International Economics, 10th Edition Solution Manual

INSTRUCTOR’S MANUAL to accompany

International Economics Tenth Edition

Dominick Salvatore Fordham University

Instructor’s Manual to accompany International Economics, 10 th Edition

CONTENTS Preface Chapter 1: Introduction

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PART ONE: INTERNATIONAL TRADE THEORY Chapter 2: The Law of Comparative Advantage

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Chapter 3: The Standard Theory of International Trade

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Chapter 4: Demand and Supply, Offer Curves, and the Terms of Trade

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Chapter 5: Factor Endowments and the Heckscher-Ohlin Theory

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Chapter 6: Economies of Scale, Imperfect Competition, and International Trade

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Chapter 7: Economic Growth and International Trade

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PART TWO: INTERNATIONAL TRADE POLICY Chapter 8: Trade Restrictions: Tariffs

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Chapter 9: Nontariff Trade Barriers and the New Protectionism

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Chapter 10: Economic Integration: Customs Unions and Free Trade Areas

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Chapter 11: International Trade and Economic Development

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Chapter 12: International Resource Movements and Multinational Corporations

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PART THREE: THE BALANCE OF PAYMENTS, FOREIGN EXCHANGE MARKETS, AND EXCHANGE RATES Chapter 13: The Balance of Payments

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Chapter 14: Foreign Exchange Markets and Exchange Rates

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Chapter 14: Exchange Rate Determination

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PART FOUR:OPEN ECONOMY MACROECONOMICS AND THE INTERNATIONAL MONETARY SYSTEM Chapter 16: The Price Adjustment Mechanisms with Flexible and Fixed Exchange Rates

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Chapter 17: The Income Adjustment Mechanism and Synthesis of Automatic Adjustments

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Chapter 18: Open Economy Macroeconomics: Adjustment Policies

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Chapter 19: Prices and output in an Open Economy: Aggregate Demand and Aggregate Supply

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Chapter 20: Flexible versus Fixed Exchange Rates, The European Monetary System, and Macroeconomic Policy Coordination

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Chapter 21: The International Monetary System: Past and Present

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Instructor’s Manual to accompany International Economics, 10 th Edition

PREFACE Purpose of this Manual The purpose of this manual is to facilitate the use of the text by the Instructor. It contains the detailed outline of each chapter, lecture guides with suggestions on how best to present the material in each chapter, and suggested answers to the end-of-chapter problems.

Course Outlines The text includes more material than can be covered in a one-semester undergraduate course in international economics, thus providing the Instructor with a great deal of flexibility as to what to include.

The core chapters for a one-semester undergraduate course in international economics are: Chapters 1-6, 8-9, 13-18, 21. I would cover each of these 15 chapters in one week (except for doubling up in one week) of the semester. I would skip the appendices, or make some of them optional. I would give the midterm after Chapter 9 and the final on all chapters covered at the end of the semester. Some Instructors, of course, may want to follow a different format.

In an undergraduate course in international trade, I would cover Chapters 1-12, and 21.

In a one-semester undergraduate course in international finance, I would cover Chapters 1, 13-21.

In a graduate course in International Trade in the MA, MBA, International Affairs, and International Political Economy, I would cover Chapters 1-12, and 21. I would also cover all the appendices and assign readings from the selected bibliography at the end of each chapter.

In a graduate course in International Finance in the MA, MBA, International Affairs, and International Political Economy, I would cover Chapters 1 and 13-21. I would also cover all the appendices and assign readings from the selected bibliography.

In a graduate course in International Economics, I would cover all 21 chapters, with or without the appendices and other readings from the selected bibliography.

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Instructor’s Manual to accompany International Economics, 10 th Edition

Content of this Manual The lecture guide given in this manual is specifically designed for a one-semester undergraduate course in international economics.

The questions for review at the end of each chapter involve only recall of what is clearly explained in the text. Their function is simply to emphasize those concepts and theories that the student needs to learn and remember. I would encourage the student to go over them on his own and check his answers in the text.

I would assign the problems at the end of each chapter. These are challenging but not tricky or very time consuming. They are intended to enlist the active participation of students so as to make international economics truly come alive.

The multiple-choice questions found in the accompanying Test Bank can be used for quizzes or to be part of the midterm and final examinations. There are also additional essays and problems with answers that can be used for class exams. The Instructor who feels that more questions and problems would be useful can consult my small and popular paperback Theory and Problems of International Economics (4th ed., 1996) in the Schaum's Outline Series, which includes a wealth of additional multiple-choice questions and solved problems and to the Study Guide prepared for this text by Professor Arthur Raymond of Muhlenberg College.

A Personal Note to You, the Instructor I welcome any comment, suggestion, or opinion that you may have on the use of the text. You can correspond by e-mail directly with me or through John Wiley, and I will personally acknowledge your letter and comment on your suggestions. I will, of course, consider your comments for the next Edition of the text and would gratefully acknowledge any such contribution.

Dominick Salvatore salvatore@fordham.edu

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CHAPTER 1: INTRODUCTION *(Core Chapter) OUTLINE 1.1 Importance of International Economics Case Study 1-1: The Dell and Other PCs Sold in the United States Are All But American Case Study 1-2: What Is an "American" Car? 1.2 International Trade and the Nation's Standard of Living Case Study 1-3: Rising Importance of International Trade to the United States 1.3 The Major U.S. Trade Partners: The Gravity Model 1.4 The Subject Matter of International Economics 1.5 Purpose of International Economic Theories and Policies 1.6 Current International Economic Challenges 1.7 The Globalization Challenge 1.8 Organization and Methodology of the Book Appendix:

A1.1 Basic International Trade Data A1.2 Sources of Additional International Data and Information

KEY TERMS Interdependence Gravity model International trade theory International trade policy New protectionism Foreign exchange markets Balance of payments

Adjustment in the balance of payments Microeconomics Macroeconomics Open economy macroeconomics International finance Globalization Anti-globalization movement

LECTURE GUIDE As the first chapter of the book, the general aim here is simply to define the field of study of international economics and its importance in today's interdependent world.

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The material in this chapter can be covered in two classes. I would utilize one class to cover Sections 1 to 4 and the second class to cover Sections 5 to 8. I would spend most of the second class on Section 6 on the major current international economic challenges facing the United States and the world today and to show how international economics can suggest ways to solve them. This should greatly enhance students' motivation.

SUGGESTED ANSWERS TO PROBLEMS 1. Go through your daily newspaper and identify: (a) Seven or eight news items of an international economic character; (b) the importance or effect of each of these problems on the United States economy; (c) the importance of each of these news items to you personally. a) International economic problems reported in our daily newspapers are likely to include: • trade controversies between the United States, Europe, Japan, and China; • great volatility of exchange rates; • Increasing international competition from China and fear of job losses in the United States and other advanced countries.

• structural unemployment and slow growth in Europe, and stagnation in Japan; • financial crises in emerging market economies; • restructuring problems of transition economies; • deep poverty in many developing nations in the world. b) Can result in trade restrictions or even a trade war, which reduce the volume and the gains from trade; • discourage foreign trade and investments, and thus reduce the benefits from trade; • Can result in trade restrictions or even a trade war, which reduce the volume and the gains from trade; • reduces European and Japanese imports and the volume and the benefits from trade; • financial crises in emerging market economies could spread to the United States; • can lead to political instability, which will adversely affect the United States; • can lead to political instability in these countries - which also adversely affect the United States. c) Can result in your paying higher prices for imported products; • lead to great fluctuations in the price of imported products and cost of foreign travel; • Can lead higher prices for imported products and increases the chances that you will have to change jobs; • can lead you to support demands for trade protection in the United States; • can reduce the value of your investments (such as a stocks) in the United States; • can lead to your paying higher taxes for the United States to respond to these threats; • can result in your paying higher taxes to help these nations.

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2. This question will involve you in measuring the economic interdependence of some nations. (a) Identify any five industrial nations not shown in Figure 1.1. (b) Go to your school library and find the latest edition of International Financial Statistics and construct a table showing the degree of economic interdependence for the nations you have chosen. Is the economic inter-dependence of the smaller nations in each group greater than that of the larger nations? a) Five industrial nations not mentioned are: Italy, France, Canada, Austria, and Ireland. b) See Table 1A. Table 1A Economic Interdependence as Measured by Imports and Exports as a Percentage of GDP, 2004 Nation Italy France Canada Austria Ireland

Imports as % of GDP 25.8 25.7 34 46.1 63.7

Exports as % of GDP 26.6 25.9 38.2 51 79

*Source: International Financial Statistics (Washington, D.C., IMF, March 2006).

Smaller nations, such as Ireland and Austria, are more interdependent than the larger ones. Note that interdependence was measured by the percentage of the value of imports and exports (line 98c and 90c, respectively in IFS) to GDP (line 99b).

3. Do the same as for Problem 2 for any five developing countries not shown in Figure 1.1. a) Five developing nations not mentioned in the text are: Brazil, Pakistan, Colombia, Nepal, and Tunisia. b) See Table 1B. Table 1B Economic Interdependence as Measured by Imports and Exports as a Percentage of GDP, 2004 Imports as % of GDP Exports as % of GDP Nation Brazil Pakistan Columbia Nepal Tunisia

13.4

18

16.7

16

20.7

19.4

31.7

17.3

49.6

46.7

*Source: International Financial Statistics (Washington, D.C., IMF, March 2006).

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In general, the smaller the nation, the greater is its economic interdependence. Note that interdependence was measured by the percentage of the value of imports and exports (line 98c and 90c, respectively in IFS) to GDP (line 99b).

4. Does the trade between the United States and Brazil and Argentina follow the predication of the gravity model?

Trade between the United States and Brazil is much larger than trade between the United States and Argentina. Since Brazil is larger and closer than Argentina, this trade does follow the predictions of the gravity model.

5. Take your principles of economics text (even if you have already had intermediate theory) and from the table of contents: (a) identify the topics presented in the microeconomics parts of the text; (b) compare the contents of the micro-economic parts of your principles text with the contents of Part One and Part Two of this text. (c) identify the topics presented in the macroeconomics parts of the text; (d) compare the contents of the macro-economics parts of your principles text with the contents of Part Three and Part Four of this text. a) Mankiw’s Economics (4th., 2007) includes the following microeconomics topics: • The market forces of demand and supply; • elasticity and its application; • the theory of consumer choice; • consumers, producers, and the efficiency of markets; • the costs of production; • firms in competitive markets; • monopoly; • oligopoly; • monopolistic competition; • markets for the factors of production; • the demand for resources; b) Just as the microeconomics parts of your principles text deal with individual consumers and firms, and with the price of individual commodities and factors of production, so do Parts One and Two of this text deal with production and consumption of individual nations with nations with and without trade, and with the relative price of individual commodities and factors of production. c) Mankiw’s Economics (4th. 2007) includes the following microeconomics topics: measuring a nation’s income and the cost of living; • production and growth; • savings investment and the financial system; • unemployment and its natural rate; • the monetary system, growth and inflation;

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money growth and inflation; open-economy macroeconomics: basic concepts; a macroeconomic theory of the open economy; aggregate demand and aggregate supply; the influence of monetary and fiscal policy on aggregate demand; the short-run tradeoff between inflation and unemployment five debates over macroeconomic policy.

d) Just as the macroeconomics parts of your principles text deal with the aggregate level of savings, consumption, investment, and national income, the general price level, and monetary and fiscal policies, so do Parts Three and Four of this text deal with the aggregate amount of imports, exports, the total international flow of resources, and the policies to affect these broad aggregates. *6. (a) What does consumer demand theory predict will happen to the quantity demanded of a commodity if its price rises (for example, as a result of a tax) while everything else is held constant? (b) What do you predict would happen to the quantity of imports of a commodity if its price to domestic consumers rose (for example, as a result of a tax on imports)? a) Consumer demand theory predicts than when the price of a commodity rises (cet. par.), the quantity demanded of the commodity declines. b) When the price of imports rises to domestic consumers, the quantity demanded of exports can be expected to decline (if everything else remains constant). *7. (a) How can a government eliminate or reduce a budget deficit? (b) How can a nation eliminate or reduce a balance-of-payments deficit? a) A government can reduce a budget deficit by reducing government expenditures and/or increasing taxes. b) A nation can reduce or eliminate a balance of payments deficit by taxing imports and/or subsidizing exports, by borrowing more abroad or lending less to other nations, as well as by reducing the level of its national income.

8. (a) How do international economic relations differ from interregional economic relations? (b) In what way are they similar? a) Nations usually impose restrictions on the free international flow of goods, services, and factors. Differences in language, customs, and laws also hamper these international flows. In addition, international flows may involve receipts and payments in different currencies, which may change in value in relation to one another through time. This is to be contrasted with the interregional flow of goods, services, and factors, which face no such restrictions as tariffs and are conducted in terms of the same currency, usually in the same language, and under basically the same set of customs and laws.

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b) Both international and interregional economic relations involve the overcoming of space or distance. Indeed, they both arise from the problems created by distance. This distinguishes them from the rest of economics, which abstracts from space and treats the economy as a single point in space, in which production, exchange, and consumption take place.

9. How can we deduce that nations benefit from voluntarily engaging in international trade?

We can deduce that nations benefit from voluntarily engaging in international trade because if they did not gain or if they lost they could avoid those losses by simply refusing to trade.

Disagreement usually arises regarding the relative distribution of the gains from specialization in production and trade, but this does not mean that each nation does not gain from trade. *10. If nations gain from international trade, why do you think most of them impose some restrictions on the free flow of international trade?

International trade results in lower prices for consumers but harms domestic producers of products, which compete with imports. Often those domestic producers that stand to lose a great deal from imports band together to pressure the government to restrict imports. Since consumers are many and unorganized and each individually stands to lose only very little from the import restrictions, governments often give in to the demands of producers and impose some import restrictions. These topics are discussed in detail in Chapter 9.

