International Economics, Sixth Edition doc

Learning objectives 1 Why international economics is a separate field 7 The organization of this volume 8 Information about international economics 10 Summary of key concepts 12 Questions

International Economics,

Sixth Edition

The latest edition of International Economics improves and builds upon the popular

features of previous editions The graphs, tables and statistics are of course all updated, butalso added are improved sections on topics including:

• new developments in international trade agreements and the latest round ofinternational trade talks

• international financial crisis

• a new section on current controversies in the international monetary system

With impressive pedagogy, learning objectives and summaries, this impressive clearly writtenbook will be another winner with students of international economics and internationalbusiness

Robert M Dunn, Jr is Professor of Economics at the George Washington University,

USA

John H Mutti is Sydney Meyer Professor of International Economics, Grinnell College,

Iowa, USA

International Economics Sixth edition

Robert M Dunn, Jr.

George Washington University

John H Mutti

Grinnell College

First published 2004

by Routledge

11 New Fetter Lane, London EC4P 4EE

Simultaneously published in the USA and Canada

by Routledge

29 West 35th Street, New York, NY 10001

Routledge is an imprint of the Taylor & Francis Group

© 2004 Robert M Dunn & John H Mutti

All rights reserved No part of this book may be reprinted or reproduced

or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording,

or in any information storage or retrieval system, without permission in writing from the publishers.

British Library Cataloguing in Publication Data

A catalogue record for this book is available from the British Library

Library of Congress Cataloging in Publication Data

A catalog record for this book has been requested

ISBN 0–415–31153–5 (hbk)

ISBN 0–415–31154–3 (pbk)

This edition published in the Taylor & Francis e-Library, 2004.

ISBN 0-203-46204-1 Master e-book ISBN

ISBN 0-203-33961-4 (Adobe eReader Format)

