percent devaluation). This devaluation was a consequence of declining U.K. foreign exchange reserves in large part due to speculative short-term capital flows. The devaluation was significant because the pound and the dollar were key currencies, that is, the two national currencies most prominently held by central banks as official inter- national reserves. The fact that the value of an international reserve asset had been changed suggested that the exchange rate pegs of Bretton Woods might not be sustainable. A second important event was the decision by major central banks in 1968 that they would no longer engage in gold transactions with private individuals and firms. This decision meant that, henceforth, the central banks would no longer buy and sell gold in the private market but would continue to do so with each other. Transactions in gold between central banks would be made at the official gold price of $35 per ounce, but private individuals would buy and sell among themselves at whatever price cleared the private market (which at one time exceeded $1,600 per ounce). This new structure for gold was called the “two-tier gold market.” Some background is necessary to understand the significance of this event. Prior to 1968, because central banks had been willing to buy and sell gold with private individuals (although the U.S. government had not been willing to do so with its own citizens), there was only one price for gold. Central banks bought and sold at the $35 price, and, if the price in private mar- kets tended to rise above (fall below) $35, dissatisfied buyers (sellers) could obtain (sell) gold from (to) the central banks at the $35 price. However, because of the uncertainties associated with the confidence problem in the 1960s, private speculators anticipated that the dollar might be devalued in terms of gold. They therefore were eager to buy gold at $35 per ounce for resale later at the expected higher price. This private demand for gold put upward pressure on its price, pressure which could be relieved only by sales of gold by central banks, reducing offi- cial reserves. To stem this outflow of gold to private buyers, the two-tier market was instituted. The refusal of central banks to deal in gold with private individuals and firms was judged to be important symbolically because it represented a first step toward reducing the relative importance of gold in the international monetary system. Because the central banks were no longer dealing in gold with private citizens, gold holdings were frozen in size in the central banks’ overall international reserve portfolios. As international reserves later grew through accumulation of more dollars in particular, gold constituted a declining fraction of total reserves. A major development in the international monetary system occurred in 1970 when a new international asset appeared. This development was the introduction of Special Drawing Rights (SDRs) by the IMF.6 Unlike gold and other international reserve assets, the SDR Early Disruptions Special Drawing Rights Final PDF to printer 738 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch29_728-764.indd 738 06/22/16 01:26 PM is a paper asset (sometimes called “paper gold”) created “out of thin air” by the IMF. On January 1, 1970, the IMF simply entered on the books of all participating members a total of $3.5 billion worth of SDRs. The SDR itself was defined as equal in value to 1⁄35 of an ounce of gold and thus as equal in value to one U.S. dollar. The total of $3.5 billion was divided among member countries in proportion to the share of total IMF quotas of each member country. Additional SDRs have been created on multiple occasions since 1970. The SDRs that a member country receives in an allocation add to international reserves and can be used to settle a BOP deficit in a fashion similar to any other type of interna- tional reserve asset. For example, if India needs to obtain Japanese yen to finance a deficit, it can do so by swapping SDRs for yen held by some other country (e.g., France) that the IMF designates. Thus, the SDR could help to alleviate the liquidity problem discussed earlier. Further, because the SDR is not a national currency, and because it might eventu- ally replace national currencies such as the dollar in reserve portfolios, the new instrument could potentially alleviate the confidence problem. In the preceding India example, where SDRs were exchanged for yen, a skeptic might question why France would be willing to part with some of its yen in exchange for a bookkeeping-entry paper asset. This question goes to the heart of a more basic question: “Why do some assets serve as money, while others do not?” The answer to this more basic question is that an asset serves as money if it is generally acceptable in exchange; one party to a transaction will accept the asset if that party knows that it too can use the asset to acquire other assets. SDRs have become “international money” among central bankers because the recipient of the SDRs knows that it can use them to acquire other currencies from other countries later. Further, in the SDR scheme, each participant agreed to stand ready to accept SDRs to the extent of twice its accumulated SDR allocations. Another feature of SDRs is that if a country is a net recipient of SDRs, meaning that it holds more than it has been allocated by the IMF, it receives interest on its excess holdings. Similarly, if a country holds less than its allocation of SDRs, that country pays interest on its shortfall. These rules help to encourage caution in the use of SDRs. A final aspect of the SDR concerns its valuation. In the initial allocation of this new asset, the SDR equaled one U.S. dollar. With the later devaluations of the dollar (discussed next) and the advent of greater flexibility in exchange rates during the 1970s, the equality of the SDR and the dollar was discarded. The SDR is now valued as a weighted average of the values of four currencies: 41.9 percent for the U.S. dollar; 37.4 percent for the euro; 11.3 percent for the British pound; 9.4 percent for the Japanese yen. These weights became effective January 1, 2011. In 2015 the IMF gave consideration to including the Chinese renminbi yuan (RMB) in the basket. It decided late in the year to include the RMB, effec- tive October 2016. The new weights for the SDR will be 41.73 percent for the U.S. dol- lar, 30.93 percent for the euro, 10.92 percent for the RMB, 8.33 percent for the yen, and 8.09 percent for the pound. Chronologically, the next event of major significance occurred on August 15, 1971. At that time, because of continuing U.S. BOP deficits, escalating inflation, and lagging economic growth, the Nixon administration undertook several drastic steps. Most importantly, the United States announced that it would no longer buy and sell gold with foreign central banks. This action amounted to an abandonment of the Bretton Woods system, because the willingness of the United States to buy and sell gold at $35 per ounce had been the linchpin of that system. In addition, the administration temporarily froze wages and prices (to help in the anti-inflation effort), imposed a temporary 10 percent tariff surcharge on all imports (to help in reducing the BOP deficit), and instituted a tax credit for new produc- tive investment (to stimulate economic growth), among other actions. From the standpoint of the exchange rate system, the cessation of the willingness to buy and sell gold was the The Breaking of the Gold–Dollar Link and the Smithsonian Agreement Final PDF to printer CHAPTER 29 THE INTERNATIONAL MONETARY SYSTEM 739 app9062x_ch29_728-764.indd 739 06/22/16 01:26 PM key policy change because it altered the nature of the existing system. Without the “gold guarantee,” there was no anchor to the value of the dollar. Foreign central banks were faced with the decision of whether or not to continue buying and selling dollars at the previously established parity values. After this action, there was considerable turbulence in the international monetary sys- tem. To stem the speculation and uncertainty, the chief monetary officials of the leading industrial nations convened in Washington at the Smithsonian Institution in December 1971 to work out a new set of exchange rate arrangements. This meeting led to the Smithsonian Agreement, which established a new set of par values (called central rates). The deutsche mark and the Japanese yen were revalued upward by 13 percent and 17 percent, respec- tively. In addition, countries agreed to permit variations of 2.25 percent on either side of the central rates, thus introducing greater exchange rate flexibility than had been allowed under the ±1 percent variations of the Bretton Woods arrangements. Further, the United States changed the official price of gold from $35 to $38 per ounce. This devaluation of the dollar against gold was important symbolically rather than practically, because the United States was no longer buying and selling gold. The symbolism was that the United States, by devaluing its currency, was politically admitting that it was at least partly responsible for the troubles of the international monetary system (through the continual U.S. BOP defi- cits). The Smithsonian Agreement generated optimism for the future among participating governments, and President Nixon called it “the most significant monetary agreement in the history of the world” (quoted in Ellsworth and Leith, 1984, pp. 508–09). This judgment regarding the Smithsonian Agreement was premature, as continued speculation against the dollar resulted in further changes. Britain began floating the pound in June 1972. Early in 1972, the six countries of the European Community also began a joint float of their currencies, which meant that these countries (Belgium, France, Italy, Luxembourg, the Netherlands, West Germany) kept their own currencies tied closely together (±2.25 percent from specified values) but the currencies could vary by larger amounts against other currencies (although the 2.25 percent variation was also maintained against the dollar). In February 1973, the U.S. dollar was again devalued against gold (to $42.22 per ounce). Other currencies began floating either freely or in controlled fashion in 1973. The next significant development occurred with the Jamaica Accords of January 1976. After consultation with officials of leading countries, the IMF made a series of changes that were incorporated into the IMF’s Articles of Agreement.7 The most important of these changes were the following: 1. Each member country was free to adopt its own preferred exchange rate arrange- ments. Thus, for example, a country might tie its currency’s value to some particular cur- rency, or it might let its currency float freely against all currencies, or it might peg its currency’s value to some “basket” of currencies of countries with which it was most heav- ily involved in trade. 2. The role of gold was downgraded in the international monetary system. To this end, the official price of gold was eventually abolished and the IMF itself sold one-third of its gold holdings. Some of the proceeds were used to benefit developing countries. 3. The role of the SDR was to be enhanced. It was anticipated that SDRs would become very important in the reserve asset portfolios of central banks, although this objective has not been achieved. The Jamaica Accords 7The changes officially went into effect on April 1, 1978. See IMF Survey, April 3, 1978, pp. 97–107. Final PDF to printer 740 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch29_728-764.indd 740 06/22/16 01:26 PM 4. The IMF was to maintain surveillance of exchange rate behavior. In general terms, this meant that the IMF intended that its members would seek to “avoid manipulating exchange rates … to prevent effective balance of payments adjustment” and would fos- ter “orderly economic and financial conditions and a monetary system that does not tend to produce erratic disruptions.”8 These broad objectives essentially mean that the IMF advises its members, through regular consultations, on their exchange rate actions so that the international monetary system does not become subject to considerable uncertainty and instability. A significant development in international monetary arrangements began in March 1979 with the inauguration of the European monetary system (EMS).9 This system was an outgrowth of the joint float (sometimes called the “European Snake” because of the wave- like movements of the six currencies as a unit against other currencies) that had begun in 1972. The first key feature of the EMS of the European Community members was the creation of a new monetary unit, the European currency unit (or ecu), in terms of which central rates for the countries’ currencies were defined. The value of the ecu was a weighted average of EMS member currencies and the ecu was used as the unit of account for recording transactions among EMS central banks. A second key feature of the original EMS was that each currency was generally to be kept within 2.25 percent of the central rates against the other participating currencies, and a mechanism was put in place requiring central bank action as exchange rates approached the limits of divergence permitted from the central rates. There were also provisions for periodic realignments of the central rates. Third, the EMS participating currencies were to move as a unit in floating fashion against other currencies, including the U.S. dollar. This set of exchange rate rules was known as the exchange rate mechanism (ERM) of the EMS. Finally, the European Monetary Cooperation Fund (EMCF), a “banker’s bank” simi- lar to the IMF, was established for receiving deposits of reserves from the EMS members and making loans to members with BOP difficulties. The EMS was conceived as a means of promoting greater exchange rate stability within Europe and, because of this stability and certainty, for generating more stable and soundly based economic growth. Because greater stability in exchange rates requires some degree of harmonization in macroeconomic policies, the EMS also promoted convergence of poli- cies and inflation rates. In December 1991, the members of the European Community (EC) extended the EMS and took a dramatic step toward future monetary union. The Maastricht Treaty laid out a plan for the establishment of a common currency and a European central bank by, at the latest, January 1, 1999. Along with the implementation of various other changes to bring about closer trade and capital market integration, the participating European countries would have at that time a full Economic and Monetary Union (EMU). The transition to EMU was to take place in stages.10 In stage I, countries not yet participating in the ERM would begin to do so. Members of the EC were also to take steps toward convergence in their economic performance, as measured by inflation differentials, exchange rate stability, dif- ferences in interest rates, and fiscal deficits and government debt. In stage II (which began on January 1, 1994), the EC was to intensify its examination of whether the various criteria The European Monetary System The Maastricht Treaty 8IMF Survey, April 3, 1978, p. 98. 9For more complete discussion, see Commission of the European Communities (1986) and The ECU (1987). 10See A Single Currency for Europe: Monetary and Real Impacts (1992), pp. xi, 3. Final PDF to printer CHAPTER 29 THE INTERNATIONAL MONETARY SYSTEM 741 app9062x_ch29_728-764.indd 741 06/22/16 01:26 PM 11“European Leaders Agree to Treaty on Monetary Union,” IMF Survey, January 6, 1992, pp. 2–3. 12Another specified criterion was that, for the two years prior to entry, the country’s currency value must not have been changed within the European Monetary System. In fact, some currency values fluctuated considerably in the period leading up to the EMU, and the other four criteria listed in the text were the main ones considered. After the EMU was initiated, the criterion became that the applying country’s currency must have maintained real and nominal exchange rate stability against the euro. This close tie to the euro was designated as Exchange Rate Mechanism II (ERMII). for convergence of economic performance were being met, and countries were expected to remove virtually all remaining restrictions on the flow of capital between them. In addi- tion, the EMCF would be replaced by the European Monetary Institute (EMI), consisting of the national central bank governors and a president, which would strengthen monetary cooperation. Finally, when stage III began, members were to irrevocably fix their exchange rates and form the monetary union with a common currency, the euro. The EMI was then to be replaced by the European System of Central Banks (ESCB), a communitywide institution consisting of the national central banks themselves working with a multinational institution known as the European Central Bank (ECB). The ESCB would be the supra- national monetary authority, with control over monetary policy and exchange rate policy for the entire European Community.11 To the surprise of doubters, the EMU did indeed begin operations on January 1, 1999. Of the 15 European Union countries at the time, 11—Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain—fixed their exchange rates by irrevocably defining their currencies in terms of the euro, which thereby defined the currencies irrevocably in terms of each other. For example, with 6.55957 French francs defined as equal to 1 euro and 1.95583 German marks equal to 1 euro, the result is that 3.35385 French francs equal 1 German mark (6.55957/1.95583 = .35385). The euro in turn floated against other non-EMU currencies, and it had a value of approximately $1.16 at the time of its introduction. Bank accounts in the Euro Area or “Euroland” or “euro zone” (the 11 members of EMU) and many financial transactions immediately began to be denominated in euros. The individual countries’ currencies remained in circulation until early 2002, when they ceased to be legal tender and were taken out of circulation. Euro notes and coins first appeared on January 1, 2002. The establishment of the EMU was a milestone in world monetary history. It is par- ticularly important to note that no one simply announces fixed exchange rates and a new currency and then assumes that all will be well for the foreseeable future. Macro policies to bring economic variables into consistency across countries are necessary for a mon- etary union and fixed rates to survive. To this end, the Maastricht Treaty had specified convergence criteria. For a country to be permitted to join the EMU, (1) the country’s inflation rate of consumer prices could not be greater than 1.5 percentage points above the average of the three lowest-inflation EU countries; (2) the country’s long-term government bond interest rate could not be more than 2 percentage points above that interest rate aver- age in the three lowest-inflation countries; (3) the government budget deficit of the enter- ing country could not exceed 3 percent of GDP; and (4) the ratio of total government debt to GDP of the country must be 60 percent or lower.12 Why are such criteria necessary? First, with regard to the inflation rate criterion, if a country inflates more rapidly than its major trading partners, it is likely to incur a trade deficit as exports fall off (because they are now less competitive) and imports rise (because they are now relatively cheaper compared to home goods). This deficit situation would put pressure on the country’s currency, moving it toward depreciation. Second, if a country’s interest rates are higher than those in other countries, there would be upward pressure on Final PDF to printer 742 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch29_728-764.indd 742 06/22/16 01:26 PM the country’s currency. This pressure could come from two sources: (1) the higher interest rates attract mobile capital from other countries and (2) the higher interest rates slow down economic activity in the country and lead to a reduction in imports. Both of these develop- ments would tend to generate an incipient surplus in the balance of payments and potential appreciation of the home currency. Turning to the fiscal criteria, an excessive deficit/GDP ratio could imply currency trou- ble because such expansionary policy could put upward pressure on the country’s currency if government borrowing bids up interest rates and attracts short-term portfolio capital. (Note: In the terminology of Chapter 24, this implies that the BP curve is flatter than the LM curve, which is surely the case in the EMU countries.) Finally, if the ratio of total gov- ernment debt to GDP exceeds 60 percent, the implication is that the high level of debt (and 60 percent per se is clearly an arbitrary number) might pose problems for the country. In particular, investors might lose confidence in the government’s ability to service and carry the debt, and this means that holdings of government bonds might be sold off. This move- ment away from the bonds, if done by foreign investors, would put downward pressure on the value of the country’s currency. When the Maastricht Treaty was originally signed, there were substantial divergences among countries with respect to interest rates, inflation rates, and the fiscal variables. However, concerted efforts (and sometimes creative bookkeeping, such as when the French government recorded a privatization sale as a regular receipts inflow for the purpose of reducing its deficit/GDP ratio) brought about remarkable convergence in the previously mentioned indicators. In the end, Greece was the only European Union member seeking admission to EMU that was denied, as it failed to meet all four criteria. Greece was granted entry after a delay. The government debt/GDP ratios of Belgium and Italy were about twice the 60 percent criterion, but these divergences were ignored. Three EU member countries at the time—Denmark, Sweden, and the United Kingdom—chose not to join the EMU. An important reason a country might not want to join the EMU is that, as has been mentioned in earlier chapters, monetary policy independence for a country’s central bank is completely lost with absolutely fixed exchange rates and, of course, with a common currency. Monetary authority in the case of the EMU is, as noted earlier, lodged with the European System of Central Banks, composed of the supranational ECB and the national central banks. The executive board of the ECB actually conducts monetary policy in accor- dance with general instructions from the governing council, which contains representatives from all Euro Area countries.13 The ESCB established early what its major priority would be: “The primary objective of the ESCB shall be to maintain price stability” (Article 2 of the ESCB Statute, quoted in Issing, 1999, p. 19). This objective (often thought to mean no more than 2 percent inflation) is consistent with the notion that the tight-money policies of the German Bundesbank, which was very anti-inflationary, was carried over into the EMU. As became clear later on, sticking to a low inflation target can be associated with a trade- off of higher unemployment. With monetary policy being conducted at the EMU level rather than at the individual country level, the only macro policy available for country governments is fiscal policy. With adherence to the relevant convergence criteria as well as with the signing of the Stability and Growth Pact of 1997, members of EMU committed themselves to keep government budgets close to balance.14 Nevertheless, because the deficit can go up to 3 percent of GDP, 13For extensive discussion of monetary policy procedures in the EMU, see Otmar Issing, “The Monetary Policy of the Eurosystem,” Finance and Development, March 1999, pp. 18–21. 14For extensive discussion of early policy in the EMU, including considerable attention to fiscal policy, see International Monetary Fund, World Economic Outlook, October 1998 (Washington, DC: IMF, 1998), chap. 5. Final PDF to printer CHAPTER 29 THE INTERNATIONAL MONETARY SYSTEM 743 app9062x_ch29_728-764.indd 743 06/22/16 01:26 PM 15See “Success Factors of the Euro and the ECB,” speech by Christian Noyer, vice president of the European Central Bank, at the symposium World Economic Climate after the Introduction of the Euro, organized by Japan Center for International Finance and Sumitomo-Life Research Institute, Tokyo (February 13, 2002); data from the European Central Bank at www.ecb.int/stats. 16European Commission, Economic and Financial Affairs, “The Euro,” obtained from http://ec.europa.eu. there is room for fiscal stimulus if the tight-money policies of the ECB, the actual operating arm of the ESCB, are deemed too restrictive. A country could, for example, set its “structural deficit,” the deficit that would exist even if the country had a high level of employment (the “natural rate” from Chapter 27), at 1 to 1½ percent of GDP to provide some net stimulus to the economy from the excess of government spending over tax revenues. Even if recession occurred and tax revenues fell, the government could still be providing stimulus and stay- ing within the 3 percent of GDP limit. Thus, there is some possible role for fiscal policy at the individual country level, but the Growth and Stability Pact did specify financial sanc- tions that can be applied to a country if the 3 percent deficit/GDP ratio is exceeded. Early on, the conversion to the euro proceeded smoothly and financial integration within Europe was enhanced. The euro became the second most widely used currency in the world (after the dollar). Although the euro fell in the beginning from its initial value of US$1.16 to below US$0.90, it soon recovered and has been greater than $1 per euro ever since, although it fell to $1.06 in late 2015. It reached a high of $1.60 in July 2008. With the financial uncertain- ties accompanying the 2007–2009 recession and the accompanying debt problems of Greece, Spain, and other EMU members, the euro subsequently experienced considerable volatility.15 At the time of this writing, the EMU consists of 19 countries—the original 11 listed on page 741 plus Cyprus (joined in 2008), Estonia (2011), Greece (2001), Latvia (2014), Lithuania (2015), Malta (2008), the Slovak Republic (2009), and Slovenia (2007). Previously, European Union members Denmark and the United Kingdom opted out of the EMU/euro arrangement. However, several EU members not presently in the EMU— Bulgaria, Czech Republic, Hungary, Poland, Romania, and Sweden—will become formal members of the EMU and adopt the euro upon meeting the convergence criteria.16 As noted earlier, there is a potential trade-off between price stability and the unemploy- ment rate. In the context of the EMU, some countries (e.g., Italy, Greece, Spain) have sought to reduce unemployment through the use of expansionary fiscal policy via budget deficits, while others (especially Germany) have opted for stricter control of inflation by way of tighter fiscal policy. The consequence of these differing country objectives has been that the deficit countries have incurred significant internal and external debt problems and have borrowed from other EMU members in the process. The lenders are not prepared to finance deficits continuously, and worries about the stability of the deficit countries’ economies have caused capital flight from the debtors, leading to even further doubts about stability. If a debtor country possessed its own independent currency, it could undergo depreciation of that currency, which in turn could give a boost to the economy through more competitive exports and import-substitutes. This trade balance improvement might also reduce the necessity of foreign borrowing. Depreciation cannot, of course, be an active policy component of the adjustment process when the deficit country is part of a common currency arrangement. Without coordinated fiscal policy across member countries, this kind of problem will continue to be a problem for the EMU. We conclude this survey of the evolution of the international monetary system by noting that, in general, exchange rate variations among major currencies have been very large since the breakdown of Bretton Woods. Fluctuations in nominal exchange rates have also been accompanied by large changes in real exchange rates. Hence, there have been substantial Exchange Rate Fluctuations in Other Currencies in the 1990s and 2000s Final PDF to printer 744 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch29_728-764.indd 744 06/22/16 01:26 PM variations in international competitiveness as well as dislocations in the export and import- competing sectors of countries. In addition, the most important variations in relative cur- rency values have occurred with respect to the U.S. dollar, which rose dramatically from 1980 to 1985 and then fell dramatically after 1985 (especially from 1985 to 1987). As a consequence of the rise, in September 1985 the Plaza Agreement was reached in New York by central bankers from France, Japan, the United States, the United Kingdom, and West Germany. In this agreement, the five countries stated that the dollar needed to be lowered in value and that their central banks stood ready to intervene to accomplish this objective. The dollar did indeed fall in subsequent months, and the Louvre Accord was then announced in February 1987. In this accord, the G-7 countries declared that the dollar had fallen far enough (40 percent since 1985). The dollar was henceforth to be stabilized in a relatively narrow range (but unspecified as to the exact range) by cooperative central bank action. Changes in the value of the dollar (as well as in the value of other currencies) continued through the 1990s. For example, from September 1992 to September 1993, the dollar rose by 14 percent in terms of the German deutsche mark, 18 percent in terms of the British pound, 31 percent in terms of the Spanish peseta, and 50 percent in terms of the Swedish krona. Greater changes occurred against the currencies of some developing countries—for example, a 95 percent rise in terms of the Brazilian cruzeiro reàl. However, while ris- ing against most currencies, the dollar fell in terms of the Japanese yen by 12.5 percent. (Indeed, the trade-weighted nominal value of the yen—the effective exchange rate—rose by 25 percent over that period.)17 Further, in 1994 the dollar fell by more than 10 percent against both the deutsche mark and the yen, and in early 1995 it dropped to post-Bretton Woods lows against those two currencies. To put these changes in perspective, in 1973, at the beginning of the floating-rate period, 2.70 deutsche marks exchanged for 1 dollar; by March 1995 the figure was 1.38 marks per dollar. For Japan, the exchange rate was 280 yen per dollar in 1973, and it had fallen to 85 yen per dollar by June 1995. However, the dollar rebounded steadily against most currencies in 1996 and gained even faster momentum in early 1997, showing especially strong gains against the mark and the yen. The strengthen- ing of the dollar against the yen took place as a lower Japanese discount rate and increased confidence in the U.S. economy revived Japanese capital flows to the United States. By June 1998, the dollar was more than 40 percent above its value at the end of 1994 in terms of yen. With respect to other currencies, the real trade-weighted value of the British pound rose by 30 percent from 1995 to 1999, while the real trade-weighted value of the yen fell by over 25 percent from 1995 to 1998 and then rose back almost to the 1995 level by the end of 1999. In considering such volatility of real exchange rates, Taylor and Sarno (1998) concluded, in a test of movements of the yen, the mark, the French franc, the pound, and the U.S. dollar, that over the long run exchange rates seek PPP levels; however, there is little evidence of movement toward PPP in the short run. In the new century, exchange rate movements (sometimes sizeable) have continued. For example, from 2000 to 2011 the nominal effective rate of the Japanese yen fell over 20  percent; it then rose 43 percent by 2012 before declining by 25 percent from 2012 to 2014. In terms of the dollar, the yen appreciated 48 percent from 2000 to 2011, but then depreciated by 37 percent from 2011 to late 2015. In the meantime, the nominal effective rate of the British pound declined by over 22 percent during the 2011–2014 period; in dol- lar terms there was little change in the value of the pound during those years. From 2001 to 2011 the trade-weighted value of the U.S. dollar against major trading partners fell by 17The Economist, October 2, 1993, p. 112. Final PDF to printer CHAPTER 29 THE INTERNATIONAL MONETARY SYSTEM 745 app9062x_ch29_728-764.indd 745 06/22/16 01:26 PM 18For discussion of the pros and cons of the use of the dollar as circulating currency by countries, see Thomas Jennings, “Dollarization: A Primer,” USITC International Economic Review, April/May 2000, pp. 8–10. Interestingly, Jennings notes that there may have been $300 billion in U.S. currency held by foreigners at that time. CONCEPT CHECK 1. What were the key elements of the interna- tional monetary system devised at Bretton Woods? 2. What led to the breakdown of the Bretton Woods system? 3. What are the convergence criteria for EMU? Why are they necessary? CURRENT EXCHANGE RATE ARRANGEMENTS Since the breakdown of the Bretton Woods pegged-rate system, and pursuant to the amended IMF Articles of Agreement of 1978, countries have chosen a variety of exchange rate arrangements. There is no longer a uniform system, and the current arrangements are often called a “nonsystem.” Table 2 on page 747 classifies the arrangements chosen by IMF individual members into 12 categories. The first category pertaining to exchange rate arrangements is obviously one of com- plete absence of rate flexibility. In fact, in the category of “exchange arrangements with no separate legal tender,” the countries generally have no independent currency of their own. Thus, for example, the Marshall Islands, Micronesia, and Panama use the U.S. dollar as their currencies, although Panama also has its own currency, the balboa, in circulation at an exchange rate of $1.00 = 1 balboa.18 The second category, “currency board arrangements,” also involves no ability to change the exchange rate. As noted in Chapter 28, under this arrangement, a country’s currency is fixed in value in terms of some particular hard currency, and the amount of the domestic currency can change only when reserves of the hard currency change. Thus, if reserves increase, the domestic money supply can be expanded; if reserves decrease, the domes- tic monetary authority must decrease the domestic money supply, thereby reducing the balance-of-payments deficit and hence the reserve outflow. Categories 3 through 7 in Table 2 indicate situations where very minimal exchange rate variations are permitted. In these categories, the exchange rate may fluctuate around a specified parity value, and the maximum and minimum values should remain within 2 percent of each other for at least 6 months. In category 3, the peg is to the U.S. dollar; in category 4 to the euro. Category 5 shows pegs to another individual currency (e.g., the Nepali rupee to the Indian rupee). In category 6, the peg is to a “basket” or “composite” of currencies of the major trading partners of the country in question or to the SDR. In Category 7, the currency varies within margins of at least 1 percent of a fixed central rate, and the difference between the maximum and minimum rates can exceed 2 percent. Categories 1 through 7 comprise 70 countries, 36.6 percent of the total number, and thus it is far wide of the mark to say that the world has fully embraced floating exchange rates. 