11. Can you think of some ways by which a nation can gain at the expense of other nations from trade restrictions?

A nation can subsidize exports of the commodity to other nations until it drives the competing nation's industry out of business, after which it can raise its price and benefit from its newly acquired monopoly power.

Some economists and politicians in the United States have accused Japan of doing just that (i.e., of engaging in strategic trade and industrial policy at the expense of U.S. industries), but this is a very complex and controversial aspect of trade policy and will be examined in detail in Chapter 9.

12. When the value of the U.S. dollar falls in relation to the currencies of other nations, what do you think will happen to the quantity of U.S. (a) imports? (b) exports? a) When the value of the U.S. dollar falls in relation to the currencies of other nations, imports become more expensive for Americans and so they would purchase a smaller quantity of imports. b) When the value of the U.S. dollar falls in relation to the currencies of other nations, U.S. exports become cheaper for foreigners and so they would purchase a greater quantity of U.S. exports.

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* = Answer provided at www.wiley.com/college/salvatore.

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CHAPTER 2: THE LAW OF COMPARATIVE ADVANTAGE *(Core Chapter) OUTLINE 2.1 Introduction 2.2 The Mercantilists' Views on Trade Case Study 2-1: Munn's Mercantilistic Views on Trade Case Study 2-2: Mercantilism Is Alive and Well in the Twenty-first Century 2.3 Trade Based on Absolute Advantage: Adam Smith 2.3a Absolute Advantage 2.3b Illustration of Absolute Advantage 2.4 Trade Based on Comparative Advantage: David Ricardo 2.4a The Law of Comparative Advantage 2.4b The Gains from Trade 2.4c Exception to the Law of Comparative Advantage 2.4d Comparative Advantage with Money Case Study 2-3: The Petition of the Candlemaker 2.5 Comparative Advantage with Opportunity Costs 2.5a Comparative Advantage and the Labor Theory of Value 2.5b The Opportunity Cost Theory 2.5c The Production Possibility Frontier Under Constant Costs 2.5d Opportunity Costs and Relative Commodity Prices 2.6 The Basis and the Gains from Trade Under Constant Costs 2.6a Illustration of the Gains from Trade 2.6b Relative Commodity Prices with Trade 2.7 Empirical Tests of the Ricardian Model Case Study 2-4: Relative Unit Labor Costs and Relative Exports – United States and Japan Appendix:

A2.1 Comparative Advantage with More than Two Commodities A2.2 Comparative Advantage with More than Two Nations

KEY TERMS Basis for trade Gains from trade Pattern of trade

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Labor theory of value Opportunity cost theory Production possibility frontier

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Mercantilism Absolute advantage Laissez-faire Law of comparative advantage

Constant opportunity cost Relative commodity prices Complete specialization Small country case

LECTURE GUIDE 1.

This is a long and crucial core chapter and may require four classes to cover adequately. In the first lecture, I would present Sections 1, 2, and 3. These are short sections and set the stage for the crucial law of comparative advantage.

2.

In the second lecture of Chapter 2, I would concentrate on Section 4 and carefully explain the law of comparative advantage using simple numerical examples as in the text. The crucial parts here are 4b (which explains the law) and 4d (which establishes the link between trade theory and international finance). I find that presenting the numerical explanations before the graphical analysis really helps the student to truly understand the law. The simple lawyer-secretary example should also render the law more immediately relevant to the student. I would also assign Problems 1-6.

3.

In the third lecture, I would cover Sections 2.5 and 2.6a. I would pay particular attention to Sections 2.5c, 2.5d, and 2.6, which are the heart of the chapter.

4.

In the fourth lecture, I would cover the remainder of the chapter. The crucial section here is 2.6b and the most difficult concept to explain is the shape of the combined supply curve for wheat and cloth. The appendixes could be made optional for the more enterprising students in the class. I would also assign Problems 7-13.

SUGGESTED ANSWERS TO PROBLEMS

1. Table 2.5 shows bushels of wheat and the yards of cloth that the United States and the United Kingdom can produce with one hour of labor time under four different hypothetical situations. In each case, identify the commodity in which the United States and the United Kingdom have an absolute advantage or disadvantage.

In case A, the United States has an absolute advantage in wheat and the United Kingdom in cloth.

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In case B, the United States has an absolute advantage (so that the United Kingdom has an absolute disadvantage) in both commodities.

In case C, the United States has an absolute advantage in wheat but has neither an absolute advantage nor disadvantage in cloth.

In case D, the United States has an absolute advantage over the United Kingdom in both commodities. *2. With respect to Table 2.5, indicate in each case the commodity in which each nation has a comparative advantage or disadvantage.

In case A, the United States has a comparative advantage in wheat and the United Kingdom in cloth.

In case B, the United States has a comparative advantage in wheat and the United Kingdom in cloth.

In case C, the United States has a comparative advantage in wheat and the United Kingdom in cloth.

In case D, the United States and the United Kingdom have a comparative advantage in neither commodity.

3. With respect to Table 2.5, indicate in each case whether or not trade is possible and the basis for trade.

In case A, trade is possible based on absolute advantage.

In case B, trade is possible based on comparative advantage.

In case C, trade is possible based on comparative advantage.

In case D, no trade is possible because the absolute advantage that the United States has over the United Kingdom is the same in both commodities. *4. Suppose that in Case B in Table 2.5 the United States exchanges 4W for 4C with the United Kingdom. (a) How much does the United States gain in terms of cloth? (b) How much does the United Kingdom gain in terms of cloth? (c) What is the range for mutually beneficial trade? (d) How much would each nation gain if they exchanged 4W for 6C instead? a) The United States gains 1C. b) The United Kingdom gains 4C. c) 3C < 4W < 8C.

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d) The United States would gain 3C while the United Kingdom would gain 2C. 5. Use the information for Case B in Table 2.5 and assume that labor is the only factor of production and is homogeneous (i.e., all of one type). (a) What is the cost in terms of labor content of producing wheat and cloth in the United States and the United Kingdom? (b) What is the dollar price of wheat and cloth in the United States if the wage rate is $6? (c) What is the pound price of wheat and cloth in the United Kingdom if the wage rate is £1? a) The cost in terms of labor content of producing wheat is 1/4 in the United States and 1 in the United Kingdom, while the cost in terms of labor content of producing cloth is 1/3 in the United States and 1/2 in the United Kingdom. b) In the United States, Pw=$1.50 and Pc=$2.00. c) In the United Kingdom, Pw=£1.00 and Pc=£0.50.

6. Answer the following questions with reference to Problem 5. (a) What is the dollar price of wheat and cloth in the United Kingdom if the exchange rate between the pound and the dollar is £1 = $2? Would the United States be able to export wheat to the United Kingdom at this exchange rate? Would the United Kingdom be able to export cloth to the United States at this exchange rate? (b) What if the exchange rate between the dollar and the pound were £1 = $4? (c) What is the exchange rate were £1 = $1? (d) What is the range of exchange rates that will allow the United States to export wheat to the United Kingdom and the United Kingdom to export cloth to the United States? a) With the exchange rate of £1=$2, Pw=2.00 and Pc=$1.00 in the United Kingdom, so that the United States would be able to export wheat to the United Kingdom and the United Kingdom would be able to export cloth to the United States. b) With the exchange rate of £1=$4, Pw=$4.00 and Pc=$2.00 in the United Kingdom, so that the United States would be able to export wheat to the United Kingdom, but the United Kingdom would be unable to export any cloth to the United States. c) With £1=$1, Pw=$1.00 and Pc=$0.50 in the United Kingdom, so that the United Kingdom would be able to export both commodities to the United States. d) $1.50 < £1.00 < $4.00 7. Assume that the data in Case B in Table 2.5 refer to millions of bushels of wheat and millions of yards of cloth. (a) Plot on graph paper the production frontiers of the United States and the United Kingdom. (b) What is the relative price of wheat (i.e., PW/PC in the United States and in the United Kingdom in autarky (no trade)? (c) What is the relative price of cloth (i.e., PC/PW in the United States and in the United Kingdom in autarky?

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a) See Figure 1.

b) In the United States Pw/Pc=3/4, while in the United Kingdom, Pw/Pc=2. c) In the United States Pc/Pw=4/3, while in the United Kingdom Pc/Pw=1/2.

8. Using the United States and United Kingdom production frontiers from Problem 7, assume that the no-trade or autarky point is 3W and 3/4C (in million units) in the United States and 1/2W and 1C in the United Kingdom. Also assume that with the opening of trade the United States exchanges 1W for 1C with the United Kingdom. Show graphically for the United States and the United Kingdom the autarky (or no-trade) point of production and consumption, the point of production and consumption with trade, and the gains from trade.

See Figure 2. The autarky points are A and A' in the United States and the United Kingdom, respectively. The points of production with trade are B and B' in the United States and the United Kingdom, respectively. The points of consumption are E and E' in the United States and the United Kingdom, respectively. The gains from trade are shown by E > A for the U.S. and E' > A' for the U.K.

9. (a) What would be the equilibrium-relative commodity price of wheat if DW(US+UK) shifted up by one-third in the left panel of Figure 2.3? How much wheat and cloth would the United States and the United Kingdom then produce? (b) What does the answer to part (a) imply for DC(UK+US) in the right panel of Figure 2.3?

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a) If DW(US+UK) shifted up in Figure 2.3, the equilibrium relative commodity price of wheat would also rise by 1/3 to PW/PC=4/3. Since the higher DW(US+UK) would still intersect the vertical portion of the SW(US+UK) curve, the United States would continue to specialize completely in the production of wheat and produce 180W, while the United kingdom would continue to specialize completely in the production of cloth and produce 120C. b) Since the equilibrium relative commodity price of cloth is the inverse of the relative commodity price of wheat, if the latter rises to 4/3, then the former falls to ¾. This means that DC(UK+US) shifts down by 1/3 in the right panel of Figure 3.

*10. What would happen if DW(US+UK) intersected the horizontal portion of SW(US+UK) at PW/PC = 2/3 and 120W in the left panel of Figure 2.3? What would this imply for specialization in production and the distribution in the gains from trade between the two nations?

If DW(US+UK) intersected SW(US+UK) at PW/PC=2/3 and 120W in the left panel of Figure 2.3, this would mean that the United States would not be specializing completely in the production of wheat.

The United Kingdom, on the other hand, would be specializing completely in the production of cloth and exchanging 20C for 30W with the United States. Since the United Kingdom trades at U.S. the pre-trade relative commodity price of PW/PC=2/3 in the United States, the United Kingdom receives all of the gains from trade.

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11. Draw a figure similar to Figure 2.2 showing that the United Kingdom is now a small country, half the size shown in the right panel of Figure 2.2, and trades 20C for 30W with the United States at PW/PC = 2/3.

See Figure 2.3 on page 15 and the discussion in the last paragraph of Section 2.6b in the text.

12. (a) How was the Ricardian trade model tested empirically? (b) In what way can the results be said to confirm the Ricardian model? (c) Why do we then need other trade models? a) The Ricardian model was tested empirically by showing the positive correlation between relative productivities and the ratio of U.S.to U.K. exports to third countries and by the negative correlation between relative unit labor costs and relative exports b) The Ricardian trade model was confirmed by the positive relationship found between the relative labor productivity and the ratio of U.S. to U.K. exports to third countries, as well as by the negative relationship between relative unit labor costs and relative exports. c) Even though the Ricardian model was more or less empirically confirmed we still need other models because the former assumes rather than explains comparative advantage (i.e., it does not explain the reason for the different labor productivities in different nations) and cannot say much regarding the effect of international trade on the earnings of factors of production.

13. How would you counter the argument that the United States needs to restrict textile imports in order to save American jobs?

The United States has a comparative disadvantage in the production of textiles. Restricting textile imports would keep U.S. workers from eventually moving into industries in which the United States has a comparative advantage and in which wages are higher.

*= Answer provided at www.wiley.com/college/salvatore.

SUGGESTED ANSWER TO PROBLEM IN APPENDIX 2 The numbers in the following table refer to the cost or price of commodities X, Y, and Z in nations A, B, and C in terms of the same currency. Thus, nation A exports commodity X to nations B and C; nation B exports commodity Y to nations A and C; nation C exports commodity Z to nations A and B.

Commodity

X Y Z

A 1 3 4

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Nation B 2 1.5 3

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*CHAPTER 3: THE STANDARD THEORY OF INTERNATIONAL TRADE (Core Chapter) OUTLINE 3.1 Introduction 3.2 The Production Frontier with Increasing Costs 3.2a Illustration of Increasing Costs 3.2b The Marginal Rate of Transformation 3.2c Reason for Increasing Opportunity Costs and Different Production Frontiers 3.3 Community Indifference Curves 3.3a Illustration of Community Indifference Curves 3.3b The Marginal Rate of Substitution 3.3c Some Difficulties with Community Indifference Curves 3.4 Equilibrium in Isolation 3.4a Illustration of Equilibrium in Isolation 3.4b Equilibrium Relative Commodity Prices and Comparative Advantage Case 3-1: Revealed Comparative Advantage of the United States, the European Union, and Japan 3.5 The Basis for and the Gains from Trade with Increasing Costs 3.5a Illustration of the Basis for and the Gains from Trade with Increasing Costs 3.5b Equilibrium Relative Commodity Prices with Trade 3.5c Incomplete Specialization Case Study 3-2: Specialization and Export Concentration in Selected Countries 3.5d Small Country Case with Increasing Costs 3.5e The Gains from Exchange and from Specialization Case Study 3-3: Job Losses in High U.S. Import-Competing Industries Case Study 3-4: International Trade and Deindustrialization in the United States, the European Union, and Japan 3.6 Trade Based on Differences in Tastes APPENDIX: A3.1 Production Functions, Isoquants, Isocosts and Equilibrium A3.2 Production Theory with Two Nations, Two Commodities and Two Factors A3.3 Derivation of the Edgeworth Box Diagram and Production Frontiers A3.4 Some Important Conclusions

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KEY TERMS Increasing opportunity costs Marginal rate of transformation (MRT) trade Community indifference curves Marginal rate of substitution (MRS) Autarky Equilibrium relative commodity price in isolation

Revealed comparative advantage Equilibrium relative commodity price with Incomplete specialization Gains from exchange Gains from specialization Deindustrialization

LECTURE GUIDE 1.