Learning objectives 1

Why international economics is a separate field 7

The organization of this volume 8

Information about international economics 10

Summary of key concepts 12

Questions for study and review 13

Suggested further reading 13

PART ONE

2 Patterns of trade and the gains from trade: insights from classical theory 17

Learning objectives 17

Absolute advantage 17

Comparative advantage 19

Additional tools of analysis 22

International trade with constant costs 27

International trade with increasing costs 32

The effect of trade 35

The division of the gains from trade 36

Comparative advantage with many goods 41

Summary of key concepts 44

Questions for study and review 45

Suggested further reading 47

Appendix: the role of money prices 47

Notes 49

3 Trade between dissimilar countries: insights from the factor

Learning objectives 51

Factor proportions as a determinant of trade 52

Implications of the factor proportions theory 55

Empirical verification in a world with many goods 68

Summary of key concepts 70

Questions for study and review 71

Suggested further reading 72

Appendix: a more formal presentation of the Heckscher–Ohlin model with

two countries, two commodities, and two factors 73

Notes 80

4 Trade between similar countries: implications of decreasing costs and

Learning objectives 82

External economies of scale 84

The product cycle 89

Preference similarities and intra-industry trade 91

Economies of scale and monopolistic competition 94

Trade with other forms of imperfect competition 97

Cartels 101

Further aspects of trade with imperfect competition 103

Summary of key concepts 104

Questions for study and review 105

Suggested further reading 106

Appendix: derivation of a reaction curve 106

Notes 107

5 The theory of protection: tariffs and other barriers to trade 109

Learning objectives 109

Administrative issues in imposing tariffs 110

Tariffs in a partial equilibrium framework 111

Quotas and other nontariff trade barriers 116

Production subsidies 122

Tariffs in the large-country case 123

General equilibrium analysis 124

The effective rate of protection 127

Export subsidies 132

Export tariffs 134

Summary of key concepts 135

Questions for study and review 137

Suggested further reading 138

Notes 138

vi Contents

6 Arguments for protection and the political economy of trade policy 140

Learning objectives 140

Arguments for restricting imports 141

Dumping 154

Secondary arguments for protectionism 158

The political economy of trade policy 161

Summary of key concepts 163

Questions for study and review 164

Suggested further reading 165

Notes 165

Learning objectives 167

Alternative forms of regional liberalization 168

Efficiency gains and losses: the general case 168

Efficiency gains and losses with economies of scale 171

Dynamic effects and other sources of gain 172

The European Union 173

NAFTA 177

Other regional groups 181

Summary of key concepts 181

Questions for study and review 182

Suggested further reading 182

Notes 182

Learning objectives 184

British leadership in commercial policy 184

A US initiative: the Reciprocal Trade Agreements program 186

The shift to multilateralism under the GATT 187

The Kennedy Round 189

The Tokyo Round 190

The Uruguay Round 191

Intellectual property 197

The rocky road to further multilateral agreements 199

The Doha Development Agenda 200

Expanding the World Trade Organization 200

Summary of key concepts 202

Questions for study and review 202

Suggested further reading 203

Notes 203

Learning objectives 205

Contents vii

Arbitrage in labor and capital markets 206

Additional issues raised by labor mobility 210

Multinational corporations 212

Summary of key concepts 220

Questions for study and review 221

Suggested further reading 221

Notes 221

Learning objectives 223

The effects of economic growth on trade 224

Trade policies in developing countries 231

Primary-product exporters 233

Deteriorating terms of trade 235

Alternative trade policies for developing countries 236

Summary of key concepts 239

Questions for study and review 240

Suggested further reading 241

Notes 241

Learning objectives 242

Environmental externalities 244

The tragedy of the commons 249

Taxation in an open economy 251

Summary of key concepts 259

Questions for study and review 260

Suggested further reading 261

Distinguishing debits and credits in the accounts 268

Analogy to a family’s cash-flow accounts 271

Calculation of errors and omissions 273

Organizing the accounts for a country with a fixed exchange rate 274

Balance-of-payments accounting with flexible exchange rates 280

The international investment position table 281

Trade account imbalances through stages of development 285

Intertemporal trade 288

Summary of key concepts 290

viii Contents

Questions for study and review 291

Suggested further reading 291

Notes 292

Learning objectives 293

Supply and demand for foreign exchange 294

Exchange market intervention regimes 295

Exchange market institutions 300

Alternative definitions of exchange rates 302

Alternative views of equilibrium nominal exchange rates 307

Summary of key concepts 308

Questions for study and review 309

Suggested further reading 309

Notes 310

14 International derivatives: foreign exchange forwards, futures, and options 312

Learning objectives 312

Forward exchange markets 312

Foreign exchange options 321

Other international derivatives 325

Summary of key concepts 326

Questions for study and review 327

Suggested further reading 328

Notes 328

15 Alternative models of balance-of-payments or exchange-rate determination 329

Learning objectives 329

Why the balance of payments (or the exchange rate) matters 331

Alternative views of balance-of-payments (or exchange rate) determination 334

Exchange rates and the balance of payments: theory versus reality 348

Summary of key concepts 349

Questions for study and review 350

Suggested further reading 350

Notes 351

Learning objectives 352

David Hume’s specie flow mechanism 352

The Bretton Woods adjustment mechanism: Fiscal and monetary policies 364

The policy assignment model: one last hope for fixed exchange rates 369

Macroeconomic policy coordination 373

Summary of key concepts 374

Questions for study and review 375

Contents ix

Suggested further reading 375

Notes 376

17 Balance-of-payments adjustment through exchange rate changes 377

Learning objectives 377

A return to supply and demand 377

Requirements for a successful devaluation 379

Effects of the exchange rate on the capital account 391

Capital losses and other undesirable effects of a devaluation 392

A brief consideration of revaluations 396

The Meade cases again 396

Summary of key concepts 399

Questions for study and review 399

Suggested further reading 400

Capital flows, monetary policy, and fiscal policy 418

Domestic macroeconomic impacts of foreign shocks 425

Domestic impacts of monetary policy shifts abroad 426

Conclusion 427

Summary of key concepts 427

Questions for study and review 428

Suggested further reading 428

Notes 429

Learning objectives 430

Clean versus managed floating exchange rates 431

The stability of the exchange market 432

Impacts of flexible exchange rates on international transactions 433

Open economy macroeconomics with a floating exchange rate 434

The domestic impacts of foreign monetary and fiscal policy shifts with

flexible exchange rates 447

Mercantilism and flexible exchange rates 449

Purchasing power parity and flexible exchange rates 451

Summary of key concepts 452

Questions for study and review 453

x Contents

Suggested further reading 453

Notes 454

20 The international monetary system: history and current controversies 455

Learning objectives 455

Events before 1973 456

The Eurocurrency market 459

Floating exchange rates 465

Alternatives to flexible exchange rates 471

The European Monetary Union 473

Changes in the role of the SDR 478

Two decades of developing country debt crises 478

The new financial architecture 486

Sovereign bankruptcy for heavily indebted crisis countries 488

Prospective issues in international economic policy in the next decade 489

Summary of key concepts 491

Questions for study and review 492

Suggested further reading 493

Notes 494

Contents xi

1.1 Trade goods as a share of GDP in the United Kingdom 1850–1990 31.2 The role of foreign direct investment in the world economy (FDI stock

2.7 Equilibrium trade in a two-country case (increasing costs) 34

2.10 Offer curves for Countries A and B with the equilibrium barter ratio and

2.12 An empirical demonstration of the relationship between relative labor

3.6 Box diagrams for Country A Production-possibility curve for Country A 763.7 Influence of factor endowments on the production-possibility curves 78

4.1 Equilibrium in a closed economy with decreasing opportunity cost 864.2 Equilibrium with foreign trade and decreasing opportunity cost 874.3 The advantage of a long-established industry where scale economies are

4.6 The impact of free trade on prices: increased competitiveness despite

4.8 Nominal and real prices of crude petroleum, 1973–2001 (dollars per barrel) 102

4.9 A possible decline in welfare from trade with domestic monopoly 103

5.1 The effects of a tariff: partial equilibrium, small-country case 112

5.3 The effect of a subsidy: partial equilibrium, small-country case 1225.4 The effect of a tariff: partial equilibrium, large-country case 1245.5 The effects of a tariff: general equilibrium, small-country case 1255.6 The effects of a tariff: general equilibrium, large-country case 127

6.4 Dumping can increase profits – an example of price discrimination 155

11.1 Marginal benefits and marginal costs of pollution abatement 244

13.2 Nominal effective exchange rate for the dollar (1970–2003) 304

16.11 Payments adjustment through a tightening of fiscal policy 366

16.13 Adjustment of a payments deficit through expansionary fiscal policy 367

16.15 Balance-of-payments adjustment through policy assignment 37116.16 Balance-of-payments adjustments through policy assignment in the

17.1 The market for foreign exchange with a balance-of-payments deficit 378

xiv Figures

17.2 The market for foreign exchange when the local currency is devalued 379

18.3 The propensity to import and the marginal propensity to import 412

18.6 Savings minus investment and the trade balance with both at equilibrium 413

18.9 Impacts of a decline in exports and an increase in domestic investment 41618.10 Effects of an expansionary monetary policy with fixed exchange rates 42018.11 Effects of fiscal policy expansion with perfect capital mobility 42318.12 Effects of fiscal policy expansion when BP is flatter than LM 42418.13 Effects of fiscal policy expansion when BP is steeper than LM 42419.1 Effects of an expansionary monetary policy with fixed exchange rates 43919.2 Effects of an expansionary monetary policy with a floating exchange rate 440

19.4 Effects of fiscal policy expansion with perfect capital mobility 44519.5 Effects of fiscal policy expansion when BP is flatter than LM 44519.6 Effects of fiscal policy expansion when BP is steeper than LM 446