23 percent in nominal terms and then rose by nearly 18 percent by August 2015. Over the same two periods, the dollar fell by 23 percent and only by 6 percent, respectively, in real terms and 24.1 percent in real terms. From 2000 to 2011, a large decline occurred against the Canadian dollar (33 percent) as well as the euro (34 percent). From 2011 into late 2015 the dollar appreciated against both the Canadian dollar (34 percent) and the euro (31 percent). Large declines in nominal terms were registered against the Canadian dollar (36.2 percent) and the euro (35.7 percent). Final PDF to printer 746 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch29_728-764.indd 746 06/22/16 01:26 PM Note that many of the countries involved in this near or complete fixity of the exchange rate are small, developing countries. In these countries, it is advantageous to tie to or adopt the currency of the major trading partner; a floating or flexible rate with the leading trading partner could generate instability in the developing country’s trade, payments, and GDP. In addition, if the small country has a debt denominated in U.S. dollars (as many countries do), it is worthwhile to peg to the U.S. dollar. Otherwise, for example, if the Bahamian dollar depreciated against the U.S. dollar, payment of interest and repayment of principal would require a greater generation of Bahamian dollar resources and a greater resource burden on The Bahamas than would otherwise be the case. Categories 8–10 in Table 2 include countries that permit greater change in exchange rates than do those in the first four categories, but the arrangements are by no means float- ing ones. Category 8, the “crawling peg” and “crawl-like” arrangements (see Chapter 28), are situations where the value of the currency is changed periodically to a small extent either in a preannounced fashion or in response to a set of indicators (e.g., changes in the international reserve position of the country). For the “crawl-like” arrangement, the aver- age rate of change must be at least 1 percent. All in all, when categories 1 through 10 are accounted for, 126 of the countries (66 percent) fall into these fixed or relatively fixed categories. Categories 11 and 12 combine to make up the other 34 percent of exchange rate arrange- ments. In category 11, “floating,” a country’s exchange rate is mostly market-determined. The central bank can intervene to moderate the amount of change and to prevent excessive fluctuations. However, no specific target exchange rate exists. Finally, in “free floating” (category 12), central bank intervention occurs only very rarely, and there is no specified target exchange rate. Also, the central bank must provide information to the IMF indicating that intervention occurred a maximum of three times (with each intervention limited to a three-day maximum) during the previous six months. The advantages and disadvantages of fixed versus floating rates were examined in the preceding chapter. It is clear that there are many forces at work and many variables to be considered by a country’s authorities when selecting the degree of exchange rate flexibility to be permitted. The type of exchange rate arrangement that is best for one country may not be the best for another country with differing features and institutions, and the best arrange- ment for a country at one point in time may not be the best at another point. For example, the liberalization in many developing countries in the 1990s led to relatively greater adop- tion of more flexible exchange rate arrangements than was previously the case. EXPERIENCE UNDER THE CURRENT INTERNATIONAL MONETARY SYSTEM The historical record of the post-Bretton Woods international monetary system has been widely discussed and widely debated. A general consensus of economists regarding the operation of that system, often characterized by the general term managed float (especially for industrialized countries), is presented in this section. However, because the experience is relatively recent and because the system is still evolving, it is not certain that the views expressed will stand the test of time. 1. The post-Bretton Woods international monetary system has been characterized by substantial variability in exchange rates of the major industrial countries. This statement applies to nominal exchange rates and real exchange rates, and it is contrary to the expec- tations of many proponents of floating rates that the rates would move to an equilibrium level and then would show reasonable stability at that level. Even for countries with fixed nominal rates, there have been periodic official devaluations, and real exchange rates have varied in the presence of the fixed nominal rates. Final PDF to printer CHAPTER 29 THE INTERNATIONAL MONETARY SYSTEM 747 app9062x_ch29_728-764.indd 747 06/22/16 01:26 PM Category Countries Number of Countries 1. Exchange arrangements with no separate legal tender Ecuador, El Salvador, Kiribati, Kosovo, Marshall Islands, Federated States of Micronesia, Montenegro, Palau, Panama, San Marino, Timor-Leste, Tuvalu, Zimbabwe 13 2. Currency board arrangements Bosnia and Herzegovina, Brunei, Bulgaria, Djibouti, Hong Kong (China), Lithuania* 12 Eastern Caribbean Currency Union: Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines 3. Conventional fixed peg against the U.S. dollar Aruba, The Bahamas, Bahrain, Barbados, Belize, Curaçao and Sint Maarten, Eritrea, Jordan, Oman, Qatar, Saudi Arabia, South Sudan, Turkmenistan, United Arab Emirates, Venezuela 15 4. Conventional fixed peg against the euro Cabo Verde, Comoros, Denmark, São Tomé and Principe 18 Central African Economic and Monetary Community: Cameroon, Central African Republic, Chad, Republic of Congo, Equatorial Guinea, Gabon West African Economic and Monetary Union: Benin, Burkina Faso, Côte d’Ivoire, Guinea-Bissau, Mali, Niger, Senegal, Togo 5. Conventional fixed peg against other currencies Bhutan, Lesotho, Namibia, Nepal, Swaziland 5 6. Conventional fixed peg against a composite (“basket”) Fiji, Kuwait, Libya, Morocco, Samoa, Solomon Islands 6 7. Pegged exchange rates within horizontal bands Tonga 1 8. Crawling pegs and crawl-like arrangements Argentina, Armenia, Belarus, Botswana, China, Croatia, Dominican Republic, Ethiopia, Guatemala, Haiti, Honduras, Jamaica, Laos, Nicaragua, Switzerland, Tunisia, Uzbekistan 17 9. Stabilized arrangement Angola, Azerbaijan, Bangladesh, Bolivia, Burundi, Democratic Republic of the Congo, Egypt, Guinea, Guyana, Iraq, Kazakhstan, Lebanon, Macedonia, Maldives, Singapore, Sri Lanka, Suriname, Tajikistan, Trinidad and Tobago, Vietnam, Yemen 21 10. Other managed arrangement Algeria, Cambodia, Costa Rica, Czech Republic, The Gambia, Iran, Kyrgyz Republic, Liberia, Malaysia, Mauritania, Myanmar, Nigeria, Pakistan, Russian Federation, Rwanda, Sudan, Syria, Vanuatu 18 11. Floating Afghanistan, Albania, Brazil, Colombia, Georgia, Ghana, Hungary, Iceland, India, Indonesia, Israel, Kenya, Republic of Korea, Madagascar, Malawi, Mauritius, Moldova, Mongolia, Mozambique, New Zealand, Papua New Guinea, Paraguay, Peru, Philippines, Romania, Serbia, Seychelles, Sierra Leone, South Africa, Tanzania, Thailand, Turkey, Uganda, Ukraine, Uruguay, Zambia 36 12. Free floating Australia, Canada, Chile, Japan, Mexico, Norway, Poland, Somalia, Sweden, United Kingdom, United States 29 European Economic and Monetary Union: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Luxembourg, Malta, Netherlands, Portugal, Slovak Republic, Slovenia, Spain 191 *Lithuania joined the European Economic and Monetary Union in 2015 and hence is now in Category 12 rather than in Category 1. Source: International Monetary Fund, “De Facto Classification of Exchange Rate Arrangements and Monetary Policy Frameworks, April 30, 2014,” (with some rearrangement), in Annual Report on Exchange Arrangements and Exchange Restrictions 2014 (Washington, DC: IMF, 2014), pp. 5–8. TABLE 2 Exchange Rate Arrangements as of April 30, 2014 Final PDF to printer 748 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch29_728-764.indd 748 06/22/16 01:26 PM 2. Another feature of the international monetary system associated with this variability in exchange rates is that overshooting of exchange rates has occurred. Overshooting was discussed in Chapter 22. 3. A third characteristic of the post-Bretton Woods monetary system is that the vari- ability in exchange rates has had real economic effects. This characteristic has occurred because the variations in nominal exchange rates have not perfectly matched the variations in PPP exchange rates, and thus real exchange rates have varied. If a country’s currency undergoes a real depreciation, then the tradeable goods sectors of that country will attract resources because those sectors are now relatively more profitable than the nontradeable goods sectors. If the exchange rate then appreciates, the incentives will be shifted in the opposite direction, and resources will move out of the tradeable goods sectors and into the nontradeable goods sectors. However, such resource movements are not costless. Factors of production may have to move physically, retraining of workers may be needed, and unemployment occurs during the transition period. In addition, exchange rate variability can operate as a disincentive for direct investment flows between countries because it can generate arbitrary losses. For example, a firm making an investment in a foreign country at one exchange rate may want to repatriate profits at a later date but may find that the foreign currency has greatly depreciated and thus fewer units of home currency are being realized than was originally expected. The firm might therefore be less inclined to make such investments in the future. Thus, by various mechanisms, exchange rate movements may well lead to reduced output in the world economy. 4. Another widely noted feature of the current international monetary system is that the system does not seem to have insulated countries from outside economic disturbances to the extent expected. Remember from earlier chapters that one of the alleged advantages of a floating-rate system is that insulation would occur, and hence that there would be little transmission of business cycles from one country to another. However, the conclusion of most observers is that business cycles have been transmitted across country lines in the floating-rate period for industrialized countries and that these countries have indeed had to worry about real external shocks. Why do observers judge that the current system does not provide insulation? The most important reason is that central banks of the major industrial countries have been unwilling to allow complete flexibility in their exchange rates. The consequent official intervention in the exchange markets reflects the fact that the central banks may well have exchange rate targets in mind, as well as targets for national income. For example, authorities may wish to avoid a depreciation because it causes dislocations in the nontradeable goods sectors and worsens home inflation. In addition, they may also wish to limit the degree of apprecia- tion, because appreciation can cause problems for the tradeable goods sectors and run into political opposition. The end result is that exchange rates have not been as flexible as in floating-rate theory, and therefore insulation from real external shocks has not occurred to the extent expected by proponents of flexible exchange rates. 5. Because exchange rates have not been fully flexible, another expectation of the pro- ponents of flexible exchange rates has not been met: it was anticipated that, with floating rates, countries would not need to hold as large a volume of international reserves as under fixed rates, because reserve movements would not be needed in a major way to finance BOP deficits. However, in the post-Bretton Woods years, countries have added to their international reserves. Thus, the demand for international reserves has not decreased abso- lutely with floating rates, although reserves relative to imports have fallen. We have at least a partial explanation for the central banks’ behavior from item 4, where we noted that intervention continues to take place. Because the United States has had BOP Final PDF to printer CHAPTER 29 THE INTERNATIONAL MONETARY SYSTEM 749 app9062x_ch29_728-764.indd 749 06/22/16 01:26 PM TABLE 3 Central Bank International Reserves, December 31, 2014 Reserve Asset† Value ($, billions) Percentage of Total Reserves 1. Gold $ 1,122.4 8.56% 2. SDRs 275.1 2.10 3. Reserve positions in the IMF 118.4 0.90 4. Foreign exchange 11,591.1 88.43 Total reserves $13,107.2 100.00% Note: Components do not sum to totals because of rounding. †SDR values have been converted to dollars at the December 31, 2014 rate of 1 SDR = $1.44881. Source: International Monetary Fund, IMF Annual Report 2015, Appendix I, pp. 1, 3, obtained from www.imf.org. deficits over much of the period, more dollars were supplied to the exchange markets than would otherwise have been the case. When foreign central banks purchased these dollars to mitigate the fall in the value of the dollar, the dollars were added to the international reserves of the foreign central banks. At the same time, because dollars are not counted as part of the reserves of the United States, there was no decline in the value of U.S. reserves. The result has been an increase in total world reserves. To explore the increase in international reserves further, Table 3 presents recent infor- mation. As can be seen, the reserves of central banks are composed of four items: Gold. The gold holdings of central banks constitute 8.56 percent of international reserves of central banks. Until very recently the IMF valued gold at the previous official price of 35 SDRs = 1 ounce of gold. The IMF now values gold at the day's London market price; the price in London used for Table 3 below was slightly over 832 SDRs per ounce (slightly over $1,205 per ounce). SDRs. Because SDRs make up only 2.1 percent of international reserves, it is clear that the IMF’s objective of developing the SDR into a major international asset has not yet been achieved. Reserve positions in the IMF. This element of international reserves roughly refers to the first 25 percent of countries’ IMF quotas. A country can automatically obtain a loan of this size from the IMF when in BOP difficulties. This item is also a small fraction of world reserves (0.9 percent). Foreign exchange. This currently accounts for 88.4 percent of central bank reserves and is clearly the major international reserve asset central banks have at their disposal for settling BOP deficits. The U.S. dollar constitutes the majority component of these foreign exchange holdings (62.9 percent), followed by euros (22.2 percent), Japanese yen (4.0 percent), and British pounds (3.8 percent).19 With regard to the foreign exchange component of reserves, however, an additional point needs to be made. Because of the very large U.S. current account deficits of recent years, the dollar reserves being accumulated in central banks are generating some nervous- ness. The fear is that if central banks, and particularly the Chinese central bank which holds well over 1 trillion of dollar assets, were to sell a sizeable amount of those assets in exchange for other types of assets, the dollar would plunge in value. If so, this decline in value of the “key currency” in the system could have important effects. Among these 19International Monetary Fund, IMF Annual Report 2015, Appendix Table 1.2, obtained from www.imf.org. Final PDF to printer 750 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch29_728-764.indd 750 06/22/16 01:26 PM effects could be exchange rate instability as countries seek a new key currency, as well as enhanced inflation in the United States. Overall, the point of this discussion of international reserves is that central banks continue to hold a sizeable volume of reserves. (Indeed, reserves increased from $166.0 billion at the end of 1972—just prior to the advent of floating—to the 2014 figure of over $12 trillion.) Such large reserves would not be needed in a truly flexible exchange rate system. 6. A further conclusion regarding the current international monetary system that com- mands fairly wide agreement is that there has not been an increase in inflation in the world economy because of the presence of greater floating of exchange rates. Recall from Chapter 28 that a fear concerning the adoption of flexible rates was that a “vicious cir- cle” of inflation would develop. While the period of 1973–1974 until the early 1980s was indeed characterized by historically high inflation rates, it is not generally thought that this inflation was directly attributable to flexible exchange rates. Rather, the behavior of the Organization of Petroleum Exporting Countries (OPEC), of macroeconomic policymakers, and of price expectations played more crucial roles. Indeed, some observers doubt that the BrettonWoods system itself could have survived this inflationary episode. The floating- rate system permitted easier adjustment to the disturbances of this period than fixed rates would have done. It is interesting to note that, recently, there has been some concern about possible deflation in the world economy, although the concern is not particularly associ- ated with floating rates per se. 7. Many observers also think the fear that the volume of world trade would shrink in the face of the risk associated with flexible rates has not been borne out. World trade grew more rapidly than world production during the 1970s. In the early 1980s, trade growth dropped off sharply with stagflation from the second oil crisis and U.S. tight monetary policy, but trade continued to grow more rapidly than world production. Since that time, trade and production growth rates rose in the late 1980s, fell off with the recession of 1990– 1991, and then recovered. In the 1990s and through 2008, trade in real terms continued to grow more rapidly than world output, although there were occasional particular years when this was not the case. However, trade volume fell by 12.0 percent in 2009 while world GDP fell only by 2.1 percent. The year 2010 saw quick recovery in trade, which grew by 14.0 percent, and in world output, which grew by 4.1 percent. Trade grew slightly more rapidly than world GDP in 2011, 2012, and 2013 but at the same rate as output in 2014.20 8. Throughout the 1980s and early 1990s, the miracle economies of Southeast Asia were touted as shining examples of successful growth and development based on “ outward-looking” strategies.21 Rather than pursuing more traditional closed-economy policies in the presence of continued domestic price distortions, these countries embraced export-oriented strategies which involved the freeing up of financial and commodity mar- kets and an openness to trade and foreign investment. The effects were extremely positive, with the result that through the early 1990s countries such as South Korea, Thailand, and Indonesia continued to demonstrate strong growth in the presence of fiscal surpluses, rea- sonably low current account deficits, and moderate rates of inflation. Only Thailand sug- gested any financial strain, as its current account deficit remained in the area of 5 percent of 20World Trade Organization, International Trade Statistics 2015, p. 4, obtained from www.wto.org. 21Much of this section draws on the following sources: International Monetary Fund (IMF), International Financial Statistics, March 2000, pp. 396, 448, 754; World Economic Outlook, May 1998 (Washington, DC: IMF, 1998), chap. 1; World Economic Outlook, May 1999 (Washington, DC: IMF, 1999), chap. 1; World Economic Outlook, October 1999 (Washington, DC: IMF, 1999), chap. 1; Bank for International Settlements, 68th Annual Report (Basle: BIS, June 8, 1998), chap. 7; Joseph P. Joyce, “The Lessons of Asia: IMF Policies and Financial Crises,” Working Paper 99–02, Department of Economics, Wellesley College, May 1999. Final PDF to printer CHAPTER 29 THE INTERNATIONAL MONETARY SYSTEM 751 app9062x_ch29_728-764.indd 751 06/22/16 01:26 PM GDP, a common early sign of potential financial problems. Nonetheless, they all continued to receive strong credit ratings by both public and private organizations. However, the seeds of the forthcoming financial crisis were being sown in several ways. The positive economic environment resulted in substantial real investment by both foreign and domestic investors, which led to overinvestment in several sectors and a consequent eroding of the rates of return on the new capital such as, for example, in the electronics indus- try. A speculative bubble of sorts emerged, abetted by bad (nonperforming) loans of finan- cial institutions. There was financial overheating that spread into inflated property and stock market prices. An additional major complication in dealing with the situation when it began to self-correct was the increasing difficulty of maintaining exchange rate policies based on a close peg to the U.S. dollar. The fixed exchange rates not only fostered foreign borrowing and/or foreign investment but also complicated the response of the monetary authorities when the initial waves of the crisis began. Finally, the situation was further hampered by political uncertainties which increasingly ate away at investor confidence and increased the reluctance of foreign creditors to roll over short-term debt once the crisis began. The Asian crisis was fueled by rapidly growing deficits in the BOP financial accounts, which appeared early in 1997 when Thailand’s capital account turned from a positive $2.4 billion surplus in the first quarter to a $3.9 billion deficit in the second quarter because of capital flight and loss of confidence. The Thai central bank floated the currency, but a massive outflow of funds still took place and the baht depreciated by more than 50 percent by January 1998. The contagion began to spread to other countries in the region; countries affected were Indonesia, the Philippines, Malaysia, Hong Kong, Taiwan, and South Korea. The effects eventually were felt in both Russian and Latin American equity markets. As the crisis in Asia deepened, real GDP fell by 6 percent in South Korea, 11 percent in Thailand, and 13½ percent in Indonesia. A genuine fear was that the real and monetary effects would be passed on to other countries through appreciation of key currencies such as the dollar and through increased current account deficits (or reduced surpluses) in the industrialized countries. Collapse of the Russian ruble and Russian default on some debt in the autumn of 1998 were attributed to the contagion from Asia, as were threats to the stability of the Brazilian currency. In retrospect, it is clear that the crisis was fueled by a combination of factors related to speculative overinvestment, inadequate institutional development (such as inadequate bank supervision), and the ease of moving short-term capital quickly from one country to another amid the prospect of worsening economic conditions. However, investor confi- dence turned positive and was a critical factor in turning the situation around, as recovery subsequently began earlier and moved faster than many imagined possible. The outbreak of the U.S. subprime mortgage crisis in early fall of 2007 is commonly viewed as the onset of the financial crisis and economic downturn that plunged the world into its worst recession since World War II. The industrialized economies experienced a 0.0 percent growth in 2008 and a 3.6 percent decline in 2009. The economic and finan- cial strains felt by the United States, which were permeating from the fall in the housing sector, quickly spread. Japan, countries in Europe, and industrializing Asia were also hit hard. Fortunately, the United States and other governments aggressively intervened to mit- igate some of the negative effects and to assist in a necessary restructuring of the financial and production sectors that is consistent with rapid financial and economic globalization. Interestingly, the emerging and developing economies grew 6.0 percent in 2008 before slowing to 2.8 percent in 2009.22 The Global Financial Crisis and the 2007–2009 Recession 22IMF, World Economic Outlook, April 2012 (Washington, DC: IMF, 2012), p. 190, obtained from www.imf.org. Final PDF to printer 752 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch29_728-764.indd 752 06/22/16 01:26 PM However, with the expansion of the financial crisis in September 2008—reflected, for example, in the default of the financial firm Lehman Brothers and the need for the gov- ernment bailout of the American International Group (AIG)—the downturn did begin to spread to the rest of the world. Developing countries that had been initially sheltered from the effects of the problems in the U.S. subprime market began feeling the effects of the recession through reduced flows of capital and the impacts on international trade. U.S. trade fell in response to increased unemployment and falling levels of income. In addition, the massive losses in wealth brought about by the deflation of the housing bubbles, home foreclosures, and the 35 to 40 percent decline in equity markets contributed to further reductions in consumption and imports. In responding to the crisis, governments followed multifaceted strategies to deal with both the economic and the institutional aspects of the problem. Active monetary policy included the provision of financial liquidity, lowering interest rates, providing funds for recapitalization, and guarantees against losses for holding troubled assets. Governments also utilized fiscal policies such as discretionary stimulus packages to help offset declin- ing demand to complement the monetary actions. However, the rapidly rising government debt that accompanied these actions put upward pressure on government bond rates and raised concerns about long-term fiscal sustainability. Even in the presence of numerous coordinated efforts among the advanced countries, the risk element increased, impeding global investment and recovery. Attempts were made by both individual countries and the IMF to counteract these disorderly market conditions and to give the developing countries greater access to credit and let exchange rates adjust in order to maintain a viable foreign trade sector. Many reasons are given for the development of this crisis situation. Fingers have been pointed at numerous financial institutions, because these institutions appear to have fos- tered management incentives that led to dangerous risk taking and profit seeking at the expense of financial stability. In the same breath, criticism has been levied toward regula- tors for “sleeping at the switch” and/or putting in place regulations that provided incen- tives for reckless risk-taking behavior. While greed and incompetence may, in fact, explain some of the underlying causes at the micro level, it has been argued that broader global imbalances were critical in providing the foundation for the ensuing crisis. In this regard, the large, persistent current account deficits of the United States, accompanied by the large current account surpluses of countries such as China, reflected the poor saving behav- ior in the United States and the need to pay for the excess of spending over production by borrowing from abroad. It was argued by some that the United States was benefiting from the worldwide saving glut at a time when U.S. citizens and the public sector seemed less inclined to worry about it. These developments resulted in a policy dilemma: Should expansionary policy be enhanced at the expense of greater deficits and debt, or should fis- cal austerity in the form of increased taxes and reduced government spending be adopted despite possible adverse effects on growth and employment?23 Fiscal policy in the United States did not subsequently follow the austerity route, and the monetary authorities pursued an extremely easy stance in the years after the Great Recession. The federal funds rate, a key target of the Federal Reserve, was set at near zero percent and remained there until December 2015 when it was raised slightly. The economy slowly recovered from the slump. From a minus 2.8 percent real GDP growth rate in 2009, 23For expanded discussion of these various points, see “When a Flow Becomes a Flood,” The Economist, January 24, 2009, pp. 74–76; International Monetary Fund, World Economic Outlook, April 2009 (Washington, DC: IMF, 2009), chap. 1; Anthony Faiola, “U.S. Downturn Dragging World into Recession,” The Washington Post, March 9, 2009, p. A1; Klaus C. Engelen, “Barely Contained Outrage,” The International Economy, Fall 2008, pp. 21–27. Final PDF to printer CHAPTER 29 THE INTERNATIONAL MONETARY SYSTEM 753 app9062x_ch29_728-764.indd 753 06/22/16 01:26 PM CONCEPT CHECK 1. How would you describe the current interna- tional monetary system in terms of the nature of the exchange rate arrangements? 2. Why might countries with one main trading partner tend to opt for a fixed exchange rate with that partner rather than a flexible rate? 3. What are two of the more serious problems that have surfaced with the current system? the U.S. economy climbed upward with growth of 2.5 percent in 2010, 1.6 percent in 2011, 2.2 percent in 2012, 1.5 percent in 2013, and 2.4 percent in 2014. Despite the fact that these rates were relatively low, however, the unemployment rate did fall by a considerable amount. From the peak unemployment rate of 9.6 percent in 2010, the rate declined to 8.9 percent in 2011, 8.1 percent in 2012, 7.4 percent in 2013, and 6.2 percent in 2014. In November 2015, the unemployment rate stood at 5.0 percent. A final complication to be noted concerns the financial issues that impeded Europe’s ability to deal with the effects of the 2007–2009 recession and subsequent developments related to the EMU. As indicated earlier, the debt problems of several members of the EMU have generated uncertainty not only in Europe but also in many trading partners. As in the United States, a policy dilemma exists in each of the approaches to the problem. Advocates of fiscal austerity insist that the debt problems of Greece and other member countries should be addressed by higher taxes and a reduction of government spending; however, this would result in the short run in slower growth and greater unemployment. The extremely high levels of unemployment (above 20 percent) and youth unemployment (around 50 percent) in Greece and Spain have created tensions that may have long-lasting political impacts. On the other hand, an approach that emphasizes greater spending and lower taxes runs the danger of increasing the debt/deficit problem and raises the possibility that continued participation in the euro arrangement will become impossible as the pros- pects of continued borrowing from abroad become dim. It is widely held that fiscal policy coordination and perhaps even unification is a necessary step to deal with these problems. Inasmuch as incompatible fiscal stances across EMU members contributed to these com- plicated problems, such coordination/unification would provide a fiscal framework to bet- ter deal with these difficulties. SUGGESTIONS FOR REFORM OF THE INTERNATIONAL MONETARY SYSTEM In view of the various performance characteristics of the current international monetary system, many observers have proposed changes in the system in order to make it work better. The principal objection to the present arrangements concerns the considerable exchange rate volatility in the currencies of the major industrialized countries (especially the United States, the EU, and Japan) and its potential adverse effects. Because these coun- tries are so important in the world economy and because much of world trade and payments is denominated in their currencies, it is thought that some means must be found for reduc- ing exchange rate variability. In this section we briefly review proposals that have been discussed. Proponents of returning to a gold standard emphasize the need for an anchor for price levels within countries. The argument for a gold standard is that if currencies are defined in terms of gold and national money supplies are tied to the size of countries’ gold stocks, then A Return to the Gold Standard Final PDF to printer 754 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch29_728-764.indd 754 06/22/16 01:26 PM long-running BOP deficits and surpluses would not exist because of automatic adjustment, and the world would have less inflation because money supplies could not grow faster than the world’s gold stock. There could also be reduced risks associated with holding cur- rencies as international reserves because exchange rates would be fixed. Further, because gold would be the principal reserve asset in official reserve portfolios, stability would be introduced because foreign currencies would constitute a small portion of international reserves. Finally, if countries do indeed stick to their gold parities, the system eliminates the substantial volatility in exchange rates that has been of so much recent concern. The principal disadvantage of this proposal is that it places the goal of external balance (i.e., BOP equilibrium) above the internal goals of full employment and economic growth. Suppose that a country is running a BOP deficit; it is then expected to undergo a reduction of its gold stock and a contraction of its money supply. However, if the BOP deficit coin- cides with recession and slow growth internally, then contraction of the money supply will reduce economic activity even further. Because prices and wages in the modern economy tend to be inflexible in the downward direction, the result of monetary contraction will be a reduction of output and a rise in unemployment. The rise in interest rates expected of a deficit country would also deter long-term investment, which is necessary for sustained economic growth. This sacrifice of internal goals in the interests of BOP equilibrium is not a sacrifice many countries are politically prepared to make. Also, a surplus country will find inflationary pressures put upon it from the inflow of gold and international reserves, and a surplus country with a strong aversion to inflation (e.g., Germany, historically) will be unlikely to sacrifice its internal goal of price stability. Another disadvantage of the gold standard is that exchange rate changes are not available for reallocating resources as comparative advantage changes, and sticky internal prices could not accomplish the real- location easily. A proposal that has some similarities to the gold standard was put forward by Ronald McKinnon (1984, 1988); indeed, it has been dubbed the “gold standard without gold.” McKinnon would have the central banks of the United States, Japan, and Germany (which would now be the banks of the European Union) jointly announce fixed nominal exchange rate targets among their currencies (with small actual deviations permitted). The rates would be set according to PPP at the time of announcement, and a constant price level for traded goods would be sought. Monetary policy would be directed toward preserving these rates and the constant price level. With exchange rates and policies thus “anchored,” destabilizing short-term capital flows would become stabilizing. Again, however, sacrifice of national autonomy and unavailability of exchange rate changes to perform resource reallocations are present in this system, and unsterilized intervention would be used when necessary. This proposal has been made in many different forms over several decades [e.g., by John Maynard Keynes in the early 1940s, Robert Triffin (1960), Richard Cooper (1986), and most recently by Robert Mundell (2000)]. The plans propose different degrees of control to be exercised by a new, centralized monetary institution, but all have some common ele- ments. To set up the institution, at least part of the international reserves of the participating countries would be deposited in the new institution. This new bank would then have at its command billions of dollars of assets with which it could manage the world money supply. If faster (or slower) monetary growth were needed, the authority could vary its purchase of government bonds in world financial markets (much as the Federal Reserve in the United States conducts its open-market operations) to accomplish its objective. It could also make loans to countries in BOP difficulties, and variations in the authority’s lending rate would influence the amount of borrowing (as the Federal Reserve in the United States does with its discount rate), which would in turn affect the size of the world money supply. A World Central Bank Final PDF to printer CONCEPT BOX 1 A WORLD CENTRAL BANK WITHIN A THREE-CURRENCY MONETARY UNION Nobel laureate Robert Mundell has reintroduced the idea of a world optimal currency area with a world central bank in an interesting and novel way. Citing the existence of