In the first lecture of Chapter 3, I would cover Sections 1, 2, and 3. Section 2 can be covered quickly, except for 2b, which requires careful explanation because of its subsequent importance.

Careful explanation is also required for 3b. I would assign Problems 1 and 2.

2.

In the second lecture, I would cover Sections 4, 5a, and 5b. This is the basic trade model and it is essential for the student to master it completely. To this end, I would assign and grade Problems 3 and 4.

3.

In the third lecture, I would cover the remainder of the chapter. The topics here represent elaborations of the basic trade model. I would assign problems 5, 6, and 7 and go over problem 7 in class even though its answer is also in the back of the book. I would make the Appendices optional for those students in the class who have had intermediate micro theory.

SUGGESTED ANSWERS TO PROBLEMS 1. On one set of axes, sketch a fairly large production frontier concave from the origin. (a) Starting near the midpoint on the production frontier, use arrows to show that the nation incurs increasing opportunity costs in producing more of X (the commodity measured along the horizontal axis) and more of Y. (b) How does the slope of the production frontier change as the nation produces more of X? more of Y? What do these changes reflect? a) See Figure 1. b) The slope of the transformation curve increases as the nation produces more of X and decreases as the nation produces more of Y. These reflect increasing opportunity costs as the nation produces more of X or Y. 2. On another set of axes, sketch three community indifference curves, making the top two curves cross each other.

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Instructor’s Manual

(a) Why have you drawn community indifference curves downward, or negatively, sloped? (b) What does the slope of the curves measure? Why is the slope of each curve smaller for lower points? (c) Which of the two intersecting indifference curves shows a greater level of satisfaction to the right of the point of intersection? to the left? Why is this inconsistent with the definition of indifference curves? What conclusion can you reach? a) See Figure 2. We have drawn community indifference curves as downward or negatively sloped because as the community consumes more of X it will have to give up some of Y to remain on the same indifference curve.

b) The slope measures how much of Y the nation can give up by consuming one more unit of X and still remain at the same level of satisfaction; the slope declines because the more of X and the less of Y the nation is left with, the less satisfaction it receives from additional units of X and the more satisfaction it receives from each retained unit of Y. c) III > II to the right of the intersection, while II > III to the left.

This is inconsistent because an indifference curve should show a given level of satisfaction.

Thus, indifference curves cannot cross. *3. On one set of axes, sketch a community indifference curve tangent to the fairly flat section of a concave production frontier. On a second set of axes, sketch another (different) community indifference curve tangent to the fairly steep portion of another (different) concave production frontier. (a) Draw in the line showing the equilibrium-relative commodity price in isolation in each nation. (b) Which is the commodity of comparative advantage for each nation? (c) Under what (unusual) condition would there be no such thing as comparative advantage or disadvantage between the two nations? a) See Figure 3.

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b) Nation 1 has a comparative advantage in X and Nation 2 in Y. c) If the relative commodity price line has equal slope in both nations. *4. (a) On the graphs of Problem 3, show, for each nation with trade, the direction (by an arrow on the production frontier) of specialization in production and the equilibrium point of production and consumption. (b) How much does each nation gain in consumption compared with its autarky point? Which of the two nations gains more from trade? Why? a) See Figure 4.

b) Nation 1 gains by the amount by which point E is to the right and above point A and Nation 2 by the excess of E' over A'. Nation 1 gains more from trade because the relative price of X with trade differs more from its pre-trade price than for Nation 2.

5. On one set of axes, sketch Nation 1’s supply of exports of commodity X so that the quantity supplied (QS) of X is QSx = 0 at Px/P y = 1/4, QSx = 40 at Px/P y = 1/2, QSx = 60 at Px/P Y = 1, and QSx = 70 at Px/P y = 11/2. On the same set of axes, sketch Nation 2’s demand for Nation 1’s exports of commodity X so that the quantity demanded (QD) ofXis QDx = 40 at Px/P y = 11/2,QDx = 60 at Px/P Y = 1, and QDx = 120 at Px/P y = 1/2. (a) Determine the equilibrium-relative commodity price of the exports of commodity X with trade.

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(b) What would happen if Px/P Y were 11/2 (c) What would happen if Px/P y = 1/2 a) See Figure 5. In Figure 5, S refers to Nation 1's supply curve of exports of commodity X, while D refers to Nation 2's demand curve for Nation 1's exports of commodity X. D and S intersect at point E, determining the equilibrium PB=Px/Py=1 and the equilibrium quantity of exports of 60X.

b) At Px/Py=1 1/2 there is an excess supply of exports of R'R=30X and Px/Py falls toward equilibrium Px/Py=1. c) At Px/Py=1/2, there is an excess demand of exports of HH'=80X and Px/Py rises toward Px/Py=1.

6. What is the relationship between the figure you sketched for Problem 5 and the results you obtained in Problem 5 and Figure 3.4 in the text? Explain.

The Figure in Problem 5 is consistent with Figure 3-4 in the text. From the left panel of Figure 3-4, we see that Nation 1 supplies no exports of commodity X at Px/Py=1/4 (point A). This corresponds with the vertical or price intercept of Nation 1's supply curve of exports of commodity X (point A).

The left panel of Figure 4 also shows that at Px/Py=1, Nation 1 is willing to export 60X (point E). The same is shown by Nation 1's supply curve of exports of commodity X. The other points on Nation 1's supply curve of exports in the figure of Problem 5 can also be derived from the left panel of Figure 4, but this is shown in Chapter 4 with offer curves.

Nation 2's demand curve for Nation 1's exports of commodity X could be derived from the right panel of Figure 4. What is important is that we can use the D and S figure in Problem 5 to explain why the equilibrium relative commodity price with trade is Px/Py=1 and why the equilibrium quantity traded of commodity X is 60 units in Figure 4.

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*7. On one set of axes, sketch a community indifference curve tangent to the fairly flat section of a concave production frontier and show the nation’s autarky equilibrium-relative commodity price, labeling it PA. Assume that this graph refers to a very small nation whose trade does not affect relative prices on the world market, given by PW. Show on the graph the process of specialization in the production, the amount traded, and the gains from trade.

See Figure 6.

The small nation will move from A to B in production, exports X in exchange for Y so as to reach point E > A. 8. (a) Explain why the small nation of Problem 7 does not specialize completely in the production of the commodity of its comparative advantage. (b) How does your answer to part (a) differ from the constant-cost case? a) The small nation specializes in the production of commodity X only until its opportunity cost and relative price of X equals PW. This usually occurs before the small nation has become completely specialized in production. b) Under constant costs, specialization is always complete for the small nation.

9. On two sets of axes, draw identical concave production frontiers with different community indifference curves tangent to them. (a) Indicate the autarky equilibrium-relative commodity price in each nation. (b) Show the process of specialization in production and mutually beneficial trade. a) See Figure 7. b) See Figure 8.

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10. What would have happened if the two community indifference curves had also been identical in Problem 9? Sketch a graph of this situation.

If the two community indifference curves had also been identical in Problem 9 the relative commodity prices would also have been the same in both nations in the absence of trade and no mutually beneficial trade would be possible.

11. What would happen if the production frontiers are identical and the community indifference curves are different, but we have constant opportunity costs? Draw a graph of this.

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If production frontiers are identical and the community indifference curves different in the two nations, but we have constant opportunity costs, there would be no mutually beneficial trade possible between the two nations.

12. Draw a figure showing the separation of the gains from exchange from the gains from specialization for Nation 2 in the right panel of Figure 3.4 if Nation 2 were now a small nation.

See Figure 11

13. During the negotiations for NAFTA (North American Free Trade Agreement among the United States, Canada, and Mexico) in the early 1990s, opponents argued that the United States would lose many jobs to Mexico because of the much lower wages in Mexico. What was wrong with this line of reasoning?

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It is true that Mexico's wages are much lower than U.S. wages (about one fifth), but labor productivity is much higher in the United States and so labor costs are not necessarily higher than in Mexico. In any event, trade can still be based on comparative advantage.

* = Answer provided at www.wiley.com/college/salvatore.

SUGGESTED ANSWER TO PROBLEMS IN APPENDIX A3.3 Problem Derive from Figure 3.10 Nation 2’s production frontier. Which commodity is L intensive in Nation 2? Why? See Figure 12. Commodity X is the L-intensive commodity in Nation 2 (as in Nation 1) because the production contract curve bulges toward the L-axis or is everywhere to the left of the diagonal.

A3.4 Problem Explain why, as Nation 2 moves from point A_ to point B_ on its contract curve (i.e., specializes in the production of Y, the commodity of its comparative advantage), its K/L ratio falls in the production of both X and Y. (If you cannot, reread Section A3.4.)

Since L and K are released from the production of X in a higher ratio than are absorbed in the production of Y, wages fall in Nation 2. This leads to the substitution of L for K in the production of X and Y, so that the K/L ratio falls in the production of both commodities.

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*CHAPTER 4 DEMAND AND SUPPLY, OFFER CURVES, AND THE TERMS OF TRADE (Core Chapter) OUTLINE 4.1 Introduction 4.2 The Equilibrium Relative Commodity Price with Trade - Partial Equilibrium Analysis Case Study 4-1: Demand, Supply, and the International Price of Petroleum Case Study 4-2: The Index of Export to Import Prices for the United States 4.3 Offer Curves 4.3a Origin and Definition of Offer Curves 4.3b Derivation and Shape of the Offer Curve of Nation 1 4.3c Derivation and Shape of the Offer Curve of Nation 2 4.4 The Equilibrium Relative Commodity Price with Trade - General Equilibrium Analysis 4.5 Relationship Between General and Partial Equilibrium Analyses 4.6 The Terms of Trade 4.6a Definition and Measurement of the Terms of Trade 4.6b Illustration of the Terms of Trade 4.6c Usefulness of the Model Case Study 4-3: The Terms of Trade of the G-7 Countries Case Study 4-4: The Terms of Trade of Developing and Developed Countries Appendix:

A4.1 Derivation of a Trade Indifference Curve for Nation 1 A4.2 Derivation of Nation's 1 Trade Indifference Map A4.3 Formal Derivation of Nation's 1 Offer Curve A4.4 Outline of the Formal Derivation of Nation 2's Offer Curve A4.5 General Equilibrium of Production, Consumption, and Trade A4.6 Multiple and Unstable Equilibria

KEY TERMS Offer Curves Commodity or net barter terms of trade Reciprocal demand curve General equilibrium model Terms of trade

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Dominick Salvatore’s International Economics – 10th Edition

Instructor’s Manual

LECTURE GUIDE 1.

Some Instructors may wish to cover only Sections 1 and 2 of this chapter and skip offer curves. I would not do that since offer curves are a very useful theoretical tool of analysis that has been utilized for over a century. Some modern authors, in the desire to be innovative, are either dropping this tool of analysis from their text or relegating it to a short appendix. I think this is misguided and wrong.

2.

I would cover Sections 1-3 in the first lecture and Sections 4-6 in the second lecture, paying special attention to the shape of offer curves and to the relationship between general and partial equilibrium analyses.

SUGGESTED ANSWERS TO PROBLEMS 1. Show graphically how the equilibrium-relative commodity price of commodity Y with trade can be derived from Figure 4.1.

1.

See Figure 1. The equilibrium Py/Px=P'2=1/P2.

2. Without looking at the text, derive a nation’s offer curve from its production frontier, its indifference map, and two relative commodity prices at which trade could take place (i.e., sketch a figure similar to Figure 4.3).

See Figure 2.

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3. Do the same as for Problem 2 for the trade partner (i.e., sketch a figure similar to Figure 4.4).

See Figure 3.

4. Bring together on another graph the offer curves that you derived in Problems 2 and 3 and determine the equilibrium-relative commodity prices at which trade would take place (i.e., sketch a figure similar to Figure 4.5).

See Figure 4.

5. In what way is a nation’s offer curve similar to: (a) a demand curve? (b) a supply curve? (c) In what way is the offer curve different from the usual demand and supply curves? a) A nation's offer curve is similar to a demand curve because it shows the nation's demand for imports. b) A nation's offer curve is similar to a supply curve because it shows the nation's supply for exports. c) An offer curve shows how much of its import commodity a nation demands in order to supply various amounts of its export commodity. The usual demand and supply curves measure the quantity demanded and supplied, respectively.

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*6. Sketch a figure similar to Figure 4.5. (a) Extend the PF_ price line and the offer curve of Nation 1 until they cross. (In extending it, let the offer curve of Nation 1 bend backward.) (b) Using the figure you sketched, explain the forces that push PF_ toward PB in terms of commodity Y. (c) What does the backward-bending (negatively sloped) segment of Nation 1’s offer curve indicate? a) See Figure 5.

b) The quantity of imports demanded by Nation 1 at PF' exceeds the quantity of exports of Y supplied by Nation 2. Therefore, Px/Py declines (Py/Px rises) until the quantity demanded of imports of Y by Nation 1 equals the quantity of exports of Y supplied by Nation 2 at PB=PB'. c) The backward bending (i.e., negatively sloped) segment of Nation 1's offer curve indicate that nation 1 is willing to give up less of X for larger amounts of Y. 7. To show how nations can share unequally in the benefits from trade: (a) Sketch a figure showing the offer curve of a nation having a much greater curvature than the offer curve of its trade partner. (b) Which nation gains more from trade, the nation with the offer curve of greater or the one with the lesser curvature? (c) Can you explain why? a) See Figure 6.

b) The nation with the offer curve with the greater curvature gains more from trade. c) The nation with the offer curve with the greater

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curvature gains more from trade because the greater curvature of the offer curve reflects the nation's weaker or less intense demand for the other nation's export commodity. *8. From the left panel of Figure 4.4, derive Nation 2’s supply curve of exports of commodity Y. From the left panel of Figure 4.3, derive Nation 1’s demand curve for Nation 2’s exports of commodity Y. Use the demand and supply curves that you derived to show how the equilibriumrelative commodity price of commodity Y with trade is determined.