Figures xv

1.1 Exports plus imports of goods and services as a share of GNP2

6.1 Dumping cases in the United States and European Community, 1979–89 157

9.1 The role of immigrants as a share of the population or work force 206

10.3 Concentration of merchandise exports for least developed countries 234

11.2 Corporate income tax rates on US manufacturing affiliates 25711.3 Taxes on corporate income as a percentage of GDP, 1965–2000 25715.1 Impact on the domestic money supply of a balance-of-payments deficit 332

19.1 Strength of fiscal policy in affecting GNP under alternative exchange

20.3 Exchange rate regimes of IMF members as of 31 December 2001 466

xviii Tables

4.2 Further reasons for economies of scale: the learning curve 98

5.3 Super sleuths: assessing the protectiveness of Japanese NTBS 121

5.5 Effective rates of protection and the Indonesian bicycle boom 131

6.2 Another view of the optimum tariff: offer curve analysis 147

10.3 The terms-of-trade effects of growth: offer curve analysis 230

15.1 Modeling the monetarist view of the balance of payments 345

16.1 The IS/LM/BP graph as a route to understanding balance-of-payments

16.2 IS/LM/BP analysis of adjustment under the Bretton Woods system 365

18.1 Japan’s chronic current account surplus: savings minus investment 41418.2 IS/LM/BP analysis of monetary policy with fixed exchange rates 42018.3 IS/LM/BP graphs for fiscal policy under fixed exchange rates 42318.4 Impacts of an expansion abroad with extensive capital market integration 42518.5 Macroeconomics expansion abroad with little capital market integration 426

19.2 IS/LM/BP analysis of monetary policy under floating exchange rates 43919.3 IS/LM/BP analysis of fiscal policy with floating exchange rates 444

xx Boxes

12.4 International investment position of the United States 1994–2001 284

19.2 Save an auto worker’s job, put another American out of work 449

This book is an introduction to international economics, intended for students who aretaking their first course in the subject The level of exposition requires as a background nomore than a standard introductory course in the principles of economics Those who havehad intermediate micro and macro theory will find that background useful, but where thetools of intermediate theory are necessary in this book they are taught within the text.The primary purpose of this book is to present a clear, straightforward, and currentaccount of the main topics in international economics We have tried to keep the student’sperspective constantly in mind and to make the explanations both intuitively appealing andrigorous

Reactions from users of the first five editions – both students and faculty – have beenencouraging The passage of time, however, erodes the usefulness of a book in a constantlyevolving area such as international economics, and we have consequently prepared a sixthedition

The book covers the standard topics in international economics Each of the two mainparts, International Trade and Trade Policy (Part One) and International Finance and OpenEconomy Macroeconomics (Part Two), develops the theory first, and then applies it torecent policy issues and historical episodes This approach reflects our belief that economictheory should be what J.R Hicks called “a handmaiden to economic policy.”

Whenever possible, we use economic theory to explain and interpret experience That iswhy this book contains more discussion of historical episodes than do most other inter-national economics textbooks The historical experience is used as the basis for showing howthe theoretical analysis works We have found that students generally appreciate thisapproach

This is the second edition of this book with John Mutti as co-author and with Routledge

as the publisher John Mutti replaced James Ingram, who is now Emeritus at the University

of North Carolina, Chapel Hill, who authored the first two editions alone, and who authored the next two with Robert Dunn Both authors of this edition would like to expresstheir great appreciation for the help which Jim Ingram provided, including his permission

co-to carry over some material which he wrote for previous editions It would have beenimpossible to continue this project without Jim’s help, and his spirit and many of hisconcepts remain central to the book

Changes in the coverage of international trade

In the first half of the book some important changes in the presentation of conceptualmaterial should be noted, in addition to the inclusion of several more recent developments

in commercial policy and multilateral trade negotiations Chapter 3 pays greater attention

to common extensions of the Heckscher–Ohlin framework for analyzing patterns of trade

It gives a more systematic presentation of the effects on patterns of production from growth

in factor endowments, and it addresses the conditions for factor price equalization moreformally Chapter 5 extends the analysis of tariffs to consider tariff escalation and tariff-ratequotas, and it assesses US safeguard protection in the steel industry and EU export subsidiesfor sugar

Following the treatment of arguments for protection in Chapter 6, the order of the nextthree chapters changes Chapter 7 now presents the analysis of regional trade blocs Thedecision of the European Union in 2002 to offer membership to ten additional countriesraises several important issues of governance and economic policy that are discussed there.With respect to the North American Free Trade Agreement, because a longer time frame

is available to observe the consequences of its creation, the scope of adjustments faced by

US industries is put in better perspective Chapter 8 now reviews world commercial policy

It especially notes significant issues that arose in initiating the Doha Development Round

of multilateral trade talks in 2001, and it notes others that will be addressed in the tiations Chapter 9 now covers issues of capital mobility, immigration, and multinationalcorporations

nego-Chapter 10 on trade and growth pays particular attention to the position of the leastdeveloped countries Chapter 11, which discusses issues of public economics, notes theadvance of the Kyoto Protocol to the Climate Change Convention, in spite of USopposition, and the success of the Irish in international tax competition

Changes in the discussion of international finance and open economy

macroeconomics

First, all graphs and tables have been updated to what was available in early 2003 WithinChapter 12, the coverage of intertemporal trade has been moved forward from an appendixinto the main text The discussion of what assets constitute foreign exchange reserves hasbeen extended, and the discussion of the IMF format for the balance of payments accountsmade more thorough In Chapter 13 the discussion of various means of evading exchangecontrols has been made far more complete, and now includes a discussion of hawala banking.The fact that all of these techniques are relevant for criminal or terrorist groups which wish

to move money in undetected ways, makes this topic of greater importance than it was beforeSeptember 11, 2001