wide swings in exchange rates that are not based on underlying economic fundamentals as the biggest threat to world pros- perity, he argues that central banks must commit themselves to active and consistent intervention in the foreign exchange markets to reduce exchange rate volatility to maintain pros- perity and stimulate growth and development worldwide. Because recent events have led to a notable convergence of inflation rates in Japan, Europe, and the United States, he states that this is a logical time to focus on a coordinated effort to stabilize exchange rates. However, to accomplish this, the “Big Three” (the European Union, the United States, and Japan) must all agree to participate in such intervention, to refrain from sterilizing the effects of such intervention, and to intervene in both the spot and the forward markets. Finally, the public must believe that the governments will actively support such exchange rate intervention with appro- priate monetary policy. This approach to exchange rate stability would logi- cally take place in a single-currency world monetary union. However, Mundell acknowledges that such a monetary union is not politically feasible at this point. The three geo- graphic areas are sufficiently large to provide a basis for world monetary integration. As mentioned in Chapter 26, increased globalization has made coordination of policies a necessary condition for realization of domestic goals among these important trading groups, and exchange rate volatility is clearly counterproductive to all concerned. In these com- plicated circumstances, Mundell argues that a reasonable compromise would be to create a world central bank produc- ing its own international asset, which would be backed by reserves of dollars, yen, euros, and gold. It would have the advantage of involving power sharing and a broader set of options to which smaller countries could tie their currencies. In many ways it is similar to the idea proposed at Bretton Woods by John Maynard Keynes, but perhaps more politi- cally palatable and at a more logical time in history. Is it possible that the time has arrived for a world central bank and an international currency built on the strength of these three strong regional currencies which would be the property of all nations of the world? Source: Robert Mundell, “Threat to Prosperity,” The Wall Street Journal, March 30, 2000, p. A30. ● CHAPTER 29 THE INTERNATIONAL MONETARY SYSTEM 755 app9062x_ch29_728-764.indd 755 06/22/16 01:26 PM In an extreme form of the proposal, the new world central bank would issue a world currency as the means of controlling the world money supply. In this version, as well as in less extreme versions such as that of Mundell, countries have absolutely fixed exchange rates. (See Concept Box 1.) If currencies are tied together permanently at fixed rates, then a next step toward a common currency is facilitated, such as has been done on a regional basis with the euro. The end result is a movement toward a worldwide currency area, and the instability associated with fluctuating exchange rates is eliminated. The principal impetus behind a controlled world money supply is the view that today’s fluctuations in exchange rates are due to the differing and uncoordinated macroeconomic policies (especially monetary policies) of the major industrialized countries. In the cur- rent system, if country A expands its money supply relative to that of country B, then the relatively lower interest rates in country A will cause an outflow of mobile short-term capital from A to B. This outflow will depress the country A currency value relative to that of B. Further, the depreciation of the A currency and the appreciation of the B cur- rency will generate greater inflation in A relative to B, which can set in motion a further depreciation of A’s currency. At the heart of the problem of the exchange rate changes is the differing monetary stance, which in turn can reflect differences in the desired inflation- unemployment trade-off in the two countries. By centralizing monetary policy in a new Final PDF to printer 756 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch29_728-764.indd 756 06/22/16 01:26 PM world institution, these destabilizing differences in monetary growth among countries can be avoided. This plan in general could indeed work to reduce the amount of exchange rate instabil- ity and the effects of divergent monetary policies in the major industrialized countries. But the main criticism of proposals for a world central bank is that it is unrealistic to think that all countries would ever completely give up autonomy over their individual monetary policies. National sovereignty over economic policy is a cherished and firmly ingrained tradition. Proponents of such plans would argue that such autonomy is largely lost already in the current system because of the extremely high mobility of short-term capital across country borders. However, the lost autonomy is not as true for large countries as for small ones, and country officials think that they have considerable monetary control and thus will oppose such a plan. The leading proponent of the target zone proposal has been John Williamson (1985, 1987, 1988). This plan attempts to reduce the element of conflict between internal goals and the external goal of BOP equilibrium. The major industrialized countries would first negoti- ate a set of mutually consistent targets for their real effective exchange rates. Absolute fixity of these rates is not envisaged, but rather each country would permit its real effec- tive exchange rate to vary in, for example, a zone of 10 percent in either direction from the  target rate. The target rate itself for each country would be chosen as the exchange rate that would be estimated to reconcile external and internal balance over a medium-run time period. If the exchange rate moved close to the ceiling or floor of the zone, this would be an indication that policy steps should be taken to moderate or reverse the movement, but there is no absolute requirement that the rates be kept between the ceiling and the floor. Rather, the limits of the zone can be thought of as soft margins instead of hard boundaries. What would be the policy actions necessary in the target zone system? The most important policy tool would be monetary policy rather than fiscal policy. Fiscal policy would play a key role in attaining the internal target (e.g., reasonably full employment with reasonable price stability), but monetary policy is crucial because it can work to attain the internal goal as well as the external goal. In Williamson’s framework, the immediate external goal is not balance-of-payments equilibrium per se but, rather, the existence of reasonable stability in the real effective exchange rate around the target rate. If the real effective exchange rate begins to move toward the ceiling price for foreign exchange (a real depreciation of the home currency), this would indicate that inflation is too high relative to that in foreign trad- ing partners. A rise in interest rates would work to moderate the inflation but also would induce an inflow of short-term capital and thus moderate the home currency depreciation. Similarly, a downward movement of the real effective exchange rate (a real appreciation of the home currency) would indicate that the country’s macroeconomic policy is too restric- tive relative to that of other countries, so an easing of monetary policy is called for with respect to attaining both the internal and external targets. Monetary policy is supposed to be mainly directed toward internal goals, but because of capital mobility, it has the side benefit of assisting in stabilizing the exchange rate. However, it is clear that the success of such a plan would be dependent upon both the use of coordinated intervention in exchange markets by key central banks and a transparent mechanism for making gradual changes in the zones if it is clear that fundamental changes in the participating economies are making the previously established zones inconsistent or obsolete. Williamson’s target zone proposal has desirable features in that it keeps internal goals at the forefront while also addressing exchange rate instability. In addition, the plan’s focus is on real exchange rates rather than on nominal exchange rates, and the former are more The Target Zone Proposal Policy Actions in the Target Zone System Final PDF to printer CHAPTER 29 THE INTERNATIONAL MONETARY SYSTEM 757 app9062x_ch29_728-764.indd 757 06/22/16 01:26 PM influential for economic activity than the latter. However, real exchange rates are more dif- ficult to manage than are nominal exchange rates, and it is also crucial that the target rate be chosen reasonably accurately. If the estimate of the target rate is incorrect, the operation of the proposal perpetuates a misalignment of exchange rates, which can interfere with efficient resource allocation in the world economy. Also, if a situation of “stagflation” occurs, in which unemployment and inflation may both be rising at the same time, it is not clear that the target zone plan would be useful without supplementation by additional policy instruments. Another version of the target zone proposal was put forward by Paul Krugman (1991). (See also Svensson, 1992, pp. 121–25.) Unlike Williamson, Krugman would set upper and lower limits to the nominal effective exchange rate rather than to the real rate, and the lim- its would be permanent rather than “soft” limits. To build the case for the zone, Krugman develops a simple monetary/asset market model for the determination of the exchange rate. The exchange rate e (home-currency price of one unit of spot foreign exchange) depends only on the home money supply, changes or shocks in the velocity of money, and the expected rate of depreciation of the home currency. In his equation, an increase in the home money supply will depreciate the home currency and its coefficient is therefore posi- tive. An increase in the velocity of money (rate of usage or turnover of money) acts like an increase in the money supply and thus would also depreciate the currency. (Krugman postulates that changes in velocity are random.) Finally, Krugman employs UIP in asset markets, so that an increase in the expected rate of depreciation of the home currency (an increase in xa in the terminology of previous chapters) depreciates the home currency (a positive coefficient). In the Krugman target zone model, the monetary authorities stand ready to decrease the money supply if e reaches the specified upper limit (i.e., a depreciation of the home currency to its lower limit). Similarly, the authorities will increase the money supply if e falls to the floor (an appreciation of the home currency to its upper limit). A difference in the Krugman proposal from the Williamson proposal in this respect is that the monetary authorities basically act only if the exchange rate hits the limits—there is no change of behavior as the rate merely approaches the limits. In addition, Krugman postulates that the ceiling and floor may well never be reached, so the monetary authorities may not have to act at all. This result would occur if market participants had full confidence in the monetary authorities’ ability to maintain the limits. The Krugman target zone proposal thus results in stability of exchange rates and offers a means of reducing the volatility of exchange rates in today’s increasingly integrated finan- cial world. Major criticisms of the plan concern the assumption of perfect credibility of the specified limits and the postulated confidence in and effectiveness of the monetary authori- ties. In addition, empirical tests of the relationship between the expected rate of change in the exchange rate and the exchange rate itself have not always yielded the Krugman relationship, and the actual existence of UIP has also been questioned. Further, other things influence the exchange rate besides the money supply, velocity, and the expected change in the exchange rate.24 Little is also said about “internal balance” objectives. Nevertheless, given the desire of many observers to see more stability in exchange rates, this proposal as well as the Williamson proposal will continue to be debated, and they may suggest forth- coming modifications in the international monetary system. The Krugman Version of the Target Zone 24Svensson (1992, pp. 125–39) discussed these and other objections to the Krugman proposal, as well as cases of imperfect credibility. Krugman regards the target zone proposal as less stabilizing when there is imperfect cred- ibility, but it is still stabilizing (see Krugman, 1991, p. 680). Final PDF to printer 758 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch29_728-764.indd 758 06/22/16 01:26 PM This approach to the problem of exchange rate instability in the currencies of major coun- tries states that the obvious major cause of the instability is the fact that short-term capital moves so freely between countries, a view enhanced by the 1997–1998 Asian crisis. Many of these flows of capital have nothing to do with “economic fundamentals” such as infla- tion rates, resource productivity, and general economic conditions. Rather, they reflect reactions to rumors, political events, and “bandwagon effects” and “herd instincts,” where speculation against a currency in and of itself generates further speculation against that currency. Such volatile short-term capital flows cause considerable instability in exchange rates, and this instability is exacerbated by overshooting. Hence, so this approach specifies, a remedy is to impose limitations on the inflow and outflow of funds from major countries that are responding to such “uneconomic” motivations. Capital flows among countries could be restricted in a number of ways. A major pro- posal that has attracted attention for some time is that of James Tobin (1978), who sug- gested imposing an international tax on all spot transactions involving the conversion of one currency into another in securities markets. Such a tax would presumably discourage speculation by making currency trading more expensive, thereby reducing the volume of destabilizing short-term capital flows. [Tobin (1995) also hypothesized that, by generating greater interest rate differentials across countries, the tax—say, of 0.5 percent of trans- action value—would create room for individual country monetary policies to be more effective in macroeconomic stabilization.] While the tax has the potential advantages of reducing some of the marginally based speculative transactions or market “noise” and of fostering international cooperation on tax policy, there are a number of problems with a transactions tax of this type. Spahn (1996, p. 24) pointed out that there are four main problems with a Tobin tax that would inhibit its effectiveness. First, to limit the market distortions resulting from such a tax, the tax base would have to be as broad as possible and would have to exclude no category of market participants. However, a strong argument can be made that finan- cial intermediaries or “market makers” who increase market liquidity should not be taxed. Unfortunately, the Tobin tax cannot distinguish between normal institutional trading that ensures market liquidity and efficiency and destabilizing financial activity. Second, there is the question of what type of transaction to tax. If the tax is applied only to spot transactions, it can easily be avoided by going into the derivatives market. Taxing the initial contrac- tional value (or notional value) of derivatives, however, would likely severely injure the derivatives market. Applying a different tax rate to derivatives than to other instruments is a possibility, but a selective tax system would be arbitrary and extremely difficult to administer. Third, it can be argued that the tax should be applied only when markets are clearly in disequilibrium. Thus, the tax rate would be zero during conditions of stability and equilibrium and increase in accordance with the deviation from equilibrium. This, how- ever, would again contradict Tobin’s idea of a one-tax system and would also be incred- ibly complex to administer. Finally, there is the question of the distribution of revenues. Distribution of tax revenues is a controversial political question within countries, to say nothing of between countries. Significant costs could be incurred in simply trying to arrive at international consensus on this issue. In response to these problems, Spahn (pp. 26–27) suggested a two-tiered Tobin tax that would consist of a minimal-rate transactions tax and an exchange rate surcharge that would be applied only during periods of great exchange market turbulence. Although it certainly would not deter sudden speculation based on fear of an event such as a payment default, the two-tier tax would be useful as a short-term monetary stabilization tool that could smooth market adjustment. It should not, however, be viewed as a means of dealing with underly- ing structural problems. In response to this idea, Stotsky (1996) argued strongly against Controls on Capital Flows Final PDF to printer CHAPTER 29 THE INTERNATIONAL MONETARY SYSTEM 759 app9062x_ch29_728-764.indd 759 06/22/16 01:26 PM employing such a tax. Like the Tobin tax, it may not work simply because there is little evidence that market volatility is reduced by these kinds of taxes. (For a different view, see Frankel, 1996, p. 156.) Further, the increased transaction costs hinder market operations and efficiency. In addition, the use of variable tax rates can create uncertainty with respect to market prices and can be burdensome administratively. Finally, Stotsky questioned the desirability of mixing monetary policy and tax policy, given the political and administra- tive differences in the way they are enacted. Thus, while discussion continues regarding the viability and/or desirability of using a Tobin-type tax to reduce exchange rate instability, the lack of any consensus on its overall effects suggests that it is unlikely that it will be adopted in the near future. Another approach to controlling capital flows which has been utilized by a number of countries involves adopting a system of dual exchange rates or multiple exchange rates. In this situation, a different exchange rate is employed depending on the nature of the for- eign transaction. If British pounds are being purchased for normal trade transactions or for long-term overseas investment, the exchange rate might be specified as $1.80/£1; however, if the transaction involved a short-term capital flow, an exchange rate of $2.70/£1 might be used. The 50 percent higher price for the short-term capital transaction would presumably discourage such transactions. Or the central bank of the country could also restrict capital flows by exercising moral suasion or “jawboning” against capital outflows, as the United States did in the late 1960s through its “voluntary” restrictions on bank lending overseas. (“Guidelines” were published by the Federal Reserve.) Stronger measures such as outright prohibitions might also be adopted. Capital movements between countries that are in the interests of economic efficiency are eminently desirable. If capital moves from a country where the marginal product of capital is low to a country where the marginal product of capital is high, there is an increase in world output and greater efficiency in resource allocation from the capital flow. However, proponents of capital controls contend that a large fraction of the capital flows in the floating-rate period has not been of this type. Rather, the daily movements of specu- lative funds in and out of leading countries’ financial markets may be hindering efficient resource allocation because traders and long-term investors are receiving misleading and uncertain signals. In addition, the fluctuations in real exchange rates that can result from these flows may be causing wasteful resource movements. In general, economists dislike capital controls. The danger is that the controls will pre- vent the flow of capital that is moving in response to true marginal productivity differences. Further, there is no effective way to sort out which capital movements are “good” and which are “bad,” and capital controls are easy to evade. For example, with dual exchange rates, a firm buying components from a foreign subsidiary could evade the capital controls by simply overstating the price of imported goods. Thus, capital is being moved out of the country to the foreign subsidiary. Nevertheless, there appears to be no time in the postwar period when at least some countries did not have capital controls (industrialized as well as developing countries). It is possible that such controls could become more widespread in the future if countries find no other solutions to the current problems with exchange rate instability. The proponents of this proposal attribute exchange rate instability among major industrial- ized countries primarily to two factors: (a) the macro policies of any given country tend to be unstable; and (b) macro policies across countries are often working in opposite direc- tions. With respect to (a), evidence is provided by the proponents of stability and coordina- tion that easy monetary policy, for example, is soon followed by an abrupt change to tight monetary policy. In this environment, short-term capital may leave the country because of low interest rates in the first period but then return in the next period when interest rates Greater Stability and Coordination of Macroeconomic Policies across Countries Final PDF to printer IN THE REAL WORLD: THE EMERGENCE OF A NEW CURRENCY: BITCOIN Historically, there has been special interest in the role and nature of a currency. Generally based on the defined political entity or nation, a number of local or regional currencies have coexisted alongside the more common national-based cur- rencies. Recent interest in this phenomenon was stimulated by work of Friedrich von Hayek in 1976 who argued that the state monopolization of money inhibited the automatic mar- ket corrections in the presence of inflation and its excesses that were needed for economic recovery. This problem would be solved by competition between the various currencies in the nation-state, much as in the commodity markets. The use of regional, geographic, virtual, or local curren- cies alongside the national currency is, in fact, common in the world. For example, several different alternative currencies exist in Spain, France, Greece, and Kenya as well as other locations. A recent special category of alternative currencies has emerged in our current technological era called crypto- currencies, which are digital in nature, are decentralized and function on a person-to-person basis, and rely on cryptogra- phy principles to validate currency transactions and currency generation. Bitcoin relies on a database utilizing 20,000 nodes of network space, which inventories all transactions of bitcoins with the cryptography providing the core of the needed security. Since the bitcoins can only be used by those who hold them, the manner in which they circulate depends solely on the economic agents who use them. It thus is a pub- lic, Internet-wide ledger, containing every transaction ever processed. Ownership of bitcoins is contained in a computer “wallet file” and they can be sent as payment to anyone with a bitcoin address without paying fees. Bitcoins themselves can be acquired by paying cash, providing a good or service, or through a complicated mathematical game involving veri- fication of bitcoin transactions (often called “mining”) which leads to the creation of more bitcoins. A maximum of 3,600 bitcoins per day can be created daily through this process. Currently the supply of this digital currency is 12,500,000, and the overall supply is expected to reach a maximum of 21,000,000 in 2140. The supply and value of this currency cannot be influenced or managed by the central banks or the government. At a “price” of $122/bitcoin, the 3,600 that can be created daily have a value of over $430,000, and the whole economy of bitcoin would have an estimated market capitalization of $1.4 billion. Some of the positive reasons for using bitcoins include the fact that it does not require physical presence to carry out the transactions, making them very flexible. In addition, they are literally costless and can be carried out anywhere in the world without concern for exchanging currencies. Their growth does not create inflationary pressures and is not subject to bank intervention or government controls. Finally, the process maintains the anonymity of all the participants in the transac- tions and can take place in short periods of time, typically 10 minutes but can take up to an hour. Another positive reason is that the growth of bitcoin is known by all participants as is the total quantity of bitcoin at any point in time. Consequently, the market price can vary depending on demand at any par- ticular point and has demonstrated considerable variability at times. For example, in January 2013 a bitcoin was worth $20, but by April 10 it had risen to $266 and then subsequently fell to $54 within several days. However, after a substantial rise in 2013 as a whole, the currency declined in price throughout 2014, and in 2015 generally moved between $200 and $300. A recent econometric study indicated that empirically the fundamental price of bitcoin was zero. On the negative side, the large daily price movements relative to national currencies and alternative currencies present considerable risk for the owner and limit bitcoin’s usefulness as a unit of account or store of value. Since trans- actions are also non-controllable and there is no central authority to keep track of them, there is an added element of risk. In addition, the fact all transactions take place between accounts and the participants remain anonymous creates concerns regarding the use the currency. It thus becomes attractive for funding illegal activities such as facilitating transactions in drugs and weapons, gambling, money laun- dering, and financing terrorist activities. It also can foster tax evasion both nationally and internationally. The possi- bility of it being used in fraudulent schemes such as a Ponzi type scheme is also a possibility. Finally, like all electronic- based systems, it is subject to hackers who could threaten the safety and security of the bitcoin asset. Mt. Gox, once the world’s largest bitcoin exchange, recently lost 850,000 bitcoin and concluded that there was a high probability that some of the bitcoins were stolen. Bitcoin is like gold, but in a virtual environment, and it offers an opportunity to serve as an alternate payments sys- tem. It thus provides a market niche as a means to facilitate market transactions nationally and internationally and to make payments between individuals. It is fast, literally cost- less and the participants remain anonymous. It does how- ever, contain elements of risk which all participants should be aware of. (continued) 760 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch29_728-764.indd 760 06/22/16 01:26 PM Final PDF to printer IN THE REAL WORLD: (continued) Sources: Friedrich von Hayek, Denationalization of Money-The Argument Refined: An Analysis of the Theory and Practice of Concurrent Currencies (Bucharest: Libertas Publishing, 2006, originally 1976); Angela Rogojanu and Liana Badea, “The Issue of Competing Currencies. Case Study—Bitcoin,” Theoretical and Applied Economics 21, no 1 (2014), pp. 103–14; Nick Bennenbroek, “Bitcoin 101: A Primer,” Wells Fargo Securities, Foreign Exchange Research Special Edition, March 7, 2014; Eng-Tuck Cheah and John Fry, “Speculative Bubbles in Bitcoin Markets? An Empirical Investigation into the Fundamental Value of Bitcoin,” Economics Letters 130 (May 2015), pp. 32–36; Julie Verhage and Olga Kharif, “Bitcoin Is Suddenly Surging Again,” BloombergBusiness, November 2, 2015, obtained from www.bloomberg.com. ● CHAPTER 29 THE INTERNATIONAL MONETARY SYSTEM 761 app9062x_ch29_728-764.indd 761 06/22/16 01:26 PM are higher. There will also be continuing reevaluation of expectations regarding the future stance of the monetary authorities, and these changes in expectations in and of themselves can induce capital flows. With respect to (b), if one country is pursuing an expansionary monetary policy while another is pursuing contractionary policy, then capital will flow toward the contractionary policy country; when both countries reverse their policies due to changing internal circumstances, capital will flow in the other direction. The result of these swings in the flow of short-term funds is a considerable amount of exchange rate variability. A view among economists is that floating exchange rates would be more stable if the private sector had firmer and less volatile expectations concerning future exchange rates. If countries adopted more stable macro policies, these policies not only would contribute to the attainment of domestic economic goals but would also stabilize expectations about exchange rates. If confident predictions can be made because of coordinated and stable policies, then minor shocks and rumors will not have sizeable impacts upon exchange rates, and the rates will by and large be stable. Thus, the basic thrust of the policy coor- dination proposal is for greater stability and uniformity in macro policy, to be achieved by periodic conferences and constant communication among the policy authorities in the major industrialized countries. For example, the semiannual joint meetings of the mem- bers of the IMF and the World Bank, as well as periodic meetings of the G-7 and G-20 (see Chapter 26), have stressed policy coordination. Operationalizing any plan for greater stability and coordination in policies faces many difficulties. The implementation of coordinated macro policies encounters variable and sometimes lengthy time lags in recognizing the current situation, devising and imple- menting the appropriate policy responses, and waiting for the policies to take effect. In addition, external shocks such as the oil crises and changes in expectations make accu- rate forecasting difficult. A major problem of policy coordination is also its feasibility. If business cycles do not hit all major countries at the same time (i.e., the countries are “out of phase” with each other), it will be difficult to get the policy authorities to agree on the proper macroeconomic stance. Finally, coordinated policymaking involves some sacrifice of national autonomy, and countries tend to resist such an infringement on their sovereignty. CONCEPT CHECK 1. What are the advantages and disadvantages of returning to a gold standard? 2. How does a target zone system differ from a world central bank system? 3. Why do economists in general not like the extensive use of capital controls? 4. How might the Tobin tax reduce exchange rate volatility? Final PDF to printer 762 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch29_728-764.indd 762 06/22/16 01:26 PM 25For elaboration, see Peera (1988, pp. 303–11). 26The conditionality issue also concerns loans from the World Bank. An additional broad topic regarding the international monetary system concerns the type of international monetary arrangements that seem most suitable for the emerging/develop- ing countries (EDCs). We have earlier discussed reasons as to why many of these coun- tries prefer fixed exchange rates to flexible rates, and developing countries in general want to avoid the volatility in exchange rates that has occurred in recent years. However, a relatively fixed-rate framework also implies that participating countries must maintain adequate holdings of international reserve assets. But the EDCs have not been able to build up or even maintain their reserve stocks because of their needs for capital goods imports as well as the capital flight from EDCs toward industrialized countries (ICs), where the real rate of return on capital may be higher and more stable. Hence, these countries conclude that any reform of the international monetary system should include adequate provision for creation of new international reserves and liquidity. Another issue of concern to EDCs with respect to the current international monetary system is the issue of IMF conditionality.25 This term refers to the fact that when a devel- oping country draws resources or borrows from the IMF, the increasing use of the credit tranches and/or other funding facilities can have “strings” attached. The strings can include such items as IMF insistence that steps be taken to halt inflation, alter fiscal policies, remove price controls, adopt more market-oriented policies, allow the currency to float for a while, and so forth.26 However, the EDCs may not judge such policy steps as necessary parts of their development strategy. Hence, the IMF is regarded as imposing a specific strategy for development upon the developing country and as interfering with national sovereignty. The IMF position is that, as with any bank, its loans must be repaid and any lender can impose conditions that it thinks will help to ensure repayment. Although conditionality is a feature of virtually all IMF loans, the kind and size of loans available from the IMF now are much larger than the original balance-of-payments loans through the reserve tranche and the credit tranches. As noted earlier (page 735), many additional loan mechanisms are now in existence beyond the original loan mechanism and in total a country can conceiv- ably borrow more than 600 percent of its quota. Therefore, though conditionality imposes unwanted restrictions on the developing countries and discussions ought to pursue the issue, the pool of resources available from the IMF is potentially very large. Nevertheless, conditionality is a very heated issue, and the topic extends beyond economics with its implications for national sovereignty and political power. There is also a developing-country view that the international monetary system ought to generate more stability in the world economy. If business cycles occur frequently in the industrialized countries, these variations in economic activity will spill over to the EDCs because the purchases of their exports by the ICs will be unstable. Hence, eco- nomic fluctuations in the industrialized countries will be transmitted to the EDCs. From this point of view, the attainment of more stability and coordination of macro policies in the industrialized countries would be very desirable. Besides reducing the instability in developed- country exchange rates, it might provide greater macro stability for the EDCs if it succeeded in stabilizing conditions in the industrialized countries. The same kind of enhanced stability could also come from the adoption of an effective target zone system. However, these stability benefits would probably not come from a return to the gold stan- dard. Economic activity within the ICs could become more variable under the BOP adjust- ment requirements of that system (even though exchange rates would be fixed). International Monetary Arrangements and the Emerging/ Developing Countries Final PDF to printer CHAPTER 29 THE INTERNATIONAL MONETARY SYSTEM 763 app9062x_ch29_728-764.indd 763 06/22/16 01:26 PM Finally, the emerging/developing countries have argued for increasing the openness and transparency of decision making in key international organizations such as the IMF and the World Bank and for a greater voice in the overall process. Without a stronger voice, these countries feel that the current decision-making machinery may tend to benefit the rich at the expense of the poor. SUMMARY The choice of an international monetary system involves con- sideration of the adequacy of the volume of international reserve assets, the confidence countries place in those assets, the extent to which effective balance-of-payments adjustment occurs, the amount of national autonomy in economic policy that is desir- able, and the degree to which variations in exchange rates cause instability in macroeconomic performance. The Bretton Woods system involved pegged but adjustable exchange rates built around parity rates defined in terms of the U.S. dollar, which in turn was defined in terms of gold. This system permitted substantial growth of trade and investment during its operation, but it broke down in the early 1970s under the strain of grow- ing trade and the uncertainty regarding the value of the dollar. Since the breakdown, countries have adopted a wide variety of exchange rate arrangements, and the current international mone- tary system is often called a “nonsystem.” Recent experience has been characterized by considerable volatility in nominal and real exchange rates of leading industrial countries and by continued transmission of economic fluctuations from country to country, although the volume of trade and payments has grown substan- tially. In particular, with increased economic interdependence around the globe, a financial crisis/recession in one country or region can trigger potential worldwide disruption, as has been the case in recent years. In addition, large and persistent cur- rent account imbalances have introduced uncertainty as to the effectiveness of adjustment mechanisms in the world economy. A number of proposals have been made for change in the current arrangements, including a return to a gold standard, the establishment of a world central bank, and the implemen- tation of target zones for exchange rates. To reduce instabil- ity in exchange rates and in the world economy, the leading industrialized countries have attempted greater coordination of their macroeconomic policies, but other possibilities include the levying of a tax on exchange market transactions and the adop- tion of additional restrictions on and supervision of short-term capital flows. Finally, the developing countries prefer an inter- national monetary system with greater stability of exchange rates and one in which they have a greater participatory voice. KEY TERMS adequacy of reserves problem (or liquidity problem) adjustment problem balance-of-payments adjustment mechanism Bretton Woods system confidence problem convergence criteria dual exchange rates (or multiple exchange rates) Economic and Monetary Union (EMU) euro European Central Bank (ECB) European currency unit (ecu) European monetary system (EMS) European System of Central Banks (ESCB) exchange rate mechanism (ERM) IMF conditionality IMF quota international liquidity International Monetary Fund (IMF) internationally acceptable reserve assets Jamaica Accords key currencies Maastricht Treaty pegged but adjustable exchange rates reserve tranche Smithsonian Agreement Special Drawing Rights (SDRs) surveillance target zone proposal QUESTIONS AND PROBLEMS 1. What are the key characteristics of an effective interna- tional monetary system? Does the current system meet these requirements? 