See Figure 7.

From the left panel of Figure 4.4, we see that Nation 2 does not export any amount of commodity Y at Px/Py=4, or Py/Px=1/4. This gives point A on Nation 2's supply curve of the exports of commodity Y (S). From the left panel of Figure 4.4, we also see that at Px/Py=2 or Py/Px=1/2, Nation 2 exports 40Y. This gives point H on S. Other point on S could similarly be derived. Note that S in Figure 7 is identical to S in Figure 4.6 in the text showing Nation 1's exports of commodity X. From the left panel of Figure 4.3, we see that Nation 1 demands 60Y of Nation 2's exports at Px/Py=Py/Px=1. This gives point E on Nation 1's demand curve of Nation 2's exports of commodity Y (D). From the left panel of Figure 4.3, we can estimate that Nation 1 demands 40Y at Py/Px=3/2 (point H on D in Figure 7) and 120Y at Py/Px=2 (point H' on D).

The equilibrium relative commodity price of commodity Y is Py/Px=1. This is determined at the intersection of D and S in Figure 7. At Py/Px=3/2, there is an excess supply of R'R=30Y and Py/Px falls to Py/Px=1. On the other hand, at Py/Px=1/2, there is an excess demand of HH'=80Y and Py/Px rises to Py/Px=1. Note also that Figure 7 is symmetrical with Figure 4.6 in the text.

9. (a) Why does the analysis in the answer to Problem 8 refer to partial equilibrium analysis? (b) Why does the analysis of Figure 4.5 refer to general equilibrium analysis? (c) What is the relationship between partial and general equilibrium analysis?

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a) The analysis in the answer to Problem 8 refers to partial equilibrium analysis because it makes use of the traditional demand and supply curves. These refer to the market for commodity Y and abstract from all the interconnections that exist between the market for commodity Y and the market for all the other commodities in the economy. As such, it provides only an approximation to the answer sought. b) The analysis of Figure 4.5 relies on offer curves. These incorporate demand and supply information in both nations and for both commodities (in our two-nation, two-commodity world).

As such, they allow us to trace a change in demand or supply, for either commodity, in either nation, on the demand and supply of the other commodity and in the other nation, as well as the repercussions from the original change on the demand and supply for both commodities in both nations. Thus, Figure 4-5 refers to general equilibrium analysis. This is admittedly more difficult than partial equilibrium analysis, but it also provides a complete and explicit answer to the problem. c) The partial equilibrium analysis shown in Figure 7 here and in Figure 4.6 in the text and the general equilibrium analysis provided by Figure 4.5 are related because both are derived from the same basic information (the production frontier and the indifference map of each nation). Partial equilibrium analysis, however, utilizes only part, not all, of the information provided by the production frontier and the indifference maps, as general equilibrium analysis does. *10. Draw the offer curves for Nation 1 and Nation 2, showing that Nation 2 is a small nation that trades at the pretrade-relative commodity prices in Nation 1. How are the gains from trade distributed between the two nations? Why? See Figure 8.

In Figure 8, Nation 2 is the small nation and we magnified the portion of the offer curve of Nation 1 (the large nation) near the origin (where Nation 1's offer curve coincides with PA=1/4, Nation 1's pretrade relative commodity price with trade). This means that Nation 2 can import a sufficiently small quantity of commodity X without perceptibly affecting Px/Py in Nation 1. Thus, Nation 2 is a price taker and captures all of the benefits from its trade with Nation 1. The same would be true

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even if Nation 2 were not a small nation, as long as Nation 1 faced constant opportunity costs and did not specialize completely in the production of commodity X with trade.

11. Draw a figure showing the equilibrium point with trade for two nations that face constant opportunity costs.

See Figure 9.

Figure 9 shows that in the unlikely event that both nations faced constant costs, the offer curves of both would be straight lines until both nations became completely specialized in production.

Afterwards, offer curves would assume their normal shape and determine the equilibrium Px/Py=PE at their intersection at point E. 12. Suppose that the terms of trade of a nation improved from 100 to 110 over a given period of time. (a) By how much did the terms of trade of its trade partner deteriorate? (b) In what sense can this be said to be unfavorable to the trade partner? Does this mean that the welfare of the trade partner has definitely declined? a) If the terms of trade of a nation improved from 100 to 110 over a given period of time, the terms of trade of the trade partner would deteriorate by about 9 percent over the same period of time. b) A deterioration in the terms of trade of the trade partner can be said to be unfavorable because the trade partner must pay a higher price for its imports in terms of its exports. This does not necessarily mean that the welfare of the trade partner has decreased because the deterioration in its terms of trade may have resulted from an increase in productivity that is shared with the other nation.

13. It has often been said that OPEC (Organization of Petroleum Exporting Countries) operates as a cartel and is able to set petroleum prices by restricting supplies. Do you agree? Explain.

Under the conditions of tight supply that prevailed during the 1970s, OPEC was given credit for the sharp increase in petroleum prices; but when excess supplies arose from the second half of the

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1980s to most of the 1990s, OPEC was unable to prevent almost equally sharp price declines.

Thus, OPEC does not seem able to set petroleum prices.

*= Answer provided at www.wiley.com/college/salvatore.

SUGGESTED ANSWER TO PROBLEMS IN APPENDIX A4.3 Problem Starting with Nation 1’s offer curve, the more advanced student should attempt to sketch (a) Nation 1’s demand curve for imports of commodity Y (with PY /PX along the vertical axis) and (b) Nation 1’s supply curve for exports of commodity X (with PX/PY along the vertical axis).

See Figures 10 and 11.

A4.4 Problem Draw a figure showing Nation 2’s trade indifference curves that would give its offer curve, including its backward-bending portion.

See Figure 12.

A4.6 Problem Draw two relative commodity price lines on Figure 4.12, one between point A and point C and one intersecting both offer curves to the right of point C. Starting from each of the two price lines that you have drawn, explain the forces that will automatically push the nations toward equilibrium point C.

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See Figure 13. At P', Nation 1 wants to import and export more than Nation 2 is willing to trade. As P' falls, Nation 1 will want to trade less and Nation 2 more, until Pc, where the amounts traded are in equilibrium. The opposite is true at P*.

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*CHAPTER 5: FACTOR ENDOWMENTS AND THE HECKSCHER-OHLIN THEORY (Core Chapter) OUTLINE 5.1 Introduction 5.2 Assumptions of the Theory 5.2a The Assumptions 5.2b Meaning of the Assumptions 5.3 Factor Intensity, Factor Abundance, and the Shape of the Production Frontier 5.3a Factor Intensity 5.3b Factor Abundance 5.3c Factor Abundance and the Shape of the Production Frontier Case Study 5-1: Relative Resource Endowments of Various Countries and Regions Case Study 5-2: Capital-Labor Ratios of Selected Countries 5.4 Factor Endowments and the Heckscher-Ohlin Theory 5.4a The Heckscher-Ohlin Theorem 5.4b General Equilibrium Framework of the Heckscher-Ohlin Theory 5.4c Illustration of the Heckscher-Ohlin Theory Case Study 5-3: Patterns of Comparative Advantage of Various Countries and Regions Case Study 5-3: Factor Intensities and Industries of U.S. Comparative Advantage 5.5 Factor-Price Equalization and Income Distribution 5.5a The Factor-Price Equalization Theorem 5.5b Relative and Absolute Factor-Price Equalization 5.5c Effect of Trade on the Distribution of Income 5.5d The Specific-Factors Model Case Study 5-5: Has International Trade Increased U.S. Wage Inequalities?

5.5e Empirical Relevance Case Study 5-6: Convergence of Real Wages Among Industrial Countries 5.6 Empirical Tests of the Heckscher-Ohlin Model 5.6a Empirical Results - The Leontief Paradox 5.6b Explanations of the Leontief Paradox 5.6c Factor-Intensity Reversal and Other Empirical Tests of the H-O Model Case Study 5-7: Capital and Labor Requirements in U.S. Trade Case Study 5-8: The H-O Model With Skills and Land Appendix:

A5.1 The Edgeworth Box Diagram for Nation 1 and Nation 2 A5.2 Relative Factor-Price Equalization A5.3 Absolute Factor-Price Equalization

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A5.4 Effect of Trade on the Short-Run Distribution of Income: The Specific-Factors Model A5.5 Illustration of Factor-Intensity Reversal A5.6 The Elasticity of Substitution and Factor Intensity Reversal A5.7 Empirical Tests of the Factor-Intensity Reversal

KEY TERMS Same technology Labor-intensive commodity Capital-intensive commodity Labor-capital ratio (L/K) Capital-labor ratio (K/L) Constant returns to scale Perfect competition Internal factor mobility International factor mobility Factor abundance Relative factor prices Derived demand

Heckscher-Ohlin (H-O) theory Heckscher-Ohlin (H-O) theorem Factor endowments Factor-proportions or factor-endowment theory Factor-price equalization (H-O-S) theorem Specific-factors model Input-output table Import substitutes Leontief paradox Human capital Factor-intensity reversal Elasticity of substitution

LECTURE GUIDE 1.

This is one of the most important chapters in the book. It is also a long chapter and requires about four lectures to adequately cover.

2.

In the first lecture, I would cover Sections 1-3.

3.

In the second lecture, I would cover Section 4. This, of course, is one of the most important sections in the book. I would proceed slowly and carefully here and I would also assign problems 18 and grade problems 1-3, 5, 6 to make sure that students clearly understand the meaning of the theory (the answer to problems 4 and 7 appears at the end of the book).

4.

In the third lecture, I would cover section 5 on the factor-price equalization theorem and income distribution. This is a difficult section. Case Studies 5-3 and 5-4 add a note of realism to the discussion. I would also assign problems 9 and 10.

5.

In the fourth lecture, I would cover section 6 on empirical tests of the Heckscher-Ohlin Model and assign problems 13, and 15.

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SUGGESTED ANSWERS TO PROBLEMS 1. Draw two sets of axes, one for Nation 1 and the other for Nation 2, measuring labor along the horizontal axis and capital along the vertical axis. (a) Show by straight lines through the origin that K/L is higher for commodity Y than for commodity X in both nations in the absence of trade and that K/L is higher in Nation 2 than in Nation 1 for both commodities. (b) What happens to the slope of the lines measuring K/L of each commodity in Nation 2 if r/w rises in Nation 2 as a result of international trade? (c) What happens to the slope of the lines measuring K/L in Nation 1 if r/w falls in Nation 1 as a result of international trade? (d) Given the results of parts b and c, does international trade increase or reduce the difference in the K/L in the production of each commodity in the two nations as compared with the pretrade situation? a) See Figure 1.

b) The slope of the lines measuring K/L of each commodity in Nation 2 falls if w/r rises in Nation 2 as a result of international trade. c) The slope of the lines measuring K/L of each commodity in Nation 1 rises if w/r falls in Nation 1 as a result of international trade. d) Given the results in parts (a) and (b), international trade reduces the difference in the K/L in the production of each commodity in the two nations as compared with the pretrade situation.

2. Without looking at the text, (a) Sketch a figure similar to Figure 5.4 showing the autarky equilibrium point in each nation and the point of production and consumption in each nation with trade. (b) With reference to your figure in part a, explain what determines the comparative advantage of each nation. (c) Why do the two nations consume different amounts of the two commodities in the absence of trade but the same amount with trade?

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a) See Figure 2.

b) The comparative advantage of each nation is determined by differences in production conditions only since tastes are identical. c) The two nations consume different amounts of the two commodities in the absence of trade but the same amounts with trade because internal prices differ without trade but are identical with trade.

3. Starting with the production frontiers for Nation 1 and Nation 2 shown in Figure 5.4, show graphically that even with a small difference in tastes in the two nations, Nation 1 would continue to have a comparative advantage in commodity X. See Figure 3.

*4. Starting with the production frontiers for Nation 1 and Nation 2 shown in Figure 5.4, show graphically that sufficiently different tastesin the two nations could conceivably neutralize the difference in their factor endowments and lead to equal relative commodity prices in the two nations in the absence of trade.

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See Figure 4.

5. Starting with the production frontiers for Nation 1 and Nation 2 shown in Figure 5.4, show that with an even greater difference in tastes in the two nations, Nation 1 could end up exporting the capital-intensive commodity.

See Figure 5.

6. A difference in factor endowments will cause the production frontiers of two nations to be shaped differently. (a) What else could cause their production frontiers to have different shapes? (b) What assumption made by Heckscher and Ohlin prevented this in the Heckscher–Ohlin model? (c) What are other possible causes of a difference in relative commodity prices between the two nations in the absence of trade? a) Besides a difference in factor endowments, the production frontier of two nations could differ also because of a difference in technology. b) A difference in the production frontier of two nations due to a difference in the technology is prevented by assumption by the H-O model.

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c) Another possible cause (besides a difference in production frontiers) of a difference in relative commodity prices between two nations in the absence of trade is a difference in tastes. *7. Draw a figure similar to Figure 5.4 but showing that the Heckscher–Ohlin model holds, even with some difference in tastes between Nation 1 and Nation 2.

See Figure 6.