In Chapter 14 the discussion of foreign exchange options, which some readers found to

be confusing, has been rewritten and extended, with an emphasis on intrinsic and timevalues in determining premiums on foreign exchanged puts and calls In Chapter 16, thetreatment of currency boards has been extended, with an emphasis on why Argentina’sinstitution failed Dollarization is also covered more thoroughly Chapter 17 now includesfar more on the disastrous effects of currency mismatches when a country devalues If banksand other firms in a country have large liabilities denominated in foreign exchange withoutoffsetting foreign exchange assets of other forms of cover, a devaluation can produce a wave

of insolvencies and create something approaching a depression, as Argentina discovered veryunhappily The diagram developed by Trevor Swann to analyze a devaluation has beenadded at the end of this chapter, with the accompanying discussion emphasizing how boththe exchange rate and domestic macroeconomic policies must be adjusted to produce bothpayments equilibrium and an acceptable level of GDP In Chapter 19, the “impossibility

xxiv Preface

trinity” of “trilemma,” which is associated with Robert Mundell is introduced If a countrywishes to have a stable price level through a fixed exchange rate, an independent nationalmonetary policy, and free mobility for international capital flows, it can have any two of thethree, but not the third In theory a fixed rate and independent monetary policy are possiblethrough rigid exchange controls, but if one believes that such controls are not likely

to succeed, the options decline to two A country can have an independent monetary policy

at the cost of living with a floating exchange rate and some price instability, or it can have

a fixed exchange rate and stable prices if it gives up all monetary policy independence,perhaps through a currency board

The largest changes in the second half of the book are in what were the last two chapters.Chapter 20 in the fifth edition has been combined with Chapter 21 to produce a newChapter 20 The discussion of the history of the international financial system before 1973had to be considerably reduced in length to stay within the planned length for the book Thetreatment of the eurodollar, or eurocurrency, market has, however, been fully retained The section on the history of floating exchange rates has, of course, been updated to early

2003 The European Monetary Union, which is now in full operation, is covered far morethoroughly than was the case in the previous edition The main change in this chapter,however, is in the discussion of developing country debt crises Less emphasis is put on theLatin American crisis of the 1980s, and far more is put on the events in Asia during 1997–9.Recent research on such crises, including the issue of crisis contagion, is covered Late in thechapter, the so-called New Financial Architecture is introduced, with the Basel I andproposed Basel II accords Sovereign bankruptcy for heavily indebted developing countries,

as proposed by Anne Krueger at the IMF, is also introduced The chapter closes with a list

of likely international policy issues during the next decade Some of those issues are carriedover from the fifth edition, but a number of them are new Finally, the Glossary has beenupdated and new terms have been added

Instructors’ options for the use of this book

Those instructors using this book for a full-year course can cover the entire volume andassign a supplementary book of readings Those who choose to use this book for a one-semester (or one-quarter) course will probably want to eliminate some chapters The corechapters are 2 through 7, and 12 through 19 For a one-semester chapter emphasizing trade,Chapters 1 through 11 provide a compact, self-contained, unit For a one-term course empha-sizing international finance and open economy macroeconomics, Chapter 1 and Chapters

12 through 20 are the appropriate choice

In writing this book, we have accumulated a number of obligations: to our students andcolleagues, and to international economists too numerous to mention whose work is drawnupon in preparing a textbook such as this We also gratefully acknowledge the economicseditors and outside reviewers both at Wiley and at Routledge: for the second edition,Maurice B Ballabon of Baruch College, Elias Dinopoulos of the University of California atDavis, Geoffrey Jehle of Vassar College, Marc Lieberman of Vassar College, Don Shilling

of the University of Missouri, and Parth Sen of the University of Illinois at Champaign/Urbana; for the third edition, Robert Gillispie of the University of Illinois at Champaign/Urbana, Henry Goldstein of the University of Oregon, Gerald Lage of Oklahoma StateUniversity, Robert Murphy of Boston College, William Phillips of the University of SouthCarolina, and Henry Thompson of Auburn University; for the fourth edition, Ron Schramm

of Columbia University, John Carlson of Purdue University, Wayne Grove of the College

Preface xxv

of William and Mary, Oded Galor of Brown University, Chong Kip of Georgia StateUniversity, Chi-Chur Chao of Oregon State University, Zelgian Suster of the University ofNew Haven, Mark Shupack of Brown University, Paolo Pesenti of Princeton University,and Francis Lees of St John’s University; for the fifth edition, Keith Bain of the University

of East London, Christopher Dent of the University of Lincoln and Humberside, MiroslavJovanovic of the Economics Commission for Europe, United Nations, Jean-Claude Léon ofthe Catholic University of America, Richard Schatz of the Nanjing University, China, andHouston Stokes at the University of Illinois at Chicago We would like to thank ProfessorRonald Shone of Stirling University in the United Kingdom, and Walter Vanthielen ofLimburg University in Belgium for their help in reviewing drafts of this edition

Finally, we thank users of the first five editions of the book who made useful commentsand suggestions

Robert M Dunn, Jr.George Washington University

Washington, DCJohn H MuttiGrinnell CollegeGrinnell, IowaJuly 2003

xxvi Preface

1 Introduction

Although world trade shrank in 2001 as a result of economic recession in the largesteconomies, a general characteristic of the entire post-World War II period has been aremarkable expansion of trade In fact, global trade and investment has grown much morerapidly than output The process of globalization has left ever fewer countries isolated orunaffected by worldwide economic conditions outside their own borders While some protestthe destruction of traditional ways of life and the challenge to national sovereignty caused

by greater trade and investment, others note that trade and investment have been engines

of growth that allow rising standards of living

What explains this expansion of global commerce? Tariffs have fallen substantially Latin

American countries that in the past avoided multilateral trade organizations such as the

General Agreement on Tariffs and Trade (GATT) have become members, a signal of their

commitment to a different approach to trade Former communist states and many countries

in the developing world whose previous goal was to be self-sufficient have become activetraders Transportation and communication costs have continued to fall, making it lessexpensive to reach foreign markets Consumer incomes have risen, and correspondingly,their demand for variety and foreign goods has risen Rapid technical change generates newproducts whose innovators aggressively seek new markets Multinational corporations, ratherthan produce complete products in a single plant or country, have located stages of theproduction process where the inputs necessary at that stage are cheaper Many host countries