2. What were the main problems in the Bretton Woods system? Are such problems present in the current system? 3. Why are SDRs often referred to as “paper gold”? What role do they play in the current system? 4. What is the similarity, if any, between a gold standard and a world central bank? What is the difference? Final PDF to printer 764 PART 7 ISSUES IN WORLD MONETARY ARRANGEMENTS app9062x_ch29_728-764.indd 764 06/22/16 01:26 PM the other hand, if this effective coordination of monetary and fiscal policy exists among the members, there is no need for a target zone system!” What is the logic behind this statement? 8. From the standpoint of any given EU member country, what are the potential advantages of joining the EMU? What are the potential disadvantages? 5. What were the original purposes of the IMF? Have they changed since Bretton Woods? What is the justification for IMF surveillance? 6. Why might it be said that a target zone system contains both the best and the worst of flexible and fixed exchange rate systems? 7. “A target zone system will work only if there is coordina- tion of economic policies among country participants. On Final PDF to printer 765 app9062x_ref_765-783.indd 765 06/22/16 10:02 AM REFERENCES FOR FURTHER READING CHAPTER 2 Coats, A. W. “Adam Smith and the Mercantile System.” In Essays on Adam Smith. Edited by Andrew S. Skinner and Thomas Wilson. Oxford: Clarendon Press, 1975, pp.  218–36. Ellsworth, Paul T. The International Economy. 4th ed. London: Macmillan, 1969. Chapters 2–3. Heckscher, Eli F. Mercantilism. Vols. I and II. London: Allen & Unwin, 1935. Hume, David. “Of the Balance of Trade.” In David Hume: Writings on Economics. Edited by Eugene Rotwein. Madison: University of Wisconsin Press, 1955, pp. 60–77. Smith, Adam. An Inquiry into the Nature and Causes of the Wealth of Nations. 1776. Reprint. London: J. M. Dent and Sons, 1977. Book IV. Viner, Jacob. Studies in the Theory of International Trade. New York: Harper & Brothers, 1937. Chapters I–IV. CHAPTER 3 Allen, William R. (ed.). International Trade Theory: Hume to Ohlin. New York: Random House, 1965. Chapter 3. Chacholiades, Miltiades. International Trade Theory and Policy. New York: McGraw-Hill, 1978. Chapters 2–3. Chipman, John S. “A Survey of the Theory of International Trade, Part 1: The Classical Theory.” Econometrica 33, no. 3 (July 1965), pp. 477–519. Haberler, Gottfried. The Theory of International Trade. London: William Hodge, 1936. Chapters X–XI. Irwin, Douglas A. Against the Tide: An Intellectual History of Free Trade. Princeton, NJ: Princeton University Press, 1996. Chapter 6. King, John E. “Ricardo on Trade.” Economic Papers 32, no. 4 (December 2013), pp. 462–69. Mill, John Stuart. Principles of Political Economy. 1848. Reprint. London: Longmans, Green, 1920. Book III, Chapters XVII–XVIII. Ricardo, David. The Principles of Political Economy and Taxation. 1817. Reprint. London: J. M. Dent and Sons, 1948. Chapters I, VII, XXII. Viner, Jacob. Studies in the Theory of International Trade. New York: Harper & Brothers, 1937. Chapters VIII–IX. CHAPTER 4 Appleyard, D. R.; P. J. Conway; and A. J. Field, Jr. “The Effects of Customs Unions on the Pattern and Terms of Trade in a Ricardian Model with a Continuum of Goods.” Journal of International Economics 27, no. 1/2 (August 1989), pp. 147–64. Balassa, Bela. “An Empirical Demonstration of Classical Comparative Cost Theory.” Review of Economics and Statistics 45, no. 3 (August 1963), pp. 231–38. Carlin, Wendy; Andrew Glyn; and John Van Reenen. “Export Market Performance of OECD Countries: An Empirical Examination of the Role of Cost Competitiveness.” Economic Journal 111, no. 468 (January 2001), pp. 128–62. Costinot, Arnaud, and Dave Donaldson. “Ricardo’s Theory of Comparative Advantage: Old Idea, New Evidence.” American Economic Review 102, no. 3 (May 2012), pp. 453–58. di Giovanni, Julian; Andrei A. Levchenko; and Jing Zhang. “The Global Welfare Impact of China: Trade Inte- gration and Technological Change.” American Economic Journal: Macroeconomics 6, no. 3 (July 2014), pp. 153–83. Dornbusch, Rudiger; Stanley Fischer; and Paul A. Samuelson. “Comparative Advantage, Trade, and Payments in a Ricardian Model with a Continuum of Goods.” American Economic Review 67, no. 5 (December 1977), pp. 823–39. Golub, Stephen S., and Chang-Tai Hsieh. “Classical Ricard- ian Theory of Comparative Advantage Revisited.” Review of International Economics 8, no. 2 (May 2000), pp. 221–34. Haberler, Gottfried. The Theory of International Trade. London: William Hodge, 1936. Chapters X–XI. MacDougall, G. D. A. “British and American Exports: A Study Suggested by the Theory of Comparative Costs, Part I.” Economic Journal 61, no. 244 (December 1951), pp. 697–724. Final PDF to printer 766 REFERENCES FOR FURTHER READING app9062x_ref_765-783.indd 766 06/22/16 10:02 AM Mill, John Stuart. Principles of Political Economy. 1848. Reprint. London: Longmans, Green, 1920. Book III, Chapters XVII–XXII, XXV. Stern, Robert M. “British and American Productivity and Comparative Costs in International Trade.” Oxford Economic Papers 14, no. 3 (October 1962), pp. 275–96. CHAPTER 5 Besanko, David, and Ronald R. Braeutigam. Microeconomics. 4th ed. Chapters 3–5, 16. Haberler, Gottfried. The Theory of International Trade. London: William Hodge, 1936. Chapter XII. Heller, H. Robert. International Trade: Theory and Empiri- cal Evidence. 2nd ed. Englewood Cliffs, NJ: Prentice-Hall, 1973. Chapter 5 and Appendix. Samuelson, Paul A. “International Factor-Price Equalisation Once Again.” Economic Journal 59, no. 234 (June 1949), pp. 181–97. Scitovsky, T. de. “A Reconsideration of the Theory of Tariffs.” Review of Economic Studies 9, no. 2 (Summer 1942), pp. 89–110. CHAPTER 6 Berg, Andrew, and Anne Krueger. “Lifting All Boats: Why Openness Helps Curb Poverty.” Finance and Development 39, no. 3 (September 2002), pp. 16–19. Bhagwati, Jagdish N.; Arvind Panagariya; and T. N. Srinivasan. Lectures on International Trade. 2nd ed. Cambridge, MA: MIT Press, 1998. Chapter 19. Burstein, Ariel, and Javier Cravino. “Measured Aggregate Gains from International Trade.” American Economic Jour- nal: Macroeconomics 7, no. 2 (April 2015), pp. 181–218. Chacholiades, Miltiades. International Trade Theory and Policy. New York: McGraw-Hill, 1978. Chapters 5 and 16. Eaton, Jonathan, and Samuel Kortum. “Technology, Ge- ography, and Trade.” Econometrica 70, no. 5 (September 2002), pp. 1741–79. Haberler, Gottfried. “Some Problems in the Pure Theory of International Trade.” Economic Journal 60, no. 238 (June 1950), pp. 223–40. Hickok, Susan. “The Consumer Cost of U.S. Trade Re- straints.” Federal Reserve Bank of New York Quarterly Review 10, no. 2 (Summer 1985), pp. 1–12. Leontief, Wassily W. “The Use of Indifference Curves in the Analysis of Foreign Trade.” Quarterly Journal of Economics 47, no. 3 (May 1933), pp. 493–503. Melitz, Marc J., and Stephen J. Redding. “Missing Gains from Trade?” American Economic Review 104, no. 5 (May 2014), pp. 317–21. Samuelson, Paul A. “The Gains from International Trade Once Again.” Economic Journal 72, no. 288 (December 1962), pp. 820–29. Spilimbergo, Antonio; Juan Luis Londoño; and Miguel Székely. “Income Distribution, Factor Endowments, and Trade Openness.” Journal of Development Economics 59, no. 1 (June 1999), pp. 77–101. Tower, Edward. “The Geometry of Community Indifference Curves.” Weltwirtschaftliches Archiv 115, no. 4 (1979), pp. 680–99. CHAPTER 7 Bhagwati, Jagdish N.; Arvind Panagariya; and T. N. Srinivasan. Lectures on International Trade. 2nd ed. Cambridge, MA: MIT Press, 1998, pp. 20–26, 72–76, and Appendixes A and C. Chacholiades, Miltiades. International Trade Theory and Policy. New York: McGraw-Hill, 1978. Chapter 6. Haberler, Gottfried. The Theory of International Trade. London: William Hodge, 1936. Chapter XI. Marshall, Alfred. Money, Credit and Commerce. London: Macmillan, 1929. Book III, Chapters 6–8 and Appendix J. Meade, James E. A Geometry of International Trade. London: George Allen and Unwin, 1952. Chapters II–III. Meier, Gerald M. The International Economics of Development: Theory and Policy. New York: Harper & Row, 1968. Chapters 2–3. Mill, John Stuart. Principles of Political Economy. 1848. Reprint. London: Longmans, Green, 1920. Book III, Chapters XVII–XVIII. CHAPTER 8 Bhagwati, Jagdish N.; Arvind Panagariya; and T. N. Srinivasan. Lectures on International Trade. 2nd ed. Cambridge, MA: MIT Press, 1998. Chapters 5–7. Busse, Matthias. “Do Labor Standards Affect Comparative Advantage in Developing Countries?” World Development 30, no. 11 (November 2002), pp. 1921–32. Chacholiades, Miltiades. International Trade Theory and Policy. New York: McGraw-Hill, 1978. Chapters 8–10. Heckscher, Eli F. “The Effect of Foreign Trade on the Distribution of Income.” In American Economic Association, Readings in the Theory of International Trade. Edited by Howard S. Ellis and Lloyd A. Metzler. Philadelphia: Blakiston, 1950. Chapter 13. Hummels, David L., and Georg Schauer. “Time as a Trade Barrier.” American Economic Review 103, no. 7 (December 2013), pp. 2935–59. Jones, Ronald W. “A Three-Factor Model in Theory, Trade and History.” In Trade, Balance of Payments and Growth: Essays in Honor of C. P. Kindleberger. Edited by J. N. Bhagwati et al. Amsterdam: North-Holland, 1971, pp. 3–20. Jones, Ronald W., and J. Peter Neary. “The Positive Theory of International Trade.” In Handbook of International Final PDF to printer REFERENCES FOR FURTHER READING 767 app9062x_ref_765-783.indd 767 06/22/16 10:02 AM Economics. Vol. I. Edited by Ronald W. Jones and Peter B. Kenen. Amsterdam: North-Holland, 1984. Chapter 1. Mundell, Robert A. “International Trade and Factor Mobility.” American Economic Review 47, no. 3 (June 1957), pp. 321–35. Neary, J. Peter. “Short-Run Capital Specificity and the Pure Theory of International Trade.” Economic Journal 88, no. 351 (September 1978), pp. 488–510. Ohlin, Bertil. Interregional and International Trade. Cambridge, MA: Harvard University Press, 1933. Samuelson, Paul A. “International Factor-Price Equalisation Once Again.” Economic Journal 59, no. 234 (June 1949), pp. 181–97. Stolper, Wolfgang F., and Paul A. Samuelson. “Protection and Real Wages.” Review of Economic Studies 9, no. 1 (November 1941), pp. 58–73. CHAPTER 9 Baldwin, Robert E. “Determinants of the Commodity Structure of U.S. Trade.” American Economic Review 61, no. 1 (March 1971), pp. 126–46. Baldwin, Robert E., and Glen G. Cain. “Shifts in Relative U.S. Wages: The Role of Trade, Technology, and Factor Endowments.” Review of Economics and Statistics 82, no. 4 (November 2000), pp. 580–95. Ball, David S. “Factor-Intensity Reversals in International Comparison of Factor Costs and Factor Use.” Journal of Political Economy 74, no. 1 (February 1966), pp. 77–80. Bhagwati, Jagdish N. “The Pure Theory of International Trade: A Survey.” Economic Journal 74, no. 293 (March 1964), pp. 1–78. (See especially pp. 21–26.) Bharadwaj, R. “Factor Proportions and the Structure of Indo- U.S. Trade.” Indian Economic Journal 10 (October 1962), pp. 105–16. Borjas, George J.; Richard B. Freeman; and Lawrence F. 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Malden, MA: Blackwell Publishers, 2003, pp. 146–87. ———. “Globalization, Outsourcing, and Wage Inequality.” American Economic Review 86, no. 2 (May 1996), pp. 240–45. Fisher, Eric O’N., and Kathryn G. Marshall. “The Empiri- cal Validity of the Heckscher-Ohlin Model.” Working Paper. Department of Economics, California Polytechnic State University, September 12, 2007. Fortin, Nicole M., and Thomas Lemieux. “Institutional Change and Rising Wage Inequality: Is There a Linkage?” Journal of Economic Perspectives 11, no. 2 (Spring 1997), pp. 75–96. Freeman, Richard B. “Are Your Wages Set in Beijing?” Journal of Economic Perspectives 9, no. 3 (Summer 1995), pp. 15–32. Gottschalk, Peter. “Inequality, Income Growth, and Mobility: The Basic Facts.” Journal of Economic Perspectives 11, no. 2 (Spring 1997), pp. 21–40. Gourdon, Julien. “Explaining Trade Flows: Traditional and New Determinants of Trade Patterns.” Journal of Economic Integration 24, no. 1 (March 2009), pp. 53–86. 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Final PDF to printer app9062x_idx_784-808 784 06/23/16 07:14 PM INDEX Abraham, Spencer, 255n absolute advantage, 22–24, 28–29 absolute purchasing power parity, 476–477 accommodating items in the balance of payments, 457 across-the-board approach to trade negotiations, 367–368 ad valorem tariffs, 270, 274, 281 defined, 259 in large-country case, 294–297 in small-country case, 282–284 adequacy of reserves problem, 736 adjustment problem Bretton Woods system, 736 currency board, 718 administrative classification, 273–274 advance deposit requirements, 273 Africa connections with Asia, 437 economic integration, 391–393, 695, 721 economic progress in sub-Saharan, 695 labor migration from, 255 African Development Fund, 443 aggregate demand, 682–688 in closed economy, 675–676 under flexible exchange rates, 684–685 in open economy under fixed exchange rates, 683–688 aggregate demand curve, 675 aggregate demand curve for labor, 676–677 aggregate production function, 676–677 aggregate supply in closed economy, 676–680 in open economy under flexible exchange rates, 693–694 aggregate supply-aggregate demand equilibrium, in closed economy, 680–682 agriculture in Doha Development Agenda, 379–380 income gains from trade liberalization, 289 U.S. agricultural exports and exchange rate changes, 582 U.S. sugar import quotas, 311 U.S. tomato imports, 365 Aguilar, Linda M., 404 Ahmed, Ahmed A., 234 “Aid for Trade,” 379–380 Air Canada, 19 Airbus Industrie, 353, 356 airline industry, government subsidies of, 353, 356 Allegretto, Sylvia, 169n Allen, Mark, 369 Altig, David E., 647n American Economic Association, 713 American International Group (AIG), 752 American options, 486n Amin, Idi, 400 Amiti, Mary, 269n Andean Community of Nations (CAN), 391 Andean Pact, 433 Andean Trade Preference Act, 409 Anderson, James E., 266 André, Christopher, 609 Ang, James B., 212 Ansari, Javed A., 425, 436 Ansberry, Clare, 383n Anthan, George, 365n Antidumping Act of 1916, 337 Antidumping Act of 1921, 337 antidumping duty, 335 antidumping provisions, 335–338, 365, 373, 381 Antimiani, Alessandro, 268n antitrade consumption effect, 207 antitrade production effect, 207, 248 Antonakakis, Nikolaos, 611n APEC (Asia-Pacific Economic Cooperation) forum, 412, 433, 706 APM (average propensity to import), 596, 598–599 Appelbaum, Binyamin, 469n Appleyard, Dennis R., 424, 570n appreciation foreign-currency, 471–472 home-currency, 471–472, 546, 547 Arab Maghreb Union (AMU), 391 arbitrage covered interest, 491 defined, 473 foreign exchange, 583 role in spot market, 473–474 stock market, 510 triangular, 473 Areddy, James T., 258n Argentina currency boards in, 647 economic crisis in, 674 in Southern Cone Common Market (MERCOSUR), 392, 411 Arnould, Eric J., 427n Arora, Vivek, 212, 212n Artana, Daniel, 674, 674n ASEAN (Association of Southeast Asian Nations), 391, 413 Asia-Pacific Economic Cooperation (APEC) forum, 412, 433, 706 Asian crisis (1997-1998), 417, 751, 758 Asian Development Bank, 413 asset demands, in portfolio balance approach, 542–544 asset/money market equilibrium, 548–554 asset-seeking FDI, 237 asset stock equilibrium, 548 Association of Southeast Asian Nations (ASEAN), 391, 413 at discount, 490 at premium, 490 Ates, Aysegul, 577, 577n auction quota system, 286 Australia effect of protection instruments on domestic prices, 276–277 interference with free trade, 275 preferential duties and, 259 autarky (pretrade) equilibrium, 85–87, 198–200 autarky (pretrade) price ratios, 22–24, 29–30, 32, 34–36, 50–51, 85–87, 198–200 Autio, Erkko, 187, 187n automatic monetary adjustment, 638 automobiles administrative classification, 273–274 impact of trade policy on, 272, 273 product differentiation and, 178–179, 181–182, 194 production in Chile, 272 autonomous consumption spending, 593 autonomous imports changes in, 604–606 defined, 596 autonomous items in the balance of payments, 457 autonomous spending multiplier, 603–606 average propensity to import (APM), 596, 598–599 Bahamas, 506 Bahmani-Oskooee, Mohsen, 580, 583n, 706 balance-of-payments accounts, 449–466 credits and debits in, 450–453 deficit (See balance-of-payments deficit) defined, 449–450 impact of foreign direct investment, 450–451 international investment position in, 463–466 monetary approach to the balance of payments, 532–539, 556–559 monetary equilibrium and, 537–539 portfolio balance approach to the balance of payments, 542–548, 559–561 Note: Page numbers followed by “n” indicate material in footnotes and source notes. 784 Final PDF to printer INDEX 785 app9062x_idx_784-808 785 06/23/16 07:14 PM sample entries in, 450–453 summary statements, 453–463 surplus (See balance-of-payments surplus) U.S., 459–465 balance-of-payments adjustment mechanism, 729, 733–734 balance-of-payments deficit, 456 fixed vs. flexible exchange rates and, 702–703, 707–709 gold standard and, 753–756 incipient, 540, 653, 684 in monetary approach to balance of payments, 538 in monetary approach to the exchange rate, 540 balance-of-payments surplus incipient, 540, 653, 684 in monetary approach to the exchange rate, 540 balance of trade. See also trade deficits favorable, 17 tariffs to improve, 324–325 unfavorable, 17 balance on goods and services, 455 balance on goods, services, and factor income, 455 balance on goods, services, and income, 455 Balassa, Bela, 52, 196, 272, 392–393, 394n, 401n Baldwin, Richard, 191, 353 Baldwin, Robert E., 151n, 155, 156, 167n, 360, 365, 366, 424 Ball, David S., 155 Ball, Dwayne, 427n bandwagon effects, 758 Bangladesh, worker remittances to, 249 bank(s). See also central banks bank loans, 499–505, 529 eurobanks, 502–505 international bank lending and, 499–505 loan participation syndicates, 529 loan-pushing, 440 world’s largest, 232 Bank for International Settlements (BIS), 500, 500n Bank of America, 232 Bank of Canada, 509–510, 719–720 Bank of Israel, 556 Barclays Bank, 232 Barkley, Tom, 381n Barrell, Ray, 234 Barrett, Christopher B., 706 basis points, 520–521 basis risk, 524 basis swaps, 521 Batson, Andrew, 381n Bayoumi, Tamim, 705 Beamish, Paul W., 188 beef, in U.S. trade policy, 380 beggar-thy-neighbor policy, 325–327 Beghin, John C., 310, 311n Beladi, Hamid, 195 Bell, Martin, 344 Belton, Terry, 520n Berg, Andrew, 97, 647n Bergner, Daniel, 427n Bergstrand, Jeffrey H., 180 Berliner, Diane T., 343, 343n Bernstein, Jared, 169, 169n Bhagwati, Jagdish N., 198, 218, 255n, 331n, 432 Bharadwaj, R., 157 Bhatia, D. P., 605, 605n Big Mac Index (BMI), 479, 480n bilateral negotiations in bilateral trade, 367 in U.S. trade policy, 382–384 Birnbaum, Jeffrey, 670 BIS (Bank for International Settlements), 500, 500n Biswas, Romita, 235 bitcoins, 760–761 Blair, Tony, 281 Blaug, Mark, 425n, 713n Blinder, Alan, 383 Blustein, Paul, 647n BNP Paribas, 232 Boeing Company, 192, 353, 380 Bonaccorsi, Andrea, 188 bonds home bond supply, in portfolio balance approach to balance of payments, 547–548 international bond market, 505–512 underwriters, 505 book value, 230 Bordo, Michael D., 610, 610n Borensztein, Eduardo, 647n Borjas, George J., 252–253, 255, 255n Bowen, Harry P., 159, 159n, 213n Bowley, A. L., 64 BP, 232 BP curve, 630–636. See also IS/LM/BP analysis defined, 630 equilibrium in open economy, 636–638 real and financial factors that influence, 654 Bradford, Scott C., 161, 276, 277n, 289, 289n Brady, Nicholas, 441 Brady plan, 441 brain drain, 227, 251–252, 255 branch plants, 229 Brander, James A., 185–186, 333, 349 Brander-Krugman model, 185–186 Branson, William H., 543 Branstetter, Lee G., 227–228, 227n Brazil capital loans to, 440 currency devaluation, 647 in Southern Cone Common Market (MERCOSUR), 392, 411 terms of trade in, 222 Bretton Woods system, 592, 613, 732–737 abandonment of, 738 adequacy of reserves problem, 736 breakdown of, 736 confidence problem, 736–737 current international monetary system vs., 746–751 International Monetary Fund (IMF) in, 733–737 origins of, 733 British Navigation Acts, 18 Broadman, Harry G., 437, 437n Brooks, Jonathan, 378 Brown, Andrew G., 375, 375n Brülhart, Marius, 196, 196n Bryan, Lowell, 520n Buchanan, Patrick J., 321 budget constraint (budget line), 68–69 Bukhari, Syed Adnan Haider Ali Shah, 180 Bukhari, Syeda Sonia Haider Ali Shah, 180 Bulgaria, in European Union (EU), 388 bullionism, 17–18, 20 Burghardt, Galen, 520n Burtless, Gary, 168, 169 Burton, John, 713n Bush, George W., 281, 372, 380, 383 Busse, Matthias, 123, 123n “Buy American” provisions, 19, 272 cabotage laws, 19 CACM (Central American Common Market), 275, 391, 433 CAFTA-DR (U.S.-Central America/ Dominican Republic Free Trade Agreement), 409–410 Caglayan, Mustafa, 706 Cain, Glen G., 167n Cairns Group, 371 Calamitsis, Evangelos A., 695n Calgene Inc., 365 call options, eurodollar, 524–525 Canada. See also North American Free Trade Agreement (NAFTA) antidumping provisions, 381–382 average propensity to import, 598–599 cabotage laws, 19 effect of protection instruments on domestic prices, 276–277 Leontief paradox and, 156, 159 preferential duties and, 259 price elasticities of demand for exports and imports, 575–576 restrictions on services trade, 273 softwood timber disputes with U.S., 381–382 synchronization of GDP movements across countries, 611 U.S.-Canadian exchange rates, 560 U.S. trade deficits with, 460–461 Canada labor and capital requirements per unit of output, 209–210 Canada-U.S. Free Trade Agreement, 403 Canadian National Hockey League, 19 cap-floaters, 525 capital. See also foreign direct; foreign direct investment (FDI) capital/labor ratios and, 151, 156 international movements of, 227–242 marginal physical product of, 72–75, 135–137, 146–148, 236–239 Final PDF to printer 786 INDEX app9062x_idx_784-808 786 06/23/16 07:14 PM Committee on Foreign Investment in the United States (CFIUS), 241 commodities composition of merchandise trade, 6–9 factor intensity and, 125 international commodity agreements (ICAs), 430 multiple, in Classical trade theory, 45–48 U.S. real GDP (1972-2011), 662–663 commodity concentration, 423 commodity-neutral technological change, 210 commodity terms of trade (net barter terms of trade), 110, 240 common external tariffs, 389 common market, 389 Common Market for Eastern and Southern Africa (COMESA), 391 community indifference curve (country indifference curve), 65–67, 96, 99 comparative advantage, 28–33, 37, 341–356 autarky (pretrade) price ratios and, 22–24, 29–30, 32, 34–36, 50–51, 85–87, 198–199 in Classical trade theory, 28–33, 37 complete specialization and, 33, 36 concluding observations on, 37 defined, 29 dynamic, 176, 192 example of, 34–36 Heckscher–Ohlin (H–O) model and, 97, 164 intra-industry trade and, 193–196 introduction of international trade and, 87–92 labor standards and, 123–124 in monetized Ricardian model, 41–42, 44 production-possibilities frontier (PPF) and, 34–36 resource constraints and, 32–33 Ricardian, 28–33, 37 total gains from trade and, 32–33, 85–87 compensation principle, 96 compensatory financing, 429–430 complete exchange rate pass-through, 574–579 of foreign exports to the U.S., 577 Japanese export pricing and, 578–579 complete specialization, 33, 36 confidence problem, of Bretton Woods system, 736–737 Conforti, Piero, 268n Conkey, Christopher, 258n constant returns to scale, 73 consumer behavior theory, 63–70 budget constraint, 68–69 consumer equilibrium, 69–70 consumer indifference curves, 63–67 consumer equilibrium, 69–70 consumer expenditure patterns and, 71 consumer indifference curves, 63–70 budget constraint and, 68–69 consumer equilibrium and, 63–70 features of, 63–67 U.S. consumer expenditure patterns and, 71 import quotas placed on, 380 labor migration from, 244, 253–254 largest corporations and banks, 232 Renminbi yuan and, 41, 620 rise as trade competitor, 407 U.S. trade policy with, 258, 380–381, 460–461 worker remittances to, 248 China National Petroleum, 232 Chinn, Menzie D., 558 Chor, David, 163, 164, 164n Chow, Peter C. Y., 436 Chrysler Corporation, 274, 277 CIP (covered interest parity), 490–493, 495, 552–553 Citigroup, 232 Clark, Don P., 406n Classical trade theory, 15–61 Adam Smith and, 22–24 challenges to Mercantilism, 20–24 comparative advantage in, 28–33, 37 complexities of real world vs., 41 David Hume and, 20–22 David Ricardo and, 26–38 DFS model and, 48 evaluating, 51–56 exchange rate limits and, 43–45 export condition in, 42–43 exporting and productivity, 56 gains from trade and, 32–33, 36 Mercantilism, 16–25 in money terms, 41–42 multiple commodities and, 45–46 multiple countries and, 50–51 Oracles and, 16 price-specie-flow mechanism, 20–22, 47–48 production-possibilities frontiers (PPF) in, 34–36 transportation costs and, 48–50 wage rate limits and, 42–45 Cline, William R., 314, 385, 440n Clinton, Bill, 132, 365, 376, 669 closed economy macroeconomics aggregate demand in, 675–676 aggregate supply in, 676–680 equilibrium in, 680–682 CME (Chicago Mercantile Exchange), 485–486, 522, 523 CNN, 363 Cobb-Douglas production function, 211n Coe, David T., 362, 362n coefficient, 556n cointegration, 559 Cole, Jeff, 353n Coleman, Brian, 353, 353n collars, option, 525–526 Collie, David, 350 Colombia crawling peg system in, 725 trade promotion agreement, 409 Combes, Pierre-Philippe, 188n COMESA (Common Market for Eastern and Southern Africa), 391 Commission on Growth and Development, 437 capital—Cont. mobility/immobility of, 145–146, 227–242, 633–634, 639–642, 652–670 requirements per unit of output, 209–210 role of natural resources, 156–157 capital flight, 440 capital-saving technological changes, 208–209 Capitalism and Freedom (Friedman), 713 caps, option, 525 cardinal utility, 63–64 Caribbean Basin Recovery Act, 410 Caribbean Community and Common Market (CARICOM), 391, 433 Caribbean Single Market and Economy (CSME), 721 CARICOM (Caribbean Community and Common Market), 391, 433 Carlin, Wendy, 53–54 Carrington, William J., 255 carry trade, 495 cartels export, 432 international trade, monopoly behavior in, 144 Carter, Jimmy, 277 Cashin, Paul, 101, 101n, 431, 432n catfish farming, 258 Cavallo, Domingo F., 441n, 647 Cayman Islands, 506 ceilings, option, 525 CEMAC (Economic and Monetary Community of Central Africa), 391, 721 Central African Economic and Monetary Community (CEMAC), 391, 721 Central American Common Market (CACM), 275, 391, 433 central banks absolute and relative reserves of, 709–710 changes in reserve assets of, 451 discontinuation of gold transactions, 738 gold reserves, 535, 749 proposed world central bank, 755 Central/Eastern Europe, 399–403 economic reforms in, 435 euro changeover, 743, 744 exchange rate trends in, 558–559 CEPGL (Economic Community of the Great Lakes Countries), 391 Cevallos, Diego, 412n Cherlow, Jay R., 311n Chicago Mercantile Exchange (CME), 485–486, 522, 523 Chile automobile production in, 272 price instability in, 431 Chilean Trade Agreements, 412 China antidumping orders, 337–338, 380–381 balance-of-payments accounts of, 449 dynamic comparative advantage and, 176 economic growth in, 204, 212 foreign direct investment (FDI) in, 227–229 Final PDF to printer INDEX 787 app9062x_idx_784-808 787 06/23/16 07:14 PM trade between countries with identical demand conditions, 93–95 unit elasticity of, 21, 111–116 demand for money defined, 534 in foreign exchange market, 470 and monetary approach to balance of payments, 534–537 demand lag, in imitation lag hypothesis, 174–175 demand reversal in Heckscher–Ohlin (H–O) model, 137–138, 152–153 Leontief paradox and, 152–153 dependent variable, 556n depreciation foreign currency, 471–472 home-currency, 471–472, 540 derivatives, 512–529 defined, 519 equity, financial, 526 eurocurrency, 512–529 exchange-traded instruments, 527–529 global market for, 527–529 nature of, 519 over-the-counter instruments, 527–529 desired aggregate expenditures, 591–592 destabilizing speculation, 709–714 Detragiache, Enrica, 255 Deutsche Bank, 232 devaluation, 647, 692 developing countries, 416–446. See also economic growth bond yields in, 508–509 brain drain and, 227, 251–252, 255 debt forgiveness, 699 debt problems, 439–446, 699 economic and noneconomic characteristics of, 417–418 economic growth in, 204–208, 221–224, 417–428 external debt problem of, 438–446 Generalized System of Preferences (GSP) and, 259–264, 330, 366, 368, 410 IMF help for poor countries, 441–442, 695 IMF quotas, 734–735 infant industries and, 342–344 interference with free trade, 275–276 international monetary system and, 762–763 labor migration from, 248–252 least developed countries, 417–418 overview of, 417–418 post-Heckscher–Ohlin theories and, 185–188 role of trade in growth of, 204–208, 418–428 stock market performance in, 511–512 trade and income inequality in, 168 trade policy and, 429–438 U.S. subprime mortgage crisis and, 751–753 Dewbre, Joe, 378 DFS (Dornbusch, Fischer, Samuelson), 48, 58–61 in Estonia and Lithuania, 717–718 extent of use, 746, 747 currency futures, 485–486, 522 options, 486 quotations, 486 current account balance, 449, 455–456. See also price adjustment mechanism under flexible exchange rates, 563–583 income equilibrium and, 602–603 Keynesian income model, 591–597 in monetary approach to balance of payments, 537–538 national income and, 590–618 open-economy multiplier and, 606, 608 price and income adjustments and, 610–613 current account deficit debt and, 457 inflation and, 612 unemployment and, 612 current account surplus, inflation and, 612–613 Cushman, David O., 560 customs unions, 389, 391–392 Dalsgaard, Thomas, 609 Dalton, Matthew, 353n Dana, L.-P., 188 Dana, T., 188 Darity, William A., 440 Davis, Bob, 372n, 383n, 670 Davis, Donald R., 151, 151n, 161, 163 Dawson, Chester, 233n Day, Phillip, 204, 204n de la Torre, Augosto, 647 De Loecker, Jan, 56, 56n deadweight losses, 283, 296–297, 300, 318–319 Dean, Judith, 235 Deardorff, Alan V., 156, 366, 371n, 372n debit items in balance-of-payments accounts, 450–451 debt bank loans, 499–505, 529 bonds, 505–512 current account deficits and, 457 debt service ratio, 439 of developing countries, 439–446, 669 external debt, 438–446 international indebtedness position, 463–466 debt-equity swaps, 445–446 debt reduction, 441–445 debt-relief Laffer curve, 442–444 debt rescheduling, 441 debt service ratio, 439 decreasing returns to scale, 73 deflation, concerns about, 703, 750 demand. See also aggregate demand for foreign goods and services and foreign exchange markets, 564–567 for imports schedule, 291–293 overlapping, in Linder hypothesis, 179–180 in portfolio balance approach, 542–544 price elasticity of, 21, 200–202, 575–576 Consumer Price Indexes, 482 consumer surplus defined, 282 in small-country case, 282–284 consumption marginal propensity to consume (MPC), 593–594 negative externalities in, 331–332 neutral consumption effect, 207 consumption function, in Keynesian income model, 593–594 consumption gain (gains from exchange), 89–90 consumption growth trade effects of, 206–208 ultra-antitrade consumption effect, 207 ultra-protrade consumption effect, 207 consumption-possibilities frontier (CPF), 34–36, 89 contractionary devaluation, 692 contractionary monetary policy, 537 convergence criteria, 740–741 Conway, Patrick J., 161 Cooper, Helene, 353n, 365, 377, 380n Cooper, Richard N., 272, 754 coordinated intervention, 724–726 Corden,W. M., 364 Córdoba, José de, 258n Corn Laws, 28 Cottani, Joaquin A., 441n Coughlin, Cletus C., 266 countervailing duties (CVD), 336, 339–340 country indifference curve (community indifference curve), 65–66, 96, 99 covered interest arbitrage, 491 covered interest parity (CIP), 490–493, 495, 552–553 Coviello, Nicole E., 187, 187n Covin, Jeffrey G., 187n Crane, Leland, 575–576 crawling peg, 723–724 in Colombia, 725 extent of use, 746 Crédit Agricole Groupe, 232 credit items in balance-of-payments accounts, 450–451 credit tranches, 735 Creedy, John, 64, 64n Crespo-Cuaresmo, Jesús, 558 crisis problem, of currency boards, 719 Cross, Edward M., 179 cross-rate equality, 474 crowding out, 639–642 Crowley, Meredith A., 575–576 crude quantity theory of money, 539 crypto-currencies, 760 Cui, Carolyn, 311n currency adjustments adjustment problem of currency boards, 718 under fixed exchange rates, 692 currency boards, 716–718 advantages of, 716–719 in Argentina, 647 defined, 646, 716 disadvantages of, 718–719 Final PDF to printer 788 INDEX app9062x_idx_784-808 788 06/23/16 07:14 PM empirical evidence on, 427 fixed vs. flexible exchange rates and, 702–703 in large-country case, 216–221 offer curve and, 219 and production-possibilities frontier (PPF), 208–214 Rybczynski theorem and, 215–216, 218–219 in small-country case, 215–216 sources of, 208–214 spillovers and, 212 technology change and, 60–61, 208–212, 426 trade effects of, 204–208, 418–428 economic integration, 387–414. See also European Union (EU); North American Free Trade Agreement (NAFTA) in Africa, 391, 392, 400 in central and eastern Europe, 399–403 dynamic effects of, 398 economic integration efforts, 391–392 in former Soviet Union, 399–403 general conclusions in trade creation/ diversion, 396–397 other integration efforts, 411–414 projects for, 433 static effects of, 389–396 in sub-Saharan Africa, 695 summary of, 398–399 trade policy and, 365–366 types of, 388–389 economic interdependence, changes in, 11–12 Economic Journal, 64 Economic Report of the President, 166, 169, 582, 582n economic unions, 389 Economics (Samuelson), 132 economies of scale constant returns to scale, 73 decreasing returns to scale, 73 in duopoly framework, 344–347 dynamic, 194 geography of trade and, 192 impact of foreign direct investment on, 240 increasing returns to scale, 73 in intra-industry trade, 194 in Krugman model, 182 model for, 198–199 nature of, 182 strategic trade policy and, 342, 344–347 Economist, The, 19, 166, 376, 378, 435–436, 479 ECOWAS (Economic Community of West African States), 391 ECSC (European Coal and Steel Commu- nity), 399 ecu (European currency unit), 740 Edgeworth box diagram, 75–78 capital immobility and, 145–146 different relative factor endowments and, 130 example of, 77 factor growth and, 214 double factoral terms of trade, 118 Drajem, Mark, 381n dual exchange rates, 759 Dufey, Gunter, 520n, 522, 529 Duhalde, Eduardo, 647 dumping. See also antidumping provisions defined, 185–186, 335 import tariffs to offset, 335–336, 369–370 persistent, 335–336 predatory, 336 in reciprocal dumping model, 185–187 sporadic, 336 Dunn, Robert M., Jr., 322 duopoly defined, 185, 344 economies of scale and, 344–347 export subsidy in, 349–352 Durbin, Richard, 281 Dutch East India Trading Company, 17 dynamic comparative advantage, 176, 192 dynamic economies of scale, 194 dynamic effects of economic integration, 398 of trade on economic development, 420–421 EACM (East African Common Market), 399, 400 East African Authority, 400 East African Common Market (EACM), 399, 400 East African Community (EAC), 400 East African Development Bank, 400 Eastern Caribbean Central Bank (ECCB), 721 Eastern Caribbean Currency (EC), 721 Eastern Caribbean Currency Union (ECCU), 721 Eastman Kodak, 192 Eatwell, John, 28n, 64n, 132n, 592n, 713n Eberts, Randall W., 405n, 406, 406n EC92, 402 ECLA (Economic Commission for Latin America), 425 Economic and Monetary Community of Central Africa (CEMAC), 391, 721 Economic and Monetary Union (EMU), 721, 740–743, 753 Economic Commission for Latin America (ECLA), 425 Economic Commission for Latin America Its Principal Problems (Prebisch), 425 Economic Community of the Great Lakes Countries (CEPGL), 391 Economic Community of West African States (ECOWAS), 391 Economic Consequences of the Peace (Keynes), 592 Economic Development of Under-Developed Countries (Prebisch), 425 economic growth, 203–224. See also developing countries; factor growth in China, 204, 212 in developing countries, 204–208, 221–224, 418–427 Dhanaraj, Charles, 188 Di, Jing, 706 Di Marco, Luis E., 425n Diakosavvas, Dimitris, 424 different income elasticities of demand, for primary products and manufactured goods, 423–428 different relative factor endowments Edgeworth box and, 130 factor content approach with many factors, 158–160 in Heckscher–Ohlin (H–O) model, 124–127, 130, 156–163, 214 in intra-industry trade, 195 in selected countries, 124–127 skill levels of labor and, 155–156, 161–163 different relative factor intensities differing income elasticities of demand for primary products and manufactured goods, 424 in Heckscher–Ohlin (H–O) model, 124–126, 138–139 reversal of, 138–139, 153 DiMare, Paul J., 365 diminishing marginal rate of substitution, 65 Dinopoulos, Elias, 178 direct loan syndicates, 529 directly unproductive activity, 364 dirty floating, 726 discount, 490–493 Disdier, Anne-Celia, 189 diversification export diversification into manufactured goods, 432 international portfolio diversification, 511 risk diversification, 234 Doha Development Agenda, 367, 377–379 Doha Round of trade negotiations (GATT), 289, 379, 382, 407 Dollar, David, 437 domestic content provisions, 272 domestic economic policy changing, 441 domestic investment, impact of foreign direct investment on, 241 external debt of developing countries, 439–442 impact of foreign direct investment on, 241 under Mercantilism, 18 domestic price, effect of protection instruments on, 276–277 domestic price shocks, 664 domestic reserves, 533–534 dominant strategy, 355 Dominguez, Kathryn, 560 Dominican Republic, U.S.