8. If you have traveled to poor developing countries, you will have noticed that people there consume very different goods and services than U.S. consumers. Does this mean that tastes in developing countries are very different from U.S. tastes? Explain.

People in developing countries consume very different goods and services than U.S. consumers not because tastes are very different from the tastes of U.S. consumers but because incomes are so different (much lower) than in the United States.

9. Starting from the pretrade equilibrium point in Figure 5.4, assume that tastes in Nation 1 change in favor of the commodity of its comparative disadvantage (i.e., in favor of commodity Y). (a) What is the effect of this change in tastes on PX/PY in Nation 1? How did you reach such a conclusion? (b) What is the effect of this change in tastes on r/w in Nation 1? (c) What is the effect of this on the volume of trade and on the trade partner? a) If tastes change in favor of commodity Y (the commodity of its comparative disadvantage) in Figure 5-4 for Nation 1, Px/Py will be lower in Nation 1 because point A will move up and to the left.

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b) The effect of the change in tastes examined in part (a) for Nation 1 will cause r/w to rise in Nation 1. c) The effect of the changes examined in parts (a) and (b) will be to increase the volume of trade.

These changes will improve the partner's terms of trade.

10. Comment on the following quotation: ‘‘The assumptions necessary to bring about complete equality in the returns to homogeneous factors among nations are so restrictive and unrepresentative of actual reality that the theory can be said to prove the opposite of what it seems to say—namely, that there is no chance whatsoever that factor prices will ever be equalized by free commodity trade.’’

The statement was made by Gottfried Haberler in his Survey of International Trade Theory, Special Papers in International Economics, No.1 (Princeton, N.J.: Princeton University Press, International Finance Section, July 1961), p. 18.

While the statement is true, it does not detract from Samuelson's great contribution in rigorously showing the conditions under which trade would bring about the complete equality in the returns to homogeneous factors among nations.

11. In what way can international trade be said to have contributed to increased wage inequalities in the United States during the past 20 years?

International trade with developing economies, especially newly industrializing economies (NIEs), contributed in two ways to increased wage inequalities between skilled and unskilled workers in the United States during the past two decades. Directly, by reducing the demand for unskilled workers as a result of increased U.S. imports of labor-intensive manufactures and, indirectly, by speeding up the introduction of labor-saving innovations, which further reduced the U.S. demand for unskilled workers. International trade, however, was only a small cause of increased wage inequalities in the United States. The most important cause was technological change.

12. (a) Discuss the meaning and importance of the Leontief paradox. (b) Summarize the empirical results of Kravis, Keesing, Kenen, and Baldwin on the importance of human capital in helping to resolve the paradox. (c) How was the paradox seemingly resolved by Leamer, Stern, and Maskus, and Salvatore and Barazesh? (d) What is the status of the controversy today? a) Leontief found that U.S. import substitutes were more K-intensive than U.S. exports even though the United States was the most K-rich nation. This implied factor-intensity reversal and rejection of the H-O trade model. b) Kravis found that wages in U.S. export industries were higher than in U.S. import-competing industries, reflecting the greater productivity of labor in U.S. exports than in U.S. import substitutes.

This was confirmed by Keesing who found that U.S. exports were more skill intensive than the exports of 9 other industrial nations. By adding human to physical capital, Kenen succeed in eliminating the paradox. Baldwin found that including human capital and excluding naturalresource industries eliminated the paradox.

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c) The paradox was seemingly resolved by Leamer, Stern and Maskus, and Salvatore and Barazesh by comparing the K/L ratio in U.S. production vs. U.S. consumption, rather than in exports vs. imports when natural-resource-based industries are excluded. d) Factor-intensity reversal seems to be rather rare in the real world. *13. (a) Draw a figure similar to Figure 5.1 showing factor-intensity reversal. (b) With reference to your figure, explain how factor reversal could take place. (c) Summarize the empirical results of Minhas, Leontief, and Ball on the prevalence of factor reversal in the real world. a) See Figure 7.

b) Factor-intensity reversal could occur if the substitutability of K for L in the production of X was much greater than for Y and r/w was lower in Nation 2 than in Nation 1. c) Minhas found factor-intensity reversal to be fairly frequent. However, by correcting an important source of bias in the Minhas study, Leontief showed that factor-intensity reversal was much less frequent. Ball tested another aspect of Minhas' conclusion and confirmed Leontief's results that factor-intensity reversal was rare in the real world.

14. Explain why, with factor-intensity reversal, international differences in the price of capital can decrease, increase, or remain unchanged with international trade.

With factor-intensity reversal, a commodity is L-intensive in one nation and K-intensive in the other. The H-O model would then predict that both nations would export the same commodity.

Since this is impossible, both nations must export the commodity intensive in the same factor.

If this is the K-intensive commodity, the demand for K will increase in both nations. If it is the Lintensive commodity, the demand for K will fall in both nations. Thus, the price of K will either rise or fall in both nations, and international differences in the price of K will decrease, increase or remain unchanged depending on the rate of change in the price of K in the two nations.

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15. (a) Explain how more recent research tried to verify the H–O model. (b) Explain the results of these more recent empirical tests. (c) What general conclusion can be reached with respect to the utility and acceptance of the H–O model? a) By allowing for different technologies and factor prices across countries, non-traded goods, transportation costs, and by using better and more disaggregated data. b) Factor endowments broadly defined seem to explain comparative advantage well. c) We retain a qualified factor-endowments H-O model of international trade.

*= Answer provided at www.wiley.com/college/salvatore.

SUGGESTED ANSWERS TO PROBLEMS IN APPENDIX A5.2 Problem Show graphically that with sufficiently less capital available, Nation 1 would have become completely specialized in the production of commodity X before relative factor prices became equal in the two nations.

See Figure 8.

A5.4 Problem What effect will the opening of trade have on the real income of labor and capital in Nation 2 (the K-abundant nation) if L is mobile between the two industries in Nation 2 but K is not?

The effect of the opening of trade on the real income of labor and capital in Nation 2 (the Kabundant nation) if L is mobile between the two industries in Nation 2 but K is not is to increase Py/Px and to cause more L to be used in the production of Y.

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Wages then fall in terms of Y but rise in terms of X. On the other hand, the return on capital increases in the production of Y but falls in the production of X. A5.5 Problem Draw a figure similar to Figure 5.10 with the X-isoquant and the Y-isoquant crossing only once within the relative factor price lines of the two nations and show that in that case there is no factor-intensity reversal.

See Figure 9.

At P1 commodity Y is K-intensive (compare point C to point A).

At P2 commodity Y is still K-intensive (compare point D to point B).

A5.6 Problem Calculate the elasticity of substitution of L and K for your X-isoquant and Yisoquant of the previous problem (where there is no factor-intensity reversal), and verify that the elasticity of substitution for the two isoquants does not differ much because of their similar curvature. Assume that the coordinates are A (4,2), B (3,3), C (3,2.5), D (2,4), and that the absolute slope of the isoquants is 1 at points A and C and 2 at B and D. For the X isoquant e = (K/L)/(K/L) = (3/3-2/4)/(2/4) = 1 slope/slope (2-1)/1 For the Y isoquant e = (4/2-2.5/3)/(2.5/3) = 1.4 (2-1)/1

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CHAPTER 6: ECONOMIES OF SCALE, IMPERFECT COMPETITION, AND INTERNATIONAL TRADE

OUTLINE *6.1 Introduction 6.2 The Heckscher-Ohlin Model and New Trade Theories *6.3 Economies of Scale and International Trade Case Study 6-1: The New International economies of Scale *6.4 Imperfect Competition and International Trade 6.4a Trade Based on Product Differentiation Case Study 6-2: U.S. Intra-Industry Trade in Automotive Products Case Study 6-3: Variety Gains from International Trade 6.4b Measuring Intra-Industry Trade Case Study 6-4: Growth of Intra-Industry Trade 6.4c Formal Model of Intra-Industry Trade 6.4d Another Version of the Intra-Industry Trade Model 6.5 Trade Based on Dynamic Technological Differences and Synthesis of Trade Theories 6.5a The Technological Gap and Product Cycle Models 6.5b Illustration of the Product Cycle Model Case Study 6-5: The United States as the Most Competitive Economy 6.6 Transportation Costs, Environmental Standards, and International Trade 6.6a Transportation Costs and Nontraded Commodities Case Study 6-6: Transport Costs by Country Groups 6.6b Transportation Costs and the Location of Industry Case Study 6-7: The Maquiladoras: U.S. Plants Along the U.S.-Mexican Border 6.6c Environmental Standards, Industry Location, and International Trade Case Study 6-8: Environmental Sustainability Index Appendix:

A6.1 External Economies and the Pattern of Trade A6.2 Dynamic External Economies and Specialization

KEY TERMS Increasing returns to scale Monopoly Oligopoly, Outsourcing International economies of scale External economies Differentiated products Intra-industry trade IM_c06_EconomiesOfScaleImperfectCompetitionAndInternationalTrade) .

Transport or logistics costs Nontraded goods and services General equilibrium analysis Partial equilibrium analysis Resource-oriented industries Market-oriented industries Footloose industries 6-1

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Intra-industry trade index Monopolistic competition Technological gap model Product cycle model

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Environmental standards Dynamic external economies Learning curve Infant industry

LECTURE GUIDE 1. Although this is not a core chapter, Sections 6.1, 6.3 and 6.4 are important ones because they present some of the most recent developments in international trade theory.

2. I would cover sections 1, 2, and 3 in lecture 1. The material is not difficult but very important. I would also assign problems 1-3.

3. I would cover section 4 in lecture 2. This is the most important section in the chapter. I would pay very close attention to Figures 6-2 and 6-3. These require reviewing from principles of economics, the meaning of differentiated products, monopolistic competition, economies of scale, and the determination of profit maximization by the firm. I would also assign problems 49 problems 4-9 and go over in class problems 6-9.

4. In lecture 3, I would cover sections 5 and 6 and assign problems 10-14.

SUGGESTED ANSWERS TO PROBLEMS *1. Draw a figure similar to Figure 6.1, showing how mutually beneficial trade can take place between two nations based on economies of scale if the nations have identical production frontiers but different tastes.

See Figure 1.

2. Do the same as in Problem 1 for two nations that have equal tastes but different production frontiers.

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See Figure 2.

3. Do the same as in Problem 1 for two nations with different production frontiers and tastes.

See Figure 3.

4. Find the degree of intra-industry trade if exports and imports are, respectively, (a) 1,000 and 1,000 (b) 1,000 and 750 (c) 1,000 and 500 (d) 1,000 and 25 (e) 1,000 and 0 a) T = 1 - /1000-1000/ = 1 - 0 = 1.

1000+1000 2000 b) T = 1 - /1000-750/ = 1 - 250 = 0.86.

1000+750 1750 c) T = 1 - /1000-500/ = 1 - 500 = 0.67.

1000+500 1500 d) T = 1 - /1000-250/ = 1 - 750 = 0.4.

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1250

e) T = 1 - /1000-0/ = 1 - 1000 = 0.

1000+0 1000 5. Do the same as in Problem 4, but interchange the values of exports and imports. a) T = 1 - /1000-1000/ = 1 - 0 = 1.

1000+1000 2000 b) T = 1 - /750-1000/ = 1 - 250 = 0.86.

750+1000 1750 c) T = 1 - /500-1000/ = 1 - 500 = 0.67.

500+1000 1500 d) T = 1 - /250-1000/ = 1 - 750 = 0.4.

250+1000 1250 e) T = 1 - /0-1000/ = 1 - 1000 = 0.

0+1000 1000 Note that the results are identical to those in Problem 4 because we take the absolute value of exports minus imports or imports minus exports. *6. Using the same AC and MC curves as in Figure 6.2, draw a figure similar to Figure 6.2 but showing that the firm can earn a profit before other firms imitate its product and reduce its market share.

See Figure 4.

The AC and the MC curves in Figure 4 are the same as in Figure 6-2. However, D and the corresponding MR curve are higher on the assumption that other firms have not yet imitated this firm's product, reduced its market share, or competed this firm's profits away. In Figure 4, MR=MC IM_c06_EconomiesOfScaleImperfectCompetitionAndInternationalTrade) .

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at point E, so that the best level of output of the firm is 5 units and price is $4.50. Since at Q=5, AC=$3.00, the firm earns a profit of AB=$2.00 per unit and $10.00 in total.

7. (a) In what way does monopolistic competition resemble monopoly? (b) How is it different? (c) Why is the difference between monopolistic competition and monopoly important for consumer welfare in our intra-industry trade model? a) Monopolistic competition resembles monopoly because under both forms of market organization the firm produces a product that is unique (i.e., no other firm produces an identical product). b) Monopolistic competition is different from monopoly because under monopolistic competition there are many other firms that produce a similar product. On the other hand, there is no close substitute for the product sold by a monopolist.

Furthermore, under monopolistic competition, entry into the industry is easy. As a result, attracted by this firm's profits, more firms enter the industry to produce similar products. This reduces the monopolistically competitive firm's market share (i.e., its demand and corresponding MR curves shift down) until we get to the situation depicted by Figure 6-2 in the text, where P=AC and our firm breaks even. On the other hand, under monopoly, entry into the industry is blocked, so that the monopolist can continue to earn profits in the long run. c) The difference between monopoly and monopolistic competition is important for consumer welfare because consumers get a greater variety of the commodity at a lower price with monopolistic competition than with monopoly.

8. How do the demand curves facing a perfectly competitive firm, a monopolistically competitive firm, and a monopolist differ from one another? Why? A perfectly competitive firm faces an infinitely elastic or horizontal demand curve. This means that the firm is a price taker and can sell any quantity of the homogenous product at the price determined at the intersection of the market demand and supply curves for the commodity.