Learning objectives

By the end of this chapter you should be able to understand:

• the extent to which international trade in goods and services and internationalcapital flows have increased more rapidly than output over the past several decadesfor the world as a whole;

• why barriers to the free flow of goods, labor, and capital are central to the study ofinternational trade;

• why separate currencies and national business cycles are central to the study

of international finance;

• how information about international economic events is available from a variety

of sources, including the Internet

now seek out rather than penalize such investment These are just some of the reasons thatthe globalization process shows no sign of reaching a plateau

Yet, this process is not proceeding at the same pace everywhere The figures in Table 1.1suggest why this trend has been particularly newsworthy in the United States Trade in goodsand services as a share of national output more than doubled in the past 30 years, from 11percent in 1970 to 26 percent in 2000 Perhaps the US rate of increase appears large becausethe country started from a small initial base In the case of Canada, however, in spite of thefact that the country was much more reliant on trade in 1970, the increase in its trade/outputratio from 43 percent to 86 percent represents an even bigger change in the share of theeconomy attributable to trade For most European economies, a similar expansion of tradeoccurs Surprisingly, the Japanese figure has changed little Does this signify an advantage toJapan as being less subject to external shocks, or does it represent a lost opportunity to gainfrom the type of trade enjoyed by other advanced nations? We hope succeeding chaptersprovide insights into the various questions raised in this introductory chapter

Other important trends also appear in these figures For developing countries such as

Korea and Malaysia that have relied upon export-led growth in recent decades, the ratio

of trade to national output is higher than for other developing countries, and it has grownover the past 30 years We might initially puzzle over the figures for Malaysia, which show

a trade to output ratio that exceeds 100 percent The explanation rests on the rapid rise ofimports of intermediate goods that are assembled into products for export; while the outputterm in the denominator depends upon the income generated in the process of assemblinggoods, the trade term in the numerator includes the value of inputs produced elsewhere, andthat has increased even more quickly

Prior to 1991 India pursued a strategy of import substitution, based on the goal of

becoming self-sufficient and avoiding dependence on a few primary exports The larger thecountry, the more feasible the goal, and the figures in Table 1.1 suggest that some countrieshave held trade to a comparatively small share of their economies Has this turned out to be

a strategy that has effectively protected those economies from major swings in economicfortunes, and has it required any sacrifice in how rapidly their standard of living grows?

Countries such as Mexico have faced major financial crises over this period and havechanged policies These changes were not simply political pronouncements that were easilyreversed Rather, Mexican trade liberalization during the 1980s shows up in a rapid increase

in the role of trade from 26 percent in 1985 to 64 percent in 2000 More gradual ization, as in the case of China, still demonstrates a pattern substantially different from that

liberal-of India

These trends are noteworthy, but we should not automatically conclude that this ence represents a major aberration compared to the past Figure 1.1 shows UK experienceover a longer period, tracing out the ratio of imports plus exports of goods to GDP from 1850

experi-to 1990 Current figures do not represent a peak, but rather a return experi-to a degree of opennessthat existed prior to the devastating effects of depression and war The pattern for the UnitedStates is similar, but the increase in trade since 1970 has been even more marked Theexpansion of the post-war period is significant, but the view that in earlier times economieswere more sheltered from the outside influence of trade is simply inaccurate

The composition of trade, however, has changed At the start of the post-war period,agricultural trade fell and manufactures rose as a share of total trade Those trends have con-tinued at a slower pace over the past 25 years A more recent phenomenon has been theexpansion of trade in services, such as banking, insurance, telecommunications, trans-portation, tourism, education and health care; they have grown faster than trade in goods.That change has not had a uniform effect across countries, either Even within the threelargest developed economies, a different picture emerges For example, between 1985 and

1997 the United States’ net exports of services rose by $74 billion, while its net imports

of goods rose by $77 billion Conversely, over that same period, Japan’s net exports of goodsrose by $37 billion while its net imports of services rose by $44 billion In the case ofGermany, net exports of goods rose by $64 billion and net imports of services rose by $34billion While all three countries may seem similar because they are net exporters of high-technology products and their producers often compete against each other in internationalmarkets, the pattern of trade in goods versus services should serve as a warning against anypresumption that industrialized countries as a bloc have identical production patterns andtrading interests

0.303

0.425 0.440

0.494

0.352 0.418

0.452

0.459 0.465

Figure 1.1 Trade in goods as a share of GDP in the United Kingdom 1850–1990.

Source: B.R Mitchell, International Historical Statistics, Europe 1750–1993, 4th edn, (London, Macmillan Reference

Ltd, 1998).

Another major aspect of the globalization process has been the explosion of internationalinvestment Economists refer to one category of this investment as “foreign direct invest-ment.” This label applies when multinational corporations control how assets are used.Generally it is motivated by longer-run considerations, because such investments cannot

be easily reversed in the short run Figure 1.2 shows that a traditional image of investment

by multinational corporations (MNCs) being dominated by a few developed countries is

no longer very accurate Such investments now come from companies headquartered in avariety of developed countries and even some developing countries Also, they do not flow

in one direction only, with a country being only an importer or only an exporter The UnitedStates, for example, is not simply an important source of foreign direct investment in othercountries, but also a major recipient of investment by MNCs based in other countries Somecountries appear to discourage such inflows that entail foreign control, as in the case of India,Japan, and Korea, while others, such as Malaysia, appear to encourage such inflows as a way

to gain access to technology and marketing networks Countries such as Brazil and Mexicoappear to have changed both their receptiveness and their attractiveness to foreign investorsover the past two decades What explains these variations across countries?