-Central America/ Dominican Republic Free Tade Agreement (CAFTA-DR), 409–410 Dornbusch, Rudiger, 48, 58–61, 548–554, 557–558 double-entry bookkeeping in balance-of-payments accounts, 451–452, 456 defined, 451 Final PDF to printer INDEX 789 app9062x_idx_784-808 789 06/23/16 07:14 PM floating exchange rates in, 739 government procurement provisions, 270–271 Maastricht Treaty and, 740–743 European Council, 401, 402 European currency unit (ecu), 740 European Economic Community (EEC), 233, 367, 399 European Free Trade Agreement, 411 European Free Trade Association (EFTA), 391, 411 European Monetary Cooperation Fund (EMCF), 740 European Monetary Institute (EMI), 741 European monetary system (EMS), 740–743 European System of Central Banks (ESCB), 741–743 European Union (EU), 399–403, 719 antidumping provisions, 369 completing internal market in, 401–402 Economic and Monetary Union (EMU), 721, 740–743, 753 euro changeover in new member states, 718, 739, 743, 744 export subsidies of, 270 formation of, 388, 389 government procurement provisions of, 270–271 growth and disappointments of, 401 history and structure of, 399–401 import tariffs of, 267–268 labor migration to, 242–245 list of countries in, 391–392 new venture internationalization and, 187 policy frictions in interdependent world, 667 preferential duties in, 259 prospects for, 402–403 recent U.S. trade actions, 380–384 synchronization of GDP movements across countries, 611 trade creation and trade diversion in the European Community, 392–393 trade policy of, 258 U.S. beef exports to, 380 value-added tax (VAT), 272–273 world central bank (proposed) and, 755 World Trade Organization and, 353, 373–375 European Values Surveys, 254 “Eurosclerosis,” 401 Evans, Catherine, 192 Evans, Don, 380n ex post income elasticity of import demand (YEM), 392–394 excess demand for money, 537 excess supply of money, 537 exchange rate. See also fixed exchange rates; flexible exchange rates; foreign exchange market currency boards, 646–647, 716–719, 745, 747 defined, 41, 469 effect of changes in, 47–48, 644–648, 667 equilibrium, 471–472, 649–650 in monetary approach to balance of payments, 537–539 offer curve, 119–121 in portfolio balance approach to balance of payments, 542–548, 559–561 producer, 74, 75, 86 relationship between exchange rate and income in, 649–650 equilibrium interest rate, 624–628, 649–650 equilibrium level of national income, 597–603 equilibrium terms of trade, 30, 105 equity derivatives, 526 equity swaps, 526 equivalent quota, 285 equivalent subsidies, 286–287 equivalent tariff, 285 ERP (effective rate of protection), 266–270 escalated tariff structure, 269 ESCB (European System of Central Banks), 741–742 Estonia, currency boards in, 717–718 EU. See European Union (EU) euro changeover to, 718, 740, 744, 745 defined, 719 eurobanks, 502–505 eurobond markets, 506–508 eurocurrency market. See also foreign exchange market defined, 501 derivatives based on, 512–529 eurobanks and, 502–505 international financial linkages and, 513–518 nature of, 501 eurodollar call options, 524–525 eurodollar cross-currency interest rate swaps, 521 eurodollar interest rate futures, 522–524 options, 524–526 risk, 518–526 swaps, 521 eurodollar market, 501–505. See also eurocurrency market hedging eurodollar interest rate risk, 518–526 interest option quotations, 523 interest rate futures, 523, 540 international financial linkages, 514–518 U.S. domestic and eurodollar deposit and lending rates, 516–517 eurodollar put options, 524–525 eurodollar strip, 524 European Aeronautic Defense and Space Company (EADS), 353 European Atomic Energy Commission (Euratom), 399 European Central Bank (ECB), 473, 641, 667, 740–743 European Coal and Steel Community (ECSC), 399 European Commission, 401–402 European Community (EC), 371, 389, 391–393, 399, 507. See also European Union (EU) Heckscher–Ohlin (H–O) model and, 131, 143–146 origins of, 63, 64 and production-possibilities frontier, 79–82, 143–146 Edgeworth, F. Y., 63, 64 education multinational corporations and, 241 skill levels of labor and, 155–156 Edwards, Sebastian, 427n EEC (European Economic Community), 233, 367, 399 effective rate of protection (ERP), 266–270 efficiency-seeking FDI, 237 efficient foreign exchange market, 493, 553 EFTA (European Free Trade Association), 391 Eken, Sena, 400, 400n El Osta, Barbara, 311n elasticities approach, 564 elasticity of demand. See also income elasticity of demand exports and, 111n imports and, 111–116, 119, 223, 571, 575–576, 596–597 offer curve and, 111–116, 119–121 price, 21, 200–202, 575–576 unit, 21, 111–116 elasticity of exchange rate pass-through, 577 Elliott, Kimberly Ann, 287n, 311n, 329n, 343n Ellsworth, P.T., 368, 424, 739 emerging market funds, 511 Emerson, Michael, 402 employment. See also labor costs of protecting industry, 329 effects of trade liberalization, 328 impact of foreign direct investment on, 239 natural level, 680 tariff to increase employment in specific industry, 328–329 EMS (European monetary system), 740–743 EMU (Economic and Monetary Union), 721, 740–743, 753 endogenous growth models, 211 Eng, Maximo, 506n Engelen, Klaus C., 752n entrepreneurship entrepreneurial learning, 188 infant industries and, 342–344 new venture internationalization, 187 environmental standards, following Uruguay Round of trade negotiations (GATT), 375–376 equilibrium. See also general equilibrium analysis; partial equilibrium analysis autarky, 85–87, 198–199 in closed economy, 680 consumer, 69–70 of exchange rate, 471, 649–650 financial market, 490–493 interest rate, 624–628, 649–650 labor market, 245–247 level of national income, 597–603 Final PDF to printer 790 INDEX app9062x_idx_784-808 790 06/23/16 07:14 PM Feenstra, Robert C., 161, 170–171, 227–228, 227n, 301 Fetzer, James J., 230n, 231n Fidler, Stephen, 670n Fidrmuc, Javko, 558 Field, Alfred J., Jr., 570n Fieleke, Norman S., 485n FIF (freight and insurance factor), 49–50 financial account balance, 458 Finger, J. Michael, 373 Fingleton, Eamonn, 321 Finland, home bias in productivity and, 161 firm-focused theories, 188 fiscal policy coordination with monetary policy, 659–661, 668–670 expansionary, 671–672 under fixed exchange rates, 639–642, 686–688 under flexible exchange rates coordination with monetary policy, 759–761 open economy, 654–657, 671–672 target zone proposal, 756–757 Fischer, Stanley, 48, 58–61, 132n, 549 Fisher, Eric O’N., 162 fixed exchange rates, 583–586 economic growth and, 704–706 effects of fiscal policy, 639–642 effects of monetary policy, 642–644 effects of official changes in exchange rate, 47–48, 644–648, 659–661 flexible exchange rates vs., 731–732, 746 general equilibrium, 624–638, 649–650 gold standard and, 583–585 hybrid systems with flexible exchange rates, 722–726 IS/LM/BP analysis, 624–650 open economy macroeconomics and, 620–650 aggregate demand, 683–688 currency adjustment, 692 effects of fiscal policy, 686–688 effects of monetary policy, 686–688 external shocks, 685–686 flexible exchange rates vs., 706–709 IS/LM/BP analysis, 683–688, 707–709, 714–715 optimum currency areas and, 719–722 two-instrument, two-target model, 621–624 Fleming, Marcus, 624 flexible exchange rates, 563–583 case for, 652 demand for foreign goods and services and, 564–567 economic growth and, 704–706 effects of fiscal policy, 654–657, 671–672 effects of monetary policy, 657–659, 671–672 fixed exchange rates vs., 731–732, 746 hybrid systems with fixed exchange rates, 722–726 imperfect capital mobility, 653–657 independent floating and, 745, 747 export condition in Classical trade theory, 42–43 defined, 42 export quotas economies of scale and, 347 gold export point, 584 import tariffs and, 347349 export subsidies, 270–271 in duopoly, 349–352 impact in large-country case, 302–303, 318–319 large country, 302–303, 318–319 export tax, 270–271 to extract domestic monopoly profit, 334–335 impact in large-country case, 299–300 impact in small-country case, 288–290 as key source of government revenue, 322, 323 external balance defined, 611 price adjustment mechanism and, 610–613 externalities as argument for protection, 331–332 negative externalities in consumption, 331–332 positive externalities in production, 331 Exxon Mobil, 232 factor growth. See also economic growth; factors of production effects of, 212–214 in large-country case, 216–221 Rybczynski theorem and, 215–216, 218–219 in small-country case, 215–216 factor-intensity reversal (FIR) in Heckscher–Ohlin (H–O) model, 138–139, 153 Leontief paradox and, 153 factor-neutral growth effect, 213 factor-neutral technological change, 208 Factor price equalization, 132–135 factor price line, 74–75 factors of production. See also capital; factor growth; labor capital movement through foreign direct investment, 227–242 fixed vs. flexible exchange rates, 706–707 full employment of, 95–96 labor movement between countries, 242–255 in Ricardian model, 27 tariffs to benefit scarce, 329–330 failure to conform to Heckscher–Ohlin (H–O) model, 175 Faiola, Anthony, 752n Falvey, Rodney E., 195 Farrell, Diana, 520n fast-track procedure, 372 favorable balance of trade, 17 Federal Reserve Bank of Boston, 577 Federal Reserve Bank of Chicago, 575–576 Federal Reserve Bank of Dallas, 363 Federal Reserve Bank of New York, 169 exchange rate—Cont. exchange rate mechanism (ERM), 740 foreign exchange arbitrage, 582 forward, 481–484 impact of foreign direct investment on, 241 link with interest rates, 502–510 market for foreign exchange, 469–472 monetary approach to, 539–542 overshooting of, 532, 548–554, 748 portfolio balance approach to, 542–548, 559–561 protection, 726 real effective exchange rate (REER), 476, 478–479, 582 spot rate, 474–480 variations in, 745–746 exchange rate limits, 43–45 defined, 43 in monetized Ricardian model, 44 Exchange Rate Mechanism (ERM), 740 exchange rate overshooting, 532, 548–554, 748 Dornbusch (uncovered interest parity) model, 548–552 Melvin (covered interest parity) model, 553–554 exchange rate protection, 726 exchange rate regimes extent of use, 747 International Monetary Fund (IMF), 745–747 types of, 745–746 exchange risk, in foreign exchange markets, 705–706 exchange-traded instruments, 527–529 expansionary fiscal policy, 671–672 expansionary monetary policy, 537 expected inflation rate, 538, 546 expected percentage appreciation of foreign currency, 489 expected spot rate, 488 expenditure switching, 564 export(s) capital/labor ratios and, 151 country leaders in merchandise trade, 5 elasticity of demand, 111n extent of concentration, 31 impact of foreign direct investment on, 239 impact of trade policies concerning, 288–291, 299–303 international interdependence in, 11–12 leaders in service, 10 Leontief paradox and, 151–157 policies to stabilize prices or earnings, 429–430 price elasticity of demand by country, 575–576 productivity and, 56 regional distribution of, 4–6, 10 relative performance U.S.-U.K., 51–53 restrictions on, 433 supply of exports schedule, 292–294 transportation costs and, 48–50 export cartels, 432–433 Final PDF to printer INDEX 791 app9062x_idx_784-808 791 06/23/16 07:14 PM future rate agreements (FRAs), 520–521 futures contracts, 485–487 defined, 485 eurodollar interest rate, 522–524 foreign currency, 486–487, 523 Gagnon, Joseph, 715 gains from trade “actual” vs. “potential,” 99 Classical trade theory, 32–33, 36 neoclassical trade theory, 84–99 total, 32–33 game theory, 186, 350–352 GATS (general agreement on trade in services), 367 GATT rounds of trade negotiations, 373, 374. See also General Agreement on Tariffs and Trade (GATT) DOHA Development Agenda, 367, 377–379 Doha Round, 289, 379, 382, 407 Kennedy Round, 367–368, 401, 407 Tokyo Round, 271, 367–371 Uruguay Round, 10, 274, 289, 367, 371–373, 411, 669 Gendreau, Brian, 486n General Agreement on Tariffs and Trade (GATT), 10, 260, 366–374. See also World Trade Organization (WTO) general agreement on trade in services (GATS), 373 General Dynamics, 353 General Electric Company, 380 general equilibrium analysis defined, 281 in large-country case, 306–309 in open economy macroeconomics, 624–638, 649–650 in small-country case, 303–306 trade diversion in, 396–397 trade restrictions in, 303–309 general equilibrium model, 281 General Theory of Employment, Interest and Money (Keynes), 592 Generalized System of Preferences (GSP), 259–264, 330, 366, 368, 410 geographical distribution of trade exports in, 4–6, 10 imports in, 4–6, 10 issues in, 192 merchandise, 3–5 services, 10 Geography and Trade (Krugman), 192 George, Henry, 324n, 342 Gephardt, Richard A., 19 Germany labor and capital per unit of output, 209–210 labor migration to, 243–245 Leontief paradox and, 159 price elasticities of demand for exports and imports, 575–576 and testing of monetary approach to the balance of payments, 557–559 vertical specialization-based trade and, 186–188 exchange controls in current financial system, 635 exchange risk, 705–706 financial market equilibrium and, 490–493 forward market, 480–487 hedging in, 470, 481, 484, 485 link between financial markets and, 487–496, 512–529 market stability and, 567–569 Marshall–Lerner condition and, 570–574, 588–589 price adjustments in fixed exchange rate system, 583–586 price adjustments in flexible-rate system, 563–583 simultaneous adjustments of financial market and, 493–496 speculation in, 470, 709–714 spot market, 474–480 supply side and, 470 foreign interest rate shock, 664–668 foreign policy, trade policy in, 330 foreign portfolio investment (FPI), 229 foreign price shock, 661–664 foreign repercussions defined, 608 open-economy multiplier with, 608–609, 616–618 Foreign Sales Corporations, 258, 273 foreign subsidiaries, 229 Forslid, Rikard, 191 Forte, Francisco, 641n Fortin, Nicole M., 169n forward exchange rate, 481, 484–485 forward-forward, 520–521 forward market, 480–487 currency futures, 485–486, 523 foreign currency options in, 486–487 forward exchange rate and, 481–484 future rate agreements (FRAs) and, 520–521 spot rate and, 482–484 forward rate contracts, 520–521 Foster, William, 268, 269n France average propensity to import, 598–599 flexible exchange rates in, 731–732 labor and capital requirements per unit of output, 209–210 price elasticities of demand for exports and imports, 575–576 Frangos, Alex, 469n Frankel, Jeffrey A., 558, 560, 759 Frankfurter, Felix, 592 Franklin, Benjamin, 23 free-rider problem, 363 Free to Choose (TV series), 713 Free Trade Area for the Americas (FTAA), 411 free-trade areas (FTAs), 388–389 Freeman, Richard B., 166–168, 253 freight and insurance factor (FIF), 49–50 Frenkel, Jacob A., 556, 557 Friedman, Milton, 713 Froyen, Richard T., 536 FTAs (free-trade areas), 388–389 IS/LM/BP analysis, 652–670 managed floating and, 724–726, 746, 747 market stability and, 567–569 Marshall–Lerner condition and, 570–574, 588–589 open economy macroeconomics and, 652–672 aggregate demand, 684–685 aggregate supply, 693–694 effects of fiscal policy, 692–693 effects of monetary policy, 688–691 fixed exchange rates vs., 706–709 IS/LM/BP analysis, 684–685, 692–693, 707–709, 714–715 optimum currency areas and, 719–722 policy coordination, 659–661, 668–670 price adjustments in short run versus long run and, 574–583 floating exchange rates. See also flexible exchange rates dirty, 726 European Community (EC), 739 independent, 745, 747 managed, 724–726, 746, 747 floating-floating swaps, 521 floors, option, 525–526 Foo, Alvi, 413, 413n food safety, in U.S. trade policy, 373, 382 foreign bond markets, 505 foreign bond supply, in portfolio balance approach to balance of payments, 547 foreign-currency appreciation, 471–472 foreign-currency depreciation, 471–472 foreign-currency options, 486–487 foreign direct investment (FDI), 227–242 analytical effects of international capital movement, 236–239 in China, 227–229, 233 defined, 229 determinants of, 234–235 domestic economic policy and, 241 host-country determinants of investment inflows, 237 potential benefits and costs to host country, 239–242 reasons for, 232–235 trends in, 229–232, 465–466 types of, 237 in the U.S., 230–232 of the U.S., 229–232, 234–235, 463–466 foreign exchange arbitrage, 583 foreign exchange market, 468–496. See also exchange rate; United States dollar backward-sloping supply curve of, 569–571 basis for international cash flows and, 487–490 covered interest parity and, 490–493, 495, 553–554 defined, 469 demand for goods and services in, 469–470, 564–567 demand for money, 470 efficient, 493, 553 eurocurrency market, 501–505, 512–529 Final PDF to printer 792 INDEX app9062x_idx_784-808 792 06/23/16 07:14 PM labor migration and, 248 Leontief paradox as test of, 151–157 Linder hypothesis and, 178–182 other tests of, 158–163 outsourcing and, 382–384 post-Heckscher–Ohlin theories of trade, 174–192 product cycle theory (PCT) vs., 175–179 production-possibilities frontier (PPF) and, 128–132, 143–146, 214 specific-factors model and, 128–132, 143–148, 330 Stolper–Samuelson theorem and, 135– 137, 155, 167, 169 theoretical qualifications of, 137–148 transportation costs and, 139–141 Trefler–Conway dialogue concerning, 158, 158n, 161–163 vertical specialization-based trade and, 186–188 hedging defined, 470 of eurodollar interest rate risk, 518–526 in foreign exchange market, 469, 474–487 Hegerty, Scott William, 583n, 706 Heilbroner, Robert L., 592n Helbling, Thomas F., 610, 610n Hellerstein, Rebecca, 577, 577n Helpman, Elhanan, 161, 189, 211–212 Henderson, Dale W., 543 Henderson, David R., 427n herd instincts, 758 Hernández-Catá, Ernesto, 695 Herron, Lanny, 187n Hertel, Thomas, 289, 289n Hessels, Jolanda, 187, 187n Hickok, Susan, 97 high-income economies, 418n Hillman, Arye, 361n Hitt, Greg, 258n, 381n Hoekman, Bernard, 379, 379n Hoftyzer, John, 179, 180 home bias, in productivity, 161–163 home bond supply, in portfolio balance approach to balance of payments, 547–548 home-currency appreciation, 471–472, 546, 547 home-currency depreciation, 471–472, 540 Honda America, 343 Hong Kong in Asian crisis (1997-1998), 751 economic growth in, 204 Hooper, Peter, 575, 575n, 576n, 598, 598n, 705 Hoover Institution, 713n Horwitz, Tony, 402n host countries defined, 230 determinants of investment inflows, 237 potential impact of foreign direct investment, 239–242 potential impact of labor migration, 252–255 HSBC Holdings, 232 gross international bank lending, 500–501 Grossman, Gene M., 151n, 211–212, 349, 352n Group of 7 (G-7) nations defined, 668 import and export demand elasticities, 575–576 macroeconomic policy coordination, 668–690 Group of 8 (G-8) nations, 669–690 Group of 20 (G-20) nations, 669–690 Grubel, Herbert G., 194, 195n Gruber, William C., 176, 177n guest workers, 248–252 Gulde, Anne-Marie, 716n Gultekin, N. B., 716n Haberler, Gottfried, 79, 104 Hagerty, James, 343n Hamilton, Alexander, 341 Hamner, Susanna, 343n Hanink, Dean M., 180 Hanke, Steve H., 647n Hanson, Gordon H., 161, 249n Harkness, Jon, 157 Harley–Davidson, 343 Harrod, R. F., 592, 592n Hart, Michael, 405, 406, 406n Hartigan, James C., 156 Hartman, Stephen W., 406, 406n, 407n Harvey, David L., 422n, 424 Harvey, Hanafiah, 580 Hauk, William, Jr., 575 Hayek, Friedrich von, 760, 761n Hazlewood, Arthur, 400n Head, Keith, 189 health issues in Doha Development Agenda, 378 in U.S. trade policy, 382 Heathcote, Jonathan, 611, 611n Heckscher, Eli F., 124 Heckscher–Ohlin (H–O) model, 124–179 assumptions of, 124, 137–148 comparative advantage and, 163–164 demand reversal and, 137–138, 152–153 different relative factor endowments and, 124–127, 130, 156–163, 214 different relative factor intensities and, 124–127, 138–139 different relative factor prices and, 131–135 Edgeworth box diagram and, 130, 143–146 factor abundance, 124–125 factor growth and, 214 factor-intensity reversal (FIR) and, 138–139, 153 factor price equalization theorem and, 132–135 firm-focused theories and, 188 Heckscher–Ohlin theorem, 128–132 home bias in productivity, 161–163 imperfect competition and, 141–142 income distribution and, 135–136, 164–171 income inequality and, 164–171 Gibson, Heather D., 502 Giddy, Ian H., 520n, 522, 529 Gill, Indermit, 417n Glencore, 232 global crisis in Argentina, 674 Asian crisis (1997-1998) and, 751, 758 in international monetary system, 729–731 recession of 2007-2008, 527 recession of 2007-2009, 751–753 global funds, 511 global logistics/supply chain management, 187 globalization of international financial markets, 499–501 world attitudes toward, 362 Glyn, Andrew, 53–54 Glytsos, Nicholas P., 248 gold in central bank reserves, 535, 749 discontinuation of transactions in, 738 gold export point, 584 gold import point, 585 gold standard, 583–585, 610 breakdown of, 730 defined, 21–22 global crisis and, 729–731 under Mercantilism, 21–22 proposals to restore, 753–756 Goldsmith, Charles, 353n Golub, Stephen S., 53 Gottschalk, Peter, 169n Gourdon, Julien, 158 government under Mercantilism, 17–18 procurement provisions of, 271 trade taxes as key source of revenue, 322, 323 government procurement provisions, 271 government spending, in Keynesian income model, 595 Graham, Edward M., 234 Graham, Frank D., 556n Graves, Robert, 64 gravity model of trade, 179–180, 188–189, 253–254 Great Depression, 367, 592, 730–731, 733 Greece debt crisis, 650–660 seasonal workers from, 243–245 worker remittances to, 248 Greenberger, Robert S., 365n Greenspan, Alan, 375, 563, 563n Greytak, David, 179, 180 Groen, Jan J. J., 558 gross domestic product (GDP) European instability and U.S. GDP, 666 historical correlation over time of country, 610 as measurement device, 11–12 price shocks and, 662–663 synchronization across countries, 611 trade deficits and growth of, 591 unemployment and U.S., 681–682 Final PDF to printer INDEX 793 app9062x_idx_784-808 793 06/23/16 07:14 PM infant industry argument for protection, 342–344 inferior goods, 115n inflation current account deficit and, 612 current account surplus and, 612–613 expected, 538, 546 flexible exchange rates and, 715 hyperinflation, 556–557 in monetary approach to balance of payments, 537, 538, 546 stagflation and, 696, 697 unemployment and, 696, 697 vicious circle hypothesis and, 703, 750 Ingersoll, Bruce, 311n, 365n Ingram, James C., 321, 322 Ingrassia, Lawrence, 372n injections, 601–602 input-output table, Leontief paradox and, 151–152 inshoring, 384 intellectual property rights, 372–373 Inter-industry trade, 193 interbank market, 473 interdependence, economic, changes in, 11–12 Interest Equalization Tax (IET), 503, 506–507 interest rate risk, 518–526 interest rates. See also IS/LM/BP analysis across countries, 508–509 equilibrium, 624–638, 649–650 eurodollar futures contracts, 522–524 foreign interest rate shock, 664–668 link with exchange rates, 502–51 in monetary approach to balance of payments, 534–536 INTERLINK, 609, 609n internal balance defined, 611 price adjustment mechanism and, 610–613 International Bank for Reconstruction and Development (IBRD), 733. See also World Bank international bank lending, 499–505 defined, 500 gross, 500–501 net, 501 international bond market, 505–510 International Coffee Organization, 429 international economics, 1–14 changes in economic interdependence and, 11–12 general reference list on, 12–14 introduction to, 1–2 international financial flows, 487–496 international financial markets, 499–529 bank lending in, 499–505, 529 bonds in, 505–510 derivatives in, 512–529 globalization of, 499–501 link between foreign exchange market and, 487–496, 512–526 loan participation syndicates, 529 stocks in, 510–512 impact in small-country case, 282–285, 303–306 to improve balance of trade, 324–325 incidence of the tariff, 295 to increase employment in particular industry, 328–329 Leontief paradox and, 155 measurement of, 265–270 national defense argument for, 322–324 to offset foreign dumping, 335–336, 381 to offset foreign subsidies, 336–341 optimum tariff rate, 325–326, 352–355 other features of, 261–264 to promote exports through economies of scale, 347 to promote exports through research and development, 347–349 to reduce aggregate unemployment, 327 reductions following Uruguay Round of trade negotiations (GATT), 374 terms-of-trade argument for, 325–327, 352–355 types of, 259 of the U.S., 155, 261–264, 281 impossible trinity, 644 incidence of the tariff, 295 incipient BOP deficit, 540, 653, 684 incipient BOP surplus, 540, 653, 684 income distribution developing countries and, 166–168 in Heckscher–Ohlin (H–O) model, 135–137, 164–170 impact of international trade on, 97 impact of trade policy on, 310 in intra-industry trade, 194 income effect, 115 income elasticity of demand for imports (YEM), 208, 392–394, 596–597 income terms of trade, 116, 117 increasing opportunity costs, 78–79 increasing returns to scale, 73 independent floating, 745, 747 independent variable, 556n India antidumping orders, 337, 339 labor migration from, 244 Leontief paradox and, 156 most-favored-nation (MFN) treatment, 260 open-economy multiplier for, 605 outsourcing trend and, 382–384 preferential duties and, 259–260 rise as trade competitor, 407 worker remittances to, 248, 249, 255 Indian Currency and Finance (Keynes), 592 indifference curves community/country, 65–67, 96, 99 consumer (See consumer indifference curves) Indonesia, in Asian crisis (1997-1998), 751 induced consumption spending, 593 induced imports, 596 Industrial and Commercial Bank of China, 232 industrial policy, 385 inelasticity of demand, concept of, 23 Hudson Bay Company, 17 Hufbauer, Gary Clyde, 55n, 155, 177n, 281, 329, 329n, 343, 343n, 401n, 405, 406 Hume, David, 20–23, 718 Hummels, David, 141, 186 Humpage, Owen F., 647n Hutchison, Michael, 715 Hutzler, Charles, 381n Hymer, Stephen, 241 hyperinflation, 556–557 Iacocca, Lee, 274 Ichimura, Shinich, 157 Ilzetski, Ethan, 607, 607n Imbs, Jean, 611, 611n IMF conditionality, 762 IMF quota, 734–735, 738 imitation lag, 174 imitation lag hypothesis, 174–175 immiserizing growth, 218–221 imperfect capital mobility defined, 633 under flexible exchange rates, 652–661 imperfect competition and Heckscher–Ohlin (H–O) model, 141–142 strategic trade policy and, 342 imperfect substitutes, 542 import(s) autonomous, 596, 604–606 average propensity to import (APM), 596, 598–599 capital/labor ratios and, 152–153 country leaders in merchandise trade, 5 demand for imports schedule, 292–293 elasticity of demand and, 111–116, 119, 208, 223, 392–394, 571, 575–576, 596–597 impact of trade policies concerning, 282–287, 292–297, 303–310 income elasticity of demand and, 208, 392–394, 596–597 induced, 596 leaders in service, 10 price elasticity of demand by country, 575–576 regional distribution of, 4–6, 10 steel industry, 54–55 import function, in Keynesian income model, 596–597 import quotas, 271, 276 impact in large-country case, 297–299, 301, 306–310, 315–316, 380–381 impact in small-country case, 285–286 on nonhomogeneous goods, 313–314 import subsidies, 259 impact in small-country case, 285–287 tariffs to offset foreign, 336–341 import tariffs, 259–260 to benefit scarce factor of production, 329–330 to extract foreign monopoly profit, 333–334 in fostering national pride, 330 impact in large-country case, 294–297, 306–309, 314–315 Final PDF to printer 794 INDEX app9062x_idx_784-808 794 06/23/16 07:14 PM effect of protection instruments on effect of domestic prices, 276–277 export pricing and exchange rate pass-through of, 578–579 flexible exchange rates and, 715 foreign exchange market, 469 labor and capital requirements per unit of output, 209–210 largest corporations, 232 Leontief paradox and, 159 policy frictions in interdependent world, 667 synchronization of GDP movements across countries, 611 U.S. trade deficits with, 460–461 world central bank (proposed) and, 774 Jenniges, Derrick T., 230n, 231n Jennings, Thomas, 745n Jensen, J. Bradford, 384, 384n Johanson, Jan J., 187, 187n, 188 Johnson, George E., 169n Johnson, Harry G., 352n Johnson, Karen, 575, 575n, 576n, 598, 598n Johnson, Leland, 272 Johnson, Lyndon B., 132 Johnson, Samuel, 23 Johnston, R. B., 501n Jones, M., 188 Jones, Ronald W., 195 Jordan, terms of trade in, 222 Joyce, Joseph P., 750n JPMorgan Chase, 232 Kaempfer, William H., 178 Kakoza, Joseph, 400n Kantor, Mickey, 365 Karfakis, Costas, 561 Karmin, Craig, 383n Karras, Georgios, 687n Kasman, Bruce, 495 Katz, Lawrence F., 168, 253 Kaufman, Herbert M., 502, 502n, 503 Kawasaki, 343 Keeney, Roman, 289, 289n Keesing, Donald B., 155, 176 Kehoe, Patrick J., 404 Kehoe, Timothy J., 404 Kellard, Neil M., 422n, 424 Kemp, Murray C., 198 Kendry, Adrian, 132n Kennedy, John F., 132 Kennedy Round of trade negotiations (GATT), 367–368, 401 Kennedy, Thomas E., 179, 180 Kenya in East African Common Market (EACM), 400 normal trade relations (NTR) and, 260 Ketenci, Natalya, 559 key currencies, 737 Keynes, John Maynard, 64, 592, 592n, 621, 754, 755 Keynes, John Neville, 592 Keynesian income model, 590–618 autonomous spending multiplier and, 603–606 suggestions for reform of, 753–761 target zone proposal, 756–757 world central bank (proposed), 755 international portfolio diversification, 511 international reserves, 533–534, 707, 709–710 International Standard Industrial Classification (ISIC) system, 9 international stock markets, 510–512 international trade. See also exchange rate; foreign exchange market; merchandise trade; trade policy attitudes toward, 362, 363 exchange rate risk and, 705–706 income distribution and, 97 introduction in neoclassical trade theory, 87–92 managed trade, 385 internationally acceptable reserve assets, 729 intra-industry trade (IIT), 193–197 defined, 181 level of, 196–197 measurement of, 202–203 reasons for, 194 investment spending. See also foreign direct investment (FDI) in Keynesian income model, 594 Ip, Greg, 375n Irwin, Douglas, 376n IS curve, 628–630. See also IS/LM/BP analysis defined, 629 equilibrium in open economy, 636–638 IS/LM/BP analysis aggregate demand, 683–685 effects of changes in exchange rates, 644–648 effects of fiscal policy, 683–684 effects of monetary policy, 684–685, 692–693 with fixed exchange rates, 624–628, 707–709, 714–715 with flexible exchange rates, 652–670, 707–709, 714–715 relationship between exchange rate and income in equilibrium, 657–659 Isard, Peter, 705 isocost lines, 73–75 isoquants, 70–73 Issing, Otmar, 742n Isuzu, 274 Italy income inequality and, 165 price elasticities of demand for exports and imports, 575–576 item-by-item approach, 367 Ito, Takatoshi, 705 J curve, 581–582 Jamaica Accords, 739–740 Japan antidumping orders, 337–338 average propensity to import, 598–599 dynamic comparative advantage and, 176 economic growth in, 204 economies of scale and, 347 international funds, 511 international indebtedness position of a country, 463–466 international interdependence in, 11–12 international investment position of a country, 463–466 International Labour Organization (ILO), 123 international liquidity, 729 international macroeconomic policy coordination, 668–690 International Monetary Fund (IMF), 450, 450n, 506, 516–517, 556, 624, 635 “Aid for Trade” and, 379, 379n balance-of-payments statistics and, 450, 462 in Bretton Woods system, 732–737 commodity prices and U.S. real GDP, 662–663 controls over trade and, 275 crawling peg system and, 725n development in Africa and, 695 exchange controls and, 635 exchange rate regimes, 745–746 freight and insurance factor, 49–50 goals of, 733–735 help for poor countries, 695 IMF conditionality, 762 IMF quotas by country, 734–735 income terms of trade, 117 Jamaica Accords and, 739–740 macroeconomic policy coordination, 668–690 origins of, 592, 733 real effective exchange rate, 476, 478–479, 582 terms of trade calculation, 110 terms of trade for major groups of countries, 112–113 terms of trade for specific countries, 222 terms-of-trade indexes and, 112–113, 117 terms-of-trade shocks and, 101 trade and income inequality for developing countries, 168 trade and income inequality in, 168 trade taxes as source of government revenue, 323 international monetary system, 729–763 Bretton Woods system in, 732–737 controls on capital flows, 758–759 current exchange rate arrangements, 745–746 early disruption, 737 European monetary system (EMS), 740–743 evolution of new, 737–745 exchange rate variations, 745–746 experience under current, 746–753 fixed vs. flexible exchange rates, 706–707, 731–732, 746 global crisis in, 729–731 return to gold standard, 753–756 Smithsonian Agreement, 739 special drawing rights (SDRs), 535, 737–738, 749 stability and coordination of macroeconomic policies, 759–761 Final PDF to printer INDEX 795 app9062x_idx_784-808 795 06/23/16 07:14 PM Lithuania, currency boards in, 717–718 Liu, Xiaming, 189 Lloyd, P. J., 194 LM curve, 624–628. See also IS/LM/BP analysis defined, 626–627 equilibrium in open economy, 636–638 Locksley, Gareth, 132n, 713n London (Ontario) Court of International Arbitration, 382 London Interbank Offered Rate (LIBOR), 502, 506, 516–517, 523, 525 Londoño, Juan Luis, 97 long hedge, 522 long position, 482 long-run aggregate supply curve, 680 Long, William J., 369 Loong, Lee Hsien, 413 Lopokova, Lydia, 592 