Both the demand curves faced by the monopolistic competitive firm and the monopolist are downward sloping, indicating that each can sell more units of the commodity by lowering its price.

However, the demand curve facing the monopolistically competitive firm generally has a smaller inclination (i.e., it is more elastic) than the demand curve facing the monopolist because the former sells a commodity for which many good substitute are available.

9. What would happen if the C curve had shifted down only half as much as curve C_in Figure 6.3?

If the C curve had shifted down only half as much as curve C' in Figure 6-3, the new equilibrium point would be at P=AC=$2.50 and N=350.

10. Draw a figure showing the exports of the innovating and of the imitating country during the various stages of the product cycle.

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See Figure 5.

11. Indicate how increased pirating or production and sale of counterfeit American goods without paying royalties by foreign producers might affect the product cycle in the United States.

The increased pirating or production and sale of counterfeit American goods without paying royalties by foreign producers shorten the U.S. product cycle or the time during which the U.S. firm can reap the benefits from the new product or technology it introduced and thus reduces the ability of U.S. firms to engage in research and development (R & D) new product cycles.

12. Show how transportation costs can be analyzed with production frontiers. (Hint: Relative commodity prices with trade will differ by the cost of transportation.)

See Figure 6.

With transportation costs specialization would proceed to point C in Nation 1 and point C’ in Nation 2. Pc in nation 1 (the nation exporting commodity X) is smaller than Pc' in Nation 2 (the country importing commodity X) by the relative cost of transporting each unit of commodity X from Nation 1 to Nation 2. Trade does not seem to be in equilibrium because transportation costs are expressed in terms of commodity X. IM_c06_EconomiesOfScaleImperfectCompetitionAndInternationalTrade) .

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13. Do the same as in Problem1 with offer curves?

See Figure 7.

P2 exceeds P1 by the relative cost of transporting one unit of commodity X from Nation 1 to Nation 2. *14. Draw a figure similar to Figure 6.5, showing that transport costs fall more heavily on the nation with the steeper demand and supply curves for the traded commodity.

See Figure 8.

*= Answer is provided at www.wiley.com/college/salvatore.

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SUGGESTED ANSWERS TO PROBLEMS IN APPENDIX A6.1 Problem Draw a figure showing external economies for a single firm.

See Figure 9.

The firm's AC=AF without and BC with external economies. Thus, at a given level of output of the firm, the firm's AC are lower (i.e., the firm's AC curve shifts down) as cumulative industry output expands.

A6.2 Problem The equation of the learning curve can be expressed as AC = aQb. Explain the meaning of each parameter and whether it needs to assume a positive or negative value to obtain a learning curve.

Parameter "a" refers to the starting AC (i.e., the AC when output or Q is zero). Parameter "b" refers to the rate of decline in AC as cumulative industry output increases. Thus, "b" should be negative.

Furthermore, the larger the absolute value of b, the more rapid is the decline in AC as cumulative industry expands over time.

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CHAPTER 7 ECONOMIC GROWTH AND INTERNATIONAL TRADE OUTLINE 7.1 Introduction 7.2 Growth of Factors of Production 7.2a Labor Growth and Capital Accumulation Over Time 7.2b The Rybczynski Theorem 7.3 Technical Progress 7.3a Neutral, Labor-Saving, and Capital-Saving Technical Progress 7.3b Technical Progress and the Nation's Production Frontier Case Study 7-1: Changes in Relative Resource Endowments of Various Countries and Regions Case Study 7-2: Change in Capital-Labor Rations in Selected Countries 7.4 Growth and Trade: The Small Country Case 7.4a The Effects of Growth on Trade 7.4b Illustration of Factor Growth, Trade, and Welfare 7.4c Technical Progress, Trade, and Welfare Case Study 7-3: Growth of Output per Worker from Capital Deepening, Technological Change, and Improvements in Efficiency 7.5 Growth and Trade: The Large-Country Case 7.5a Growth and the Nation's Terms of Trade and Welfare 7.5b Immiserizing Growth 7.5c Illustration of Beneficial Growth and Trade Case Study 7-4: Growth, Trade, and the Giants of the Future 7.6 Growth, Change in Tastes, and Trade in Both Nations 7.6a Growth and Trade in Both Nations 7.6b Change in Tastes and Trade in Both Nations Case Study 7-5: Change in the Revealed Comparative Advantage of Various Countries or Case Study 7-6: Growth, Trade, and Welfare in the Leading Industrial Nations Appendix:

A7.1 Formal Proof of Rybczynski Theorem A7.2 Growth with Factor Immobility A7.3 Graphical Analysis of Hicksian Technical Progress

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KEY TERMS Comparative statics Dynamic analysis Balanced growth Rybczynski theorem Labor-saving technical progress Capital-saving technical progress Protrade production and consumption

Antitrade production and consumption Neutral production and consumption Normal goods Inferior goods Terms-of-trade effect Wealth effect Immiserizing growth

LECTURE GUIDE 1. This is not a core chapter and it is one of the most challenging chapters in international trade theory. It is included for more advanced students and for completeness.

2. If I were to cover this chapter, I would present two sections in each of three lectures. Time permitting, I would, otherwise cover Sections 1 and 2, paying special attention to the Rybczynski theorem.

SUGGESTED ANSWERS TO PROBLEMS 1. Starting with Nation 2’s pregrowth production frontier of previous chapters, draw a new production frontier for Nation 2 showing that: (a) The amount of both capital and labor available to Nation 2 doubled. (b) Only the amount of capital doubled. (c) Only the amount of labor doubled. a) See Figure 1. b) See Figure 2 c) See Figure 3.

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2. Starting with Nation 2’s pregrowth production frontier of previous chapters, draw a new production frontier for Nation 2 showing the Rybczynski theorem for the doubling of the amount of capital only.

See Figure 4.

3. Starting with Nation 2’s pregrowth production frontier, draw a production frontier for Nation 2 showing neutral technical progress that doubles the productivity of labor and capital in the production of: (a) Both commodity X and commodity Y. (b) Commodity X only. (c) Commodity Y only. a) See Figure 5. b) See Figure 6. c) See Figure 7.

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4. Compare the graphs in Problem 3 with those in Problems 1 and 2.

Compare Figure 5 to Figure 1. Compare Figure 6 to Figure 3. Note that the two production frontiers have the same vertical or Y intercept in Figure 6 but a different vertical or Y intercept in Figure 3. Compare Figure 7 to Figure 2. Note that the two production frontiers have the same horizontal or X intercept in Figure 7 but a different horizontal or X intercept in Figure 2.

*5. Draw for Nation 2 a figure analogous to the top panel of Figure 7.4 under the following assumptions: (a) Only the amount of capital doubles in Nation 2. (b) The free trade equilibrium-relative commodity price is PX/PY = 1. (c) Nation 2 is too small to affect the relative commodity prices at which it trades before and after growth. (d) Nation 2 exports 150Y after growth.

See Figure 8.

*6. Draw for Nation 2 a figure analogous to the bottom panel of Figure 7.4 under the same assumptions as in Problem 5.

See Figure 9.

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7. Draw for Nation 2 a figure analogous to the top panel of Figure 7.5 under the following assumptions: (a) Nation 2 is now large enough to affect the relative commodity prices at which it trades. (b) The terms of trade of Nation 2 deteriorate from PY /PX = 1 with free trade before growth to PY /PX = 1/2 with growth and free trade. (c) Nation 2 exports 140Y with growth and free trade.

See Figure 10.

8. Draw for Nation 2 a figure analogous to the bottom panel of Figure 7.5 under the same assumptions as in Problem 7.

See Figure 11.

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*9. Draw a figure analogous to Figure 7.6 showing immiserizing growth for Nation 2 when the productivity of capital and labor doubled only in the production of commodity Y in Nation 2.

See Figure 12.

10. Draw a figure similar to Figure 7.6 but showing immiserizing growth for an increase in the population and labor force of a nation.

See Figure 13.

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11. Draw for Nation 2 a figure analogous to the top panel of Figure 7.7 under the following assumptions: (a) Only the amount of labor doubles in Nation 2. (b) The terms of trade of Nation 2 improve from PY /PX = 1 with free trade before growth to PY /PX = 2 with growth and free trade. (c) Nation 2 exports 20Y with growth and free trade.

See Figure 14.

12. Draw for Nation 2 a figure analogous to the bottom panel of Figure 7.7 under the same assumptions as in Problem 11.

See Figure 15.

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13. The data in Table 7.3 indicate that the United States has the smallest increase in output per worker, no improvements in efficiency, and a small improvement in technology in relation to other countries in the table. This seems to contradict the information in Table 6.3. How can this seeming contradiction be resolved?

The United States has become the most competitive economy in the world since the early 1990s while the data in Table 7.3 refers to the 1965-1990 period.

The data in Table 7.4 seem to indicate that China had a comparative advantage in capital-intensive commodities and a comparative disadvantage in unskilled-labor intensive commodities in 1973. This was very likely due to the many trade restrictions and subsidies, which distorted the comparative advantage of China. Its true comparative advantage became evident by 1993 after China had started to liberalize its economy.

* = Answer provided at www.wiley.com/college/salvatore.

SUGGESTED ANSWERS TO PROBLEMS IN APPENDIX A7.1 Problem (a) Starting from pretrade, or autarky, equilibrium point A* in Nation 2, prove graphically the Rybczynski theorem for a doubling in the amount of K in Nation 2. (b) What restrictive assumption is required for production and consumption actually to occur at the new equilibrium point after the doubling of K in Nation 2? (c) How are relative commodity prices likely to change as a result of growth only? A result of both growth and free trade? a) See Figure 16. b) For production and consumption to actually occur at the new equilibrium point after the doubling of K in Nation 2, we must assume either than commodity X is inferior or that Nation 2 is too small to affect the relative commodity prices at which it trades. c) Px/Py must rise (i.e., Py/Px must fall) as a result of growth only. Px/Py will fall even more with trade.

A7.2 Problem What happens if the supply of capital increases in Nation 1 in the production of commodity Y only?

If the supply of capital increases in Nation 1 in the production of commodity Y only, the VMPLy curve shifts up, and w rises in both industries. Some labor shifts to the production of Y, the output of Y rises and the output of X falls, r falls, and Px/Py is likely to rise.

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A7.3 Problem Using the tools of analysis developed in this chapter, comment in detail on the following statement: Capital investments tend to increase real wages while technical progress, depending on its type, may increase or reduce real wages.

Capital investments tend to increase real wages because they raise the K/L ratio and the productivity of labor. Technical progress tends to increase K/L and real wages if it is L-saving and to reduce K/L and real wages if it is K-saving.

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*CHAPTER 8: TRADE RESTRICTIONS: TARIFFS (Core Chapter) OUTLINE 8.1 Introduction 8.2 Partial Equilibrium Analysis of a Tariff Case Study 8-1: Average Tariff on Non-Agricultural Products in Major Developed Countries Case Study 8-2: Average Tariff on Non-Agricultural Products in Some Major Developing Countries 8.2a Partial Equilibrium Effects of a Tariff 8.2b Effects of a Tariff on Producer and Consumer Surplus 8.2c Costs and Benefits of a Tariff Case Study 8-3: The Welfare Effects of Liberalizing Trade in Some U.S. Products Case Study 8-4: The Welfare Effects of Liberalizing Trade in Some EU Products 8.3 The Theory of Tariff Structure 8.3a The Rate of Effective Protection 8.3b Generalization and Evaluation of the Theory of Effective Protection Case Study 8-5: Rising Tariff Rates with Degree of Domestic Processing Case Study 8-6: Structure of Tariffs on Industrial Products in U.S., EU, Japan, and Canada 8.4 General Equilibrium Analysis of a Tariff in a Small Country 8.4a General Equilibrium Effects of a Tariff in a Small Country 8.4b Illustration of the Effects of a Tariff in a Small Country 8.4c The Stolper-Samuelson Theorem 8.5 General Equilibrium Analysis of a Tariff in a Large Country 8.5a General Equilibrium Effects of a Tariff in a Large Country 8.5b Illustration of the Effects of a Tariff in a Large Country 8.6 The Optimum Tariff 8.6a The Meaning of the Concept and Retaliation 8.6b Illustration of the Optimum Tariff and Retaliation Appendix:

A8.1 Partial Equilibrium Effects of a Tariff in a Large Nation A8.2 Derivation of the Formula for the Rate of Effective Protection A8.3 The Stolper-Samuelson Theorem Graphically A8.4 Exception to the Stolper-Samuelson Theorem - The Metzler Paradox A8.5 Short-run Effect of a Tariff on Factors' Income A8.6 Measurement of the Optimum Tariff

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KEY TERMS Trade or commercial policies Import tariff Export tariff Ad valorem tariff Specific tariff Compound tariff Consumption effect of a tariff Production effect of a tariff Trade effect of a tariff Revenue effect of a tariff

Consumer surplus Rent or producer surplus Protection cost or deadweight loss of a tariff Nominal tariff Rate of effective protection Domestic value added Prohibitive tariff Stolper-Samuelson theorem Metzler paradox Optimum tariff

LECTURE GUIDE 1. I would cover sections 1 and 2 and assign problems 1-2 in the first lecture. The most difficult part of section 2 is the meaning and measurement of consumer and producer surplus. Since a clear understanding of the meaning and measurement of consumer and producer surplus is crucial in evaluating the effect of tariffs, I would explain these concepts very carefully.

2. I would then cover section 3 and assign problems 3-6 in the second lecture. The theory of tariff structure is also very difficult and important, and so I would also explain this concept very carefully.

I found that the best way to explain it is by using the simple example used in the text of the suit with and without imported inputs.

3. The rest of the chapter can be skipped without loss of continuity by those Instructors who do not wish to cover the general equilibrium effects of tariffs.

4. For those Instructors who wish to cover the rest of the chapter, I would take up another two lectures to do so. I would also assign and grade problems 8-14 to make sure that students understand the material.

