Solution Manual For International Economics, 18th Edition Thomas Pugel Chapter(1-25)

Solution Manual For International Economics, 18th Edition Thomas Pugel Chapter 1-25

Chapter 1 International Economics Is Different Overview The introduction to the subject of international economics has three major purposes: 1. Show that international economics addresses important and interesting current events and issues.

2. Show why international economics is special.

3. Provide a broad overview of the book.

We begin with four controversial developments that show the importance of current issues addressed by international economics.

The first controversy examines the economic effects of the global COVID-19 pandemic. The pandemic led to great harm to global health and millions of deaths. The global pandemic crisis also had global economic effects, including a swift, deep global recession in the first half of 2020. With the effects of the pandemic and the recession, international trade also collapsed, declining by 8% in 2020.

A surprising development was the difference in the declines of good trade and services trade globally. In previous global recessions, the trade decline was large for goods, especially durable goods, and small for services. But in 2020, the decline in good trade was smaller than the decline in services trade. Economists usually examine trade drivers through the demand for imports and focus on the roles of relative product prices and changes in real income. For goods, these drivers predicted a decline of 10%, but it was only 6%. For services, these drivers predicted a decline of 8%, but it was 25%.

The COVID-19 recession was different from previous recessions in many ways. Two help us to understand why the predictions from the standard demand drivers were so wrong.

Why did goods trade fall by less, even though lockdowns limited goods production and created problems for international transport of goods? The pandemic recession led to a shift in demand, away from services and toward goods, especially durable goods like electronics, furniture, and appliances. Trade in goods did not decline by as much as the standard drivers would predict.

Why did services trade fall so much? Much of the shift in demand was a very large decrease in international travel and tourism, which declined by 80% in the second quarter of 2020 and remained at that much lower level through 2021.

In a pandemic, access to medical goods is crucial. In the United States, access to imports from China became controversial. Of the four main types of medical goods, the United States was dependent on China for a large part of its total supply of personal protective equipment (PPE).

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China has a comparative advantage in producing PPE, based on its relative abundance of medium-skill workers.

How did the United States end up short of PPE as the pandemic hit in March 2020? First, the pandemic had hit China in January, and Chinese exports fell off as demand within China increased. Second, U.S. stockpiles of PPE were low, in part because U.S. tariffs imposed on imports from China in 2019 reduced U.S. buying.

With strong U.S. demand and limited supply, prices rose dramatically. That incentivized additional supply. For U.S. production, the U.S. government added subsidies to the incentives.

But, increased U.S. production was not enough. The higher prices also incentivized Chinese and other foreign export producers, and U.S. imports increased. By early to mid-2021, the global shortage of PPE was resolved.

Concerns about the availability of imports spread to other goods, especially those produced through sometimes complex global supply chains (GSCs). At their core, GSCs are also based on comparative advantage. To lower the cost of producing a final product, site each production step in its lowest cost location. The COVID-19 pandemic exposed GSCs to a range of risks including lockdowns and restrictions that cut access to components. How could production of the final products be made more resilient? Should all or most of the production steps be brought back (―reshored‖) to a firm’s main country? Each business manages its supply chain risks, and most GSCs turned out to be more resilient than many initially feared. (An exception was automobiles, because the auto firms could not regain their access to enough semiconductors.) Reshoring sounds like a way to reduce risk, but it would actually concentrate risks in a single country. And, in eliminating international trade within the GSC, the gains from trade (discussed in Chapters 2– 6) would be lost.

The economic effects of the global COVID-19 pandemic crisis appear throughout the rest of the book:  The trade collapse (Chapter 2)  Export restrictions on PPE and other goods (Chapter 8)  The decline and rebound of migrant remittances (Chapter 15)  The increases in the U.S. trade and current account deficits (Chapter 16)  Financial disruptions and increased deviations from covered interest parity (Chapter 18)  A large new allocation of SDRs and expanded emergency lending by the IMF (Chapters 20 and 21)  U.S. inflation rates first declined then went much higher (Chapter 22)  The U.S. fiscal response and the effects on private saving and government dissaving (Chapter 24)  Investors’ ―dash for cash‖ in March 2020 and the expansion of central bank liquidity swaps (Chapter 24)  The EU suspension of national fiscal policy rules and its first large unionwide fiscal policy (Chapter 25)

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The second controversy arises from international migration, especially the increasingly vehement complaints about immigrants in many of the major receiving countries. In these countries, a rather large (10% or more) and rising percentage of the population is foreign-born, including many who are undocumented. Opponents accuse immigrants of causing general economic harm, imposing fiscal costs as immigrants use government services, and increasing crime. International economics is often about emotional issues like immigration, yet we do our best to use economic analysis to think objectively about actual economic effects. In a preview of the analysis of Chapter 15, we highlight two key conclusions about the effects of immigration on the receiving country. First, as with many issues in international economics, there are both winners and losers in the receiving country. Second, we can determine the net effect on the receiving country. As we often conclude when we examine freer international exchange, the net national effect of immigration is positive according to the basic economic model, in this case even if we ignore the gains to the immigrants themselves.

The third controversy is about Britain’s exit from the European Union (EU). A slim majority of U.K. voters in 2016 voted to leave the EU. While proponents of ―remain‖ stressed the economic benefits of being part of the EU, proponents of ―leave‖ stressed the need to reassert national control in such areas as business regulation and control of immigration. After the controversial vote, the process of leaving (Brexit) brought new controversies, because the vote itself said nothing about the relationship that Britain would have with the EU after Britain separated. A ―hard Brexit‖ would reassert British sovereignty but would be very disruptive to businesses and markets. A ―soft Brexit‖ would be less disruptive but would mean that Britain would remain subject to many EU laws and regulations. Britain formally withdrew from EU the in early 2020, and on January 1, 2021, the EU-UK Trade and Cooperation Agreement established a free trade area for goods. Britain had pursued a hard Brexit, and the EU had agreed. One feature has continued to be controversial. To prevent a hard border on the Irish island, Northern Ireland remains part of the EU’s single market. Instead, there is a customs border ―in the Irish Sea,‖ dividing the United Kingdom.

Chapter 12 presents the economics of a free trade area, as well as the evolution of the EU from a customs union toward a single market and increasing economic union. Nontariff barriers, which remain and are important in the new EU-UK free trade area, are discussed in Chapter 9.

The fourth controversy is the exchange rate value of the Swiss franc. Many countries are skeptical of the exchange rate policies used by other countries, because exchange rates have effects that cross national boundaries, especially effects on relative prices that influence imports and exports. The United States has two laws, one more qualitative and one more quantitative, that direct the U.S. Department of the Treasury to monitor the exchange rate practices of other countries. These laws have seldom been used, but in late 2020 the Treasury Department concluded that the Swiss government was a currency manipulator. How did Switzerland, a wellregarded high-income, low-risk country, come to be so labeled?

Before September 2011, Switzerland’s exchange rate policy was managed floating, and the exchange rate with the euro was key to Swiss international price competitiveness. With the beginning of euro crisis in March 2010, international investors shifted their investments to safe havens, including Switzerland. The Swiss franc appreciated against the euro, with the Swiss central bank sometimes intervening in the foreign exchange market to resist this appreciation.

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When the euro crisis intensified in mid-2011, the Swiss government shifted to a one-sided pegged exchange, in which the franc could not appreciate past 1.2 Swiss francs per euro. This worked well until early 2015. Under renewed pressure for appreciation, the Swiss government decided to shift back to a managed float (a very messy exit from the pegged rate). The Swiss central bank then intervened, sometimes in large amounts, to stabilize the franc–euro exchange rate, including in 2020, when again international investors sought safe havens as the global COVID-19 pandemic crisis hit. The large Swiss interventions to prevent the franc from appreciating were part of the evidence cited by the U.S. Treasury Department.

In the controversy over the Switzerland’s exchange rate policy, we can see many issues that we will examine in the second half of the book, including a country’s balance of payments (Chapter 16), foreign financial investment (Chapters 18 and 19), exchange rate policy (Chapters 20 and 25), and exchange rates in macroeconomic analysis (Chapters 22–24).

These four controversies show that international economics addresses important current issues.

They also can be used to show why international economics is special—why national boundaries matter in economics. The first reason that international economics is special is that some resources do not move freely between countries. Land is essentially immobile. There are substantial impediments to the movement of labor internationally, as we see in the analysis of international migration, because of the personal and economic costs to people of moving from one country to another, and because of restrictive government policies. Financial capital moves more freely, but there still seems to be a home bias to many people’s financial investments.

The second reason that international economics is special is that national government policies matter—in fact, they matter in two ways. One way is that national governments can adopt and change policies toward international transactions, as we see in in the decision by the UK government to leave the EU. The other way is that national governments adopt different economic policies. These national policies usually are designed to serve national interests, but they often have international effects. We see the tension between national interests and international effects in the discussion of Switzerland’s exchange rate policy.

Tips for teaching One good way to begin the first class session is with a look at current events, even before the mechanics and requirements of the course are presented. The instructor might use the day’s newspaper (for instance, the Financial Times or Wall Street Journal) or the week’s magazine (for instance, the Economist or Business Week) to highlight a few stories related to the content of the course. We have found that this is a good way to get the students’ attention and interest.

Another good beginning would be to provide a discussion that updates one or more of the four controversies in Chapter 1. For example, the instructor could look at the most recent information about the effects of the COVID-19 pandemic and its aftermath or about the effects of Brexit.

You may want to consider beginning other class sessions of the course (not only the first class session) with a look at one or two stories in that day’s newspaper. The stories should relate in some way to the material covered in the course, but they do not necessarily have to relate to the specific material covered in that day’s session. We have found that this look at current events 5 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

reinforces the relevance of international economic analysis. It also encourages students to read good news sources and to keep up with current events. In addition, we can model critical reading, if we both summarize the article’s information and offer our own opinion or analysis (or ask the students for their opinions).

The instructor may also point out that there is a lot of information on international issues available on the Web. In additional to good newspapers, magazines, and journals that are available online, Appendix A provides a list of some important sources and sites.

One issue in teaching is to get students to ―take ownership‖ of the learning of the material. One good way to accomplish this is to get them to teach some of the material. In doing so they gain greater understanding as well as appreciation for the applicability of what sometimes sound like dry concepts and abstract issues. You may want to consider an assignment like the one that Pugel (and others at New York University) have been using successfully. It asks students working in groups to choose a topic based on current and recent events or developments and prepare and make a brief presentation to the rest of the class, during the second half of the course term. The accompanying pages under the heading ―Sample Assignment‖ show a version of this assignment.

It is good to get such an assignment set up early in the term, so that students have enough time to gather information and prepare the talk. One more thought—in evaluating each presentation, you may want to get the students in the audience involved by asking each to complete a brief evaluation form for each presentation.

Sample assignment NEW YORK UNIVERSITY Stern School of Business The Global Economy Group Presentations Each group will make a presentation to the class about one of the topics listed below. Your presentation is an opportunity to hone your research and presentation skills, to apply concepts from this course (and possibly from other courses), to attack a real issue, and to show off your creativity.

The formal presentation should last no longer than 15 min. In addition, after the presentation, you will have 5 min to take and answer questions from the class. I suggest you plan a talk that fills about 14 min to ensure that you finish within time. Going over the time limit for the presentation will result in a lower evaluation score for ―style‖ and overall assessment.

For the oral part of the presentation, all group members must be involved in speaking. One aspect of the presentation is the ability to transition from one group member to the next as each in turn makes part of the presentation.

Evaluation will be based on three criteria: 6 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

  

Informativeness: Information and data—how much did we learn from your presentation?

Analysis and interpretation: Did you effectively use concepts and relationships from the course (and possibly from other courses) to analyze and/or interpret the information that you have? Were your conclusions sound? Did we gain novel insights into the topic?

Style: Was your presentation logically structured, clear, and compelling? Were the slides effective? Did you keep within the time limit?

Above all, keep your classmates interested. If you use PowerPoint or similar slides, you should bring your presentation file to class on a USB memory stick.

Presentation Topics Choose your topic from the list below. Topics will be allocated on a first-come, first-served basis. Each topic comes with a set of indicative questions. There is some scope to modify the questions, if you think it would lead to a more interesting presentation. Just ask me first.

After you know your topic, the group should search for information and start to plan the presentation. For many topics you can find much information on the Web. With Web research, it is up to you to verify that a source is credible and accurate.

Here are the possible topics.

International Outsourcing/Offshoring of Services Beginning in the 1990s, firms in the United States and other industrialized countries increasingly shifted service activities and jobs to developing countries, especially India. How large is this type of offshoring? How large could it be in the future? Why has it been controversial in the United States? Is it different from regular international trade? Should the U.S. government limit the ability of U.S. firms to send these jobs to other countries?

Do African Countries Trade Too Little With Each Other?

Countries that are closer to each other geographically tend to trade more with each other. Does this pattern hold as strongly across Africa as it does in other areas of the world? What do the data show? To the extent that African countries tend to trade less with each other than might otherwise be expected, how large is the ―shortfall‖? Why is there less international trade within Africa? Is the problem mostly a lack of free trade areas and similar bilateral and multilateral governmental agreements? Would African countries benefit from trading more with each other?

What is the outlook for growing international trade within Africa during the next decade or so?

Locating a New Business Processing Center: India or Ghana?

A major firm in the business processing industry is looking to expand its capacity for providing call center and data entry services for its clients. It is considering locating a new facility in India, where it already has other facilities, or in Ghana, a country in which it does not currently operate.

What are the strengths and weaknesses of Ghana, relative to India, as a location for this facility?

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What could the company request from Ghana’s government if the company were to decide to locate the facility in Ghana? What would Ghana’s government agree to provide to the company?

Overall, would you recommend that the company locate its new facility in India or in Ghana?

U.S.-China Phase One Agreement In an effort to begin to resolve the U.S.-China trade war that began in 2018, a phase one agreement between the two countries entered into effect in early 2020. What was the U.S. government trying to accomplish with the agreement? What was the Chinese government trying to accomplish? What was included in this agreement? How successful was the agreement in moving toward resolution of the trade war? Do you think the United States should pursue a follow-on phase two agreement?

Carbon Border Tax Carbon border taxes have been proposed as a way to address concerns of countries that have strict policies toward greenhouse gas emissions. What is a carbon border tax? Consider the economics and environmental effects of such a tax, as well as the trade rules that member countries of the World Trade Organization have agreed to. What are the strengths (or advantages) of countries’ use of carbon border taxes? What are the weaknesses (or disadvantages) of countries’ use of carbon border taxes? Should the United States be in favor of countries’ use of carbon border taxes?

USMCA The North American Free Trade Area (NAFTA) came into existence in 1994. As a candidate for president in 2016, Donald Trump called it the worst trade deal ever. Negotiations that began in 2017 and the process of U.S. ratification in late 2019 led to the U.S.-Mexico-Canada Agreement (USMCA). What were the objectives of each of the countries in the negotiations? What are the major changes to NAFTA as it becomes the USMCA? From the point of view of economic efficiency, which of the changes increase U.S. national economic well-being? Which probably harm U.S. national well-being? Overall, what will be the net economic impact on the United States? Did the U.S. government achieve its economic and political objectives?

Trans-Pacific Partnership (TPP) In October 2015, the United States and 11 other countries announced an agreement to form the Trans-Pacific Partnership, a new regional trade agreement, and the agreement was signed (but not ratified) in February 2016. What was the TPP? What were its key elements and features?

What would have been the economics of the agreement for each of: the United States, Malaysia or Vietnam (an emerging country signatory), and a country like China (an emerging country that would not be a member)? In January 2017, President Trump withdrew the United States from the TPP. In late 2018, a slightly modified version of TPP began to operate without the United States.

From the point of view of the U.S. national interest, was Trump correct to withdraw from the TPP? Ecuador 8 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Ecuador dollarized in 2000. Why did the Ecuadorian government choose this policy? In what ways does it seem to have helped the Ecuadorian economy? In what ways has it hurt or caused problems or costs? Do you think that it was a good or bad idea for Ecuador to dollarize?

Argentina and IMF In 2018, the IMF agreed to lend Argentina’s government $50 billion. Why did Argentina seek this loan from the IMF? What terms did the IMF set for this ―exceptional access‖ arrangement?

By most reckonings the loan was a failure. What went wrong? Why did the lending program fail to meet its goals and purposes? What changes (if any) should the IMF make for its future lending to a country in a similar situation?

Sovereign Wealth Funds Some national governments use sovereign wealth funds to invest in a wide range of international financial assets. How large are these funds? What are their funding sources? Are they like other international investors? Should countries receiving their investments be concerned? How should sovereign wealth funds be regulated?

Should Hong Kong Alter Its Fixed Exchange Rate Policy?

The Hong Kong government has maintained a fixed exchange rate between the Hong Kong dollar and the U.S. dollar for more than three decades. What are the advantages and disadvantages for Hong Kong of having this exchange rate policy? If the Hong Kong government is now considering changing its policy, what are two most likely alternative exchange rate policies that the Hong Kong government could adopt in place of the current fixed value to the U.S. dollar? What are the advantages and disadvantages of each of these? What is the case for Hong Kong to continue to fix at the current value to the U.S. dollar? What is the case for Hong Kong to switch to the next best alternative policy (one of the two you have examined)?

What do think will actually happen during the next 5 years or so?

Internationalization of the RMB Until about 2010, the Chinese yuan (or renminbi) was not much used internationally. In what ways, and to what extent, has this changed? Why? What are the benefits and costs to China from greater international use of the yuan? How could China promote greater international use?

Should China do so? What do you think will happen in the next 5–10 years? When will the yuan become the equal of the U.S. dollar in international uses?

Sweden to Join the Euro Area?

Sweden could be the next country to adopt the euro and join the euro area. Does Sweden qualify to join? What are the economic and political advantages to Sweden of joining? What are the economic and political disadvantages of joining? Should Sweden join the euro area in the next few years? Do you think that Sweden actually will join the euro area in the next few years?

What Country Is Ripe for a Speculative Attack on Its Currency?

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Identify a country that you think has a substantial probability of a speculative attack on the exchange rate value of its currency, sometime during the next several years. Why do think that a speculative attack may be imminent? If a speculative attack does not occur in the next several years, what do think will be the most likely explanation for why the attack did not occur? What do you think is the probability that a speculative attack on this currency will actually occur during the next several years?

Chapter 2 The Basic Theory Using Demand and Supply Overview This chapter indicates why we study theories of international trade and presents the basic theory using supply and demand curves. Trade is important to individual consumers, to workers and other factor owners, to firms, and therefore to the whole economy. The box ―Trade Is Important‖ provides useful data about the types of products traded and the increasing role of trade in national economies.

Trade is also contentious, with perpetual battles over government policies toward trade. To understand the controversy, we need to develop theories of why people trade as they do.

It is useful to organize the analysis of international trade by contrasting a world of no trade with a world of free trade, leaving analysis of intermediate cases (e.g., nonprohibitive tariffs) for Chapter 8–14. The analysis seeks to answer four key questions about international trade: 4. Why do countries trade? What determines the pattern of trade?

5. How does trade affect production and consumption in each country?

6. What are the gains (or losses) for a country as a whole from trading?

7. What are the effects of trade on different groups in a country? Are there groups that gain and other groups that lose?

Theories of international trade provide answers to these four questions.

Basic demand and supply analysis can be used to provide early answers to these four questions, as well as to introduce concepts that can be used in more elaborate theories. Using motorbikes as an example, Chapter 5 reviews the basic analysis of both demand (the demand curve and the role of the product’s price, other influences on quantity demanded, movements along the demand curve and shifts in the demand curve, and the price elasticity of demand as a measure of responsiveness) and supply (the supply curve, the role of marginal cost, other influences on quantity supplied, movements along the supply curve and shifts in the supply curve, and the 10 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

price elasticity of supply). It pays special attention to the meaning and measurement of consumer surplus and producer surplus. This section, which focuses on review and development of basic tools, ends with the picture of market equilibrium in a national market with no trade as the intersection of the domestic demand curve and the domestic supply curve.

The remainder of the chapter examines the use of supply and demand curves to analyze international trade. If there are two national markets for a product and no trade between them, it is likely that the product’s price will differ between the two markets. Someone should notice the difference and try to profit by arbitrage between the two markets. If governments permit free trade, then the export supply from the initially low-priced market (the rest of the world in the textbook example) can satisfy the import demand in the initially high-priced market (the United States in the textbook example) and the world shifts to a free-trade equilibrium. We can show this free trade equilibrium by deriving the supply-of-exports curve for the rest of the world and the demand-for-imports curve for the United States. The international market for the product clears at the intersection of the export–supply and import–demand curves, indicating the equilibrium international or world price and the quantity traded. This equilibrium world price also becomes the domestic price in each country with free trade.

The same set of three graphs (the two national markets and the international-trade market) is used to show the effects of the shift from no-trade to free-trade on different groups in each country and to show the net gains from trade for each nation. In the importing country, consumers of the product gain consumer surplus and producers of the product lose producer surplus. Using the one-dollar, one-vote metric, the country as a whole gains, because the gain in consumer surplus is larger than the loss of producer surplus. In the exporting country producers of the product gain producer surplus and consumers of the product lose consumer surplus. The analysis shows that the country as a whole gains because the gain in producer surplus is larger than the loss of consumer surplus. Furthermore, the country that gains more from the shift to free trade is the country whose price changes more—the country with the less elastic trade curve (import–demand or export–supply).

Tips We believe that this chapter is an excellent way to introduce the analysis of trade. The four questions about trade focus student attention on key issues that are interesting to most of them.

Students then get a quick payoff through the use of the familiar supply–demand framework. By the end of this short chapter we have preliminary answers to all four trade questions. We have also laid a solid foundation for the analysis of trade using supply and demand curves, the approach that will receive the most attention in Chapter 8–14 on trade policies.

In class presentations it may be useful to show the graphs in a sequence, perhaps using a series of slides. After presenting the review of demand and supply and the national market equilibrium with no trade, the following sequence works well.

1. Two national market graphs with no trade, one with a high no-trade price (the United States), and one with a low no-trade price (the rest of the world or ROW). Question to the class: ―If you were the first person to notice this situation, could you make a profit?‖ This is a good way to motivate international trade driven by arbitrage.

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2. The U.S. national market graph and the international market graph. Question to the class: ―Let’s say that the United States is willing to open up to free trade and integrate into the world market. If it does this, the world price will also be the price within the United States.

How much will the United States want to import?‖ It depends on what the world price is. The instructor can pick one or two hypothetical world price(s) (below the no-trade U.S. price) and measure the gap between domestic quantity demanded and domestic quantity supplied. This is the U.S. demand for imports, and these import quantity–price combinations can be used to plot the U.S. demand-for-imports curve in the international market.

3. A graph of the international market and the ROW national market. A comparable discussion to Item 2 above, to derive the supply-of-exports curve.

4. Superimpose the graphs from Item 2 on the graphs from Item 3. Question to the class: ―What will happen with free trade? When there is ongoing free trade, what is the equilibrium world price?‖ This set of three graphs can be used to show the free-trade equilibrium: world price, quantity traded, and quantities produced and consumed in each country.

5. A single graph showing the U.S. national market, to contrast no trade with free trade.

Questions to the class: ―What group is made happier by the shift from no trade to free trade?

What group is a loser? Can we somehow say that the country gains or loses from free trade?‖ 6. A single graph showing the ROW national market, with the same questions in Item 5.

The next Chapters 3–7 present additional theories of trade. The figure shown on the accompanying page provides a summary of the key features of these theories. It may be useful to copy and distribute this figure to your students. If it is distributed when the class begins to study the material, it can serve as a roadmap. If it is distributed when the class finishes the sessions covering the material, it can serve as a summary and review.

For instructors who want to begin with the discussion of absolute and comparative advantage rather than with the supply-and-demand framework that focuses on a single product, this is possible. After covering the introductory material (the first two pages of Chapter 2, and, possibly, the two boxes in the chapter), the course would skip to Chapter 3. The remaining material from Chapter 2 on the supply and demand analysis can be inserted right after Chapter 4’s section referring to analysis using supply and demand curves, or this material can be presented as a separate topic elsewhere in the course.

Chapter 2 has the first of four boxes that examine aspects of the global crises of the past two decades. The box ―The Trade Mini-Collapses of 2009 and 2020‖ documents and discusses the sharp declines in international trade that resulted from the global financial and economic crisis and the global COVID-19 pandemic crisis. With the book’s coverage of these crises in the text and the boxes, an instructor can weave discussions of them throughout the course.

Suggested answer to case study discussion question Trade Is Important: For most countries during the past several decades, trade has become more important in the economy. A country’s total international trade (exports and imports) has risen as a percentage of national GDP for most countries. Whatever the effects of international trade, they have probably become larger or more pronounced. As discussed in this chapter (and subsequent chapters), some people in the country benefit from international trade, while other people in the 12 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

country tend to be harmed by international trade. If trade often creates winners and losers, then trade has probably become more controversial as it has become more important in the economy.

Suggested answers to end-of-chapter questions and problems 1.

Consumer surplus is the net gain to consumers from being able to buy a product through a market. It is the difference between the highest price someone is willing to pay for each unit of the product and the actual market price that is paid, summed over all units that are demanded and consumed. The highest price that someone is willing to pay for the unit indicates the value that the buyer attaches to that unit. To measure consumer surplus for a product using real-world data, three major pieces of information are needed: (1) the market price, (2) the quantity demanded, and (3) the slope (or shape) of the demand curve in terms of how quantity demanded would change if the market price increased.

Consumer surplus could then be measured as the area below the demand curve and above the market-price line.

2.

Producer surplus is the net gain to producers from being able to sell a product through a market. It is the difference between the lowest price at which some producer is willing to supply each unit of the product and the actual market price that is paid, summed over all units that are produced and sold. The lowest price at which someone is willing to supply the unit just covers the extra (marginal) cost of producing that unit. To measure producer surplus for a product using real world data, three major pieces of information are needed.

First, the market price. Second, the quantity supplied. Third, some information about the slope (or shape) of the supply curve. How would quantity supplied change if the market price decreased? Or, what are the extra costs of producing each unit up to the actual quantity supplied? Producer surplus could then be measured as the area below the market price line and above the supply curve.

3.

The country’s supply of exports is the amount by which the country’s domestic quantity supplied exceeds the country’s domestic quantity demanded. The supply-of-exports curve is derived by finding the difference between domestic quantity supplied and domestic quantity demanded for each possible market price for which quantity supplied exceeds quantity demanded. The supply-of-exports curve shows the quantity that the country would want to export for each possible international market price.

4.

The country's demand for imports is the amount by which the country's domestic quantity demanded exceeds the country’s domestic quantity supplied. The demand-for-imports curve is derived by finding the difference between domestic quantity demanded and domestic quantity supplied, for each possible market price for which quantity demanded exceeds quantity supplied. The demand-for-imports curve shows the quantity that the country would want to import for each possible international market price.

5.

There is no domestic market for winter coats in this tropical country, but there is a domestic supply curve. If the world price for coats is above the minimum price at which the country would supply any coats (the price at which the supply curve hits the price 13

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axis), then in free trade, the country would produce and export coats. The country gains from trade because it creates producer surplus—the area above the supply curve and below the international price line, up to the intersection (which indicates the quantity that the country will produce and export).

6.

If there were no exports of scrap iron and steel, the domestic market would clear at the price at which domestic quantity demanded equals domestic quantity supplied. But the United States does export scrap iron and steel. The extra demand from foreign buyers increases the market price of scrap iron and steel. Domestic users of scrap iron and steel pay a higher price than they would if there were no exports. Thus, some support a prohibition on these exports, in order to lower the market price of the scrap that they buy.

7.

It is true that opening trade bids prices into equality between countries. With a competitive market this also means that marginal costs are equal between countries. But ongoing trade is necessary to maintain this equilibrium. If trade were to stop, the world would return to the no-trade equilibrium. Then prices would differ, and there would be an incentive for arbitrage. The ongoing trade in the free-trade equilibrium is why prices are equalized—trade is not self-eliminating.

8. a. With free trade at $6000 per ton: Domestic consumption QD : 6, 000  16,800  6QD , or QD  1,800 thousand tons.

Domestic production QS : 6, 000  300  5QS , or Qs  1,140 thousand tons.

b.

With no imports, domestic quantity demanded must equal domestic quantity supplied (both equal to QN ) at the domestic equilibrium price PN : 16,800  6QN  300  5QN , or QN  1,500 billion tons produced and consumed.

Using one of the equations, we can calculate that the domestic price would be $7,800 per ton.

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c.

9.

Domestic producers of copper would gain, receiving an increase of producer surplus shown as area a in the graph. Domestic consumers of copper would lose, experiencing a loss of consumer surplus shown as area a + b + c in the graph.

D The demand curve DUS shifts to the right. The U.S. demand-for-imports curve m shifts to the right. The equilibrium international price rises above 1,000. It is shown by the D S intersection of the new U.S. m curve and the original x curve.

10.

The supply curve S US shifts down (or to the right). The U.S. demand-for-imports curve Dm shifts to the left (or down). The equilibrium international price decreases below D S 1,000—it is shown by the intersection of the new U.S. m curve and the original x curve.

11.

For the first country, for any world free-trade equilibrium price above $2.00 per kilogram, the country will want to export raisins. For the other country, for any world free-trade equilibrium price above $3.20 per kilogram, this other country will also want to export raisins. With only sellers (exporters) internationally and no buyers (importers) internationally, the international market cannot be in equilibrium. Instead, at this high price, there is an excess supply of raisins. As the graphs below show, at the price of $3.50 per kilogram, both countries want to export—at that price, domestic quantity supplied exceeds domestic quantity demanded for each country.

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12.

We can still use the basic analysis from this chapter, but changes in consumer surplus count for more than changes in producer surplus. We can examine this case as a deviation from the one-dollar, one-vote metric.

Does the importing country still gain from trade? For the one-dollar, one-vote metric, the importing country gains from trade because the increase in consumer surplus is larger than the loss in producer surplus. If we give more weight to the change in consumer surplus, then, yes, the importing country still gains from trade. Giving more weight to consumer well-being reinforces the net gain from trade.

Does the exporting country still gain from trade? For the one-dollar, one-vote metric, the exporting country gains from trade because the increase in producer surplus is larger than the loss in consumer surplus. If we give more weight to the change in consumer surplus, then we are no longer sure that the exporting country gains from trade. Giving more weight to consumer well-being increases the perceived size of the consumer surplus loss, relative to the size of the producer surplus gain. If consumer well-being is sufficiently more important, then we would conclude the exporting country has a net loss from trade.

13. a. With no international trade, equilibrium requires that domestic quantity demanded  QD  equals domestic quantity supplied  QS  . Setting the two equations equal to each other, we can find the equilibrium price with no trade: 350 –  P / 2    200  5 P The equilibrium no-trade price is P = 100. Using one of the equations, we find that the notrade quantity is 300. b.

At a price of 120, Belgium’s quantity demanded is 290 and its quantity supplied is 400.

With free trade Belgium exports 110 units.

c.

Belgian consumer surplus declines. With no trade it is a larger triangle below the demand curve and above the 100 price line. With free trade it is a smaller triangle below the demand curve and above the 120 price line.

16

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Belgian producer surplus increases. With no trade it is a smaller triangle above the supply curve and below the 100 price line. With free trade, it is a larger triangle above the supply curve and below the 120 price line. The net national gain from trade is the difference between the gain of producer surplus and the loss of consumer surplus. This net national gain is a triangle whose base is the quantity traded (110) and whose height is the change in price (120 – 100 = 20), so the total gain is 1,100.

14. a. In the graphs below, the free trade equilibrium price is PF , the price at which the quantity of exports supplied by Country I equals the quantity of imports demanded by Country II. (The quantity-of-imports demanded curve for Country II is the same as the country's regular demand curve.) This world price is above the no-trade price in Country I. The quantity traded with free trade is QT .

P S PF P

S

P I

a

b c

PF

XI

e c

P PF

e

NI

QT

b.

Q

D

D

DI

II

MII

Q

QT

QT

Q

In Country I producer surplus increases by area a + b + c, and consumer surplus falls by area a + b. The net national gain from free trade is area c. In Country II, consumer surplus increases by area e and this is also the net national gain from trade. Because there is no domestic production in Country II with or without trade, there is no change in producer surplus.

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A guide to the trade theories of Chapter 2–7

Name of Theory A.

The basic theory (Chapters 2–5)

B.

Supply-oriented theories of trade (special cases of the basic theory, with the demand side neutral):

1.

What Forces Determine Trade Flows?

Some Key Assumptions

Productivities Factor Supplies Product demands

Competition in all markets Constant or increasing costs Any number of production factors (types of labor, land, etc.)

Absolute advantage (in Chapter 3)

Absolute productivities

Competition in all markets Constant marginal costs Only one factor (labor)

2.

Comparative advantage (in Chapter 3)

Relative productivities

Competition in all markets Constant marginal costs Only one factor (labor)

3.

Factor proportions (Heckscher– Ohlin theory, in Chapters 4–5)

Relative factor endowments

Competition in all markets Increasing marginal costs Small number of factors Technology neutral

C.

Additional theories of trade:

1.

Monopolistic competition (Krugman and others, in Chapter 6)

Product differentiation Moderate scale economies

Imperfect competition De-emphasize factor supplies

2.

Global oligopoly (in Chapter 6)

Substantial internal scale economies History, luck, or government policy

Imperfect competition De-emphasize factor

3.

External economies (in Chapter 6)

Substantial external scale economies Large home market, history, luck, or government policy

Competition De-emphasize factor supplies

4.

Technology differences, including product cycle (Vernon and others, in Chapter 7)

Technological innovation Technological "age" of the industry

Competition Importance of research and development

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Why Everybody Trades: Comparative Advantage Overview This chapter extends the analysis of international trade to consider trade in a multiple-product economy. An economy composed of two products is useful to bring out insights about international trade. This general equilibrium approach explicitly shows the effects of resource reallocations between industries. The chapter culminates in showing the importance of comparative advantage for understanding why countries trade.

The story begins with Adam Smith and absolute advantage. (A box on mercantilism summarizes the view that Smith opposed and shows how mercantilist thinking continues today.) The analysis focuses on the productivity of labor (output per hour) in producing each of two products (wheat and cloth) in two countries (the United States and the rest of the world). Smith examined the case of absolute advantage, in which labor productivity in producing one product is higher in one country and labor productivity in producing the other product is higher in the other country. With no trade each country must produce both products to meet national demands. The discussion of the Smith case focuses on the increase in global production efficiency achieved by shifting production in each country toward the product in which it has the higher labor productivity.

National demands can be met by international trade—apparently excess supplies can be exported and apparently excess demands can be met by imports. The increase in total world production is the evidence of gains from international trade.

Smith's approach does not indicate what would happen if the same country has absolute advantage in both products. Ricardo took up this case and demonstrated the principle of comparative advantage—a country will export products that it can produce at low opportunity cost and import products that it would otherwise produce at high opportunity cost. The Ricardian example is developed in more detail. The ratio of resource costs (labor hour input–output coefficients, the inverse of labor productivities) indicates the opportunity costs or relative prices of the products in each country with no trade. The difference in prices with no trade sets up the opportunity for arbitrage, with each good being exported from the initially low-price country and imported by the initially high-price country. The shift to a free-trade equilibrium results in an equilibrium international price. Without information on demand, we cannot say exactly what this price will be, but we do know that it is in the range bordered by the two no-trade price ratios.

The chapter uses the Ricardian example to introduce a key analytical device—the production possibility curve, which shows all combinations of outputs of different goods that an economy can produce with full employment of resources and maximum productivity. The resource costs of producing each product in the country and the total amount of labor hours available in the country are used to graph the country's production possibility curve, a straight line whose slope equals the (negative of the) extra (or marginal) cost of additional cloth. The straight line indicates that the marginal or opportunity cost of each good in each country is constant, following Ricardo's assumptions. The slope of this line also indicates the relative price of cloth (the good on the x-axis) with no trade.

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If free trade results in an equilibrium international price ratio that is strictly between the two notrade price ratios (because both countries are "large countries"), then each country specializes completely in producing only the good in which it has the comparative advantage. Each trades at the equilibrium international price ratio (along a trade line or price line) to reach its consumption point. Both countries gain from trade. Each is able to consume more of both goods than it consumed with no trade.

Tips This chapter begins the full sweep of the development of thinking about comparative advantage as an explanation of the pattern of trade, starting with absolute advantage, and continuing with comparative advantage according to Ricardo. Most instructors will want to emphasize the continuity of thinking by tying this chapter closely to Chapter 4, which presents Heckscher and Ohlin's insight that comparative advantage can be based on differences in factor proportions and factor endowments. We have divided the discussion of comparative advantage into these two chapters (3 and 4), because students (especially students who find this conceptual material challenging to master) are likely to appreciate that the reading comes in more manageable sizes.

This chapter has the first of a series of boxes that ―Focus on Labor.‖ Issues of wages and work conditions are prominent in criticisms of globalization. These boxes should be of major interest to many students, as they take up these issues. The box in this chapter examines the link between (real) wages and productivity. It argues that wages in developing countries are low because labor productivity is low. This is not caused by international trade or foreign exploitation—wages will be low with or without trade. The key to raising wages and living standards is raising productivity, perhaps through education, better health, and better government policies toward labor markets. Problem 9 at the end of the chapter focuses on the calculation of real wages in a Ricardian example.

Suggested answer to case study discussion question Mercantilism: Older Than Smith—And Alive Today: Key features of mercantilism include that it places most value on domestic production and exports, that it deemphasizes domestic consumption and denigrates general imports of products, and that it views international trade as a zero-sum activity. The proponents of national competitiveness are using a version of mercantilist thinking. The emphasis is on national producers and their share of world sales. Domestic consumers who buy imports are bad because they are reducing domestic firms’ share of global sales. And, the emphasis on market share creates a zero-sum game, because the market shares must by definition total 100%.

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Suggested answers to end-of-chapter questions and problems 15.

Disagree. This statement describes absolute advantage. It would imply that a country that has a higher labor productivity in all goods would export all goods and import nothing.

Ricardo instead showed that mutually beneficial trade is based on comparative advantage—trading according to maximum relative advantage. The country will export those goods whose relative labor productivity (relative to the other country and relative to other goods) is high, and import those other goods whose relative labor productivity is low.

16.

Agree. Imports permit the country to consume more (or do more capital investment using imported capital goods). Anything that is exported is not available for domestic consumption (or capital investment). Although this loss is bad, exports are like a necessary evil because exports are how the country pays for the imports that it wants.

17.

Disagree. Mercantilism recommends that a country should export as much as it can because of the purported benefits of large exports. In its original form mercantilism argued that exports were good because the country could receive gold and silver in payment for its exports. In its modern form, exports are good because they seem to create jobs in the country. Mercantilism does not hold local consumption to be as important an objective as gold and silver (original version) or employment (modern version).

18.

If the countries trade with each other at the relative price of 1 W / C , then shifting only half way to complete specialization in production would be worse for each country than shifting to complete specialization. If the United States shifted only half way, then its new ―trade line‖ would be parallel to the trade line shown in Figure 3.1, and it would start S S from the point on the ppc that is half way between 0 and 1 . While this new trade line would allow the United States to consume at a point that had more consumption than at S the initial 0 , the United States could do even better by shifting production all the way to S points 1 and consuming along the trade line shown in Figure 3.1. Consuming at a point like C would have even more consumption than consuming at a point on the new ―halfway‖ trade line. Essentially the same reasoning can be used for the rest of the world, for a new trade line that is parallel to the rest of the world’s trade line shown in Figure 3.1, but S S that begins at a point on the rest of the world’s ppc that is half way between 0 and 1 .

19.

Using the information on the number of labor hours to make a unit of each product in each country, you can determine the relative price of cloth in each country with no trade.

With no trade, the relative price of cloth is 2W / C   4 / 2  in the United States, and it is

0.4 W / C   1/ 2.5  in the rest of the world. Using the arbitrage principle of buy low– sell high, you acquire cloth in the rest of the world, giving up 0.4 wheat unit for each cloth unit that you buy. Your profit is 1.6 (= 2.0 − 0.4) wheat units for each unit of cloth 5 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

that you export from the rest of the world. (You could also explain the arbitrage as buying and exporting wheat from the United States.)

20.

Using the information on the number of labor hours to make a unit of each product in each country, you can determine the relative price of cloth in each country with no trade.

With no trade, the relative price of cloth is 2W / C   4 / 2  in the United States, and it is

0.4 W / C   1/ 2.5  in the rest of the world. With free trade the equilibrium world price of cloth must be in the range bounded by these two no-trade prices. So, yes, it is possible that the free-trade equilibrium relative price of cloth is 1.5 W / C (1.5 is greater than 0.4, and less than 2).

21. a. Pugelovia has an absolute disadvantage in both goods. Its labor input per unit of output is higher for both goods, so its labor productivity (output per unit of input) is lower for both goods. b.

Pugelovia has a comparative advantage in producing rice. Its relative disadvantage is lower  75 / 50  100 / 50  .

c.

With no trade, the relative price of rice would be 75 /100  0.75 unit of cloth per unit of rice.

d.

With free trade the equilibrium international price ratio will be greater than or equal to 0.75 cloth unit per rice unit and less than or equal to 1.0 cloth unit per rice unit (the notrade price ratio in the rest of the world). Pugelovia will export rice and import cloth.

22. a. Moonited Republic has an absolute advantage in wine—it takes fewer labor hours to produce a bottle (10 < 15). Moonited Republic also has an absolute advantage in producing cheese—it takes fewer labor hours to produce a kilo (4 < 10). b.

Moonited Republic has a comparative advantage in cheese. The opportunity cost of producing a kilogram of cheese is 0.4   4 /10  bottles of wine in Moonited Republic, while the opportunity of a kilo of cheese in Vintland is 0.67   10 /15  bottles. Vintland has a comparative advantage in wine. The opportunity cost of a bottle of wine is 1.5 kg of cheese in Vintland, while it is 2.5 kg in Moonited Republic.

c.

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Wine

Vintland

Wine

1

Moonited Republic

2

2

NV

NM

0.8

d.

e.

When trade is opened, Moonited Republic exports cheese and Vintland exports wine. If the equilibrium free trade price ratio is ½bottle per kg, Moonited Republic will specialize completely in producing cheese, and Vintland will specialize completely in producing wine.

With free trade Moonited Republic produces 5   20 / 4  million kilos of cheese. If it exports 2 million kilos, then it consumes 3 million kilos. It consumes the 1 million bottles of wine that it imports. With free trade Vintland produces 2   30 /15  million bottles of wine. If it exports 1 million bottles, then it consumes 1 million bottles. It consumes the 2 million kilos of cheese that it imports.

Wine

Wine

Vintland

2

2

1

TV

Moonited Republic

TM

1

NV

NM 3 Cheese

2 3 Cheese f.

5

3 Cheese

1.5 3 Cheese

5

Each country gains from trade. Each is able to consume combined quantities of wine and cheese that are beyond its ability to produce domestically. The free trade consumption point is outside of the production possibility curve.

23. a. With no trade, the real wages in the United States are ½  0.5 wheat unit per hour and ¼  0.25 cloth unit per hour. The real wages in the rest of the world are 1/1.5  0.67 wheat unit per hour and 1/1  1.0 cloth unit per hour. The absolute advantages (higher

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labor productivities) in the rest of the world translate into higher real wages in the rest of the world. b.

With free trade the United States completely specializes in producing wheat. The U.S. real wage with respect to wheat remains 0.5 wheat unit per hour. Cloth is obtained by trade at a price ratio of one, so the U.S. real wage with respect to cloth is 0.5 cloth unit per hour. The gains from trade for the United States are shown by the higher real wage with respect to cloth (0.5 > 0.25). As long as U.S. labor wants to buy some cloth, the United States gains from trade by gaining greater purchasing power over cloth. With free trade the rest of the world completely specializes in producing cloth. Its real wage with respect to cloth is unchanged at 1.0 cloth unit per hour. Its real wage with respect to wheat rises to 1.0 wheat unit per hour because it can trade for wheat at the price ratio of one. The rest of the world gains from greater purchasing power over wheat.

c.

The rest of the world still has the higher real wage. Absolute advantage matters—higher labor productivity translates into higher real wages.

24.

If the number of labor hours to make a bushel of wheat is reduced by half to 1 hr, this reinforces the U.S. comparative advantage in wheat. (In fact, the United States then has an absolute advantage in wheat.) The United States is still predicted to export wheat and import cloth. If, instead, the number of hours to make a yard of cloth is reduced by half to 2 hr, this reduces the U.S. absolute disadvantage in cloth, but it does not change the pattern of comparative advantage. The relative price of cloth is now 1   2 / 2  bushel per yard in the United States with no trade, but this is still higher than the price of 0.67 bushel per yard in the rest of the world. The United States still has a comparative advantage in wheat, so the United States is still predicted to export wheat and import cloth.

25.

For the United States (left side of Figure 3.1), the new trade line still begins at the S production point 1 , and it is steeper than the initial trade line shown in the figure. The intercept of the new trade line with the horizontal axis is 50 /1.2  41.7 (rather than 50 for the initial trade line). The United States still gains from trade—it can consume more S than it can consume with no trade (at point 0 ). But the United States gains less when the world price is 1.2 W / C because the new trade line is inside of the initial trade line.

The United States is not able to consume at the initial trade-enabled consumption point C. For the rest of the world (right side of Figure 3.1), the new trade line begins at the production S point 1 and is steeper than the trade line shown in the figure. The intercept of the new trade line with the vertical axis is 100 × 1.2 = 120 (rather than 100 for the initial trade line). The rest of the world gains from trade—it can consume more than it can consume S with no trade (at point 0 ). And the rest of the world gains more when the world price is 1.2 W / C , because the new trade line is outside of the initial trade line. The rest of the world is able to consume at points on the new trade line that allow more consumption of both goods than at the initial trade-enabled consumption point C. 8

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26. a. The opportunity cost of producing a unit of Product Z is 2 units   8 / 4  of Product V. b.

With no trade the price of Product Z in the country is 2 V/Z. With free trade and the equilibrium world price of Z of 1.5 V/Z, the country will want to import Product Z. So, the country will shift toward producing (and exporting) Product V.

c.

Yes, it is possible. If the price 1.5 V/Z is an equilibrium world price for Product Z, then the other country must want to export Product Z (and import Product V). With no trade the opportunity cost of producing v in the other country is 1 (=6/6) V/Z. Because 1 V/Z is less than 1.5 V/Z, the other country will want to export Product Z.

Chapter 4 Trade: Factor Availability and Factor Proportions Are Key Overview This chapter continues the analysis of international trade in a two-product economy. It picks up from the end of Chapter 3, where it was noted that the assumption of constant marginal cost and the implication that countries will completely specialize in producing only one (or a few) product(s) are unrealistic. In the modern theory of international trade, we use the assumption of increasing marginal costs—as one industry expands at the expense of others, increasing amounts of other goods must be given up to obtain each extra unit of the expanding output. Increasing marginal cost results in a bowed-out production possibility curve. This is linked to upwardsloping supply curves for each product. Increasing marginal costs arise because some resources are better suited to producing one good rather than the other (including differences in factor input proportions between the two products—Appendix B shows this explicitly). The market price ratio determines which production point will actually be chosen. Competition drives production to levels at which the marginal (or opportunity) cost of producing another unit just equals the price at which the output can be sold. On the graph this is a tangency between the production possibility curve and the price line whose slope reflects the market price ratio.

The second key analytical tool that we need is a way to picture demand for two products at the same time. For individuals this can be done using indifference curves and income or budget lines. The chapter reviews (or summarizes) the basics of indifference curves (levels of well-being or happiness or utility, bowed shape, infinite number of which only a few are usually pictured). It then indicates that we are going to use community indifference curves, even though there are serious questions about them. At the least, they are reasonable for depicting national demand patterns for two goods simultaneously. Under certain assumptions, they also provide information on national well-being or welfare, but this use is more debatable.

Putting the production possibility curve together with the community indifference curves results in a picture of an entire (two-product) economy. The chapter shows the equilibrium with no trade (a tangency of a community indifference curve with the production possibility curve). It then shows two countries whose no-trade price ratios differ. When trade is opened between the two countries, an equilibrium international price ratio is established that clears the international 9 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

markets for the two goods. Production in each country shifts to the tangency with the new price line (whose slope shows the equilibrium international price), and each country trades along the price line to a consumption point determined by a tangency between the price line and a community indifference curve. The right-angle triangle between the production point and the consumption point is a trade triangle showing export and import quantities for each country.

(The chapter also indicates how the graph can be used to derive a demand curve for cloth, so that the analysis is shown to be consistent with the supply–demand analysis from Chapter 2.)

The graph can be used to show that each country gains from trade. Trade allows each country to consume beyond its ability to produce (shown by the production possibility curve). Trade allows each country to reach a higher community indifference curve. How much the country gains from trade depends on the country’s terms of trade—the price of its exports relative to the price of its imports. The graph also shows the effects on the production and consumption quantities for each good in each country.

The chapter ends by returning to the first of the four key questions about trade—what determines the pattern of trade. While demand differences might explain some trade, most analysis focuses on production side differences. If demand is neutral, then the trade pattern is determined by production side differences that cause no-trade price ratios to differ. In our graph, these differences skew one country’s production possibility curve toward producing wheat and the other country’s toward producing cloth. The skewness could arise for two reasons. First, production technologies or resource productivities may differ between countries. This explanation is the one used in the Ricardian approach, and we will return to it in Chapter 7. But, for the remainder of this chapter and the next chapter, we ignore technology or resource productivity differences, and instead focus on the second reason—differences in resource availability and resource use.

The skewness of production possibility curves can arise because resource availability differs between countries and the use of these factors in producing differs between products. These differences in factor endowments and factor proportions lead to the Heckscher–Ohlin theory of trade patterns—countries export the products that use their relatively abundant factors relatively intensively (and import the products that use their relatively scarce factors relatively intensively).

With no trade the abundant production factors will be cheap, so that the product that uses these factors intensively will have a low no-trade price. As trade is opened, this product is exported.

Tips This chapter begins the sweep of analysis of the Heckscher–Ohlin theory of trade, here focusing on the determinants of the product pattern of trade. Next steps are taken in Chapter 5, which develops the implications of H–O theory for the earnings power of the factors of production, Additional steps are taken in Chapter 7, which examines changes in the national availability of resource inputs.

If you use offer curves to show the determination of the equilibrium international price ratio, you can assign and cover the material in Appendix C.

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Suggested answers to end-of-chapter questions and problems 27.

Disagree. The Heckscher–Ohlin theory indicates that two countries will trade with each other because of differences in their relative endowments of the various factors that are needed to produce the products. Each country will export products that use its relatively abundant factors intensively and import products that use its relatively scarce factors intensively. Even if there are no technology differences that otherwise could drive international trade, the Heckscher–Ohlin theory indicates that the countries may still trade a lot with each other as long as there are differences in the relative availability of factor inputs between the countries.

28.

Disagree. If trade is based on Hecksher–Ohlin differences in factor availability, then international trade allows each country to make better use of its resources. Relatively land-abundant countries can shift toward producing more of the land-intensive products, and relatively labor-abundant countries can shift toward producing more of the laborintensive products. Global efficiency rises as total global production increases. This international trade is a like a positive sum game, and it is expected that each country gains from international trade in which it can exploit its Heckscher–Ohlin comparative advantage.

29.

Pugelovia has 20% of the world’s labor  20 /  20  80 , whereas it has 30%

 3 / 3  7  of the world’s land. Pugelovia is land-abundant and labor-scarce relative to the rest of the world. H–O theory predicts that Pugelovia will export the land-intensive good (wheat) and import the labor-intensive good (cloth).

30.

As shown below, for a given relative price of cloth, the quantity produced and supplied of cloth is shown by the point of tangency between the production possibility curve and a line with a slope equal to the (negative of the) relative price ratio. By varying the relative price of cloth, the quantities of cloth supplied at different relative prices can be determined, and these combinations graphed to produce a supply curve for cloth. The same procedure can be used to derive the supply curve for wheat. The quantity of wheat must be measured from the vertical axis in the production–possibility–curve graph, and the relative price of wheat is the reciprocal of the slope of the price line. (The supply curve for wheat is actually a curve, not a straight line, in this case.)

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31.

Refer to the graphs below. To derive the country’s cloth demand curve, we need to find the price line for each price ratio, and then find the tangency with a community indifference curve. The tangency indicates the quantity demanded at that price ratio. The price line has the slope indicated by the price ratio, and it is tangent to the country’s production–possibility curve. (This tangency indicates the country’s production at this price ratio.) As each price ratio is lower, the tangency with the production–possibility curve shifts to the northwest, as shown in the graph below. As the price line shifts and becomes flatter, the tangency with a community indifference curve shifts to the right.

Representative numbers are shown, with each decrease of price by 0.5 increasing quantity demanded by 10.

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32.

For price ratios below 2 bushels per yard, the country exports wheat and imports cloth.

As the price becomes lower, the quantity produced of cloth decreases and the quantity consumed of cloth increases. Thus, the quantity of imports demanded increases as the price ratio declines. (This is the downward-sloping demand-for-imports curve from Chapter 2.) As the relative price of cloth, the import good, declines (equivalently, as the relative price of wheat, the export good, increases), the country's terms of trade improve.

As the relative price of cloth declines, the country reaches higher community indifference curves, so the country's well-being or welfare is increasing.

33. a. With increasing marginal opportunity cost, Puglia’s production–possibility curve has a bowed-out shape, as shown in the graph on the next page. With no international trade, the country produces and consumes at the point at which one of Puglia’s community indifference curves  I1  is tangent to the production–possibility curve at point N. The slope of the price line at this tangency indicates that the no-trade relative price of pasta is 4.

The world relative price of pasta (3) is lower than Puglia’s no-trade relative price (4), so Puglia will import pasta. Looked at the other way, the world relative price of togas 1/ 3 is higher than Puglia’s no-trade price 1/ 4  , so Puglia will export togas. In the graph below, the price line whose slope indicates a relative price of 3 T / P is tangent to the production–possibility curve at point R. With free trade, production of pasta declines in Puglia and resources shift to producing togas. With the price line based on the relative price of 3 T / P and production at point R, Puglia chooses its consumption to reach the highest possible community indifference curve  I 2  , the one that is tangent to this price line at point V. Puglia gains from trade. One way to see this is that trade allows Puglia to consume amounts of the two products that are beyond its own abilities to produce these products (point V is outside of the ppc). Another way to see this is that Puglia reaches a higher community I I indifference curve ( 2 is better that 1 ).