Loria, Eduardo, 559 Louvre Accord, 744 Lovely, Mary, 235 low-income economies, 418n lower-middle-income economies, 418n Luce, Geoffrey, 520n Lunsford, J. Lynn, 353n Maastricht Treaty, 740–743 MacDonald, Alistair, 248n MacDonald, Ronald, 545, 558 MacDougall, G. D. A., 51–53 Machlup, Fritz, 736n, 737n macroeconomic interpretation of trade deficit, 324–325 Madsen, Jakob B., 212, 367 Magee, Christopher, 370, 370n Maggard, Kasey Q., 249n magnification effect, 136 Magraw, Daniel, 505 Makin, John H., 549n Malaysia, in Asian crisis (1997–1998), 751 Malkiel, Burton G., 736n Mallampally, Padma, 237, 237n managed floating, 724–726, 746, 747 managed trade, 385 management problem, of currency boards, 718 Mankiw, N. G., 383, 383n Mann, Catherine, 591, 591n, 606 maquiladora program, 406 marginal cost (MC), in monopoly, 333–334 marginal physical product of capital, 72–75, 135–137, 146–148, 236–239 marginal physical product of labor, 72–75, 135–137, 146–148 marginal propensity to consume (MPC), 593–594 marginal propensity to import (MPM), 596 marginal propensity to save (MPS), 593–594 marginal rate of substitution (MRS), 65–67 defined, 65 diminishing, 65 marginal rate of technical substitution (MRTS), 72–73 marginal rate of transformation (MRT), 79, 85–86 surplus, 246–247 trade adjustment assistance and, 95, 368, 370, 410 unit labor costs, 51–53 worker remittances, 248–249, 255 labor-saving technological changes, 208–209 Labor standards comparative advantage and, 123–124 following Uruguay Round of trade negotiations (GATT), 373–375 labor theory of value, 17, 22–24, 27 Lachica, Edward, 274n Laffer, Arthur B., 621, 621n Lafourade, Miren, 188n laissez-faire defined, 22 under Mercantilism, 22–24 Lamy, Pascal, 360, 379 land use, impact of trade policy on, 310 Lane, Morton, 520n large country defined, 109 export subsidies in, 302–303, 318–319 export taxes and, 299–302, 317–318 factor growth in, 216–221 general equilibrium analysis, 306–309 impact of trade policies in, 282–291, 306–310, 314–318 import quotas, 297–299, 301, 306–310, 315–318, 380–381 import tariffs, 294–297, 306–309, 314 shifts in offer curve, 109–111 Latin American Integration Association (LAIA), 392 Lauricella, Tom, 469n law of one price, 476 leakages, 601–602 Leamer, Edward E., 151, 151n, 159, 163 leaning against the wind, 724–725 leaning with the wind, 724–725 Lees, Frances A., 506n Leff, Nathaniel H., 301 legal tender, exchange arrangements with no separate, 741 Lehman Brothers, 752 Leith, J. Clark, 368 Lemieux, Thomas, 169n Leontief paradox, 151–157, 159 capital/labor ratios and, 152–157 described, 151 explanations, 152–157 Leontief statistic, 152–157, 154n Leontief, Wassily W., 151–157 Levinsohn, James, 151, 151n Liang, Hong, 432n LIBOR (London Interbank Offered Rate), 502, 506, 516–517, 523, 525 Lincoln, Abraham, 321 Linder hypothesis, 178–181 Linder, Staffan Burenstam, 178–182, 196 Linnemann, Hans, 188 Lipsey, Robert E., 176–177 liquidity international, 729 liquidity problem, 736 List, Frederick, 341 consumption function in, 593 current account balance, 591–597 equilibrium level of national income in, 597–603 import function in, 596–597 saving function in, 593–594 Khan, M. Shahbaz, 441n Kharas, Homi, 417n Kierzkowski, Henryk, 195 King, Neil, Jr., 248n, 281n, 360n, 379n, 380n, 381n Klein, Michael, 706 Kletzer, Lori G., 384, 384n Klitgaard, Thomas, 578, 578n, 579n Klonsky, Joanna, 411n Kobayashi, Kiyoshi, 268, 269n Kohlhagen, Steven, 705 Kolb, Robert W., 486n Konings, Josef, 269n Korhonen, Iikka, 716n, 718n Kravis, Irving B., 176–177 Kreicher, Lawrence L., 504n Krueger, Anne O., 97, 344 Krugman model characteristics of, 181–185 economies of scale in, 181 monopolistic competition, 182–185, 200–202 Krugman, Paul R., 182–188, 192, 200–202, 234, 344–347, 346n, 757, 757n Kuroda, Haruhiko, 413, 413n Kuwait, 503 Kvasnicka, Joseph G., 502n Kyle, John F., 157 labor. See also employment; unemployment aggregate demand curve in closed economy, 676–677 brain drain and, 227, 251–252, 255 capital/labor ratios and, 152 costs of protecting industry employment, 329 different skill levels of, 155–156 foreign direct investment (FDI) and, 234–235 in Heckscher–Ohlin (H–O) model, 155–156, 248 impact of foreign direct investment on, 241 international movements of, 242–255 in Krugman model, 182–184 labor force growth and per capita income, 217 labor market equilibrium, 245–248 Lawrence, T. E., 64 marginal physical product of, 72–73, 135–137, 146–148 under Mercantilism, 18 migration from developing countries, 248–252 outsourcing and, 170–171, 186–187, 382–384 permanent migration, 243–245 requirements per unit of output, 209–210 seasonal workers, 242–243 skill levels of, 170 Final PDF to printer 796 INDEX app9062x_idx_784-808 796 06/23/16 07:14 PM money market, general equilibrium in, 624–628 money market instruments, 506 money multiplier, 533 monopolistic competition defined, 182 in Krugman model, 182–185, 200–202 monopoly model export tax to extract domestic monopoly profit, 334–335 and Heckscher–Ohlin (H–O) model, 141–142 impact of foreign direct investment on, 240, 241 under Mercantilism, 17–18 tariff to extract foreign monopoly profit, 333–334 monopsony market power, under Mercantilism, 17–18 Moonie, Ken, 365 Morocco, terms of trade in, 222 Morrow, Peter, 163–164, 164n Morse, Dan, 381n Mossberg, Walter S., 274n most-favored-nation (MFN) treatment, 260–262, 367 motorcycle industry, infant industry protection for, 343 Mozambique, trade and income inequality in, 168 MPC (marginal propensity to consume), 593–594 MPM (marginal propensity to import), 596 MPS (marginal propensity to save), 593–594 MRS (marginal rate of substitution), 65–67 MRT (marginal rate of transformation), 79, 85–86 MRTS (marginal rate of technical substitution), 72–73 Multi-Fiber Agreement, 372–373, 376, 381 multilateral negotiations, 367 multinational corporations (MNCs) defined, 229 dynamic comparative advantage and, 176 education and, 241 foreign direct investment (FDI) and, 229–232 product cycle theory (PCT) and, 175–179, 233 and transfer pricing, 240 trends concerning, 227–242 world’s largest, 232 multiple exchange rates, 759 multiplier autonomous spending, 603–606 money, 533 open-economy, 604–609, 614–615 Mundell-Fleming model, 624 Mundell, Robert, 135, 621, 622n, 719, 720, 722, 755, 755n Muriel, Beatriz, 160 Murphy, Ricardo Lopez, 674n Murray, Shailagh, 380n mutual funds, 511 Myrdal, Gunnar, 223 leading exporters and importers by country, 5 nontariff barriers to, 271–277 U.S., 7–9, 459–465 merchandise trade balance, 453 MERCOSUR (Southern Cone Common Market), 392, 411, 412 Mexico. See also North American Free Trade Agreement (NAFTA) labor migration from, 244, 255 Leontief paradox and, 172 maquiladora program, 406 tomato exports to the U.S., 365 trade policy of, 258 worker remittances to, 248–249 Michaels, Daniel, 353n migration of labor, 242–255 additional considerations for, 248–252 labor surplus and, 246–247 permanent, 243–245 potential benefits and costs to host country, 252–255 seasonal, 242–243 worker remittances to home country, 248–249 Milgate, Murray, 28n, 64n, 132n, 592n, 713n Mill, John Stuart, 32, 37, 47, 56 Miller, John W., 49, 353n, 360n, 378n, 380n, 667n Miller, Scott, 360n Minhas, B. S., 153 mint par, 583 Mishel, Lawrence, 169n Moffett, Matt, 431n Mohanty, Samarendu, 311n Mollenkamp, Carrick, 670n monetary approach. See also international monetary system; monetary policy to the balance of payments, 532–539 demand for money, 534–537 to the exchange rate, 539–542 monetary equilibrium and balance of payments, 537–539 nature of, 539 supply of money, 533–534, 537–539 testing, 556–559 two-country framework, 540–542 monetary base, 533–534 Monetary History of the United States 1867–1960 (Friedman and Schwartz), 713 monetary policy contractionary, 537 coordination with fiscal policy, 659–661, 668–670, 759–761 expansionary, 537, 671–672 under fixed exchange rates, 642–644, 686–688 under flexible exchange rates, 657–659, 671–672, 688–691 aggregate demand, 686–688 monetary policy-fiscal policy coordination, 659–661, 668–670, 759–761 monetary sovereignty problem, 719 monetary unions, 389, 391–392, 721 marginal revenue (MR) in monopolistic competition, 200–202 in monopoly, 333–334 Marjit, Sugata, 195 market failure, externalities and, 331–335 market-seeking FDI, 237 market stability, 567–574 defined, 567 and price adjustment mechanism, 567–574 Markusen, James R., 178, 234 Marquez, Jaime, 575, 575n 576n, 598, 598n Marsh, Ian W., 558 Marshall, Alfred, 192 Marshall, Kathryn G., 162 Marshall–Lerner condition defined, 573 derivation of, 588–589 estimates of import and export demand elasticities, 575–576 nature of, 570–574 Martin, William, 379, 379n Maskus, Keith E., 157–158, 178 Mathematical Psychics (Edgeworth), 64 Mattoo, Aaditya, 379, 379n maturing-product stage, 175 maturity mismatching, 520 Mayer, Thierry, 185n, 190–191 Mayo, Herbert B., 511 McAuley, Andrew, 187, 187n McCulloch, Rachel, 704 McDermott, C. John, 431, 432n McDonnell Douglas, 353 McDougall, Patricia P., 187, 187n, 188 McHugh, Richard, 179, 180 McKinnon, Ronald, 720, 754 McPherson, M. A., 180 McVey, Rick, 520n median-voter model, 361 Meese, Richard A., 558, 560 Mehta, Dileep, 176, 177n Meier, Gerald M., 219, 239, 344 Melitz, Marc, 189–191 Melloan, George, 667n Melvin, James R., 178 Melvin, Michael, 553, 554 Mendelsohn, M. S., 506 Mendelson, Morris, 505 Mendoza, Entrique G., 607, 607n Mercantilism, 16–24 balance of trade argument for tariffs and, 324 challenges to, 20–24 defined, 16 domestic economic policy under, 18 economic system under, 16–17, 23 government role under, 17–18 recent examples of, 19 trade policy and, 325, 341 merchandise trade, 3–9 commodity composition of, 6–9 export taxes and subsidies, 270–271 geographical composition of, 3–5 growth of, 3 import tariffs, 259–260 interdependence in, 11–12 Final PDF to printer INDEX 797 app9062x_idx_784-808 797 06/23/16 07:14 PM Omnibus Trade and Competitiveness Act of 1988, 19 open economy macroeconomics, 620–650, 673–700 effects of fiscal policy, 639–642 effects of monetary policy, 642–644 effects of official changes in exchange rate, 644–648 external shocks and, 685–686, 696–700 fixed exchange rates and, 620–650 aggregate demand, 683–688 currency adjustment, 692 effects of fiscal policy, 686–688 effects of monetary policy, 686–688 effects of official changes in exchange, 659–661 effects of official changes in exchange rate, 47 external shocks, 685–686 flexible exchange rates vs., 706–709 IS/LM/BP analysis, 683–688, 707–709, 714–715 flexible exchange rates, 652–672 aggregate demand, 684–685 aggregate supply, 693–694 effects of fiscal policy, 652–657, 671–672, 692–693 effects of monetary policy, 657–661, 671–672, 688–691 fixed exchange rates vs., 706–709 IS/LM/BP analysis, 661–668, 684–685, 692–693, 707–709, 714–715 policy coordination, 668–670 flexible exchange rates vs., 731–732, 746 general equilibrium, 624–628, 649–650 IS/LM/BP analysis, 624–650 multiplier with foreign repercussions, 608–609, 616–618 two-instrument, two-target model, 621–624 Open Economy Macroeconomics ( Dornbusch), 549 open-economy multiplier, 604–609, 614–615 current account and, 606–608 defined, 604 with foreign repercussions, 608–609, 616–618 for India, 605 when taxes depend on income, 614–615 open interest, 523 open positions, 481 Operation Desert Storm, 503 Opinion Research Corporation, 363 opportunity costs, increasing, 78–79 optimal size of international reserves, 707 optimum currency areas, 719–722 defined, 719 “true” vs. “pseudo,” 720 optimum tariff rate, 325–326, 352–355 option premium, 524 options eurodollar interest rate, 524–526 on swaps, 526 options foreign currency, 486–487 Oracle at Delphi, 16 Newman, Peter, 28n, 64n, 132n, 592n, 713n Nixon, Richard, 738 Nomani, Asra Q., 274n nominal effective exchange rate (NEER) defined, 474–475 of U.S. dollar, 477–478 nominal tariff rate, 266–270 nonhomogeneous goods, impact of trade policy on, 313–314 nonreciprocity principle, 369–371 nontariff barriers (NTBs), 271–277 additional domestic policies, 274–277 types of, 271–274 nontraded goods, 49 normal trade relations (NTR), 260–264. See also most-favored-nation (MFN) Treatment North American Free Trade Agreement (NAFTA), 392, 403–409 antidumping provisions, 381 claimed violations of, 258 impact of, 85, 258–261, 272, 365, 372, 405–409 myths vs. facts, 405–409 new venture internationalization and, 187 origins of, 12, 85, 382, 389, 403–404 preferential duties and, 259–260 recent U.S. free-trade agreements and, 409–411 U.S. tariff rates, 155, 261–264 Norway, flexible exchange rates in, 731–732 notional values, 527 Noyer, Christian, 743n Nyerere, Julius, 400 Obama, Barack, 19, 258, 272, 381, 382, 409, 410, 413–414, 693 Obote, Milton, 400 Obstfeld, Maurice, 499n Occupy Wall Street movement, 166–167 Odessey, Bruce, 311n Oehmke, James F., 178 offer curve (reciprocal demand curve) alternative terms of trade and, 103–104 in analyzing impact of trade policy, 306–307 economic growth and, 219 elasticity and, 111–116, 119–121 equilibrium of, 119–121 in neoclassical trade theory, 101–105, 107–111 shifts in, 107–111 tabular approach to deriving, 104–105 trading equilibrium and, 105–106 official reserve transactions (ORT), 638 official reserve transactions balance, 456, 503 offshore assembly provisions (OAP), 260 offshore centers, 506–507 offshoring, 170–171, 186, 382–384 O’Grady, Mary Anastasio, 412n, 647n Ohlin, Bertil, 124–125 oil shocks, 112, 144, 506 O’Leary, Christopher J., 405n, 406n Olivei, Giovanni P., 577, 577n NAFTA. See North American Free Trade Agreement (NAFTA) Narayan, Seema, 575, 576n national defense, as argument for tariffs, 322–324 national income current account and, 590–618 equilibrium in Keynesian income model, 597–603 income adjustments and, 610–613 multiplier when taxes depend on, 614–615 price adjustments and, 610–613 unemployment and U.S., 681–682 national pride, trade policy in fostering, 330 natural level of employment, 680 natural level of income, 680 natural resources. See also oil shocks fixed vs. flexible exchange rates and, 706–707 in Heckscher–Ohlin (H–O) model, 157 Navajas, Fernando, 674, 674n NBC, 363 Neary, J. Peter, 191, 266 neoclassical trade theory, 62, 150–172. See also Heckscher–Ohlin (H–O) model assumptions in analysis of, 95–97 autarky equilibrium and, 85–87, 198–199 basis for trade, 122–149 consumer behavior theory in, 63–70 Edgeworth Box diagram and, 63, 64, 75–78 equilibrium terms of trade in, 105–106 gains from trade and, 84–99 introduction of international trade in, 87–92 introduction to, 63 minimum conditions for trade and, 92–95 offer curves and, 101–105, 107–111 production-possibilities frontier (PPF) and, 70–75, 78–82 production theory in, 70–76 terms of trade in, 100–121 net barter terms of trade (commodity terms of trade), 110, 240 net creditor country, 463 net debtor country, 463 net debtor status, 465 net errors and omissions, 462 net international bank lending, 501 net international investment position, 449 net lag, in imitation lag hypothesis, 174–175 Netherlands international trade, monopoly behavior in, 144 largest corporations, 232 Netherlands Antilles, 506 network theory, 188 neutral consumption effect, 207 neutral production effect, 205 new-product stage, 175 new products imitation lag hypothesis and, 174–175 product cycle theory (PCT) and, 175–176, 179, 233 new venture internationalization, 187 Final PDF to printer 798 INDEX app9062x_idx_784-808 798 06/23/16 07:14 PM under fixed exchange rate system, 583–586 under flexible-rate system, 563–583 market stability and, 567–569 in short run vs. long run, 574–583 price definition of factor abundance, 124 price elasticity of demand concept of, 21 estimates by country, 575–576 in Krugman model, 200–202 price index, 110 price ratios in autarky, 22–24, 29–30, 32, 34–36, 50–51, 129 price shocks domestic, 664 foreign, 661–664 foreign interest rate, 664–668 price-specie-flow mechanism, 20–22, 47–48 principles of, cryptography, 760 Principles of Political Economy and Taxation, The (Ricardo), 27, 28 Priority Foreign Countries, 369 private capital account, in monetary approach to balance of payments, 538 producer equilibrium, 74–75, 86 producer surplus defined, 283 in small-country case, 283–285 product aggregation, in intra-industry trade, 194 product cycle theory (PCT) and, 175–179, 233 product differentiation automobiles and, 181, 186–188, 194 defined, 181 in gravity model, 253–254 in intra-industry trade (IIT), 194 production aggregate production function, 676–677 Cobb-Douglas production function, 211n neutral production effect, 205 positive externalities in, 332 production effect, 115 production efficiency locus, 76–78 production efficiency points, 81–82 production growth production gain (gains from specialization), 89–90 trade effects of, 204–206 ultra-antitrade production effect, 206, 248 ultra-protrade production effect, 206 production-possibilities frontier (PPF), 78–82 autarky equilibrium and, 85–87, 198–200 consumption-possibilities frontier (CPF) and, 89 costless factor mobility and, 95 economies of scale and, 181, 198–200 effects of technological change on, 208–212 Edgeworth box and, 79–82, 143–146 factor growth and, 213–214 full employment of factors of production, 95–96 Phillips, Matt, 495n physical definition of factor abundance, 124 Pigott, Charles, 495 Pittelko, Brian M., 405n, 406, 406n Plastina, Alejandro, 427n Plaza Agreement of 1985, 744 Political Discourses (Hume), 20 political economy of state building, 16–18 of trade policy, 360–366 U.S. attitudes toward international trade, 363 world attitudes toward foreign trade, 362 political problem, of currency boards, 719 portfolio adjustments, in portfolio balance approach, 545–548 portfolio balance approach to the balance of payments, 542–548, 559–560 to the exchange rate, 542–548, 559–560 positive-sum game defined, 23–24 in Ricardian model, 24, 30 Posner, Michael V., 174 post-Heckscher–Ohlin theories of trade, 174–192 concluding comments, 191–192 economies of scale, 181 firm-focused theories, 188 gravity model, 188–189 imitation lag hypothesis, 174–175 Krugman model, 182–185 Linder hypothesis, 178–181 multiproduct exporting firms, 189–191 product cycle theory, 175–178 reciprocal dumping model, 185–186 vertical specialization-based trade, 186–188 Pöyhönen, Pentti, 195 Prebisch, Raul, 223 precautionary demand for international reserves, 707 precious metal, in Mercantilism, 17–18 predatory dumping, 336 preferential duties, 259–260, 263–264 premium option, 490–493, 524 price(s) different relative factor prices, 131–135 domestic, impact of protection instruments on, 276–277 domestic price shocks, 664 factor price equalization theorem, 132–135 factor prices line, 74–75 foreign price shock, 661–664 law of one price, 476 in monetary approach to balance of payments, 534 national income and, 610–613, 626–628 and simultaneous external and internal balance, 610–613, 626–628 transfer pricing, 240 price adjustment mechanism, 562–586 defined, 564 demand for goods and services in, 564–567 ordinal utility, 63–64 Organization for Economic Cooperation and Development (OECD), 162, 276–277, 377, 609 Organization of Petroleum Exporting Countries (OPEC) oil price shocks, 112–113, 144, 503 role of, 750 terms-of-trade indexes, 112–113 Orser, B., 188 outsourcing, 170–171, 186–187, 382–384 Outtara, Alassane D., 695n over-the-counter instruments, 527–529 overall balance, 456 overlapping demand, in Linder hypothesis, 178–180 overshooting, exchange rate, 532, 548–554 Oviatt, Benjamin M., 187n, 188 Pain, Nigel, 234 Pakistan, interference with free trade, 275 Palma, J. G., 425n Panagariya, Arvind, 198 Panama home bias in productivity and, 161 trade promotion agreement, 410 Paraguay, in Southern Cone Common Market (MERCOSUR), 392, 411 Pareto efficiency, 78 Pareto, Vilfredo, 78 partial current account adjustment, 608, 623 partial equilibrium analysis defined, 281 in large-country case, 291–303 in small-country case, 282–291 trade restrictions in, 282–303 partial exchange rate pass-through, 577 Patinkin, Don, 592n Pattillo, Catherine, 101, 101n payoff matrix, 350–352, 354 Peera, Nural, 762n pegged rate system, 585–586 crawling peg, 723–725, 746, 747 extent of use, 745, 747 fixed peg, 747 pegged but adjustable exchange rates, 733–35 per capita income, labor force growth and, 217 perfect capital immobility, 634 perfect capital mobility, 633 perfect competition, in Ricardian model, 28 performance requirements, for foreign direct investment, 242 Perot, Ross, 19 Perri, Fabrizio, 611, 611n Perry, Guillermo, 647n persistent dumping, 355–356 Peterson Institute for International Economics, 287, 405 Petri, Peter A., 327 Pew Global Attitudes Project, 362, 363 Pew Research Center, 165 Philippines in Asian crisis (1997-1998), 751 Leontief paradox and, 172 Final PDF to printer INDEX 799 app9062x_idx_784-808 799 06/23/16 07:14 PM Royal Dutch Shell, 232 Ruffin, Roy J., 174, 174n rules-based trade policy, 384 rules of origin, 388 rules of the game, 583 Russia. See also Central/Eastern Europe; Soviet Union, former collapse of ruble, 751 Rybczynski theorem, 215–216, 218–219 Saa, President, 647 SAARC (South Asian Association of Regional Cooperation), 392 SACU (Southern African Customs Union), 392 Sailors, Joel W., 179 Salgado, Uberto, 559 Salvantici, Luca, 268n Samuelson, Paul A., 48, 58–61, 79, 99, 132, 135–136, 549 Samuelson, Robert, 383, 384n Sánchez, Armando, 559 Sarno, Lucio, 744 Sauvant, Karl P., 242, 242n saving impact of foreign direct investment on, 241 marginal propensity to save (MPS), 593–594 saving function, in Keynesian income model, 593–594 Saxena, Shishir, 212 Scharler, Johann, 611n Schipke, Alfred, 721n Schmukler, Sergio L., 647n Schott, Jeffrey J., 405–406 Schott, Peter K., 162 Schroeder, Michael, 258n, 360n, 383n Schwartz, Anna J., 713 seasonal workers, 242–243 second best, 390 Seers, Dudley, 425n Segerstrom, Paul S., 178 seigniorage problem, of currency boards, 718 self-interest approach, to trade policy, 361–364 Sematech, 322 Serven, Luis, 647n service trade, 9–10 general agreement on trade in services (GATS), 373 geographical composition of, 10 interdependence in, 11–12 leading exporters and importers, 10 outsourcing in, 382–384 restrictions on, 273 Shackleton, J. R., 132n, 713 Shambaugh, Jay, 706 Sharer, Robert, 400n Shimpo, Kazushige, 161 shock to the expected exchange rate, 668 shocks, economic domestic price, 664 exchange rate, 668 external, 685–686, 696–700 fixed vs. flexible exchange rates and, 714–715 Reciprocal Trade Agreements Act of 1934, 367 recognized interdependence, 344–345 REER (real effective exchange rate), 476, 478–479, 582 Reeve, T. A., 161 regional funds, 511 Regulation Q, 502–503 Reid, Scott, 242n relative capital immobility, 639–642 relative capital mobility, 640–641 relative purchasing power parity, 477 rent-seeking activity, 364 research and development (R&D) product cycle theory (PCT) and, 175–179, 233 tariffs to promote exports through, 347–349 reserve tranches, 735 reserves adequacy of reserves problem, 736 balance, 503 in balance of payments, 451 of central banks, 451, 535, 709–710, 748, 749 domestic, 533–535 under fixed vs. flexible exchange rates, 709–710 international, 533–534, 707, 709–710, 729–731, 749 official reserve transactions (ORT), 631 official reserve transactions balance, 456 resource-exchange theory, 188 resource-seeking FDI, 237 results-based trade policy, 384 retail spread, 481 retail trading margin, 481 Reynolds, Paul D., 187, 187n Ricardian model, 26–38 assumptions of, 27–28 comparative advantage in, 28–33 monetized, 41–42, 44 total gains from trade and, 32–33 Ricardo, David, 16, 24, 26–38, 41–42, 63, 175–176 Richardson, J. David, 349, 352n Richardson, Pete, 609 risk diversification, 234 risk premium (RP), 490 Rivera-Batiz, Francisco L., 547 Rivera-Batiz, Luis A., 547 Robinson, Richard B., Jr., 187n Rodrik, Dani, 428n Rogoff, Kenneth, 151n, 558, 560 Romania, in European Union (EU), 388, 392, 401 Romer, Paul M., 211n Roosevelt, Franklin D., 592 Root, Franklin R., 234n Rose, Andrew K., 558 Rosefielde, Steven, 157 Roskamp, Karl W., 157 Ross-Larson, Bruce, 344 rounds of spending in the multiplier process, 603–604 Royal Bank of Scotland Group, 232 gains from trade and, 99 Heckscher–Ohlin (H–O) model and, 128–132, 143–146 increasing opportunity costs on, 78–82 international trade and, 87–92 in neoclassical trade theory, 70–75, 78–82 sources of growth and, 208–216 trade between countries with identical, 92–93 production-sharing arrangements, 260 production theory, 70–75 isocost lines in, 73–75 isoquants in, 70–73, 76 producer equilibrium and, 74, 75, 86 productivity. See also economies of scale exporting and, 56 home bias and, 161–163 steel industry, 54–55 prohibitive tariff, 265 protrade consumption effect, 207 protrade production effect, 206 public-choice economics, 361 purchasing power parity (PPP), 476–480, 730–731, 748 absolute, 476–477 relative, 477 spot market, 482–483 pure price discrimination, 142 put options, eurodollar, 524–525 quantity theory of money, 21 crude, 539 Quayyum, Saad, 575, 576n Quesnay, François, 23 quota rent, 285, 298–299 quotas export (See export quotas) IMF, 734–735 import (See import quotas) Qureshi, Usman A., 179 Raby, Geoff, 427n Ramanarayanan, Ananth, 611, 611n, 692 Ramstad, Evan, 411n random walk, 560 Rapach, David E., 558 Rapoport, Dana, 170 Ratha, Dilip, 249n rational expectations, 542 Rauh, Alison, 181 reaction functions defined, 344–345 tariff, 352–355 real economic effects, 748 real effective exchange rate (REER), 582 defined, 476 of U.S. dollar, 477–478 real exchange rate (RER), 476 real income, in monetary approach to balance of payments, 534 real interest rates across countries, 508–509 behavior of, 439 recession of 2007-2008, 41, 527, 751–753 reciprocal dumping model of trade, 185–186 Final PDF to printer 800 INDEX app9062x_idx_784-808 800 06/23/16 07:14 PM Stolper, Wolfgang F., 135–136, 157 Stolper–Samuelson theorem, 135–137, 155, 167, 169 Stotsky, Janet G., 758 Strachey, Lytton, 592 Strategic Petroleum Reserve, 322 strategic trade policy, 341–356 concluding observations on, 355–356 economies of scale in duopoly frame- work, 342, 344–347 export subsidy in duopoly, 349–352 imperfect competition and, 342 infant industry argument for protection, 342–344 nature of, 341–342 research and development sales of home firm, 347–349 strike price, 523 strips, eurodollar, 524 Subramanian, Arvind, 428n, 437 subsidiaries, foreign, 229 substitution imperfect substitutes, 542 marginal rate of (MRS), 65–67 marginal rate of technical (MRTS), 72–73 substitution effect, 115 sugar quotas, 310 supply of exports schedule, 292–294 supply of money defined, 533 excess, 537 in foreign exchange market, 470 and monetary approach to the balance of payments, 533–534, 537–539 surplus labor, 246–247 surveillance, 740 Survey of Current Business (U.S. Department of Commerce), 166 Suzuki Motors, 274 Svaleryd, Helena, 160 Sveikauskas, Leo, 159, 213n Svensson, Lars E. O., 757, 757n Swan, T. W., 613 swaps equity, 526 eurodollar cross-currency interest rate, 521 eurodollar interest rate, 521 options on, 526 swaptions, 526 Symanski, Steven, 705 synchronization of GDP, 611 Székely, Miguel, 97 Tadesse, Bedassa, 254, 254n Taiwan in Asian crisis (1997-1998), 751 economic growth in, 204 Tanzania, in East African Common Market (EACM), 400 target zone proposal, 756–757 Krugman version of, 757 policy actions in, 756–757 tariff(s). See also import tariffs escalated tariff structure, 269 nominal tariff rate, 266–270 Spain, income inequality and, 166 Special Drawing Rights (SDRs), 446, 446n, 535 in central bank reserves, 535, 749 defined, 737 development of, 737–738 in IMF quota, 738 special interest groups, impact on political economics, 361–364 specialization complete, 33 extent of export concentration and, 31 gains from, 89 vertical specialization-based trade, 186–188 specific-factors model (SF model), 143–148, 327, 330 specific tariffs, 259, 263–264 specificity principle, 376 speculation, 709–714 defined, 470 destabilizing, 709–714 in foreign exchange, 470, 709–714 stabilizing, 711–714 Spencer, Barbara J., 333, 349 Spilimbergo, Antonio, 97 spillovers, and economic growth, 212 sporadic dumping, 336 spot market, 472–480 different measures of spot rate and, 474–480 expected spot rate, 488 forward exchange rates and, 480–481 principal actors in, 473 purchasing power parity (PPP) exchange rates and, 482–483 role of arbitrage in, 473–474 Srinivasan, T. N., 198 Stability and Growth Pact (1997), 742 stabilizing speculation, 711–714 stack contracts, 524 stage theory described, 188 new venture internationalization, 187, 188 stagflation, 696, 697 Staiger, Robert W., 156 Standard International Trade Classification (SITC) system, 31, 194, 196 standardized-product stage, 176 startup problem, of currency boards, 718 State Grid, 232 state-owned enterprises (SOEs), 228 static effects of economic integration, 389–396 of trade on economic development, 419–420 statistical discrepancy, 462 status quo bias, 362–363 steel industry labor productivity and import penetration in, 54–55 restraints on imports to U.S., 380 U.S. import tariffs and, 281 sterilization, 538, 638, 644, 646 Stern, Robert M., 52, 156–158, 371n, 375 stock markets, international, 510–512 shocks, economic—Cont. foreign interest rate, 664–668 foreign price, 661–664 oil, 112, 144, 520 in open economy macroeconomics, 685–686, 696–700 terms of trade, 101 short hedge, 522–523 short position, 483 short-run aggregate supply curve, 677 short-term assets, 451 Silva, Julie A., 168, 168n Sims, Christopher, 691n Singer, Hans W., 223 Single European Act of 1986, 402 single factoral terms of trade, 116–117 Sinopec Group, 232 skill levels, of labor, 155–157, 161–163 Slater, Joanna, 495n Slaughter, Matthew S., 162n Slotkin, Michael H., 350 small country consumer surplus in, 282–284 defined, 109 exchange rate overshooting, 548–554 export quotas in, 290 export subsidies in, 290–291 export taxes and, 288–290 factor growth in, 215–216 general equilibrium analysis, 303–306 impact of trade policies in, 282–291, 303–306 import quotas, 285–286 import tariffs, 282–285, 303–306 shifts in offer curve, 110–111 Smith, Adam, 16, 20, 22–24, 27–29, 56 Smith, David, 383n Smoot–Hawley Tariff of 1930, 366 social policy, trade policy in, 321–330, 364–366 softwood lumber, 287, 381–382 Solomon, Robert, 669 Solow, Robert M., 132, 132n South Asian Association for Regional Cooperation (SAARC), 392 South Korea antidumping orders, 337–338 in Asian crisis (1997-1998), 751 dynamic comparative advantage and, 176 economic growth in, 204 free trade agreement, 410 labor migration from, 244 Southern African Customs Union (SACU), 392 Southern Cone Common Market ( MERCOSUR), 392, 411–412 Southern Minnesota Beet Sugar Cooperative, 310 Soviet Union, former currency boards in, 717–718 eurodollar market and, 502–503 Leontief paradox and, 156 moving toward market economy in, 399–403 Spahn, Paul Bernd, 758 Final PDF to printer INDEX 801 app9062x_idx_784-808 801 06/23/16 07:14 PM general conclusions on, 396–397 nature of, 389–390 trade effects of consumption growth, 206–208 of economic growth, 204–208 terms-of-trade effect, 115 Trade Expansion Act of 1962, 367–368 trade policy. See also economic integration; United States trade policy arguments for interventionist, 321–356 automobiles in, 272, 274 Baldwin’s framework for analyzing, 366 comparative advantage and, 341–356 conduct of, 384–385 in developing countries, 41 differential protection as part of, 330 effect on domestic prices, 277 export taxes and subsidies, 270–271 impact of, 281–319 exports, 288–291, 299–303 imports, 282–287, 292–297, 303–310 in large-country case, 291–297, 306–310, 314–318 other effects, 309–311 in small-country case, 282–291, 303–306 import tariffs in, 259–270 instruments of, 257–277 (See also specific instruments of trade policy) international policy distortions and, 335–341 miscellaneous invalid arguments for, 341 nontariff barriers, 271–277 to offset market imperfections, 331–335 political economy of, 360–366 self-interest approach to, 361–364 in social policy objectives, 321–331, 364–366 strategic, 341–356 vignettes, 360 world attitudes to foreign trade, 362 Trade Promotion Authority, 372 trade-related intellectual property rights (TRIPs), 274, 372–373 trade-related investment measures (TRIMs), 273, 372–373 trade restrictions in general equilibrium, 303–309 trade triangle, 89, 102–104 trading line, 89 trading partners, 91–92 traditional foreign bank lending, 501 Trans-Pacific Partnership (TPP), 412 transactions demand for international reserves, 707 transfer pricing, 240 transformation, marginal rate of (MRT), 79, 89 transition economies euro changeover in, 744 exchange rate trends in, 558 stock market performance in, 511–512 transition problem, of currency boards, 718–719 transitivity, 64 income, 116, 117 indexes of, 112–113, 117 for major groups of countries (1973–2010), 112–113 measurement of, 110 in neoclassical trade theory, 10–121 shocks related to, 100 single factoral, 116–117 for specific countries, 221–222 tariff reaction function and, 352–355 trade triangle and, 89, 102 terms-of-trade argument, 325–327 terms-of-trade effect, 115 Terra, Cristina, 160 textile industry import quotas on China, 380 Multi-Fiber Agreement, 372–373, 376, 381 NAFTA and, 404 nonhomogeneous goods in, 314 trade complexities and, 41 Thailand, terms of trade in, 222 Theory of Moral Sentiments, The (Smith), 23 Theory of the Consumption Function, A (Friedman), 713 Thursby, Jerry G., 180, 705 Thursby, Marie C., 180, 705 Tieslau, M. A., 180 Tinbergen, Jan, 188 Tobin, James, 758–759 Tobin tax, 759 Tokarick, Stephen, 289, 289n Tokyo Round of trade negotiations (GATT), 271, 367–371 tomato imports, 365 Tomson, Bill, 311n Topel, Robert H., 169n Total, 248 total factor requirements, Leontief paradox and, 151–153 total gains from trade, 32–33, 90 total revenue, in monopolistic competition, 200–202 Touzlatzi, Hasan, 243 Tower, Edward, 96 Toyota Motor, 232 Trade Act of 1974, 335, 368 trade adjustment assistance (TAA), 95, 368, 370, 410 Trade Adjustment Assistance Act of 2011, 370 Trade Adjustment Assistance Reform Act of 2002, 368 Trade and International Economic Policy Reform Act of 1987, 19 trade creation in the European Community (EC), 392–393 general conclusions on, 396–397 trade deficits macroeconomic interpretation of, 325–327 in merchandise trade balance, 453 U.S., 460–461 trade diversion in the European Community (EC), 392–393 Tariff Act of 1930 (Smoot-Hawley), 366, 730–731 tariff factories, 233 tariff negotiations, 355 tariff reaction function, 352–355 tariff to benefit a scarce factor of production, 329–330 tariff to extract foreign monopoly profit, 333–334 tariff to improve balance of trade, 324–325 tariff to increase employment in specific industry, 328–329 tariff to offset a foreign subsidy, 336–341 tariff to offset foreign dumping, 335–336, 380–381 tariff to promote exports through economies of scale, 347 tariff to promote exports through research and development, 347–349 tariff to reduce aggregate unemployment, 327 Tatemoto, Masahiro, 157 taxes. See also export tax impact of foreign direct investment on, 239 Interest Equalization Tax (IET), 503, 523–524 international tax on spot transactions, 758 as key source of government revenue, 322, 323 offshore centers and, 506–507 open-economy multiplier and, 614–615 tax relief for U.S. firms engaged in export, 380–381 value-added tax (VAT), 272–273 Taylor, Alan M., 499, 499n Taylor, Mark P., 545, 558–560, 726, 744 technology effects of technological change on growth, 60, 208–212 imitation lag hypothesis and, 174–175 impact of foreign direct investment on, 239 labor-saving technological changes, 208–209 marginal rate of technical substitution (MRTS), 72–73 product cycle theory (PCT) and, 175–179 relative skill levels of labor and, 161–163 in Ricardian model, 27 technology cycle, in product cycle theory (PCT), 178 Tejada, Carlos, 380n Templin, Neal, 274n terms of trade alternative, 103–104 as argument for trade protection, 325–327, 352–355 changes in, 101, 107–111 commodity (net barter), 110, 240 defined, 29–30 double factoral, 118 equilibrium, 30, 105–106 in Heckscher–Ohlin (H–O) model, 128–132 impact of growth on, 215–221 Final PDF to printer 802 INDEX app9062x_idx_784-808 802 06/23/16 07:14 PM balance-of-payments summary statement, 459–463 beef exports in, 380 with China, 258, 380–381, 460–461 concluding observations on, 384 countervailing duties in, 339–340 domestic content provisions of, 272 effects of trade restrictions on, 85 European instability and U.S. GDP, 666 exchange rate pass-through of foreign exports to, 577 exchange risk and, 705–706 export performance relative to U.K., 51–53 export subsidies of, 270 foreign direct investment by, 229–232, 234–235, 463–466 foreign direct investment in, 230–233 General Agreement on Tariffs and Trade (GATT) and, 366–373 Generalized System of Preferences (GSP), 259–264, 330, 366, 368 hegemony of, 366 import quotas of, 301, 310, 380–381 import tariffs of, 155, 261–264, 281 income distribution changes with increased trade in, 97 international cartels and, 144 international investment position, 463–466 international trade, 7–9 Mercantilist, 19 merchandise trade, 459–460 monetary approach to balance of payments and, 535 motorcycle industry in, 343 policy frictions in interdependent world, 667 preferential duties and, 259 price elasticities of demand for exports and imports, 575–576 recent foreign trade actions, 380–384 restrictions on services trade, 273 softwood timber disputes with Canada, 381–382 steel industry in, 54–55, 281, 380 tariff structure of, 155, 261–274, 281 terms of trade calculation, 110 tomato imports in, 365 trade adjustment assistance in, 95 trade deficits of, 460–461 United States trade policy merchandise trade, 7–9 United We Stand, 19 unweighted-average tariff rate, 265–266 Uruguay, in Southern Cone Common Market (MERCOSUR), 392, 411 Uruguay Round of trade negotiations (GATT), 10, 274, 289, 367, 371–376, 411, 669 provisions of, 372–373 tariff reductions following, 374 trade policy issues after, 373–376 U.S. attitudes toward international trade, 363 U.S. Census Bureau, 164, 164n flexible exchange rates in, 731–732 labor and capital requirements per unit of output, 209–210 labor strikes in, 248 largest corporations and banks, 232 preferential duties of British Common wealth, 259 price elasticities of demand for exports and imports, 575–576 vertical specialization-based trade and, 186–188 United Nations Monetary and Financial Conference, 732 Standard International Trade Classification (SITC) system, 194, 196 United Nations Conference on Trade and Development (UNCTAD), 49, 50, 229–230, 237 United States. See also United States dollar; United States trade policy administrative classification, 273–274 automobile product differentiation, 194, 196–197 brain drain for developing countries and, 227, 251–252 cabotage laws, 19 commodity composition of trade, 8, 9 Heckscher–Ohlin prediction for, 152–153, 156 income and unemployment, 681–682 income distribution in, 167–171 income inequality in, 167–171 inflation and unemployment, 696, 697 labor and capital requirements per unit of output, 209–210 labor migration to, 244, 251–255 Leontief paradox and, 156 price shocks and real GDP, 662–663 recession of 2007-2008, 527 recession of 2007-2009, 751–753 relationship between monetary concepts, 535 stagflation in, 696, 697 subprime mortgage crisis, 751–753 synchronization of GDP movements across countries, 611 wage inequality in, 167 United States dollar. See also United States; United States trade policy Big Mac Index (BMI) and, 480, 480n breaking of gold-dollar link, 738–739 in exchange arrangements with no separate legal tender, 745 in IMF quota, 738 nominal and real exchange rates of, 477–478 short-run fluctuations in the 1990s and 2000s, 743–745 U.S.