An even larger share of international investment is accounted for by purchases and sales of stocks and bonds and by deposits and loans from financial institutions when one ofthe parties to the transaction is a foreigner Often, the time horizon that motivates suchinvestments is quite short and the volatility of such investment flows has given them the

26.8 27.9

30.9

11.1

1.5 0.2

22.6 5.5

4.7

30.6 13

2.5

0 10 20 30 40 50 60 70 Mexico

India Malaysia Korea Germany Japan UK Canada US

In

1980

21.1 1.8

20.6 3.1

pejorative label “hot money.” Financial liberalization has allowed the growth of such flows

to accelerate, as national capital markets become integrated into a world market wheresavers have many more options regarding the assets they acquire Critics of globalization faultthe rapid pace at which financial markets in developing countries have been liberalized,because it has occurred without adequate supervision Not only have banking systems beenadversely affected by rapid increases and decreases in the availability of funds from abroad,but national governments face more constraints over the way they conduct macroeconomicpolicy

In part, the expansion of capital flows can be attributed to changing economic stances and government policies For example, the rapid rise in oil prices that the OPEC

circum-cartel achieved in the 1970s led to a major increase in international financial

inter-mediation Major petroleum exporting countries such as Saudi Arabia were able to depositlarge amounts of funds in banks in industrialized countries, who in turn recycled or lent them

to developing countries In the 1980s, Japanese regulations of financial institutions wereliberalized to allow them to acquire foreign assets, just at the time the United States ran largegovernment budget deficits and attracted large capital inflows In the 1990s, however,Japanese economic recession, bad loans and near bankruptcy of many financial institutionsslowed the rapid expansion of its capital flows in the earlier decade Many developingcountries and transition economies experienced large inflows of private capital in the 1990s,which often came from countries such as Germany or the United States, even though thosecountries themselves were net borrowers internationally

Table 1.2 reports balance-of-payments measures of three categories of capital flows: directinvestment, already examined in Figure 1.2; portfolio investment, applicable when foreignbuyers of stocks or bonds have no management control; and other investment, whichincludes operations of banks and other financial institutions Consider first the total figures.Aside from Japan, they indicate that the rate of growth of international capital flows wasmuch greater than the rate of growth of trade in goods over all of the decades shown Forexample, in Germany and the United Kingdom trade flows measured in dollars increased by

a factor of five over the decade, but capital flows started from a small base and rose by a muchgreater multiple In the United States, the same pattern can be observed, although it is not

as pronounced

Table 1.2 also demonstrates that while portfolio investment rose in importance, the role

of banks and other financial institutions remains a dominant factor The fact that these four countries have both large capital inflows and large capital outflows likely indicates that they play a role as intermediaries of international investment flows, accepting deposits fromsources that seek security and making loans to riskier borrowers How should such risk-taking

be regulated, and who should bear the consequences of failed loans?

These snapshots of aggregate inflows and outflows from major economies do not quately reflect the rapidity with which capital flows can shift from one country to another,thereby affecting the value internationally of a country’s currency (its exchange rate), stan-dards of living, and the competitive positions of goods produced in different locations Also, we have said nothing of the way macroeconomic policies in individual countries mayaffect incentives to invest in a country and influence the exchange rate, or the freedom thatcountries have in determining those policies

ade-In the 1950s and 1960s, for example, capital flows were often regulated but exchange rateswere fixed; countries were not free to pursue any domestic monetary policy that they chose

if they were to maintain a stated exchange rate In the 1990s, exchange rates were no longerfixed between many countries, but capital flows internationally were much less restricted

1 – Introduction 5

Because of that greater capital mobility, countries still faced constraints on the type ofmacroeconomic policy they pursued For example, a country may have little freedom to fight

a recession by following an expansionary fiscal policy, if any tendency for interest rates

to rise results in a capital inflow that causes its currency to appreciate and reduce foreigndemand for its goods

Additionally, events outside the borders of a country can have a significant impact on its economic performance and policy choices For example, recession in Europe in 1992slowed Japanese and US recovery at that time Financial turmoil in Asia and in Russia in1997–8 gave industrialized countries an incentive to pursue more expansionary macro-economic policies to spur domestic demand

An asymmetry in the international financial system exists because the US dollar plays therole of a reserve currency Other countries can acquire reserves by selling more goods andassets to the United States than they buy from it When the European Union introducedthe euro in January 1999, many expected it to challenge the role of the US dollar as thedominant reserve currency Weakness of the euro after its introduction, however, meant thatthis challenge did not materialize during the first four years of its existence

Why international economics is a separate field

International trade theory and domestic microeconomics both rest on the same assumptionthat economic agents maximize their own self-interest Nevertheless, there are importantdifferences between domestic and foreign transactions Similarly, international finance isclosely tied to domestic macroeconomics, but political borders do matter, and internationalfinance is far more than a modest extension of domestic macroeconomics The differencesbetween international and domestic economic activities that make international economics

a separate body of theory are as follows:

1 Within a national economy labor and capital generally are free to move among regions;this means that national markets for labor and for capital exist Although wage rates may

differ modestly among regions, such differences are reduced by an arbitrage process in

which workers move from low- to high-wage locations There are even smaller ences in the return to financial capital across regions because investors have lower costs(the price of a postage stamp) of moving funds from one location to another As a result,domestic microeconomic analysis generally rests on the assumption that firms competing

differ-in a market pay comparable wages and borrow funds at comparable differ-interest rates.International trade is quite different in this regard Immigration laws greatly limit the arbitraging of wage rates among nations, so that wage rates differ sharply across theworld Labor in manufacturing can be hired in Sri Lanka for 40 rupees per hour Industrialwages in the United Kingdom, including fringe benefits, are typically over £11 per hour,implying a ratio of the UK to the Sri Lankan wage rate of about 30:1 Although capitalflows among nations more easily than does labor, exchange controls, additional risks,costs of information, and other factors are sufficient to maintain significant differencesamong interest rates in different countries Therefore, international trade theory centers

on competition in markets where firms face very different costs

2 There are normally no government-imposed barriers to the shipment of goods within

a country Accordingly, firms in one region compete against firms in another region of

the country without government protection in the form of tariffs or quotas Domestic

microeconomics deals with such free trade within a country In contrast, tariffs, quotas,