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34. a. The increase in the international relative price of cloth causes the price line to be steeper S than the line anchored by point 1 . The higher relative price of cloth creates an incentive to expand cloth production, and wheat production decreases as resources are shifted toward producing more cloth. The tangency of the new steeper price line with the rest of S the world production possibility curve is at point 2 , the new production point. With S production at 2 and the new price line, the rest of the world trades to reach its new C consumption point 2 , determined by the tangency with the highest achievable I community indifference curve, 3 .

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Wheat

I2

I3

C2 C1

S1 S2 Cloth Price = Price = 1 W/C 1.3 W/C

The rest of the world exports cloth and imports wheat. The terms of trade are the international price of the export good relative to the international price of the import good. Therefore, the increase in the international relative price of cloth is an improvement in the terms of trade of the rest of the world. As shown in the graph above, as a result of this improvement in its terms of trade, the rest of the world gains well-being. The purchasing power of its exports rises, so it gains real income.

35.

In Figure 4.4A, the shape of the U.S. production–possibility curve skews toward producing wheat, and the rest of the world production–possibility curve skews toward producing cloth. The Heckscher–Ohlin theory has a specific explanation for the skew.

The United States has relatively a lot of the factor inputs (e.g., land) that are most important for producing wheat, so the United States is relatively strong at producing wheat. The rest of the world has relatively a lot of the factor inputs (e.g., labor) that are most important for producing cloth, so the rest of the world is relatively strong at producing cloth.

36. a. Production remains at

S0

, and the country can trade with the rest of the world at a price C ratio of one bushel per yard. The country's consumption shifts to point 0.5 , and the I country reaches community indifference curve 1.5 . The country gains from trade—its consumption point is outside of its production capabilities and it reaches a higher community indifference curve.

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If the country adjusts its production point to the tangency at point C1 I and reach an even higher indifference curve 2 .

S1

, it can consume at point

The trade volume grows. This is easiest to see for cloth imports. The quantity consumed of cloth increases and the quantity produced of cloth decreases, so the quantity imported of cloth increases. Because trade is balanced in both cases and the price ratio is the same (1 bushel per yard), the volume of wheat exports also increases.

37. a. They could make 7 wheat, with no cloth production.

They could make 6 cloth, with no wheat production.

The ppc is not a straight line between (6 cloth, 0 wheat) and (0 cloth, 7 wheat). Rather, it has four parts with different slopes. Here is a tour of the ppc, starting down on the cloth axis (x-axis). They could produce anything from (6 cloth, 0 wheat) up to (5, 2) by having A shift between cloth and wheat while the others make only cloth. Then they could make anything from (5, 2) up to (3, 5) by keeping A busy growing wheat and B and C busy at cloth, while D switches between the two tasks. Then they could make anything from (3, 5) up to (2, 6) by choosing how to divide C’s time, keeping B in wheat making and A and D in cloth. Finally, they could make anything between (2, 6) and (0, 7) by varying B’s tasks while the others make cloth.

Study this result to see how the right assignments relate to people’s comparative advantages.

Note that, with four different kinds of comparative advantage, there is a bowed-out curve with four slopes. In general, the greater the number of different kinds of individuals, the smoother and more bowed out the curve. Therefore, we get an increasing-cost ppc for the nation, even if every individual is a Ricardian constant–cost type.

38.

Firms in industries that obtain key inputs through complicated, longer term contracts benefit from a national legal system that leads to strong enforcement of contracts. In a country with a weak legal system in which contracts are poorly enforced, the firms in 16

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these industries incur higher costs because they cannot rely on contracts to reliably deliver such inputs. We have an analog of the Heckscher–Ohlin theory based on differences in national legal systems rather than on differences in national factor endowments. A country with a relatively strong legal system for contract enforcement will export products produced using key inputs obtained through complicated, longerterm contracts, and the country will import products produced using key inputs obtained through simpler purchasing arrangements.

Chapter 5 Who Gains and Who Loses From Trade?

Overview This chapter has two major purposes. First, it examines the implications for factor incomes of trade that follows the Heckscher–Ohlin (H–O) theory. Second, it examines the empirical evidence on the Heckscher–Ohlin theory and some of its implications.

The implications of H–O trade for factor incomes follow from the pressures for changes in production levels as a country shifts from no trade to free trade. The export-oriented sector tries to expand production, as the relative price of the exportable good increases. The importcompeting sector shrinks its production, as the relative price of the importable good decreases. In the short run, production factors cannot move easily between sectors. Therefore, in the short run, many or all factors employed in the export industry benefit from strong demand for their services and gain income. In the short run, many or all factors employed in the import-competing industry suffer from reduced demand for their services and lose income.

In the long run, the period of time that is emphasized by the Heckscher–Ohlin approach, factors can easily move between sectors. The implications for factor incomes then depend on the factors demanded by the expanding sector relative to the factors released by the contracting sector.

According to the H–O theory, the expanding sector is intensive in the country’s relatively abundant factor, while the shrinking sector is intensive in the country’s relatively scarce factor.

In the shift to free trade, there is strong demand for the abundant factor (relative to the small amount released as the import-competing sector shrinks), and there is weak demand for the scarce factor (relative to the large amount released as the import-competing sector shrinks.) The shift to free trade increases the price and income of the abundant factor, and it decreases the price and income of the scarce factor. (The box ―A Factor-Ratio Paradox‖ is difficult for some students, but it does show how full employment can be reached after the shift, as each sector alters the proportions in which it uses factors in response to the change in factor prices.)

Generally, the H–O approach has three major implications for factor incomes. First, the conclusion about the effect of opening to free trade is an example of the more general Stolper– Samuelson theorem—the real return to the factor used intensively in the rising-price industry increases, and the real return to the factor used intensively in the falling-price industry declines.

This theorem applies in a number of situations, if certain conditions apply (including that the

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country produces both products both before and after the price change, and that the menu of technologies available does not change).

Second, another way to view the broad pattern of the effects of shifting to free trade (or other shifts which change relative product prices) is through the specialized-factor pattern—factors more specialized in the production of exportable products (or rising-price products more generally) tend to gain income, and factors more specialized in the production of importcompeting products (or falling-price products more generally) tend to lose income. This pattern applies to both the short and the long run, and especially applies to factors that can only be used in one industry (sector-specific factors).

Third, the H–O approach has a surprising implication for the earnings of a single factor in different countries. The factor price equalization theorem states that free trade that equalizes product prices between countries also equalizes the prices of individual factors between countries. The logic of this can be developed intuitively. With no trade, the price of a factor will be "high" in the country in which it is scarce, and "low" in the country in which it is abundant.

The shift to free trade increases the factor's price in the abundant country and decreases its price in the scarce country. Under "ideal" conditions, the factor's prices (in real terms) become equal in different countries. In its impact on differences in factor prices, product trade can be a substitute for international movement of factors.

The chapter then shifts to examine empirical evidence on the Heckscher–Ohlin theory. The box ―The Leontief Paradox‖ summarizes the early tests. The text emphasizes the kinds of information that we need to examine real-world trade patterns—factor endowments and trade patterns, along with knowledge of the factor proportions used in producing different products. It provides evidence on endowments for seven factors—physical capital, highly skilled labor, mediumskilled labor, unskilled labor, crop land, pasture land, and forest land, and it discusses endowments of other natural resources. The examination of the U.S. pattern of international trade suggests that some of its trade seems consistent with the H–O predictions, but some does not seem consistent. In general, trade patterns for the United States and other countries match the H– O theory reasonably well but not perfectly. (The box ―China’s Exports and Imports,‖ the first in the series of boxes that Focus on China, shows that much of China’s trade is also consistent with the H–O predictions, especially once we recognize China’s role in labor-intensive assembly of electrical and electronic products that are then exported.)

Finally, the chapter provides evidence on international factor price equalization. While it clearly does not hold perfectly, even if we define factors carefully, we do see tendencies toward factor price equalization. Most obviously, as countries in Asia have integrated themselves into world trade, real wages in these countries have increased, to lessen international wage gaps. For China, increased demand for less-skilled workers has led to rapidly rising real wages.

The box ―U.S. Jobs and Foreign Trade‖ (another Focus on Labor) provides a survey of the effects of international trade that focuses on employment. While this is not the most valid way to examine the effects of trade (as noted at the end of the box), it is the way that much of the debate actually occurs politically, including various claims by former President Trump. The box shows that even on these terms the net effects on jobs are not clear, because reducing imports also tends to reduce exports.

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The chapter’s summary pulls together the answers that have been developed in Chapters 2–5 to the four key questions about trade presented at the beginning of Chapter 2.

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Tips We deliberately choose to bring out the implications for factor incomes using intuition and verbal logic. Although this sometimes requires statements that are a bit vague (e.g., high or low factor prices), it seems to work well in guiding most students to appreciate the reasons for and meanings of the implications. For instructors who wish to do this more formally, Appendix B is a starting point that presents the basics of the more formal analysis using the Edgeworth-Bowley box diagram.

The theory of international trade can appear to be abstract. In the book, we try to bring out its application to the real world, often using the example of the United States (and also offering the box that applies it to China). You may want to consider an assignment that asks students to apply the theory to another country. The accompanying two pages under the heading ―Sample Assignment‖ shows a version of this assignment that Pugel (and others at New York University) have been using successfully. In this version, students worked in groups on the assignment, but they could also be asked to work individually. (In addition, each group worked on a second assignment later in the course using the same country.) The assignment might be distributed about the time that you cover Chapter 5 in the course. However, as you can see, it does ask for the application of concepts like intraindustry trade that are not covered until Chapter 6. In addition, in answering the question about major trading-partner countries, students may want to draw on the description of the gravity model in the box in Chapter 6. The due date should be after Chapter 6 is covered in the course, if you use a comparable assignment.

Suggested answer to case study discussion question The Leontief Paradox: Leontief’s results appeared to directly contradict the Heckscher–Ohlin theory. The United States, a relatively physical capital-abundant country and a relatively laborscarce country, exported relatively labor-intensive products and imported relatively capitalintensive products. There are several different scientific responses to such an empirical result.

First, economists could abandon the Heckscher–Ohlin theory. However, to abandon the theory, economists would need some other theory to replace it. Two contenders existed. A theory based on demand-side differences seemed even less plausible. Theories based on technology and labor productivity differences (like the Ricardian theory) also seemed too limited. Second, economists could question the quality of the data on which the tests were based. Leontief was a careful researcher, and his handling of the data seemed to be reasonable. Third, economists could question the way in which the test was designed and executed. Instead of abandoning the Heckscher–Ohlin theory, economists took this route. The H–O theory is based on factor endowments and factor intensities, but the theory does not name the factors, and it certainly does not say that the only factors are physical capital and labor. It turned out to be useful to consider additional factors (e.g., types of land) and refinement of broad factors (e.g., less-skilled and more-skilled labor).

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Suggested answers to end-of-chapter questions and problems 39.

Mexico is abundant in unskilled labor and scarce in skilled labor relative to the United States or Canada. With freer trade Mexico exports a greater volume of unskilled-labor-intensive products and imports a greater volume of skilled-laborintensive products. According to the Stolper–Samuelson theorem, a shift toward freer trade then increases the real wage of unskilled labor in Mexico, reduces the real wage of unskilled labor in the United States or Canada, decreases the real wage of skilled labor in Mexico, and increases the real wage of skilled labor in the United States or Canada.

40.

Not correct. First, it is not clear what this statement means. The real wage is measured per unit of labor and the real rental rate is measured per unit of land. Because the units of labor and land are not comparable, it is not clear in what sense the real wage and real rental rate could be ―equal.‖ Second, the factor price equalization theorem holds for each type of income across countries. It says that free trade leads to the same real wage rate for labor (of a given type or skill) in different countries. Separately, it also says that free trade leads to the same real rental rate (for a given type of land) in different countries.

41.

Disagree. Opening up free trade does hurt people in import-competing industries in the short run—essentially due to the loss of producer surplus. The long-run effects are different because people and resources can move between industries, but everyone will not gain in the long run. If trade develops according to the Heckscher–Ohlin theory, then the owners of the factors of production that are relatively scarce in the country lose real income. Because the country imports products that are intensive in these factors, trade effectively makes these factors ―less scarce‖ and reduces their returns.

42.

First, you might point out that stopping trading would also eliminate exports, so that many jobs would be lost in exporting industries. It is not clear that there would be a net gain in jobs, and any net gain would likely be small. In addition, total employment in the whole economy is essentially a macroeconomic concern that is best addressed through macroeconomic policies (the topic of Chapters 22–25 of this book). Second, national well-being is much more than jobs. If we ended all trade, we would be giving up the gains from trade. Trade allows the country to sell some of its production as exports.

These exports are used to pay for imports. Imports allow us to expand our consumption by giving us access to low-priced goods (and to goods that we cannot or do not produce domestically).

43.

Leontief conducted his research shortly after World War II, when it seemed clear that the United States was abundant in capital and scarce in labor, relative to the rest of the world. According to the Heckscher–Ohlin theory, the United States then should export capital-intensive products and import labor-intensive products. But in his empirical work using data on production in the United States and U.S. trade flows, Leontief found that the United States exported relatively labor-intensive products and imported relatively capital-intensive products.

21

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44.

A decrease in the relative price of wheat leads to a decrease in domestic production of wheat. This is also an increase in the relative price of cloth, so there is an increase in the production of cloth. In the short run, factors are mainly tied to their initial industries, because there is limited mobility between industries. With a lower price of wheat and lower production, there is less demand for land and labor in the wheat industry, and both land and labor initially employed in the wheat industry tend to lose earnings (real income). With a higher price of cloth and efforts to expand cloth production, there is more demand for both land and labor in the cloth industry, and both land and labor initially employed in the cloth industry tend to gain earnings. In the long run, factors are mobile between industries. The shrinking of wheat production (assumed to be landintensive) releases a relatively large amount of land and relatively little labor, while the expansion of the cloth industry requires a relatively large amount of labor and relatively little land. Thus, labor (throughout the economy) benefits from strong demand for its services, and the earnings of labor throughout the economy increase. Land (throughout the economy) experiences weak demand and the earnings of land decreases. The Stolper– Samuelson theorem predicts these long-run effects. A decrease in the relative price of wheat leads to a decrease in the real rental rate of land (the factor used intensively in the decreasing-price industry) and an increase in the real wage of labor (the factor used intensively in the other, rising-price industry).

45.

Yes. The Heckscher–Ohlin theory states that a country will export products that require (in their production) relatively large amounts of the country’s relatively abundant factor inputs. First, consider the relatively abundant factor inputs in China and South Korea. As shown in Figure 5.3 (reading across the row for China), China is relatively abundant in medium-skilled labor, with 27% of the world total. South Korea is relatively abundant in highly skilled labor and physical capital, with 2% of the world’s total of each. Second, apply this information to the product examples. China, abundant in medium-skilled labor, exports basic bulk-carrying ships, which require relatively intensive general use of labor in production. South Korea, relatively abundant in highly skilled labor, exports complex ships, which depend more on the relatively intensive use of highly skilled labor for technical work and design.

46.

International factor price equalization is the theory to help us understand the change. This is an example of how increases in international trade (in this case, trade in software development services) has narrowed the international difference in the earnings of a factor (programmers) used intensively in the industry. The narrowing of the difference in earnings is an example of a tendency to factor price equalization for programmers.

47. a. With prices of 100, the two equations are 100  60w  40r 100  75w  25r Solving these simultaneously, the equilibrium wage rate is 1 and the equilibrium rental rate is 1. The labor cost per unit of wheat output is 60 (60 units of labor at a cost of 1 per unit of labor). The labor cost per unit of cloth is 75. The rental cost per unit of wheat is 40. The rental cost per unit of cloth is 25.

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With the new price of cloth, the two equations are 100  60w  40r 120  75w  25r Solving these simultaneously, we see that the new equilibrium wage rate is about 1.53 and the new equilibrium rental rate is 0.2.

The real wage with respect to wheat increases from 0.01 (or 1/100 ) to about 0.0153 (or 1.53 /100 ). The real wage with respect to cloth increases from 0.01 (or 1/100 ) to about 0.01275 (or 1.53 /120 ). On average, the real wage is higher—labor benefits from the increase in the price of cloth. The real rental rate with respect to wheat decreases from 0.01 (or 1/100 ) to 0.002 (or 0.2 /100 ). With respect to cloth, it decreases from 0.01 (or 1/100 ) to about 0.0017 (or 0.2 /120 ). On average, the real rental rate is lower—landowners lose real income as a result of this increase in the price of cloth.

These results are an example of the Stolper–Samuelson theorem. Wheat is relatively intensive in land, and cloth is relatively intensive in labor. The increase in the price of cloth raises the real income of labor (its intensive factor) and lowers the real income of the other factor (land).

48. a. If all factors are immobile, the increase in the relative price of corn and the effort to expand corn production tends to benefit the earnings of all factors initially employed in corn production. This is also a decrease in the relative price of vehicles, so that vehicle production tends to decrease. This means that all factors initially employed in the vehicle industry tend to lose earnings.

If all factors are freely mobile between the corn and vehicle industries, the winners and losers depend on the increased demand for each factor as corn production expands, relative to the release of each factor as vehicle production decreases. The labor intensity of the two industries is almost the same ($0.60 of labor use per dollar of corn output and $0.59 per dollar of vehicle output). The overall demand for labor is affected only a little as vehicle production shrinks and corn production expands, because the release of labor by vehicles closely matches the need for additional labor in corn. Labor throughout the economy is likely to be affected only a little by the change. Corn is relatively land-intensive. The extra demand for land as corn expands, relative to the smaller amount released as vehicles shrink, leads to an increase in the real return to land. Vehicles is capital-intensive. The release of capital as vehicles shrink, relative to the smaller amount demanded as corn expands, leads to a decrease in the real return to capital.

49.

The total input share of labor in each dollar of cloth output is the sum of the direct use of labor plus the labor that is used to produce the material inputs into cloth production: 0.5 + 0.1 × 0.3 + 0.2 × 0.6 = 0.65 The total input share of capital is calculated in the same way: 0.2 + 0.1 × 0.7 + 0.2 × 0.4 = 0.35

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Cloth is labor-intensive relative to the country’s import substitutes (0.65 > 0.55). Thus the country’s trade pattern is consistent with the Heckscher–Ohlin theory. This laborabundant country exports the labor-intensive product.

50.

According to Figure 5.3, Japan is relatively abundant in physical capital, highly-skilled labor, and medium-skilled labor. Japan is relatively scarce in unskilled labor, crop land, pasture land, and forest land. Japan is also relatively scarce in natural resources generally.

(1) The following appear to be consistent with the predictions of the Heckscher–Ohlin theory. Japan is a substantial net importer of food (land-intensive), metal ores and crude petroleum products (natural resource-intensive), and clothing and accessories and shoes and other footwear (unskilled labor-intensive). Japan is a substantial net exporter of iron and steel (physical capital-intensive). Substantial net exports of automobiles also appear to be consistent with the Heckscher–Ohlin theory, to the extent that their production is relatively physical capital-intensive (or skilled labor-intensive). (2) The following appear to be inconsistent. The substantial net imports of pharmaceuticals, aircraft, and medical instruments appear to be inconsistent with the Heckscher–Ohlin theory, as production of these products is intensive in skilled labor. In addition, the imports and exports of hair care products are about equal.

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Sample assignment NEW YORK UNIVERSITY Stern School of Business Economics of Global Business Country Assignment #1 The text of your group's answers to the assignment should be typed single-spaced, with an extra space between each paragraph. The text must be limited to a maximum of four pages. You may also attach additional tables and charts to this four pages of text, if these tables and charts are of direct importance to your answers.

The group members are not to discuss this assignment with anyone else who is not in the group (except for consulting reference librarians in order to locate materials). The group may utilize any published materials—you are not limited to the sources noted in the assignment description below.

Each group must choose one country that will be used for both this assignment and the second country assignment. For several different reasons, the country chosen cannot be any of the following: the United States, Germany, France, Italy, Austria, Belgium, Finland, Greece, Ireland, Luxembourg, Netherlands, Portugal, Spain, Slovenia, Malta, Cyprus, Slovakia, Estonia, Latvia, Lithuania, Japan, Canada, China, Hong Kong, Macau, Singapore, Argentina, and Venezuela.

Also, the country chosen cannot be a country which is the country of citizenship of any group member or a country in which any group member has lived for a period of one year or more.

Before your group commits to a choice of country, you might want to check to make sure that data are available for that country. Most importantly, you might want to check to make sure that the country chosen has useful data not only in the sources shown in the assignment below, but also in a publication of the International Monetary Fund—International Financial Statistics— that may be a major source for the second country assignment. Some countries are not shown in the UN and IMF sources—for these countries, one must use other data sources (e.g., national reports), and this may be challenging. One final note on selecting a country—for the second country assignment, analysis of a country that has experienced very high inflation rates for part or all of the time since 2000 will be very interesting, but gathering and interpreting the data may be challenging.

The Assignment 51.

For the most recent year for which data are available in the UN database noted below (or in a comparable data source), present a full set of data (in easily readable form) on the country’s exports and imports, at the two-digit SITC level. (The SITC is the Standard 25

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International Trade Classification.) Which products are the country’s major export products? Which products are the country’s major import products? (The text discussion for this part of the assignment should be brief and descriptive. It serves as an introduction to the rest of the report.)

Most likely data source: United Nations, Comtrade Database (comtrade.un.org/data).

Here are a few tips for using this database. Use SITC Rev. 4, if possible. For desired data, use import and export for trade flows, and use all two-digit commodity codes. After you form your selection, note that you are able to download the data.

52.

Using these data, examine how well (or poorly) theories of trade appear to explain the country's commodity (product) pattern of trade (or to explain various aspects of this pattern). In your answer here, you might analyze one or more of the following: the commodity pattern of exports, the commodity pattern of imports, the commodity pattern of net exports (exports minus imports) in money amounts, and/or the commodity pattern of net exports of each product as a percentage of total trade (exports plus imports) of this product by the country. In addition, the extent of intraindustry trade in the various products should be documented and examined with reference to theory.

53.

For the most recent year for which data are available, document the five countries that are the largest buyers of your country’s exports. For the most recent year for which data are available, document the five countries that are the largest sources of your country’s imports. Discuss briefly the probable reasons for this pattern of major trading-partner countries. (Your discussion may need to incorporate reasons that go beyond what we have discussed in class.)

Most likely data source: International Monetary Fund, Direction of Trade Statistics.

Chapter 6 Scale Economies, Imperfect Competition, and Trade Overview Standard trade theory presented in Chapters 3–5 is based on perfect competition, with constant returns to scale at the level of the individual firm and constant or increasing cost of expanding production at the level of the industry. Comparative advantage predicts that countries will trade with other countries that are different (the source of the comparative cost differences) and that each country will export some products and import other, quite different products. While much international trade conforms to these patterns, a substantial amount does not. Most obviously, industrialized countries trade a lot with each other, and in much of their trade each is exporting and importing similar products.

This chapter looks at three theories of trade based on market structures that differ from the standard theory. Each of these theories includes a role for scale economies, so that unit costs tend to decline as output increases. The first section of the chapter defines and examines scale 26 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

economies, and it explains the difference between scale economies that are internal to the individual firm, and scale economies that are external to the firm but apply to a cluster of firms in a geographic area.

The next section of the chapter defines intra-industry trade (IIT), in which a country both exports and imports the same product or very similar product varieties. It explains how IIT is measured for an individual product, with examples shown in Figure 6.2. The importance of IIT in a country’s overall trade is the weighted average of the IIT shares for each of the individual products. Figure 6.3 provides original estimates of the overall importance of IIT. The remainder of the chapter presents the three additional trade theories. The first is based on monopolistic competition. While there may be a number of explanations of intra-industry trade, product differentiation seems to be the major one. The market structure of monopolistic competition is useful for analyzing the role of product differentiation. Each producer faces a downward-sloping demand curve for its product variety. If scale economies (internal to the firm) are moderate (relative to the size of the total market for all varieties of this product), then easy entry drives each firm to earn zero economic profit (the average cost curve is tangent to the firm’s demand curve). If a monopolistically competitive national market is opened to international trade, then domestic consumers have access to additional varieties of the product— those that can be imported. Domestic producers have access to additional buyers—foreigners who prefer their varieties. Product differentiation in this monopolistically competitive global market is the basis for intra-industry trade, as some varieties are imported while others are exported. (The box on ―The Gravity Model of Trade‖ examines an empirical approach that is consistent with trade based on product differentiation and monopolistic competition. It discusses some of the key findings about national economic size, geographic distance, and other impediments to trade.)

With this kind of trade based on product differentiation and monopolistic competition, an additional source of gains from trade for the country is the increase in varieties that become available. Furthermore, trade may also lead to lower prices for the domestic varieties. These benefits accrue to consumers generally. The implications of trade for the well-being of different groups in the country are also modified. First, if most trade is intra-industry, then there may be little pressure on factor prices caused by inter-industry shifts in factor demand. Second, the gains from increased variety reduce the loss to factors that suffer income losses due to Stolper– Samuelson effects. Some may be better off even though they appear to lose income. In addition, increased international competition drives national production toward domestic firms with lower costs, a process of restructuring within the national industry.

The second theory is global oligopoly. In some industries, a few large firms account for most global sales, perhaps because internal scale economies are large. Although we do not have a single dominant full theory of oligopoly, we can make several observations about oligopoly and trade. First, scale economies tend to concentrate production in a few production sites. When they were chosen by the firms, these may have been the lowest cost sites. Over time production tends to continue in these sites, even though they may not remain the lowest cost sites if all sites could achieve the same production scale.

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Second, in an oligopoly each large firm should recognize interdependence with the other large firms—its actions and decisions are likely to elicit responses from the other firms. Competition then resembles a game, but it is still not clear how the firms should play the game. If they compete aggressively, then they may earn only normal profits. They may be caught in the prisoners’ dilemma of competing aggressively, unless they can find some way to cooperate. If instead they restrain their competitive thrusts, then they may be able to earn high profits.

The fact that oligopoly firms can earn high profits means that it matters where these firms are located (or who owns them). The high profit earned on export sales creates another source of national gains from trade for the exporting country, in the form of better terms of trade, at the expense of foreign buyers of the imports.

Our third theory is based on scale economies that are external to the individual firm but arise from advantages of having a high level of production in a geographic area. With external scale economies (also called agglomeration economies), an expansion of demand (such as that caused by increased exports) can result in a lower unit cost for all producers in the area and a lower product price. With free-trade production tends to be concentrated in one or a few locations. In the shift from no trade to free trade, production in some locations would increase so that their unit costs and prices fall, while production in other locations would decrease or cease. It is not easy to predict which locations become dominant—luck, a large domestic market, or government policy may be important. The importing countries gain from trade, even if local production ceases, because consumers benefit from the lower prices of the imported product. A key difference from the standard model is that with external scale economies consumers in the exporting country also gain surplus as trade leads to lower costs and prices, because production is concentrated in few locations that can better achieve the external economies.

The chapter concludes with a summary that pulls together the sweep of the analysis of international trade covered in Chapters 2–6.

Tips The analysis of monopolistic competition in the chapter text is at the level of the market and uses the graph with the price curve and the unit cost curve. The analysis of the individual firm in a monopolistically competitive market is in an Extension box. An instructor has the option to omit this box from the assigned required reading—students will still be able to follow the discussion in the text. If you omit the extension box, also omit end of chapter Question 10.

The link of global oligopoly to trade policy—often called strategic trade policy—is presented in Chapter 11. An analysis of global cartels is presented in Chapter 14.

The country assignment included as a Suggested Assignment for Chapter 5 includes a question referring to the country's intra-industry trade. If appropriate, you could ask a more specific question, which might include calculations of the intra-industry trade shares for individual products using the formula in the text or the calculation for the country of the weighted average of these IIT shares.

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Suggested answers to end-of-chapter questions and problems 54.

Disagree. The Heckscher–Ohlin theory indicates that countries should export some products (products that are intensive in the country’s abundant factors) and import other products (products that are intensive in the country’s scarce factors). Heckscher–Ohlin theory predicts the pattern of interindustry trade. It does not predict that countries would engage in a lot of intra-industry trade, which involves both exporting and importing products that are the same (or very similar).

55.

Scale economies exist when unit (or average) cost declines as production during a period of time is larger. (1) The key role of scale economies in the analysis of markets that are monopolistically competitive is to provide an incentive for larger production levels of each variety of the industry's product. The product is differentiated, but it is not fully customized to each individual consumer's exact desires. Larger production runs of each variety of the product can benefit from scale economies. Still, these scale economies apply mainly to relatively small levels of production, so that a large number of firms and product varieties can exist and compete in the market. (2) The key role of scale economies in the analysis of oligopoly is that they drive firms to become large, so that a small number of firms come to dominate the market. These scale economies apply over a large range of output, so that firms that are large relative to the size of the market enjoy cost advantages over any smaller rivals.

56.

There are two major reasons. First, product differentiation can result in intra-industry trade. Imports do not lead to lower domestic output of the product because exports provide demand for much of the output that previously was sold at home. Output levels do not change much between industries, so there are (1) little shift between industries in factor demand and (2) little pressure on factor prices. There are likely to be fewer losers from Stolper–Samuelson effects. Second, there is a gain from trade that is shared by everyone—the gain from having access to greater product variety through trade. Some groups that otherwise might believe that they are losers because of trade can instead be winners if they place enough value on this access to greater product variety.

57.

If the government is going to permit free export of the pasta (no export taxes or export limits), then the government should choose to form the industry as a monopoly. The country is likely to gain more from trade if it charges a higher price to foreign buyers, because the country benefits from higher export prices and better terms of trade. A monopoly will charge higher prices (in order to maximize its profits), in comparison with the equilibrium price for a comparable but competitive industry. Because all of the product is exported, there is no concern about charging domestic consumers high prices.

The goal is to charge foreign buyers suitably high prices. The gains from better terms of trade accrue mainly to the monopoly as higher profits. This benefits the country as long as the monopoly is owned by the country's residents (or the country's government can gain some of these profits through taxation).

58.

Disagree. External scale economies are cost or quality advantages to firms in an industry that locate close to each other, that is, in the same small geographic area. The key 29

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influence of external scale economies on the pattern of international trade is that they lead to a small number of locations producing much of the world output of the industry’s product because firms in these locations benefit from the external scale economies.

Countries that have such centers of large production become the exporting countries, and countries without them, the importing countries. The activities of firms in these centers could include the creation of product varieties, but they need not. Variety is not necessary to the explanation of why external scale economies affect the pattern of trade.

59. a. The market equilibrium price depends on how intensely Boeing and Airbus compete in order to gain sales. A low-price equilibrium occurs if Boeing and Airbus compete intensely to gain extra sales, including attempts to use price-cutting to "steal" sales from each other. A high-price equilibrium occurs if Boeing and Airbus recognize that price competition mainly serves to depress the profits of both firms, so that they both restrain their urges to compete using low prices.

From the perspective of the well-being of the United States or Europe, a high-price equilibrium could be desirable because it involves setting high prices on export sales to other countries. This equilibrium also results in sales to domestic buyers at high prices, so there is some loss of pricing efficiency domestically. But the benefits to the country from charging high prices on exports and improving its terms of trade can easily be larger, so that overall the high-price equilibrium can be desirable.

The low-price outcome is desirable for a country like Japan or Brazil that imports all of its large passenger jet airplanes (e.g., for use by its national airlines). The country's terms of trade are better if import prices are lower.

Yes, Japan or Brazil still gains from importing airplanes. Some amount of "consumer surplus" is obtained by these countries—that is why they import even at the high price.

But their surplus would be even greater if airplane prices were low.

60. a. Consumers in Pugelovia are likely to experience two types of effects from the opening of trade. First, consumers gain access to the varieties of products produced by foreign firms, as these varieties can now be imported. Consumers gain from greater product variety.

Second, the additional competition from imports can lower the prices of the domestically produced varieties, creating an additional gain for domestic consumers.

Producers in Pugelovia also are likely to experience two types of effects from the opening of trade. First, imports add extra competition for domestic sales. As we noted in the answer to Part a, this is likely to force domestic producers to lower their prices, and some sales will be lost to imports. Second, domestic producers gain access to a new market, the foreign market. They are likely to be able to make additional sales as exports to consumers in the foreign market who prefer these producers’ varieties over the ones produced locally there.

61.

Yes, it is possible. (a) If the product is undifferentiated and has a perfectly competitive market, the extra demand in the rest of the world is likely to result in an increase in the world price of the product. Essentially, the shift to the right in the world demand curve 30

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moves the equilibrium along an upward-sloping world supply curve, resulting in an increase in the world equilibrium price for the product. As an individual consumer, you are likely to be worse off—you pay a higher price and may buy less, so you lose personal consumer surplus. (b) If, instead, the product is differentiated and has a monopolistically competitive market, it is more likely that you will benefit from the increase in demand in the rest of the world, especially if there is enough time for the global market to adjust to a new long-run (zero-profit) equilibrium. The increase in global demand creates the incentive for firms to offer new varieties of the product. The extra varieties intensify competition and increase the elasticity of demand for each variety, so the typical price of a product variety tends to decline. As an individual consumer, you are likely to be better off—you have access to more varieties and you may pay a lower price for the product.

62.

We can use a graph like Figure 6.5, as shown on the next page, to examine the change in the number of models. In the initial situation, the global market was in equilibrium with 40 models and a typical price of $600 per washer. The increase in global demand shifts the unit cost curve from UC0 to UC1 . Here is one way to see why the unit cost curve shifts this way. For any given number of models, each firm would be able to produce more units of its own version with greater demand, so each firm would be able to achieve additional scale economies that would lower its unit cost. Therefore, the unit cost curve shifts down. With the new unit cost curve UC1 , the new long-run equilibrium is at point R, with a typical price P1 less than $600 and the number of models N1 larger than 40.

How did we get from the initial equilibrium to the new long-run equilibrium? With the increase in global demand, the firms producing the initial 40 models began to earn economic profits. The positive profits attracted the entry of additional firms that offered new models. With the entry of new firms and new models, the demand for each of the established firms’ models eroded. In addition, the arrival of new close substitute models increased the price elasticity of demand for each model. The decrease in demand for each model and the increase in the price elasticity forced each firm to lower the price of its model. The new long-run equilibrium occurs when the typical firm is back to earning zero economic profit on its model. This occurs with a larger total number of models offered, and with a lower price for the typical model.

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63. a. In the initial free-trade equilibrium, the typical firm was earning zero economic profit. At the price of $600 per washer, the downward-sloping demand curve D0 for this firm’s model was just tangent to the firm’s average cost curve for producing the model. When global demand increases by about 15%, the typical firm’s demand curve shifts up or to the right, to D  , in the short run just after the general demand increase. The firm’s marginal revenue curve also shifts up to MR ' with the shift in the demand curve. The new marginal revenue curve intersects the firm’s marginal cost curve at point H  . In comparison with the initial situation, the firm produces a larger quantity ( Q rather than Q0 ) and charges a higher price ( P  rather than $600). The firm earns positive economic

profit, equal to the difference ( P ' C) between price and average cost at the output level Q , times the output level Q . The economic profit is the area of rectangle P ' G ' ZC .

In the new long-run equilibrium, the typical firm faces a more elastic demand curve D1 and earns zero economic profit. This occurs at the price P1 and the quantity Q1 .

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64. a. Here is the calculation for cosmetics: IIT share  ( 4, 417  1,530  4, 417  1,530  0.515 (or 51.5%). Using the same type of calculation for the other products, here are the IIT shares for each product: Cosmetics 51.5% Hair care products 99.6 Electronic microcircuits 82.9 Automobiles 22.0 Motorcycles 42.8 Watches 16.1 Books and brochures 78.9 For Japan, total trade in these seven products is $167,853 million. The weighted average of the IIT shares is:  5,947 /167,853  51.5  1, 026 /167,853  99.6   44, 438 /167,853 

82.9  110,105 /167,853  22.0   3,121/167,853  42.8   2,988 /167,853  16.1 

 228 /167,853  78.9  40.0% The United States has relatively more IIT in these products.

65.

There are a small number of firms that produce electric railroad locomotives, and two countries (Germany and China) account for most world exports. Global oligopoly that results from internal scale economies that extend over a large range of output is the economic model that fits best. A few firms dominate the global industry as they achieve low cost through scale economies. These firms produce in only a few locations to achieve low costs through scale economies. It is also possible that there are some external scale economies that help to explain the concentration of most production in two countries, but the industry structure is not a large number of competitive firms, so the situation for 33

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electric railroad locomotives does not completely fit the model for external scale economies presented in the chapter.

66. a. External scale economies mean that the average costs of production decline as the size of an industry in a specific geographic area increases. With free trade and external economies, production will tend to concentrate in one geographic area to achieve these external economies. Whichever area is able to increase its production can lower its average costs. Lower costs permit firms in this area to lower their prices so that they gain more sales, grow bigger, and achieve lower costs. Eventually production occurs in only one country (or geographic area) that produces with low costs.

Both countries gain from trade in products with external economies. The major effect is that the average cost of production declines as production is concentrated in one geographic area. If the industry is competitive, then the product price declines as costs decline. In the importing country, consumers’ gains from lower prices more than offset the loss of producer surplus as the local industry ceases to produce the product. In the exporting country, producer surplus may increase as production expands, although this effect is countered by the decrease in the price that producers charge for their products. In the exporting country, consumer surplus increases as the product price declines. Thus the exporting country can gain for two reasons: an increase in producer surplus and an increase in consumer surplus.

67. a. Among the strong arguments are the following. First, free trade brings gains from trade, even for products that can be produced locally. With free trade resources can be reallocated to producing exports. These exports can be used to buy imports at a cost that is lower than the cost of producing these products domestically. Because of relatively cheap imports, the country's total consumption can exceed its abilities to produce domestically. Second, some products are not produced domestically but can be imported.

The country gains because consumers have access to a wider variety of products. Third, import competition provides competitive discipline for domestic monopolies and oligopolies. Prices will be driven closer to marginal costs, so that the efficiency of the market is enhanced.

With respect to short-run pressures on economic well-being, owners of factors employed in industries that could expand exports are likely to support the policy shift, because the demand for these factors increases as firms attempt to expand production. Owners of factors employed in industries that will receive increased competition from imports are likely to oppose the policy shift (unless they feel that other benefits from such changes as greater product variety more than offset their direct income losses). With respect to longrun pressures on economic well-being, the Stolper–Samuelson theorem is relevant.

Owners of India's abundant factors of production are likely to support the policy shift, because they will gain real income. Owners of India's scarce factors are likely to oppose the shift, because they will lose real income (again, unless other benefits more than offset the direct income loss).

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Growth and Trade Overview This chapter has two major purposes. First, it shows how the Heckscher–Ohlin model can be used to analyze economic growth and its impact on international trade. Second, it examines additional aspects of technological progress and its relationship to international trade.

Growth in a country's production capabilities shifts the country's production–possibility curve out. Growth is balanced if the ppc shifts out proportionately. Balanced growth could occur because all factors are growing at similar rates, or because production technology is improving at the same rate in both sectors. Growth is biased if the outward shift in the ppc is skewed, so that the growth favors producing more of one product than the other. Biased growth could occur if one factor is growing more quickly than the other, or if production technology is improving more in one sector than the other. (For instance, if only one product's production technology is improving, then the ppc intercept with the other product's axis does not change—see Footnote 1 in the text.)

One example of very biased growth is growth in only one factor, the other factor unchanged.

While the entire ppc shifts out, the growth is strongly biased in favor of the product that uses the growing factor intensively. The Rybczynski theorem indicates that, if product prices are constant, then the output quantity of the product that uses the growing factor intensively will increase, while the output quantity of the other product must contract. The reason is that expanding production of the intensive good also requires some of the other factor. This amount of the other factor must be drawn from the other industry, so its output declines. A box applies this concept to the "Dutch disease" of deindustrialization following discovery and development of production of a natural resource.

The growth of the country's production capabilities is likely to change the country's willingness to trade—the quantities that it wants to export and import—even if product prices do not change.

The change in the country's willingness can be documented by examining the change in the country's trade triangle for the price ratio that held in the free-trade equilibrium before the growth occurs. The change in the production point depends on whether growth is balanced or biased. The change in the consumption point depends on tastes in the country. At the same price ratio, the quantities consumed of both products will increase if both goods are normal. Growth that is balanced or biased toward producing the exportable product is likely to increase the country's willingness to trade. Growth that is sufficiently biased toward producing more of the importable product will reduce the country's willingness to trade.

If the country is small, then changes in its trade have essentially no impact on the world equilibrium price ratio. In this case, the analysis just presented using the initial price ratio is the complete picture.

If instead this is a large country, then changes in its willingness to trade change the equilibrium international price ratio. If the growth reduces the country's willingness to trade, then the reduced supply of exports and the reduced demand for imports results in an increase in the equilibrium 35 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

relative price of the country's exportable product. The well-being of the country increases for two reasons—the country's production capabilities increase and its terms of trade improve.

If growth of a large country increases its willingness to trade, then the increased supply of exports and the increased demand for imports results in a decrease in the equilibrium relative price of the country's exportable product. If the price does not change by too much, then the country's well-being is higher—but the increase in well-being is less than it would be if the country's terms of trade did not deteriorate. If the price ratio changes by a lot then immiserizing growth is possible—growth that expands the country's willingness to trade causes such a large decline in the country's terms of trade that the well-being of the country declines. The loss from the decline in the terms of trade is larger than the gain from the larger production capabilities.

This is more likely if the growth is strongly biased toward producing more of the exportable product, foreign demand for the country's exports is price inelastic, and the country is heavily engaged in international trade.

The discussion of technology and trade focuses on several main points. First, differences in production technologies available in different countries can be the source of comparative advantage, because technology differences result in production possibility curves that are skewed differently in different countries. Second, much new technology is the result of organized research and development (R&D). The location of the production of new technology through R&D follows the Heckscher–Ohlin theory. R&D is intensive in the use of highly skilled labor (especially scientists and engineers) and also in capital that is willing to take large risks (for instance, venture capital). Consistent with H–O theory, most new technology is created by R&D located in the developed countries, which are well-endowed with these factors. And, as China has graduated more scientists and engineers, China’s R&D has increased. Third, although production using new technology may first occur in the country that creates the new technology, the technology is also likely to diffuse internationally. The product cycle hypothesis suggests that there is a regular pattern as new technology diffuses, with developing countries often becoming the exporters of many products after the products become standardized or mature. Although the product cycle describes the evolution of production and trade for a number of products, it is also subject to a number of limitations.

Openness to international trade can also increase a country’s growth rate. Imports can speed diffusion of new production technology into a country, through imports of advanced capital goods and, more generally, through greater awareness of new foreign technology. Openness to trade can also place additional competitive pressure on domestic firms to develop and adopt new technology, and export sales can increase the returns to their R&D activities. According to the ―new growth theory,‖ these increases in the country’s technology base can enhance ongoing innovation, resulting in a higher ongoing growth rate.

Finally, the box ―Trade, Technology, and U.S. Wages‖ (another Focus on Labor) confronts an important issue—why has the difference in wages between skilled and less skilled workers widened since the 1970s, in the United States and other countries. This could be the Stolper– Samuelson theorem at work, if expanding trade with developing countries placed downward pressure on the prices of products intensive in less-skilled labor. But several studies conclude that this effect is smaller than another—biases in technological change. Technological change seems to have created rising demand for skilled labor for two reasons. First, technological 36 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

progress has been faster in industries that are intensive in skilled labor, resulting in their faster growth. Second, technological progress is biased in favor of using more-skilled labor.

Tips This chapter is written to take the reader through the analysis of growth step-by-step—the change in the production possibility curve, the change in the willingness to trade, the change in the international equilibrium price ratio, and the overall effects of growth on the country, including both the production growth and the change in the country's terms of trade. It provides a major application of the key tools from Chapter 4—the production–possibility curve, the community indifference curves, and trade triangles. It attempts to cover the range of major cases that can arise, without becoming overly taxonomic.

In class presentation of this material, we have found that it is useful for the instructor, after briefly summarizing the generic process of the analysis, to present the entire analysis of each of several specific examples. For instance, the example of growth of the scarce factor of production can be used to introduce the Rybczynski theorem and to bring out the terms-of-trade effects of growth that reduces a large country's willingness to trade. The example can include discussion of comparison of the country's well-being and its production and consumption points before the growth and after the growth (inclusive of the change in the price ratio). In addition, the implication for factor incomes can be noted by referring back to the general Stolper–Samuelson theorem. It is also possible to draw out the implications for the other (the non-growing) country.

Then, a second example can be examined from start to finish, such as technological improvement only in the country's export sector (with no diffusion to the other country). This example can be used to bring out the terms-of-trade effects of growth that increases a large country's willingness to trade, and this can lead into a discussion of the possibility of immiserizing growth.

The table shown with Chapter 2 of this Manual could be used as a summary device at the conclusion of the classroom presentation of the material in Chapter 7.

Suggested answer to case study discussion question The Dutch Disease and Deindustrialization: There are several reasons that developments in energy products are prominent as examples of Dutch disease. First, the discovery of major new energy sources, especially new sources of recoverable oil and natural gas, is itself newsworthy.

Second, the discoveries are often large, and there is often an incentive to develop production rather quickly. Third, developing large-scale extraction requires large amounts of resources, which shift away from other uses rather quickly. So, the changes in resource allocation happen quickly and by a large amount, making the resulting changes more noticeable and dramatic. Most other shifts in resource usage in the national economy as an industry expands are not as large or develop more gradually over time.

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68.

By expanding its export industries, Pugelovia wants to sell more exports to the rest of the world. This increase in export supply tends to lower the international prices of its export products, so the Pugelovian terms of trade (price of exports relative to the price of imports) tend to decline.

69.

Disagree. According to the Rybczynski theorem, an increase in the country's labor force will result in an increase in the quantity produced of the labor-intensive good, and a decrease in the quantity produced of the other good. The additional labor goes to work in the labor-intensive industry. But, to expand production of this good, extra nonlabor resources (e.g., land) are needed to work with the extra labor. These extra nonlabor resources are drawn from the other industry, so production of the other good decreases.

70.

The drought itself reduces production in these Latin American countries and tends to lower their well-being. (Their production–possibility curves shrink inward.) But the lower export supply of coffee tends to raise the international price of coffee, so the terms of trade of these Latin American countries tend to improve. The improved terms of trade tend to raise wellbeing. (The purchasing power of their exports rises.) If their terms of trade improve enough, the countries’ well-being improves. The greater purchasing power of the remaining exports is a larger effect than the loss of export (and production) volumes. The gain in well-being is more likely (1) if these Latin American countries represent a large part of world coffee supply, so that their supply reduction can have a noticeable impact on the world price; (2) if foreign demand for coffee is price-inelastic (as it probably is), so that the coffee price rises by a lot when supply declines; and (3) if exports of coffee are a major part of the countries’ economies, so that the improvement in the terms of trade can have a noticeable benefit to the countries. (This answer is an example of immiserizing growth ―in reverse.‖)

71.

Disagree. Immiserizing growth can occur if growth in the country leads the country to want to trade more, and the country's terms of trade deteriorate by a large amount. If a country's trade has almost no impact on world prices, then its growth will have almost no impact on its terms of trade, and immiserizing growth is very unlikely.

72.

R&D is a production activity that is intensive in the use of highly skilled labor (scientists and engineers) and perhaps in the use of capital that is willing to take large risks (e.g., venture capital). The developed countries are relatively abundant in highly skilled labor and in risk-taking capital. According to Heckscher–Ohlin theory, a production activity tends to locate where the factors that it uses intensively are abundant.

73.

According to the product life cycle approach, the technological originator of a product eventually will import the product. But its overall trade need not develop into chronic "deficits.‖ As the technological originator continues to develop new products, it will export these products, while importing older products.

74. a. This is balanced growth through increases in factor endowments. The production– possibility curve shifts out proportionately, so that its relative shape is the same.

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This is balanced growth through technology improvements of similar magnitude in both industries. The production–possibility curve shifts out proportionately, so that its relative shape is the same.

The intercept of the production–possibility curve with the cloth axis does not change. (If there is no wheat production, then the improved wheat technology does not add to the country’s production.) The rest of the production–possibility curve shifts out. This is growth biased toward wheat production.

75. a. This can lead to a reversal of the trade pattern. If the initially scarce factor grows by enough, then it will become the relatively abundant factor in the country, and Heckscher– Ohlin theory predicts that the trade pattern will reverse. b. This can lead to a reversal of the trade pattern. If a country initially exported a product because it had a technological advantage in that product, then diffusion of the technology to other countries could result in these other countries' becoming the low-cost producers, so the first country becomes an importer of the product. This pattern is stressed in the product cycle approach.

This can lead to a reversal of the trade pattern. Consider a country that initially exports wheat.

If local consumers shift their tastes strongly toward consuming more wheat, they may demand so much wheat that none is left for export, and some amount of imports may be needed to satisfy the increased domestic demand.

76. a. The entire U.S. production–possibility curve shifts out, with the outward shift relatively larger for the good that is intensive in capital. If the U.S. trade pattern follows the Heckscher–Ohlin theory, then this good is machinery. Growth is biased toward machinery production. b. According to the Rybczynski theorem, the quantity produced of machinery increases and the quantity produced of clothing decreases if the product price ratio is unchanged. The extra capital is employed in producing more machinery, and the machinery industry must also employ some extra labor to use with the extra capital. The extra labor is drawn from the clothing industry, so clothing production declines. c. The U.S. willingness to trade increases. With growth of production and income, the United States wants to consume more of both goods. Demand for imports of clothing increases because domestic consumption increases while domestic production decreases.

(Supply of exports also increases because the increase in domestic production of machinery is larger than the increase in domestic consumption.) d. The increase in demand for imports tends to increase the international equilibrium relative price of clothing. (The increase in supply of exports tends to lower the international equilibrium relative price of machinery.) e. The change in the international equilibrium price ratio is a decline in the U.S. terms of trade. U.S. well-being could decline—immiserizing growth is possible. If the decline in the 39 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

terms of trade is large enough, then this negative effect can be larger than the positive effect of growth in production capabilities.

77. a. Typically, we expect that the drought in East Asia would result in East Asia demanding more imports of food, so East Asia becomes more willing to trade. b. The increase in East Asian demand for imports of food (or, equivalently, the decrease in world supply of food) results in an increase in the equilibrium relative price of food. c. In the United States, there is no drought and no change in the U.S. production possibility curve. The increase in the relative price of food (decrease in the relative price of clothing) causes production to shift from S1 , to S 2 more food produced and less clothing produced domestically. Given the new production point S 2 , the United States can trade at the new price ratio to reach consumption point C2 . In comparison with initial consumption at C1 , the United States has higher well-being or welfare, reaching community indifference curve I 2 rather than I1 . (The higher well-being is the result of the improved terms of trade.) The relative price of clothing decreases and U.S. real income increases, so the quantity consumed of clothing increases. Quantity consumed of food could increase, stay the same, or decrease. The United States tends to consume more food because U.S. real income has increased. The United States tends to consume less food because the relative price of food has increased. The actual change in the quantity of food consumed depends on the relative sizes of these two effects—the income and substitution effects.

d. According to the Stolper–Samuelson theorem, the factor (land) used intensively in food production (the rising-price good) gains real income. The factor (labor) used intensively in producing clothing (the falling-price good) loses real income.

78. a. The U.S. production–possibility curve shifts out for all points except its intercept with the food axis. This is growth biased toward clothing production.

The U.S. willingness to trade probably decreases because the United States is now capable of producing its import good at a lower cost. Although the extra production and income lead to an increase in U.S. demand for clothing, the expansion of the supply of clothing that 40 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

results from the improved technology is likely to be larger, so U.S. demand for clothing imports probably decreases.

The decrease in U.S. demand for imports reduces the equilibrium international relative price of clothing. The U.S. terms of trade improve.

79. a. For the rest of the world, the production possibility curve does not change, but the equilibrium relative price of clothing declines. Production in the rest of the world shifts S from, say, point 1 to point S ' . Clothing production declines and food production increases in the rest of the world. The rest of the world can trade at the new price ratio, C and its consumption point shifts from point 1 to point C ' . The rest of the world shifts I from 1 to I ' , a lower community indifference curve, so its well-being declines. The relative price of food increases and real income is lower in the rest of the world, so its quantity consumed of food decreases. The quantity consumed of clothing can decrease, stay the same, or increase. Real income is lower, which tends to lower quantity consumed of clothing. The relative price of clothing is lower, which tends to increase the quantity consumed of clothing. The actual change depends on which of these two effects is larger.

Well-being in the rest of the world decreases because its terms of trade deteriorate. The price that it gets for its exports of clothing decreases. The purchasing power of its exports decreases, so the country can afford to buy fewer imports, and the country is poorer.

80. a. With unchanged product prices, wheat production increases by 25%   50  40 / 40  .

Cloth also increases by 25%   80  64 / 64  . This is balanced growth.

Along the new production–possibility curve, the change in product prices has caused production of wheat to increase from 50 to 52 units, and production of cloth to decrease from 80 to 77 units. The relative price of wheat increased (or, equivalently, the relative price of cloth decreased.)

81. a. Country B produces at point J, Q1 of oats and no newts, and trades with the rest of world at the world equilibrium price shown by the slope of the price line through point J. By 41 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

trading along this price or income line, the country consumes at point T, Q2 of oats and Q3 of newts. Country B exports  Q1 – Q2  of oats and imports Q3 of newts.

When Country B gains the newt technology, it can produce newts, so its capabilities are a complete bowed-out production–possibility curve. The intercept of the ppc with the oat axis remains at point J—possession of newt technology does not alter Country B’s production quantity if it does not produce any newts.

Both are possible. It depends on the shape and position of Country B’s new ppc, relative to the shapes and positions of its community indifference curves (representing its demands for the two products).

County B continues to export oats if the new ppc is skewed toward oat production.

Production is at point K and consumption at point U:

Country B exports newts if the new ppc is skewed toward producing newts. Production is at point L and consumption at point V:

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In the initial situation, the key driver of the trade pattern was the technology difference.