-Canadian exchange rates, 560 world central bank (proposed) and, 755 United States trade policy, 258, 366–384. See also North American Free Trade Agreement (NAFTA); United States; United States dollar antidumping actions in, 337–338, 381 average propensity to import, 598–599 transportation costs in Classical trade theory, 48–50 freight and insurance factor (FIF), 49–50 in Heckscher–Ohlin (H–O) model, 139–141 in intra-industry trade (IIT), 49–50, 194 transshipment strategy, 389 Treaties of Rome (1957), 399, 403 Treatise on Probability, A (Keynes), 592 Treaty for East African Cooperation, 400 Treaty of Basseterre (1983), 721 Treaty of Paris (1951), 399 Trefler, Daniel, 161–162 triangular arbitrage, 473 Triffin, Robert, 730, 736n, 754 trigger price, 335 TRIMS (trade-related investment measures), 273, 372–373 Trinh, Bui, 268, 269n TRIPS (trade-related intellectual property rights), 274, 372–373 Tsiang, S. C., 731, 732n Tuchinda, Ukrist, 180 Tuncer, Baran, 344 Turkcan, Kemal, 577, 578n UEMOA (West African Economic and Monetary Union), 392, 721 Uganda in East African Common Market (EACM), 400 worker remittances to, 249 UIP (uncovered interest parity), 489, 493, 548–554 Ujiie, Junichi, 556n ultra-antitrade consumption effect, 207 ultra-antitrade production effect, 207, 248 ultra-protrade consumption effect, 207 ultra-protrade production effect, 206 uncovered interest parity (UIP), 489, 493, 548–554 uncovered positions, 481 UNCTAD (United Nations Conference on Trade and Development), 49, 50, 229–230, 237 unemployment. See also labor current account deficit with, 612 impact of foreign direct investment on, 241 income and U.S., 681–682 inflation and, 696, 697 labor migration and, 248–252 stagflation and, 696, 697 tariffs to reduce aggregate, 327 trade adjustment assistance and, 95, 368, 370 unfavorable balance of trade, 17 unit elasticity of demand, 21, 111–116 unit labor costs, 51–53 United Kingdom average propensity to import, 598–599 Commonwealth or imperial preference, 259 effect of protection instruments on domestic prices, 276–277 export performance relative to U.S., 51–53 Final PDF to printer INDEX 803 app9062x_idx_784-808 803 06/23/16 07:14 PM reciprocal dumping model and, 185–186 of strategic government interaction, 352–355 Wellington, Duke of, 28 Wells, Louis T., Jr., 177 Wessel, David, 383n, 670n West African Economic and Monetary Union (WAEMU/UEMOA), 392, 721 Westphal, Larry E., 344 White, Roger, 253, 254n Whitt, Preston, 407n wider bands, 722–723 Willett, Thomas D., 641n Williams, Walter, 311n Williamson, Elizabeth, 381n, 411n Williamson, John H., 719n, 756–757 Wilson, Edward, 376n, 378n Winestock, Geoff, 281n, 380n Winkelmann farming group, 242–243 Wohar, Mark E., 558 Wood, Adrian, 169–170 worker remittances, 248–249 World Bank, 157, 323, 506, 733 “Aid for Trade” and, 379–380 immigration remittances and, 249 origins of, 733 world central bank (proposed), 755 World Trade Organization (WTO), 360 “Aid for Trade” and, 379–380 antidumping provisions, 336, 337, 339 conduct of trade policy, 384 countervailing duties, 339–340 Doha Development Agenda, 367, 377–379 European border taxes, 272–273 European Union (EU) and, 353, 373–376 government procurement provisions on, 271–272 most-favored-nation status and, 260 national sovereignty and, 377 new venture internationalization and, 187 origins of, 10, 260, 373 recent U.S. trade actions, 380–384 value-added tax (VAT), 272–273 Yang, Jiawen, 577 YEM (income elasticity of import demand), 208, 392–394, 596–567 Yeyati, Eduardo Levy, 647n Yi, Kei-Mu, 170, 186 Yilmaz, K., 716n Zacharakis, Andrew L., 188 zero-sum game defined, 16–17 under Mercantilism, 16–17, 23 Zlowe, David, 549n Zoellick, Robert, 360 Végh, Carlos A., 607, 607n VER (voluntary export restraints), 271, 274, 299, 301, 306–309, 366, 369, 372 Vernon, Raymond, 175–177, 177n vertical specialization-based trade, 186–188 Veugelers, Reinhilde, 234 vicious circle hypothesis, 703, 750 Vietnam, nominal and effective tariffs, 268–269 Viner, Jacob, 390, 394 Vlachos, Jonas, 160 voluntary export constraints (VER), 271, 274, 299, 301, 306–309, 366, 369, 372 Vousden, Neil, 363 Wacziarg, Romain, 438, 438n WAEMU (West African Economic and Monetary Union), 392 wage rate limits, 42–45 defined, 43 in monetized Ricardian model, 44 wage rates effect of changes in, 46–47 foreign direct investment and, 239 inequality in U.S., 167–171 labor migration and, 248–252 specific-factors model, 143 Wahl, Donald F., 157 Wal-Mart Stores, 232 Walker, Marcus, 248n Wall, Howard J., 85 Wall Street Journal, 383, 486, 495 wallet file, 760 Walsh, Carl E., 715 Walters, Alan, 713n Wang, Chengang, 189 Wang, Hua, 235 Wang, Kai-li, 706 Warsh, David, 621n wealth under Mercantilism, 18 in monetary approach to balance of payments, 536 in portfolio balance approach to balance of payments, 538 Wealth of Nations, The (Smith), 22, 23, 28 Wei, Yingqi, 189 weighted-average tariff rate, 265 Weinstein, David E., 151, 151n, 161, 163 Welch, Karen Horn, 438, 438n welfare effects community indifference curves and, 96 of economic growth, 221–224 of economic integration, 392–396 of export subsidy in large country, 302–303, 318–319 of export tax in large country, 300–301 of import quota in large country, 298–299, 301 of import subsidy in small country, 287 of import tariff in small country, 284–285 optimum tariff rate and, 325–327, 352–355 U.S.-Central America/Dominican Republic Free Trade Agreement (CAFTA-DR), 409–410 U.S.-Colombia Trade Promotion Agreement (CTPA) of 2011, 409 U.S. Customs Service, 273, 274 U.S. Department of Agriculture, 582 U.S. Department of Commerce, 166, 336, 337, 339, 343, 353, 365, 381 Bureau of Economic Analysis, 166 U.S. Department of Defense, 272 U.S. Department of Labor, 370 U.S. Department of Transportation, 19 U.S. Federal Reserve, 473, 504–505, 515, 518, 535 relationships between monetary concepts, 535 U.S. generalized system of preferences, 263–264 U.S. International Trade Commission (USITC), 281 antidumping provisions, 336–338 countervailing duties in the U.S., 339–340 effects of sugar quota system, 310 export taxes and subsidies, 270–271, 271n impact of liberalizing import restraints, 301 import competition, 289, 368 import quotas, 271, 271n industry employment effects of trade liberalization, 328 infant industries, 343 offshore assembly provisions, 260 protecting markets with nonhomogeneous goods, 313–314 welfare costs of U.S. import quotas and VERS, 301 U.S.-South Korea Free Trade Agreement of 2012, 410 U.S. Tariff Commission, 144 U.S. tariff rates, 261–264 U.S. Trade Adjustment Assistance (TAA) Program, 410 U.S. Trade Representative, 369, 408–409 U.S. Treasury Department, 337, 339 utility cardinal, 62–63 ordinal, 62–63 Uz, Idil, 559 Vahlne, Jan-Eric, 187, 187n Valdés, Alberto, 268, 269n value-added tax (VAT), 272–273 value date, 480 Vamvakidis, Athanasios, 212, 212n Van Biesebroeck, Johannes, 56 Van Reenen, John, 53–54 Vanek, Jaroslav, 158n variable dependent, 556n independent, 556n Final PDF to printer app9062x_idx_784-808 804 06/23/16 07:14 PM Final PDF to printer app9062x_idx_784-808 805 06/23/16 07:14 PM Final PDF to printer app9062x_idx_784-808 806 06/23/16 07:14 PM Final PDF to printer app9062x_idx_784-808 807 06/23/16 07:14 PM Final PDF to printer app9062x_idx_784-808 808 06/23/16 07:14 PM Final PDF to printer Cover International Economics About the Authors Preface Brief Contents Contents CHAPTER 1 The World of International Economics Introduction, The Nature of Merchandise Trade The Geographical Composition of Trade The Commodity Composition of Trade U.S. International Trade World Trade in Services The Changing Degree of Economic Interdependence Summary Appendix, A General Reference List in International Economics PART 1: The Classical Theory of Trade CHAPTER 2 Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo Introduction The Oracle in the 21st Century Mercantilism The Mercantilist Economic System The Role of Government Mercantilism and Domestic Economic Policy The Challenge to Mercantilism by Early Classical Writers David Hume—The Price-Specie-Flow Mechanism CONCEPT BOX 1: Capsule Summary of the Price-Specie-Flow Mechanism CONCEPT BOX 2: Concept Review—Price Elasticity and Total Expenditures Adam Smith and the Invisible Hand TITANS OF INTERNATIONAL ECONOMICS: Adam Smith (1723–1790) Summary CHAPTER 3 The Classical World of David Ricardo and Comparative Advantage Introduction Some Common Myths Assumptions of the Basic Ricardian Model TITANS OF INTERNATIONAL ECONOMICS: David Ricardo (1772–1823) Ricardian Comparative Advantage IN THE REAL WORLD: Export Concentration of Selected Countries Comparative Advantage and the Total Gains from Trade Resource Constraints Complete Specialization Representing the Ricar dian Model with Production-Possibilities Frontiers Production Possibilities—An Example Maximum Gains from Trade Comparative Advantage—Some Concluding Observations Summary CHAPTER 4 Extensions and Tests of the Classical Model of Trade Introduction Trade Complexities in the Real World The Classical Model in Money Terms Wage Rate Limits and Exchange Rate Limits CONCEPT BOX 1: Wage Rate Limits and Exchange Rate Limits in the Monetized Ricardian Framework Multiple Commodities The Effect of Wage Rate Changes The Effect of Exchange Rate Changes Transportation Costs IN THE REAL WORLD: The Size of Transportation Costs Multiple Countries Evaluating the Classical Model IN THE REAL WORLD: Labor Productivity and Import Penetration in the U.S. Steel Industry IN THE REAL WORLD: Exporting and Productivity Summary Appendix, The Dornbusch, Fischer, and Samuelson Model PART 2: Neoclassical Trade Theory CHAPTER 5 Introduction to Neoclassical Trade Theory: Tools to Be Employed Introduction The Theory of Consumer Behavior Consumer Indifference Curves TITANS OF INTERNATIONAL ECONOMICS: Francis Ysidro Edgeworth (1845–1926) The Budget Constraint Consumer Equilibrium Production Theory Isoquants IN THE REAL WORLD: Consumer Expenditure Patterns in the United States Isocost Lines Producer Equilibrium The Edgeworth Box Diagram and the Production-Possibilities Frontier The Edgeworth Box Diagram The Production-Possibilities Frontier Summary CHAPTER 6 Gains from Trade in Neoclassical Theory Introduction The Effects of Restrictions on U.S. Trade Autarky Equilibrium Introduction of International Trade The Consumption and Production Gains from Trade Trade in the Partner Country Minimum Conditions for Trade Trade between Countries with Identical PPFs Trade between Countries with Identical Demand Conditions Conclusions Some Important Assumptions in the Analysis Costless Factor Mobility Full Employment of Factors of Production The Indifference Curve Map Can Show Welfare Changes IN THE REAL WORLD: Changes in Income Distribution and Welfare with Increased Trade Summary Appendix, “Actual” versus “Potential” Gains from Trade CHAPTER 7 Offer Curves and the Terms of Trade Introduction Terms-of-Trade Shocks A Country’s Offer Curve CONCEPT BOX 1: The Tabular Approach to Deriving an Offer Curve Trading Equilibrium Shifts of Offer Curves CONCEPT BOX 2: Measurement of the Terms of Trade Elasticity and the Offer Curve IN THE REAL WORLD: Terms of Trade for Major Groups of Countries, 1973–2013 Other Concepts of the Terms of Trade Income Terms of Trade Single Factoral Terms of Trade IN THE REAL WORLD: Income Terms of Trade of Major Groups of Countries, 1973–2013 Double Factoral Terms of Trade Summary Appendix A, Derivation of Import-Demand Elasticity on an Offer Curve Appendix B, Elasticity and Instability of Offer Curve Equilibria CHAPTER 8 The Basis for Trade: Factor Endowments and the Heckscher-Ohlin Model Introduction Factor Endowments and the Heckscher-Ohlin Theorem Factor Abundance and Heckscher-Ohlin Commodity Factor Intensity and Heckscher-Ohlin IN THE REAL WORLD: Relative Factor Endowments in Selected Countries The Heckscher-Ohlin Theorem IN THE REAL WORLD: Relative Factor Intensities in Canada TITANS OF INTERNATIONAL ECONOMICS: Paul Anthony Samuelson (1915–2009) The Factor Price Equalization Theorem The Stolper-Samuelson Theorem and Income Distribution Effects of Trade in the Heckscher-Ohlin Model Conclusions Theoretical Qualifications to Heckscher-Ohlin Demand Reversal Factor-Intensity Reversal Transportation Costs Imperfect Competition Immobile or Commodity-Specific Factors IN THE REAL WORLD: Monopoly Behavior in International Trade Other Considerations CONCEPT BOX 1: The Specific-Factors Model and the Real Wage of Workers Summary CHAPTER 9 Empirical Tests of the Factor Endowments Approach Introduction Theories, Assumptions, and the Role of Empirical Work The Leontief Paradox Initial Explanations for the Leontief Paradox Demand Reversal Factor-Intensity Reversal IN THE REAL WORLD: Testing for Factor-Intensity Reversals U.S. Tariff Structure Different Skill Levels of Labor The Role of Natural Resources More Recent Tests of the Heckscher-Ohlin Theorem Factor Content Approach with Many Factors Technology, Productivity,and “Home Bias” IN THE REAL WORLD: Heckscher-Ohlin and Comparative Advantage Heckscher-Ohlin and Income Inequality IN THE REAL WORLD: Trade and Income Inequality in a Less Developed Country: The Case of Mozambique IN THE REAL WORLD: Outsourcing and Wage Inequality Summary PART 3: Additional Theories and Extensions CHAPTER 10 Post–Heckscher-Ohlin Theories of Trade and Intra-Industry Trade Introduction A Trade Myth Early Post–Heckscher-Ohlin Theories of Trade The Imitation Lag Hypothesis The Product Cycle Theory The Linder Theory Economies of Scale More Recent Alternative Trade Theories The Krugman Model The Reciprocal Dumping Model Vertical Specialization-Based Trade IN THE REAL WORLD: New Venture Internationalization Firm-Focused Theories The Gravity Model The Melitz Model and Multiproduct Exporting Concluding Comments on Post–Heckscher-Ohlin Trade Theories IN THE REAL WORLD: Geography and Trade Intra-Industry Trade Reasons for Intra-Industry Trade in a Product Category The Level of a Country’s Intra-Industry Trade Summary Appendix A, Economies of Scale Appendix B, Monopolistic Competition and Price Elasticity of Demand in the Krugman Model Appendix C, Measurement of Intra-Industry Trade CHAPTER 11 Economic Growth and International Trade Introduction China—A Regional Growth Pole Classifying the Trade Effects of Economic Growth Trade Effects of Production Growth Trade Effects of Consumption Growth Sources of Growth and the Production-Possibilities Frontier The Effects of Technological Change IN THE REAL WORLD: Labor and Capital Requirements per Unit of Output IN THE REAL WORLD: “Spillovers” as a Contributor to Economic Growth The Effects of Factor Growth Factor Growth, Trade, and Welfare in the Small-Country Case Growth, Trade, and Welfare: The Large-Country Case CONCEPT BOX 1: Labor Force Growth and Per Capita Income CONCEPT BOX 2: Economic Growth and the Offer Curve Growth and the Terms of Trade: A Developing-Country Perspective IN THE REAL WORLD: Terms of Trade of Brazil, Jordan, Pakistan, and Thailand, 1980–2014 Summary CHAPTER 12 International Factor Movements Introduction International Capital Movements through Foreign Direct Investment and Multinational Corporations Foreign Investors in China: “Good” or “Bad” from the Chinese Perspective? Definitions Some Data on Foreign Direct Investment and Multinational Corporations Reasons for International Movement of Capital IN THE REAL WORLD: Determinants of Foreign Direct Investment A Theoretical Framework for Analyzing International Capital Movements IN THE REAL WORLD: Host-Country Determinants of Foreign Direct Investment Inflows Potential Benefits and Costs of Foreign Direct Investment to a Host Country Labor Movements between Countries Seasonal Workers in Germany Permanent Migration: A Greek in Germany IN THE REAL WORLD: Migration Flows into the United States, 1986 and 2013 Economic Effects of Labor Movements Additional Considerations Pertaining to International Migration IN THE REAL WORLD: Immigrant Remittances Immigration and the United States—Recent Perspectives IN THE REAL WORLD: Immigration and Trade IN THE REAL WORLD: Immigration into the United States and the Brain Drain from Developing Countries Summary PART 4: Trade Policy CHAPTER 13 The Instruments of Trade Policy Introduction In What Ways Can Governments Interfere with Trade? Import Tariffs Specific Tariffs Ad Valorem Tariffs Other Features of Tariff Schedules IN THE REAL WORLD: U.S. Tariff Rates IN THE REAL WORLD: The U.S. Generalized System of Preferences Measurement of Tariffs IN THE REAL WORLD: Nominal and Effective Tariffs in the European Union IN THE REAL WORLD: Nominal and Effective Tariff Rates in Vietnam and Egypt Export Taxes and Subsidies Nontariff Barriers to Free Trade Import Quotas “Voluntary” Export Restraints (VERs) Government Procurement Provisions Domestic Content Provisions European Border Taxes Administrative Classification Restrictions on Services Trade Trade-Related Investment Measures Additional Restrictions Additional Domestic Policies That Affect Trade IN THE REAL WORLD: Examples of Control over Trade IN THE REAL WORLD: The Effect of Protection Instruments on Domestic Prices Summary, CHAPTER 14 The Impact of Trade Policies Introduction Gainers and Losers from Steel Tariffs Trade Restrictions in a Partial Equilibrium Setting: The Small-Country Case The Impact of an Import Tariff The Impact of an Import Quota and a Subsidy to Import-Competing Production The Impact of Export Policies IN THE REAL WORLD: Real Income Gains from Trade Liberalization in Agriculture Trade Restrictions in a Partial Equilibrium Setting: The Large-Country Case Framework for Analysis The Impact of an Import Tariff The Impact of an Import Quota The Impact of an Export Tax IN THE REAL WORLD: Welfare Costs of U.S. Import Quotas and VERs The Impact of an Export Subsidy Trade Restrictions in a General Equilibrium Setting Protection in the Small-Country Case IN THE REAL WORLD: Welfare Effects of Restrictive Rice Policies in Japan Protection in the Large-Country Case, Other Effects of Protection IN THE REAL WORLD: Domestic Effects of the Sugar Quota System Summary Appendix A, The Impact of Protection in a Market with Nonhomogeneous Goods Appendix B, The Impact of Trade Policy in the Large-Country Setting Using Export Supply and Import Demand Curves CHAPTER 15 Arguments for Interventionist Trade Policies Introduction Calls for Protection Trade Policy as a Part of Broader Social Policy Objectives for a Nation Trade Taxes as a Source of Government Revenue National Defense Argument for a Tariff IN THE REAL WORLD: The Relative Importance of Trade Taxes as a Source of Government Revenue Tariff to Improve the Balance of Trade The Terms-of-Trade Argument for Protection Tariff to Reduce Aggregate Unemployment Tariff to Increase Employment in a Particular Industry IN THE REAL WORLD: Industry Employment Effects of Trade Liberalization IN THE REAL WORLD: Costs of Protecting Industry Employment Tariff to Benefit a Scarce Factor of Production Fostering “National Pride” in Key Industries Differential Protection as a Component of a Foreign Policy/Aid Package Protection to Offset Market Imperfections The Presence of Externalities as an Argument for Protection Tariff to Extract Foreign Monopoly Profit The Use of an Export Tax to Redistribute Profit from a Domestic Monopolist Protection as a Response to International Policy Distortions Tariff to Offset Foreign Dumping Tariff to Offset a Foreign Subsidy IN THE REAL WORLD: Antidumping Actions in the United States IN THE REAL WORLD: Countervailing Duties in the United States Miscellaneous, Invalid Arguments Strategic Trade Policy: Fostering Comparative Advantage The Infant Industry Argument for Protection Economies of Scale in a Duopoly Framework Research and Development and Sales of a Home Firm Export Subsidy in Duopoly Strategic Government Interaction and World Welfare IN THE REAL WORLD: Airbus and Boeing Concluding Observations on Strategic Trade Policy Summary, CHAPTER 16 Political Economy and U.S. Trade Policy Introduction Contrasting Vignettes on Trade Policy The Political Economy of Trade Policy The Self-Interest Approach to Trade Policy IN THE REAL WORLD: World Attitudes toward Foreign Trade IN THE REAL WORLD: U.S. Attitudes toward International Trade The Social Objectives Approach IN THE REAL WORLD: Politics Puts the Squeeze on Tomato Imports A Review of U.S. Trade Policy and Multilateral Negotiations Reciprocal Trade Agreements and Early GATT Rounds The Kennedy Round of Trade Negotiations The Tokyo Round of Trade Negotiations IN THE REAL WORLD: Trade Adjustment Assistance and its Implementation The Uruguay Round of Trade Negotiations Trade Policy Issues after the Uruguay Round IN THE REAL WORLD: Tariff Reductions Resulting from the Uruguay Round IN THE REAL WORLD: National Sovereignty and the World Trade Organization The Doha Development Agenda Recent U.S. Actions Concluding Observations on Trade Policy The Conduct of Trade Policy Summary, CHAPTER 17 Economic Integration Introduction Promise and Problems of Integration Types of Economic Integration Free-Trade Area Customs Union Common Market Economic Union The Static And Dynamic Effects Of Economic Integration Static Effects of Economic Integration IN THE REAL WORLD: Economic Integration Units IN THE REAL WORLD: Trade Creation and Trade Diversion in the Early Stages of European Economic Integration General Conclusions on Trade Creation/Diversion CONCEPT BOX 1: Trade Diversion in General Equilibrium Dynamic Effects of Economic Integration Summary of Economic Integration The European Union History and Structure IN THE REAL WORLD: The East African Community Early Growth and Disappointments Completing the Internal Market U.S. Economic Integration Agreements NAFTA Effects of NAFTA IN THE REAL WORLD: Nafta—Myths vs. Facts Recent U.S. Integration Agreements Other Major Economic Integration Efforts MERCOSUR FTAA Chilean Trade Agreements APEC Trans-Pacific Partnership IN THE REAL WORLD: Asian Economic Interdependence Leads to Greater Integration Transatlantic Trade and Investment Partnership Summary CHAPTER 18 International Trade and the Developing Countries, Introduction Recovery in East Asia after Financial Crisis An Overview of the Developing Countries The Role of Trade in Fostering Economic Development The Static Effects of Trade on Economic Development The Dynamic Effects of Trade on Development Export Instability Potential Causes of Export Instability Long-Run Terms-of-Trade Deterioration TITANS OF INTERNATIONAL ECONOMICS: Raul Prebisch (1901–1986) and Hans Wolfgang Singer (1910–2006) Empirical Evidence on Trade and Development Trade Policy and the Developing Countries Policies to Stabilize Export Prices or Earnings Problems with International Commodity Agreements Suggested Policies to Combat a Long-Run Deterioration in the Terms of Trade IN THE REAL WORLD: Managing Price Instability IN THE REAL WORLD: The Length of Commodity Price Shocks Inward-Looking versus Outward-Looking Trade Strategies IN THE REAL WORLD: Emerging Connections between Asia and Africa The External Debt Problem of the Developing Countries Causes of the Developing Countries’ Debt Problem Possible Solutions to the Debt Problem IN THE REAL WORLD: The HIPC and MDRI Debt Relief Initiatives Summary, PART 5: Fundamentals of International Monetary Economics CHAPTER 19 The Balance-of-Payments Accounts Introduction China’s Trade Surpluses and Deficits Credits, Debits, and Sample Entries in Balance-of-Payments Accounting Assembling a Balance-of-Payments Summary Statement IN THE REAL WORLD: Current Account Deficits Balance-of-Payments Summary Statement for the United States IN THE REAL WORLD: U.S. Trade Deficits with Canada, China, Japan, and Mexico International Investment Position of the United States IN THE REAL WORLD: Trends in the U.S. International Investment Position Summary, CHAPTER 20 The Foreign Exchange Market Introduction The Yen Also Rises (and Falls) The Foreign Exchange Rate and the Market for Foreign Exchange Demand Side Supply Side The Market The Spot Market Principal Actors The Role of Arbitrage, Different Measures of the Spot Rate IN THE REAL WORLD: Nominal and Real Exchange Rates of the U.S. Dollar The Forward Market IN THE REAL WORLD: Spot and PPP Exchange Rates CONCEPT BOX 1: Currency Futures Quotations The Link between the Foreign Exchange Markets and the Financial Markets The Basis for International Financial Flows Covered Interest Parity and Financial Market Equilibrium Simultaneous Adjustment of the Foreign Exchange Markets and the Financial Markets Summary, CHAPTER 21 International Financial Markets and Instruments: An Introduction Introduction International Bank Lending The International Financial Markets IN THE REAL WORLD: Interest Rates across Countries International Stock Markets Financial Linkages and Eurocurrency Derivatives Basic International Financial Linkages: A Review International Financial Linkages and the Eurodollar Market IN THE REAL WORLD: U.S. Domestic and Eurodollar Deposit and Lending Rates, 1989–2014 Hedging Eurodollar Interest Rate Risk CONCEPT BOX 1: Eurodollar Interest Rate Futures Market Quotations The Current Global Derivatives Market Summary, CHAPTER 22 The Monetary and Portfolio Balance Approaches to External Balance Introduction International Interdependence of Money The Monetary Approach to the Balance of Payments The Supply of Money The Demand for Money IN THE REAL WORLD: Relationships between Monetary Concepts in the United States Monetary Equilibrium and the Balance of Payments The Monetary Approach to the Exchange Rate A Two-Country Framework The Portfolio Balance Approach to the Balance of Payments and the Exchange Rate Asset Demands Portfolio Balance Portfolio Adjustments Exchange Rate Overshooting TITANS OF INTERNATIONAL ECONOMICS: Rudiger Dornbusch (1942–2002) Summary Appendix, Examples of Empirical Work on the Monetary and Portfolio Balance Approaches, CHAPTER 23 Price Adjustments and Balance-of-Payments Disequilibrium Introduction Price Adjustment: The Exchange Rate Question The Price Adjustment Process and the Current Account under a Flexible-Rate System The Demand for Foreign Goods and Services and the Foreign Exchange Market Market Stability and the Price Adjustment Mechanism CONCEPT BOX 1: Elasticity of Import Demand and the Supply Curve of Foreign Exchange when Demand Is Linear The Price Adjustment Process: Short Run versus Long Run IN THE REAL WORLD: Estimates of Import and Export Demand Elasticities IN THE REAL WORLD: Estimates of Exchange Rate Pass-Through IN THE REAL WORLD: Japanese Export Pricing and Pass-Through in the 1990s IN THE REAL WORLD: U.S. Agricultural Exports and Exchange Rate Changes The Price Adjustment Mechanism in a Fixed Exchange Rate System Gold Standard The Price Adjustment Mechanism and the Pegged Rate System Summary Appendix, Derivation of the Marshall-Lerner Condition, CHAPTER 24 National Income and the Current Account Introduction The Current Account and National Income The Keynesian Income Model, TITANS OF INTERNATIONAL ECONOMICS: John Maynard Keynes (1883–1946) Determining the Equilibrium Level of National Income IN THE REAL WORLD: Average Propensities to Import, Selected Countries The Multiplier Process The Autonomous Spending Multiplier IN THE REAL WORLD: Multiplier Estimates for India The Current Account and the Multiplier IN THE REAL WORLD: The Government Spending Multiplier in Developed and Developing Countries Foreign Repercussions and the Multiplier Process IN THE REAL WORLD: Historical Correlation over Time of Countries’ GDP An Overview of Price and Income Adjustments and Simultaneous External and Internal Balance IN THE REAL WORLD: Recent Synchronization of GDP Movements of Countries Summary Appendix A, The Multiplier When Taxes Depend on Income Appendix B, Derivation of the Multiplier with Foreign Repercussions, PART 6: MacroeconomicPolicy in the Open Economy CHAPTER 25 Economic Policy in the Open Economy under Fixed Exchange Rates Introduction The Case of the Chinese Renminbi Yuan TITANS OF INTERNATIONAL ECONOMICS: Robert A. Mundell (Born 1932) Targets, Instruments, and Economic Policy in a Two-Instrument, Two-Target Model General Equilibrium in the Open Economy: The Is/Lm/Bp Model General Equilibrium in the Money Market: The LM Curve General Equilibrium in the Real Sector: The IS Curve Simultaneous Equilibrium in the Monetary and Real Sectors Equilibrium in the Balance of Payments: The BP Curve IN THE REAL WORLD: The Presence of Exchange Controls in the Current Financial System Equilibrium in the Open Economy: The Simultaneous Use of the LM, IS, and BP Curves The Effects of Fiscal Policy under Fixed Exchange Rates The Effects of Monetary Policy under Fixed Exchange Rates The Effects of Official Changes in the Exchange Rate IN THE REAL WORLD: The Historical Rise and Fall of a Currency Board—The Case of Argentina Summary Appendix, The Relationship between the Exchange Rate and Income in Equilibrium, CHAPTER 26 Economic Policy in the Open Economy under Flexible Exchange Rates Introduction Movements to Flexible Rates The Effects of Fiscal Policy under Flexible Exchange Rates with Different Capital Mobility Assumptions CONCEPT BOX 1: Real and Financial Factors That Influence the BP Curve The Effects of Monetary Policy Under Flexible Exchange Rates with Different Capital Mobility Assumptions Policy Coordination under Flexible Exchange Rates The Effects of Exogenous Shocks in the Is/Lm/Bp Model with Imperfect Mobility of Capital IN THE REAL WORLD: Commodity Prices and U.S. Real GDP,1972–2014 IN THE REAL WORLD: European Instability and U.S. GDP IN THE REAL WORLD: Policy Frictions in an Interdependent World IN THE REAL WORLD: Macroeconomic Policy Coordination: The Imf,the G-7/G-8,and the G-20 Summary Appendix,Policy Effects, Open-Economy Equilibrium, and the Exchange Rate under Flexible Rates, CHAPTER 27 Prices and Output in the Open Economy: Aggregate Supply and Demand Introduction Crisis in Argentina Aggregate Demand and Supply in the Closed Economy Aggregate Demand in the Closed Economy Aggregate Supply in the Closed Economy Equilibrium in the Closed Economy IN THE REAL WORLD: U.S. Actual and Natural Income and Unemployment Aggregate Demand and Supply in the Open Economy Aggregate Demand in the Open Economy under Fixed Rates Aggregate Demand in the Open Economy under Flexible Rates The Nature of Economic Adjustment and Macroeconomic Policy in the Open-Economy Aggregate Supply and Demand Framework Shifts in the Aggregate Demand Curve under Fixed and Flexible Rates The Effect of Monetary and Fiscal Policy on the Aggregate Demand Curve under Fixed and Flexible Rates Summary Monetary Policy in the Open Economy with Flexible Prices Currency Adjustments under Fixed Rates Fiscal Policy in the Open Economy with Flexible Prices Economic Policy and Supply Considerations IN THE REAL WORLD: Economic Progress in Sub-Saharan Africa External Shocks and the Open Economy IN THE REAL WORLD: Inflation and Unemployment in the United States, 1970–2014 Summary, PART 7: Issues in World Monetary Arrangements CHAPTER 28 Fixed or Flexible Exchange Rates? Introduction Exchange Rate Experiences Central Issues in the Fixed–Flexible Exchange Rate Debate IN THE REAL WORLD: Exchange Risk and International Trade IN THE REAL WORLD: Reserve Holdings under Fixed and Flexible Exchange Rates TITANS OF INTERNATIONAL ECONOMICS: Milton Friedman (1912–2006) IN THE REAL WORLD: “Insulation” with Flexible Rates—The Case of Japan Currency Boards Advantages of a Currency Board IN THE REAL WORLD: Currency Boards in Estonia and Lithuania Disadvantages of a Currency Board Optimum Currency Areas IN THE REAL WORLD: The Eastern Caribbean Currency Union and Other Monetary Unions Hybrid Systems Combining Fixed and Flexible Exchange Rates Wider Bands Crawling Pegs Managed Floating IN THE REAL WORLD: Colombia’s Experience with a Crawling Peg Summary, CHAPTER 29 The International Monetary System: Past, Present, and Future Introduction Monetary System Uncertainties IN THE REAL WORLD: Confidence in Exchange Rates Under the Gold Standard IN THE REAL WORLD: Flexible Exchange Rates in Post–World War I Europe: The United Kingdom,France, and Norway The Bretton Woods System The Goals of the IMF The Bretton Woods System in Retrospect Gradual Evolution of a New International Monetary System Early Disruptions Special Drawing Rights The Breaking of the Gold–Dollar Link and the Smithsonian Agreement The Jamaica Accords The European Monetary System Exchange Rate Fluctuations in Other Currencies in the 1990s and 2000s Current Exchange Rate Arrangements Experience under the Current International Monetary System The Global Financial Crisis and the 2007–2009 Recession Suggestions for Reform of the International Monetary System A Return to the Gold Standard A World Central Bank CONCEPT BOX 1: A World Central Bank within a Three-Currency Monetary Union The Target Zone Proposal Controls on Capital Flows Greater Stability and Coordination of Macroeconomic Policies across Countries IN THE REAL WORLD: The Emergence of a New Currency: Bitcoin International Monetary Arrangements and the Emerging/Developing Countries Summary, References for Further Reading Index 2016-08-01T19:57:13+0000 Preflight Ticket Signature