5. In covering section 8.4, I would pay special attention to the explanation of Figure 8-5 and to the Stolper-Samuelson theorem.

6. In covering Section 8.6, please note that the optimum tariff can only be discussed intuitively without trade indifference curves (examined in Appendix A8.6).

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SUGGESTED ANSWERS TO PROBLEMS 1. Draw a figure similar to Figure 8.1 for Nation 1 but with the quantity of commodity Y on the horizontal axis and the dollar price of Y on the vertical axis. Draw SY for Nation 1, identical to SX for Nation 2 in Figure 8.1, but draw DY for Nation 1 crossing the vertical axis at PY = $8 and the horizontal axis at 80Y. Finally, assume that PY = $1 under free trade and that Nation 1 then imposes a 100 percent ad valorem import tariff on commodity Y. With regard to your figure, indicate the following for Nation 1: (a) The level of consumption, production, and imports of commodity Y at the free trade price of PY = $1. (b) The level of consumption, production, and imports of commodity Y after Nation 1 imposes the 100 percent ad valorem tariff on commodity Y. (c) What are the consumption, production, trade, and revenue effects of the tariff? a) Consumption is 70Y, production is 10Y and imports are 60Y (see Figure 1).

b) Consumption is 60Y, production is 20Y and imports are 40Y (see Figure 1). c) The consumption effect is -10Y, the production effect is +10Y, the trade effect is -20Y and the revenue effect is $40 (see Figure 1).

2. For the statement of Problem 1: (a) Determine the dollar value of the consumer surplus before and after the imposition of the tariff. (b) Of the increase in the revenue of producers with the tariff (as compared with their revenues under free trade), how much represents increased production costs? Increased rent, or producer surplus? (c) What is the dollar value of the protection cost, or deadweight loss, of the tariff? a) The consumer surplus is $245 without and $l80 with the tariff (see Figure 1).

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b) Of the increase in the revenue of producers with the tariff (as compared with their revenues under free trade), $l5 represents the increase in production costs and another $15 represents the increase in rent or producer surplus (see Figure 1). c) The dollar value or the protection cost of the tariff is $l0 (see Figure 1).

3. Suppose that a nation reduces import tariffs on raw materials and intermediate products but not on finished products. What effect will this have on the rate of effective protection in the nation?

This will increase the rate of effective protection in the nation.

*4. Calculate the rate of effective protection when t (the nominal tariff on the final commodity) is 40 percent, ai (the ratio of the cost of the imported input to the price of the final commodity in the absence of tariffs) is 0.5, and ti (the nominal tariff on the imported input) is 40 percent. g = 0.4 - (0.5)(0.4) = 0.4 - 0.2 = 0.2 = 40% 1.0 - 0.5 0.5 0.5

5. For the given in Problem 4, recalculate g with the following values of ti: (a) ti = 20 percent. (b) ti = 0. (c) ti = 80 percent. (d) ti = 100 percent. a) g=60% b) g=80% c) g=0 d) g=20%

6. For the given in Problem 4, (a) Recalculate g if ti = 20 percent and ai = 0.6. (b) What general conclusion can you reach about the relationship between g and t from your answer to Problem 4 in Chapter 3 and Problem 6(a) above? a) g=70% b) See the first paragraph of section 8.3b.

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*7. Starting with the trade model of Figure 3.4 for Nation 1 and assuming that Nation 1 is small, draw a figure analogous to Figure 8.5 showing the general equilibrium effects resulting when Nation 1 imposes a 100 percent ad valorem import tariff on commodity Y, starting from its free trade position. (Hint: See Figure 4.3but assume that, with the tariff, individuals exchange 30X for 15Y, instead of the 40X for 20Y in Figure 4.3.)

See Figure 2.

*8. Using the Stolper–Samuelson theorem, indicate the effect on the distribution of income between labor and capital in Nation 1 (assumed to be a small nation) when it imposes an import tariff on commodity Y. When Nation 1 (assumed to be a small nation) imposes an import tariff on commodity Y, the real income of labor falls and that of capital rises.

9. Explain the forces at work that lead to the redistribution of income in your answer to Problem 8, in a way analogous to the explanation given in Section 8.4c for the redistribution of income in Nation 2 when that nation imposed an import tariff on commodity X. Py/Px rises for domestic producers and consumers. As production of Y (the K-intensive commodity) rises and that of X falls, the demand and income of K rises and that of L falls. Therefore, r rises and w falls.

10. How would the result in Problem 8 be affected if Nation 1 were instead assumed to be a large nation?

If Nation 1 were instead a large nation, then Nation 1's terms of trade rise and the real income of L may also rise.

11. Is India more likely to restrict its imports of L-intensive or K-intensive commodities?

Why? What effect is this likely to have on the distribution of income between labor and capital in India?

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India is more likely to restrict imports of K-intensive commodities in which India has a comparative disadvantage and this is likely to increase the return to capital and reduce the return to labor according to the Stolper-Samuelson theorem.

12. Starting with the free trade offer curve of Nation 1 and Nation 2 in Figure 8.6 and building on your figure in Problem 1, draw a figure analogous to Figure 8.6 showing the general equilibrium effects of the 100 percent ad valorem import tariff on commodity Y imposed by Nation 1, now assumed to be a large nation.

See Figure 3.

13. Draw a figure analogous to Figure 8.7 for Nation 1 showing that with the optimum tariff Nation 1 will trade 25X for 40Y and also showing the effect of Nation 2 retaliating with an optimum tariff of its own.

See Figure 4.

14. What happens if the two nations retaliate against each other’s optimum tariff several times?

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The volume of trade may shrink to zero (the origin of offer curves).

*= Answer provided at www.wiley.com/college/salvatore.

SUGGESTED ANSWERS TO PROBLEMS IN APPENDIX A8.1 Problem What is the relationship between the price elasticity of SH and SF and the price of the commodity under free trade and with the specific tariff?

The more elastic SH and SF are, the lower is the free trade price of the commodity and the lower is the increase in the domestic price of the commodity as a result of the tariff.

A8.2 Problem (a) What effect will the imposition of a tariff on imported inputs going into the domestic production of a commodity have on the size of the consumption, production, trade, revenue, and redistribution effects of the tariff on the final commodity? (b) What effect will it have on the size of the protection cost, or deadweight loss, of the tariff? (Hint: Determine which curve shifts and in which direction in Figure 8.1 as a result of the tariff on imported inputs.) a) The supply curve of the nation for the commodity shifts up and to the left (as with the imposition of any tax); this does not affect the consumption of the commodity with free trade, but it reduces domestic production and increases imports of the commodity; it also increases the revenue effect and reduces producers' surplus. b) The imposition of a tariff on imported inputs going into the domestic production of the commodity will have no effect on the size of the protection cost or deadweight loss.

A8.3 Problem Utilizing the Edgeworth box diagram for Nation 1 in the top panel of Figure 3.9 and in Figure 5.6, show that a 100 percent import tariff on commodity Y alters production from point B to point F, reduces K/L in the production of both commodities, and thus increases the productivity and income of capital in Nation 1.

See Figure 5

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A8.4 Problem Draw a figure analogous to Figure 8.10 showing in the left panel that the Stolper– Samuelson theorem holds when Nation 1 imposes an export tariff and showing the Metzler paradox in the right panel.

See Figure 6.

A8.5 Problem What effect on real w and r will the imposition of an import tariff on commodity Y (the K-intensive commodity) have in Nation 1 (the L-abundant nation) if labor is mobile but capital is not?

Real w will fall in terms of Y and rise in terms of X. On the other hand, real r will rise in terms of Y and fall in terms of X. This can be seen by drawing a figure similar to Figure 8-10, but with the VMPLy curve shifting upward.

A8.6 Problem (a) Draw a figure analogous to Figure 8.12 showing the optimum export tariff on commodity X for Nation 1. (Hint: For the general shape of Nation 1’s trade indifference curves, see Figure 4.8.) Can you show on the same figure the optimum tariff for Nation 2 after Nation 1 has already imposed its optimum tariff? (Hint: See Figure 8.7.) (b) What are the approximate terms of trade of Nation 1 and Nation 2 after Nation 1 has imposed an optimum tariff and Nation 2 has retaliated with an optimum tariff of its own? (c) How has the welfare of each nation changed from the free trade position? a) See Figure 7.

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b) After Nation 1 has imposed an optimum tariff and Nation 2 has retaliated with an optimum tariff of its own, the approximate terms of trade for Nation 1 is 0.8, while the approximate terms of trade of Nation 2 is 1.25. c) Nation 1's welfare declines from the reduction in the volume and in the terms of trade. Although nation 2's terms of trade are higher than under free trade, the volume of trade has shrunk so much that nation 2's welfare is also likely to be lower than under free trade.

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*CHAPTER 9: NONTARIFF TRADE BARRIERS AND THE NEW PROTECTIONISM (Core Chapter)

OUTLINE 9.1 Introduction 9.2 Import Quotas 9.2a Effects of an Import Quota Case Study 9-1: The Economic Effects of the U.S. Quota on Sugar Imports 9.2b Comparison of an Import Quota to an Import Tariff 9.3 Other Nontariff Barriers and the New Protectionism 9.3a Voluntary Export Restraints Case Study 9-2: Voluntary Export Restraints on Japanese Autos to the United 9.3b Technical, Administrative, and Other Regulations 9.3c International Cartels 9.3d Dumping Case Study 9-3: Antidumping Measures in Force in 2004 9.3e Export Subsidies Case Study 9-4: Agricultural Subsidies in Developed Nations Case Study 9-5: Countervailing Measures in Force in 2004 Case Study 9-6: The Pervasiveness of Nontariff Barriers

States

9.4 The Political Economy of Protectionism 9.4a Fallacious and Questionable Arguments for Protection 9.4b Infant-Industry and Other Qualified Arguments for Protection 9.4c Who Gets Protected?

Case Study 9-7: Welfare Effects on the U.S. Economy of Removing All Import Restraints Case Study 9-8: Effects on the World Economy of Removing All Import Restraints 9.5 Strategic Trade and Industrial Policies 9.5a Strategic Trade Policy 9.5b Strategic Trade and Industrial Policies with Game Theory 9.5c The U.S. Response to Foreign Industrial Targeting and Strategic Trade

Policy

9.6 History of U.S. Commercial Policy 9.6a The Trade Agreements Act of 1934 9.6b The General Agreements on Tariffs and Trade (GATT) 9.6c The 1962 Trade Agreements Act and the Kennedy Round 9.6d The Trade Reform Act of 1974 and the Tokyo Round

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9.6e The 1984 and 1988 Trade Acts 9.7 The Uruguay Round and Outstanding Trade Problems 9.7a The Uruguay Round Case Study 9-9: Gains from the Uruguay Round Case Study 9-10: The Multilateral Rounds of Trade Negotiations 9.7b Outstanding Trade Problems Case Study 9-11: Benefits from a “Likely” Doha Scenario Appendix:

A9.1 Centralized Cartels A9.2 International Price Discrimination A9.3 Tariffs, Subsidies and Domestic Goals

KEY TERMS Quota Nontariff trade barrier (NTBs) New protectionism Voluntary export restraints (VERs) Technical, administrative, and other regulations International cartel Dumping Persistent dumping Predatory dumping Sporadic dumping Trigger-price mechanism Export subsidies Export-Import bank Foreign Sales Corporations Countervailing duties (CVDs) Scientific tariff Infant-industry argument Strategic trade policy Industrial Policy Game theory

Smoot-Hawley Tariff Act of 1930 Trade Agreements Act of 1934 Most-favored-nation principle Bilateral Trade General Agreement on Tariff and Trade (GATT) Multilateral Trade Negotiations International Trade Organization (ITO) Peril-point provisions Escape clause National security clause Trade Expansion Act of 1962 Trade Adjustment Assistance (TAA) Kennedy Round Trade Reform Act of 1974 Tokyo Round Trade and Tariff Act of 1984 Omnibus Trade and Competitiveness Act of 1988 Uruguay Round World Trade Organization (WTO) Globalization Anti-Globalization Movement

LECTURE GUIDE

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1. This is an important core chapter examining some of the most recent developments in international trade policy.

2. I would cover sections 1 and 2 in lecture 1. I would pay particular attention to Figure 9-1, which examines the partial equilibrium effects of an import quota.

3. I would cover section 3 in lecture 2. Here I would clearly explain the difference between a regular import quota and a voluntary export restraint. I would also clearly explain dumping and Figure 92 (which deals with export subsidies). The five case studies serve to highlight the theory and show the relevance of the theory in today's world.

4. I would cover section 4 in lecture 3. Here I would give special attention to the fallacious arguments for protection since they are often heard in common discussions of trade matters. I would also clearly explain the importance of strategic trade and industrial policy and the political economy of who gets protected.

5. I would cover section 5 in lecture 4, which examines strategic trade and industrial policies policies with game theory. This is not difficult and the students will find it very interesting.

6. Sections 6 and 7 can be covered in lecture 5. Here I would stress the Uruguay Round and the outstanding international trade problems.

SUGGESTED ANSWERS TO PROBLEMS 1. Explain why nations impose trade restrictions if free trade is the best policy.

Nations restrict trade either in response to lobbying by the producers of a commodity in which the nation has a comparative disadvantage or to gain a strategic advantage in relation to other nations. The first leads to a welfare loss for the nation as a whole. The second is very difficult to achieve.

2. Starting with DX and SX and PX = $1 with free trade in Figure 9.1, analyze the partial equilibrium effects of an import quota of 30X if DX shifts down to D"X in such a way that D"X is parallel to DX and crosses SX at PX = $2.50.

The partial equilibrium effects of the import quota are: Px=$1.50; consumption is 45X, of which 15X are produced domestically; by auctioning off import licenses, the revenue effect would be $15.