Because Country B had a relative disadvantage in newt technology (it did not have this production technology), it imported newts and exported oats.

In the new situation, the key driver of the trade pattern is something other than technology, because Country B now has access to the same technologies as the rest of the world has. If demand patterns are similar, then the key driver of the trade pattern is the combination of differences in factor endowments between Country B and the rest of the world and differences in factor usage in producing the products (Heckscher-Ohlin theory).

82.

South Korea allowed more international trade with the rest of world, and this probably contributed in important ways to the country’s rapid growth since the 1960s. First, the country benefited from the standard gains from trade. Factor inputs were reallocated across industries toward their most productive uses, raising the value of national production and income. South Korean households gained by buying cheaper and more varied foreign products. Second, and probably more important, the country’s firms benefited from access to foreign technologies. Through imports South Korean firms gained access to innovative machinery that brought new and better technology into the country. South Korean firms more generally gained greater awareness of foreign technologies. Once aware, they could find ways to bring these technologies into use in South Korea, through import purchases, licensing, and imitation. Third, international trade put competitive pressure on South Korean firms (e.g., Samsung) to raise their productivity, through more cost-effective employment of factors and through improved products and production technology. South Korean firms increased their own research and development activities to try to gain their own technology advantages. In contrast, North Korea largely remained closed to the rest of the world. It did not achieve gains from trade, and its production did not incorporate foreign technology. It remains a very poor country.

Chapter 8 Analysis of a Tariff 43 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Overview This chapter starts the analysis of government policies that limit imports, by examining the tariff—a government tax on imports. The chapter has two major purposes. First, the analysis shows the effects of a tariff when the importing country is small, so that its import policies have no effect on world prices. Second, the analysis of a large importing country—one whose policies can affect world prices—shows that a large country can use a tariff to lower the price that it pays foreigners for its imports. Furthermore, the box ―They Tax Exports, Too‖ shows that analysis of an export duty parallels that of an import tariff.

Early in the chapter, the box ―The Tariff-Driven Trade War of 2018-2019‖ serves as an initial case study that can provide motivation for the economic analysis in this chapter and some parts of the next two chapters. Following investigations which found that imports of steel and aluminum were threats to U.S. national security, in 2018, the Trump administration imposed tariffs on imports of these products from most countries. (His administration induced South Korea and Argentina to accept ―voluntary‖ steel export restraints and imposed quotas [instead of tariffs] on steel imports from Brazil.) The first front of the trade engaged as China, Mexico, the EU, Turkey, Canada, and Russia imposed retaliatory tariffs on imports from the United States.

The second front of the trade war began as a U.S. Section 301 case. The Trump administration concluded that the Chinese government was using and continued to use unfair policies and practices to gain access to the technologies and other intellectual property of U.S. firms. In July and August, Trump imposed tariffs, and the Chinese government immediately retaliated with tariffs on imports from the United States. The war on this second front then escalated, with three rounds of U.S. retaliatory tariffs and Chinese retaliatory tariffs, in September, 2018 and June and September, 2019. The box also summarizes research on the effects of the trade war, including some numerical estimates.

The chapter’s analysis begins by examining the effects of an import tariff imposed by a small country (contrasted with free trade), using supply and demand within the importing country.

Since foreign exporters do not change the price that they charge for the product, the domestic price of the imported product rises by the amount of the tariff. Domestic producers competing with these imports can also raise their domestic prices as the domestic price of imports rises.

Domestic producers gain when the government imposes a tariff on competing imports. They get a higher price for their products, they produce and sell a larger quantity (a movement along the domestic supply curve), and they receive more producer surplus. (The effects of the entire tariff system on domestic producers can be more complicated than this, because other tariffs can raise the costs of materials and components. The box on ―The Effective Rate of Protection‖ discusses this more complete analysis, focusing on the effects of the tariff system on value added per unit of domestic production.)

Domestic consumers of the product are also affected by the imposition of the tariff. They must pay a higher price (for both imported and domestically produced products), they reduce the quantity that they buy and consume (a movement along the domestic demand curve), and they suffer a loss of consumer surplus.

The government also collects tariff revenue, equal to the tariff rate per unit imported times the quantity that is imported with the tariff in place (less than the free-trade import quantity).

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We thus have two domestic winners (domestic producers and the national government) and one domestic loser (domestic consumers) because of the imposition of a tariff. We can evaluate the net effect on the whole country, if we have some way of comparing winners and losers. As we did beginning in Chapter 2, we can, for instance, use the one-dollar, one-vote metric. Part of what consumers lose is matched by the gain to domestic producers, and another part is matched by the revenue gain to the government. But there is an additional amount that consumers lose and that is not a gain to the other groups. This is the net national loss from a tariff (for a small country). In the national market graph this loss is two triangles; equivalently, in the import– export graph this loss is one triangle.

If we look at the national market graph, we can see why these are deadweight losses. The consumption effect of the tariff is the loss of consumer surplus for those consumers who are squeezed out of the market because the tariff ―artificially‖ raises the domestic price, even though foreigners remain willing to sell the product to the importing country at the lower world price.

The production effect of the tariff is the loss from using high-cost domestic production to replace lower cost imports (available to the country at the unchanged world price). The high production cost is shown by the height of the domestic supply curve, for each of the extra units produced because of the tariff.

The analysis is affected in important ways if the importing country is a large country, one that has monopsony power in world markets. A large country can gain from the terms-of-trade effect when it imposes a tariff. The tariff reduces the amount that the country wants to import, so foreign exporters lower their price (a movement along the foreign supply-of-exports curve). We analyze the large country case using the international market (imports and exports), and we show the tariff as driving a wedge between import demand and export supply, so the price to the import buyers exceeds the price received by foreign exporters by the amount of the tariff. For the large importing country, the imposition of the tariff causes a triangle of national loss (comparable to the one shown for the small country) but also a rectangle of national gain because the price paid to foreign exporters is lowered, for the units that the country continues to import.

The net effect on the importing country depends on which of these two is larger. For a suitably small tariff, the rectangle is larger, so the importing country has a net gain from imposing a tariff.

A prohibitive tariff would cause a net national loss, because the rectangle would disappear. It is possible to determine the country’s nationally optimal tariff—the tariff rate that makes the net gain to the importing country as large as possible. The optimal tariff rate is inversely related to the price elasticity of foreign supply of the country’s imports.

We conclude by pointing out that the optimal tariff causes a net loss to the whole world. The loss to the foreign exporting country is larger than the net gain to the importing country. And a country trying to impose an optimal tariff risks retaliation by the foreign countries hurt by the country’s tariff.

Tips

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This chapter is crucial to understanding the effects of government policies toward trade. We recommend a strategy of ―stereo‖ coverage. Every key point should be expressed in written words as well as in diagrams, in a class session as well as in the textbook.

A requirement for clear understanding throughout Chapters 8–15 is that students know how to interpret the height of the demand curve as marginal benefits and the height of the supply curve as marginal costs, leading them to measures of consumer surplus and producer surplus. If students have not mastered these concepts in other courses, they must be taken through this material in Chapter 2. Even a course that wants to go quickly to government policies toward trade, skipping the details of trade theory, should start with Chapter 2.

In the textbook, we choose to show the optimal tariff (in Figure 8.6) using only demand-forimports and supply-of-exports in the international market. In class session you may also want to show the analysis in the equivalent way, using the national market (as for the small tariff in Figure 8.4). The national market can be used to show the full range of effects when a large country imposes an optimal tariff: increase in domestic producer surplus; decrease in domestic consumer surplus; government tariff revenue, with some of it paid by domestic consumers and some effectively paid by foreign exporters, compared with the free-trade price; and the net effect on national well-being as the difference between the rectangle of gain from the lower price paid to foreign exporters and the two triangles of loss.

We present the analysis of a tariff in this chapter for both the small country and the large country, and we present the analysis of an import quota and a voluntary export restraint (VER) in the next chapter. In your class presentation, you might consider a different way of organizing this material, in which you present the small country analysis of the tariff, the quota, and the VER as a package, and then turn to looking at the large country analysis of the tariff and the quota. This alternative approach is designed to emphasize the fundamental similarities of the analyses of these different government policies, as well as the specific ways in which they are different.

Students generally find it easier to grasp the small country analyses, so it can be useful to do all three policies for this easier case before turning to the large country analyses.

For those who want to present a more technical analysis of the optimal tariff, the first section of Appendix D presents the basic mathematics. The third section of Appendix D shows how to use offer curves and trade indifference curves to determine the optimal tariff.

Suggested answer to case study discussion question The Tariff-Driven Trade War of 2018–2019: A superhero has a just cause or objective and special abilities to thwart malefactors while causing little or no harm to bystanders. Former President Trump had two just causes that he said he was upholding: U.S. national security and the rights of U.S. firms to their intellectual property, especially technology. His power was the ability to use certain (previously passed) U.S. laws to impose new tariffs on imports from foreign countries.

For steel and aluminum, the cause was debatable. While steel and aluminum are used in the production of defense products, U.S. production capabilities seemed to be adequate. At the same 46 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

time, imposing tariffs on imports from U.S. allies, as if they were miscreants, seemed to be counterproductive. And, the U.S. tariffs caused substantial harm in the United States, especially to the many U.S. firms that used steel and aluminum in producing their own products.

Furthermore, several foreign countries whose steel and aluminum exports were hit by the U.S. tariffs retaliated by imposing tariffs that harmed U.S. exporters of those products.

For China, the cause was reasonable. The Chinese government and Chinese firms sought to obtain the technology of U.S. firms. U.S. firms mounted their own defenses, but Chinese government policies still tilted the outcomes. Again, however, the U.S. tariffs caused substantial harm in the United States. Trump claimed that Chinese exporters were paying the U.S. tariffs, but research indicates that U.S. firms and households were actually paying the U.S. tariffs. (In economic language, the incidence of the tariffs was on them.) And, China retaliated through several rounds by imposing tariffs on imports from the United States, harming a broad range of U.S. industries.

In short, Tariff Man was not a villain, though the trade war caused substantial harm in the United States. Tariff Man was not a classic hero; he seemed to be more of a bungler.

They Tax Exports, Too: There are a number of possible reasons that a country would limit the export of a product like cotton. First, if the government uses a tax, it would gain revenue.

Second, the limit on exports would tend to force additional sales of the product in the local market, so the domestic price would fall below the world price, and domestic consumers would benefit. Third, if the country is a large exporter of the product, then the world price will rise when the country exports less, and the country can gain from an improvement in its terms of trade. An export ban is an extreme limitation, and two of the three possibilities do not apply.

There is no government revenue. Even if the world price of the export product increases, there are no exports on which to receive the gain from the higher price paid by foreigners. The most likely reason for the Indian prohibition of cotton exports is then the one remaining, that the ban benefits the local consumers of cotton. Domestic producers of textiles gain from the lower price of cotton, an input into their production.

Suggested answers to end-of-chapter questions and problems 83.

You can calculate it if you know only the size of the tariff and the amount by which it would reduce imports. (See Figure 8.4.)

84.

Agree. The tariff raises the domestic price of the imported product, and domestic producers of the product raise their price when the domestic price of imports increases.

Domestic consumers lose consumer surplus on the total amount that they consume, both imports and domestically produced product, because of the increase in domestic price.

Domestic producers gain producer surplus on the amount that they produce and sell, because of the increase in domestic price. Consumers lose more because the domestic quantity consumed is larger than the domestic quantity produced.

85.

The production effect of a tariff is the deadweight loss to the nation that occurs because the tariff encourages some high-cost domestic production (production that is inefficient by the 47

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world standard of the international price). Producing the extra domestic output that occurs when the tariff is imposed has a domestic resource cost that is higher than the international price that the country would have to pay to the foreign exporters to acquire these units as imports with free trade. The domestic resource cost of each unit produced is shown by the height of the domestic supply curve. Thus, the production effect is the triangle above the free-trade world price line and below the domestic supply curve, for the units between domestic production quantity with free trade and domestic production quantity with the tariff. It can be calculated as one-half of the product of the change in domestic price caused by the tariff and the change in production quantity caused by the tariff.

86.

The consumption effect of a tariff is the loss of consumer surplus for the units that consumers would consume with free trade but do not consume when the tariff increases the domestic price. The tariff ―artificially‖ raises the domestic price and causes some consumers to buy less of the product. On a diagram like Figure 8.3 or 8.4A, it is the triangular area d.

87. a. Consumers gain $420 million per year.

Producers lose $140 million per year.

The government loses $240 million per year.

The country as a whole gains $40 million a year.

88.

For a small country the world price of $400 will not be affected by the tariff. The size of the net national loss from imposing a $40 tariff will depend on the shapes of the domestic supply and demand curves. The graph shows several possible domestic supply and demand curves. (These possible supply and demand relationships are straight lines.)

The maximum net national loss occurs when the two triangles of deadweight loss are as large as possible. The maximum loss occurs when the $40 tariff just eliminates all imports, so that the country shifts to no trade with a domestic price of $440. The tariff imposes a full $40 price distortion on the full amount of free-trade imports of 0.4 million D S per year. In the graph, any curves like 1 and 1 , which have free-trade at A and B and intersect each other at a price of $440, will cause a net national loss shown by the shaded triangle. The size of the loss is ½  1.4  1.0   $40   $8 million .

The minimum net national loss is zero. This can occur in any of several extreme cases.

First, if both the supply curve and the demand curve are vertical  S0 and D0  , then the domestic price increases to $440, but there are no changes of quantities. With no distortion of domestic producer and consumer decisions, there are no triangles of inefficiency. Second, if the domestic demand curve is flat  D3  , then domestic consumers receive no consumer surplus at the price of $400, and they will not pay more than $400 per bike. When the tariff is imposed, imports fall to zero, domestic price remains at $400, and domestic production remains at 1.0 million bikes. There are no triangles of loss. Third, if the domestic supply curve is flat  S3  , then domestic producers receive no producer surplus at the price of $400, and they can supply more bikes at the 48

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same price. When the tariff is imposed, imports fall to zero, domestic price remains at $400, and domestic production increases to match domestic consumption at 1.4 million bikes. There are no triangles of loss.

89. a. Consumers gain $5,125,000.

Producers lose $1,875,000.

The government loses $6,000,000 in tariff revenue.

The country as a whole loses $2,750,000 each year from removing the tariff. The national loss stems from the fact that the tariff removal raises the world price paid on imported motorcycles. In Question 5, removing the duty had no effect on the world price (of sugar).

90.

If imports are 0.33 million bicycles, the tariff-inclusive price paid by domestic consumers must be $350, and the export price is $250, so the tariff is $100 per bicycle. The importing country gains the rectangle equal to $500.33 million = $16.7 million. It loses the triangle equal to ½  $50 0.67  $16.7 million . The net national gain from a tariff of $100 per unit (compared to free trade) is zero. This cannot be nationally optimal, because a tariff of less than $100 per unit results in an increase in national well-being.

91.

The $1.25 is made up of 60 cents of value added, 35 cents of cotton payments, and 30 cents of payments for other fibers. The effective rate is  60¢  40¢ / 40¢  50% .

92.

The formula is one divided by the price elasticity of foreign supply of our imports. If the foreign supply is infinitely elastic, then the optimal tariff is zero ( 1/ ) .

93.

Agree. Consider the example shown in Figure 8.5. The free-trade world price is $300 per bike. The country then imposes a $6 tariff. Because the country is large, the price charged by exporters falls to $297 per bike. With the $6 tariff, the domestic price rises to $303 per 49

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bike. Area e is the gain to the country by paying less to foreign exporters ($297 rather than $300 for each bike imported). We can look at this in a different way, focusing on who pays the tariff. The total tariff revenue collected by the government is area c plus area e ($6 times the number of bikes imported). Who actually pays this tariff revenue?

Compared to the no-tariff (free-trade) initial situation ($300 per bike), domestic consumers pay $3 per bike ($303 − $300) and foreign exporters effectively pay (or absorb) the other $3 per bike ($300 − $297). That is, the foreign exporters in total effectively pay area e, a part of the total tariff revenue collected by the government. This is another way to look at why a large country can gain by imposing a tariff.

94.

With the domestic supply curve S d , the domestic demand curve Dd , and the world price

of $150 per ton, the country would export  S0  D0  tons if there is no export tax. With the export tax of $10 per ton, domestic firms receive $150 per ton from foreign buyers, but the domestic firms must pay the government $10 for each ton exported. They have revenue net of the tax of only $140 per ton exported. Competitive domestic producers are willing to sell to domestic buyers at this same price of $140 per ton (with no tax applied to domestic sales). So exports shrink to  S1  D1  , equal to 10 million tons. The export tax distorts the market, with area AER showing the inefficiency of domestic overconsumption, and area FHT showing the inefficiency of domestic underproduction.

If the government were to reduce the export tax to $5 per ton, then the price net of the export tax would be $145 per ton exported, and the domestic price would be $145 per

ton. The quantity exported would increase to  S 2  D2  . The inefficiencies would decrease to area ABJ (overconsumption) and area GHK (underproduction).

Would the inefficiency be reduced by half? No, it would be reduced by more than half.

For each type of inefficiency, the height of the triangle (the size of the tax) would be reduced by half, and the base of the triangle (the amount by which the tax-distorted quantity differs from the no-tax quantity) would also be reduced by half. The area of a triangle is one-half base times height. With both the base and the height decreasing by

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half for each triangle, the size of the inefficiency with the $5 export tax would be only one-quarter the size of the inefficiency with the $10 export tax.

Chapter 9 Nontariff Barriers to Imports Overview This chapter has four major purposes: 95. Analyze an import quota and a voluntary export restraint (VER), for both a small importing country and a large one.

96. Provide an overview of other nontariff barriers (NTBs) to imports.

97. Explore the relative sizes of the economic costs of tariffs and nontariff barriers.

98. Present the World Trade Organization (WTO), including its roles in reducing tariffs, attempting to liberalize NTBs, and settling international trade disputes, as well as the current challenges it faces.

Governments use a variety of other barriers to imports in addition to tariffs. The chapter begins with examples of nontariff barriers to imports and several kinds of effects that they can have.

NTBs lower imports by directly limiting the quantity of imports (e.g., import quota, VER, government procurement policies that prohibit or limit government purchasing of imports), increasing the costs of getting imports into the market (e.g., product standards and testing procedures), and creating uncertainty about whether imports will be permitted (e.g., arbitrary licensing procedures).

Early in the chapter, the first in a series of boxes on Global Governance introduces the World Trade Organization (WTO), created in 1995, which subsumed the General Agreement on Tariffs and Trade (GATT), formed in 1947. The major principles of the WTO include trade liberalization, nondiscrimination, and no unfair encouragement of exports. Eight completed GATT rounds of multilateral trade negotiations were successful in lowering tariffs imposed on most nonagricultural imports into industrialized countries. The box also notes the different path that developing countries have taken for their tariff reductions. Recent rounds of GATT multilateral trade negotiations have included NTBs, but with less success in lowering them. The box also discusses how the WTO has extended into nontraditional areas. The Uruguay Round, completed in 1994, began the process of liberalizing trade in agricultural products, established rules about protecting patents, copyrights, and trademarks, and began the process of setting rules for trade in services. The box concludes by noting that the WTO faces major challenges, including failure to complete a new round of multilateral trade negotiations, complaints that WTO rules do not address some of China’s trade-distorting practices, failure to head off or reverse the trade war of 2018–2019, U.S. dissatisfaction with the WTO dispute settlement process, and shut down of the appeals process for dispute settlement as the United States refused to approve new judges. (Later in the chapter, another box looks at ―China in the WTO.‖) After describing the types of nontariff barriers to imports, the text of the chapter develops the analysis of an import quota. If both the domestic industry and the foreign export industry are 51 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

perfectly competitive, then the effects of a quota are almost all the same as the effects of a tariff that permits the same quantity of imports. For a small importing country, the increase in domestic price, the increase in domestic production, the decrease in domestic consumption, the increase in domestic producer surplus, the decrease of domestic consumer surplus, the consumption inefficiency, and the production inefficiency are the same. The possible difference is what happens to the amount that would be government revenue with a tariff. With an import quota this is the amount that is the difference between the cost of imports purchased from foreign exporters at the world price and the value of these quota-limited imports when sold in the domestic market at the higher domestic price. (We presume that the holders of the import quota rights are domestic and can continue to buy at the world price. If any foreign exporter tried to charge more, the importers would turn to other export suppliers who would sell at the going world price.)

If the government gives away these quota rights to import with no application procedure (fixed favoritism), then the import price markup goes as extra profits to whoever is lucky enough to receive the rights. If the government auctions the quota rights (import-license auction), then the government gains the markup as auction revenues because bidders vie for these valuable import rights. If the government uses elaborate applications procedures (resource-using application procedures), then some of the markup amount is lost to resource usage in the application process, leading to a larger net national loss because of the extra resource costs of the quota process.

For the large-country case, again the effects of imposing a quota are nearly all the same as the equivalent tariff, except for what happens to what would be tariff revenue. Specifically, the importing country can benefit from imposing an import quota, if the rectangle of gain from the lower price paid to foreign exporters for the quota quantity imported is larger than the triangle of losses from distorting domestic production and consumption.

If the domestic industry is a monopoly, then the effects of imposing a quota are different from the effects of imposing a tariff. The box ―A Domestic Monopoly Prefers a Quota‖ explains that a quota cuts off foreign competition, so the quota permits the domestic firm to use its monopoly power. The quota leads to a higher domestic price and greater net national losses.

The VER is usually not voluntary, but it is an export restraint. Because the government of the exporting country must organize its exporters into a kind of cartel, they should realize that they should raise the export price. If the exporters do raise the export price, then the exporters get the amount that otherwise would be government revenue with a tariff, or the price markup with an import quota. The net national loss is larger for the importing country with a VER because of this additional rectangle loss. The box ―VERs: Two Examples‖ discusses (1) the costs to the United States of the VER on imports of Japanese automobiles and (2) the web of export restraints that developed to limit international trade in textile and clothing products.

The chapter then examines three other NTBs based on product standards, domestic content requirements, and government procurement. Product standards can be worthy efforts to protect health, safety, and the environment. But they can also be written to limit imports and protect domestic producers. Domestic content requirements mandate that a minimum percentage of the value of a product produced or sold in a country be local value added (including domestically produced components and materials). They can limit imports that do not meet the requirements, 52 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

and they can limit the import of components and materials used to produce the product.

Government purchasing practices are often an NTB because they are often biased against buying imported products.

How relatively large are the economic costs of tariffs, quotas, VERs, and other nontariff barriers to imports? The chapter shows that the net national loss is probably a small fraction of the value of domestic production (GDP), for a country like the United States that has moderate import barriers and is not highly dependent on imports, if the only national losses are the deadweightloss triangles. The true cost is probably larger than this basic analysis indicates, because of foreign retaliation and losses in export industries, the resource costs of enforcing import barriers, the resource costs of rent-seeking activities like lobbying for import protection, the losses from such barriers as VERs when foreign exporters raise their prices, and the losses from reduced pressures to innovate. The chapter also presents a second way to look at the relative size of the costs of protection, per dollar of increase in domestic producer surplus.

The final section of the chapter examines international trade disputes and how they can be resolved. The GATT had a dispute settlement procedure, but it was weak and became increasingly ineffective. The United States moved outside of the GATT by enacting Section 301 of the U.S. Trade Act of 1974, which aims to lower foreign barriers to U.S. exports by threatening to raise U.S. barriers to the foreign country’s exports if the foreign country does not change its policies. Other countries have resented such a heavy-handed unilateral approach, and well-being for both countries would probably decline if the U.S. government carries out the threat. Fortunately, the United States decreased its use of Section 301; the U.S. government is more likely to send its complaints about unfair foreign trade practices to the WTO for resolution.

But, in a Section 301 case that began in 2017, the U.S. government found that China had used unfair government policies and practices toward the intellectual property of U.S. firms. In 2018, President Trump imposed tariffs on imports from China, and China retaliated with tariffs on imports from the United States.

A key advance of the WTO over the GATT is that the WTO has a stronger dispute settlement process. The WTO dispute settlement procedures generally have been successful, with most disputes resolved by negotiations or after a WTO ruling. As a last resort, member countries that are harmed by another member country’s policy that has been found to violate WTO rules are permitted to retaliate if the offending government does not bring its policy in line with the rules.

Actual retaliation would lower world well-being, so it is fortunate that it happens infrequently.

However, U.S. dissatisfaction with what it viewed as overreach in some dispute settlement decisions led the U.S. government to stop approving new appointments to the Appellate Body.

The appeals process ceased to function in late 2019.

Tips Many of the tips for Chapter 8 also apply to this chapter. We strongly recommend showing the effects of quotas and VERs using both words and diagrams.

The material of Chapter 9 can be supplemented with outside readings on the WTO or news items on current trade policy issues. One area of interest is current (or recent) cases that are in the 53 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

WTO’s dispute settlement process. Students appreciate seeing how the concepts and analyses connect to real issues, and governments are usually accommodating in serving up fresh examples.

Suggested answers to case study discussion questions VERs: Two Examples: In 1981, the U.S. government forced the Japanese government to impose a ―voluntary‖ export restraint, so that total Japanese automobile exports in 1981 had to be 8% less than the total exports in 1980. The Japanese government told Honda (and each of the other Japanese auto companies) the maximum number of cars that the company could export to the United States. With quantity strictly limited, Honda raised the prices of the cars that they did export. For the Civic, the increase was about $1,000. When your grandfather went to the Honda dealer to buy a new Civic, he saw and paid the higher price. Essentially, a slice of area c in a graph like Figure 9.2 was the extra $1,000 that your grandfather had to pay for the Civic in 1981 (above what he would have paid for a new Civic in 1980).

Carrots Are Fruit, Snails Are Fish, and X-Men Are Not Humans: You may be able to play the same game that the U.S. importers described in the case study used, careful definition of the product so that the import duty is as low as possible. Your woven textile could be either a rug or a wall hanging. You should try to find out which product has the lower tariff rate. Probably, a rug (a manufactured product in the textile category) has a higher tariff rate than a wall hanging (a work of art). If so, then you should answer that your woven textile is a wall hanging.

Suggested answers to end-of-chapter questions and problems 99.

Import quotas are government-decreed quantitative limits on the total quantity of a product that can be imported into the country during a given period of time. Here are three reasons why a government might want to use a quota rather than a tariff: (1) A quota constrains the quantity of imports to the amount set by the quota. This can be useful if the government wants to assure domestic producers that imports are actually limited. (2) A quota gives government officials greater power and discretion over who gets the valuable right to import. (3) The government may accede to the desires of domestic producers who could have monopoly pricing power if import competition is removed at the margin. For instance, a quota would be preferred by a domestic monopoly because the monopoly could raise its price with no fear of growing imports as long as a quota limits the quantity imported.

A quota does not bring a greater national gain. From the point of view of the national interest, a quota is no better than an equivalent tariff, and it may be worse.

100.

Voluntary export restraint (VER) agreements are nontariff barriers to imports. Despite their name, the importing-country government coerces the exporting-country government into allocating a limited quota of exports among its exporting firms. Import-country governments often force exporters into accepting VERs because the government wants to limit imports without explicit import barriers like tariffs or import quotas that would 54

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violate international agreements. (The Uruguay Round agreements included a provision to eliminate the use of VERs, but it has not been fully effective.) In choosing VERs, the importing-country government does not create a bigger national gain than with tariffs or import quotas. On the contrary, a VER allows foreign exporters to gain the price markup that the importing country would have kept for itself if it had used a tariff or quota.

(Gaining this price markup is a reason that the exporting country may agree to a VER, rather than risking that the importing-country government will impose its own import limits.)

101.

This would happen if the domestic product market were perfectly competitive and the import quota rights were auctioned off competitively.

102.

a.

Product standards are imposed to ensure that products meet minimum requirements to protect health, safety, or the environment. But they can be written to discriminate against imports, by setting unreasonable requirements that penalize imports.

To the extent that product standards enhance health, safety, and the environment, they can raise national well-being. To the extent that they are used as nontariff barriers to imports, they bring the net national losses that usually accompany protection.

Domestic content requirements mandate that a minimum percentage of the value of a product be domestic value-added. This can provide protection to domestic producers of the product if imports of the product are impeded by the domestic content requirements. In addition, this can provide protection for domestic producers of materials and components by forcing domestic producers of the product to limit their use of foreign materials and components. For both of these reasons, domestic content requirements result in the net national losses that usually accompany protection.

103.

The tariff would be less damaging to the United States because it gives the United States the tariff revenue that instead would be a price markup pocketed by foreign bulldozer makers with a VER. Both would bring the same overall loss in world welfare.

104.

a.

The U.S. government is deeply committed to assuring that food products are safe for consumers to eat, and to protecting the health and safety of workers growing the food.

These are surely noble and correct goals for government regulations. We have established regulations for growing and harvesting apples that assure that the standards meet these objectives. In particular, U.S. standards regulate the use of various pesticides and prohibit the use of unsafe pesticides, to protect worker health and to minimize or prevent ingestion by consumers of trace amounts of pesticides. The U.S. government must insist that U.S. production standards be followed in foreign countries for all apples exported to the United States. Otherwise the U.S. government could not be certain to meet its objectives for imported apples.

The U.S. government has no business forcing us to adopt its production standards. First, our own governments are the best judges of the standards to apply to worker safety within our own countries. Because work and environmental conditions vary from country to country, it is simply inappropriate to apply U.S. standards. Indeed, what is safe in the United States could be unsafe in another country. Second, the U.S. government must regulate 55 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

product quality by specifically examining product quality as our apples arrive in the United States. The issue here is not the techniques of growing and harvesting, but rather whether the product is safe for the consumer. The U.S. government should test for that directly. If they did this, they would find that our apples are perfectly safe, even though we do not use the same production techniques used in the United States. The emphasis of the U.S. government on production techniques is misplaced—it is an effort to protect its domestic apple growers by raising our costs of production or forcing us to cease exporting to the United States.

105.

a.

The change in producer surplus is a gain of $0.02 per pound for the 120 million pounds that are produced with free trade plus the producer surplus on the increased production of 40 million pounds. The latter is 1/2 × $0.02 per pound × 40 million pounds (assuming a straight-line domestic supply curve). The gain in producer surplus totals $2.8 million.

The change in consumer surplus is a loss of $0.02 per pound for the 400 million pounds that the consumers continue to purchase after the quota is imposed plus the loss of consumer surplus on the 20 million pounds that consumers no longer purchase because of the quota.

The latter is 1/ 2  $0.02  20 million (assuming a straight-line domestic demand curve). The loss in consumer surplus totals $8.2 million.

The right to import is a right to buy sugar at the world price of $0.10, import it, and sell it domestically at the price of $0.12. If the bidding for the rights is competitive, then the buyers of the rights bid $0.02 per pound. The government collects $4.8 million (= $0.02 per pound × 240 million pounds).

The net loss to the country is $0.6 million. By limiting imports, the quota causes two kinds of economic inefficiency. First, the increased domestic production is high cost by world standards. The country uses some of its resources inefficiently producing this extra sugar rather than producing other products. Second, the consumers squeezed out of the market by the higher price lose the consumer surplus that they would have received if they were allowed to import freely.

106.

With a price elasticity of demand for imports of 1, the 50% tariff rate has resulted in a 50% reduction in imports. The net national loss of the tariff as a percentage of the country’s GDP equals ½   0.50  0.50  0.20, or 2.5% . The increase in producer surplus in the protected sectors, as a percentage of GDP, is approximately the 50% increase in domestic price times the 15% share of these sectors in GDP or 7.5%. Thus, the net national loss from the tariff is about 33% of the gain to protected producers. For every dollar that domestic producers gain, the rest of the society loses $1.33.

107.

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Before the demand increase, as shown in the graph above, the tariff and the quota are S essentially equivalent (domestic price P1 , domestic production quantity 1 , domestic consumption quantity

D1

, import quantity D1  S1 , domestic producer surplus VAP1 ,

domestic consumer surplus UBP1 , deadweight losses AEC and BGJ, and government tariff revenue or quota import profits ABGE). With the increase in demand to D ' d , the unchanged tariff and the unchanged quota are no longer equivalent:

After domestic demand has increased, the domestic price is higher with the quota than with the tariff, domestic quantity produced is higher with the quota than with the tariff, domestic quantity consumed is lower with the quota than with the tariff, domestic producer surplus is larger with the quota than with the tariff, domestic consumer surplus is smaller with the quota than with the tariff, and the deadweight losses are larger with the quota than with the tariff.

108.

Free trade will bring the largest well-being for the entire world. Generally, the United States has few barriers against imports, and we believe that open competition has made 57

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the U.S. economy strong. But other countries often have protectionist policies. This hurts the U.S. economy, because we lose export opportunities that would allow us to take maximum benefits from our comparative advantages. Protectionist policies in foreign countries usually also impose net national costs for those countries, and they certainly harm consumers in those countries. The protectionist policies exist to benefit certain producer groups in those countries, at the expense of others in the countries.

Section 301 is a tool that the U.S. government can use to reduce foreign protectionism and reduce or eliminate unfair foreign trade practices. Yes, it does involve threats by the U.S. government to raise its own import barriers if the foreign government does not lower its barriers, but this is a useful risk to take. The United States is large enough to influence foreign countries’ governments, and the power here is being used for the good of the world. It has been successful much of the time. When it is successful, the world moves toward free trade, bringing benefits to the United States, to the foreign countries through net gains from free trade, and to the world as a whole.

109.

a.

Relative to free trade, the tariff gives the United States a terms-of-trade gain of $180 million and an efficiency loss of $100 million for a net gain of $80 million. In terms of Figure 9.3, this is area e minus area (b + d). The VER costs the United States $300 million (area c) plus $100 million (b + d again) for a loss of $400 million. For the United States, then, the tariff is best and the VER is worst.

If the United States imposes the $80 tariff, Canada loses $180 million (area e) and $60 million (area f) for a total loss of $240 million. By contrast, if the United States and Canada (Bauer) negotiate a VER arrangement, Canada gains $300 million on price markups (area c) and loses $60 million (area f ) for a net gain of $240 million. For Canada, the U.S. tariff is the most harmful, whereas the VER actually brings a net gain.

For the world as a whole (the United States plus Canada here), either the tariff or the VER brings a net loss of $160 million (areas b + d and f ). Free trade is still best for the world as a whole.

110.

The perspective of the Ministry of the Economy is presumably the national interest and the overall functioning of the economy, so your presentation will make the case that the tariff would be better than the quota. The tariff will increase the domestic price of motorcycles by 20%, and the domestic motorcycle firm will also raise its motorcycle prices by 20%. Total domestic consumption of motorcycles will decrease, imports will decrease, and domestic production of motorcycles will increase. The tariff will lead to the standard triangles (consumption effect and production effect) of deadweight loss from a tariff. (You would prefer to maintain free trade, but politically that seems not be an option in this case).

If, instead, a quota is imposed, the domestic motorcycle producer will gain monopoly power, because the quantity of competing imports is strictly limited. Taking account of the quota quantity, the domestic firm will set the monopoly price, which is more than 20% above the world price. The inefficiency caused by the quota includes both the inefficiency that would be caused by the tariff (the standard triangles of deadweight loss) and the additional inefficiency caused by monopoly pricing. To minimize the damage to

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the national economy (the inefficiency that harms the national economy), the tariff is preferred to the quota.

111.

Partly disagree, partly agree.

The WTO has been less successful than the GATT at completing rounds of multilateral trade negotiations. Under the GATT its member countries reached eight multilateral trade agreements, culminating in the Uruguay Round agreement that created the WTO. The WTO has started one round, the Doha Round, in 2001, but the round failed to reach a broad agreement.

The WTO does have a better dispute settlement procedure than did the GATT, at least as the WTO procedure functioned before late 2019. Under the WTO process, a country’s government that is found to be in violation of its WTO commitments is instructed to change its policy, offer compensation in some way, or face possible consequences (a retaliatory action by the complaining country). The country’s government that is found to be in violation cannot simply block the decision (as it could under the GATT procedure).

For the WTO procedure, most cases in which violations are found result in the countries’ governments changing their policies. But, starting in late 2019, the WTO procedure could result in no final decision, because the appeal process was nonfunctional. The United States refused to approve any appointments of new members to the Appellate Body.

Chapter 10 Arguments for and against Protection Overview This chapter has three purposes: to present a framework and a rule for evaluating arguments offered in favor of limiting imports, to apply the framework and rule to several prominent arguments for protection, and to examine the political processes that result in government policies toward imports.

The framework allows us to look at situations in which the free market may not result in economic efficiency, because of distortions that result from market failures or from efficiencyreducing government policies. In the ―first-best‖ world with no distortions, private marginal benefits (MB) to consumers who make buying decisions equal social marginal benefits (SMB), because there are no positive externalities or spillovers, private marginal costs (MC) recognized by sellers equal social marginal costs (SMC), because there are no negative externalities or spillovers, and all of these are equal to market price, because the market is perfectly competitive and there are no distorting government policies like a tax or a subsidy. When external costs, external benefits, monopoly power, monopsony power, a distorting tax, or a distorting subsidy exists, the market usually does not yield the first-best outcome, because social marginal benefit does not equal social marginal cost.

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In situations in which the free-market outcome is second-best because of a market failure, there is a potential role for government policy to contribute to economic efficiency. We mention the approach of creating new property rights, but we focus in this chapter on the tax-or-subsidy approach to eliminate distortions in private incentives.

In such a situation, a question is what government policy (tax or subsidy) to use. Fortunately, there is a rule that works well in most cases. If the problem is an incentive distortion, the specificity rule indicates that government policy should intervene at the source of the problem, to act as directly as possible on the source of the distortion. (Later in the chapter, we offer a second version of the specificity rule. If the government has a noneconomic objective, the government policy to achieve this noneconomic objective with the least economic cost is usually the policy that acts directly to achieve it.)

The specificity rule is powerful in its applications. Consider the situation in which there is too little domestic production in an import-competing industry, because of marginal external benefits from this production. What is the best government policy to address the distortion? A tariff can be used to increase domestic production, so it may be better than doing nothing, but it is not the direct policy, because it acts on imports directly, not on domestic production. The best government policy is a subsidy to domestic production. Domestic production is increased, correcting the distortion. The production subsidy is better because it does not distort domestic consumption. A tariff would squeeze some consumers out of buying, resulting in the inefficiency of the consumption effect (triangle d). The tariff is indirect and not the best policy to address the production distortion. In fact, if we can be more specific about exactly what the source of the distortion is, we should employ a more specific policy. If the distortion arises from external benefits (e.g., training or acquiring better work habits) to working in the industry, then the best government policy acts directly, by subsidizing employment or training in the industry.

The box ―How Much Does It Cost to Protect a Job?‖ (another Focus on Labor) examines the cost of maintaining jobs in import-competing industries using trade barriers. Estimates for highly protected industries in the United States show that the costs to consumers per job maintained can be very high, and that the net costs to country per job are substantial. For consumers, it would be much less expensive for them to pay those workers not to work.

The infant industry argument leads to another application of the specificity rule, as well as raising a set of other interesting issues. The argument is that import competition prevents an initially uncompetitive domestic industry from starting production. But, if the industry is shielded from foreign competition, it can begin production, and over time it will be able to lower its production costs, so that it becomes competitive. At that time in the future the protection can be removed, and the industry will provide national benefits in the form of producer surplus. In this scenario, a tariff can be better than doing nothing, for national well-being over the long term.

But the specificity rule indicates that the better government policy is one that acts directly on the source of distortion. If the issue is to foster initial domestic production, then a production subsidy is a better government policy. One may even wonder why this is needed. Why cannot the firms in the infant industry borrow to finance initial losses and then pay back the loans using future profits when the industry is grown up? If there are defects in the lending markets, then the government could extend loans. If the industry will create external benefits, such as training workers or new technologies, then the best government policy acts directly on the source of the 60 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

external benefits (for instance, subsidies to training, or subsidies to research and development).

In addition, one may wonder if the infant industry will actually ―grow up.‖ Another argument in favor of protection is assistance to industries that are declining because of rising import competition. Moving resources out of an industry is costly. People who lose their jobs because of increased imports often have a difficult time finding new jobs and often suffer substantial declines in earnings. For example, research on the rapid increase in imports from China from the early 1990s to 2007 (the ―China shock‖) shows the large and enduring harm to U.S. workers and local communities. The marginal external benefit of continuing domestic production in a declining industry is avoiding these costs of moving resources to other uses.

Again, a tariff can be used to maintain domestic production, and it may be better than doing nothing (so that the industry shrinks). But, again, the specificity rule says to attack the externality directly. A subsidy to domestic production will be better than a tariff, and other policies like subsidizing retraining of workers can be even better (more direct). The U.S. government does offer trade adjustment assistance to some workers who lose their jobs because of rising imports.

Unfortunately, the retraining offered through this program is generally not that effective.

A different argument in favor of protection is that the government gains revenue. For a poor country with a weak tax system, the lack of government revenue can lead to inadequate supply of public goods (disease control, schooling, infrastructure). Tariffs on imports and/or taxes on exports may be some of the few taxes that the government can collect effectively—they are a direct response to the source of the distortion. The benefits from better public goods can be much larger that the deadweight losses from the trade taxes. While this is potentially a valid argument for taxing trade, there is no guarantee that the government will use the revenues to fund socially useful investments. And as the country develops, it should shift toward broader-based taxes that are less distorting.

The chapter then examines several arguments in favor of protection that involve national pursuit of ―noneconomic objectives.‖ First, national pride gained by production of a product calls for a production subsidy as the least-cost way to achieve the objective. National pride in selfsufficiency calls for a tariff or other import limit, because in this case the objective is specifically to reduce or eliminate imports. Second, providing for the national defense is usually least costly using a subsidy to domestic production capacity, leaving depletable resources in the ground, or building stockpiles. The U.S. tariffs on steel and aluminum imports imposed by President Trump in 2018 are an example of an excessively costly policy—in this case, the first of these three alternative policies, a subsidy to production or production capacity, would be less costly. For the latter two alternative policies imports can be part of the solution, if they are the least costly way to acquire items during peacetime for consumption or to build up the stockpiles. Third, income redistribution is best achieved through income taxes and transfers.

The chapter concludes by surveying the political economy of trade policy, using analysis based on five major elements:   

how much the winners gain from protection and how many benefit. how much the losers are harmed by protection and how many lose. what reasons individual people and companies have for taking positions for or against protection.

61

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 

what types of political activities people and companies can use and their costs. what the political institutions and processes are.

Tariffs and other trade barriers are unlikely under at least two combinations of these elements:  

when decisions are made by direct voting and people vote based on whether they are winners or losers from protection, or when individuals are willing to devote all of their gains from winning (for or against protection) to lobbying or contributions and elected representatives (or other government officials) decide on the basis of the amount of lobbying or contributions they receive.

Tariffs and other trade barriers are more likely to be adopted when the group that will gain from protection is better organized in its lobbying and contributions. In fact, we often expect that the group with the smaller number of individuals can be more effective, because the larger gain per individual is likely to result in more activity by the smaller group, and because the smaller group is more likely to find ways to overcome the free-rider problem. The small number of importcompeting producers are motivated to participate and overcome the free-rider problem, so they become a well-organized group with substantial resources to use politically to seek protection.

The outcome is that the well-organized protectionist lobby sways a majority of politicians to enact tariffs or other import barriers. The box on sugar protection provides an example of these forces and the outcome.

In addition to explaining the general political process that leads to protection, this model of political activity can explain several specific features of trade policy. Tariff escalation occurs because the buyers of materials and component are firms that can organize to oppose tariffs on these intermediate goods. Offers to reduce tariffs in a multilateral trade negotiation are called concessions because producer groups are politically powerful. In addition, sudden damage creates sympathy, so that even those who are hurt by protection sometimes say that they favor protection to assist those hurt by rising imports. In fact, given this discussion, the surprising thing is not that there is some protection, but that there is not more protection than we actually have in countries with representative democracies.

The box ―Dodging Protectionism,‖ the second in the series on the global financial and economic crisis, provides an example in which the world resisted pressures toward greater protectionism. It contrasts the big increase in protectionism during the Great Depression of the 1930s with the remarkably small increase in import barriers during the more recent crisis.

Tips This chapter builds on the analysis of Chapters 8 and 9, but the flavor of the analysis is different.

Students who like conceptual depth but dislike graphs will find relief here. The spotlight is now on the ideas, with the geometry more in the shadows. Logic still rules, but it is now more verbal and less mechanical.

Role playing can be used to bring the issues raised in the chapter to life. For instance, the class can be divided in half, with each half taking the opposite side in a debate about an actual trade problem. One possible topic: To protect U.S. jobs and raise the low U.S. wages in the 62 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

refrigerator manufacturing industry, the U.S. government should impose quotas or raise tariffs on imported refrigerators drastically. Another possible topic: The Japanese government should sell its scarce rights to make international flights at its airports to the highest bidders, even if this means that fewer slots go to Japanese airlines. Yet another: Brazil should limit its imports of smartphones, in order to foster the development of its own smartphone industry. Current and recent events (including Trump’s trade policies) can offer other topics. After playing the assigned roles in the debate, the students can be asked to drop their roles and vote on the question.

Suggested answer to case study discussion question How Sweet It Is (or Isn’t): For a U.S. company that makes jelly beans in the United States, U.S. policies that limit sugar imports increase sugar prices and raise the cost of obtaining the key input into its production. The U.S. firm would like to change U.S. policy, to lower the domestic price of sugar, for instance, by moving to or toward free trade in sugar. On its own, the firm probably cannot have much impact politically, because anything it can do would be too small.

The firm could join the Alliance for Fair Sugar Policy and contribute to the Alliance’s efforts to oppose protectionist U.S. policies that limit sugar imports. However, this group’s efforts have had little effect, because the sugar producers are better organized and willing to spend more (campaign contributions and lobbying) to maintain the existing import-limiting policies. The U.S. firm does have some other options. First, the firm could consider making jelly beans with less sugar, but this probably would be risky for a gourmet brand. Second, the firm could consider shifting its jelly bean production to another country which has free trade in sugar (so that country’s domestic sugar price is at or close to the low world price for sugar). The firm then would import jelly beans for sale in the United States. (Jelly Belly actually moved some of its production of jelly beans to Thailand in 2007.)

Suggested answers to end-of-chapter questions and problems 112.

a.

Yes, there are external benefits—a positive spillover effect. The benefits to the entire country are larger than the benefits to the single firm innovating the new technology. Other firms that do not pay anything to this firm receive benefits by learning about and using the new production technology.

The economist would say that the production subsidy is preferable to the tariff. Both can be used to increase domestic production, but the tariff distorts domestic consumption, leading to an unnecessary deadweight loss (the consumption effect).

The economist would use the specificity rule. The actual problem is that innovating firms do not have enough incentives to pursue new production technologies (because other firms get benefits without paying). The economist would recommend some form of subsidy to new production technology as better than a production subsidy or tariff. The technology subsidy could be a subsidy to undertake research and development or monetary awards or prizes for new technology once it is developed.

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113.

The specificity rule is a guide to government policy that tries to enhance economic efficiency by addressing incentive distortions or market failures. It states that it is more efficient to use a policy that is closest to the source of a distortion separating private and social benefit or cost. It is also useful as a guide to government policy that tries to achieve a noneconomic objective with the least economic cost. For a noneconomic objective, it is least costly to use a policy that acts directly to achieve the objective.

114.

One such set of conditions described in this chapter is the developing government argument. If the government is so underdeveloped that the gains from starting or expanding public programs exceed the costs of taxing imports, then the import tariff brings net national gains by providing the revenue so badly needed for those programs.

Another answer could be: Tax imports if our consumption of the product brings external costs. For example, a country that does not grow tobacco could tax tobacco imports for health reasons.

115.

The infant industry argument states that a country can benefit by shielding an industry (the infant) that is currently uncompetitive against foreign rivals, if that industry can lower its costs over time and become competitive in the future. It is potentially a valid argument for the government to do something to assist the infant industry, because the future benefits can be larger than the current costs of doing so. But, it has a number of weaknesses. First, even if some form of government assistance is appropriate, the specificity rule indicates that the best form of assistance is not a tariff or other barrier to imports. Rather, a subsidy to initial production or to whatever is the source of cost reductions over time is usually the best policy. Second, if the industry is so promising, it is often the case that no government assistance to the initial firms is needed. Instead, these firms should borrow from private lenders to cover their initial losses and repay these loans from future profits. Third, the argument is subject to abuse, because it is speculative. Will the industry really grow up—lower its costs to become competitive over time?

116.

Yes, even though no such case was explicitly introduced in this chapter. Think about distortions and ask how a nation could have too little private incentive to buy imports.

The most likely case is one in which buying and using foreign products could bring new knowledge benefits throughout the importing country, benefits that are not captured by the importers alone. To give them an incentive matching the spillover gains to residents other than the importers, the national government could use an import subsidy.

117.

The national defense argument states that the government must limit imports during peacetime to ensure that the country can meet its needs for defense goods during times of war. While the need to provide for the national defense is clear, the specificity rule says to think clearly about what the actual problems are, and then use policies that act directly on them. If the need is for production capabilities for a product, then the government should subsidize production capacity. If the need is for materials that can be stockpiled, then the government should build the stockpiles. If the need is for access to depletable mineral resources, then the government should forego domestic production during peacetime, but have production capability ready if needed. Barriers to imports would 64

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achieve some of these objectives, but at a higher economic cost. In fact, imports during peacetime may be part of the solution, for building stockpiles or acquiring depletable resources so that domestic supplies are not used up.

118.

Agree. The infant-industry argument states that a domestic industry that is currently uncompetitive by world standards (uncompetitive against low-priced imports) will, if it can begin producing with assistance from the government, grow up to become internationally competitive in the future. Whether this is really an argument for a tariff depends on whether a tariff is the best policy that the government can use to assist the domestic industry to get its production started. The specificity rule indicates that the best government policy is one that attacks the problem directly. Using the specificity rule, the infant-industry argument is actually an argument for government assistance (a subsidy) to some aspect of domestic production, not for a tariff.

119.

a. i. The tariff would raise the domestic price from the world price P0 to the tariffinclusive price P1 . Domestic production increases from S0 to S1 , and domestic consumption falls from D0 to D1 . ii. By increasing domestic production from S0 to S1 , the country gains external benefits (worker training and skills) equal to area g. iii. The tariff causes the usual production and consumption inefficiencies equal to areas b and d. The net gain or loss to the country is the difference between area g and areas (b + d).

iv. With a production subsidy instead of a tariff, the market price remains at P0 .

Domestic consumption remains at D0 . Producers receive revenue per unit produced equal to P1 , which includes both the market price and the government subsidy per unit produced. They increase domestic production from S0 to S1 . By increasing domestic production from S0 to S1 , the country gains external benefits (worker training and skills) equal to area g. The production subsidy causes a production inefficiency equal to area b, but it does not distort domestic consumption. The net national gain or loss to the country is the difference between area g and area b. As we expect from the specificity rule, the production subsidy is the better policy—it creates a larger net economic gain (or smaller economic loss) for the country, because it acts more directly on the source of the incentive distortion.

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v. The tariff creates revenue for the government equal to area c. The production subsidy creates a cost to the government equal to area (a + b). The deficit-conscious finance minister, looking only at the government budget, would favor the tariff.

The specificity rule indicates that the best policy is to subsidize or support worker training directly.

120.

Policy A, the production subsidy, would be the lowest cost to the country. By comparison, the tariff (Policy B) would raise the domestic price of aircraft, which will distort buyer decisions and thwart the growth of the domestic airline industry. The tariff adds a deadweight loss (the consumption effect). Policy C, the import quota, would be the most costly to the country. The sole Australian producer would gain monopoly power, and it will raise the domestic price even higher. The deadweight loss will be larger.

121.

The interests of the sock exporting countries are probably to export a large quantity of socks and to receive a high price for the socks that they export. Presume that the sock importing countries are going to use one of these policies to achieve a specific target quantity of domestic sock production. Consider first the effect on quantity of sock imports/exports. To achieve the target domestic production in the sock importing countries, the tariff and the VER would reduce sock imports by the same amount. But a production subsidy in the importing countries could achieve the same production objective with a smaller reduction in sock imports, because domestic consumers continue to be able to buy socks at the world price and do not cut back on their purchases. The sock exporting countries would tend to favor the production subsidy, because it results in a smaller decrease in the quantity that they export. Consider next the effect on the price received by the sock exporters. Both the tariff and the production subsidy reduce sock import demand, so that they would tend to put downward pressure on sock export prices.

(The downward pressure is larger for the tariff, because the reduction in sock imports is larger.) The VER could be used by the exporting countries to form a kind of sock exporting cartel and raise export prices. The sock exporting countries would tend to favor the VER, because it will ―force‖ them to raise sock export prices. Overall, the sock exporting countries would rate the tariff as the least desirable. Their rating of the production subsidy and the VER would depend on their priority between a smaller reduction in quantity exported (favors the production subsidy) or a higher price for sock exports (favors the VER).

122.

In favor: Adjustment assistance is designed to gain the benefits of increased imports by encouraging workers to make a smooth transition out of domestic production of the import-competing good. A key problem is that workers pushed out of import-competing production suffer large declines in earnings when forced to switch to some other industry or occupation. Adjustment assistance can overcome this problem by offering workers retraining, help with relocation, and temporary income support during retraining and relocation. Adjustment assistance represents an application of the specificity rule. It is better than using a tariff or nontariff barrier to limit imports and resist shrinking the domestic industry. And politically, it can reduce the pressure to enact these import barriers.

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Opposed: Workers are faced with the need to relocate and develop new skills for a variety of reasons—not only increased imports but also changing consumer demand and changing technologies. There is nothing special about increasing imports, and workers affected by increasing imports deserve no special treatment. In fact, offering adjustment assistance could encourage workers to take jobs in import-competing industries that are shrinking because they have the social insurance offered by adjustment assistance. In addition, adjustment assistance is not that effective. It does offer temporary income assistance to those who qualify, but it is much less successful at effective retraining and smooth relocation.

123.