Running head: FINANCIAL STATEMENTS OF “XYZ”

1

FINANCIAL STATEMENTS OF “XYZ”
3

Financial Statements of Chosen Company by the Student

Student’s Full Legal Name

Westcliff University

BUS 710: Finance for Managers

Professor: Dr. Alex Sherm

May 15, 2019

Financial Statements of Chosen Company by the Student

Introduce material here… Remember, each case study must have the heading listed below and must be answered according to instructions; each heading is worth a percentage of each case grade. This is how I want your paper turned in. Your audience is someone like your roommate – intelligent, educated, but has NO IDEA what the case study is about (Bealey, 2016)

This is generally one paragraph. The easiest way to explain this section is to think of it like an abstract or introduction. This section, if written properly, can actually act as the abstract for this paper. It will, in a sense, set up the rest of the paper, which is the review of the case, analysis, recommendations, and the summary and conclusions sections. Remember that when you get information from the textbook, you should cite Beasley, Myers, and Allen (2016). You should NOT write “According to the textbook,” as your reader has NO IDEA who or what is that.

If there is a second paragraph, it will look like this. The paper should be written in third person narrative. I do not want to see you writing in the first person (or use the second person). Note: I have bolded suggested headings that you can use for the paper. Please, keep bolded. One other note: a business is an “it,” not a “they.” Remember that when you use pronouns describing a business.

Review/Analysis of the Case

In this section, you will briefly describe what you will cover. It should only take a few sentences.

Working Capital, and WC of Company “XYZ”

Note: I do not want to see headings written as questions or you asking questions within the paper. You will put your response to the first question here, but in essay format. I want you to answer here to this question “Explain what is working capital, and what is WC of your company?”

Value a stock, and Stock Value of company “XYZ”

Note: I do not want to see headings written as questions or you asking questions within the paper. You will put your response to the second question here, but in essay format. I want you to answer here to this question: “How do you value a stock, and what is Stock Value of chosen your company?”

The Four Cause-Related Marketing Consumer Segments’ Responses Angry Birds

Note: I do not want to see headings written as questions or you asking questions within the paper. You will put your response to the third question here, but in essay format. I want you to answer here to this question:

Calculate of the value, and Value of the company “XYZ”

Note: I do not want to see headings written as questions or you asking questions within the paper. You will put your response to the fourth question here, but in essay format. . I want you to answer here to this question: “How do you calculate its value, and what is Value of your company”

Also, you must provide at least eight peer-reviewed references and cite the references in the form of in-text citations in the body of the paper (i.e., the textbook and eight additional peer-reviewed sources). Again, when you reference material in your paper, you must also have in-text citations in the body of the paper for each reference. Remember, EVERY citation must correspond to a reference and EVERY reference must correspond to a citation. You CANNOT have one without the other.

Summary and Conclusions

This section will tie together all sources used for this case study, conclusions drawn from the reading and any inconsistencies. This section will generally be one to two paragraphs. Notice the paper has a continuous flow; there are no page breaks between sections. The only page breaks occur between the title page and the introduction and the summary/conclusions and the reference page. All references for the case study must appear on a separate page, see the following page for an example).

References

This section will reference all original work cited throughout the paper. The heading should appear at the top of the page and all reference material should be listed below in alphabetical order by first last name; also, the title for books is always in italic format and in sentence form. In contrast to book references, the title for articles is in sentence format, not in italic, but the name of the publisher is in italic. See examples below:

Barzani, R. S. (2014). Studying the effects of business strategies on the organization’s
performance in regards to human resources’ policies at the social security insurance
companies based. International Journal of Academic Research in Business and Social
Sciences, 4(5), 549-561.

Bealey, M. a. (2016). Principles of Corporate Finance (12 th ed.). New York, NY, USA: McHraw Hill . Retrieved May 15, 2019

Chopra, M., Munro, S., Lavis, J. N., Vist, G., & Bennett, S. (2008). Effects of policy options for

human resources for health: An analysis of systematic reviews. The Lancet, 371(9613),

668-74.

Hawkins, D., Mothersbaugh, D., & Best, R. (2015). Consumer behavior: Building marketing
strategy (13th ed.). New York, NY: McGraw-Hill

McShane, S., & Von Glinow, M. (2013). Organizational behavior (6th ed.). New York, NY:
McGraw-Hill

Mela, C., & Moorman, C. (2018). Why marketing analytics hasn’t lived up to its promise.
Harvard Business Review (online). Retrieved from: https://hbr.org/2018/05/why-
marketing-analytics-hasnt-lived-up-to-its-promise

You must also provide a reference for all sources used to support the case study. (Note: As a minimum, the textbook and eight additional peer-reviewed sources will be used and referenced.)

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