1 – Introduction 7

and other government-imposed barriers to trade are almost universal in internationaltrade A large part of international trade theory deals with why such barriers are imposed,how they operate, and what effects they have on flows of trade and other aspects ofeconomic performance

3 Domestic macroeconomics normally deals with monetary and fiscal policy choices thataddress cyclical economic fluctuations that affect the country as a whole With onecurrency used throughout the country, establishing a different monetary policy orinterest rate for different regions is not possible While there are differences acrossregions in the way central government spending is allocated and in the location ofinterest-sensitive industries, essentially fiscal and monetary policies that exist in onepart of the country also prevail in other parts

International finance, or open economy macroeconomics, is about a very differentsituation Different countries have different business cycles; the significance of strikes,droughts, or shifts in business confidence, for example, regularly differs across countries.Because some countries may be in a recession while others enjoy periods of economicexpansion, they generally choose different monetary and fiscal policies to address thesecircumstances These differences in macroeconomic conditions and policies amongcountries have major consequences for trade flows and other international transactions.The second half of this book, which deals with international finance, discusses theseissues

4 A country normally has a single currency, the supply of which is managed by the centralbank operating through a commercial banking system Because a New York dollar is thesame as a California dollar, for example, there are no internal exchange markets orexchange rates in the United States

International finance involves a very different set of circumstances There are almost

as many currencies as there are countries, and the maintenance of a currency is typicallyviewed as a basic part of national sovereignty The choice of eleven European nations

to give up some of this sovereignty in forming the European Monetary Union andlaunching the euro in 1999 represents a remarkable political achievement Internationalfinance is concerned with exchange rates and exchange markets, and the influence ofgovernment intervention in those markets

The organization of this volume

This book is divided into two broad segments, the first of which deals with internationaltrade, and the second with international finance Chapters 2 to 4 examine alternativeexplanations of the pattern of trade among countries and the potential economic gains fromtrade We pay particular attention to differences in technology, the availability of capital,

labor and other factors of production, and the existence of economies of scale, all of which

are important determinants of trade

Chapters 5 and 6 assess the consequences of policies to restrict international trade andconsider possible motivations for protectionist policies that are chosen Some policydecisions that affect international trade are taken unilaterally by a single country, but oftenthese choices are made by several countries acting together Chapter 7 treats preferentialtrade agreements, a form of trade liberalization that favors members of a trade bloc but dis-criminates against nonmembers Chapter 8 addresses multilateral trade agreements, tracingprogress since the 1930s to establish nondiscriminatory rules for international trade and toreduce trade barriers

8 International economics

Chapter 9 extends the basic framework for analyzing trade in goods to treat trade in factorservices, including capital flows, labor migration and the operations of multinational corpo-rations Chapter 10 considers the relationship between international trade and economicgrowth, and includes an analysis of trade and investment policies particularly relevant todeveloping countries Chapter 11 recognizes that devising an efficient trade policy whileignoring the existence of other national and international distortions may leave a countryworse off, and therefore it addresses areas where domestic policy choices over environmentalregulation and government taxation have important implications for the design of tradepolicy.

The treatment of international finance begins with Chapter 12 and continues throughthe remainder of the book It begins with a discussion of balance-of-payments accounting.Chapters 13 and 14 discuss foreign exchange markets Initially we focus on the relationshipbetween what is occurring in the balance-of-payments accounts and events in exchangemarkets, and then consider in more detail the financial instruments, commonly referred to

as derivatives, that have resulted in greater interdependence among national financialmarkets

Chapters 12 to 16 focus on the problem of balance-of-payments disequilibria, primarilyunder the assumption of a fixed exchange rate This early emphasis on a regime of fixedexchange rates may seem strange because countries such as Britain, Japan, and the UnitedStates do not attempt to maintain fixed exchange rates among their currencies This organ-izational approach has been adopted for two reasons First, the vast majority of the countries

of the world do not have fully flexible exchange rates, but instead maintain some form ofparity or very limited flexibility More important still, students find it much easier to under-stand a fixed exchange rate system than a regime of floating exchange rates Once studentsunderstand the problems of balance-of-payments disequilibria and adjustment under fixedexchange rates, they will find it much easier to learn how a flexible exchange rate systemoperates

Chapter 17 discusses changes in otherwise fixed rates, that is, devaluations and tions Chapter 18 deals with open economy macroeconomics for countries with fixedexchange rates The theory of flexible exchange rates is then covered at some length inChapter 19, with particular emphasis on open economy macroeconomics in such a setting.Chapter 20 applies the previously developed theory to historical and current events

revalua-A glossary follows Chapter 20 The first time a word in the glossary appears in the text it

is printed in bold type Readers encountering terms in the text that are unclear should refer

to the glossary for further help The inclusion of a glossary and a detailed index is intended

to make this book useful to readers long after a course in international economics has beencompleted

This book is designed for students whose previous exposure to economics has been limited

to a two-semester principles course, but it also attempts to teach the theory of internationaleconomics with some rigor Each chapter begins with a statement of learning objectives

to alert you to the main ideas to be covered in it At the end of the chapter we include

a summary of key concepts, a set of questions to give you practice in explaining concepts andapplying principles presented in the chapter, and suggestions for further reading Some ofthe tools of intermediate microeconomics and macroeconomics are presented in the text andare used to treat international issues Offer curves and Edgeworth boxes are introduced inthe trade theory chapters, and the IS–LM model, modified to include the balance ofpayments, is taught in the international finance chapters These analytical tools are treated

in self-contained sections separate from the main text Students and instructors who wish to

1 – Introduction 9

omit these entirely self-contained sections can do so, because the main text is designed to

be understood without necessary reference to this material However, the student will gain

a fuller understanding of the theory by working through these graphical explanations

A web site that students have found useful in supplementing material presented here

is maintained by Professor A.R.M Gigengack of the University of Groningen, theNetherlands, at http://www.eco.rug.nl/medewerk/gigengack