The free-rider problem is the incentive that each individual has to contribute little or nothing to a common endeavor, hoping that others will contribute and the individual will get the benefits of the endeavor without bearing the costs. For the political process of trade policy, the free-rider problem can affect how well organized and effective the lobbying groups for and against protection are. Groups like household consumers who are hurt by protection are often ineffective politically. Most household consumers do not become active politically, because of the free-rider problem (or for other reasons). As a result, inefficient import protection policies are adopted.

124.

Imposing the quota will create one clear winner—domestic baseball bat producers. It will create one clear loser—domestic consumers of baseball bats. And it will create one group that may have mixed feelings—the three import distributors—because they will have a smaller volume of business, but the profit margin on the limited business that they conduct will be larger. Baseball bat producers probably will be an effective lobbying group because there are a small number of firms that need to organize to lobby (and they may already have a trade association). Baseball bat consumers are unlikely to be an effective lobbying group because each has a small stake and it would be difficult to organize them into a political group. The three import distributors should be an effective lobbying group if they can agree among themselves whether to favor or oppose the quota.

125.

Tariff escalation is that the size of the tariff rate tends to increase with the stage of processing. The tariff rates on final consumer goods are usually higher than the tariff rates on intermediate products and raw materials used to make the final products.

Because household consumers are a weak lobbying group, producers of final goods are effective at political action to gain higher tariffs on consumer goods. But for intermediate goods and raw materials, the companies that buy and use these goods can mount effective lobbying efforts to oppose tariffs sought by firms producing these goods. For the companies buying these goods, tariffs would increase costs. There is a clear reason for these buying companies to oppose the tariffs, and they are often already organized into trade associations.

126.

None. The loss in consumer surplus from imposing a tariff is larger than the gain in producer surplus. (The consumer loss is also larger than the combined gains of producer surplus and government tariff revenue, if the latter has ―votes.‖)

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127.

The government has committed to the objective of reducing imports by one third. The specificity rule offers guidance for the choice of government policy to achieve this objective. To achieve the goal at the least economic cost to the country, the government should choose the policy that acts as directly as possible on the objective. Because the objective is to reduce imports, the government should use the tariff.

In the graph, S d is domestic supply and Dd is domestic demand. With free trade at the P world price W , the country imports  Q4  Q1  , which is half of domestic consumption Q4 . To reduce imports by one third, the government would impose a tariff equal to tar

per unit. The domestic price rises to  PW  tar  , domestic consumption decreases to Q3 , and domestic production increases to Q2 . The quantity imported with the tariff  Q3  Q2  is equal to two thirds of the free trade  Q4  Q1  . The tariff causes two area of inefficiency, area AEC (production inefficiency) and area BGF (consumption inefficiency).

What happens if, instead, the country’s government would use a production subsidy?

Consumers can still buy imports at PW , so they continue to buy Q4 . To reduce imports by one third, with domestic consumption at Q4 , domestic production must increase more

(than with a tariff), to Q5 (rather than to Q2 with the tariff), so that imports  Q4  Q5  are equal to two thirds of  Q4  Q1  Therefore, the production subsidy per unit (sub) must be larger than the tariff rate (tar). The production subsidy causes inefficiency of area JKC (production inefficiency).

Which policy causes a larger inefficiency? For the two triangles AEC and BGF, the combined base is the reduction in imports, and the height is the tariff rate (tar). For the one triangle JKC, the base is the same reduction in imports, and the height is the subsidy rate (sub). Because the triangle JKC has a larger height, it is larger than the combination of the two triangles AEC and BGF. The inefficiency of the tariff is smaller than the inefficiency of the production subsidy. To achieve the import-reduction goal, the economic cost to the country is smaller if the country uses a tariff.

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Chapter 11 Pushing Exports Overview Chapters 8 through 10 focused on government policies toward imports, with little attention to government policies and business practices in the exporting countries. This chapter shifts to looking at various practices and policies that can increase exports, as well as the effects of these export-enhancing activities on importing countries. The chapter has two major purposes: 128. Examine dumping—what it is, why it occurs, how it affects importing countries, and what government policies are used in importing countries.

129. Examine export subsidies, looking at these same issues and a few others.

Dumping is selling exports at a price that is ―too low.‖ There are two standards sanctioned by WTO rules: selling exports at a price that is lower than the price in the home market (or in a third country market), or selling exports at a price that is lower than the full average cost of production (including a profit margin). The legal standard is one or the other, not both.

There are at least four different reasons that an exporter would dump (based on one or the other of the two definitions). Predatory dumping is intended to drive out rivals. Cyclical dumping occurs during an industry downturn in demand, with sales at prices that cover average variable cost but are below average total cost. Seasonal dumping unloads excess inventories, especially on products that are perishable or going out of fashion. Persistent dumping is international price

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discrimination, with the exporting firm facing less elastic demand in the home market, and having some way to limit or prevent reimport back into its home market.

What should the importing country think of dumping? The first reaction should be to welcome it—why argue if someone is willing to sell you something at a low price? This seems to be the best reaction to both seasonal and persistent dumping. Predatory dumping is potentially the most troubling to the importing country. If the exporter succeeds, it will raise prices in the future, and the importing country can be harmed. But predatory dumping probably is rare. The importing country could also have concerns about cyclical dumping. If used aggressively, cyclical dumping can export unemployment.

Actual importing-country government policies toward dumping generally do not make these economically sensible distinctions. The policy usually investigates alleged dumping by looking at whether the export price is too low, by either standard, and looking at whether there is injury to domestic industry. If both are found, then the importing country imposes antidumping duties equal to the difference between the low export price and the ―normal price‖ or ―fair market value.‖ The policy does not look at the overall effect of alleged dumping on the national wellbeing of the importing country, because it does not examine the effects on domestic consumers, and it does not attempt to determine the reason for the dumping. It appears that the process is biased in favor of finding dumping and imposing antidumping duties. And even the threat of a dumping suit can induce foreign exporters to raise their prices. Antidumping policy has become a way for import-competing producers to gain new protection against imports. The box on ―Antidumping in Action‖ illustrates these concerns with two examples. The chapter also examines three proposals for reform: limit antidumping actions to cases in which predatory dumping is plausible, expand the injury standards to include domestic consumers, and replace antidumping policy with safeguard policy.

Governments in exporting countries sometimes use export subsidies to increase their exports. In fact, a large enough export subsidy can turn an import-competing product into an export product.

If markets are competitive, these export subsidies create inefficiency by distorting production and consumption. For a large exporting country an export subsidy causes a decline in its international terms of trade. For both a small and a large country, an export subsidy results in net national loss as well as a loss for the whole world. As a case study, the box ―Agriculture is Amazing‖ discusses subsidies to food production and export.

WTO rules generally prohibit export subsidies and permit importing countries to impose countervailing duties in response. We examine the peculiar economics of all of this, using the case in which the export subsidy lowers the price of exports, and the market is otherwise competitive. Because of the lower import price, the importing country gains well-being in the shift from free trade with no subsidy to free trade with the foreign export subsidy (and no countervailing duty). If the importing country then imposes a countervailing duty, the importing country still gains, in comparison with free trade with no subsidy and duty, but it does not gain as much as it would if it did not impose the duty. The countervailing duty does improve world efficiency, by reversing the international distortionary effects of the export subsidy.

The economics of an export subsidy are rather different if the market is not perfectly competitive—a major insight of strategic trade policy. The text shows the example of 70 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

competition between Boeing and Airbus for the world market for a new type of airplane. With no government support, it is possible that neither firm will enter the new market, because both will lose if both enter. But if one government offers a suitable subsidy, its firm will enter. If the other government does not offer support, then the other firm will not enter, and the first firm will earn high profits, bringing a benefit to its country and possibly to the entire world. But, if the other government also offers a subsidy, both firms produce. The world’s consumers gain, but each of the producing countries can end up with lower well-being because of its firm’s loss net of the government subsidy (the subsidy is a transfer within the country). (The box ―Dogfight at the WTO,‖ the third in the series on Global Governance, discusses the cases that the United States and the European Union filed against each other about subsidies that each has given to its aircraft firm. The case effectively ended as a draw in 2021.)

Tips There is much here to interest the student who gravitates toward policy debate or business relevance. There are often current cases of alleged dumping (e.g., steel in the United States) that can be incorporated into class discussion.

The material, especially that on dumping, can lead to lively class discussion. For instance, the instructor can present the legal definitions of dumping, and then ask students why an exporting firm would engage in dumping. The follow-up question can be to ask what the importing country should think of dumping.

In a class discussion of reforms or alternatives to antidumping policy, an instructor may want to include use of standard antitrust policy (also called competition policy or antimonopoly policy) to deter predatory dumping, as a replacement for antidumping policy.

In the discussion of effects of an export subsidy, it is possible to present an integrated discussion of the exporting and importing countries. By adding a third graph to Figure 11.4, the instructor can examine the effects in the importing country. (This set of three graphs is the same basic form used in Figures 2.3 and 2.4.) An export subsidy effectively shifts the supply-of exports curve down by the amount of the subsidy, and a countervailing duty effectively shifts the demand-forimports curve down by the amount of the duty.

Suggested answers to case study discussion questions Antidumping in Action: In the U.S. procedure for investigating and determining a case that alleges foreign dumping, the U.S. International Trade Commission (ITC) examines whether there is sufficient evidence of injury to domestic producers caused by imports that have been dumped.

(Separately, the U.S. Department of Commerce investigates whether these exports were sold at prices below ―fair market value,‖ also called ―normal value.‖) The ITC is reasonably strict in the standards that it uses. For this industry and its products, here is what the ITC found1: 1

The findings are reported in depth in Fabricated Structural Steel from Canada, China, and Mexico. Publication 5031, U.S. International Trade Commission, March 2020.

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  

Imports had not been increasing as a percentage of domestic consumption of the products, and it was not likely that there would be an import surge in the near future.

Imports had not depressed domestic prices for the products. Imports were not consistently priced lower than comparable domestic products, and domestic firms did not lose substantial amounts of sales to low-priced imports.

The domestic producers had generally strong business performance, as measured by several indicators, including growing sales quantity and revenue, increased profit, and rising capacity utilization. Domestic firms made substantial capital expenditures to expand their production capacity.

In short, the ITC concluded that there little or no (that is, insufficient) evidence of actual or threatened injury to the domestic industry. The case ended, and no antidumping duties were imposed. (A possible follow-on question: Why did the U.S. producers bring such a weak case?

One possibility is that the firms thought that they had a reasonable case and hoped that the ITC would find some form of injury. Another possibility is that the American firms filed the case as a way of harassing the foreign steel exporters, a way to send a message to them to restrain their exports.)

Agriculture Is Amazing: A high tariff or a zero quota can reduce imports of butter to zero. But, the high tariff or zero quota cannot turn butter into an EU export product, because production costs behind the import barrier will be too high to export successfully into foreign markets.

Instead, the country will be at the no-trade national equilibrium, with a no-trade domestic price that is well above the world price. A price support in which the government purchases any production that is not sold to private buyers can turn butter into an EU export product. If the price support is set above the no-trade national equilibrium price, then there will be excess domestic supply at that price (domestic quantity supplied at the high support price is greater than domestic quantity demanded at that high price). The government then must decide what to do with the butter that it has purchased. It may decide to regain some of the money spent on the butter purchases by selling to foreign buyers at the world price, and the EU becomes an exporter of butter. The government makes a loss on these sales (it buys butter at a high price from domestic producers and resells the butter at a low price to foreign buyers). That is, the government is effectively subsidizing these butter exports.

Suggested answers to end-of-chapter questions and problems 130.

One definition of dumping is selling an export at a price lower than the price charged to domestic buyers of the product within the exporting country. This definition emphasizes international price discrimination. The second definition is selling an export at a price that is lower than the full average cost of the product (including overhead) plus a reasonable profit margin. This definition emphasizes pricing below cost (counting some profit as a cost of capital).

131.

Disagree. The injury test used by the U.S. government in dumping cases solely examines whether or not U.S. producers were hurt by the imports that were dumped by the foreign exporters. For an examination of U.S. national well-being, the effect of the imports on other groups in the country, especially U.S. consumers and users of the product, also 72

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must be examined. To determine whether or not the imports cause damage to the country overall, the losses to some groups (domestic import-competing producers) must be compared to the benefits for other groups (consumers of the product, who gain consumer surplus from low-priced imports).

132.

Tipper Laurie, because its at-brewery price is lower for exports to the United States than for domestic sales. Bigg Redd, because its at-brewery export price is below average cost.

133.

Persistent dumping is a situation in which the exporting firm uses international price discrimination by setting a higher price in its home market and charging a lower price to buyers in the foreign market. The price discrimination is used to maximize total economic profit. The low export price charged to foreign buyers does not result in lost profit. Rather, the low price allows the firm to increase profit by charging a lower price and selling more in the market that has buyers who are more price sensitive. If the firm instead set one price to all buyers in both the home market and the export market, the firm would have a lower total profit. The importing country benefits from persistent dumping. In comparison with a higher price for this imported product if there were no persistent dumping, consumers in the importing country gain more than importcompeting producers in the country lose.

134.

The objective of the revision is to make antidumping policy contribute to U.S. national well-being. The policy should be targeted toward addressing predatory dumping and aggressive cyclical dumping. It should consider domestic consumer interests as well as domestic producer interests. It generally should not impose antidumping duties on persistent dumping that involves international price discrimination in favor of U.S. buyers. The specific provisions could include one (or more) of the following. First, the definition of dumping should be changed. Dumping should be defined as pricing an export below the average variable cost (or marginal cost) of production. This change will permit the definition of dumping to be focused on overly aggressive pricing that is often characteristic of predatory dumping or aggressive cyclical dumping. Second, the test for injury should include consideration of benefits to domestic consumers from low-priced imports, in addition to harm to domestic producers. The injury test should be a test of effect on net national well-being. Alternatively, a radical change would be to abolish the antidumping law and substitute use of safeguard policy. Another radical alternative is to abolish the antidumping law and instead focus on prosecuting any predatory dumping using U.S. antitrust laws that prohibit monopolization.

135.

A countervailing duty is a tariff imposed to offset the amount by which a foreign government subsidizes its exports to the importing country imposing the duty.

136.

The $5 export subsidy would lower the price charged to Canadian buyers, but the $5 countervailing duty would raise the price backup. If Canadian buyers are paying the same price (inclusive of the export subsidy and the countervailing duty) that they would pay with free trade (no export subsidy and no duty), then they are importing the same quantity that they would import with free trade. World well-being is the same in both cases because all of the quantities are the same.

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The United States would lose. The U.S. government pays a subsidy of $5 for each pair of blue jeans to Canada. The export price is lower, but the quantity exported is the same as with free trade. Canada would gain the $5 on each pair. The gain would be collected as government revenue from the countervailing duty. Otherwise, the domestic price in Canada and all quantities are the same as with free trade. Because Canada’s gain equals the U.S.’s loss, this is another way to see that the well-being of the world as a whole is the same as it would be with free trade.

137.

a.

With free trade, price is P0 and the quantity exported and imported is M 0 . The

S export subsidy ―artificially‖ shifts the export supply curve down to Sx  . (The original X curve still shows the resource cost of exports, but the foreign exporters are willing to sell at the lower market prices shown by Sx  because the foreign government also pays them the export subsidy.) The international market price falls to P1 and the quantity traded

increases to M 1 .

The countervailing duty returns the market to P0 and M 0 . This is good for the world, because the marginal resource cost of the last unit exported (shown by the height of SX at M 0 ) just equals the marginal benefit of that unit to the buyer (shown by the height of DM at M 0 ). We return to the economic efficiency of the free-trade outcome. The export subsidy alone caused a global economic inefficiency equal to triangle ABC, the inefficiency of too much exporting. In comparison with just the export subsidy, the countervailing duty can increase the well-being of the importing country, in the same way that a tariff can increase the well-being of a large country. By imposing the countervailing duty, the importing country loses triangle ACF and gains rectangle P1 FEPS. The importing country gains if the rectangle is larger than the triangle.

138.

a.

In this case, Airbus would gain by producing even without government intervention. Airbus would gain 5 if Boeing did produce and 100 if Boeing did not produce. There would be no reason for European governments to subsidize Airbus.

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In this case, Boeing is sure to produce because Boeing gains whether or not Airbus produces.

The EU should recognize this. With Boeing producing, the net gain for Airbus without government help is zero. If none of Airbus’s customers were in Europe, there would be no reason to encourage Airbus to produce. Notice, however, that consumers might be better off if Airbus did produce. You can see this either by noticing that production by Airbus would deprive Boeing of 100 in profits taken from consumers (presumably by charging higher prices) or by reasoning that more competition is a good thing for consumers. Either way, the EU would have reason to subsidize Airbus if its consumers could reap gains from the competition.

139.

If the world price declines from $100 to $90, the revenue per unit exported declines from $120 to $110, which is also the new price paid by domestic consumers of the product.

Because of the decline in revenue per unit, domestic quantity produced declines from 190 million to 175 million. Because of the decline in the domestic price, domestic quantity consumed rises from 50 million to 60 million. Quantity exported declines from 140 million to 115 million. Because of the decline in revenue per unit and the decrease in quantity produced, domestic producer surplus declines by area ACGE. Because of the decline in price and the increase in quantity consumed, domestic consumer surplus increases by area ABFE. Because of the decrease in the quantity exported, the cost to the government of paying the export subsidy declines from area BCLH to area FGUN. The production inefficiency changes from area CLK (using the efficiency standard of $100, the initial world price) to area GUT (using the new efficiency standard of $90, the new world price). The consumption inefficiency changes from area BJH to area FRN. If the domestic supply and domestic demand curves are straight lines, the sizes of the inefficiencies are the same at the new world price as they were at the initial world price.

Price

120 110 100 90

Sd A

B

C G

F

E

J

H N

L

K R

T

initial world price new world price

U

Dd 50 60

140.

175 190

Quantity

One way to build the case is to claim that the industry is a global oligopoly, with substantial scale economies and high profit rates (like the Boeing–Airbus example in this chapter). The nation can gain if the country’s firm(s) can establish export capabilities and earn high profits on the exports. Another way to build the case is to claim that this industry is an infant industry (discussed in Chapter 10). If the industry could get some 75

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assistance, it would grow up and generate new producer surplus when it is strong enough to export.

141.

One way is to say that most actual and potential export industries are highly competitive.

In this case, export subsidies distort resource allocation within the economy, leading to overproduction of the exportable goods. The export subsidies bring a national net loss, as shown in Figures 11.3, 11.4, and 11.5. The counter to the infant industry argument is that in most cases the infant fails to grow up, so the country then faces the choice of whether or not to provide ongoing assistance to a high-cost, uncompetitive industry.

Chapter 12 Trade Blocs and Trade Blocks Overview This chapter examines two types of trade barriers that are intended to discriminate between foreign countries. A trade bloc has lower or no barriers for trade between its members, while they maintain higher barriers for trade with outside countries. A trade embargo or trade block places extra barriers against trade with a specific foreign country, usually because of a broader policy disagreement.

There are four major types of trade or economic blocs: free-trade area, customs union, common market, and economic union. WTO rules generally call for equal trade barriers against all other countries (at least those that are also members of the WTO)—the most-favored-nation principle.

But the WTO rules also have a few exceptions, including an exception for a trade bloc that achieves substantially free trade among its members.

A trade bloc can have several effects on the well-being of its member countries and the world overall. We usually analyze trade blocs by comparing them to countries maintaining barriers against all other countries. To the extent that forming or joining the trade bloc results in lower prices in an importing member country, the country and the world gain as additional trade is created. To the extent that forming or joining the trade bloc results in shifting the source of a member country’s imports from low-priced suppliers in countries outside the trade bloc to higher-priced partner suppliers, the country and the world lose as trade is diverted from low-cost to higher-cost producers. The net effect depends on whether the gains from trade creation are larger than the losses from trade diversion. There are also possible dynamic gains from forming or joining a trade bloc, including gains if extra competition within the larger, bloc-wide market area leads to lower prices, lower costs, or greater innovation, gains if scale economies are achieved within the larger area, and gains if consumers obtain access to product varieties produced in partner countries.

For the European Union, most estimates are that the EU gains from its internal free trade in manufactures, because trade creation has been larger than trade diversion, and because there are probably also dynamic gains, although these are harder to measure. Additional gains came as the move toward a true common market in 1992 removed nontariff barriers and freed resource 76 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

movements. However, the EU also incurs substantial losses from its protectionist common agricultural policy. In 2004, 10 additional countries joined the EU; in 2007, two more; and in 2013, one more (Croatia), bringing the total number of members to 28. Integration of the new members has been relatively smooth, though some features of EU policies have been phased in slowly for them.

In 2016, the United Kingdom voted to leave the EU (Brexit), and its exit formally occurred in 2020. Britain opted for a hard Brexit, in which it gained sovereignty over business regulations and immigration. Britain and the EU implemented a free trade agreement for goods, which maintained no tariffs on this trade but resulted in new nontariff barriers. A controversial part of the overall agreement was a customs barrier between Northern Ireland and the rest of the United Kingdom. Northern Ireland remained in the EU single market, to prevent emergence of a hard barrier on the Irish Island.

The North American Free Trade Area (NAFTA) began in 1994, subsuming the previous Canada–U.S. Free Trade Area. NAFTA eliminated tariffs, reduced some nontariff barriers, and liberalized trade in services and cross-border business investments. The formation of NAFTA was controversial. In Mexico, there were fears of jobs lost to more productive U.S. and Canadian firms, as well as the loss of political sovereignty as NAFTA committed Mexico to change a number of its government policies. In the United States, there were fears of job losses to lowwage Mexico, as well as complaints about linking with a country that has a corrupt political system and poor environmental protection. Proponents in both Mexico and the United States hoped that NAFTA would commit the Mexican government to maintain and extend its marketoriented reforms.

NAFTA resulted in substantial increases in trade among the three members. The standard view is that trade creation was larger than trade diversion, with substantial net gains for Mexico.

However, there is also some research that suggests that trade diversion was large, so that the net gains were close to zero. Studies of Canada indicate that it gained from increased competition that forced high-cost plants to close down, from the achievement of scale economies through longer production runs as access to the large U.S. market became assured, and from increased innovation driven by increased competition and assured market access. In addition to the trade effects, Mexico gained from the substantially increased inflows of direct investment by foreign firms that located production in Mexico to serve the other NAFTA countries. NAFTA did not caused massive shifting of total employment between the member countries, but it did alter the composition of jobs, with pressures on wage rates for different types of workers.

The Trump administration insisted on renegotiating the free trade area, and in 2020 the United States–Mexico–Canada Agreement (USMCA) superseded NAFTA. Much of the USMCA is the same as NAFTA. The USMCA updates rules in some areas, and it has rules for some new areas (e.g., digital trade and regulatory practices). It strengthens the rules for labor and the environment. In some ways the USMCA is more protectionist, especially toward trade in autos.

For decades efforts to form functioning trade blocs among developing countries failed. Success is now more likely, as many developing countries have shifted toward outward-oriented and market-oriented government policies. MERCOSUR (the Southern Common Market) began in 1991, and in its first decade was successful in freeing internal trade and establishing common 77 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

external tariffs. Yet, new intrabloc trade barriers since 2000 have contributed to a decline in the relative importance of trade among the members of MERCOSUR. A trade embargo is economic warfare. It hurts both the target country and the country imposing the trade block, and it creates opportunities for other countries that are not taking part in the embargo. An embargo can fail to force the target country to change its policy for at least two reasons. First, the target country’s national decision makers may decide that they can and must endure their losses, even if these losses are large—political failure of an embargo. Second, the embargo may simply fail to inflict much loss on the target country—economic failure of an embargo. An embargo that prohibits exports to the target country is more likely to succeed economically when the target country has an inelastic demand for imports and countries outside the embargo have low elasticities of export supply. This is more likely when a group of large countries imposes an embargo on a small country, and when the embargo is sudden and extreme.

Tips The unifying theme is trade discrimination, and the material is not too difficult. The diagrams represent fairly straightforward extensions from those in previous chapters.

For class analysis of trade blocs, it may be useful to present a case of pure trade creation (in which the partner country is the low-priced world supplier), a case of pure trade diversion (in which the partner’s export price is just slightly less than the tariff-inclusive outsider price), and then the general case in which there is both trade creation and trade diversion.

Early in the section on trade embargoes, a new text paragraph describes the sanctions imposed on Russia for its invasion of Ukraine, as of mid-2022. You could use this example in either or both of two ways. First, you could discuss any updates to these sanctions since mid-2022. Second, you could apply the conclusions of the text presentation to the sanctions on Russia. As of mid2022, here is what I see. The sanctions imposed substantial costs on Russia, they were not an economic failure. The initial sanctions were sudden and large, and they were imposed by large countries (though China and India did not join the sanctions). Russia is not a small country, but its economy is not that large. Russia relies on imports of many products (rather inelastic import demand), and it relies on exports of energy products (rather inelastic export supply). Russia had difficulties shifting to more trade with nonsanctioning countries (rather inelastic export supply and import demand in these countries). But, as of mid-2022, the sanctions seem to be a political failure. Russia is a dictatorship, and Putin remained committed to the invasion.

There are two distinct parts to the chapter, and they are separable. For instance, an instructor can assign and cover only the material on trade blocs if there is a need to slim down the total course content.

Suggested answer to case study discussion question Postwar Trade Integration in Europe: The EU had 27 member countries as of 2022. There are four groups of countries that could be candidates the join the EU. 78 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

First, there are several relatively high-income Western European countries, including Switzerland, Norway, and Iceland, that are not members of the EU but could join in the future.

None of these countries seems to be eager to join, though Iceland did pursue accession talks for a few years after its banking crisis of 2008.

Second, there are a number of countries in the Balkans, including Serbia, Montenegro, North Macedonia, Albania, Kosovo, and Bosnia and Herzegovina, that are or could be candidates to join the EU. Serbia is the largest of these, it is in accession negotiations with the EU, and it may be the most likely next country to join the EU. Montenegro, Albania, and North Macedonia are also in accession negotiations.

Third, Ukraine and Moldova, two countries of the former Soviet Union in Eastern Europe, have candidate status for EU membership. These countries appear to be years from starting accession negotiations, but the Russian invasion of Ukraine could speed its process.

Fourth, Turkey has been in accession negotiations since 2005, but with only modest progress.

Political changes seem to have made it less likely, but Turkey has a chance to be the next country to join the EU.

Suggested answers to end-of-chapter questions and problems 142.

Members of a customs union have the same tariff on each category of imported good or service, regardless of which member country receives the imports. In this case, there is no need to scrutinize goods that move between countries in the customs union, even if the product might have been imported from outside the union.

In a free-trade area, by contrast, each member country can have a different tariff rate on the import of a product. Therefore, the free-trade area needs to scrutinize goods that move between countries in the free-trade area to make sure that they were not imported from outside the area into a low-tariff country and then shipped on to a high-tariff country in an effort to avoid the high tariff.

143.

No. The most favored nation principle states that any trade policy concession given by a country to any foreign country must be given to all other foreign countries having MFN status. WTO rules state that all WTO members are entitled to MFN status, but there are some exceptions. A trade bloc is one exception. Countries in a trade bloc treat imports from other member countries more favorably than imports from outside countries.

144.

Trade creation is the increase in total imports resulting from the formation of a trade bloc. Trade creation occurs because importing from the partner country lowers the price in the importing country, so that some high-cost domestic production is replaced by lower-priced imports from the partner, and because the lower price increases the total quantity demanded in the importing country. Trade diversion is the replacement of imports from lower-cost suppliers outside the trade bloc with higher-cost imports from the partner. It occurs because the outside suppliers remain hindered by tariffs, while there is no tariff on imports from the partner. Trade creation creates a gain for the importing country and the world. Trade diversion creates a loss for the importing 79

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country and the world. The importing country and the world gain from the trade bloc if trade creation gains exceed trade diversion losses.

145.

In a free trade area the member countries permit free trade among themselves but each maintains its own set of tariffs and nontariff barriers to imports from outside countries.

Rules of origin are necessary to prevent outside countries from sending their exports into a low-barrier member country and then shipping these products on to a high-barrier member country, to circumvent the high barriers in this second member country. Rules of origin can be protectionist in two ways. First, they can make it harder for firms in one member country to export to other member countries (contravening ―free trade‖ between the member countries). Second, they act like area-wide local content requirements. If a high local content is required, then it can force firms to use materials and components produced within the free trade area (rather than importing these items from outside the area).

146.

a.

10 million winter coats times ($110 − $100) = $100 million.

To offset this $100 million loss, with linear demand and supply curves, the change in imports, ΔM, would have to be such that the trade-creation gain (area b in Figure 12.2) has an area equal to $100 million. So 1/ 2*  $130  $110  * M  $100 million requires ΔM = 10 million, or a doubling of Homeland’s winter coat imports.

147.

The standard estimates were that Mexico probably gained from NAFTA, as trade creation was likely to have been larger than trade diversion, and Mexican firms also gained from better access to selling to the large U.S. market. In Mexico, the gains were largest for those sectors tied to exports and for those resources (including less-skilled labor) that were relatively abundant in Mexico. The standard estimates were that the United States and Canada also probably gained, with gains to those export sectors that increased their sales to Mexico and to resources that were relatively abundant in these countries, including skilled labor. (There is also some research that suggests that trade diversion was larger than the standard estimates, so that the net gains from trade creation and trade diversion for the member countries were close to zero.) Outside countries were hurt by trade diversion.

148.

This case resembles that shown in Figure 12.2A, assuming the United States is a pricetaking country. U.S. consumers gain, as the domestic price drops from $30 to $25. We cannot quantify the dollar value of their consumer–surplus gain without knowing the level of domestic consumption or production.

U.S. producers would lose from the same price drop, though again we cannot say how much they would lose. (We do know, however, that the consumer gain would exceed this producer loss plus the government revenue loss by the triangular area 1/ 2  * $5*0.2 million  $0.5 million .)

The U.S. government would lose the $10 million it had collected in tariff revenue on the imports from China.

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The world as a whole would gain the triangular area 1/ 2  * $5*0.2 million  $0.5 million , but lose the rectangular area

 $25  20  *1 million  $5 million because of the diversion of 1.0 million pairs from the lower-cost producer (China) to the higher-cost producer (Mexico). So overall, the world would lose $4.5 million.

149.

Trade creation gains and trade diversion losses follow from the basic analysis of the effects of joining a trade bloc like the European Union. If these were the only effects, then the speaker should have concluded that the gain to Serbia will be about 1% of its GDP (equal to 2% trade creation gains minus 1% trade diversion losses). Why did the speaker say that the gains instead would be about 3% of Serbia’s GDP? The most likely explanation is that the speaker believes that other sources of gains will contribute about 2% of GDP. These other sources of gains could include increased competition that can lower prices and costs in Serbia, expanded market size that can allow Serbian firms to achieve economies of scale, and Serbian access to greater product variety offered by firms in other EU countries.

150.

Trade embargoes are usually imposed by large countries that are important in the trade of the target country. An embargo has a better chance to succeed if it is imposed suddenly rather than gradually because a sudden interruption of economic flows damages the target country by a large amount for some time before it can develop alternatives. (In economic terms, for a good that the target imports, its import demand tends to be more inelastic in the short run, and the supply of exports from alternative (nonembargo) countries tends to be more limited and more inelastic in the short run as well.)

151.

Figure 12.3B shows the effects of the embargo on the target country and on the initial embargoing countries. Let’s focus first on the target country. The target country’s demand for imports is Dm . If there were no embargo, the world export supply to the target country would be  S n  Se  , and the price that the target country pays for its

imports would be P0 . Initially, with the embargo in place, the embargoing countries

remove their export supply to the target country  Se  , so the only export supply to the target country is from the nonembargoing countries  S n  . The price that the target P country pays for its imports is 1 . With the higher price paid for its exports and a smaller quantity imported, the target country suffers a loss of well-being equal to area b + c.

Then, half of the nonembargoing countries join the embargo. This removes about half of the nonembargo supply, so the export supply from the smaller number of nonembargoing S countries is n . With the smaller nonembargo supply, the price that the target country pays for its imports rises to P1 . As the price rises and the imported quantity shrinks further, the target country suffers an additional loss of area f + g. Because the damage to the target country increases as more countries join the embargo, the embargo is probably more likely to succeed.

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Now consider briefly the initial embargoing countries. Initially, they suffer harm from the embargo equal to area a. As more countries join the embargo, the size of area a may change, but it is not easy to see exactly what will happen using this graph. Some of the export supply from the countries that join the embargo is likely to be shifted to sell in other markets, so world prices outside the target country will fall somewhat. The initial embargoing countries suffer a further loss in their terms of trade as the world prices of their exportable products decrease, so the embargo becomes somewhat costlier for them.

(Essentially, for the initial embargoing countries, the size of area a would increase somewhat.)

152.

The ―most certain‖ is (a), a countervailing duty, which, for a competitive industry, brings net gains for the world as a whole if it just offsets the foreign export subsidy that provoked it. Whether the world as a whole gains from a customs union depends on whether it brings more trade creation than trade diversion. Whether the world gains from an antidumping duty also depends on the specifics of the case, as explained in Chapter 11.

153.

There are three relevant types of countries—the embargoing countries that otherwise would import, the nonembargo importing countries, and the target country (say, Iraq).

Before the embargo (free trade), the world equilibrium is at point F, and the world price is P0 . When the embargo is imposed, the price in the embargoing countries rises to P2 , and the price that Iraq gets for its exports to the nonembargo countries falls to P1 . The cost of the embargo to the embargoing countries is area a. The loss to Iraq from exporting less at a lower price is area (b + c).

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



The embargo is more powerful if area (b + c) is larger. Starting from point F, Iraq’s loss is larger if Iraq’s export supply is less elastic, or the nonembargo countries’ import demand is less elastic (so that the new P1 is lower than the P1 shown in the graph).

The embargo is probably more powerful if the loss to the embargoing countries is smaller. Starting from point F, this cost is smaller if the embargoing countries’ import demand is more elastic (so the new P2 is lower than the P2 shown in the graph). It is easier for embargoing countries to do without Iraq’s products during the embargo.

Chapter 13 Trade and the Environment Overview We begin the chapter with two provocative questions. First, is free trade anti-environment? We argue that it is not. There is no reason to think that trade generally promotes production or consumption of products that cause large harm to the environment. Surprisingly, the incentive to relocate production into ―pollution havens‖ is usually small. Trade tends to raise world production and incomes. While some environmental problems become worse as production and income rise, others become less severe, in part because protecting the environment is a normal good. Figure 13.2 provides estimates from the trade liberalization of the Uruguay Round, for the composition and combined production and income effects. The overall environmental effects are generally small.

Second, is the World Trade Organization anti-environment? WTO rules recognize environmental protection exceptions to its general thrust toward free trade, but the WTO also worries that restrictions that governments claim to be necessary to protect the environment are pretexts for common protectionism. A country can impose product standards to protect the environment, but the standards must apply to all consumption, not just imports, and the standards must be based on scientific evidence. For environmental issues arising from foreign production methods, the position of the WTO has evolved. The WTO allows countries to limit imports because they are 83 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

produced in foreign countries using methods that the importing country considers to be damaging to the environment, but at the same time the WTO imposes strict requirements, to minimize the use of such policies as subterfuge for limiting imports for nonenvironmental (protectionist) reasons. The box ―Dolphins, Turtles, and the WTO,‖ the third in the series on Global Governance, discusses cases that show the changes in WTO rulings.

Adverse environmental effects like pollution are negative externalities, distortions that lead to failures of the market to be fully efficient. The specificity rule introduced in Chapter 10 is a handy guide to government policy to address negative environmental externalities. In fact, there are two types of government policy that can directly attack the distortion—imposing taxes and subsidies, or changing property rights. As in Chapter 10, we usually use the tax-and-subsidy approach.

The specificity rule says to use the direct approach; for instance, tax pollution directly. If this is not possible, then the specificity rule says to select the tax or subsidy that is as close as possible to the act creating the pollution. An additional complication is that the source of the pollution can be our own country’s activity, another country’s activity, or the entire world’s activity. If our country cannot achieve an international agreement, we may be left to take our own policy action, even though the source of much of the problem is foreign activity. In this case, trade barriers could be a second-best policy that can enhance well-being. Figure 13.3 is a useful summary of the main conclusions that can be drawn for the various possible cases.

In our formal analysis, we begin with the case in which pollution caused by an activity within the country has effects only on this country. We use tools similar to those that we developed in Chapter 10. If the country simply allows the pollution to occur, with no government policy to limit the negative externality, we show that free trade can make the country worse off, and that the country can export the wrong products. This occurs because of the marginal external costs, in our example resulting from pollution that accompanies domestic production of the export good.

A government policy that taxes pollution or production that causes pollution (or that establishes suitable property rights) can reverse these effects, assuring that the country exports and imports the appropriate products and gains from free international trade.

Domestic producers subject to the pollution-related tax may complain that other countries, especially the countries that become the suppliers of the country’s imports, are not imposing a comparable pollution-related tax on their firms. They may complain that the foreign firms are engaged in ―eco-dumping.‖ From the perspective of the importing country, lax foreign controls should not matter to its well-being, as long as the foreign pollution does not affect it.

The analysis of transborder pollution raises new issues. We use the example of production activity in one country that pollutes a river flowing into a neighboring country. The best solution would balance the gains to the polluting country from dumping waste into the river with the costs of pollution to the receiving country. Generally, this best solution is less pollution than the amount that occurs with no government policy, but more than zero pollution. However, the government in the polluting country may resist imposing a pollution tax (or some other way to limit pollution by its firms), because it bears the national costs while the other country gets the national benefits. If international negotiations fail, what should the receiving country do? It cannot tax the foreign pollution or even the foreign production that causes pollution. If the 84 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

receiving country imports the product from the polluting country, it could try to reduce the foreign production and pollution by restricting its imports. The country will gain if its benefits from lower foreign pollution exceed the usual deadweight losses of protection. (If instead the receiving country is an exporter of this product to the polluting country, it could subsidize its exports.) However, the WTO generally interprets its environmental exceptions narrowly, so it is not clear that the WTO would uphold the import restriction (or export subsidy), if the polluting country complained to the WTO. The difficulty of addressing transborder pollution is also shown through a discussion of the slow progress that NAFTA and the USMCA have made in attempting to ameliorate environmental problems along the Mexico–U.S. border.

Some environmental problems are global—the whole world’s economic activity imposes an external cost on the whole world. Each country might be willing to make some effort to reduce its own pollution, because it recognizes that its own activities have some adverse effect on itself.

But each country on its own would not decrease enough, because it would not recognize the costs that its pollution imposes on other countries. Yet the world, and most countries, would be better off if the countries cooperated to reduce the pollution more. Such global agreements are difficult to achieve, because of disagreements about the how serious the problem is, the incentive to free ride and the difficulty of enforcement.

The chapter concludes with four examples of global environmental problems. The Convention on International Trade in Endangered Species of Wild Fauna and Flora (CITES) attempts to prevent extinction of species by restricting or banning commercial trade in threatened species. It has been reasonably effective. But it may need to shift toward encouraging sustainable use of many threatened species, through economic management of the species for commercial uses.

Overfishing is an example of the tragedy of the commons. It does not threaten extinction for most species, but rather it results in fish catches that are smaller than they could be. We pay a global cost (recently estimated to be $83 billion per year) for our inability to conclude effective international agreements to prevent overfishing.

Release of chlorofluorocarbons (CFCs) has resulted in ozone depletion. The Montreal Protocol, signed in 1987, is an example of an effective international agreement. It began with restrictions on trade in CFCs and has spread to reduction of production of CFCs. It has been successful in replacing CFCs with less harmful alternatives, and concentrations of CFCs in the atmosphere are slowly declining.

The buildup of carbon dioxide and other greenhouse gases in the atmosphere, and the likelihood that this is causing global warning, is perhaps the largest global environmental challenge. We cannot use science to predict exactly how much global warming will occur or exactly what the effects of global warming will be. Three palatable policy options—removing fossil fuel subsidies, planting new forests, and waiting for scarcity to raise the prices of fossil fuels—would have effects that are too small to help much. Furthermore, the specific problem is clearly not international trade in fossil fuels or other sources of greenhouse gases. The problem is the worldwide activity, especially burning fossil fuels, that releases greenhouse gases.

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Actual global negotiations to reach agreements to reduce greenhouse gas emissions have been challenging. In the Kyoto Protocol, many industrialized countries made commitments to reduce their greenhouse gas emissions, but developing countries refused to do so. The Protocol came into effect in 2005, but the United States and Australia decided not to ratify it. (Australia ratified in 2007.) The Protocol did not accomplish much. Some industrialized countries did not meet their emissions targets. Emissions increased in the United States and in many developing countries.

The Paris agreement, signed by almost all the world’s countries, came into effect in 2016. Each country agreed to make a voluntary pledge of actions that it would take to reduce its greenhouse gas emissions, and these pledges are to be reviewed and upgraded every 5 years. The agreement relies on exchanges of information and peer pressure. In 2017, President Trump began the process for U.S. withdrawal from the agreement, and the United States formally withdrew in 2020. In 2021, President Biden returned the United States to the agreement.

A good economics-based solution to limiting global warming includes three elements: 

Government policies drive emission reductions at the lowest feasible cost to the global economy.  Most (if not all) countries, including (nearly) all large-emission countries, participate.  The policy process extends over decades.

The Paris Agreement has features that correspond to this desirable global approach. But, as of mid-2022, nationally determined contributions are well short of what is needed. A series of announcements offers some hope. Government of countries that are the source of most greenhouse gas emissions have stated their support for achieving national net zero emissions by 2050 to 2070.

Tips The material of this chapter lends itself to additional examples. The instructor can introduce extra material in class discussions, class handouts, or additional readings. Some examples include the threat to the marine population of the Galapagos, threats to the global jaguar population, water quality and air quality along the Rio Grande, the U.S. diversion of water in the Colorado River before it gets to Mexico, the paper mills in Uruguay that have been opposed by Argentina, dams on the Mekong River, the drift of air pollution from China to South Korea and Japan, overfishing of tuna (especially bluefin tuna), the role of deforestation in contributing to global warming, and the near death and resuscitation of the EU’s emissions trading system.

As interesting examples are included in the discussion, we recommend keeping economic principles in full view. It is useful to remind students that:  

incentive distortions and imperfect property rights are crucial causes of environmental problems, whether these problems are international or not; there are two basic policy approaches—the (Pigovian) tax-and-subsidy approach, and the (Coasian) property rights approach; 86

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 

we keep discovering new uses for the specificity rule introduced in Chapter 10; and this rule almost never recommends trade policy as a first-best approach to environmental problems, though it may be a second-best approach.

An instructor may want to consider an assignment in which students (working individually or in groups) report on a country’s environmental problems and policies or report on an international environmental issue.

Suggested answers to end-of-chapter questions and problems 154.

There are two effects. First, rising production and consumption bring rising pollution if the techniques used to produce and consume are unchanged. Second, rising income brings increased demand for pollution control because a cleaner environment is a normal good. As Figure 13.1 shows, there are three basic patterns that arise for different types of pollution and related issues like sanitation. For some types of pollution, the first effect is larger, and pollution rises with rising income and production per person. For other types, the second effect is generally larger, so pollution declines with rising income and production per person. For yet other types, there is a turning point, so pollution at first rises and then falls as income and production per person increase.

155.

Disagree. The distortion caused by pollution is the result of the difference between the private costs and the social costs of the activity that creates the pollution. Because the person choosing to take an action that creates pollution does not care about the external costs of the pollution, he tends to create too much pollution. Free trade does not alter the fact that there will remain a gap between private cost and the social cost (inclusive of the cost of pollution).

156.

Both (b) and (d). For item (b), the WTO places strict requirements on a country using trade limits to punish a foreign country for having environmental standards for production in the foreign country that are different from those of the importing country. If the country does not recognize that other methods for controlling this pollution may also be acceptable, or if the country is acting unilaterally rather than negotiating with the foreign countries, then the WTO is likely to view the policy as a violation of WTO rules. For (d ), the WTO would consider the pollution issue to be a pretext for unacceptable protectionist import barriers because the imported products are not the only source of the pollution.

157.

The first thing to consider is whether the mine-related pollution in the lax countries has any adverse environmental effect on the strict country. If it does not, then the strict country has no national concern about lax policies in other countries. The strict country should get its own environmental policies right. If it can import ores cheaply from lax countries, then this increases its national gains from trade. If lax-country mine-related pollution does have an adverse effect on the strict country, then the official should be concerned, not because the lax policies are unfair, but rather because of the external cost imposed on the country. The government in the strict country should negotiate with the lax country government for appropriate regulations. If these fail, the strict country 87

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government might benefit from imposing limits on imports of ores from the lax countries, because this would lower the production and pollution created in the lax countries.

158.

While there is some room for interpretation here, the specificity rule definitely prefers (c), followed by (d ), then (a), and then (b).

The defeatism of (e) is misplaced. Oil spills are the result of shippers’ negligence to a large extent, and not just uncontrollable acts of God. One drawback to (a) and (b) is that they force each nation’s importers or consumers to pay insurance against shippers’ carelessness. The more direct approach is to target the shippers themselves. In addition, many oil spills ruin the coastlines of nations that are not purchasers of the oil being shipped, making it inappropriate to charge them.

It might seem that the most direct approach, (c), is unrealistic because it is hard to get full damages from the oil-shipping companies in court. Yet it is not difficult to make them pay for most or all of the damages. A key point is that the most damaging spills occur within the 200-mile limit, meaning that they occur in the national waters of the country suffering the damage. Full legal jurisdiction applies. The victimized country can legally seize oil shippers’ assets, apply jail sentences, and even demand that a shipping company post bonds in advance of spills in exchange for the right to pass through national waters.

As for (d ), intercepting and taxing all tankers in national waters is a reasonable choice.

Its workability depends, however, on the cost of such coast guard vigilance. If all tankers entering national water must put into port, they could be taxed in port. That is unlikely, however, and it might be costly to pursue them all along the 200-mile coast. Furthermore, such a tax, like many insurance schemes, makes the more careful clients (shippers) pay to insure the more reckless.

159.

a.

The shaded loss area b is now $15 million. Free trade makes the country better off, because the usual gain from trade (area a, equal to $25 million) is larger than the loss from increased pollution ($15 million).

If there is no way to reduce pollution per ream of paper produced, then the first-best outcome can be achieved if the government imposes a tax of $0.05 per ream produced domestically. This shifts the domestic supply curve up to  Sd  $0.05  . The country should still export paper, but the amount that it should export is less. With the tax, the country will produce 2.15 billion reams domestically at the international price $1.10, so it will export 350 million reams.

160.

Item (b). This tax would lead to substantial reductions in the use of fossil fuels, the major source of human-made greenhouse gases. The other items would have small effects over the next 30 years.

161.

a.

The governments should determine the external costs imposed by the pollution on both countries combined, and impose this as a tax per unit of pollution emitted by the cement producers. When the tax is imposed, the cement producers will adopt the lower pollution technology, if its cost is less than the tax. The price of cement will increase as the tax and the new technology (if adopted) increase the costs recognized by the cement producers. Pollution will decline to its appropriate level (probably not zero) because the 88

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higher price reduces quantity demanded, so cement production declines, as well as because pollution per unit of cement produced is lower if new technology is adopted.

If the Pugelovian government must fashion a solution on its own, it should consider restricting its imports of cement from Lindertania. This is not the first-best solution. It does not create any incentive to adopt the lower pollution technology. But it can lower Lindertania’s production, so pollution will be lower. This brings a net gain to Pugelovia if the gains from lower pollution are greater than the usual losses from restricting imports.

162.

No trade barriers are called for by the information given here. If the wood is, in fact, grown on plantation land that would have been used for lower-value crops, there is no clear externality, no basis for government intervention. Only if the plantations would have been rain forest and only if there were serious environmental damage (e.g., extinction of species or soil erosion) from the clearing of that rain forest land for plantations would there be a case for Indonesia’s restricting the cultivation of jelutong.

As for the greenhouse gas effects of cutting more tropical rain forest, they could easily be outweighed by the longer growing life of cedar trees in the temperate zone

163.

a.

The graph shows the marginal benefit to Germany  MBG  from dumping waste

into the Danube and the marginal cost to Austria  MC A  of that waste dumping by Germany. Initially, the German firm is dumping 180 tons of waste into the river. We can use the numbers given in Figure 13.5 to determine that the equation for the marginal cost curve is MCA  60  4.25·QG , where QG is the quantity of waste (in millions of tons) dumped by the German firm. Therefore, for the last tons dumped, the marginal cost to Austria from the additional pollution of the river is €825 per ton.

When Austria imposes the tariff on imports of paper, the German dumping of waste declines by 10% to 162 million tons. The reduced dumping brings benefits to Austria, beginning at €748.5 per ton for the first tons above 162 million, and rising to €825 per ton for the last tons to 180 million. In total, Austria gains a benefit from avoiding pollution of these 18 million tons that is equal to area HJKA. The area of this trapezoid is (base) 18 million tons times (average height) half of (748.5 + 825), equal to €14.1615 billion.

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Austria is better off than it was before imposing the tariff. It gains about €14.2 billion in reduced pollution cost from German waste dumping, at a cost of only €5 billion in standard deadweight losses from the tariff (production inefficiency and consumption inefficiency).

164.

For the rhino, as an endangered species, CITES bans commercial international trade in horns (and other parts). One challenge for CITES is making this ban work. If the ban is combined with education of potential buyers to decrease demand, then the price of horns decreases and the incentive to poach (in which a rhino is killed to obtain its horn) decreases. However, poaching is difficult to police, and the ban on international trade is difficult to enforce. If demand is strong, the price of horns increases and the incentive to poach increases. A second challenge for CITES is deciding whether or not to shift away from a ban on commercial international trade and toward a policy of ―sustainable use‖ for rhinos. Horns can be harvested without killing the rhino. If such harvesting is developed as a business, those who run the business have the incentive to keep rhinos alive, so their horns can be harvested more than once over time. The goal is to align economic incentives with protection and preservation of the species. But there may then be a third challenge for CITES. If it allows commercial trade in rhino horns that are harvested without killing the rhino, it may become easier for horns obtained by poaching to be traded internationally because it may be difficult to design a system that distinguishes between harvested and poached horns. So, a system of sustainable use and commercial trade for harvested horns could also create a conduit that enables increased poaching.

165.

The success of the Montreal Convention in limiting CFCs was largely due to these facts: (a) the scientific evidence that CFCs were depleting the ozone was clear; (b) relatively few countries and companies accounted for most of the world’s production of CFCs, limiting the number of negotiating parties; (c) these countries are located at high 90

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latitudes, where the danger of ozone depletion was greatest; (d) these countries are highincome and therefore relatively willing to make economic sacrifices to protect the environment; and (e) reasonable substitutes for CFCs became available. The conditions surrounding the emission of carbon dioxide and other greenhouse gases are not as favorable. The science that links greenhouse gases to global warming and its effects is less certain. The burning of fossil fuels does concentrate somewhat in the higher income countries, especially the United States, but all countries burn fuels and release greenhouse gases, and the emissions are growing fastest in some of the developing countries. There are not yet reasonable and acceptable substitutes that can be used on a large scale to replace the burning of fossil fuels for energy and heat. Because the conditions are less favorable, the negotiated agreements (Kyoto, Paris) to limit the emission of greenhouse gases have not (yet) been strong and effective.

Chapter 14 Trade Policies for Developing Countries Overview This chapter examines trade issues affecting developing countries. It begins by noting differences between high-income developed countries and low- and medium-income developing countries, as well as differences among the developing countries. Some developing countries are growing quickly, while others are stagnating or declining.

The comparative advantages of developing countries (relative to developed countries) derive from abundance of unskilled labor and, for many, abundance of natural resources and/or a tropical climate for agriculture. Furthermore, financial capital markets and labor markets are less efficient in developing countries. Given these differences, a developing country must decide what trade policy (and other government policies) to adopt. (1) It can focus on exporting primary products based on the country’s comparative advantage in natural resources and its tropical climate. (2) It can adopt a policy that tries to raise world prices for its export of primary products by joining international cartels or taxing its exports. (3) It can tax and restrict imports of manufactured goods to develop new domestic industries through import substitution. (4) It can promote and subsidize new export products, especially manufactured goods. Given the less efficient capital and labor markets, there may be a role for an active government trade policy.

Some developing countries rely on primary products for most of their exports. Evidence indicates that these countries appear to have experienced a slow deterioration in their terms of trade over time. It appears that the adverse effects of Engel’s Law and the development of synthetic substitutes have been more important than the limits of natural scarcity and slow growth of productivity in primary goods production. The conclusions are tentative, because there are biases in the data—declining transport costs and faster unmeasured quality improvements for manufactured goods (including new manufactured products).

One possible approach to the problem of declining primary product prices is to form international cartels to raise their prices. OPEC did this for oil in the 1970s. The analysis of a 91 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

cartel as a group that has monopoly power because it controls a large part of the world’s production indicates the limits to this power and why cartels usually erode over time. Demand becomes more elastic over time, new competing supplies from outside the cartel enter the market, increasing the noncartel supply elasticity and decreasing the cartel’s market share, and cheating by cartel members often increases over time. The large decrease of oil prices during 2014–2016 shows the importance of the new noncartel supply (increased U.S. production of crude oil using hydraulic fracturing and horizontal drilling). The ability of OPEC to work with Russia and several other non-OPEC oil-producing countries to reduce their collective output and raise oil prices during 2016–2018 and again in 2020–2021 indicates that OPEC still has some power. Outside of oil, the prospects for even temporary success of primary product cartels seem poor, and there are currently no other effective cartels.

Import-substituting industrialization (ISI) was the dominant policy in the 1950s and 1960s, and it is still important today. At its best, it is an application of the infant-industry argument, guided by the existence of a market for the goods produced by the new domestic producers, with tariff revenues that may be justified by the developing-government argument, and it can also improve the country’s terms of trade by reducing demand for imports. However, because the terms of trade effects are usually small, it imposes substantial economic costs through deadweight losses—it often results in domestic industries that have high costs, domestic monopoly power, and low-quality products. Taiwan, South Korea, and a number of other developing countries that have shifted from a policy of ISI to a more outward-oriented policy that encourages development through exporting usually grow faster with the outward-oriented policy, and comparison of countries that had outward-oriented policies with those that practiced ISI shows that the former grew more quickly on average.

Developing countries have turned increasingly toward emphasizing new exports of manufactured goods to developed countries as their trade policy to promote development. The success of this policy can be limited by protectionism in the developed countries, but reasonable success is still possible.

Tips The chapter is designed so that the instructor can emphasize some policy issues more than others, if this is desired. The introduction and first section provide the setting. Most courses probably will include the theory and practice of ISI, and comparisons with outward-oriented policies. This is a topic on which much evidence has been gathered since the 1970s, with a relatively clear consensus against the earlier hopes for the ISI strategy. Most courses also probably will want to cover the section on ―Exports of Manufactures to Developed Countries,‖ because this follows from the discussion of outward-oriented policies. By contrast, the sections on primary products and cartels may be omitted if it is necessary to conserve time for other topics.

The second section of Appendix D has a technical treatment of optimal export taxes and the optimal markup for an international cartel.

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166.

The four arguments in favor of ISI are the infant-industry argument, the developinggovernment argument, the chance to improve the terms of trade for a large importing country, and economizing on market information by focusing on selling in the local market rather than in more uncertain foreign markets. The drawbacks to ISI are the deadweight losses from the inefficiencies of import protection, the danger that government officials directing the policy will try to enrich themselves rather than the country, and the lack of competitive pressure on local firms to ―grow up‖ by reducing costs, improving technology, and raising product quality. The arguments in favor of a policy of promoting manufactured exports are that it encourages use of the country’s abundant resources (comparative advantage), export sales can help to achieve scale economies, and the drive to succeed in foreign markets creates competitive pressure. A major drawback is that the foreign importing countries may erect trade barriers that limit the exporter’s ability to expand its exports of manufactures.

167.

The four arguments in favor of ISI are the infant-industry argument, the developinggovernment argument, the chance to improve the terms of trade for a large importing country, and economizing on market information. The conditions under which ISI is likely to be better than alternative strategies include the following: First, being a large country is probably important, not only for the terms of trade effect but also because a large domestic market makes it possible for a number of domestic firms to compete for sales while still achieving scale economies. Second, conditions favoring the maturing of infant industries, such as a trainable labor force or spillovers from technology brought into domestic production, are probably important. Third, it is probably useful for the government to have poor ability to raise revenues using more broadly based taxes, so that tariff revenues are important to the government budget. Fourth, it is probably useful that poor information makes evaluation of opportunities for successful export products difficult. ISI should be accompanied by investment in training and education, investment in domestic infrastructure such as roads and other domestic transportation facilities and a competent and honest civil service.

168.

The available data do indicate that the relative prices of primary products have declined since 1900, perhaps by as much as 0.6% per year. But there are biases in the data. Some of the decline could reflect declining transport costs, and some could be offset by the rising quality of manufactured products that is not reflected in the price comparison. The true trend decline is probably less than 0.6% per year, and it may even be no decline.

169.

Two forces are likely to drive toward a deteriorating terms of trade—a decrease in the prices of the primary product exports relative to the prices of the manufactured good imports. First, the global demand for primary products is likely to rise more slowly than the global demand for manufactured goods will rise, as global incomes rise, because primary products have lower income elasticities of demand (Engel’s Law). Second, new synthetic substitutes are likely to be developed for some of the primary products, lowering global demand for the primary products. Two forces are likely to drive toward an improved terms of trade. First, natural limits could restrain global supply of some primary products. Second, slow growth in primary product productivity is likely to limit cost decreases, so primary product prices do not fall as much as (or rise more than) the 93

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cost and prices of manufactures that experience more rapid productivity growth. In addition, more rapid quality improvements in manufactured product imports effectively increase the country’s terms of trade.

170.

For its first few years, TAR has the ability to be successful as an international cartel if its member countries can agree on and abide by its policies. TAR will have several advantages during its first few years. It has a large share of world production, so its actions can have a substantial impact on the world price. The price elasticity of demand is rather low, so it can raise the world price without too much of a falloff in world sales. It will not face much pressure from outside suppliers because they cannot enter or increase their production quickly. The biggest challenges facing TAR in its first few years are establishing its policies and having its members comply with them. The five countries may have different views on how much to increase the price in the first few years, they may disagree on how much each of them should reduce their own production to limit global supply, and so forth. Even if they can reach agreement on the cartel’s policies, each of them has an incentive to cheat on the agreement. Given how different the five countries are, agreeing to and abiding by the cartel policies are major challenges.

In the longer run, the cartel is unlikely to remain successful, even if it achieves success in its first few years. If it succeeds in raising the world price in its first years, two forces come into play that erode its effectiveness over time. First, the price elasticity of demand becomes larger, so world sales of tobacco decline if the price is kept high. Second, new outside suppliers can enter into production, and existing outside suppliers can expand their production. The cartel members are squeezed from both sides. The price that maximizes the cartel’s total profit declines. Furthermore, it becomes more difficult, and eventually impossible, to reach agreement on which cartel members should continue to reduce their own production to keep the world price above its competitive level by limiting total global supply.

171.

First, taxing exports of primary products could improve the country’s international terms of trade, if the country is large enough to affect international prices (the optimal export tax, the counterpart of the optimal import tariff presented in Chapter 8, and the national equivalent of the international cartel analyzed in this chapter). If there are net national gains, they are likely to be largest in the first years after the export tax is imposed, before the monopoly power of the country is eroded (in ways shown in the discussion of an international cartel). Second, taxing exports of primary products will induce resource reallocations to other production sectors, including manufactured goods that can replace imports and perhaps develop into new export industries. Third, the revenues from the export tax can be used to pay for national public goods like education and infrastructure.

Or, these revenues can be used to subsidize infant industries that can develop into mature, internationally competitive industries in the future. Drawbacks loom large in practice.

First, the country may lack monopoly power, in which case the export tax just distorts domestic resource allocation and creates deadweight losses. Second, the government often lacks information about which new industries to encourage. Third, the additional revenues are often siphoned off to the private wealth of government officials.

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172.

a.

The demand that remains for the cartel’s oil falls by 10 million barrels per day, for any price above $5 per barrel. In the graph below, this is a shift of the demand curve for cartel oil to the left, from D to D ' . The new demand curve for the cartel’s oil is parallel to the original demand curve and lower by 10 million barrels. Its intercept with the price axis is below $195. (Using the equation for the market demand curve, P  195   95 / 30  * QD , the intercept for the new demand curve is $163.33.) The marginal revenue curve for the cartel also shifts down and to the left, from MR to MR .

The intersection of the new marginal revenue curve and the (unchanged) marginal cost curve for cartel production occurs when oil exports are X ' , less than 30 million barrels, and the new profit-maximizing price for the cartel is P ' , less than $100 per barrel.

The quantity demanded for the cartel’s oil is unchanged if the market price is $5 per barrel, but each $1 increase in the market price takes away another 0.5 million barrels from the demand remaining for the cartel’s oil. The new demand curve for the cartel’s oil is shown as the colored line D " in the graph on the next page. With the new outside supply the quantity demanded of the cartel’s oil falls to zero at a price less than $100. (The price intercept of the new demand curve for the cartel’s oil is $78.55.) Because both the old and the new straight-line demand curves show the same quantity demanded at a price of $5, the new marginal revenue curve MR " intersects the original marginal revenue curve MR at $5 per barrel. This point is also the intersection with the cartel’s marginal cost curve, so the cartel continues to produce 30 million barrels. Because of the new and elastic outside supply of oil, the cartel’s new profit-maximizing price P " is much less than $100.

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173.

The prediction is that the shift to an outward oriented policy will result in an increase in India’s growth rate, so that it is higher than India’s growth rate was before the shift, and possibly also that it is among the higher growth rates for developing countries. The data shown in Figure 14.1 are consistent with the prediction. India’s rate of growth of per capita GDP was 5.3% during 1995–2019, which is substantially faster growth than the 2% India achieved during 1970–1990. India’s 5.3% growth rate is also among the higher growth rates shown for developing countries.

174.

Disagree. The country is doing well using exports of manufactured products as an important part of its development strategy. However, there is a limit to how far this policy can carry the country. Competitiveness in less-skilled-labor-intensive products depends on low wages. Real wages cannot rise too high, or the country will begin to lose its ability to compete for foreign sales. In addition, other developing countries with lower wages may shift to a similar strategy based on exports of these products, adding to the international competition that the country’s exporters face. If the country is to continue to develop, it probably needs another dimension for its strategy. As we noted back in Chapter 3, payment of high wages depends largely on workers’ being able to achieve high levels of productivity. Workers with more skills are more productive and can be paid more. A better educational system is part of a national effort to equip the country’s people with skills and with the ability to learn new skills.

175.

a.

Unilaterally taxing corn exports has the advantage of being collectible by a small customs staff at the nation’s major border crossings, as in the developing-government argument. The export-tax revenues could be invested in public goods such as health, education, and infrastructure, or they could be used to subsidize other promising sectors of the economy. However, Argentina probably cannot force up the world price of corn, because it is not large enough, given severe competition from other corn exporters. So, the export tax probably would mostly cause misallocation of domestic resources.

96

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An international corn cartel is politically unlikely and would break down almost immediately, given competition from suppliers that would stay outside the cartel and cheating by members of the cartel.

This classic infant-industry argument has possibilities, but all of Chapter 10’s doubts about its wisdom are reinforced by this chapter’s recitation of the evidence about how poorly ISI has worked in practice. Still, the encouragement of exports has promise, if it drives the domestic manufacturers to become competitive by world standards.

176.

The four types of trade policies that a developing country can use in its effort to promote growth of its economy are expanding primary product exports, raising the prices of its primary product exports, restricting imports to encourage the growth of import-replacing domestic production, and promoting exports of new products (other than primary products) that make use of the country’s comparative advantage. The policy of encouraging development of local production of basic business services is an example of the fourth policy. Business services are not primary products, so it is not an example of the first two. Basic business services are not major import items, and the demand to be served is mostly not within the country, so it is not an example of the third. Rather, basic business services are products that can be produced using the country’s abundant lowskilled and medium-skilled labor and that can be exported to buyers in other countries.

The most successful country that has pursued this strategy is India, and other developing countries have been adopting policies to add this set of products to their development strategies.

177.

By itself, the reduction of Thai exports as the Thai government removed Thai-grown rice from the market would tend to drive up the world price of rice. Why did the world price fail to rise, even though the Thai government did purchase large amounts of Thai rice?

There are several possible factors that may contribute to keeping the price steady. First, the supply of rice grown in other countries may have increased. Second, demand for rice may have decreased for some reason(s), including stagnant or declining income, or decreases in prices or increases in the availability of other grains or food products that are reasonably close substitute for rice. Third, the fact that the Thai government was building its own stockpiles of rice may have prevented rice prices from rising much. (Here is what we know about actual developments. Of the three possible reasons, the first appears to be the most relevant. Other countries continued to increase their rice production. India resumed its rice exports in 2011. [Vietnam had resumed before 2011.] No major exporting country other than Thailand imposed new restrictions on exporting. The Philippines, an important importing country, increased local rice production, so it imported less. With growing world supply to meet the normal growth of world demand, there was no upward pressure on price. The third reason may also be relevant, but it is difficult to know for sure. Buyers and speculators knew that the Thai government was buying large amounts of rice, and that in the near future the Thai government was likely to be a large seller of this previously acquired rice. The expectation of future Thai government rice sales and future lower price would tend to limit how much the rice price increases in the present.)

Why did Thailand fall from being the largest rice exporting country to the third largest?

That is straightforward. The policy of the Thai government reduced Thai rice exports 97

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starting in 2011, but other major exporting countries (including India and Vietnam) did not restrict their exports. By reducing its exports, Thailand fell from first to third.

Chapter 15 Multinationals and Migration: International Factor Movements Overview This chapter provides a survey of the economics of foreign direct investment (FDI) and the economics of labor migration.

Foreign direct investment is a flow of funding provided by an investor (usually a firm) to establish or acquire a foreign company or to finance an existing foreign company that the investor owns. Ownership is important because the investor has or acquires the power to have a substantial influence on the management of the foreign company. The share of the equity of the foreign company that the investor must own to have substantial influence on management is probably less than 50%. The standard (arbitrary) minimum amount used by most countries to define FDI is 10% of the equity of the foreign company. (FDI may also refer to the stock of such investments in existence at a point in time.)

A multinational enterprise (MNE) is a firm that owns and controls operations in more than one country. Thus, FDI is a way that the parent company of the MNE can finance its foreign affiliates. However, an MNE is more than just a way to move financial capital between countries.

The foreign affiliate (subsidiary or branch) often receives managerial skills and methods, technology and trade secrets, marketing capabilities and brand names, and instructions about business practices from its parent company. Often much of the financing of the affiliate is raised locally, perhaps to reduce exposure to exchange rate risk or to the risk of expropriation by the host-country government.

Developed countries are the source of most FDI, and most FDI goes into developed countries (although recently the share going to developing countries has risen). Direct investment is more important in some industries than in others. In manufacturing, FDI is important in such industries as chemicals, electrical and electronic products, automobiles, machinery, and food. In services, FDI is important in such activities as financial services, business services, and wholesaling and retailing.

What explains why MNEs exist? Purely financial theories cannot explain MNEs because they cannot explain why managerial control over the foreign affiliates, with its focus on production and marketing, is necessary if the goal is only to move capital from one country to another in pursuit of higher returns or diversification of risk.

A useful framework for understanding why MNEs exist stresses five elements. First, firms face inherent disadvantages (costs and risks) in operating affiliates in foreign countries. Second, to overcome the disadvantages and to be successful with its FDI, a firm must have some firmspecific advantages not held by its local competitors in the foreign country. These firm-specific 98 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

productivity advantages may derive from technologies, marketing assets, managerial capabilities, or access to large amounts of financial capital. Third, location factors, such as comparative advantage or government barriers to trade, influence where production should occur (export or FDI). Fourth, there may be advantages to using the firm’s advantages internally within the MNE, rather than incurring the transactions costs and risks of selling or renting these assets to independent firms (license or FDI). Fifth, FDI can be part of global oligopolistic rivalry. (The box on CEMEX shows the roles of firm-specific assets and oligopolistic rivalry in the growth of this MNE based in Mexico.)

The taxation of the profits of multinational firms raises important issues. Although the details are overwhelming, the general approach to how the profits are taxed is that the profits of the foreign affiliates are taxed by the host country and the profits of the parent company on its own activities are taxed by the home country. To minimize total taxes paid worldwide, multinational firms can try to locate activities in low-tax countries. More controversially, multinational firms can use transfer pricing on transactions that occur within their global organizations to show more of their profits in countries where the profits will be lightly taxed. Governments know this incentive for profit-shifting. They often attempt to police transfer pricing to assure that transfer prices are similar to market prices, but this determination is often difficult, so the firms have some scope to manipulate transfer pricing.

Multinational firms are active in international trade in goods and services, and about one third of world trade is intra-firm trade between units of multinational firms in different countries.

Although some FDI is a substitute for trade, because local production replaces products that otherwise would be imported, FDI and trade are also often complements. This is especially true when multinational firms exploit differences in comparative advantages by locating different stages of production in different countries. It can also be true when better local marketing by an affiliate leads to increased sales of some products that the multinational firm produces in other countries, even if other parts of the firm’s product line are produced locally by the affiliate. Most studies conclude that FDI overall is somewhat complementary to international trade in products.

Economic analysis indicates that the home (or source) country can receive net benefits from its outward FDI, because the gains to the owners of the MNEs exceed the losses to workers and other providers of resource inputs. There are several other sources of possible loss to the home country. The government may lose tax revenues as profits are now shown in foreign affiliates.

Positive externalities may be lost when the activities are shifted out of the country. The multinationals may gain too much influence over the home country's foreign policies. While there are some arguments for the home county to tax or restrict outbound FDI, the actual policies of the major home countries are neutral to mildly supportive toward outward FDI. Economic analysis suggests that the host country gains from inward FDI, even if the profits of the local affiliates do not belong to the host country, and even though some local competitors may be harmed by the competition from the affiliates. There is some case for the host-country government to tax or restrict inward FDI, because of fear of the local political power of the foreign multinationals, or to impose an optimal tax on the affiliate’s profits. But the FDI may also bring technological spillovers and other positive externalities. In the 1950s and 1960s, host governments, especially in developing countries, stressed controls and restrictions on the entry and operations of MNEs. Since the mid-1970s host countries have generally been liberalizing 99 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

their policies toward inward FDI, and many actively compete for it by offering various forms of subsidies to multinational firms that will locate new facilities in their countries.

The box ―China as a Host Country‖ (another Focus on China) provides a look at the second largest recipient of FDI inflows in recent years. It shows applications of many concepts developed in the first half of this chapter. It notes key features and issues, including that much FDI into China has come from Taiwan and Hong Kong (including some that is ―roundtripping‖), that the Chinese government requires joint ventures with Chinese firms for foreign direct investment in some industries, that the Chinese government pressures foreign firms to transfer technology and other intellectual property to Chinese firms (including joint venture partners), and that China’s government has both policies that restrict inward FDI and policies that encourage inward FDI. The latter part of the chapter examines international migration, including the benefits and the costs to the migrants, the effects of migration on other groups and on the sending and receiving countries overall, the fiscal effects of migration, and government policies toward migration. For the United States and Canada, immigration was relatively large until the 1920s, was low in the 1930s, and has been higher since the 1950s. For the shorter history of the European Union, immigration was curtailed in the mid-1970s and early 1980s, but has increased again since the late 1980s.

The basic theory of labor migration is presented by picturing labor markets in the ―North‖ and the ―South‖ of the world. Higher wage rates in the North provide the incentive for migration, but migration is also limited by the economic and psychic costs of migration. The analysis shows that migrants themselves gain, workers remaining in the South gain, employers in the South lose, workers in the North lose, and employers in the North gain. The South overall (excluding the migrants who have left) loses, the North overall (again excluding the migrants) gains, and the world gains from this migration.

Recent research on the effects of immigrants on (native) workers in the North add refinements to this basic analysis of the receiving country. First, the higher returns to employers in the North incentivizes them to invest to expand their businesses, thereby increasing their demand for labor and putting upward pressure on wage levels in the North. Second, different types of North workers (e.g., different skill levels) are affected differently by immigrants. Overall, the effects of immigrants on wages of North workers are probably small, except for types of North workers (e.g., high school dropouts and previous immigrants in the United States) who compete directly with a large group of (new) immigrants.

The basic analysis of the effects of migration indicates that the sending country loses economic well-being. In addition, most emigrants are young adults, so the fiscal effect is adverse. The loss of future tax payments from these emigrants is likely to be larger than the reduction in future government spending. The loss is likely to be especially large for the emigration of highly educated people (the ―brain drain‖). On the other side, some sending countries receive substantial remittances sent by the emigrants back to their family and friends.

The basic analysis of the effects of migration indicates that the receiving country gains economic well-being. There are several other possible effects of immigration. First, immigrants often bring 100 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

external benefits through knowledge spillovers. Second, immigrants can bring external costs through increased congestion and crowding. Third, immigrants can raise social frictions based on bigotry, which can become severe during periods when the rate of immigration is high. In addition, in a number of receiving countries the fiscal effects of immigration have become increasingly controversial.

The box ―Are Immigrants a Fiscal Burden?‖ summarizes studies for the United States and some other high-income-receiving countries. For a receiving country the fiscal effects of immigration depend both on the immigrants’ payments of taxes and on how much expansion of government spending on goods and services is necessary to provide these goods and services to the immigrants while also maintaining the same level of consumption value to natives in the country.

Presumably, any transfer payments received by immigrants are an expansion of government expenditures, but the effects on other government goods and services must be estimated. One way to examine this is to look at a snapshot for a single year. According to a recent OECD study, the net effect varies somewhat across receiving countries, and it is generally relatively small.

Another way to look at this is to examine the net effects over the entire lifetimes of immigrants and their descendants. One comprehensive study of the United States concludes that the average net fiscal effect is slightly negative for the typical immigrant and substantially positive for the immigrant’s descendants. In addition, the study concludes that the net fiscal effect of the immigrant depends on the immigrant’s level of education, used as indicator of labor skill and earnings potential. Immigrants with a high school education or less impose a net cost; immigrants with at least some college provide a net benefit. Because, for the United States after about 1970, the average education and earnings of immigrants declined relative to those of natives, the fiscal balance probably shifted toward immigrants being a fiscal burden.

The analysis has implications for the policies used by receiving countries to limit immigration.

First, the types of immigrant admitted have an impact on which native group suffers loss.

Second, the types of immigrants admitted have an impact on the net fiscal effects. To gain greater fiscal benefits (and to minimize the negative impact on low-skilled native workers who already have low earnings), the receiving country should skew its immigration policies to favor young adults with some college education. However, for countries like the United States, this would mean shifting away from other worthy goals pursued by their current immigration policies, including family reunification and assisting refugees.

Tips Figure 15.1 has quite a bit of information that can be used to generate class discussion, including the identity of the major home countries (why are these the major home countries?), the relatively small amount of FDI into developing countries and more generally what countries and regions host most FDI (why?), and the specific pattern of FDI for each home country (why?).

Migration is a sensitive topic, and any presentation needs to keep its scientific standards up, by distinguishing what is known or plausibly estimated from what is common folklore.

This chapter can be assigned and covered in conjunction with the material on policy issues (Chapters 8–14 of the book). Or, some or all of the chapter can be assigned with the material on 101 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

the pure theory of trade, if the goal is to link it closely to the issues raised in Chapter 5 (trade and factor movements as substitutes), Chapter 6 (imperfect competition), or Chapter 7 (technology).

Suggested answers to case study discussion questions CEMEX: A Model Multinational from an Unusual Place: CEMEX saw sufficient internalization advantages to conclude that CEMEX wanted to own its operations in Spain, Colombia, and the Philippines, rather than licensing local independent producers. Negotiating such licenses probably would have been costly, and the local firms would try to make low payments with few restrictions on how they use CEMEX’s operations technologies. The licensed local firms could attempt to use the CEMEX technologies to grow and eventually to become stronger rivals that could challenge CEMEX in other countries. The licensed local firms may not guard secret aspects of the technologies as carefully as CEMEX does, so that the technologies are more likely to leak to other cement firms who are not licensed by CEMEX. There are some advantages to licensing local firms rather than undertaking direct investment into the country.

These include lower financial investment and avoiding the inherent disadvantages of being a foreign firm operating in the country. CEMEX concluded that the internalization advantages— avoiding the shortcomings of licensing by using ownership of the local operations to control and safeguard the technologies and to receive all the profits earned on the local operations—were larger.

Are Immigrants a Fiscal Burden? These characteristics matter for the (current) fiscal effects of the immigrants. Because they are young, immigrants will pay relatively large amounts of social security taxes while drawing few social security (pension) benefits. Because they have low wage rates, they will tend to pay low income taxes (and similar taxes like sales or value added taxes).

Because they are healthy (and young), they will tend to receive little medical care. Because they have a large number of children, they will tend to make substantial use of public education (and possibly also receive large amounts of family and child benefits). The net effect of all of these characteristics could go either way. The immigrants bring a net fiscal benefit if their large social security payments (and low pensions) and low medical care are dominant. They bring a net fiscal cost if their low income (and similar) taxes paid and their large use of education (and other family and child benefits) are dominant.

Suggested answers to end-of-chapter questions and problems 178.

Disagree. Most FDI is in developed countries, especially the United States and Europe.

Wages are not low in these countries. This FDI instead is used to gain access to large markets and to gain the insights and marketing advantages of producing locally in these markets.

179.

Disagree. Developed countries do have large amounts of financial capital that they want to invest. Even if they want to invest part of this capital in other countries, this does not explain why they are the source of most foreign direct investment. If the goal is only to invest financial capital in other countries, then the easier way to do so is through portfolio 102

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investments in foreign stocks, bonds, and loans. Foreign direct investment also involves a transfer of technology, marketing skills, managerial capabilities, and other firm-specific assets to the foreign subsidiary, and these are usually more important than the financial investment in the subsidiary. Developed countries are the source of most FDI because firms based in these countries have developed these intangible assets, which then serve as the base for successful FDI. 180.

Agree. One exposure is to exchange rate risk. The home-currency value of the assets of foreign affiliates will vary as exchange rates vary. If foreign-currency borrowings and other liabilities are used to finance the affiliates’ assets, they provide a hedge against exchange rate risk by more closely balancing foreign-currency assets and liabilities.

Another exposure is to the risk of expropriation. The host government sometimes exercises its power to seize the affiliates of multinational firms. If most of the affiliates’ assets are financed by local borrowings and other local liabilities, then the parent firms lose less because they can refuse to honor the liabilities once the assets are seized.

181.

We can guess that there are two possible types of reasons. One is that Japan is not attractive as a host country, based on its economic and business characteristics. The second is that Japanese government policy artificially limits FDI into Japan. First, the low level of FDI into Japan could be the result of economic and business conditions. Foreign firms may find Japan a difficult place in which to establish a business, because Japanese practices and procedures are different and difficult to learn about. Cultural and language differences make foreign management more difficult and more prone to misunderstandings and mistakes. Foreign firms also may find that Japan is a relatively expensive place to run a business, because of the high cost of land, or the difficulty of hiring experienced skilled labor (given "lifetime employment" at established large Japanese companies). Second, the low level of FDI into Japan could be the result of Japanese government policies. Until the late 1960s to mid-1970s, Japanese government policies explicitly prevented direct investment into Japan. Since then, foreign firms may be deterred by more subtle governmental barriers, including the tendency of the Japanese government to find ways to favor its own firms. In addition, the Japanese government imposes a large amount of regulation which tends to deter entry into business by both new Japanese firms and foreign firms. Probably, both of these reasons are of some importance in explaining why Japan is host to rather little direct investment, but there is controversy over which one is more important.

182.

There are inherent disadvantages of FDI arising from lack of knowledge about local customs, practices, laws, and policies and from the costs of managing across borders.

Therefore, firms that undertake FDI successfully generally have some firm-specific advantages. These firm-specific productivity advantages allow them to compete successfully with local (and other foreign) firms in the host country. Major sources of firm-specific advantages include better technology, managerial and organizational skills, and marketing capabilities. These types of firm-specific advantages are important in industries such as pharmaceuticals and electronic products. The firms that have the advantages can undertake FDI successfully. These types of firm-specific advantages are

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less important in industries such as clothing and paper products. Fewer firms possess these types of advantages, and there is less FDI in these industries.

183.

a.

Not FDI, assuming that the U.S. investor ends up owning less than 10% of the outstanding shares of BMW.

FDI. A flow of lending to a foreign affiliate that is more than 10% owned by the U.S. firm providing the loan.

FDI. Additional purchases of ownership of a foreign company by the U.S. investor that then owns more than 10% of the foreign affiliate.

The $100,000 is FDI, because the Brazilian affiliate is owned by the U.S. firm. The loan from the Brazilian bank is not FDI because it is not foreign, and because it is not direct (the Brazilian bank does not own equity in the Brazilian company).

184.

a.

To maximize global after-tax profit, the controller should try to show as much profit as possible in Ireland and as little profit as possible in Japan, because Ireland’s tax rate of 12.5% is lower than Japan’s tax rate of 31%. If possible, the controller should choose the third alternative, to raise the price of the component to $22. For each unit of the component exported from Ireland to Japan, this shifts $2 of before-tax profit from Japan to Ireland in comparison with the second alternative (price of $20) and it shifts $4 of before-tax profit compared to the first alternative (keep the price at $18). For each unit of the component exported, tax paid in Japan is reduced by $0.62 (or $1.24) and the extra tax paid in Ireland is only $0.25 (or $0.50). For each unit exported, the increase in global after-tax profit is $0.37 compared to the second alternative and $0.74 compared to the first alternative.

Ireland’s government may be pleased with this change in transfer price. More profits are shown in the country, so its tax revenues are higher than they would be if the transfer price were lower. Japan’s government is likely to be displeased. Its tax revenues are lower. It can try to police transfer pricing to ensure that the ―correct‖ prices are used to show the ―correct‖ amount of profit in the affiliates in Japan.

185.

Labor groups seek restrictions on the flow of direct investment out of the United States because outward FDI tends to lower labor income. The income reduction may occur for three major reasons. First, the FDI is shifting jobs out of the United States, so some U.S. workers lose as they become unemployed. Second, the general decrease in demand for labor puts downward pressure on wage rates. Third, the bargaining power of unionized labor is reduced when companies can threaten to shift production out of the United States. Unions cannot bargain so effectively to gain higher wages. Standard economic analysis shows that the losses to labor generally are more than offset by the gains to the owners of the companies undertaking the FDI. This standard analysis suggests that labor is mainly defending its special interest. But, there are other possible effects that would favor restricting outbound FDI in the national interest of the home country. The home government may lose tax revenue when profits are shown in foreign affiliates, and external technological benefits may shift out of the country. If these other effects are 104

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large enough, then the opposition of U.S. labor to outward FDI may also be in the national interest.

186.

Key points that should be included in the report: (1) FDI brings new technologies into the country.

(2) FDI brings new managerial practices into the country.

(3) FDI brings marketing capabilities into the country. These can be used to better meet the needs of the local market. They may be particularly important in expanding the country’s exports by improving the international marketing of products produced by the multinational firms that begin production in the country.

(4) FDI brings financial capital into the country and expands the country’s ability to invest in domestic production capabilities.

(5) The local affiliates of the multinationals raise labor skills by training local workers.

(6) Technological (and similar) spillover benefits accrue to the country as it hosts FDI because some of the multinationals’ technology, managerial practices, and marketing capabilities spread to local firms as they learn about and imitate the multinational’s intangible assets. Taken together, these first six items increase the country’s supply-side capabilities for producing (and selling) goods and services.

(7) In addition, the country’s government can gain tax revenues by taxing (in a reasonable way!) the profits of the local affiliates established by the foreign multinationals.

187.

Agree or disagree, depending on whether you think the import-reducing effects or the import-increasing effects are larger. As Chinese companies expand their FDI into the United States, the growing operations of Chinese companies in the United States are likely to have several effects on U.S. imports from China. On the one hand, U.S. imports would tend to decrease, because U.S. production in the U.S. affiliates of Chinese companies could replace some products that otherwise would have been imported from China. On the other hand, two effects would tend to increase U.S. imports from China.

U.S. production in the affiliates of Chinese companies could lead to importing machinery, components, and materials from China. And, the U.S. affiliates of Chinese companies could improve the marketing of the Chinese companies’ products in the United States. If some of these products are not made in the United States, then they could be sourced from China. It is not possible to say for sure which of these opposing tendencies will be larger, so U.S. imports could increase or decrease, as a result of Chinese companies expanding their FDI into the United States.

188.

First, in 1924, the United States passed a law that severely restricted immigration, using a system of quotas by national origin. Second, the Great Depression, with its very high rates of labor unemployment, probably reduced the economic incentive to immigrate because potential immigrants would expect that it would be very difficult to find employment.

189.

Agree. For the sending country, the basic economic analysis indicates that local employers lose more than the remaining workers gain. In addition, it is likely that the sending country government loses more in decreased future tax payments than the 105

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government is able to reduce its future expenditures. For one or both of these reasons, the sending country would lose from international migration. A key potential benefit for the sending country is that emigrants from the country may send remittances back to relatives and friends in the sending country. The remittances add to the purchasing power of the recipients. If the remittances are large enough, the sending country can gain overall from migration.

190.

a.

A rise in labor demand in the North.

A ―push‖ factor in the South, such as labor force growth or decreased demand for labor.

A drop in the cost or difficulty of migration.

191.

The reduction in the annualized cost of migration would lead to more migration (the number of migrants would be greater than 20 million). In the new equilibrium, with a smaller gap (c), the wage rate after migration would be greater than $3.20 in the South, and less than $5.00 in the North. Each of the areas of gain and loss (a, b, d, e, and f) would be larger.

192.

The migrants don’t gain the full Southern wage markup from $4.00 to $6.40 because some of their extra labor was supplied only at a marginal cost of their own time that rose S  Smig from $4.00 to $6.40. That’s shown in Figure 15.4 by the fact that the curve r leans Sr further out to the right than does the curve .

As for the full international wage gain from $4.00 up to $10.00, it is true that the migrants do get paid that full extra $6. However, $3.60 of it is not a real gain in their well-being.

It’s just compensation for the economic and psychic costs of migrating.

193.

This statement is probably false. The migrants do improve their economic well-being.

But once they leave they are no longer part of the sending country. The sending country can lose in two ways. First, analysis of the labor-market effects of emigration indicates that, while workers remaining in the sending country gain, employers and others in the sending country lose more, so the net effect on the sending country is a loss. Second, the net fiscal effect of emigration is probably a loss for the sending country. The emigrants have often received education paid for by the government, but the emigrants shift to paying taxes to the receiving-country government once they leave. We should also note one major way that the sending country can gain—emigrants often send back remittances to relatives and friends. The overall effect on the sending country is then unclear, but a loss is likely unless remittances are large.

194.

Here are several arguments. First, standard economic analysis shows that there are net economic gains to the Japanese economy, even if the gains to the immigrants are not counted. Japanese employers gain from access to a larger pool of workers, and these gains are larger than any losses to Japanese workers who must compete with the new immigrants (see Figure 15.4). Second, some of the immigrants will take on work that most Japanese shun, such as janitorial work. These immigrants view this work as an opportunity and better than what they had back in their home countries. Third, if immigrants are selectively 106

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admitted, the Japanese government can assure that they are net contributors to public finance—that they will pay more in taxes than they add to the costs of running government programs. The Japanese government should favor young adult immigrants, including many with skills that will be valued in the workplace. This effect on public finance is especially important for Japan because it has a rapidly aging native population, so the costs of providing social security payments to retirees is going to rise quickly in the next decades.

Fourth, immigrants bring with them a range of knowledge that can create spillover benefits for Japan. The immigrants bring food recipes, artistic talent, know-how about science and technology, and different ways of doing things. Japan wants to increase the creativity of its people and firms to be more successful in high-tech and information-intensive industries.

Immigrants can be a source of creative sparks.

195.

Here are several arguments. First, Japan is already a crowded place, with many Japanese living in densely populated metropolitan areas (especially Tokyo). Allowing more immigrants will add to the external costs of congestion, because most immigrants will want to live and work in urban areas. Second, increased immigration will add to social frictions. It will not be easy to change Japanese attitudes against foreigners. Instead, the immigrants are likely to face substantial discrimination. Japan’s policy must be decided with this reality in mind. Third, the immigrants easily could be a net fiscal burden. If the policy is not suitably selective, Japan will receive many immigrants who have little education and low labor skills. These immigrants will pay low taxes, but they will receive substantial benefits from Japanese government programs, including government-financed medical care. Fourth, the native groups that will lose from increased immigration include lower skilled Japanese workers who already have low earnings. The Japanese government should not institute a policy change that harms the least well off within the country, even if it might bring net gains to the country overall.

196.

The greatest net contributors were probably (b) electrical engineers arriving around 2005, whose high average salaries made them pay a lot of U.S. taxes and draw few government benefits. As for who contributed least, one could make a case for either (a) the political refugees or (c) the grandparents. The political refugees, as people who had not been preparing themselves for life in a new economy until displaced by political events, are generally less well equipped to earn income and pay taxes in the United States when they arrive. The grandparents are also likely to pay little taxes and may make some claims on government aid networks, though their qualification for Social Security is limited.

Chapter 16 Payments among Nations Overview This chapter begins the discussion of international finance and macroeconomics—the subject of the rest of the book. Its major purpose is to show how the balance of payments accounts for international transactions and how the different balances (or sub-balances) can be interpreted. It also presents the international investment position.

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A country's balance of payments records all economic transactions between the residents of the country and residents of the rest of the world. Each transaction or exchange results in two opposite flows of value. By convention, a credit or positive item is the flow for which the country is paid—it is the item that the country gives up in the transaction, and it sets up a claim on the foreign resident, so that funds (or "money") flow into the country. A debit or negative item is the flow that the country must pay for—it is the item that the country receives in the transaction, and it sets up a foreign claim on a resident of the country, so that funds (or "money") flow out of the country.

Each transaction has both a credit and a debit item—double-entry bookkeeping—at least once we create a fictional "goodwill" item for things that are given away (unilateral or unrequited transfers). Therefore, if we add up all items for the country's balance of payments, it must add up to zero. What we find interesting about the balance of payments is not that it must completely add up to zero, but rather how it does so. What are the values of different categories of items?

Typically, the first categories we examine are items that are international flows of goods (or merchandise), services, income, and gifts—the current account. Services include flows of transportation, financial services, education, consulting, and so on. Income includes flows of payments such as interest, dividends, and profits. In addition to the full current account balance, we can examine the goods and services balance.

The (private) financial account includes items that are nonofficial international flows of financial assets. (Note that we use the name ―financial account,‖ following current standard terminology, in place of the traditional name ―capital account.‖) Financial capital inflows are credit items— capital or funds flow into the country as the country "exports" financial assets (by increasing liabilities to foreigners or decreasing assets previously obtained from foreigners). Financial capital outflows are debit items—capital or funds flow out of the country as the country "imports" financial assets (by increasing the country's assets obtained from foreigners or decreasing its liabilities to foreigners). Direct investments are international capital flows between units of a company located in different countries (Chapter 15 has a detailed discussion of foreign direct investment and multinational firms). If the investor does not have management control, international investments in stocks and bonds are usually called international portfolio investments. Cross-border loans and bank deposits are other capital flows included in the financial account.

The third and final major part of the country's balance of payments records official international flows of financial assets that serve as official international reserves. The country's monetary authority (usually, its central bank) undertakes these transactions. Official international reserves include financial assets denominated in readily accepted foreign currencies, the country's holdings of Special Drawing Rights (SDRs), the country's reserve position at the International Monetary Fund (IMF), and gold.

If all items are recorded correctly, the sum of all of these items equal zero. In practice, they are not and do not, so that a line called "statistical discrepancy" is added to make the accounts add to zero. It represents the net of many items that are mismeasured or missed (net errors and omissions).

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The current account balance (CA) has several meanings. First, CA equals the value of the country's net flow  I f  of foreign investments (both private and official). Second, CA equals the difference between national saving and domestic real investment  S  I d  . Third, because CA is approximately equal to the difference (X − M) between the value of the country's exports of goods and services and the value of its imports of goods and services, CA is (approximately) equal to the difference between domestic production of goods and services and national expenditures on goods and services (Y − E). The text shows how the current account and goods and services balances have changed over time for four countries—the United States, Canada, Japan, and Mexico.

The overall balance should indicate whether a country's balance of payments has achieved an overall pattern that is sustainable over time. While there is no perfect indicator of overall balance, we often examine the country's official settlements balance (B), which is the sum (CA + FA) of the current account balance and the private financial account balance (including the statistical discrepancy). The official settlements balance also equals the (negative of the) official reserves balance (OR). Most of the official reserves flows indicate official intervention by the monetary authorities in the foreign exchange market.

The international investment position is a statement of the stocks of a country's foreign assets and foreign liabilities at a point in time. The text shows that the United States has changed from being an international debtor to creditor and back to a debtor during the past 110 years. ―International Indicators Lead the Crisis‖ is the first box in a series on the euro crisis. The box provides information on the current account balances and net international investment positions for four countries—Greece, Portugal, Ireland, and Spain—at the center of the euro crisis.

Growing CA deficits and rising net debtor positions indicated increasing risk of a crisis.

Tips A decision that an instructor must make is whether or not to cover the posting of individual transactions to the credit and debit items. The discussion of posting of individual items is in Appendix E. Chapter 16 itself focuses on using information from the balance of payments. We believe that students generally can grasp the meaning of the balance of payments by focusing on the various lines (showing types of items) and balances—as long as the students also see that it is double-entry bookkeeping so that all items must add up to zero. Instructors who want their students to see how individual transactions enter into the balance of payments should assign and cover the material in Appendix E in conjunction with Chapter 16.

A good source of up-to-date information on many countries is Balance of Payments Statistics from the International Monetary Fund (IMF). The format for the current account is similar to the presentation used in the text. What we call the financial account in the text is actually the combination of the Financial Account and the Capital Account in the IMF presentation method.

In addition, the official reserves account shown by the IMF includes only changes in official reserve assets held by the country’s own central bank or monetary authority. The omission of changes in foreign official holdings of the country’s liabilities is not a major issue for most 109 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

countries, but it is important for a country like the United States, whose own liabilities are held in large amounts by foreign central banks.

Another set of decisions is how to handle more recent changes that the IMF has made to its presentation format. In Figure 16.1 we have chosen to follow the new IMF standard to present the credit (+) and debit (−) status of each individual item separate from the value (size) of the item itself (examples: export of goods and services, imports of goods and services), and to present items measured as net credits and debits with the sign of the net value (examples: unilateral transfers, net; current account balance). In Figure 16.1, we have chosen, as noted in Footnote 2 to keep the older names ―income‖ and‖ unilateral transfers‖ rather than using the new names ―primary income‖ and ―secondary income.‖ And, as noted in Footnote 3, we have chosen to maintain the debit-credit-based sign for the financial account balance rather than using the new IMF convention that reverses its sign.

Suggested answers to end-of-chapter questions and problems 197.

National saving (S) equals private saving plus government saving (or dissaving if the government budget is in deficit). For this country, national saving equals $678 billion (or $806 − $128). The current account balance equals the difference between national saving and domestic real investment  I d  . For this country, the current account balance is a deficit of $99 billion (or $678 − $777).

198.

Disagree, at least as a general statement. One meaning of a current account surplus is that the country is exporting more goods and services than it is importing. One might easily judge that this is not good—the country is producing goods and services that are exported, but the country is not at the same time getting the imports of goods and services that would allow it do more consumption and domestic investment. In this way, a current account deficit might be considered good—the extra imports allow the country to consume and invest domestically more than the value of its current production. Another meaning of a current account surplus is that the country is engaging in foreign financial investment—it is building up its claims on foreigners, and this adds to national wealth.

This sounds good, but as noted above it comes at the cost of foregoing current domestic purchases of goods and services. A current account deficit is the country running down its claims on foreigners or increasing its indebtedness to foreigners. This sounds bad, but it comes with the benefit of higher levels of current domestic expenditure. Different countries at different times may weigh the balance of these costs and benefits differently, so that we cannot simply say that a current account surplus is better than a current account deficit.

199.

Saving can be used to make investments. The country can use its national saving to make domestic real investments in new production capital (buildings, machinery, and software and other intellectual property), new housing, and additions to inventories or it can use its national saving to invest in foreign financial assets. If it uses its national saving to make domestic real investments, benefits to the nation include the increases in production capacity and capabilities that result from new production capital and the housing services 110

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that flow from a larger stock of housing. If it uses its national saving to make foreign investments, benefits to the nation include the dividends, interest payments, and capital gains that it earns on its foreign investments, which add to the national income of the country in the future.

200.

Disagree. If the country has a surplus (a positive value) for its official settlements balance, then the value for its official reserves balance must be a negative value of the same amount (so that the two add to zero). A negative value for this asset item means that funds are flowing out in order for the country to acquire more of these kinds of assets.

Thus, the country is increasing its holdings of official reserve assets.

201.

Transaction c contributes to a surplus in the current account because it is an export of merchandise that is paid for through an item in the financial account. (Transaction a leaves the current account unchanged because it is both an export and an import.

Transaction b contributes to a deficit in the current account because it is an import.

Transaction d affects no items in the current account.)

202.

CA  I f , so if net foreign investment increases, then the value of the current a. account increases.

If both exports (a positive item) and imports (a negative item) increase by $10 billion, the value of the current account balance stays the same.

CA ≈ Y − E, so the combination of an increase in production (Y) by $100 billion and an increase in expenditures (E) by $150 billion tends to result in a decrease in the value of the current account balance.

The transport equipment is an export of goods, so it is a positive item in current account. It must be paired with a negative item of the same amount showing the unilateral transfer (gift). Because both of these items are included in the current account, the value of the current account balance stays the same.

203.

Disagree. A shift to saving more would increase the surplus, not reduce it. The current account balance equals net foreign investment, and net foreign investment is the difference between national saving and domestic real investment. If national saving increases, then net foreign investment increases, and the current account balance increases (the surplus increases).

204.

a.

Goods and services balance: $330 − 198 + 196 − 204 = $124 Current account balance: $330 − 198 + 196 − 204 + 3 − 8 = $119 Official settlements balance: $330 − 198 + 196 − 204 + 3 − 8 + 102 − 202 + 4 = $23

b. Change in official reserve assets (net) = −official settlements balance = −$23.

The country is increasing its net holdings of official reserve assets.

205.

a.

A capital inflow (a credit or positive item in the country’s financial account or in its transactions in official international reserve assets) can provide financing for a current 111

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account deficit. Yes, this item can provide financing. When residents of the country sell previously acquired foreign bonds, they have a monetary claim on the foreign buyers—a positive item in the financial account of the country’s balance of payments. b. No, this item is not a financing item. Residents receiving income from foreign sources is part of the current account. It is already included in the calculation of the overall current account deficit. c. Yes, this item can provide financing. The start-up companies have a monetary claim on the foreign buyers of the equity—a positive item in the financial account of the country’s balance of payments.

206.

a.

The current account balance is exports of goods and services, minus imports of goods and services, plus income received from foreigners, minus income paid to foreigners, plus net unilateral transfers. For this country, the current account balance is $60 million (= 200 start-up 160 + 60 + [−40]) minus income paid to foreigners. For the country to have a current account surplus, the income paid to foreigners must be less than $60 million.

b. The goods and services balance is a surplus of $40 million (= 200 − 160). There is no value of income paid to foreigners that can change this into a goods and services deficit. c. The country is a net borrower from the rest of the world if its current account balance is in deficit. Using the initial information for the answer to Part a, the country’s current account is in deficit if income paid to foreigners is greater than $60 million.

207.

a.

The U.S. international investment position declines—an increase in foreign investments in the United States (an increase in what the United States owes to foreigners).

b. The U.S. international investment position rises—an increase in private U.S. investment abroad (an increase in U.S. claims on foreigners). c. The U.S. international investment position is unchanged. The composition of foreign investments in the United States changes, but the total amount does not change.

208.

a.

International investment position (billions): $30 + 20 + 15 − 40 − 25 = $0.

The country is neither an international creditor nor a debtor. Its holding of international assets equals its liabilities to foreigners.

A current account surplus permits the country to add to its net claims on foreigners. For this reason, the country's international investment position will become a positive value. The flow increase in net foreign assets results in the stock of net foreign assets becoming positive.

Chapter 17 The Foreign Exchange Market 112 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Overview The purpose of this chapter is to present the foreign exchange market and exchange rates, with an emphasis on spot exchange rates. Foreign exchange is the act of trading different countries' moneys. An exchange rate is the price of one money in terms of another. The spot exchange rate is the price for "immediate" exchange. The forward exchange rate is the price agreed to today for exchanges that will take place in the future. An exchange rate is confusing because there is no natural way to quote the price. The currency that is being priced or valued by the rate is the currency that is in the denominator.

At the center of the foreign exchange market are a group of banks that use computers and telecommunications to conduct trades with their customers (the retail part of the market) and with each other (the interbank part of the market). Most foreign exchange trades are conducted by exchanging ownership of demand deposits denominated in different currencies. The box ―Foreign Exchange Trading‖ notes the immense size and some of the characteristics of the foreign exchange market.

We can picture the foreign exchange market by using demand and supply curves. Exports of goods and services and capital outflows (as well as income payments to foreigners) create a demand for foreign currency, as payments for these items typically require that at some point in the payment process the home currency is exchanged for the foreign currency to pay for the items that the home residents are buying. Imports of goods and services and capital inflows (as well as income received from foreign sources) create a supply of foreign currency, as payments for these items typically require that at some point in the payment process, the foreign currency is exchanged for the home currency to pay for the items that the foreign residents are buying.

The text explains the downward slope of the demand curve for foreign currency through changes in the dollar price of products that the home country might buy from the foreign country, as the going spot exchange rate would be one or another value. (The text assumes that the supply curve slopes upward, without much discussion at this point. The details of how values of exports and imports respond to changes in the exchange rate are deferred until the last part of Chapter 23.)

In a floating exchange rate system without intervention by monetary authorities, the equilibrium is at the intersection of the demand and supply curves, where the curves show all private (or nonofficial) demand and supply. The floating exchange rate value changes as demand and supply curves shift over time. In a fixed exchange rate system, government officials declare that the exchange rate should be a certain level, usually within a small band around a par value. We can still use demand and supply to analyze this system. If the equilibrium rate that the market would set on its own (shown by the intersection of the private or nonofficial demand and supply curves) is outside of this band, then the officials must do something to prevent the actual rate from moving outside of the band. We focus on defense through official intervention—the officials must buy or sell foreign currency (in exchange for domestic currency) to keep the exchange rate value within (or at the edge of) the band. This can be pictured as filling the gap between nonofficial supply and demand at the support-point exchange rate. (The intervention could also be pictured as shifting the overall supply or demand curve—each overall curve would include both nonofficial and official supply or demand—so that the new intersection occurs at the support point.)

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The chapter concludes by introducing the two different kinds of arbitrage that can occur using the spot foreign exchange market. The simpler form is arbitrage of the same exchange rate between two locations. This arbitrage assures that, at a particular time, the same exchange rate is essentially the same value in different locations (at least within a small range that reflects transactions costs). The more complicated form is triangular arbitrage—profiting from misalignments among two exchange rates against a common currency (usually the dollar, which is the vehicle currency in the market) and the cross-rate between the other two currencies (for instance, pounds and Swiss francs). This type of arbitrage assures that the cross-rate essentially equals the ratio of the other two exchange rates.

Tips Footnote 4 explains the conventions used by traders to quote exchange rates. It also notes that we ignore the distinction between bid and ask prices in our general discussion.

This chapter is intended to introduce key features of the foreign exchange market and present the basic demand–supply analysis of spot exchange rates. A key goal is to get students thinking about exchange rates as prices, about demand–supply pressures on exchange rates, and about the opportunity for arbitrage using the foreign exchange market. At the same time students should be assured that many of the topics, including what shifts the nonofficial supply and demand curves, as well as government policies toward the foreign exchange market, will be taken up in more depth as we cover the next four chapters.

We choose to picture the foreign exchange market using a standard demand and supply graph in which the demand curve slopes downward and the supply curve slopes upward. Of course, this is most consistent with discussions that focus on flow demand and supply. Students seem to have success grasping this approach, as it builds on their previous economics learning. The examples in the text focus on the shape of and shifts in the demand curve, so that the instructor may choose to present class discussion using stocks of money supply and demand, and this will appear to be reasonably consistent with the text (except that the supply curve used in class may be vertical).

Also, as noted in the overview, we choose not to go into details at this point about the slope of the supply curve. This detailed discussion tends to confuse some students and it diverts them from the basic points about using demand–supply logic. Footnote 7 notes that the actual slope of the supply curve is not clear-cut.

Suggested answers to case study discussion question Foreign Exchange Trading: In Europe, there is one major location for foreign exchange trading, London. In North America (really, the Americas, or the Western Hemisphere), there is one major location, New York. Asia is different, it has three locations that are all about equal in size—Singapore, Hong Kong, and Tokyo (Japan). Foreign exchange trading is a business that seems to benefit from external scale economies (discussed in Chapter 6), as shown by the clustering of trading in banks in each of London and New York. London dominates foreign exchange trading in Europe, with its time zones of overlapping banking hours, and New York 114 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

dominates foreign exchange trading in the Western Hemisphere, with its time zones of overlapping banking hours. Because external scale economies seem to be important in this industry, it is surprising that no one location has come to dominate foreign exchange trading in Asia, with its time zones of overlapping banking hours.

Suggested answers to end-of-chapter questions and problems 209.

Imports of goods and services result in demand for foreign currency in the foreign exchange market. Domestic buyers often want to pay using domestic currency, while the foreign sellers want to receive payment in their currency. In the process of paying for these imports, domestic currency is exchanged for foreign currency, creating demand for foreign currency. International capital outflows result in a demand for foreign currency in the foreign exchange market. In making investments in foreign financial assets, domestic investors often start with domestic currency and must exchange it for foreign currency before they can buy the foreign assets. The exchange creates demand for foreign currency. Sales of this country’s financial assets that the foreigners had previously acquired and foreign borrowing from this country are other forms of capital outflow that can create demand for foreign currency.

210.

Exports of merchandise and services result in supply of foreign currency in the foreign exchange market. Domestic sellers often want to be paid using domestic currency, while the foreign buyers want to pay in their currency. In the process of paying for these exports, foreign currency is exchanged for domestic currency, creating supply of foreign currency. International capital inflows result in supply of foreign currency in the foreign exchange market. In making investments in domestic financial assets, foreign investors often start with foreign currency and must exchange it for domestic currency before they can buy the domestic assets. The exchange creates supply of foreign currency. Sales of foreign financial assets that the country's residents had previously acquired, and borrowing from foreigners by this country's residents are other forms of capital inflow that can create supply of foreign currency.

211.

a.

The value of the dollar decreases. (The SFr increases.)

The value of the dollar decreases. (This is the same change as in Part a.)

The value of the dollar increases. (The yen decreases.)

The value of the dollar increases. (This is the same change as in Part c.)

212.

The U.S. firm obtains a quotation from its bank on the spot exchange rate for buying yen with dollars. If the rate is acceptable, the firm instructs its bank that it wants to use dollars from its dollar checking account to buy 1 million yen at this spot exchange rate. It also instructs its bank to send the yen to the bank account of the Japanese firm. To carry out this instruction, the U.S. bank instructs its correspondent bank in Japan to take 1 million yen from its account at the correspondent bank and transfer the yen to the bank account 115

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of the Japanese firm. (The U.S. bank could also use yen at its own branch if it has a branch in Japan.)

213.

The British bank could use the interbank market to find another bank that was willing to buy dollars and sell pounds. The British bank should be able to sell its dollars to another bank quickly and with very low transactions costs.

214.

The trader would seek out the best spot rate for buying euros with dollars quoted by other banks in the interbank market. The trader would use the best rate to buy euro spot.

Sometime in the next hour or so (or, typically, at least by the end of the day), the trader will enter the interbank market again, to obtain the best quoted spot rate for selling euros for dollars. The trader will use the best spot rate to sell her previously acquired euros. If the spot value of the euro has risen during this short time, the trader makes a profit.

215.

a.

Demand for yen. The Japanese firm will sell its dollars to obtain yen.