Information about international economics

A course in international economics will be both more enjoyable and better understood if

an attempt is made to follow current events in the areas of international trade and finance.Both areas are full of controversies and are constant sources of news We note here someuseful sources of current information, some of which are available through the Internet Inmany cases they provide extensive access to the most current publication without requiring

a user subscription

(daily newspaper)

(a weekly magazine)

The New York Times http://nyt.com/

(financial section, daily newspaper)

The Wall Street Journal http://online.wsj.com/

(daily, international news in section 1,

market data in section 3)

Important sources of current and historical statistics in the areas of international trade andfinance are given below We first list international organizations, which compile comparableinformation for a broad range of countries and issue regular reports These agencies oftenprovide working papers on selected topics that can be downloaded; they usually charge forelectronic access to their data

Bank for International Settlements • Annual Report

• http://www.bis.org/wnew.htm

International Monetary Fund • Annual Report

• http://www.imf.org/ • Balance of Payments Statistics Yearbook

• Direction of Trade Statistics

• Government Finance Statistics Yearbook

• International Financial Statistics Organization for Economic Cooperation

and Development • Main Economic Indicators

• Revenue Statistics of OECD Countries United Nations • International Trade Statistics Yearbook

• http://www.unctad.org/ • Monthly Bulletin of Statistics

10 International economics

• http://unstats.un.org/unsd/mbs/ • World Investment Report

• Trade and Development Report World Bank (International Bank for • Finance and Development (quarterly, by the

Reconstruction and Development) IMF and the World Bank)

• http://www.worldbank.org • World Development Report (annual)

• World Tables (annual)

• Global Development Finance (annual) World Trade Organization • Annual Report

• http://www.wto.org • International Trade Statistics

• Country Trade Policy Reviews

• Dispute Resolution Activity

In its statistics directory, the WTO site provides links to national statistical offices Weinclude some common ones here:

US data sources and agency reports that are particularly relevant for internationaleconomists are:

Bureau of Labor Statistics http://www.bls.gov/

(Export and import price indices)

US Bureau of the Census http//www.census.gov/

(Trade and balance of payments data)

Federal Reserve Board http://www.federalreserve.gov/releases/

(Exchange rates and financial flows)

US Department of Commerce, http://www.ita.doc.gov/

International Trade Administration

(Trade data, unfair trade cases)

US Department of State, (Country http://www.state.gov/www/issues/economic/

Reports: Economic Policy and Trade trade_reports/

Practices)

US International Trade Commission http://www.usitc.gov/

(Investigations and trade cases)

A particularly useful compilation of international data for 1950–92 on real output andprices, created by Professors Heston and Summers of the University of Pennsylvania, isaccessible in a form that allows you to download data and view it graphically:

1 – Introduction 11

Penn World Tables http://datacentre.chass.utoronto.ca:5680/pwt/Commercial investment houses often provide current financial information and analysis.For example:

Many non-profit organizations or “think tanks” publish studies on international economicissues Groups in this category include:

The Brookings Institution http://www.brook.edu

The Center for Economic Policy http://www.cepr.org/home_ns.htm

Research

The Institute for International http://www.iie.com

Economics

Summary of key concepts

1 Since 1970 international trade in goods and services has grown faster than nationalincome in most industrialized countries The pattern among developing countries ismore mixed, but since 1980 trade has become more important to a larger number ofdeveloping countries

2 Foreign direct investment has grown more rapidly than national income in mostindustrialized countries since 1980 Other capital flows have grown rapidly, too, due tothe liberalization of government restrictions previously imposed on them

3 In a world with complete factor mobility and free trade, there would be less reason tostudy international trade as a separate field Because it is costly to move labor, capital,and technology internationally, international economists study the incentives for trade

in goods that exist, as well as government intervention to influence these trade patterns

4 In a world with a single currency and economic shocks that affected all parts of theworld equally, there would be less reason to study international finance as a separatefield Because economic shocks have different impacts on individual countries, andgovernments often choose to maintain their own currencies to help address thoseshocks, international economists study the way exchange rates between currencies aredetermined and the effectiveness of macroeconomic policy in an open economy

12 International economics

Suggested further reading

For a collection of accessible articles by leading economists that elaborate many of the issuesaddressed in this textbook, see:

• King, Philip, International Economics and International Economic Policy, a Reader, 3rd edn,

New York: McGraw-Hill, 1999

A concise and sharply worded critique of many popular but misleading pronouncementsabout international economics is:

• Krugman, Paul, Pop Internationalism, Cambridge, MA: MIT Press, 1996.

For debate over globalization issues as framed by economists, see:

• Bhagwati, Jagdish, The Wind of the Hundred Days, Cambridge, MA: MIT Press, 2000.

• Rodrik, Dani, Has Globalization Gone Too Far? Washington, DC: Institute for

International Economics, 1997

• Stiglitz, Joseph, Globalization and its Discontents, New York: Norton, 2002.

1 – Introduction 13

Questions for study and review

1 Table 1.1 shows that trade plays a bigger role in smaller economies such as Irelandand the Netherlands than in larger economies such as Germany, Japan, and theUnited States What do you think explains such differences? Why is a smallcountry less likely to be self-sufficient?

2 In 2000 exports as a share of gross national income were 31 percent in Israel and

88 percent in Ireland Both countries have populations less than 7 million Whatother factors might explain the different role of trade in the two countries? How

is the opportunity to trade with neighboring countries relevant to your answer?

3 In Figure 1.2, for which countries do you observe a change greater than 10percentage points between 1980 and 1999 in the value of inward foreign directinvestment as a share of GDP? a change greater than 20 percent? In 1980 overthree-fourths of foreign direct investment occurred between industrializedcountries Explain whether you would expect that number to have fallen in

2005

4 Of the four countries shown in Table 1.2, which one experienced a net outflow

of capital in 2000? Was German and UK experience more or less the same?

To evaluate the effect of capital flows on a country, in what cases might we be moreinterested in the flow of dollars, and when might we want to express this flow as ashare of the country’s income?