Demand for yen. The U.S. import company probably begins with dollars, and the Japanese producer probably wants to receive payments in yen. Dollars must be sold to obtain yen.

Supply of yen. The Japanese importer probably begins with yen, and the U.S. cooperative probably wants to receive payment in dollars. Yen must be sold to obtain dollars.

Demand for yen. The U.S. pension fund must sell its dollars to obtain yen, using these yen to buy the Japanese shares.

216.

a.

The cross rate between the yen and the krone is too high (the yen value of the krone is too high) relative to the dollar–foreign currency exchange rates. Thus, in a profitable triangular arbitrage, you want to sell kroner at the high cross rate. The arbitrage will be: Use dollars to buy kroner at $0.20/krone, use these kroner to buy yen at 25 yen/krone, and use the yen to buy dollars at $0.01/yen. For each dollar that you sell initially, you can obtain 5 kroner, these 5 kroner can obtain 125 yen, and the 125 yen can obtain $1.25. The arbitrage profit for each dollar is therefore 25 cents.

Selling kroner to buy yen puts downward pressure on the cross rate (the yen price of krone).

The value of the cross rate must fall to 20   0.20 / 0.01 yen/krone to eliminate the opportunity for triangular arbitrage, assuming that the dollar exchange rates are unchanged.

217.

a.

Increase in supply of Swiss francs reduces the exchange rate value  $ / SFr  of the franc. The dollar appreciates.

Increase in supply of francs reduces the exchange rate value  $ / SFr  of the franc. The dollar appreciates.

Increase in supply of francs reduces the exchange rate value  $ / SFr  of the franc. The dollar appreciates.

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Decrease in demand for francs reduces the exchange rate value  $ / SFr  of the franc. The dollar appreciates.

218.

a.

The increase in supply of Swiss francs puts downward pressure on the exchange rate value  $ / SFr  of the franc. The monetary authorities must intervene to defend the fixed exchange rate by buying SFr and selling dollars.

The increase in supply of francs puts downward pressure on the exchange rate value  $ / SFr  of the franc. The monetary authorities must intervene to defend the fixed exchange rate by buying SFr and selling dollars.

The increase in supply of francs puts downward pressure on the exchange rate value  $ / SFr  of the franc. The monetary authorities must intervene to defend the fixed exchange rate by buying SFr and selling dollars.

The decrease in demand for francs puts downward pressure on the exchange rate value  $ / SFr  of the franc. The monetary authorities must intervene to defend the fixed exchange rate by buying SFr and selling dollars.

219.

Yes. State both exchange rates in the same way and then buy low, sell high. Bank A is quoting a rate of 0.67 Swiss franc per dollar   1/1.50  , and this can be compared to Bank B’s quote of 0.50 Swiss franc per dollar. Arbitrage: Buy dollars from Bank B, and sell dollars to Bank A. Pocket 0.17 Swiss franc for each dollar. (Equivalently, buy Swiss francs from Bank A at $1.50 per franc and simultaneously sell them to Bank B at $2.00 per franc.)

220.

Let’s look at the foreign exchange market as a market for buying and selling dollars (in exchange for dinars), so we can use the exchange rate as it is quoted. The central or par value for the fixed rate is 5 dinars per dollar. The band is 2% above or below the central rate, so the exchange rate value is permitted to vary between 4.9 dinars per dollar and 5.1 dinars per dollar. If the rate threatens to fall below 4.9, then the country’s central bank must intervene to buy dollars (and sell dinars). If the rate threatens to rise above 5.1 dinars per dollar, then the country’s central bank must intervene to sell dollars and buy dinars.

In March the country’s central bank intervened to defend the fixed exchange rate by buying $2 billion of dollars. During March, for nonofficial supply and demand as shown D by the dollar supply curve S$M and the dollar demand curve $M , there was a nonofficial excess supply of dollars equal to AB at the exchange rate 4.9 dinars per dollar. In April the country’s central bank instead intervened to defend the fixed exchange rate by selling $3 billion of dollars. Something changed in the foreign exchange market so that in April there was a nonofficial excess demand for dollars at the fixed rate 5.1 dinars per dollar.

The two basic changes are either (1) that the nonofficial demand for dollars increased 117

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(shifted to the right) to D$A , with nonofficial excess demand for dollars equal to GH, as shown in the graph on the left, or (2) that the nonofficial supply of dollars decreased (shifted to the left) to S$A , with nonofficial excess demand for dollars equal to JK, as shown in the graph on the right.

Chapter 18 Forward Exchange and International Financial Investment Overview This chapter presents the uses of forward foreign exchange rates and the returns and risks of international financial investments, both covered and uncovered. It begins by noting that in many situations people or organizations are exposed to exchange rate risk, because the value of the individual's income, wealth, or net worth changes when exchange rates change unexpectedly in the future. A net asset position in the foreign currency is called a long position; a net liability position is called a short position. Some individuals want to reduce their risk exposure by hedging—an action to reduce a net asset or net liability position in a foreign currency. Other individuals may actually want to take on risk exposure in order to profit from exchange rate changes, by speculating—an action to take on a net asset or net liability position in a foreign currency.

A forward foreign exchange contract is an agreement to exchange a certain amount of one currency for a certain amount of another currency on some date in the future, with the amounts based on the price (forward exchange rate) set when the contract is entered. A forward foreign exchange contract is a kind of derivative contract based on exchange rates. A box in the text discusses other foreign exchange derivative contracts—currency futures, options, and swaps.

Because the forward exchange contract establishes a position in foreign currency, it can be used to hedge or to speculate. One hypothesis based on the use of forward foreign exchange contracts to speculate is that the pressures on the supply and demand of forward foreign exchange should drive the forward exchange rate to equal the average expected value of the future spot exchange rate.

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International financial investment has grown rapidly in recent decades. Decisions about international investments depend on both returns and risks. The text focuses on calculating returns. It also discusses risks, including mention of risk as a portfolio issue (although a full treatment of international portfolio diversification is not provided).

An investor who calculates her wealth and returns in her home currency can easily calculate returns on investments denominated in her own currency. Investments in foreign currencydenominated assets are more complicated. She must first convert her own currency into the foreign currency at the spot exchange rate. Then she uses this foreign currency to buy the foreign asset and earns returns in foreign currency. Then, she must convert this foreign currency in the future back into her own currency (either actually or simply to determine the value of her wealth). She could contract now for the future currency conversion using a forward exchange contract, in which case she has a covered international investment, and she is hedged against exchange rate risk. Or, she can wait until the future and convert currencies at the spot exchange rate that exists at that date in the future, in which case she has an uncovered international investment, and she is exposed to exchange rate risk.

An investor can compare the return on a covered international investment to the return on a home investment using the covered interest differential (CD). The exact expression is CD  1  if   f / e  1  i  , where the is are the foreign (subscript f) and domestic interest rates, e is the spot exchange rate, and f is the forward exchange rate. A useful approximation is CD  F   if  i  , where F is the forward premium (discount if negative) on the foreign currency. If CD is not zero (or within a small range close to zero, determined by transactions costs), then international investors can engage in covered interest arbitrage—buying a country's currency spot and selling it forward, while making a net profit from the combination of the interest rate difference and the forward premium or discount. Because covered interest arbitrage is essentially riskless (as long as there is no threat of exchange controls or similar government impediments), this arbitrage should drive the covered differential to be essentially zero—covered interest parity. Covered interest parity links four current market rates together—the forward exchange rate, the spot exchange rate, and the interest rates in the two countries. If one of these rates changes, then at least one other also must change to reestablish covered interest parity.

At the time that an investor makes the investment, he can calculate the return expected on an uncovered international investment using the spot exchange rate that he expects to exist in the future. He can compare this expected return to the return on a home investment using the expected uncovered interest differential (EUD). The exact expression is EUD  1  if   eex / e  1  i  , where eex is the expected future spot exchange rate. A useful approximation is that EUD equals the expected rate of appreciation (depreciation if negative) of the foreign currency plus the interest differential  if  i  .

An uncovered international investment is exposed to exchange rate risk. Nonetheless, the investor may still undertake the uncovered investment, because the expected return is high enough to compensate for the risk, or, more subtly, because the uncovered investment may actually reduce the risk of the investor's overall portfolio because of the benefits of diversification of investments. If risk considerations are small, then investors will shift toward 119 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

investments with higher (expected) returns. Demand–supply pressures on market rates will drive rates to eliminate the return differential, so that the uncovered interest differential is essentially zero—uncovered interest parity.

The final section of the chapter presents some evidence on whether the various parity conditions actually hold. For several decades up to 2007, covered interest parity holds well between currencies of countries whose governments permit free movements of international capital.

Larger deviations from covered interest parity arose during the global financial and economic crisis, the global COVID-19 pandemic crisis, and for the euro during the euro crisis. While it is not surprising that such deviations arose during the turmoil of these crises, it has been surprising that larger deviations of up to a full percentage point from parity arose during the final months of the year, starting in 2015, as shown in the Figure 18.3. Research indicates that stricter bank regulation imposed since the global crisis has limited the willingness of banks to commit funds to covered interest arbitrage. The covered interest parity relationship is not as close as it was before 2007.

It is more difficult to test uncovered interest parity, because we cannot observe the expected future spot exchange rate in the market. (If we use the forward rate as an indicator of the expected future spot exchange rate, then we are really just testing covered interest parity.)

Indirect tests of uncovered interest parity suggest that it does not hold as tightly as covered interest parity. While divergences from uncovered interest parity could simply indicate risk premiums to compensate for exposure to exchange rate risk, some studies suggest that the deviations are larger than seem necessary to compensate for such risk. Instead, expectations of future spot exchange rates seem to be biased. Such an apparent bias would not be troubling if market participants are correctly anticipating the probability of a large shift in the exchange rate at some time in the future (even if the rate does not actually change). The apparent bias is troubling if it reflects consistent errors, implying inefficiency in the foreign exchange market.

Tips In presenting this material, it is useful to build the overall return on a foreign financial investment step-by-step: spot exchange (e), invest in the foreign currency-denominated financial asset 1  if  , and exchange back into home currency  f or eex  . The lake diagram (Figure 18.1) pictures this process for covered investments and permits movements in any direction. A comparable diagram for uncovered investments could be provided to the class, in which f is ex replaced by e (for analysis ex ante).

This points out a broader goal of the style of presentation used in the text. We strive to show how similar covered and uncovered investments are (as well as the specific ways in which they are different). The focus on the similarities allows students to transfer insights from the discussion of covered investments to their analysis of uncovered investments.

An excellent device for getting students to plunge into the foreign exchange market and to gain insights into exchange rate risk and future spot exchange rates is to ask them to predict what exchange rates (and perhaps the price of gold) will be one or three months in the future. This 120 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

exercise can be submitted at the beginning of the term, at the beginning of the material on international finance (if this is not the beginning of the term), or at the conclusion of the presentation of the material in this Chapter 18. If desirable, prizes can be offered to the best guessers, either rate-by-rate or overall (using lowest average absolute percentage errors). The sample assignment on the accompanying page offers one version of this exercise. After all guesses are submitted, the instructor could provide graphs showing the distributions of guesses by the class. In addition, the "debriefing" at the conclusion of the contest could include charts of how the rates moved day-by-day during the contest time period, along with information on the class median guess and the instructor's guess.

Suggested answer to case study discussion question Eurocurrencies: Not (Just) Euros and Not Regulated: The beginning and early growth of the Eurocurrency market included deposits from the government of the Soviet Union and the governments of Arab oil-exporting countries. These governments did not trust the U.S. government, but they still wanted to hold dollar bank deposits. So, they found banks outside the United States that were willing to take dollar deposits. Even if the Soviet Union and the Arab countries had not played such a role, the Eurocurrency market probably would still have developed into a large market. Other depositors were looking to get better returns on their deposits. Banks in some countries found that they could take dollar deposits (and make dollar loans) while avoiding both U.S. bank regulations and the bank regulations of their own countries.

By avoiding some of the costs of these regulations, the banks could pay a somewhat higher interest rate on the Eurodollar deposits. The growth of the Eurocurrency market, in dollars and in other currencies, has been based on the lack of regulation, rather than on avoiding country political risk (even though political risk played a role in the early years of the market).

Suggested answers to end-of-chapter questions and problems 221.

Agree. As an investor, I think of my wealth and returns from investments in terms of my own currency. When I invest in a foreign-currency-denominated financial asset, I am (actually or effectively) buying both the foreign currency and the asset. Part of my overall return comes from the return on the asset itself—for instance, the yield or rate of interest that it pays. The other part of my return comes from changes in the exchange rate value of the foreign currency. If the foreign currency increases in value (relative to my own currency) while I am holding the foreign asset, the value of my investment (in terms of my own currency) increases, and I have made an additional return on my investment. (Of course, if the exchange rate value of the foreign currency goes down, I make a loss on the currency value, which reduces my overall return.)

222.

You will need data on four market rates: The current interest rate (or yield) on bonds issued by the U.S. government that mature in one year, the current interest rate (or yield) on bonds issued by the British government that mature in one year, the current spot exchange rate between the dollar and pound, and the current 1-year forward exchange

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rate between the dollar and pound. Do these rates result in a covered interest differential that is very close to zero?

223.

a.

The U.S. firm has an asset position in yen—it has a long position in yen. The risk is that the dollar exchange rate value of the yen in 60 days is uncertain. If the yen depreciates, then the firm will receive fewer dollars.

The student has an asset position in yen—a long position in yen. The risk is that the dollar exchange rate value of the yen in 60 days is uncertain. If the yen depreciates, then the student will receive fewer dollars.

The U.S. firm has a liability position in yen—a short position in yen. The risk is that the dollar exchange rate value of the yen in 60 days is uncertain. If the yen appreciates, then the firm must deliver more dollars to buy the yen to pay off its loan.

224.

a.

The U.S. firm has an asset position in yen—it has a long position in yen. To hedge its exposure to exchange rate risk, the firm should enter into a forward exchange contract now in which the firm commits to sell yen and receive dollars at the current forward rate. The contract amounts are to sell 1 million yen and receive $9,000, both in 60 days.

b. The student has an asset position in yen—a long position in yen. To hedge the exposure to exchange rate risk, the student should enter into a forward exchange contract now in which the student commits to sell yen and receive dollars at the current forward rate. The contract amounts are to sell 10 million yen and receive $90,000, both in 60 days. c. The U.S. firm has a liability position in yen—a short position in yen. To hedge its exposure to exchange rate risk, the firm should enter into a forward exchange contract now in which the firm commits to sell dollars and receive yen at the current forward rate.

The contract amounts are to sell $900,000 and receive 100 million yen, both in 60 days.

225.

226.

For forward speculation the relevant comparison is between the current forward exchange rate and the expected future spot exchange rate. Comparing these two rates, we hope to make a profit by buying low and selling high. You expect the Swiss franc to be relatively cheap at the future spot rate ($0.51) compared with the current forward rate ($0.52). To speculate you should therefore enter into a forward contract today that requires that you sell (or deliver) SFr and buy (or receive) dollars. If the spot rate in 180 days is actually $0.51/ SFr , then you can buy SFr at this low spot rate, deliver them into your previously agreed forward contract at the higher forward rate, and pocket the price difference, $0.01, for each franc that you agreed to sell in the forward contract.

Relative to your expected spot value of the euro in 90 days  $1.22 / euro  , the current forward rate of the euro  $1.18 / euro  is low—the forward value of the euro is relatively low. Using the principle of "buy low, sell high," you can speculate by entering into a forward contract now to buy euros at $1.18 / euro . If you are correct in your expectation, then in 90 days you will be able to immediately resell those euros for $1.22 / euro , pocketing a profit of $0.04 for each euro that you bought forward. If many people 122

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speculate in this way, then massive purchases now of euros forward (increasing the demand for euros forward) will tend to drive up the forward value of the euro, toward a current forward rate of $1.22 / euro .

227.

a.

Invest in dollar-denominated asset: $1 × (1 + 0.0605) = $1.0605.

Invest in yen-denominated asset: $1  1/ 0.0100   1  0.01   0.0105   $1.0605 .

b. Invest in dollar-denominated asset: $1  1  0.0605   1/ 0.0105   101 yen .

Invest in yen-denominated asset: $1  1/ 0.0100   1  0.01  101 yen .

Invest in dollar-denominated asset: 100 yen   0.01  1  0.0605   1/ 0.0105   101 yen .

Invest in yen-denominated asset: 100 yen × (1 + 0.01) = 101 yen.

228.

a.

The Swiss franc is at a forward premium. Its current forward value  $1.010 / SFr 

is greater than its current spot value  $1.000 / SFr  . b. The covered interest differential "in favor of Switzerland" is  1  0.005  1.010  / 1.000   1  0.01  0.005 . (Note that the interest rate used must match the time period of the investment.) There is a covered interest differential of about 0.5% for 30 days (about 6% at an annual rate). The U.S. investor can make a higher return, covered against exchange rate risk, by investing in SFr denominated bonds, so presumably the investor should make this covered investment.

Although the interest rate on SFr -denominated bonds is lower than the interest rate on dollar-denominated bonds, the forward premium on the franc is larger than this difference, so that the covered investment is a good idea. c. The lack of demand for dollar-denominated bonds (or the supply of these bonds as investors sell them in order to shift into SFr -denominated bonds) puts downward pressure on the prices of U.S. bonds—upward pressure on U.S. interest rates. The extra demand for the franc in the spot exchange market (as investors buy SFr in order to buy SFr denominated bonds) puts upward pressure on the spot exchange rate. The extra demand for SFr -denominated bonds puts upward pressure on the prices of Swiss bonds— downward pressure on Swiss interest rates. The extra supply of francs in the forward market (as U.S. investors cover their SFr investments back into dollars) puts downward pressure on the forward exchange rate. If the only rate that changes is the forward exchange rate, this rate must fall to about $1.005 / SFr . With this forward rate and the other initial rates, the covered interest differential is close to zero.

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229.

a.

From the point of view of the U.S.-based investor, the expected uncovered interest differential is ((  0.03 1.77 /1.80) – 1  0.02   0.0072 . Because the differential is negative, the U.S.-based investor should stay at home, investing in dollardenominated bonds, if he bases his decision on the difference in expected returns. (The approximate formula could also be used to reach this conclusion.)

b. From the point of view of the UK-based investor, the expected uncovered differential is (1  0.02  1/1.77  1.8) – 1  0.03  0.0073 . (Note that the position of the interest rates is reversed and that the exchange rates are inverted so that they are pricing the dollar, which is now the foreign currency. Note also that this differential is approximately equal to the negative of the differential in the other direction, calculated in part a.)

Because the differential is positive, the UK-based investor should undertake an uncovered investment in dollar-denominated bonds if she bases her decision on the difference in expected returns. (Again, the approximate formula could be used to reach this conclusion.) c. If there is substantial uncovered investment flowing from Britain to the United States, this increases the supply of pounds in the spot exchange market. There is downward pressure on the spot exchange rate to drop below $1.80 / pound . The pound tends to depreciate. (The dollar tends to appreciate.)

230.

To evaluate the validity of the statement, one needs to examine two questions. First, what speculative position would you establish if you expected that the future spot exchange rate would be 3.26 Polish złoty per U.S. dollar? Second, is that speculative position profitable if the actual future spot exchange rate turns out to be 3.25 złoty per dollar?

The current 6-month forward exchange rate is 3.24 złoty per dollar, and you expect the future spot exchange rate to be 3.26 złoty per dollar. The dollar is relatively cheap in the forward contract, so you would establish your speculative position by entering into a forward contract in which you will receive (buy) dollars and deliver (sell) złoty. For the dollars that you receive or buy at 3.24 in the forward contract, you hope to immediately resell the dollars at 3.26 in the spot exchange market, receiving a profit of 0.02 złoty per dollar contracted.

If the actual future spot rate is 3.25 złoty per dollar, you still make a profit. You receive or buy dollars at 3.24 złoty per dollar and immediately resell the dollars at 3.25 złoty per dollar, so you actually make a profit of 0.01 złoty per dollar contracted. The profit is half of what you expected to make, but it is still a profit.

231.

a.

For the expected future value of the euro, the future spot exchange rate expected in 90 days is U.S.$1.408 / euro   1/ 0.71 . This value is larger than the current spot rate, $1.400/euro, so investors are expecting the euro to appreciate.

With the United States as the home country of the investor, for each dollar invested: Invest in the euro-denominated bond, expected in 90 days: (1/1.400  1  0.08 / 4 1.408)  $1.026 Invest in the dollar-denominated bond, in 90 days: 124

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1  0.16 / 4   $1.04 There is no incentive for flows from the United States to the euro area, based on the comparison of returns 1.026  1.04  .

With the euro area as the home country of the investor, for each euro invested: Invest in the dollar-denominated bond, expected in 90 days: (1/ {1/1.400}  1  0.16 / 4  [1/1.408 )   €1.034 Invest in the euro-denominated bond, in 90 days: 1  0.08 / 4   €1.02 The uncovered interest differential favors investing in the United States 1.034  1.02  , so uncovered investment will tend to flow from the euro area to the United States to invest in dollar-denominated bonds. The 90-day expected return in the United States (3.4%) is 1.4 percentage points higher than the 90-day return in the euro area (2.0%). (Note that the approximation formula could be used for all calculations.)

232.

In testing covered interest parity, all of the interest rates and exchange rates that are needed to calculate the covered interest differential are rates that can observed in the bond and foreign exchange markets. Determining whether the covered interest differential is about zero (covered interest parity) is then straightforward (although some more subtle issues regarding timing of transactions may also need to be addressed). In order to test uncovered interest parity, we need to know not only three rates—two interest rates and the current spot exchange rate—that can be observed in the market, but also one rate—the expected future spot exchange rate—that is not observed in any market. The tester then needs a way to find out about investors' expectations. One way is to ask them, using a survey, but they may not say exactly what they really think. Another way is to examine the actual uncovered interest differential after we know what the future spot exchange rate actually turns out to be, and see whether the statistical characteristics of the actual uncovered differential are consistent with an expected uncovered differential of about zero (uncovered interest parity).

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Sample assignment University of California—Davis International Macroeconomics

Speculate!!

What will the yen, the Mexican peso, the pound sterling, the euro, and gold be worth a month from now? Show your financial genius by filling in your forecasts below. Return this form to lecture this Thursday, April 7.

For the purposes of this exercise, ―a month from now‖ means the Wall Street Journal spot quotes for late New York trading on Thursday, May 5. The winning guesses will be announced in class on Tuesday, May 10. If you are the winner of any of these categories, yours is the satisfaction of knowing that you could have made a bundle if your guess had been backed by millions of dollars. There is an additional incentive: the best guessers in each category are my guests for a free Winner Dinner on May 24 at 6:00 p.m. In addition, there is a special prize for the individual with the very best set of forecasts (smallest average percentage error, with percentage errors calculated against the final actual values).

To guide your choice, here are some recent data on spot exchange rates and gold prices: A month ago

Yesterday

$1.3214

$1.3116

Japanese yen

$0.009295

$0.009036

Mexican peso

$0.04776

$0.0565

Euro

$1.0912

$1.0992

$1,945.30

$1,930.30

British pound sterling

Gold (LBMA Gold Price PM) (ballot on the next page)

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Sterling: I predict that the spot price of the British pound in late New York trading on May 6 will be, in dollars with four decimal places: $_ . _ _ _ _ Yen: I predict that the spot price of Japanese yen, same time and place, will be, with six decimal places: $_ . _ _ _ _ _ _ Peso: I predict that the spot price of the Mexican peso, same time and place, will be, with five decimal places: $_ . _ _ _ _ _ Euro: I predict that the spot price of the euro, same time and place, will be, with four decimal places: $_ . _ _ _ _ Gold: I predict that the LBMA Gold Price PM (in the data section ―Cash Prices‖), same date, will be, in dollars and cents per troy ounce: $_ , _ _ _ . _ _ My name _____________________________

Chapter 19 What Determines Exchange Rates?

Overview Since the general shift to floating exchange rates in the early 1970s, exchange rates between the U.S. dollar and other major currencies have been variable or volatile. The charts at the beginning of the chapter suggest three types of variability. First, there are long-term trends in which some currencies tend to appreciate against the dollar, and others tend to depreciate. Second, there are medium-term trends which are sometimes counter to the longer trends. Third, there is substantial variability during the short run. The chapter presents what we know about exchange movements during these time periods of different lengths.

The chapter first examines short-run movements in exchange rates. It presents the version of the asset market approach to exchange rates that focuses on debt securities and the uncovered interest parity relationship developed in Chapter 18, presuming that this relationship holds approximately if not exactly. The basic discussion examines the pressure on the current spot exchange rate if one of the other three rates (the domestic interest rate, the foreign interest rate, and the expected future spot exchange rate) changes, with the other two held constant. If the domestic interest rate increases, then the foreign currency depreciates (the home currency

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appreciates). If the foreign interest rate increases, then the foreign currency appreciates. (The text notes that what really matters is the change in the interest differential.)

If the expected future spot exchange rate value of the foreign currency increases, then the current spot exchange rate value of the foreign currency increases. Many different things can influence the expected future spot exchange rate. First, if expectations simply extrapolate recent trends, then a bandwagon is possible. Speculation then may be based on destabilizing expectations— expectations formed without regard to the economic fundamentals—and (speculative) bubbles can occur. Second, if expectations are based on a belief that exchange rates eventually follow PPP, then they lead to stabilizing speculation—speculation that tends to move the exchange rate toward a value consistent with the economic fundamentals of national price levels. Third, expectations are affected by various kinds of news about economic and political circumstances.

The chapter then examines long trends in exchange rates. Our understanding of exchange rates in the long run is based on the purchasing power parity (PPP) hypothesis. Three versions of PPP are presented: the law of one price for a single product, absolute PPP, and relative PPP. Absolute PPP posits that a basket of products will have the same price in all countries when the prices are converted into a single currency using the market exchange rates. In symbols absolute P  e  Pf  or e  P / Pf  PPP is , where the Ps are prices (measured in local currencies) in the home and foreign countries, and e is the exchange rate measured as units of domestic currency per unit of foreign currency. When we examine actual prices and exchange rates, divergences from absolute PPP (and the simpler law of one price) can be large.

Relative PPP posits that the exchange rate will change to offset differences in the rates of product price inflation in different countries. In symbols,  et / e0    Pt / P0  /  Pf ,t / Pf ,0  , where the subscript 0 indicates the initial year values and the subscript t indicates values in a subsequent year. The text presents evidence on the relative version of PPP by examining inflation rates (rates of change of product prices) in different countries and the rates of change of the exchange rates between the countries' currencies. A relationship consistent with relative PPP is clear—lowinflation countries tend to have appreciating currencies and high inflation countries tend to have depreciating currencies. In addition, examination of the U.S. dollar–yen and the U.S. dollar– Canadian dollar exchange rates shows that there is a tendency to follow relative PPP in the long run, but that there are also substantial deviations from relative PPP in the short run.

If exchange rates follow national price levels in the long run, what determines national price levels in the long run? In the long run the national money supply (or its growth rate) is related to the national price level (or the national inflation rate), through the equilibrium between money supply and money demand. In the text we use the demand for money that follows the quantity theory of money, in order to draw out the relationships in the most direct manner possible.

Money is held to facilitate transactions, so that money demand is based on the annual turnover of transactions that require money, and this turnover is proxied by the level of (nominal) domestic product ( P  Y , where Y is real GDP). The quantity theory then says that, for each country, M s  k  P  Y , where M s is the national money supply, which is controlled by national monetary policy, and k is a behavioral parameter.

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Combining PPP and the quantity theory equations for two countries, we obtain a basis for the monetary approach to explaining or predicting exchange rates in the long run: e  P / Pf   M s / M s f    kf / k   Yf / Y  . If the ratio of the ks is steady, then the exchange rate will change over the long run as the money supplies change and as real GDPs grow, with elasticities of one. Other things equal, in the long run a lower level (or slower growth over time) of a country's money supply, or a higher level (or faster growth) of its real GDP, tend to result in a higher value (an appreciation over time) of the country's currency, because each implies a lower level (or slower rate of increase) in the country's price level.

How do we get from the short run in which portfolio adjustments by international investors place the major pressures on exchange rates to the long run of PPP? We can view this as a process in which the exchange rate overshoots (relative to the value consistent with PPP) in the short run, and then (gradually) reverts to PPP in the long run. This can be seen most clearly by considering an abrupt change in the domestic money supply. The additional (and presumably realistic) assumption is that product price levels adjust slowly toward the level consistent with the quantity theory equation. If the domestic money supply increases abruptly, then, at first, the domestic price level does not rise much, but eventually it will. With the increase in the money supply (and not so much of an increase in money demand at first), domestic interest rates decrease. In addition, investors expect that eventually the foreign currency will appreciate (the domestic currency will depreciate) relative to its initial value, because the domestic price level eventually will be higher (PPP in the long run). For both of these reasons (lower interest rate and expected appreciation of the foreign currency relative to its initial value), investors shift their investments toward foreign-currency assets. This causes an abrupt, large appreciation of the foreign currency—more than is consistent with the small amount of change in the domestic price level in the short run, and also more than is consistent with the long run change in the price level. Once the exchange rate value of the foreign currency overshoots in the short run, it then is expected to and does decline back toward the long run value that is consistent with PPP. In fact, this subsequent expected depreciation of the foreign currency is necessary to reestablish uncovered interest parity. The overall return on foreign-currency assets is then lowered by the expected depreciation of the foreign currency, so that it is about equal to the lower domestic return resulting from the lower domestic interest rate.

The chapter next discusses how difficult it is to predict spot exchange rate movements in the short run (a time period up to one year in the future). Generally, economic models (like the asset market approach or the monetary approach) cannot beat the naive model of a random walk, which predicts that the exchange rate in the future will simply be the same as the exchange rate today. A major reason for this inability to forecast is that the current spot exchange rate reacts quickly and strongly to unexpected (and therefore unpredictable) news. A second reason may be that traders and investors form their short-run expectations of exchange rates based less on economic fundamentals and more on recent trends. The expectations are then self-confirming, resulting in bubbles in the movement of exchange rates over time. Beyond 1 year, an economic model based on reductions in deviations from relative PPP provides some ability to forecast future spot exchange rates, but forecast errors are still large.

The chapter concludes by introducing some concepts and distinctions that are useful in measuring and examining exchange rate values. Nominal bilateral exchange rates are simply the 129 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

standard rates quoted in the foreign exchange market. The nominal effective exchange rate is an index that tracks the weighted-average nominal value of a county's currency. Deviations from PPP can be measured using the real exchange rate, which can be measured as an index between two currencies (bilateral) or as a weighted average index relative to a number of other currencies (effective). If PPP holds in the long run, then the real exchange rate tends to return to its "normal" value (e.g., 100). As we will discuss in Chapter 22, changes in the real exchange rate also can be used as an indicator of changes in the international price competitiveness of a country’s products.

Tips For understanding short-run movements in exchange rates, one point is clear—short-run pressures on major currencies and many others result from portfolio adjustments or financial repositioning by international investors and traders. Beyond this, we must be somewhat humble.

While we have some understanding of the basic reasons for these adjustments and repositioning, there is also much that we cannot explain or predict by relatively simple theories.

The presentation of the short-run pressures on the current spot rate from changes in the other rates emphasizes two compatible explanations. The first is the flow pressure on the current spot rate that results from financial repositioning of international portfolios. This seems to be the best way to get students to grasp intuitively the logic of the relationships. The second is the rate adjustment necessary to reestablish (at least approximately) uncovered interest parity. This is consistent with a stock equilibrium in the holding of financial assets.

During class discussion of the short-run pressures on exchange rates, inquisitive students may ask if both the interest rate (say, the domestic interest rate) and the expected future spot exchange rate change at the same time. Here is one possible way to respond. If the increase in the nominal domestic interest rate is caused by a higher expected rate of inflation, then it may also be accompanied by an expectation (based on PPP) that the domestic currency will depreciate in the future. In this case, there is no simple prediction for the pressure on the current spot exchange rate, because the higher domestic interest rate and the expected depreciation are pushing in opposite directions. (Alternatively, the discussion of overshooting presents a different scenario in which both the domestic interest rate and the expected future spot exchange rate change.)

The more complicated version of the asset market approach that emphasizes variations in risk premiums is mentioned in Footnote 2. We do not develop this version in the text—it seems needlessly complicated, and empirical tests generally fail to show that it is important.

In the presentation of the monetary approach, we choose not to elaborate on the money demand function at this time. In Chapters 22–25, we formally add the interest rate as a determinant of money demand, but for the long-run analysis emphasized in the monetary approach it does not seem necessary. An instructor could incorporate the interest rate as a determinant of money demand by discussing what might determine the k value in the quantity equation.

Some students find grasping the technical aspects of overshooting to be challenging. Figure 19.5 may help some students by showing the sequences of effects. Still, an instructor can deemphasize 130 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

the analysis of overshooting without encountering serious problems in covering the material of subsequent chapters.

Students benefit from the application of the concepts from Chapters 16–19 to the real world. You may want to consider an assignment like the one that Pugel and others at New York University have used successfully. It asks students to apply the concepts to a country other than the United States. The sample assignment on the accompanying pages shows one version, in which students worked in groups, but the students could instead be asked to work individually. If you use a comparable assignment, it can be distributed about the time that you finish covering the material from Chapter 19, especially PPP and real exchange rates. (In addition, each group used the same country that it had used for a previous assignment in the course, shown as the sample assignment for Chapter 5 in this Instructors Manual.)

Appendix F shows that interest rate parities and purchasing power parity can be combined. This combination provides additional insights, including the proposition of the equality of real interest rates across countries.

Suggested answers to case study discussion questions PPP from Time to Time: In the 1950s and 1960s, the major countries had fixed exchange rates between their currencies, and these countries generally had rather low inflation rates. In this setting any deviations from PPP were rather small and slow to develop. Essentially, PPP predicts that the exchange rates between the currencies of countries that have similar inflation rates should not change much, and fixed exchange rates meant that the exchange rates generally did not change. Relative PPP held fairly well, but this was not that interesting—it simply seemed to follow from having fixed exchange rates.

Price Gaps and International Income Comparisons: The list of countries is ordered by national income per capita using common prices (sometimes called national income per capita at PPP exchange rates), as shown in the middle column of numbers. Singapore is at the top of the list because it has the highest value for this common-price income per capita. Yes, national income per capita for Singapore is lower than Switzerland, Norway, and the United States using market exchange rates to convert national income values into the same currency, as shown in the first column. But, at those market exchange rates, Singapore has surprising low average prices for goods and services, as shown in the third column. For example, average Singapore prices are only 62% of the prices for the same bundle of goods and services in the United States. After we adjust for the remarkably low Singapore prices (or, equivalently, for the high purchasing power of Singapore currency within Singapore), Singapore’s purchasing-power national income per capita is substantially higher than national income per capita in Switzerland, Norway and the United States (and higher than any other country shown).

Suggested answers to end-of-chapter questions and problems

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233.

Disagree. First, exchange rates can be quite variable in the short run. This much variability does not seem to be consistent with the gradual changes in supply and demand for foreign currency that would occur as trade flows change gradually. Second, the volume of trading in the foreign exchange market is much larger than the volume of international trade in goods and services. Only a small part of total activity in foreign exchange markets is related to payments for exports and imports. Most is related to international financial flows. International financial positioning and repositioning are likely to be quite changeable over short periods of time, explaining the variability of exchange rates in the short run.

234.

a.

The euro is expected to appreciate at an annual rate of approximately  1.005  1.000  /1.000   360 /180   100  1% . The expected uncovered interest

differential is approximately 3% + 1%  4% = 0, so uncovered interest parity holds (approximately).

If the interest rate on 180-day dollar-denominated bonds declines to 3%, then the spot exchange rate is likely to increase—the euro will appreciate, the dollar depreciate. At the initial current spot exchange rate, the initial expected future spot exchange rate, and the initial euro interest rate, the expected uncovered interest differential shifts in favor of investing in euro-denominated bonds (the expected uncovered differential is now positive, 3% + 1% − 3% = 1%, favoring uncovered investment in euro-denominated bonds. The increased demand for euros in the spot exchange market tends to appreciate the euro. If the euro interest rate and the expected future spot exchange rate remain unchanged, then the current spot rate must change immediately to be $1.005/euro, to reestablish uncovered interest parity. When the current spot rate jumps to this value, the euro's exchange rate value is not expected to change in value subsequently during the next 180 days. The dollar has depreciated immediately, and the uncovered differential then again is zero (3% + 0% − 3% = 0).

235.

a.

If we use the approximation formula, uncovered interest parity holds (approximately) when the foreign interest rate plus the expected rate of appreciation of the foreign currency equals the domestic interest rate. Using the pound as the foreign currency, we find that it is expected to change (depreciate) at an annual rate of −6%, or 1.98  2.00  / 2.00  360 / 60  100 . The uncovered annualized return on a pounddenominated bond is expected to be approximately 11% − 6% = 5%, which equals the annual return of 5% on a dollar-denominated bond. Uncovered interest parity holds approximately. (We could also use the full formula from Chapter 18 to show that the uncovered expected interest differential is approximately zero.)

This shifts the uncovered differential in favor of investing in dollar-denominated bonds. The additional demand for dollars in the foreign exchange market results in an appreciation of the dollar. To reestablish uncovered interest parity with the other rates unchanged, the expected annual rate of change (depreciation) of the pound must be 3%, so the spot rate now must change to about $1.99/pound. The pound depreciates.

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236.

a.

For uncovered interest parity to hold, investors must expect that the rate of change in the spot exchange rate value of the yen equals the interest rate differential, which is zero. Investors must expect that the future spot value is the same as the current spot value, $0.01/yen.

If investors expect that the exchange rate will be $0.0095/yen, then they expect the yen to depreciate from its initial spot value during the next 90 days. Given the other rates, investors tend to shift their investments toward dollar-denominated investments. The extra supply of yen (and demand for dollars) in the spot exchange market results in a decrease in the current spot value of the yen (the dollar appreciates). The shift to expecting that the yen will depreciate (the dollar appreciate) sometime during the next 90 days tends to cause the yen to depreciate (the dollar to appreciate) immediately in the current spot market.

237.

a.

Sell pesos. Weaker Mexican exports of oil in the future are likely to lower the peso’s exchange rate value.

Sell Canadian dollars. The expansion of money and credit is likely to lower the exchange rate value of the Canadian dollar because Canadian interest rates will decline (in the short run) and Canadian inflation rates are likely to be higher (in the long run).

Sell Swiss francs. Foreign investors are likely to pull some investments out of Swiss assets (and to invest less in the future), reducing the exchange rate value of the franc.

238.

The law of one price will hold better for gold. Gold can be traded easily so that any price differences would lead to arbitrage that would tend to push gold prices (stated in a common currency by converting prices using market exchange rates) back close to equality. Big Macs cannot be arbitraged. If price differences exist, there is no arbitrage pressure, so the price differences can persist. The prices of Big Macs (stated in a common currency) vary widely around the world.

239.

As a tourist, you will be importing services from the country you visit. You would like the currency of this foreign country to be relatively cheap, so you would like it to be undervalued relative to PPP. If it is undervalued, then the current spot exchange rate allows you to buy a lot of this country’s currency, relative to the local-currency prices that you must pay for products in the country.

240.

According to PPP, the exchange rate value of the DM (relative to the dollar) increased since the early 1970s because Germany experienced less inflation than did the United States—the product price level rose less in Germany since the early 1970s than it rose in the United States. According to the monetary approach, the German price level did not rise as much because the German money supply increased less than the money supply increased in the United States, relative to the growth rates of real domestic production in the two countries. The British pound is the opposite case—more inflation in Britain than in the United States, and higher money growth in Britain.

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241.

According to purchasing power parity, attaining a stable exchange rate between the peso and the dollar requires that the Mexican inflation rate fall so that it is about equal to the 3% inflation in the United States. If k is constant, then the rate of growth of the Mexican money supply must fall to about 9% (9% money growth equals 6 percent real growth in Y + 3% inflation in Mexican prices, P).

242.

a.

Because the annual growth rate of the domestic money supply  M s  is two

percentage points higher than it was previously, the monetary approach indicates that the nominal exchange rate value (e) of the foreign currency will be higher than it otherwise would be—that is, the nominal exchange rate value of the country's currency will be lower. Specifically, the foreign currency will appreciate by two percentage points more per year, or depreciate by two percentage points less. Equivalently, the domestic currency will depreciate by two percentage points more per year or appreciate by two percentage points less.

The faster growth of the country's money supply eventually leads to a faster rate of inflation of the domestic price level (P). Specifically, the annual inflation rate will be two percentage points higher than it otherwise would be. According to relative PPP, a faster rate of increase in the domestic price level (P) leads to a higher rate of appreciation of the foreign currency.

243.

a.

If we use 2000 as the base year, the nominal exchange rate of $1/pnut corresponds to a ratio of U.S. prices to Pugelovian prices of 100/100. According to PPP, this relationship should be maintained over time. If the price level ratio changes to 260/390 in 2022, then the nominal exchange rate should change to $0.67/pnut. The pnut should depreciate during this time period because of the higher Pugelovian inflation rate (the reason why Pugelovia’s price level increased by more than the U.S. price level increased).

If the actual exchange rate is $1/pnut in 2018, then the pnut is overvalued. Its exchange rate value is higher than the rate that would be consistent with PPP (using 2000 as the base year).

244.

a.

For the United States in 2000, 20,000 = k × 100 × 800, or k = 0.25.

For Pugelovia in 2000, 10,000 = k × 100 × 200, or k = 0.5.

For the United States, the quantity theory of money with a constant k means that the quantity equation with k = 0.25 should hold in 2022: 65,000 = 0.25 × 260 × 1,000. It does.

Because the quantity equation holds for both years with the same k, the change in the price level from 2000 to 2022 is consistent with the quantity theory of money with a constant k. Similarly, for Pugelovia, the quantity equation with k = 0.5 should hold for 2022, and it does (58,500 = 0.5 × 390 × 300).

245.

If PPP held, the exchange rate (e) should rise steadily by 2% per year for 5 years, ending up 10% higher after 5 years. This matches the path of changes in the domestic price level (relative to the foreign price level) during these 5 years. PPP does not hold in the short 134

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run because the actual exchange rate jumps immediately by more than 10% (rather than rising gradually by about 2% per year). In the medium run, the actual rate remains above its PPP value, but the two are moving closer together, as the actual rate declines and the PPP rate rises over time. In the long run, PPP holds. According to PPP, the exchange rate eventually should be 10% higher, and it actually is 10% higher.

246.

a.

The tightening typically leads to an immediate increase in the country's interest rates. In addition, the tightening probably also results in investors' expecting that the exchange rate value of the country's currency is likely to be higher in the future. The higher expected exchange rate value for the currency is based on the expectation that the country's price level will be lower in the future, and PPP indicates that the currency will then be stronger. For both of these reasons, international investors will shift toward investing in this country's bonds. The increase in demand for the country's currency in the spot exchange market causes the current exchange rate value of the currency to increase.

The currency may appreciate a lot because the current exchange rate must "overshoot" its expected future spot value. Uncovered interest parity then is reestablished with a higher interest rate and a subsequent expected depreciation of the currency.

If everything else is rather steady, the exchange rate (the domestic currency price of foreign currency) is likely to decrease quickly by a large amount. After this jump, the exchange rate may then increase gradually toward its long-run value—the value consistent with PPP in the long run.

247.

Because the nominal spot exchange rate declined from 1.12 to 0.76 SFr per Canadian dollar, the Canadian dollar experienced a nominal depreciation. However, the Canadian inflation rate was greater than the Swiss inflation rate. The change in the real exchange rate incorporates all three changes. The real exchange rate value of the Canadian dollar in 2017 (relative to a base value of 100 in 2007) is  126   0.76      110   1.12  100  83.0  103     110  Between 2007 and 2017 the Canadian dollar experienced a real depreciation (83.0 < 100). The nominal depreciation was much more than enough to offset the higher rate of Canadian price inflation.

248.

No. The change in the nominal effective exchange rate is a weighted average of the changes in the two constituent nominal bilateral exchange rates. Relative to the Canadian dollar, the euro experienced a nominal appreciation (the Canadian dollar depreciated from 2.0 euro to 1.9 euro). Relative to the Japanese yen, the euro also experienced a nominal appreciation (the euro’s value went from 48 to 50 yen). If both constituent pieces of a weighted average change in the same direction, then the weighted average also changes in this direction. Therefore, the euro experienced a nominal effective appreciation.

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We can also calculate the nominal effective exchange rate values of the euro. There are several mathematical ways to do the calculations. Here is one. First, transform the euro– Canadian dollar nominal exchange rate so it is pricing the euro: the initial value is Canadian $0.50 per euro, and the final value is Canadian $0.5263 per euro. Second, restate the nominal bilateral exchange rate values as index numbers with each equal to 100 for the initial time, so that the initial value of the nominal effective exchange rate index is also 100 (a weighted average of two values each with a value of 100 is 100.)

Third, determine the final value of the nominal effective exchange rate index: NEER final  0.60   0.5263 / 0.50  100   0.40  50 / 48  100   104.8 In going from 100 to 104.8, the euro has experienced a nominal effective appreciation.

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Sample assignment NEW YORK UNIVERSITY Stern School of Business Economics of Global Business Country Assignment #2 The text of your group's answers to the assignment should be typed single-spaced, with an extra space between each paragraph. The text must be limited to a maximum of four pages. You may also attach additional tables and charts to this four pages of text, if these tables and charts are of direct importance to your text discussion.

The group members are not to discuss this assignment with anyone else who is not in the group (except for consulting reference librarians in order to locate materials). The group may utilize any published materials—you are not limited to the sources noted in the assignment description below.

The Assignment 249. What have been the trends in the nominal exchange rate values (annual averages) of your country's currency since 2000, relative to the U.S. dollar? Relative to the U.S. dollar, has the currency of your country tended to appreciate or to depreciate?

Note: Most likely source of data (for this part and for the next part): IMF, International Financial Statistics (IFS). Use period-average annual values of exchange rates.

250. Calculate and report the real bilateral exchange rate values (annual averages) of your country's currency since 2000, relative to the U.S. dollar. If possible, use price indexes called ―Producer Prices,‖ ―Wholesale Prices,‖ or a similar name, even if the names are somewhat different between your country and the United States. If there is more than one price index of this type for your country, choose the one that is most suitable. If your country does not have full data for this type of price index, then use the price index that is usually called the ―Consumer Price Index‖ for both your country and the United States. In reporting the values of the real exchange rates, use a base year of 2000 = 100. (Please attach an appendix in which the methods of calculating the real exchange rates are documented.)

Relative to the base year of 2000, what do these values of the real exchange rate imply for your country’s international price competitiveness for various times during this period?

251. You are a U.S. investor who calculates your income and wealth in U.S. dollars. Currently you have no assets or liabilities denominated in your country’s currency. On the day that you 137 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

begin to write up your answers to this part, you are considering an uncovered international financial investment into a debt security denominated in your country’s currency, rather than investing in a comparable U.S. dollar-denominated debt security.

The foreign debt security that you are considering should be one that is issued by your country’s national government (or by a high-quality domestic bank or a high-grade corporate issuer based in your country), and the U.S. debt security should be one that is issued by the federal government (or by a comparable high-quality U.S. organization).

The two debt securities you are comparing should have the same (or very similar) maturity— specifically, a maturity in the range 1–2 years. You will need to find source(s) that provide yields-to-maturity (or interest rates) for the appropriate debt securities.

In your answer to this part, use concepts and tools from the course that are relevant to the analysis. (In addition, you may also use other concepts and methods that you think are relevant.)

A) What are the key factors that one should consider in an analysis of whether or not to make this uncovered international financial investment into the debt security of your country? Using actual information about these factors: 1. Which of these factors appear to be favorable for making the uncovered international investment? Explain.

2. Which of these factors appear to be unfavorable for making the uncovered international investment? Explain.

3. What factors are approximately neutral? Explain.

B) To conclude your answer to this part, indicate whether or not you would make this uncovered international financial investment. Explain why you would or would not make the investment.

Note: There are many possible sources of information and data. You may find information from various Web sites (such as those for multilateral organizations (including the IFS from the International Monetary Fund), the central bank or national government of your country, and so forth). Another source that may be useful is the Economist Intelligence Unit (eiu.com), including the EIU’s Country Report. If you use a website, be sure to consider whether or not the information for the site is reliable.

Chapter 20 Government Policies toward the Foreign Exchange Market Overview

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The first half of this chapter examines types of government policies toward the foreign exchange market and provides analysis of government intervention and exchange controls. The second half examines the actual policies that governments have adopted during the past 150 years.

Government policies toward the foreign exchange market exist for a variety of reasons, including to reduce variability in exchange rates, to keep the exchange value of its currency either high or low, or to raise national pride in a steady or strong currency. The two major aspects of government policies toward the foreign exchange market are policies toward the exchange rate itself and policies that permit or restrict access to the foreign exchange market. Governmentimposed restrictions on the use of the foreign exchange market are called exchange controls, which may be broad-based or may be applied only to some types of transactions (e.g., capital controls).

The basic choice that a government faces with its policy toward the exchange rate itself is between an exchange rate that is floating and one that is set or fixed by the government. In the polar case of a clean float, the government permits private market demand and supply to set the exchange rate with no direct involvement by government officials. In a managed float or dirty float, the government officials do intervene at times to try to influence the exchange rate, which otherwise is driven by private demand and supply.

If the government chooses to impose a fixed exchange rate, there are three additional choices that the government faces. First, what to fix to? Answers could include gold (or some other commodity), the U.S. dollar or some other single currency, or a basket of currencies. (With the exception of the specific examination of the gold standard, subsequent discussion assumes that a fix is to one or several foreign currencies.) Second, when to change the fixed exchange rate?

Never is a polar case, but it probably is not completely credible (and we often then speak of a pegged exchange rate instead of a fixed exchange rate). If occasionally, we call the system an adjustable peg. If often, we have a crawling peg. The choice of when to change the peg is closely related to how wide the band around the central or par value chosen for the fix. Third, how to defend the fixed rate? There are four basic ways—official intervention in which the government buys and sells currencies; exchange controls, in which the government tries to suppress excess demand or supply; altering domestic interest rates to influence short-term international capital flows; and adjusting the country's macroeconomic position to make it fit the fixed exchange rate.

Of course, the government also has a fifth option—to alter the fixed rate value or shift to a floating rate.

The first line of defense is often official intervention. If the country's currency is experiencing pressure toward depreciation, the country's monetary authority can defend the fixed rate by entering the foreign exchange market to buy domestic currency and sell foreign currency. The intervention is financing the country's official settlements balance deficit and preventing this excess private demand for foreign currency from driving the foreign currency's value above the top of the band. The monetary authority obtains the foreign currency that it sells into the market by using its holdings of official reserves or by borrowing foreign currency. In addition, by buying domestic currency, the monetary authority is removing domestic money from the economy, which tends to lower the domestic money supply. (Chapter 23 takes up the implications of this induced change in the domestic money supply.) Analysis of defending

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against appreciation of the country's currency follows similar logic, with "the directions reversed."

If the imbalance in the country's official settlements balance is temporary, then official intervention that smoothens the time path of the exchange rate can enhance the country's economic well-being (although stabilizing private speculation could do the same thing without government intervention). If the disequilibrium is ongoing or fundamental rather than temporary, then intervention alone is not likely to be able to sustain the fixed exchange rate. Instead, the government must shift to one of the other defenses or devalue. A key problem here is that it is not easy for officials to judge whether a payments imbalance is temporary or fundamental.

Exchange controls are used by many countries, especially developing countries. They cause economic inefficiency analogous to quantitative limits (quotas) on imports. They also incur substantial administrative costs. Efforts to evade them lead to bribery and parallel markets.

The second half of the chapter surveys exchange rate regimes used during the past century and a half. During the gold standard era (1870–1914), most countries pegged their currencies to gold, with each central bank willing to buy and sell gold in exchange for its own currency. This implies that the exchange rates between currencies are also fixed (within a band resulting from the transactions costs of moving gold). Britain was at the center of the system. The gold standard looked successful because it was not subject to severe shocks (until it was suspended during World War I) and because success was defined leniently, given that governments were not so concerned with stabilizing their macroeconomies.

The interwar period brought instability. In the years after the World War I, Britain made the mistake of attempting to return to its prewar gold parity. Germany suffered from hyperinflation, and other European countries also experienced substantial inflation. The early 1930s brought turbulence that led to the general abandonment of the gold standard. Compared with the gold standard era, exchange rates were quite variable. Experts at the time concluded that this experience showed the instability of flexible exchange rates, so that the world should return to fixed exchange rates. More recent analysis of this period concludes almost the opposite—that it shows the futility of trying to keep exchange rates fixed in the face of severe shocks and unstable domestic monetary and fiscal policies. In addition, research shows that the workings of the gold standard contributed to the global spread and the severity of the Great Depression.

A compromise between the United States and Britain led to an agreement in 1944 that established the Bretton Woods System, a regime of adjustable pegged exchange rates. While this system looked successful for almost two decades, it had two defects. One was that it set up oneway speculative gambles when currencies were in trouble. The second arose from the role of the U.S. dollar in the system. As the system developed, other countries pegged their currencies to the dollar, and the U. S. government was committed to buy or sell gold for dollars with other central banks. Continuing U.S. payments deficits in the 1960s led some other countries to amass large holdings of U.S. dollar-denominated assets as official reserves. Confidence that the U.S. government could continue to honor the official gold price dwindled. The U.S. government was unwilling to contract the U.S. economy to reduce the U.S. payments deficits. Instead, the private market for gold was freed in 1968. U.S. payments deficits continued. In 1971, the U.S. government suspended convertibility of dollars into gold and imposed a temporary tariff on all 140 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

imports until other countries agreed to revalue their currencies (so that the dollar would be devalued). The Smithsonian Agreement of December 1971 attempted to reestablish the system (with many other currencies being revalued), but the pegged rate system was abandoned by the major countries in 1973.

The box on ―The International Monetary Fund,‖ another in the series on Global Governance, presents the objectives of the IMF, the multilateral organization created at Bretton Woods in 1944 to oversee the international monetary system. This box also describes the IMF’s activities in pursuit of orderly foreign exchange arrangements and current account convertibility. (A second box on the IMF, in the next chapter, examines IMF lending practices.)

The current system is often described as a system of managed floating exchange rates, and the trend is generally in this direction. But there is also much official resistance to market-driven exchange rates. Some of the resistance is seen in the active management of floating exchange rates. More dramatically, the countries of the European Union have attempted to create a zone of stability in Europe, first by using the snake within the tunnel, then through the Exchange Rate Mechanism of the European Monetary System, and now with European Monetary Union and the euro. A goodly number of countries maintain fixed or heavily managed exchange rates.

However, the series of exchange rate crises during the 1990s and early 2000s show how difficult it is for a government to defend a fixed or a heavily managed exchange rate in the face of wide swings in speculative international financial flows.

The actual current system is in many ways a nonsystem—countries can choose almost any exchange rate policies that they want, and there is much variety. Two major blocs of currencies exist—one is the U.S. dollar and the currencies fixed to it, and the other is the countries adopting the euro and other currencies fixed to the euro. A growing number of countries have floating exchange rates for their currencies, with a greater or lesser degree of ―management.‖ Yet other countries use a fixed exchange rate to another currency, a fixed exchange rate to a basket of currencies, or a crawling pegged exchange rate. A number of countries are ―dollarized‖—each simply uses the currency of some other country as its own.

Tips This is a long chapter. For reading assignments, it is possible to split the chapter into two or three assignments. The first would cover the concepts and analysis of government policies toward the foreign exchange market (through the section on ―Exchange Control‖). The second would cover the evolution of the international monetary system since 1870, and this could be either the rest of the chapter or all but the last section on the current system. If the latter is used, then a third reading assignment would cover the current system. The two-assignment approach presumably would be useful if all of this material is covered in class in the order that it is presented in the text. The three-assignment approach would be useful, for instance, if the material on the history of regimes is deferred until later in the course. In this latter approach, it still seems useful to describe the current system before the material of Chapters 22–25 is covered in the course, but the sections on regime history would be shifted to later in the course.

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Figure 20.9 is a useful summary description of the current system. Although it is based on the table in the IMF Annual Report, we reworked this information and added other information to create Figure 20.9.

An instructor could decide to combine the box on the IMF in this chapter with the box ―Short of Reserves? Call 800-IMF-LOAN‖ in Chapter 21, for the reading assignment and/or for class presentation and discussion.

Suggested answers to end-of-chapter questions and problems 252.

In a clean float, the government allows the exchange rate value of its currency to be determined solely by private (or nonofficial) supply and demand in the foreign exchange market. The government takes no direct actions to influence exchange rates. In a managed float, the government is willing to and sometimes does take direct actions to attempt to influence the exchange rate value of its currency. For instance, the monetary authorities of the country may sometimes intervene in the market, buying or selling foreign currency (in exchange for domestic currency) in an effort to influence the level or trend of the floating exchange rate.

253.

We often use the term pegged exchange rate to refer to a fixed exchange rate, because fixed rates generally are not fixed forever. An adjustable peg is an exchange rate policy in which the "fixed" exchange rate value of a currency can be changed from time to time, but usually it is changed rather seldom (for instance, not more than once every several years). A crawling peg is an exchange rate policy in which the "fixed" exchange rate value of a currency is changed often (for instance, weekly or monthly), sometimes according to indicators such as the difference in inflation rates.

254.

The disequilibrium is the difference between private demand for foreign currency and private supply of foreign currency at the fixed level of the exchange rate. Official intervention by the central bank can be used to defend the fixed exchange rate, selling foreign currency if there is an excess private demand or buying foreign currency if there is an excess private supply. Another way to see the disequilibrium is that the country’s overall payments balance (its official settlements balance) is not zero.

A temporary disequilibrium is one that will disappear within a short period of time, without any need for the country to make any macroeconomic adjustments. If the disequilibrium is temporary, official intervention can usually be used successfully to defend the fixed exchange rate. The country usually will have sufficient official reserve holdings to defend the fixed rate if there is a temporary private excess demand for foreign currency (or a temporary overall payments deficit); the country usually is willing and able to accumulate some additional official reserves if there is a temporary private excess supply of foreign currency (or a temporary overall payments surplus). Indeed, for temporary disequilibriums the well-being of the country can be higher if the government stabilizes the currency by defending the fixed exchange rate through official intervention, as Figure 20.4 shows.

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If the disequilibrium is fundamental, then it tends to continue into the future. The country cannot simply use official intervention to defend the fixed exchange rate. The country will run out of official reserves (if its defense involves selling foreign currency), or it will accumulate unacceptably large official reserves (if the defense involves buying foreign currency). Thus, a major adjustment is necessary if the disequilibrium is fundamental.

The government may surrender the fixed rate, changing its value or shifting to a floating exchange rate. Or the government may adjust its macroeconomy to alter private demand and supply for foreign currency.

255.

Disagree. If a country is expected to impose exchange controls, the government will impose limits on international capital flows. This creates risks for foreign investors. They are likely to try to shift funds out of the country before the controls are imposed. The increase in supply of domestic currency into the foreign exchange market (or increase in demand for foreign currency) puts downward pressure on the exchange rate value of the country's currency—the currency tends to depreciate.

256.

The exchange controls are intended to restrain the excess private demand for foreign currency (the source of the downward pressure on the exchange rate value of the country’s currency). Thus, some people who want to obtain foreign currency, and who would be willing to pay more than the current exchange rate, do not get to buy the foreign currency. This creates a loss of well-being for the country as a whole because some net marginal benefits are being lost. Furthermore, these frustrated demanders are likely to turn to other means to obtain foreign currency. They may bribe government officials to obtain the scarce foreign currency. Or they may evade the exchange controls by using an illegal parallel market to obtain foreign currency (typically at a much higher price than the official rate).

257.

a.

The market is attempting to depreciate the pnut (appreciate the dollar) toward a value of 3.5 pnuts per dollar, which is outside of the top of the allowable band (3.06 pnuts per dollar). In order to defend the pegged exchange rate, the Pugelovian monetary authorities could use official intervention to buy pnuts (in exchange for dollars). Buying pnuts prevents the pnut’s value from declining (selling dollars prevents the dollar’s value from rising). The intervention satisfies the excess private demand for dollars at the current pegged exchange rate.

To defend the pegged exchange rate, the Pugelovian government could impose exchange controls in which some private individuals who want to sell pnuts and buy dollars are told that they cannot legally do this (or cannot do this without government permission, and not all requests are approved by the government). By artificially restricting the supply of pnuts (and the demand for dollars), the Pugelovian government can force the remaining private supply and demand to "clear" within the allowable band. The exchange controls attempt to stifle the excess private demand for dollars at the current pegged exchange rate.

To defend the pegged exchange rate, the Pugelovian government could increase domestic interest rates (perhaps by a lot). The higher domestic interest rates shift the incentives for international capital flows toward investments in Pugelovian bonds. The increased flow 143 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

of international financial capital into Pugelovia increases the demand for pnuts on the foreign exchange market. (Also, the decreased flow of international financial capital out of Pugelovia reduces the supply of pnuts on the foreign exchange market.) By increasing the demand for pnuts (and decreasing the supply), the Pugelovian government can induce the private market to clear within the allowable band. The increased domestic interest rates attempt to shift the private supply and demand curves so that there is no excess private demand for dollars at the current pegged exchange rate value.

258.

a.

Nonofficial supply and demand are pressuring the dirham to appreciate above the central bank’s informal target value. The Moroccan monetary authority has to intervene in the foreign exchange market to sell dirhams and buy dollars.

d. For this situation in the foreign exchange market to be a temporary disequilibrium, the Moroccan monetary authority expects that nonofficial supply and demand will shift in the near future, so that the market will be close to clearing at $0.10 per dirham without official intervention. That is, the central bank expects that nonofficial demand for the dirham will decrease (shift to the left) and/or that nonofficial supply of dirhams will increase (shift to the right). e. If private investors and speculators believe that this is a fundamental disequilibrium, then they expect that the monetary authority will need to continue to intervene, selling dirhams and buying dollars. The private investors and speculators may believe that the Moroccan monetary authority will not or cannot continue to intervene in this way for a long period of time. Instead, the Moroccan central bank will decide to allow the dirham to appreciate.

To profit from the coming large dirham appreciation, investors and speculators should increase their long positions in dirhams, for example, by shifting into dirhamdenominated financial investments. To make these investments, investors and speculators increase the demand for dirhams on the foreign exchange markets. (The actions by the investors and speculators also make dirham appreciation more likely. The size of intervention by the Moroccan authority needed to defend the informal target rate increases, and the Moroccan monetary authority is more likely instead to allow the dirham to appreciate.)

259.

a.

Let’s use the exchange rates as quoted (Danish krone per euro). The nonofficial demand for euros  Deuro  and the nonofficial supply of euros  Seuro  intersect at point A, corresponding to an exchange rate of 7.1 krone per euro. This value is below the bottom of the band around the central fixed rate of 7.46 per euro (the bottom band rate is about 7.29, equal to 7.46 minus 0.0225 times 7.46).

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Nonofficial or private demand and supply is pressuring the exchange rate to fall below the bottom of the band. The Danish central bank must intervene to defend the fixed exchange rate by buying euros, to resist the pressure for the euro to depreciate. To keep the exchange rate from falling below the bottom of the band, the Danish central bank must buy  Qs  Qd  of euros, equal to the gap KR at the band-bottom exchange rate of about 7.29 krone per euro. The Danish central bank will use these  Qs  Qd  euros to add to its holdings of official reserve assets, for example, by using the euros to buy eurodenominated bonds issued by the German government.

The Danish money supply will tend to increase. In the foreign exchange intervention, the Danish central bank buys euros and sells Danish krone. The intervention adds newly created krone into the Danish banking system, so the Danish money supply tends to increase.

260.

a.

The implied fixed exchange rate is about $4.87/pound  or 20.672 / 4.2478  .

You would engage in triangular arbitrage. If you start with dollars, you buy pounds using the foreign exchange market (because as quoted the pound is cheap). You then use gold to convert these pounds back into dollars. If you start with $4, you can buy one pound. You turn in this pound at the British central bank, receiving about 0.2354  or 1/ 4.2478  ounces of gold. Ship this gold to the United States and exchange it at the U.S. central bank for about $4.87 (or 0.2354 × 20.672). Your arbitrage gets you (before expenses) about 87 cents for each $4 that you commit.

Buying pounds in the foreign exchange market tends to increase the pound’s exchange-rate value, so the exchange rate tends to rise above $4.00/pound (and toward $4.87/pound).

261.

a.

The gold standard was a fixed rate system. The government of each country participating in the system agreed to buy or sell gold in exchange for its own currency at a fixed price of gold (in terms of its own currency). Because each currency was fixed to gold, the exchange rates between currencies also tended to be fixed, because individuals 145

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could arbitrage between gold and currencies if the currency exchange rates deviated from those implied by the fixed gold prices.

Britain was central to the system, because the British economy was the leader in industrialization and world trade, and because Britain was considered financially secure and prudent. Britain was able and willing to run payments deficits that permitted many other countries to run payments surpluses. The other countries used their surpluses to build up their holdings of gold reserves (and of international reserves in the form of pound-denominated assets). These other countries were satisfied with the rate of growth of their holdings of liquid reserve assets, and most countries were able to avoid the crisis of running low on international reserves.

During the height of the gold standard, from about 1870 to 1914, the economic shocks to the system were mild. A major shock—World War I—caused many countries to suspend the gold standard.

Speculation was generally stabilizing, both for the exchange rates between the currencies of countries that were adhering to the gold standard, and for the exchange rates of countries that temporarily allowed their currencies to float.

262.

Key features of the interwar currency experience were that exchange rates were highly variable, especially during the first years after World War I and during the early 1930s.

Speculation seemed to add to the instability, and governments sometimes appeared to manipulate the exchange rate values of their currencies to gain competitive advantage.

One lesson that policymakers learned from this experience was that fixed exchange rates were desirable to constrain speculation and variability in exchange rates, as well as to constrain governments from manipulating exchange rates. These lessons are now debated because subsequent studies have shown that the experience can be explained or understood in other ways. Exchange rate changes in the years after World War I tended to move in ways consistent with purchasing power parity, which suggests that the fundamental problems were government policies that led to high inflation rates in some countries. The currency instability of the early 1930s seems to be reflecting the large shocks caused by the global depression. Indeed, the research suggests that it may not be possible to keep exchange rates fixed when large shocks hit the system.

263.

a.

The Bretton Woods system was an adjustable pegged exchange rate system.

Countries committed to set and defend fixed exchange rates, financing temporary payments imbalances out of their official reserve holdings. If a "fundamental disequilibrium" in a country's international payments developed, the country could change the value of its fixed exchange rate to a new value.

The United States was central to the system. As the Bretton Woods system evolved, it became essentially a gold-exchange standard. The monetary authorities of other countries committed to peg the exchange rate values of their currencies to the U.S. dollar. The U.S. monetary authority committed to buy and sell gold in exchange for dollars with other countries' monetary authorities at a fixed dollar price of gold.

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To a large extent speculation was stabilizing, both for the fixed rates followed by most countries, and for the exchange rate value of the Canadian dollar, which floated during 1950–1962. However, the pegged exchange rate values of currencies sometimes did come under speculative pressure. International investors and speculators sometimes believed that they had a one-way speculative bet against currencies that were considered to be "in trouble.‖ If the country did manage to defend the pegged exchange rate value of its currency, the investors betting against the currency would lose little. They stood to gain a lot of profit if the currency was devalued. Furthermore, the large speculative flows against the currency required large interventions to defend the currency's pegged value, so that the government was more likely to run so low on official reserves that it was forced to devalue.

264.

The Bretton Woods system of fixed exchange rates collapsed largely because of problems with the key currency of the system, the U.S. dollar. The dollar’s problems arose partly as a result of the design of the system and partly as a result of U.S. government policies. As the system evolved, it became a gold-exchange standard in which other countries fixed their currencies to the U.S. dollar, largely held U.S. dollars as their official reserve assets, and intervened to defend the fixed exchange rates using dollars. The United States was obligated to exchange dollars for gold with other central banks at the official gold price. This caused two problems for the system. First, other central banks accumulated dollar official reserves when the United States ran a deficit in its official settlements balance. In the early years of Bretton Woods, this was desirable as other central banks wanted to increase their holdings of official reserves. But in the 1960s, this became undesirable as the U.S. deficits became too large. Expansionary U.S. fiscal and monetary policies led to the large U.S. deficits and to rising inflation in the United States. Second, other central banks saw their rising dollar holdings and a declining U.S. gold stock, and they began to question whether the United States could continue to honor the official gold price.

The U.S. government probably could have maintained the system, at least for longer than it actually lasted, if it had been willing to change its domestic policies, tightening up on government spending to contract the economy and cool off its inflation. The United States instead reacted by changing the rules of Bretton Woods, severing the link between the private gold market and the official gold price in 1968 and suspending gold convertibility and forcing other countries to revalue their currencies in 1971. An agreement in late 1971 reestablished fixed exchange rates after a short period in which some currencies floated, but most major currencies shifted to floating by 1973.

Another contributor to the collapse of the system was the ability of investors to take one-way speculative gambles against currencies that were perceived to be candidates for devaluation. The adjustable-peg system gave speculators a bet in which they could gain a lot if the currency was devalued but would lose little if it was not. Most governments did not have large enough holdings of official reserves to defend the fixed exchange rate against a determined speculative attack.

265.

a.

The dollar bloc and the euro bloc. A number of countries peg their currencies to the U.S. dollar. A number of European countries use the euro, and, in addition, a number of other countries peg their currencies to the euro.

147

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Other major currencies that float independently include (as of 2022) the Japanese yen, the British pound, the Canadian dollar, the Australian dollar, and the Swedish krona.

The exchange rates between the U.S. dollar and the other major currencies have been floating since the early 1970s. The movements in these rates exhibit trends in the long run—over the entire period since the early 1970s. The rates also show substantial variability or volatility in the short and medium runs—periods of less than 1 year to periods of several years. The long-run trends appear to be reasonably consistent with the economic fundamentals emphasized by purchasing power parity—differences in national inflation rates. The variability or volatility in the short or medium run is controversial because it is large. It may simply represent rational responses to the continuing flow of economic and political news that has implications for exchange rate values. The effects on rates can be large and rapid, because overshooting occurs as rates respond to important news.

However, some part of the large volatility may also reflect speculative bandwagons that lead to bubbles that subsequently burst and are reversed.

Chapter 21 International Lending and Financial Crises Overview International capital movements can bring major gains both to the lending or investing countries and to the borrowing countries, through intertemporal trade and through portfolio diversification for the lenders/investors. But international lending and borrowing sometimes is not wellbehaved—financial crises are recurrent. This chapter examines both the gains from well-behaved lending and borrowing and what we know about international financial crises.

We begin with the economic analysis of international capital flows that focuses on the stock of wealth of two countries and how that wealth can be lent or invested in the two countries. With no international lending, the country that has much wealth relative to its domestic investment opportunities will have a lower rate of return or interest rate. Freeing international capital flows permits the low-rate country to lend to the high-rate country. As the world shifts to an equilibrium with free capital movements, both countries gain. As usual, however, within each country there are groups that gain and groups that lose from the international lending.

We can also use this analysis to show that either nation could gain by imposing a small tax on the international capital flows, because it could shift the pretax foreign interest rate in its favor.

Either country could seek to impose a nationally optimal tax, but this works well only if the other country does not impose a comparable tax.

International lending and borrowing often is well-behaved but not always. The chapter next examines financial crises in developing countries during 1982 to 2002. Following defaults in the 1930s, lending from developed countries to developing countries was low for four decades. Such lending dramatically increased in the 1970s for four reasons. First, oil-exporting countries deposited large amounts of petrodollars in banks following the increases in oil prices. Second, 148 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

the banks did not see good prospects for lending this money to borrowers for capital spending in the developed countries. Third, developing countries resisted foreign direct investment from multinationals based in the developed countries, so increased capital flows to the developing countries took the form of bank loans to these countries. Fourth, herd behavior among banks increased the total amount lent to developing countries.

Crisis struck in 1982, when first Mexico and then many other developing countries declared that they could not repay. The crisis was brought on by rising interest rates in the United States, which raised the cost of servicing the loans, and declining export earnings for the debtor developing countries, as the developed countries endured a deep recession. This debt crisis wore on through the 1980s. Beginning in 1989, the Brady Plan led to reductions in debt and conversion to bonds. By 1994, the 1980s debt crisis was finally over.

Beginning in about 1990 lending to developing countries began to grow rapidly. Low U.S. interest rates led lenders and investors to seek out better returns elsewhere, and many developing countries became more attractive as places to invest by shifting to more market-oriented policies.

In addition, individual investors and fund managers began to view developing countries as emerging markets for financial investments.

Still, the 1990s were punctuated by a series of financial crises. In late 1994, a large current account deficit, a weak banking system, and rapid growth in dollar-indexed Mexican government debt (tesobonos) led to a large devaluation and depreciation of the Mexican peso and a financial crisis as foreign investors refused to buy new tesobonos. Contagion (the ―tequila effect‖) spread the crisis to other countries. A large rescue package offered mostly by the U.S. government and the International Monetary Fund (IMF) contained the crisis and the contagion.

The Asian crisis of 1997 hit Thailand first and then spread to Indonesia and South Korea, as well as Malaysia and the Philippines. The problems differed somewhat from one country to another, but one cause of the crisis was weak government regulation of banks, so that the banks borrowed large amounts of foreign currency, and then lent these funds to risky local borrowers. In addition, the growth of exports generally was declining for these countries, leading to some weakness in the current account.

Russia was not much affected directly by the Asian crisis, but it had a large fiscal deficit and the need for large borrowing by the government. By mid-1998, foreign lenders reduced their financing, and an IMF loan foundered when the Russian government failed to enact changes in its fiscal policy. In the face of rising capital flight, the Russian crisis hit, as the Russian government allowed the ruble to depreciate and defaulted on much of its debt. With no rescue from the IMF, foreign lenders and investors suffered large losses. They reassessed the risk of lending to developing countries, and flows of capital to developing countries declined for the year.

Argentina pegged its peso to the U.S. dollar and succeeded in ending its hyperinflation in the early 1990s. However, the peso experienced an increase in its real effective exchange rate value, and an extended recession began in 1998. The fiscal deficit widened, and the IMF stopped lending to it in late 2001. In early 2002, the government ended the pegged exchange rate and the peso lost three-fourth of its value relative to the U.S. dollar. The banking system largely ceased 149 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

to function and the economy went into a severe recession. After a few months delay, Argentina’s crisis spread to neighboring countries, especially Uruguay.

Based on a survey of studies of financial crises in developing countries, the chapter discusses five reasons why they occur or are as severe as they are. The explanations have a common theme—once foreign lenders realize that there is a problem, each has an incentive to stop lending and to try to get repaid as quickly as possible. If the borrower cannot immediately repay, a crisis occurs.

The first explanation is overlending and overborrowing. This can occur when the government borrows and guarantees private borrowing, and lenders view this as low risk. The box on ―The Special Case of Sovereign Debt‖ uses a benefit–cost analysis to show when a sovereign debtor would default. The Asian crisis showed that overlending and overborrowing could occur with private borrowers as well, especially if rising stock and land prices show high returns until the bubble bursts. The second explanation is exogenous shocks—for instance, a decline in export prices or a rise in foreign (often U.S.) interest rates—that make it more difficult for the borrower to service its debt. The third is exchange rate risk. This can be acute if private borrowers use liabilities denominated in foreign currency to fund assets denominated in local currency, betting that the exchange rate value of the local currency will not decline (too much). If it does, borrowers attempt to hedge their risk exposure, putting further downward pressure on the exchange rate value of the local currency, and then they may be forced to default if the local currency is depreciated or devalued more, before they can fully hedge their risk exposures. The fourth explanation is a large increase in short-term debt to foreigners. The risk is that short-term debt denominated in foreign currency cannot readily be rolled over or refinanced.

The first four explanations indicate why a financial crisis can hit a country. The fifth explanation—contagion—indicates why a crisis in one country can spread to others. Contagion can be herding behavior by investors, perhaps fed partly by incomplete information on other countries that might have problems similar to those of the crisis country. Contagion can also be based on a new recognition of real problems in other countries, with the crisis in the first country serving as a ―wake-up call.‖ When a financial crisis hits a developing country, two major types of international efforts are used to help resolve it. First, a rescue package, often led by an IMF lending facility, can be used to compensate temporarily for the lack of private lending, to try to restore lender confidence, to try to limit contagion, and to induce the government of the borrowing country to improve its macroeconomic and other policies. While the Mexican rescue in 1994 was very successful in helping Mexico weather the crisis, the rescue packages for the Asian crisis countries were only moderately successful. A key question is whether the rescue packages increase moral hazard, so that future financial crises become more likely because lenders lend more freely if they expect to be rescued. The Mexican rescue probably increased moral hazard, with mixed effects from the Asian rescues. The lack of a rescue for Russia reduced moral hazard as lenders lost substantial amounts with no rescue package implemented. (The box ―Short of Reserves? Call 800-IMFLOAN,‖ another in the series on Global Governance, describes the IMF’s lending activities and its use of conditionality.)

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Second, debt restructuring (rescheduling and reduction) is used to create a more manageable stream of payments for debt service. Restructuring can be difficult because an individual lender has an incentive to free ride, hoping that other creditors will restructure while demanding full repayment as quickly as possible for its own loans. The Brady Plan overcame the free rider problems to resolve the debt crisis of the 1980s. During the debt crises of the 1990s, it was relatively easy to restructure debt owed to foreign banks. A new problem was the great difficulty of restructuring bonds, because the legal terms of most bonds gave powers to small numbers of bondholders to resist restructuring. The shift to bonds that include collective action clauses has reduced this problem.

Financial crises impose large costs on borrowers and lenders, so we seek ways to reduce the likelihood or frequency of financial crises in developing countries. Some proposals for improved practices in borrowing countries, including better macroeconomic policies, better disclosure of information and data, avoiding government short-term borrowing denominated in foreign currencies, and better regulation of banks, enjoy widespread support. Other proposals are controversial, with experts sometimes pointing in opposite directions. Developing countries should shift to relatively cleanly floating exchange rates, or they should move to rigid currency fixes through currency boards. The IMF should have access to greater amounts of resources so it can help countries fight off unwarranted financial attacks, or the IMF should be abolished to reduce moral hazard. The text looks more closely at two proposals for reform, the need for better bank regulation, and the controversial proposal that developing countries should make greater use of capital controls to limit capital inflows, and especially to limit short-term borrowing.

Financial crises also hit developed countries, and the chapter concludes with an examination of the global financial and economic crisis. The crisis began in the United States, which had experienced a credit boom and a bubble in house prices. As the house price bubble began to deflate in 2006, an increasing number of mortgages went into default. In August 2007, problems at BNP Paribas signaled the depth of losses on securities backed by these mortgages.

Furthermore, financial institutions became reluctant to lend to each other, because potential lenders became worried that the borrowing institutions may hold dodgy assets that made it more likely that they could not service their debts in the future. With the failure of Lehman Brothers in September 2008, short-term financial markets and lending among financial institutions froze, and the crisis entered a much worse phase. The U.S. Federal Reserve and other central banks responded with efforts to inject liquidity and shore up financial institutions and markets. By late 2009, most financial markets were operating reasonably well. The chapter concludes with an examination of how the causes of the global crisis are in several ways similar to the causes of crises in developing countries.

The box ―National Crises, Contagion, and Resolution,‖ the second euro crisis box, discusses how the euro crisis was three interlocking crises (sovereign debt, banking, and macroeconomic) that fed on each other.

Tips

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Many students have a keen interest in international lending and investing and financial crises.

This chapter can readily be supplemented with class discussion of or readings from recent articles about developments in recent and current crises and defaults.

The first section or two of this chapter on the gains from international capital flows and the taxation of international capital flows can be assigned and covered in conjunction with the material of Chapters 2–15 (especially, the analysis of direct investment and migration in Chapter 15).

If this chapter is assigned before students read the second half of Chapter 20, the instructor may want to assign the box ―The International Monetary Fund‖ as required reading to introduce the organization.

Suggested answers to questions and problems 266.

Disagree. Borrowing from foreign lenders provides a net gain to the borrowing country, as long as the money is used wisely. For instance, as long as the money is used to finance new capital investments whose returns are at least as large as the cost of servicing the foreign debt, then the borrowing country gains well-being. This is the gain of area (d + e + f ) in Figure 21.1.

267.

Disagree. In a sense a national government cannot go bankrupt, because it can print its own currency. But a national government can refuse to honor its obligations, even if it might be able to pay. If the benefit from not paying exceeds the cost of not paying, the government may rationally refuse to pay. And, a national government can run short of foreign currency to pay obligations denominated in foreign currency, because it cannot print foreign money.

268.

The surge in bank lending to developing countries during 1974–1982 had these main causes: (1) a rise in bank funds from the ―petrodollar‖ deposits by newly wealthy oil exporting governments; (2) bank and investor concerns that investments in developed countries would not be profitable because the oil shocks had created uncertainty about the strength of these economies; (3) developing countries’ resistance to foreign direct investment, which led these countries to prefer loans as the way to borrow internationally; and (4) some amount of herding behavior by bank lenders, which built on the momentum of factors (1) through (3) and led to overlending.

269.

The debt crisis in 1982 was precipitated by (a) increased cost of servicing debt, because of a rise in interest rates in the United States and other developed countries as tighter, monetary policies were used to fight inflation; (b) decreased export earnings in the debtor countries, because of decreased demand and lower commodity prices as the tighter monetary policies resulted in a world recession; and (c) an investor shift to curtailing new lending and trying to get old loans repaid quickly, once it became clear that (a) and (b) would lead to some defaults.

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270.

a.

World product without international lending is the shaded area. We first need to calculate the intercepts for the two MPK lines. The negative of the slope of MPK Japan is 1 percent per 600, so the intercept for Japan is 12%. The ―negative‖ of the slope of MPK America is also 1% per 600, so the intercept for America is about 14.7%. Japan’s product is the rectangle of income from lending its wealth at 2% (120) plus the triangle above it (300), which is income for everyone else in Japan. America’s product is the rectangle of income from lending its wealth at 8% (320) plus the triangle above it (about 134), which is income to everyone else in America. Adding up these four components yields a total world product of 874.

Free international lending adds area RST (54), so total world product rises to 928.

The 2% tax results in a loss of area TUV (6), so total world product falls to 922.

271.

With free international lending Japan lends 1,800 (= 6,000 − 4,200) to America, at point T. If Japan and America each impose a 2% tax on international lending, the total tax is 4%. The gap WZ restores equilibrium, and the amount lent internationally declines to 600 (=6,000 − 5,400). The interest rate in Japan (and the one received net of taxes by Japan’s international lenders) is 3% and the interest rate in America (and the one paid including taxes by America’s international borrowers) is 7%. (The difference is the 4% of taxes.)

Japan’s government collects international-lending tax revenues equal to area r, but this is effectively paid by Japanese lenders who see their earnings on the 600 of foreign lending that continues decline by this amount. The net effect on Japan is a loss of area n (which equals 6) because the taxes prevent some previously profitable lending from occurring.

America’s government collects tax revenues equal to area k, but this is effectively paid by American borrowers who must pay a higher interest rate on their foreign borrowing. The net effect on America is a loss of area j (which equals 6) because of the decline in international borrowing.

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272.

a.

A large amount of short-term debt can cause a financial crisis because lenders can refuse to roll over the debt or refinance it and instead demand immediate repayment. If the borrowing country cannot meet its obligations to repay, default becomes more likely.

Lenders can become concerned that other countries in the region are also likely to be hit with financial crises. This contagion can then become a self-fulfilling panic. If lenders refuse to make new loans and sell off investments, the country may not be able to meet its obligations to repay, so default becomes more likely. And the prices of the country’s stocks and bonds can plummet as investors flee.

273.

a.

The increase in the interest rate rotates the line showing the debt service due, which is also the benefit from not repaying, upward to (1  i) D from 1  i  D . The threshold amount of debt beyond which the country’s government should default declines to Dlim from Dlim . This change can lead to default, even if the country’s government would not default before the change, if the actual amount of debt is between Dlim and Dlim .

The increase in the cost of defaulting causes an upward shift to C from C in the curve showing the costs of not repaying. In this case, the threshold increases to Dlim from Dlim .

This change cannot lead to default if the country would not default before the change.

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274.

a.

If lenders had detailed, accurate, and timely information on the debt and official reserves of a developing country, they should be able to make better lending and investing decisions, to avoid overlending or too much short-term lending. Better information should also reduce pure contagion, which is often based on vague concerns that other developing countries might be like the initial crisis country. In addition, developing countries that report such detailed information are more likely to have prudent macroeconomic policies, so that they do not have to report poor performance.

Controls on capital inflows can (1) limit total borrowing by the country to reduce the risk of overlending and overborrowing, (2) reduce short-term borrowing if the controls are skewed against this kind of borrowing, and (3) reduce exposure to contagion by reducing the amount of loans and investments that panicked foreign lenders can pull out when a crisis hits some other country.

275.

Disagree. The IMF can make loans to governments of countries that have serious balance of payments problems (including a national inability to borrow internationally to finance current account deficits) or serious problems repaying government debt, especially debt owed to foreign investors and lenders. However, these were not the problems for the developed countries (including the United States) at the center of the global financial and economic crisis. The crisis developed within the private financial sector, as financial institutions and financial investors became unwilling to lend to each other. The IMF does not lend to private financial institutions. The U.S. government and the governments of the other large developed countries at the center of the crisis were not constrained by inability to borrow, so there was no role for the IMF to lend to them. Instead, it was these national governments, mostly working through their central banks, that had to take the lead in providing support for financial institutions and financial markets to resolve the crisis.

276.

The likelihood of a banking crisis following an unexpected depreciation of the local currency is fairly high. Banks in this country appear to have substantial exposure to exchange rate risk. The banks are short dollars because their liabilities (the deposits) 155

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denominated in dollars appear to be unhedged against exchange rate risk—the dollar liabilities exceed any assets that they may have denominated in dollars. (Looked at the other way, the banks are long the local-currency—the loans.) An unexpected devaluation of the country’s currency would lead to large losses for the banks because the local-currency value of their liabilities would increase. If the losses are large enough, a banking crisis is likely. Because of the large losses, the banks would become insolvent (negative net worth) and may have to cease functioning. Even if the banks are not immediately bankrupt, depositors may create a run on the banks, as the depositors fear losing their deposits and try to withdraw their deposits quickly. The banks would not be able to find sufficient funds to pay the depositors quickly and would have to suspend payments.

277.

If a default has no other effect on Puglia, its government should default when the incremental cost of servicing the debt (interest payment plus repayment of principal) becomes larger than the incremental inflow of funds from new loans. This occurs at the end of Year 3, so the Puglian government should default at that time.

Chapter 22 How Does the Open Macroeconomy Work?

Overview This chapter provides a framework and model for analyzing international macroeconomics. We judge the performance of a national economy against two objectives. Internal balance involves both full employment and price stability or an acceptable rate of inflation. External balance involves a reasonable and sustainable makeup of the country's international payments, taken to be approximately an official settlements balance that is zero. The framework generally assumes that the domestic price level is sticky or sluggish in the short run, although it does respond to supply and demand conditions beyond the short run.

In the short run (and within the economy's supply capabilities), domestic production is determined by aggregate demand: Y  AD  C  I d  G   X  M   E   X  M  , where Y is both domestic production and national income, and E is national expenditure on goods and services. Consumption C is a positive function of Y (inclusive of the effects of taxes T), and real domestic investment I d is a negative function of the interest rate i. Imports M are a positive function of Y, according to the marginal propensity to import m.

If the interest rate and price level are constant, then the equilibrium is the level of real GDP (and income) that equals desired aggregate demand at that level of income, or, equivalently, the level of real GDP for which desired national saving S equals desired domestic and foreign investment I d  I f , given that X − M is (approximately) equal to I f . The spending multiplier shows how equilibrium GDP responds to exogenous changes in any component of aggregate demand. The spending multiplier in a small open economy is 1/  s  m  , where s is the marginal propensity to

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save (including any "forced saving" caused by the tax system). The multiplier is smaller than in a comparable closed economy (in which m is zero).

For a large country, the change in its imports has spillover effects on foreign GDP. A change in this large country's income changes its imports, which changes foreign exports by enough to alter foreign production and income. In turn, the change in foreign income changes foreign imports, which changes the first country's exports, leading to a further change in this country's production and income. These foreign income repercussions increase the size of the spending multiplier for a large country.

The IS-LM-FE model provides a more complete framework for analyzing the open macroeconomy. It shows the determination of the short-run equilibrium levels of the country's real GDP and interest rate while also indicating the state of the country's official settlements balance (or, equivalently, the pressure on the exchange rate value of the country's currency). We are relaxing the assumption that the interest rate is steady.

The downward-sloping IS curve shows all combinations of Y and i that represent equilibrium in the domestic product market. A change in an influence on aggregate demand other than Y or i results in a shift in the IS curve. The upward-sloping LM curve shows all combinations of Y and i that represent equilibrium in the money market. A change in the money supply or a change in an influence on money demand other than Y or i results in a shift in the LM curve. (A new box ―A Deeper Look at Monetary Policy‖ discusses some variations in how central banks execute their monetary policies.) The intersection of the IS and LM curves shows the short-run equilibrium values for real GDP and the interest rate.

The FE curve shows all combinations of Y and i that result in a zero official settlements balance.

If the country's current account balance CA is a negative function of Y (because of import demand), and the country's (nonofficial) financial account FA is a positive function of i (because of the incentive for international capital flows), the FE curve generally slopes upward. A point above or to the left of the FE curve indicates that the country's official settlements balance is in surplus; a point below or to the right indicates a payments deficit. Given the marginal propensity to import, how flat or steep the FE curve is depends on how responsive international capital flows are to interest rate changes. The more responsive, the flatter the FE curve. In the extreme, with perfect capital mobility the FE curve is a horizontal line. A change in an influence on the current or financial accounts other than Y or i causes a shift in the FE curve. The text also notes that the ability of a higher domestic interest rate to attract inflows of capital probably falls off beyond a short time period.

As the economy moves beyond the short run, the product price level does change, for three basic reasons. First, most countries have some amount of ongoing inflation. Second, strong or weak aggregate demand (relative to the economy's supply capabilities) puts pressure on the price level—strong demand causes overheating and weak demand causes a "discipline" effect. Third, price shocks, including oil price shocks and large, abrupt changes in the exchange rate value of the country's currency, can change the price level. (Appendix G describes a model using aggregate demand and aggregate supply that can be used to analyze more formally pressures that change the price level.)

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The final piece of the framework that we develop in the text is that the country's exports and imports depend on international price competitiveness, in addition to depending on national incomes. The price of foreign-produced traded products relative to the price of home-produced substitute products is Pf  e / P , where e is measured as units of domestic currency per unit of foreign currency. This ratio is essentially the (inverse of the country’s) real exchange rate introduced in Chapter 19. The country's demand for imports is a negative function of this price ratio, while demand for the country's exports is a positive function. A change in price competitiveness causes a change in net exports, so that both the IS and the FE curves shift.

Tips We present a framework that can be used to analyze both fixed (Chapter 23) and floating (Chapter 24) exchange rates. Clearly, any one framework is not perfect, but we believe that this framework (the Mundell–Fleming model) is a good framework that includes a large number of relationships that must be juggled in analyzing the open macroeconomy. Footnote 3 presents some shortcomings of this approach. The aggregate demand–aggregate supply model of Appendix G is one way to address some of these shortcomings.

We have chosen to focus more on the complete model, and to limit the treatment of spending multipliers by presenting the explicit formula for only the small, open-economy multiplier.

Foreign income repercussions are covered intuitively and with examples. An instructor who wants to cover more on multipliers may want to prepare a class handout of a few pages that works through multipliers with foreign income repercussions.

Suggested answers to end-of-chapter questions and problems 278.

Mexico. The United States and Mexico have close trading ties, with most of Mexico’s exports destined for the United States. If national production and income increase in the United States, the relatively large increase in Mexican exports to the United States increases Mexico’s domestic product by a substantial amount. For countries other than Mexico and Canada, the shares of their exports that go to the United States generally are lower.

279.

Disagree. The recession in the United States reduces U.S. national income, so U.S. residents reduce spending on all kinds of things, including spending on imports. The decrease in U.S. imports is a decrease in the exports of other countries, including Europe’s exports to the United States. The reduction in European exports reduces production in Europe, so the growth of real GDP in Europe declines. A recession in the United States is likely to lower the growth of European real GDP.

280.

a.

The spending multiplier is 1/  0.2  0.1  3.3 , so domestic product will increase by $3.3 billion.

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For a closed economy, the spending multiplier is 1/ 0.2  5 , so domestic product will increase by $5 billion. The spending multiplier is larger for a closed economy than for a small open economy because there is no import ―leakage‖ for the closed economy. For both economies, as production and income rise following the initial increase in spending, some of the extra income goes into saving (and to pay taxes), so that the next rounds of increases in production and income are smaller. For the open economy, as production and income rise, there is an additional leakage out of the domestic demand stream as some of the country’s spending goes to additional imports. Spending on imports does not create extra demand for this country’s production. The next rounds of increases in the country’s production and income become smaller more quickly, resulting in a smaller multiplier.

281.

a.

The spending multiplier in this small open economy is about 1.82   1/  0.15  0.4  . If real spending initially declines by $2 billion, then domestic product and income will decline by about $3.64 billion (= 1.82 × $2 billion)

If domestic product and income decline by $3.64 billion, then the country's imports will decline by about $1.46 billion (=$3.64 billion × 0.4).

The decrease in this country's imports reduces other countries' exports, so foreign product and income decline.

The decline in foreign product and income reduce foreign imports, so the first country's exports decrease. This reinforces the change (decline) in the first country's domestic product and income—an example of foreign-income repercussions.

282.

The intersection of the IS and LM curves indicates a short-run equilibrium in the country’s market for goods and services (the IS curve) and a short-run equilibrium in the country’s market for money (the LM curve). The intersection indicates the equilibrium level of the country’s real domestic product and income (its real GDP) and the equilibrium level of its interest rate. We evaluate internal balance by comparing the actual level of domestic product to the level that we estimate the economy is able to produce when it is fully using its supply-side production capabilities. If the short-run equilibrium level of domestic product is too low—less than this ―full-employment‖ level—the country has an internal imbalance that results in high unemployment. If the short-run equilibrium level of domestic product is pushing to be too high—more than its ―full-employment‖ level—the country has an internal imbalance that results in rising inflation (driven by excessive demand).

283.

External balance is the achievement of a reasonable and sustainable makeup of a country's overall balance of payments with the rest of the world. While specifying a precise goal is not simple, we often presume that achieving a balance of approximately zero in a country's official settlements balance is external balance. The FE curve shows all combinations of interest rate and domestic product that result in a zero balance for the country's official settlements balance. Thus, any point on the FE curve is consistent with this concept of external balance.

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284.

a.

A decrease in the money supply tends to raise interest rates (and lower domestic product). Thus, the LM curve shifts up (or to the left).

The LM curve is based on central bank control of the money supply. If the central bank does not change the money supply, then an increase in the interest rate does not shift the LM curve. Rather, the increase in the interest rate results in a movement along the LM curve.

285.

a.

A decrease in government spending tends to decrease domestic product (and decrease interest rates because the government has to borrow less when it has a smaller budget deficit). Thus, the IS curve shifts to the left (or down).

An increase in foreign demand for the country's exports increases the country's domestic product. Thus, the IS curve shifts to the right (or up).

An increase in the interest rate does not shift the IS curve. Rather, it results in a movement along the IS curve.

286.

a.

An increase in foreign demand for the country’s exports tends to drive the country’s overall international payments into surplus. To reestablish payments balance, the country’s domestic product and income could be higher (so imports increase) or the country’s interest rates could be lower (to create a capital outflow and reduce the country’s financial account balance). Thus, the FE curve shifts to the right or down.

An increase in the foreign interest rate tends to drive the country’s overall international payments into deficit because of capital outflows seeking the higher foreign returns. To reestablish payments balance, the country’s domestic product could be lower (to reduce imports) or its interest rates could be higher (to reverse the capital outflow). Thus, the FE curve shifts to the left or up.

An increase in the country’s interest rate does not shift the FE curve. Rather, it results in a movement along the FE curve.

287.

a.

Imports increase, according to the marginal propensity to import.

Our exports decrease, as foreign imports decrease according to the foreign marginal propensity to import.

This makes our products relatively more expensive, and foreign products relatively less expensive. The relative price of foreign products (or the real exchange rate value of P e / P foreign currency) f decreases if P increases. The reduction in the price competitiveness of our products internationally tends to decrease our exports and increase our imports.

This makes our products relatively less expensive. The relative price of foreign products (or P e / P P real exchange rate value of foreign currency) f increases if f increases more

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than P. The increase in the price competitiveness of our products internationally tends to increase our exports and decrease our imports.

288.

The real exchange rate value of the dollar increased from 90 to 105, so the U.S. dollar had a real appreciation. The United States lost international price competitiveness. (For  P  e / P the import and export functions shown in equations 22.13 and 22.14, the ratio f is an indicator of the U.S. international price competitiveness. Stated this way, the real exchange rate is measuring the real exchange rate value of the foreign (rest of the world) currency—the nominal exchange rate e is valuing foreign currency and the foreign P currency product price index f is in the numerator. The rest of the world experienced a real depreciation (from 111 to 95), so the rest of the world gained international price competitiveness.) A change in international price competitiveness drives a change in the country’s net exports and current account, so the IS and FE curves shift. A decline in U.S. international price competitiveness tends to decrease U.S. exports and to increase U.S. imports. Aggregate demand for U.S. products decreases, so the IS curve shifts to the left.

The current account balance tends to deteriorate, so the FE curve shifts to the left.

289.

The size of the spending multiplier for this nonstandard small open economy is smaller.

Consider the situation in which the government purchases an extra $1 of goods and services. How much of this initial increase in spending and income will be transmitted into additional production and income in the next round? In the standard economy, people in the country save $0.25 (s) and import $0.15 (m), so the extra production and income in the next round would be $0.60 (1 − s − m). Instead, in this nonstandard economy there is an additional effect, exports decrease by $0.10 (z), so the extra production and income in the next round is only $0.50 (1 − s − m + z), where is z = −0.1.

Each successive round of production and income are smaller for the nonstandard economy, so the spending multiplier is smaller. The mathematical expression for the spending multiplier for this country with the unusual export behavior is 1/  s  m  z  . If z is negative, then this nonstandard spending multiplier is less than the standard multiplier 1/  s  m  .

Chapter 23 Internal and External Balance With Fixed Exchange Rates Overview This chapter presents the analysis of the macroeconomy of a country that has a fixed exchange rate. As noted in the introduction, this analysis is important because some countries currently have fixed exchange rates or floating rates that are so heavily managed that they resemble fixed rates, and because there are ongoing discussions of proposals to return to a system of fixed rates among the world's major currencies. We focus on defense of the fixed exchange rate through official intervention in the foreign exchange market.

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To see the effects of defense through intervention, it is useful to describe the balance sheet of the country's central bank. The central bank holds two types of assets relevant to our discussion— official international reserve assets (R) and domestic assets (D). Its two relevant liabilities are domestic currency and deposits that (regular) banks place with the central bank. These two liabilities are the country's monetary base. With fractional reserve banking by regular banks, the country's money supply can be a multiple of the size of its base of "high-powered money."

When the country has an official settlements balance surplus, and its central bank intervenes to prevent its currency from appreciating, the central bank must sell domestic currency and buy foreign currency. This increases the central bank's holdings of official reserves and increases its liabilities as the domestic currency is added to the economy. The domestic money supply increases, probably by a multiple of the size of the intervention. If the money supply expands, then in the short run interest rates decrease. The financial account tends to deteriorate, and the increase in real spending and income increases the demand for imports, so the current account balance also tends to decrease. The overall payments surplus decrease. This is pictured as a downward shift in the LM curve toward a triple intersection of the new LM curve and the initial IS and FE curves. (In addition, the price level is likely to increase, at least beyond the short run, so that the current account also deteriorates as the country loses some international price competitiveness.) Intervention to prevent a currency from depreciating (in the face of an overall payments deficit) causes the opposite changes.

Rather than allowing these automatic adjustments toward external balance, the monetary authority can resist by sterilization—taking an offsetting domestic action (like an open market operation) to reduce or eliminate the effect of the intervention on the domestic money supply.

This is a wait-and-see strategy. There are limits to how long the country can continue to run an overall payments imbalance. A key implication of this discussion is that a fixed exchange rate greatly constrains a country's ability to pursue an independent monetary policy, because the monetary policy must be consistent with maintaining the fixed rate.

A change in fiscal policy has two opposing effects on the country's overall payments balance.

For instance, a shift to expansionary fiscal policy tends to increase both interest rates and real GDP, so the financial account tends to improve while the current account tends to deteriorate. If the former predominates, then the country's overall payments tend to go into surplus. If not sterilized, the intervention to defend the fixed exchange rate expands the domestic money supply, further expanding demand, domestic product, and income. In this case, fiscal policy gains effectiveness to change real GDP. If the latter effect is larger (as it may be after a short period of time), then the opposite occurs. Both cases are shown as a shift first in the IS curve, with the position of the new IS–LM intersection being above or below the FE curve, depending on how steep or flat the FE curve is. The intervention then shifts the LM curve to a new triple intersection.

In the extreme case of perfect capital mobility (and with investors expecting the fixed rate to be maintained), monetary policy has no independent effectiveness even in the short run, while fiscal policy has a strong (full spending multiplier) effect on real GDP. The FE curve is a flat line, and the LM curve is effectively this same flat line.

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We can examine how shocks affect the economy of a country with a fixed exchange rate. A domestic monetary shock has a limited effect. A change in fiscal policy is an example of a domestic spending shock. An international capital flow shock shifts the FE curve. The intervention to defend the fixed exchange rate results in effects on the domestic economy.

International trade shocks tend to cause payments imbalances that require intervention that changes the domestic money supply in the way that magnifies the effect of the shock on real GDP. Countries often face both external and internal imbalances. Two combinations (high unemployment–payments surplus and excessive inflation–payments deficit) can be addressed with a change in government policy (expansionary or contractionary) but the other two seem to pose dilemmas. A possible short-run solution is a monetary–fiscal policy mix that follows the assignment rule. The change in monetary policy should address the external imbalance and the change in fiscal policy should address the internal imbalance. In practice countries often find it difficult or impossible to apply the assignment rule.

In the face of a payments imbalance, a country's government that is not willing to adjust domestic policies and the domestic economy may conclude that surrendering—changing or abandoning the fixed exchange rate—is best. For instance, with an overall payments deficit the country could devalue its currency. The devaluation should improve international price competitiveness, so net exports increase. This tends to decrease the payments deficit, and also to increase demand and domestic product. We can picture this as a rightward shift of the FE and IS curves. A key challenge for the country is to prevent the devaluation and the subsequent increase in demand from causing so much domestic inflation that it eliminates the gain in international price competitiveness.

The effect of a large, abrupt change in the exchange rate on the value of the country's current account (or trade) balance is not straightforward. The value of the country's current account, measured in foreign currency (superscript fc), is CA  Pfc x  X  Pfc m  M . The effects of a devaluation of the country's currency are: (1) no change or decrease in the foreign currency price of its exports  P fc x  , (2) no change or increase in the volume of exports (X), (3) no change or decrease in the foreign currency price of its imports  P fc m  , and (4) no change or decrease in the

volume of imports (M). The response of the trade balance could be unstable (that is, the value of the balance could decline rather that improve) if the decrease in the foreign currency price of exports is large relative to the other changes—an extreme example is perfectly inelastic demands for exports and imports. The response will generally be stable (the balance will improve), at least if we allow enough time, because sufficiently high elasticities result in large enough changes in the trade volumes. One extreme example is the small-country case in which foreign elasticities are infinite so that foreign currency prices are fixed. (Appendix H derives a general formula relating demand and supply elasticities to the change in the value of the current account. It also discusses specific cases and the Marshall–Lerner condition.)

After a currency devaluation we generally expect that the country’s trade balance deteriorates at first, because the price changes occur quickly while trade quantities change more slowly. After a moderate time period, the volume effects become large enough that the balance improves. In this 163 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

case, the response of the current account balance to a devaluation of the country's currency traces out a pattern called the J curve.

Tips The text includes the t-account showing the relevant assets and liabilities of a central bank. In class presentations, an instructor may want explicitly to use t-accounts to show the changes in assets and liabilities that accompany unsterilized intervention and sterilized intervention.

The analysis of each policy change or economic shock is deliberately presented first using schematics and words, and only then using the IS-LM-FE graph. Our goal is to impart the process of thinking logically about international macroeconomics. We believe that the graph is a great tool for organizing thinking, but it is not a substitute for understanding the logic of the relationships. Indeed, some instructors may wish to make the IS-LM-FE graphs optional if these are inappropriate for the preparation of the students and the objectives of the class. We believe that it is possible to present this material using both class discussion and the text while indicating to students that the IS-LM-FE graphs are not required and will not be tested.

The box ―A Tale of Three Countries‖ provides an application of the fixed rate analysis to the experiences during the early 1990s of Germany, France, and Britain in the Exchange Rate Mechanism of the European Monetary System. Germany, the lead country, focused its policies on domestic performance issues arising from German unification. France successfully defended the pegged rate of the franc to the mark, but at substantial costs in terms of domestic macroeconomic performance. Britain surrendered and the depreciation of the pound permitted the British economy to reduce its unemployment rate, even as the unemployment rates in France and Germany continued to rise.

Appendix G uses the aggregate demand–aggregate supply framework to examine some of the same issues analyzed using the IS-LM-FE model. In the presentation in Appendix G, the aggregate demand curve incorporates the effects of any unsterilized intervention to defend the fixed exchange rate. In addition to the four types of shocks analyzed in the text and a devaluation, Appendix G also examines shocks to aggregate supply.

Suggested answer to case study discussion question A Tale of Three Countries: (a) If Germany had raised taxes in 1991, then the story probably would have turned out better. If Germany raised taxes, then more of the effort to restrain the excessive growth and overheating of the German economy would have been driven by a shift to the left of Germany’s IS curve (from IS2 back toward IS1 ), so less of the restraint would have come from the tightening of German monetary policy (Germany’s new LM 3 would be to the right of the LM 3 shown in the box). German interest rates would not have risen so much (maybe not at all). There would have been less (or no) pressure on France and Britain to tighten their monetary policies to try to match rising German interest rates. (b) If, instead, France had reduced taxes in 1991, the story also probably would have turned out better (at least for France). France 164 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

could have used the assignment rule. Direct monetary policy to achieve external balance—in this case, the French LM curve would still shift toward the left as German interest rates increased.

Direct fiscal policy to address internal balance, which in this case required expansion of aggregate demand and real GDP. With a tax cut, France’s IS curve would shift to the right from IS1 . The decline in France’s GDP could have been resisted and possibly prevented.

Suggested answers to end-of-chapter questions and problems 290.

Disagree. The risk is rising unemployment, not rising inflation. The deficit in its overall international payments puts downward pressure on the exchange rate value of the country’s currency. The central bank must intervene to defend the fixed exchange rate by buying domestic currency and selling foreign currency in the foreign exchange market.

As the central bank buys domestic currency, it reduces the monetary base and the country’s money supply falls. The tightening of the domestic money supply puts upward pressure on the country’s interest rates. Rising interest rates reduce interest-sensitive spending, lowering aggregate demand, domestic product, and national income. The risk is falling real GDP and rising unemployment.

291.

The increase in government spending affects both the current account and the financial account of the country's balance of payments. The increase in government spending increases aggregate demand, production, and income. The increase in income and spending increases the country's imports, so the current account tends to deteriorate (to become a smaller positive value or a larger negative value). The increase in production, income, and spending increases the demand for money. If the country's central bank does not permit the money supply to expand, then interest rates increase. (Similarly, the increase in the government budget deficit requires the government to borrow more to finance its deficit, increasing interest rates.) The increase in interest rates increases the inflows of financial capital into the country (and decreases outflows), so that the financial account improves.

We are not sure about the effect of the policy change on the country's official settlements balance. It depends on the sizes of the changes in the two accounts. If the financial account improvement is larger (as we often expect in the short run), then the official settlements balance goes into surplus. If the current account deterioration is larger (as we often expect in the long run), then the official settlements balance goes into deficit.

If the official settlements balance goes into surplus, then the central bank must defend the fixed exchange rate through intervention by buying foreign currency and selling domestic currency. As the central bank sells domestic currency, this expands the domestic money supply if the intervention is unsterilized. This reinforces the expansionary thrust of the increase in government spending.

If the official settlements balance goes into deficit, then the central bank must defend the fixed exchange rate through intervention by selling foreign currency and buying domestic currency. As the central bank buys domestic currency, this contracts the domestic money supply if the intervention is unsterilized. This tends to reduce the expansionary thrust of the increase in government spending.

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292.

Perfect capital mobility essentially eliminates the country’s ability to run an independent monetary policy. The country must direct its monetary policy to keeping its interest rate in line with foreign interest rates. If it tried to tighten monetary policy, its interest rates would start to increase, but this would draw a massive inflow of capital. To defend the fixed exchange rate, the central bank would need to sell domestic currency into the foreign exchange market. This would increase the domestic money supply, forcing the central bank to reverse its tightening. If it tried to loosen monetary policy, interest rates would begin to decline, but the massive capital outflow would require the central bank to defend the fixed rate by buying domestic currency. The decrease in the domestic money supply forces the central bank to reverse its loosening.

Perfect capital mobility makes fiscal policy powerful in affecting domestic product and income in the short run. For instance, expansionary fiscal policy tends to increase domestic product, but the increase in domestic product could be constrained by the crowding out of interest-sensitive spending as interest rates increase. With perfect capital mobility the domestic interest rate cannot rise if foreign interest rates are steady, so there is no crowding out. Domestic product and income increase by the full value of the spending multiplier.

293.

The assignment rule says that a country with a fixed exchange rate can pursue both external balance and internal balance by assigning fiscal policy the task of achieving internal balance and assigning monetary policy the task of achieving external balance.

The possible advantages of the assignment rule include: (1) It provides clear guidance to both types of policy, so that they can address macroeconomic stabilization even in cases in which apparent policy dilemmas exist, and (2) It directs each type of policy to focus on the target that each tends to care more about. The possible disadvantages of the assignment rule include: (1) It depends on the effect of interest rates on international capital flows, so that it will not work if capital flows are not that responsive to interest rate changes, or it may not work beyond the short-run period, because in the long run, capital flows stop responding or tend to reverse, (2) lags in policy responses could destabilize the economy rather than stabilize it, (3) it may not be politically possible in some countries to run monetary policy separately from fiscal policy, (4) it may not be politically possible in some countries to run fiscal policy to address economic objectives such as internal balance, and (5) the policy mix can result in high domestic interest rates that can reduce domestic real investment and slow the growth of the country's supply capabilities in the long run.

294.

Agree. Consider the value of the country’s current account measured in foreign currency (superscript F ): CAF  ( PFx  X ) – ( PFm  M ) According to the logic of the J-curve analysis, the price changes resulting from the exchange rate change occur first, and the effects on export and import volumes occur more slowly. The revaluation quickly increases the foreign-currency price of the country’s exports (because it now takes more foreign currency to yield the same homecurrency price). Therefore, the current account improves in the months immediately after the revaluation. (Eventually, the revaluation leads to a decrease in export volume, an

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increase in import volume, and perhaps an increase in the foreign-currency price of imports, so eventually the current account value is likely to decrease.)

295.

a.

Pugelovian holdings of official international reserves decrease by $10 billion, a decline in holdings of foreign-exchange assets (assuming that the Pugelovian central bank did not just borrow the dollars used in the intervention).

The Pugelovian central bank is also buying pnuts in the intervention, so the Pugelovian money supply declines. Because this is removing high-powered money from the Pugelovian banking system, the Pugelovian money supply decreases by more than the size of the intervention, with the actual decrease depending on the size of the money multiplier.

The Pugelovian money supply does not change (or does not decrease as much) if the Pugelovian central bank sterilizes. To sterilize the intervention, the Pugelovian central bank would buy Pugelovian government bonds. As the central bank pays for the bonds, it is adding high-powered Pugelovian money back into the banking system. If it adds back the amount that was removed by the intervention, then the overall amount of highpowered money in the economy is unchanged, and the regular money supply can also be unchanged.

296.

a.

The FE curve shifts to the right or down.

The capital inflows drive the country’s overall international payments into surplus. They put upward pressure on the exchange rate value of the country’s currency. The central bank must intervene to defend the fixed exchange rate by selling domestic currency in the foreign exchange market.

As the central bank intervenes by selling domestic currency in the foreign exchange market, the country’s monetary base and its money supply increase. The increase in the money supply lowers domestic interest rates. The lower interest rates encourage interest-sensitive spending, raising aggregate demand, domestic product, and income. External balance is reestablished through two adjustments. First, domestic product and income are higher, so imports increase. Second, the country’s interest rates are lower, so the capital inflows are discouraged and capital outflows are encouraged.

The increase in the country’s domestic product and income alters its internal balance. If the country began with high unemployment, then this would be welcome as a move toward internal balance. If, instead, the country does not have the resources to produce the extra output, the country would develop the internal imbalance of rising inflation as the economy tries to expand and overheats.

In the IS-LM-FE graph below the increased capital inflows shift the FE curve to the right to FE ' . The country’s international payments are then in surplus as the E intersection of the original IS and LM curves at 0 is to the left of FE ' . The intervention to defend the fixed rate shifts the LM curve down (or to the right). External E balance is reestablished at the new triple intersection 1 .

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297.

a.

If the country's financial account is always zero, then the country's interest rates have no direct effect on the country's balance of payments. The FE curve is a vertical line. (The country's overall payments balance is the same as its current account balance.

The current account balance is affected by the country's domestic product and income through the demand for imports, but it is essentially not affected directly by the country's interest rates.)

The increase in foreign demand for the country’s exports shifts the IS curve to the right to IS' in the accompanying graph. The shock increases demand for the country's products, so domestic product and income tend to rise. The increase in foreign demand for the country’s exports shifts the FE curve to the right also, to FE ' . At the initial level of income and domestic product, the current account and the overall payments balance go into surplus. A zero balance can be reestablished on the new FE ' curve by increasing imports through an increase in domestic product and income. The LM curve is not directly affected, if this shock does not directly change money supply or money demand.

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The rightward shift of the IS curve results in a new IS'– LM intersection with some increase in the level of domestic product. The increase in domestic product and income also increases the country's imports. To proceed, let's examine the "normal" case in which the country then has a current account and overall payments surplus, because the increase in exports is larger than the initial increase in imports. This means that the intersection of the original LM curve and the new IS' curve at E ' is to the left of the new FE ' curve. If the country's official settlements balance goes into surplus, then the country's central bank must intervene to defend the fixed exchange rate by buying foreign currency and selling domestic currency.

Assuming that the intervention is not sterilized, the intervention increases the country's money supply. The LM curve shifts to the right (or down). The country returns to external balance at the triple intersection E " when the LM curve has shifted to LM ' . The Y to Y1 country's domestic product and income have increased, from 0 . If the country initially began with a high unemployment rate, then this is a movement toward internal balance. If the country initially began with internal balance or with an inflation rate that was considered too high, then this is a move away from internal balance, because the extra foreign and domestic spending on the country's products tends to drive the inflation rate up as the stronger demand exceeds the economy's supply capabilities.

298.

The country initially has an overall payment deficit. In the IS-LM-FE graph below, the IS–LM intersection at point A is to right of the FE curve. (The FE curve is steeper than the LM curve because international capital flows are relatively unresponsive to changes in interest rates.) If the country’s central bank does nothing else, it would have to intervene in the foreign exchange market to defend the fixed exchange rate value because the country’s currency is under pressure to depreciate. The central bank would need to buy domestic currency and sell foreign currency (e.g., U.S. dollars). If the country does not sterilize, then the country’s LM curve will slowly shift to the left, and eventually the payments deficit will be eliminated when the LM curve reaches LM ' , with the new triple intersection at point E. But, if the country uses its international reserve holdings as the source of the foreign currency it sells in the intervention, then the country’s holdings of official international reserves will decrease.

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Is there anything that the central bank can do to avoid (or to minimize) the loss of international reserves? The central bank could take a domestic action to shift the LM curve more quickly to the left. For example, the central bank could use domestic open market operations to sell national government bonds, and the domestic money supply will shrink more quickly. The LM curve will shift to the left. The overall payments deficit will decrease more quickly, with less intervention to defend the fixed-rate value and less loss of international reserves. In the graph, the domestic monetary action shifts the LM curve quickly to LM ' . (Another possibility is that the country’s central bank could borrow the foreign currency, for example, from other central banks. Its gross holdings of official reserve assets would remain steady, but its holdings net of what it owes would decrease, and it will eventually need to repay the loans.)

299.

a.

Sterilized intervention would allow the situation to continue for a while, but it would not address the initial macroeconomic situation in the sense of resolving it. The initial macroeconomic situation is shown in the graph. The country’s initial IS0 curve Y intersects the country’s initial LM 0 curve at point E, with the level of real GDP 0 being Y greater than the full-employment level full . The country has an overall payments surplus because point E is to the left of (or above) the country’s initial FE 0 curve. The country must intervene to defend the fixed exchange rate by buying foreign currency and selling domestic currency in the foreign exchange market. The country’s central bank sterilizes the intervention by taking a domestic action (e.g., by selling domestic government bonds in an open market operation) to remove the domestic currency, so the country’s money supply does not expand. The LM curve does not shift, so both the external imbalance (payments surplus) and the internal imbalance (excessive aggregate demand) continue. (If the country actually does experience more product price inflation because of the excessive aggregate demand, then the country’s rising domestic product prices over time would reduce the country’s international price competitiveness. Eventually, the IS curve and FE curve then would shift to the left.)

170

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The country can use a change in the fixed exchange rate value to address the international payments surplus. The country should revalue its currency (increase the exchange rate value of the currency). The revaluation will reduce the country’s international price competitiveness, shifting the IS curve to the left from IS0 to IS , and shifting the FE curve to the left from FE 0 to FE . The correct size of revaluation will establish external balance at point E , the triple intersection of IS, FE , and LM 0 . The revaluation will also tend to reduce the internal imbalance, in the sense that real GDP declines from

Y0 to Y 

. As

shown in the graph, the new level of GDP Y  is closer to the full-employment value

300.

Yfull

.

a.

Tighten fiscal policy to address the internal imbalance of rising inflation and tighten monetary policy to address the external imbalance of the deficit.

Tighten fiscal policy to address the internal imbalance of rising inflation and loosen monetary policy to address the external imbalance of the surplus.

Loosen fiscal policy to address the internal imbalance of low demand and loosen monetary policy to address the external imbalance of the surplus.

301.

a. is:

The value of the Pugelovian current account, measured in foreign currency units, CA  Pfc x  X  Pfc m  M .

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If there is no change in quantities demanded (X and M are unchanged), then export and import markets must clear at the same supply prices. Pugelovian exporters receive the same competitive export price (measured in Pugelovian pnuts), so that the foreigncurrency price of Pugelovian exports  P fc x  falls when the Pugelovian currency is devalued. Also, the foreign suppliers of Pugelovia's imports continue to charge the same fc foreign currency supply price ( P m is unchanged). Thus, the Pugelovian current account deficit becomes larger, because the foreign-currency value of Pugelovian exports declines, and the foreign-currency value of Pugelovian imports is unchanged. Because the import demand elasticities are low (actually, zero), the response of the current account balance to the devaluation is perverse (it deteriorates rather than improves).

If Pugelovian firms keep the pnut prices of their exports the same, then the devaluation results in a decrease in the foreign-currency price of Pugelovian exports  P fc x  .

Generally, foreign buyers will buy a larger quantity of Pugelovian exports (X increases).

If foreign firms keep the foreign-currency prices of their exports  P fc m  the same, then the devaluation results in a higher pnut price of imports in Pugelovia. Generally, Pugelovian buyers will buy a smaller quantity of imports (M falls). In this case, the Pugelovian current account could deteriorate, stay the same, or improve. Given the price changes (especially the decrease in the foreign-currency price of Pugelovian exports), the change in the value of the Pugelovian current account depends on the size of the responses in quantities demanded. If the responses are large enough (X rises and M falls enough), then the value of the Pugelovian current account deficit will decrease (its current account will improve). If the responses are small (X increases and M decreases only a little), then the value of the deficit will increase (the current account will deteriorate). The quantity changes are larger if the price elasticities of import demand in the two countries are larger (in absolute values).

Chapter 24 Floating Exchange Rates and Internal Balance Overview This chapter presents the analysis of the macroeconomy of a country that has a floating exchange rate. If government officials allow the exchange rate to float cleanly, then the exchange rate changes to achieve external balance.

With floating exchange rates monetary policy exerts strong influence on domestic product and income. A change in monetary policy results in a change in the country's interest rates. Both the current account and the financial account tend to change in the same direction. To keep the overall payments in balance, the exchange rate must change. The exchange rate change results in a change in international price competitiveness, assuming that it is larger or faster than any change in the country's price level—overshooting. The change in price competitiveness results in a change in net exports that reinforces the thrust of the change in monetary policy. We can 172 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

picture the change in monetary policy as a shift in the LM curve, and then a shift in the IS and FE curves to a new triple intersection as the exchange rate and price competitiveness change.

With floating exchange rates, the effect of a change in fiscal policy depends on how responsive international capital flows are to changes in interest rates. If capital flows are sufficiently responsive, then the exchange rate changes in the direction that counters the thrust of the fiscal policy change—an effect sometimes called international crowding out. If capital flows are not that responsive (or, as we enter into the longer time period when the capital flows have slowed), the change in the current account dominates, so that the exchange rate changes in the direction that reinforces the thrust of the fiscal policy change. Both cases are shown as a shift in the IS curve, with the position of the intersection between the new IS curve and the LM curve being above or below the initial FE curve, depending on how flat or steep the FE curve is. The exchange rate change then shifts both the IS and FE curves toward a new triple intersection.

Domestic monetary shocks have strong effects on domestic product, with the exchange rate change reinforcing the thrust of the shock. The effects of domestic spending shocks depend on how responsive international capital flows are to changes in interest rates. International capital flow shocks affect the domestic economy by changing the exchange rate and the country's international price competitiveness. International trade shocks result in changes in the exchange rate that mute the effects of these shocks on domestic product.

While a cleanly floating exchange rate ensures external balance, it does not ensure internal balance, and changes in the floating exchange rate to achieve external balance can exacerbate an internal imbalance. Government monetary or fiscal policies may be used to address internal imbalances.

Changes in government policies adopted by one country can have spillover effects on other countries. International macroeconomic policy coordination involves some degree of joint determination of several countries' macroeconomic policies to improve joint performance.

Efforts at policy coordination in the late 1970s and 1980s include the agreement at the Bonn Summit of 1978, the Plaza Agreement of 1985, and the Louvre Accord of 1987, but major efforts at coordination are infrequent. Countries disagree about goals and about how the macroeconomy works, and the benefits of coordination often are probably rather small.

The box ―Can Governments Manage the Float?‖ discusses whether selective intervention which is often sterilized can have significant effects on floating exchange rates between the major currencies. The conventional wisdom in the early 1980s was that sterilized intervention was ineffective, but several studies in the early 1990s challenged that conclusion. Recent studies use recently released data on daily intervention. The general conclusions are that intervention is usually effective for a number of days, but often there is no effect one month later, and that larger interventions and coordinated interventions tend to be more effective.

The chapter has the final two boxes in the series on the global financial and economic crisis. The box ―Liquidity Trap!‖ examines the challenge for monetary policy when the country’s short-term nominal interest rate hits the lower bound, and the use of quantitative easing as an unconventional monetary policy to try to escape the trap. The box ―Central Bank Liquidity Swaps‖ describes the coordinated efforts by central banks to use a new kind of swap line to 173 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

address dollar shortages in foreign financial systems that arose during the crisis. The U.S. Fed essentially lends dollars to foreign central banks so they can lend these dollars to their banks.

Tips This chapter is deliberately organized to parallel that of the previous Chapter 23 to the extent possible. This allows for carryover of students' insights and capabilities through Chapters 22, 23, and 24. It also results in clear contrasts between the behavior of a macroeconomy that has a fixed exchange rate and one that has a floating exchange rate. The contrasts in the effects of shocks are summarized in Figure 24.7, and other contrasts are reviewed in the next Chapter 25.

The method of analysis of policy changes and shocks used in the text is a bit mechanical, but it does seem to assist students in grasping the implications of floating exchange rates. We deliberately follow the same sequence for each change or shock: (1) the effects of the shock on the economy if (hypothetically) the exchange rate were unchanged, (2) the resulting pressure that causes a change in the floating exchange rate, and (3) the (additional) effects on the economy of this exchange rate change.

In presenting this material, one should probably offer cautions that the effects do not always play out as suggested by the theory, because floating exchange rates do not always move in the directions indicated. This may be due to changes in investors' expectations of future exchange rates that are not captured by the approach, or it may be due to other shocks and news that are also influencing exchange rates.

The box ―Why Are U.S. Trade Deficits So Big?‖ provides an application of the floating-rate analysis to the macroeconomic experience of the United States since 1980. The box shows that changes in the real exchange rate and changes in the trade deficit (with the expected lag) have been closely correlated. Digging behind this relationship to examine saving and real investment, it appears that the large U.S. trade deficits were the result of government budget deficits in the 1980s, and were the result of a real investment boom in the late 1990s, with fiscal deficits again becoming important in the early 2000s.

Appendix G uses the aggregate demand–aggregate supply framework to examine the effects of shocks, with the AD curve incorporating the effects of the induced change in the floating exchange rate to maintain external balance.

Suggested answers to case study discussion questions Why Are U.S. Trade Deficits So Big? The U.S. trade deficit will decrease. If the government budget deficit will decrease, then national saving will increase. If domestic real investment will decrease, and national saving will increase, then the United States will need less foreign financial capital inflows. The United States reduces its borrowing from foreigners—less is needed to fund the decreased government budget deficit and decreased domestic real private investment. With decreased financial capital inflows, the trade deficit tends to decrease. (In a floating rate system, the country achieves external balance. If the financial account becomes less positive, then the 174 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

current account must become less negative.) Using our model, a decrease in domestic real investment shifts the IS curve to the left, and a shift to contractionary fiscal policy (if it is the cause of the decreased government budget deficit) shifts the IS curve further to the left.

Can Governments Manage the Float? Here is some additional background. The tsunami killed more than 15,000 people and caused hundreds of billions of dollars of property damage. The Japanese economy was weakened, with real GDP declining as production was severely disrupted. Yet, the exchange rate value of the Japanese yen increased in the week after the tsunami. Trading positions in the foreign exchange market seemed to be dominated by the expected need for Japanese insurance companies and other entities to sell off foreign financial investments and brings funds back into Japan. Japanese investors then would be selling foreign currency and buying yen. The yen was expected to appreciate in the future, so the yen actually appreciated immediately.

The Japanese government was concerned that the yen appreciation would hurt Japan’s international price competitiveness at a time when the Japanese economy was already severely weakened by the tsunami. The rapid appreciation of the yen did not seem to be consistent with economic fundamentals, but rather the appreciation was driven by financial expectations that had begun to feed on themselves. The Japanese government decided that it should intervene, and this seems like a sensible decision. To weaken the yen, the monetary authority should sell Japanese yen and buy foreign currencies like the U.S. dollar. To increase the effect of the intervention, it should be large, and, if possible, it should be carried out by a number of central banks in a coordinated fashion.

This is what did happen. On March 18, the monetary authorities of Japan, the United States, Britain, Canada, and the euro area conducted a coordinated intervention totaling about $10.4 billion. Within an hour of the announcement of the impending intervention, the yen depreciated 3% to 4% and then stayed at the lower exchange rate values for the next week.

Suggested answers to end-of-chapter questions and problems 302.

Agree. The change in the exchange rate that occurs when there is a change in monetary policy is the basis for the enhanced effectiveness of monetary policy under floating exchange rates. For instance, when monetary policy shifts to be more expansionary, the decrease in the country’s interest rate results in a depreciation of the country’s currency.

This is essentially overshooting (although overshooting also emphasizes that this depreciation is very large). It is overshooting relative to the path of the exchange rate implied by PPP, so that the depreciation improves the country’s international price competitiveness. The improvement in price competitiveness enhances the effectiveness of the policy. The country exports more and shifts some of its spending from imports to domestic products, further increasing aggregate demand, domestic product, and income.

303.

The increase in government spending affects both the current account and the financial account of the country's balance of payments. The increase in government spending increases aggregate demand, production, and income. The increase in income and spending increases the country's imports, so the current account tends to deteriorate 175

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(become a smaller positive value or a larger negative value). The increase in production, income, and spending also increases the demand for money. If the country's central bank does not permit the money supply to expand, then interest rates increase. (Similarly, the increase in the government budget deficit requires the government to borrow more to finance its deficit, increasing interest rates.) The increase in interest rates increases the inflows of financial capital into the country (and decreases outflows), so that the financial account tends to improve.

The effect of this policy change on the exchange rate value of the country's currency depends on the effect on the official settlements balance. However, we are not sure about the effect of the policy change on the country's official settlements balance. It depends on the sizes of the changes in the two accounts. If the financial account improvement is larger (as we often expect in the short run), then the official settlements balance tends to go into surplus. If the current account deterioration is larger (as we often expect in the long run), then the official settlements balance tends to go into deficit.

If the official settlements balance tends to go into surplus, then the exchange rate value of the country's currency increases. The country loses international price competitiveness, and net exports tend to decrease. This reduces the expansionary thrust of the increase in government spending.

If the official settlements balance tends to go into deficit, then the exchange rate value of the country's currency decreases. The country gains international price competitiveness, and net exports tend to increase. This reinforces the expansionary thrust of the increase in government spending.

304.

Disagree. Under floating exchange rates the decrease in our exports reduces demand for our currency in the foreign exchange market, so our currency depreciates. The depreciation improves our international price competitiveness, so exports tend to rebound somewhat, and some spending is shifted from imports to domestic products. This increase in aggregate demand counters the initial drop in demand for our exports, so the adverse effect on our domestic product and income is lessened. This exchange rate adjustment is not possible if the exchange rate is fixed. In addition, with a fixed exchange rate our overall international payments go into deficit when our exports decline. The central bank then intervenes to defend the fixed rate by buying domestic currency. The reduction in the domestic money supply raises our interest rate and makes the decline in our domestic product larger.

305.

The decrease in demand for money tends to reduce domestic interest rates. The lower domestic interest rates encourage borrowing and spending, so domestic product and income increase because of the increase in domestic expenditure. The country's current account tends to deteriorate because the increase in domestic product and income increases imports. In addition, the country's financial account tends to deteriorate, because the lower domestic interest rates encourage a capital outflow. As the country's official settlements balance tends to go into deficit, the exchange rate value of the country's currency depreciates. The country gains international price competitiveness, and net exports tend to increase. This reinforces the expansion of domestic product and income.

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Under fixed exchange rates, the central bank instead must resist the downward pressure on the exchange rate value of the country's currency by intervening in the foreign exchange market—the central bank must buy domestic currency and sell foreign currency. In buying domestic currency, the central bank reduces the domestic money supply (assuming that it does not sterilize). The contraction of the domestic money supply tends to counter the initial expansion of domestic product and income.

306.

The tendency for the overall international payments to go into deficit puts downward pressure on the exchange rate value of the country’s currency, and it depreciates. This moves the country further from internal balance. The depreciation of the currency tends to increase aggregate demand by making the country’s products more price-competitive internationally. The extra demand adds to the inflationary pressure. In addition, the depreciation raises the domestic-currency price of imports, adding to the inflation pressure.

307.

a.

The contractionary monetary policy increases domestic interest rates, so borrowing and spending decrease. Domestic product and income tend to decline. The decline in demand puts downward pressure on the British inflation rate.

The increase in British interest rates draws a capital inflow, so Britain's financial account tends to improve. The decrease in British product and income reduces imports, so Britain's current account tends to improve. Thus, Britain's overall payments tend to go into surplus, so the exchange rate value of the pound tends to increase (the pound tends to appreciate).

As the pound appreciates, Britain tends to lose international price competitiveness (assuming overshooting—the currency appreciation occurs more quickly than the decline in the British inflation rate). British net exports tend to decline. This reinforces the contractionary thrust of British monetary policy on domestic product and income. In addition, it also reinforces the downward pressure on the British inflation rate, both because demand declines further, and because the appreciation tends to reduce the British pound prices of imports into Britain.

308.

a.

The increase in taxes reduces disposable income and reduces aggregate demand.

U.S. domestic product and income will fall (or be lower than they otherwise would be). If national income is lower, spending on imports will be lower, so the U.S. current account will improve. The increase in taxes reduces the government budget deficit. The government borrows less, and U.S. interest rates are lower. If international capital flows are responsive to changes in interest differentials, then the lower U.S. interest rates lead to capital outflows (or less capital inflows). The U.S. financial account declines.

The pressures on the exchange rate value of the dollar depend on which change is larger: the improvement in the current account or the deterioration in the financial account. If the effect on capital flows is larger, then demand for dollars will decrease (relative to the supply of dollars) in the foreign exchange market, so the dollar will depreciate. If the current account change is larger, then the supply of dollars (relative to demand) will decrease, so the dollar will appreciate.

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If the dollar depreciates, then the United States gains international price competitiveness.

U.S. exports increase and imports decrease. The current account improves further. The increase in exports and shift of domestic spending from imports to domestic products add some aggregate demand, so domestic product and income rebound somewhat (or do not decline by as much).

309.

The increase in the foreign money supplies tends to lower foreign interest rates. The lower foreign interest rates spur borrowing and spending in foreign countries. The increase in foreign product and income increases the demand for imports, so our exports increase. In addition, the exchange rate values of foreign currencies decline, so that our currency appreciates. Foreign currencies depreciate because the overall foreign payments tend to go into deficit. The foreign current accounts tend to decline as foreign imports increase, and the foreign financial accounts tend to decline as the lower foreign interest rates spur capital outflows. The appreciation of our currency lowers our international price competitiveness, so our net exports tend to decrease. This counters the more direct effect of changes in international trade on our domestic product and income. This is an example of how floating exchange rates tend to reduce the domestic impact of an international shock, in this case, a foreign monetary shock.

310.

a.

The FE curve shifts to the right or down.

The country’s international payments tend toward surplus. The extra demand for the country’s currency leads to its appreciation.

The appreciation reduces the country’s international price competitiveness, so the country’s exports decrease and its imports increase. The current account worsens, reducing the overall surplus. In addition, the decrease in aggregate demand as the current account worsens reduces domestic product and income. Money demand declines and the country’s interest rate declines. The decline in the interest rate discourages some capital inflow or encourages some capital outflow. The financial account worsens, so the overall surplus also falls for this reason. The combined effects on the current and financial accounts reestablish external balance. The declines in aggregate demand and domestic product affect the county’s internal balance. If rising inflation was initially a problem, then this change is desirable. However, the decrease in aggregate demand could instead create or add to an internal imbalance of high unemployment.

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In the graph above the increased capital inflows shift the FE curve to the right or down to FE ' . The country’s currency appreciates, so the FE curve shifts back to the left somewhat to FE " , and the IS curve shifts to the left to IS" as the country loses E international price-competitiveness. The new triple intersection is at point 2 . External balance is reestablished, the interest rate is lower, and domestic product is lower, relative E to the initial equilibrium at point 0 .

311.

a.

The increase in foreign demand for the country’s exports shifts the IS curve to the right to IS' in the accompanying graph. The shock increases demand for the country's products, so domestic product and income tend to rise. The increase in foreign demand for the country’s exports shifts the FE curve to the right also, to FE ' . At the initial level of income and domestic product, the current account and the overall payments balance go into surplus. A zero balance can be reestablished on the new FE ' curve by increasing imports through an increase in domestic product and income. The LM curve is not directly affected, if this shock does not directly change money supply or money demand.

The rightward shift of the IS curve results in a new IS'– LM intersection with some increase in the level of domestic product. The increase in domestic product and income also increases the country's imports. To proceed, let's examine the "normal" case in which the country then tends to have a current account and overall payments surplus, because the increase in exports is larger than the initial increase in imports. This means that the intersection of the original LM curve and the new IS' curve at E ' is to the left of the new FE ' curve. If the country's official settlements balance tends to go into surplus, then the exchange rate value of country's currency appreciates.

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The currency appreciation reduces the country's international price competitiveness, and the country's net exports decrease. As the reduction in net exports reduces demand for the country's domestic product, the IS' curve shifts back toward the original IS curve. As the current account declines with the loss of price competitiveness, the FE ' curve shifts back toward the original FE curve. If nothing else fundamental changes, then the curves shift back to their original positions, and the new triple intersection is back to the original one at E. There may be little or no effect on internal balance of all of this taken together (the international trade shock in favor of the country's exports plus the appreciation of the country's currency).

312.

a.

The central bank probably made a profit. The central bank bought pesos at $3.00/peso, sold pesos at $3.50/peso, bought pesos at $3.10/peso, and sold pesos at $3.40/peso. The central bank bought pesos low and sold them high. (You reach the same conclusion if you look at the dollar sales and purchases. The central bank bought dollars at 0.286 peso/dollar and 0.294 peso/dollar, and it sold dollars at 0.333 peso/dollar and 0.323/dollar.) To determine the exact profit or loss, you need to bring in dollar and peso interest rates.

The central bank probably made a profit. The central bank sold yen at $0.60/yen, $0.55/yen, and $0.51/yen. Then, with the exchange rate value stabilized, the central bank could, if it wanted to, buy yen to replace those it had sold, at the price $0.50/yen. The central bank sold yen high and could rebuy them low. (You reach the same conclusion if you look at dollar purchases. The central bank bought dollars at 1.67 yen/dollar, 1.82 yen/dollar, and 1.96 yen/dollar. The central bank could then sell the dollars at 2.00 yen/dollar.) To determine the exact profit or loss, you need to bring in dollar and yen interest rates.

313.

In this situation, there is a case for international macroeconomic policy coordination.

Each country is trying to gain international price competitiveness by using expansionary monetary policy to depreciate its currency—to lower the exchange rate value of its currency. Each country is trying to generate more national economic growth by exporting 180

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more and importing less. There are several ways in which international policy coordination could be useful. First, not all countries can depreciate their currencies against the other currencies. For each currency that depreciates, at least one other currency must appreciate. Uncoordinated pursuit of depreciations can lead to excessively expansionary monetary policies. And, in any case, all countries cannot succeed in exporting more and importing less. Second, using currency depreciation to grow a country’s economy is a form of beggar thy neighbor policy. It could generate retaliations by those neighbors who feel harmed. For example, those countries could raise barriers to importing from the aggressive country, and in the process harm all or most countries through a reduction in the general gains from trade. Third, this should not be a competitive situation. The countries share a common goal, to increase the rate of economic growth. With a common goal, there should be policies that that can be adopted in a coordinated manner so that all countries can achieve the growth objective. It may be that all countries should use expansionary monetary policies, but in manner that drives growth more from domestic expansion and from the reinforcing effects of foreign-income repercussions through generally rising international trade, rather than by each country trying to gain international sales at the expense of the other countries.

Chapter 25 National and Global Choices: Floating Rates and the Alternatives Overview This chapter provides a capstone to the discussion of international finance and international macroeconomics by examining the choice between fixed and floating exchange rates. Much of the discussion examines this choice from the point of view of a single country, but the discussion also examines some issues related to the functioning of the entire system.

The text examines five key issues that can influence a country's choice. Figure 25.1 presents a summary of implications of the key issues for the advantages of each policy choice.

First, different types of shocks have different effects, depending on which exchange rate policy is chosen. Internal shocks, especially domestic monetary shocks, are less disruptive to the domestic economy with a fixed exchange rate. External shocks, especially international trade shocks, are less disruptive with a floating exchange rate. If a country believes that it is mainly hit with internal shocks, it would favor a fixed rate; if it believes that it is mainly hit by external shocks, it would favor a floating rate.

Second, monetary policy is less effective as an independent policy influence on the domestic economy with a fixed exchange rate (compared to its effectiveness with a floating rate). One expression of this limitation is the trilemma—a country can have any two of a fixed exchange rate, free international capital flows, and an independent monetary policy, but a country cannot have all three. Differences in the effectiveness of fiscal policy depend on the responsiveness of capital flows to interest rate changes. The key conclusion is that a country that desires to use

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monetary policy to address domestic objectives (internal balance) will favor a floating exchange rate.

Third, countries that have their currencies linked through fixed exchange rates must achieve consistency in their macroeconomic policies, so that the fixed rate can be defended and maintained. If countries have different goals, priorities, and policies, then they will favor floating exchange rates.

Fourth, the choice of exchange rate policy is linked to inflation rates in several ways. Countries that have fixed exchange rates between their currencies are committed to having similar inflation rates in the long run (an important specific example of the third point). Proponents of fixed rates argue that this imposes a discipline effect on countries that otherwise would tend to have high inflation rates. If the price discipline is stronger on countries that would tend to inflate and run payments deficits, then the overall average global inflation rate is likely to be lower with fixed rates. On the other hand, countries that might prefer to have even lower inflation rates (than the lead country in the fixed rate system) are likely to "import inflation" as their inflation rates tend to rise toward that of the lead country. Floating rates simply allow countries to have different inflation rates. In the 1970s, it seemed that the average global inflation rate was higher with floating exchange rates, but the experience since the early 1980s indicates that the tendency toward higher inflation with floating rates is not that serious. What really matters is the resolve of the national monetary authorities.

Fifth, floating exchange rate values have been highly variable. The variability can increase exchange rate risk, which can discourage international transactions, especially trade in goods and services. In addition, overshooting can create signals for resource reallocations that are too strong. The defenders of floating rates indicate that this is a market doing what it is supposed to do—setting a market clearing price given demand and supply conditions at each time. The opponents of floating exchange rates believe that the variability is excessive, at least from the point of view of its effects on the macroeconomy.

Each country must make its own decision about its exchange rate policy. Several of these key issues seem to be important for most countries. Strong arguments in favor of a country's choosing a floating exchange rate are the use of changes in the floating exchange rate to achieve external balance, so that monetary policy can be used to pursue domestic objectives, the ability to set its own goals and policies, and the reduced need to hold official international reserves to defend against speculative attacks on the fixed rate. The strong argument in favor of a fixed rate is that floating rates are disturbingly variable. Many countries have shifted to a floating exchange rate during the past several decades. Even for countries that float, the government authorities typically use some form of management of the float. A managed floating exchange rate seems to be a reasonable compromise choice for many countries.

A number of countries maintain fixed exchange rates, but a fixed rate that is adjustable (called a ―soft peg‖) sometimes seems to invite speculative attack. Some countries have adopted exchange rate arrangements (called ―hard pegs‖) in which the fixed exchange rate value is very difficult to change. A currency board, such as that adopted by Hong Kong and several other countries, requires the country’s monetary authority to focus almost completely on defending the fixed exchange rate through intervention, with almost no possibility for sterilizing the effects of any 182 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

intervention. The case of Argentina illustrates some of the advantages of a currency board, as well as the disadvantages and the problems of an exit strategy. With ―dollarization,‖ used by El Salvador, Ecuador, Montenegro, Panama, and several very small countries, the country’s government abolishes its own currency and uses the currency of some other country (e.g., the U.S. dollar or the euro).

The members of the European Union (EU) are pursuing an international fix—a monetary union in which exchange rates are permanently fixed among the currencies of the countries in the union and a single monetary authority conducts a unionwide monetary policy. As mentioned previously in Chapter 20, in 1979 the EU countries established the European Monetary System, and most became members of its Exchange Rate Mechanism (ERM), an adjustable pegged rate system among its members' currencies. By mid-1992, all EU members except Greece were members of the ERM. Then a series of speculative attacks weakened the ERM—Britain and Italy left it in 1992, realignments were necessary for the central rates of the currencies of some other countries, and the bands for nearly all currencies were widened to plus or minus 15% in 1993. After 1993, the exchange rates within the ERM were generally steady, and a number of countries joined or rejoined the ERM. The ERM experience provides examples of several points from earlier in the chapter. The ERM exchange rates generally were steadier than floating rates, and inflation rates in other ERM members decreased to the low levels of Germany. But differences in priorities and policies led to the strains that weakened the system in the early 1990s.

At the same time as the turmoil in the ERM, the EU countries drafted and approved the Maastricht Treaty, which called for creation of European Monetary Union, for countries that met five criteria contained in the treaty. In 1998, 11 countries were deemed to meet the criteria and chose to join. On January 1, 1999, the union began, with the euro as a new common currency and the European Central Bank (ECB) conducting monetary policy for the union. Greece joined in 2001, and the euro replaced all national currencies of the twelve member countries in 2002.

Slovenia joined in 2007, Cyprus and Malta in 2008, Slovakia in 2009, Estonia in 2011, Latvia in 2014, and Lithuania in 2015. (By the time you read this, Croatia and Bulgaria may also have joined.)

Key gains from European Monetary Union are the elimination of exchange rate risk and the elimination of the transaction costs of exchanging currencies. Key risks include the loss of national use of exchange rate changes and monetary policy to address shortcomings in national economic performance. The ECB’s monetary policy can address unionwide macroeconomic performance shortcomings, as it did starting in 2015 when the ECB began an aggressive quantitative easing to address very low euro area inflation rates, slow real GDP growth, and high unemployment rates. But, a major challenge for the member countries is finding effective mechanisms for national adjustments when adverse economic shocks affect different countries in different ways (for instance, Germany and Ireland during the early 2000s). Labor mobility between member countries is low. ―Internal devaluation‖ to improve international price competitiveness can be painfully slow. There is almost no unionwide fiscal policy (though the EU did innovate two unionwide fiscal programs in response to the macroeconomic effects of the COVID-19 pandemic).

Fiscal policy has become a flash point for the euro area. In the absence of national monetary policy and national exchange rate policy, national fiscal policy should be valuable as the key tool 183 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

for national macroeconomic stabilization. But national governments may sometimes run excessive fiscal deficits and build up excessive government debt. The Stability and Growth Pact attempted to impose limits on the size of national government budget deficits, but the pact was weakened in 2005. Then the global financial and economic crisis led to ballooning deficits in some euro-area countries. Greece had to be rescued from a government debt crisis in 2010, followed by Ireland and Portugal. In mid-2011, the government debts of Spain and Italy came under market pressures. National fiscal policies and national government debt were central to the crisis that threatened the viability of the euro. The euro-area countries adopted a revised fiscal compact, but, in response to the COVID-19 pandemic, the fiscal rules were suspended.

Tips One classroom exercise that can be both fun and challenging is to divide the class into several groups and have a class debate about the desirability of different exchange rate systems for the USMCA. For instance, one group could be the proponent of a rapid shift to monetary union, a second the proponent of fixed but adjustable exchange rates among the Canadian dollar, the U.S. dollar and the Mexican peso (a system like the European Exchange Rate Mechanism), and the third the proponent of continuing the floating exchange rates among the USMCA currencies. If this is done without formal group preparation, then the instructor can call on a person from each group to present one point, and then rotate around the groups until most points have been made.

Or, groups can meet and prepare formal statements of key arguments, with class presentations of the groups' statements. After any follow-on discussion, the class could end with a vote—if you were a Canadian (or a Mexican, or an American) politician or businessperson, what system would you favor?

Suggested answer to case study discussion question What Role for Gold? Probably not. Internal balance is achieved by maintaining a reasonable level (and growth rate) of GDP so that the county has a reasonable (probably fairly low) unemployment rate and an acceptable (probably fairly low) rate of product price inflation.

Macroeconomic shocks hit a country’s economy from time to time. Some of these shocks reduce aggregate demand and lead to recessions and rising unemployment. Some of these shocks expand aggregate demand excessively and put upward pressure on domestic prices and the country’s inflation rate. A national government has three types of macroeconomic policy that can be used to pursue internal balance. The national government generally can use monetary policy, fiscal policy, and exchange rate policy. A new gold standard would obligate the central banks of countries who choose it to defend the fixed price of gold by buying and selling gold at the fixed price. If the country’s central bank is fully committed, then this is a rather strong form of fixed exchange rates, because the exchange rates among the currencies of the countries on the gold standard are implied by the fixed gold prices. Exchange rate policy cannot be a major tool to pursue internal balance. And, monetary policy is also not a major tool to pursue internal balance, because the central bank alters the country’s money supply in response to changes in gold supply and demand, rather than in response to shock-driven shifts in aggregate demand and GDP. Fiscal

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policy is still available as a tool for the government to pursue internal balance, but in many countries fiscal policy is the least flexible or the most politicized tool.

Suggested answers to end-of-chapter questions and problems 314.

Disagree. Countries must follow policies that are not too different if they are to be able to maintain the fixed exchange rates. The policies need not be exactly the same, but the policies must lead to private demand and supply in the foreign exchange market that permits the countries to defend the fixed rates successfully. The most obvious need for consistency is in policies toward inflation rates. For fixed rates to be sustained, inflation rates must be the same or very similar for the countries involved. If inflation rates are the same, then fixed rates are consistent with purchasing power parity over time. If, instead, the inflation rates are different, then with fixed exchange rates the high-inflation countries will lose price-competitiveness over time. Their international payments will tend toward deficits, and the fixed rates will not be sustainable in the face of the ―fundamental disequilibrium.‖ Another need for consistency is in policies that can have a major influence on international capital flows. If policies lead to large capital flows, especially outflows, they may overwhelm the government’s ability to defend the fixed exchange rate.

315.

Probably agree, but with a caution. It is usually argued that the average rate of global inflation would tend to be lower if most countries adhered to a system of fixed exchange rates. Countries that succeed in maintaining fixed exchange rates among their currencies must have similar inflation rates in the long run. This tends to discipline countries that otherwise would drift or surge toward higher inflation rates. Furthermore, there is more pressure on countries with payments deficits to adjust than there is on surplus countries.

In defending the fixed exchange rates, countries with payments deficits must intervene to buy their own currency. This tends to contract their money supplies and reduce their inflation rates. Thus, overall, the world tends toward less money growth and a lower average rate of world inflation. There is one caution, however. If the system has a lead country, then the inflation rate that forms the standard for the system is this country's inflation rate. Some countries that otherwise would prefer to have an even lower inflation rate will find that their inflation rate is drifting up toward the rate in the lead country.

316.

A floating exchange rate provides some insulation from foreign business cycles because the rate tends to change in a way that counters the spread of the business cycle through international trade. For instance, when a foreign country goes into recession, its demand for imports declines. This lowers the focus country’s exports, reducing its aggregate demand, and it tends to go into recession. With floating exchange rates, the focus country’s international payments tend to go into deficit when the country’s exports decline, and the country’s currency depreciates. The depreciation improves the country’s international price-competitiveness. Its exports rebound somewhat, and it shifts some spending away from imports and toward domestic products. Therefore, aggregate demand rises backup. The tendency toward recession is not so strong, so floating exchange rates provide some insulation from foreign business cycles.

185

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317.

Agree or disagree. If you say agree, then you will emphasize points like the following.

With a clean floating exchange rate, the rate is set by private competitive supply and demand in the market. This rate is a market price that represents all information about currency values that is available at that time. Governments have no special information, so that they cannot improve on the clean float. Intervention by the government in the foreign exchange market often seems to have little effect on exchange rate values. When it does have an impact, it distorts the exchange rate, usually for political purposes, especially to respond to the desires of powerful special interests.

If you disagree, then you will emphasize points like the following. Cleanly floating exchange rates are excessively variable, perhaps because private supply and demand are sometimes driven not by rational examination of information on the economic fundamentals, but rather by bandwagons and similar speculative behavior, or simply because exchange rates tend to overshoot their long-run values. Thus, a managed float permits a country to obtain many of the benefits of a floating exchange rate, including some policy independence and the ability to use exchange rate changes in the process of adjustment to external imbalances, while using intervention to limit wide swings and excessive variability in exchange rate values.

318.

Possible criteria include the following. First, if the country wants to shift to a fixed exchange rate to promote international trade by reducing exchange rate risk, then it should consider fixing its exchange rate to the currency of one of its major trading partners. Second, the country should look for a country whose priorities and policies are compatible with its own. For instance, if the country wants to have and maintain a low inflation rate, then it should consider fixing its rate to the currency of a foreign country that has and is likely to maintain policies that result in a low inflation rate. Third, the country should look for a foreign country that is seldom subject to large domestic shocks.

With a fixed exchange rate, any economic shocks in the foreign country will be transmitted to this country. (From this country’s point of view, these are external shocks.)

The country will lose the ability of floating exchange rates to buffer the disruptiveness of these external shocks, so it should consider fixing its rate to the currency of a foreign country that has a relatively stable domestic economy.

319.

a.

These economists believe that the variability exists for good reasons, and that many of the supposed bad effects of exchange rate variability are not that large. They believe that the variability results from rational and reasonable responses of market participants, especially international investors, to various kinds of shocks and news. As economic and political conditions change, exchange rates should change to reflect the new information about the relative values of currencies. They believe that variability does not lead to risk that unreasonably reduces international transactions. Those engaged in international transactions like trade in goods and services have a variety of ways to hedge their exposures to exchange rate risk, including forward foreign exchange contracts as well as currency futures, options, and swaps.

These economists believe that the variability is excessive, and that the risks do have an undesirable impact on international transactions. They believe that the variability sometimes results from bandwagons and similar expectations that carry exchange rates away from their appropriate economic values. In addition, overshooting can cause 186 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

exchange rates to deviate from their longer run values, even if the rates follow a path that is economically rational. They believe that some of the resulting exchange rate risk does have an impact on international transactions, because it is not possible to hedge perfectly and costlessly. Risk may especially affect real investments that support exports and similar international transactions, because the risk that must be hedged is further in the future, and because the payments at risk are themselves often of uncertain sizes.

Furthermore, they believe that excessive rate movements that persist beyond the short run, such as the overshooting that can keep exchange rates away from their longer run values for a number of years, create signals for resource reallocations that are too large or too rapid.

320.

a.

In the short run, the country must implement policies to reduce aggregate demand.

The reduction in aggregate demand will create the discipline of weak demand in putting downward pressure on the inflation rate. Tightening up on monetary policy is one way to do this in the short run, and it may be crucial to reducing the inflation rate in the long run.

In the long run the growth of the money supply is a major policy-controlled determinant of the country’s inflation rate. The floating exchange rate can be affected by these policy changes, but the key to reducing the inflation rate is getting domestic policies pointed in the right direction.

The major countries of the world generally have low inflation rates. Adopting a currency board and a fixed exchange rate with one of these currencies may help the country reduce its inflation rate for several reasons. First, the country is accepting the discipline effect of fixed exchange rates. If the country’s demand expands too rapidly or its inflation rate is too high, its international payments tend to go into deficit. By intervening to defend the fixed exchange rate, the country’s currency board will buy domestic currency. This tends to force a tighter monetary policy on the country. Second, the shift to the currency board and fixed exchange rate can enhance the credibility of the government’s policy, signaling that the government is truly serious about reducing the country’s inflation rate. Actually reducing the inflation rate is easier if people expect that it is going to decrease. Third, with a fixed exchange rate the local-currency prices of imported goods tend to be steady.

The steady prices of imports not only reduce the country’s measured inflation rate directly but also put competitive pressure on the prices of domestic products, so these prices do not rise as much.

321.

A currency board is a form of national monetary authority that focuses solely on maintaining a fixed exchange rate value of the country’s currency. It holds only foreign currency monetary assets, and its monetary liabilities are high-powered domestic money.

Essentially, its purpose is to buy or sell domestic currency in exchange for foreign currency at the declared fixed rate. Whether a fixed rate with a currency board is better for a country than a fixed rate with a standard central bank depends on several things.

If the only relevant national goal is to defend the fixed rate, then the currency board is probably better. Because the currency board holds no domestic-currency assets, the currency board cannot sterilize its foreign exchange intervention. The domestic money supply must change with the intervention, and the adjustments to eliminate the payments imbalance takes place. The currency is considered a form of hard peg or extreme fix, and 187

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the credibility of the country’s commitment to the fixed exchange rate increases. With a currency board, the fixed rate value is less likely to be hit by a private speculative attack.

However, defending the fixed exchange rate may not be the only relevant national goal, and sometimes, the payments imbalance may be temporary. In this case, sterilization of a currency intervention could be a sensible way to defend a fixed exchange rate and delay or slow down the adjustment process, for instance, because the adjustment would lead to rising unemployment or, in another situation, to rising inflation. A currency board cannot pursue sterilized intervention, but a standard central bank that holds both domesticcurrency assets and foreign-currency assets can.

322.

Dollarization is the process of a country (unilaterally) replacing its own currency with the currency of some other country, for general use in transactions within the country.

Compared to using the national currency, having a national central bank, and maintaining a fixed exchange rate between the country’s currency and the currency of the other country, dollarization has advantages and disadvantages, so dollarization may be better or worse for the country. Advantages: First, dollarization eliminates the exchange rate risk that the country’s government could change the fixed rate value in the future (although there is some perhaps small risk that a dollarized country could reintroduce its own currency). Second, dollarization eliminates transactions costs between the local currency and the foreign currency. Disadvantages: First, the dollarized country loses the seigniorage profit from issuing its own currency. (Instead, the foreign central bank earns the seigniorage profit, which can be viewed as the profit from issuing zero-interest money as a financial asset.) Second, the dollarized country loses the ability to adjust its exchange rate as a tool of macroeconomic policy. The dollarized country also loses the ability to conduct its own monetary policy, although this ability would still be much diminished if instead the country was committed to the fixed exchange rate to the foreign currency.

323.

The five convergence criteria are: (1) the country's inflation rate must be no more than 1.5 percentage points above the average inflation rate of the three lowest inflation EU countries, (2) the country's exchange rates must have been maintained within the ERM band with no realignments during the previous 2 years, (3) the country's long-term interest rate on government bonds must be no more than 2 percentage points above the average of the rates in the three lowest inflation countries, (4) the country's government budget deficit must be less than or equal to 3% of the value of its GDP, and (5) the country's gross government debt outstanding must be less than or equal to 60% of the value of its GDP. For the latter two criteria, the country need not meet them exactly, as long as the country shows adequate progress toward achieving them in the near future.

We can guess about the logic for each requirement. The inflation criterion shows that the country is ready to switch smoothly to fixed exchange rates with other low inflation countries. It is based on the logic of relative purchasing power parity—that countries must maintain similar inflation rates if fixed rates are to be sustained. The exchange rate criterion shows that the country already has been able to maintain a pegged exchange rate, so that it is ready to switch smoothly to completely fixed exchange rates. In addition, the criterion may be intended to limit a country's ability to use "one last" devaluation to gain a competitive edge in pricing just before it enters into "permanently" fixed exchange rates. The interest rate criterion may show that credit markets judge the country to be a 188

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good inflation rate risk and a good credit risk. A country that is not expected to maintain a low inflation rate probably has to pay a higher interest rate on its long-term debt. Its tendency toward higher inflation in the future would threaten the viability of the fixed exchange rates. Even worse, a country whose government might run into problems in repaying its debts also probably has to pay a higher interest rate on its long-term government debt. If the government does then run into problems, the other countries may be forced to bail it out in order to defend the monetary union. The two criteria related to the government budget deficit and debt seem to be related to achieving fiscal policies that are not too different between the countries that enter into the fixed exchange rates. This may limit strains within the system. Especially, it keeps out countries who might favor more inflationary monetary policies to bail them out in the face of excessive government budget deficits and debt.

Given the importance of having and maintaining similar inflation rates for the success of fixed exchange rates, the most important criterion is probably that related to the country's inflation rate. The criteria related to government budget deficits and debt seem to be more debatable. A country that shifts to completely fixed exchange rates has given up the ability to use national monetary policy and exchange rate changes in seeking to address imbalances. This country may need to use fiscal policy more actively, including sometimes running large budget deficits. If the criteria also restrain the independence of fiscal policy, the country's government is left with little in the way of policy tools to address national imbalance. However, the series of government debt crises that hit Greece, Ireland, and Portugal beginning in 2010 show that excessive fiscal deficits and government debts can create large problems for the monetary union.

324.

There are several strong arguments. Here are three. First, joining the monetary union and adopting the euro will eliminate the transactions costs of exchanging złoty for euros.

Resources used for this purpose can be shifted to other uses. The lower costs will encourage more Polish trade and investment with the member countries of the euro area.

Second, joining the monetary union will eliminate exchange rate risk between the złoty and the euro. Again, trade and investment with the euro area are encouraged. Third, the risk of rising Polish inflation is reduced, to the extent that the European Central Bank, with its mandate to keep inflation in the euro area to 2%, is likely to be better at controlling inflation than the Polish central bank would be.

325.

Here are several arguments in favor of a Poland staying out of the European Monetary Union and instead maintaining its policy of an independently floating exchange rate for the złoty. First, changes in the floating exchange rate value of the złoty can be used in adjusting to reduce external imbalances that Poland might face. Changes in the exchange rate value of the złoty can also reduce the Poland’s vulnerability to external shocks, including shocks coming from other EU countries. Second, adoption of floating exchange rates allows Poland to pursue its own monetary policy. Monetary policy can be used to seek internal balance, and Poland’s government has a greater ability to pursue its own goals and priorities. The ability to use monetary policy to fight a Polish recession and high Polish unemployment can be especially valuable if fiscal policy is not flexible enough to be useful in pursuing internal balance, and if movements of labor between countries of the union are not likely to be large enough (or perhaps even not desirable) as 189

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a way to smooth cyclical differences between these countries. Third, those affected by the variability of floating exchange rates have a variety of means of hedging their exposures to exchange rate risks, including forward foreign exchange contracts and currency futures, options, and swaps. These contracts are available with very low transactions costs. Fourth, Poland’s inflation rate is best controlled by a Polish central bank that is committed to this goal. Although the European Central Bank is structured like the German central bank, it is also subject to political pressures that could reduce its commitment to maintaining low inflation, so there is no guarantee that Poland will have lower inflation if it joins the monetary union. Finally, staying out of the European Monetary Union assures that Poland is not so directly exposed to the fiscal problems in some euro-area countries (e.g., Greece).

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