3. Starting with DX and SX and PX = $1 with free trade in Figure 9.1, analyze the partial equilibrium effects of an import quota of 30X if SX shifts up to S"X (parallel to SX) and crosses DX at PX = $3.50.

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The partial equilibrium effects of the import quota are: Px=$2.50; consumption is 40X, of which 10X are produced domestically; the revenue effect is $45.

4. Starting with DX and SX and PX = $1 with free trade in Figure 9.1, analyze the partial equilibrium effects of an import quota of 30X if SX shifts down to S"X (parallel to SX) and crosses DX at PX = $2.50.

The partial equilibrium effects of the quota are: Px=$2; domestic production and consumption are 50X; The revenue is zero.

5. Starting with DX and SX and PX = $1 with free trade in Figure 9.1, analyze the partial equilibrium effects of an import quota of 30X if SX shifts down to S*X (parallel to SX) and crosses DX at PX = $2.00.

The partial equilibrium effects of the quota are: Px=$1; consumption is 70X, production is 30X, and revenue is zero.

6. Starting with DX and SX and PX = $4.50 with free trade in Figure 9.1, analyze the partial equilibrium effects of a negotiated export quota of 30X. The partial equilibrium effects of a negotiated export quota of 30X are: Px=$4; domestic production is 40X, of which 10X are consumed at home.

7. Explain how the effects of a negotiated export quota of 30X, found in Problem 6, are similar to and different from those of an equivalent import tariff or quota.

An export tariff or quota, as an import tariff or quota, affects the price of the commodity and domestic consumption and production. But the effects are the opposite.

8. Draw a straight-line demand curve for a commodity crossing both axes and its corresponding marginal revenue curve (lying everywhere halfway between the vertical axis and the demand curve). On the same graph, draw a hypothetical supply curve for the commodity crossing the demand and marginal revenue curves. If the demand and supply curves refer to the perfectly competitive market for exports of the commodity, determine the equilibrium price and quantity of exports of the commodity.

See Figure 1.

The equilibrium price of the commodity is Px=OC and the equilibrium quantity is Qx=OB in Figure 1.

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9. For the same statement in Problem 8, determine the equilibrium price and quantity of exports of the commodity if the supply curve refers to a cartel of exporters acting as a monopolist.

If the supply curve of the commodity in Figure 1 referred to a cartel of exporters acting as a monopolist, Px=OF and Qx=OA (see Figure 1).

10. Compare your results of Problems 8 and 9. (Hint: Review the perfectly competitive and monopoly models in your principles text or notes.)

Px is higher and Qx smaller when exporters behave as a monopolist.

*11. Draw three sets of price-quantity axes side by side. On the first set of axes (graph), draw a straight-line demand curve (D1) that is steep, starts at a high price, and refers to the domestic market. On the same set of axes, draw the corresponding marginal revenue curve (MR1). On the second graph, draw a straight-line demand curve (D2) that is low and flat and refers to the international market. On the same (second) set of axes, draw the corresponding MR2 curve. On the third graph, sum horizontally the MR1 and MR2 curves (ΣMR) and draw a marginal cost curve (MC) that intersects the ΣMR curve from below in the third graph; then draw a horizontal dashed line and extend it to the second and first graphs. The point where the horizontal dashed line crosses the MR1 curve indicates how much the domestic monopolist should sell in the domestic market, and where the horizontal line crosses the MR2 curve indicates how much he should sell on the international market. (a) What price should the monopolist charge in the domestic market (P1) and in the foreign market (P2)? (b) Why does this represent the best, or optimal, distribution of sales between the two markets?

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a) The monopolist should charge P1=$4 in the domestic market and P2=$3 in Figure 9-5 in Appendix A9.2. b) This represents the best, or optimal distribution of sales between the two markets because any other distribution of sales in the two markets gives less revenue.

12. On a set of axes measuring average costs of production on the vertical axis and the level of output on the horizontal axis, illustrate the infant-industry argument for protection by drawing the long-run average cost curve of an efficient foreign firm facing constant returns to scale and the long-run average cost curve of an infant industry in a developing nation that becomes more efficient than established foreign firms as it grows.

See Figure 2. To the left of point A, the domestic firm faces higher long-run average costs of production (LACD) than the foreign firm (LACF). To the right of point A the opposite is the case.

13. Indicate the strategic trade policy required (if any) if the entries in the top left-hand corner of Table 9.6 were changed to: (a) 10, +10; (b) + 10, 0; (c) + 5, −10. a) If the entries in the top left-hand corner of Table 9-5 were changed to +10, +10, then both Boeing and Airbus would produce the aircraft without any subsidy, and so no strategic trade and industrial policy would be needed in the U.S. or Europe. b) If the entries in the top left-hand corner of Table 9-5 were changed to +5, +0, then both Boeing and Airbus would produce the aircraft without any subsidy, and so no strategic trade and industrial policy would be needed in the U.S. or Europe.

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*Note that even though Airbus only breaks even, in economics we include a normal return on investment as part of costs. Thus, Airbus would remain in business because it would earn a normal return on investment. c) If the entries in the top left-hand corner of Table 9-5 were changed to +5, -10, then both Boeing produces and Airbus does not produce without any subsidy. With a subsidy of at least $10 million per year, however, Airbus would enter the market and lead to a loss of $100 million for Boeing unless the U.S. government would provide a subsidy of at least $5 million per year to Boeing.

14. Suppose that from the free trade production point B, the nation of Figure 8.5 wants to produce 65X (point F). Indicate: (a) How the nation could do this with a tariff or with a subsidy. (b) Why the subsidy would be better.

The answer to part (a) and (b) are presented in Appendix A9.3.

*= Answer provided at www.wiley.com/college/salvatore.

SUGGESTED ANSWERS TO PROBLEMS IN APPENDIX A9.1 Problem. Starting with DX and SX in Figure 9.4, draw a figure showing the monopoly result if there are only two identical exporters of commodity X and they agree to share the market equally. This is a market-sharing cartel.

See Figure 3.

A9.2 Problem. If the absolute value of the price elasticity of demand in the domestic market (ed) is 2 and ef in the foreign market is 3, and ΣMR = MC = $10, calculate at what price the

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domestic monopolist practicing international price discrimination should sell in the domestic market (Pd) and in the foreign market (Pf ) in order to maximize total profits.

[Hint: Use the formula MR = P(1−1/e) from microeconomic theory.]

In order to maximize to maximize total profits the domestic monopolist practicing international price discrimination should sell at the price of Pd=$20 in the domestic market and at the price of Pf=$15 in the foreign market.

A9.3 Problem. Indicate how the nation of Figure 9.6 can reach production point B if external diseconomies in the production of X make the nation produce at point F at the free trade prices of PX/PY = PW = 1.

By imposing a 100% tax on the production of commodity X and giving it as a subsidy to producers of commodity Y.

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CHAPTER 10: ECONOMIC INTEGRATION: CUSTOMS UNIONS AND FREE TRADE AREAS OUTLINE 10.1 Introduction 10.2 Trade-Creating Customs Unions 10.2a Trade Creation 10.2b Illustration of a Trade-Creating Customs Union 10.3 Trade-Diverting Customs Unions 10.3a Trade Diversion 10.3b Illustration of a Trade-Diverting Customs Union 10.4 The Theory of the Second Best and Other Static Welfare Effects 10.4a The Theory of the Second Best 10.4b Conditions More Likely to Lead to Increased Welfare 10.4c Other Static Welfare Effects of Customs Unions 10.5 Dynamic Benefits of Customs Unions *10.6 History of Attempts at Economic Integration 10.6a The European Union Case Study 10-1: Economic Profile of the EU, NAFTA, and Japan Case Study 10-2: Gains from the Single EU Market 10.6b The European Free Trade Association 10.6c The North American and Other Free Trade Agreements Case Study 10-3: Mexico's Gains from NAFTA – Expectations and Outcome 10.6d Attempts at Economic Integration Among Developing Nations Case Study 10-4: Economic Profile of Mercosur Case Study 10-5: Changes in Trade Patterns with Economic Integration 344A 10.6e Economic Integration in Central, Eastern Europe & Former Soviet Republics Case Study 10-6: Per Capita Income of Transition Economies Appendix:

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A10.1 General Equilibrium Analysis of Static Effects of a Trade-Diverting Customs Union A10.2 Regional Trade Agreements Around the World

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KEY TERMS Economic integration Preferential trade arrangements Free-trade area Customs union Common market Economic union Duty-free zones Trade creation Trade diversion Trade-diverting customs union Theory of the second best Tariff factories European Union (EU) Baltic States Free Trade Area (BAFTA)

Variable import levies European Free Trade Association (EFTA) Trade deflection North American Free Trade Agreement (NAFTA) Southern Common Market (Mercosur) Council of Mutual Economic Assistance (CMEA) State trading companies Bilateral agreements Bulk purchasing Central and Eastern European Countries (CEEC) New Independent States (NIS) Commonwealth of Independent States (CIS) Central European Free Trade Association (CEFTA)

LECTURE GUIDE 1. This is not a core chapter and I would skip it except for section 6. Section 6 is an important section and can be regarded as an extension of Chapter 9, which is a core chapter. Section 6 deals with a very important set of current events.

2. Section 6 is a long section and may require two classes to be adequately presented. I would cover subsections a-d in one class and subsection e as well as both case studies in the second class. Case Studies 10-1 to 10-6 can be used for a very stimulating class discussion.

3. While section 6 can be presented without covering the material in sections 1-5, some terms discussed in sections 1-5 (such as trade creation and trade diversion) need to be defined.

4. In a one-year course in international economics, I would cover the entire chapter. I would then cover sections 10-1 to 10-3 in one class and sections 10-4 and 10-5 in the second class. In the first class, the most important aspect would be the presentation and clear explanation of Figures 10-1 and 10-2.

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SUGGESTED ANSWERS TO PROBLEMS *1. Suppose that the autarky price of commodity X is $10 in Nation A, $8 in Nation B, and $6 in Nation C, and that Nation A is too small to affect prices in Nation B or C by trading.

If Nation A initially imposes a nondiscriminatory ad valorem tariff of 100 percent on its imports of commodity X from Nations B and C, will Nation A produce commodity X domestically or import it from Nation B or Nation C? If Nation A imposes a 100 percent ad valorem tariff on imports of commodity X from Nation B and Nation C, Nation A will produce commodity X domestically because the domestic price of commodity X is $10 as compared with the tariff-inclusive price of $16 if Nation A imported commodity X from Nation B and $12 if Nation A imported commodity X from nation C.

*2. Starting with the given of Problem 1: (a) If Nation A subsequently forms a customs union with Nation B, will Nation A produce commodity X domestically or import it from Nation B or Nation C? (b) Is the customs union that Nation A forms with Nation B trade creating, trade diverting, or neither? a) If Nation A forms a customs union with Nation B, Nation A will import commodity X from Nation B at the price of $8 instead of producing it itself at $10 or importing it from Nation C at the tariff-inclusive price of $12. b) When Nation A forms a customs union with Nation B this would be a trade-creating customs union because it replaces domestic production of commodity X at Px=$10 with tariff-free imports of commodity X from Nation B at Px=$8.

*3. Suppose that the autarky prices of commodity X in Nations A, B, and C are the same as in Problem 1, and that Nation A is too small to affect prices in Nations B and C by trading. If Nation A initially imposes a nondiscriminatory ad valorem tariff of 50 percent (rather than 100 percent) on imports of commodity X from Nations B and C, will Nation A produce commodity X domestically or import it from Nation B or Nation C? If Nation A imposes a 50 percent ad valorem tariff on imports of commodity X from Nation B and Nation C, Nation A will import commodity X from nation C at the tariff-inclusive price of $9 instead of producing commodity X itself or importing it from Nation B at the tariff-inclusive price of $12.

4. Starting with the given of Problem 3: (a) If Nation A subsequently forms a customs union with Nation B, will Nation A produce commodity X domestically or import it from Nation B or Nation C? (b) Is the customs union that Nation A forms with Nation B trade creating, trade diverting, or neither?

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a) If Nation A forms a customs union with Nation B, Nation A will import commodity X from Nation B at the price of $8 instead of importing it from Nation C at the tariff-inclusive price of $9. b) When Nation A forms a customs union with Nation B this would be a trade-diverting customs union because it replaces lower-price imports of commodity X of $6 (from the point of view of Nation A as a whole) with higher priced imports of commodity X from Nation B at $8.

Specifically, Nation A's importers do not import commodity X from Nation C because the tariff-inclusive price of commodity X from Nation C is $9 as compared with the no-tariff price of $8 for imports of commodity X from Nation B. However, since the government of Nation A collects the $3 tariff per unit on imports of commodity X from Nation C, the net effective price for imports of commodity X from Nation C is really $6 for Nation A as a whole.

5. Draw a figure illustrating the effects of a trade-creating customs union.

See Figure 10-1 in the text. Any figure similar to Figure 10-1 in the text would do.

6. Measure the welfare gain of a nation joining this customs union.

The welfare gains that Nation 2 receives from joining Nation 1 to form a customs union is given by the sum of the areas of triangles CJM and BHN in Figure 10-1 in the text. Any similar figure and sum of corresponding triangles would, of course, be adequate.

7. Draw a figure illustrating the effects of a trade-diverting customs union that reduces the welfare of a nation joining it.

See Figure 10-2 in the text. Any figure similar to Figure 10-2 in the text would do.

8. Measure the net welfare loss suffered by a nation joining this customs union.

The welfare loss that Nation 2 receives from joining Nation 1 to form a customs union is given by C'JJ'+B'HH'- MNH'J'=$11.25 in Figure 10-2 in the text. Any similar figure and sum of corresponding triangles minus the area of corresponding rectangle would, of course, be adequate.

9. Draw a figure illustrating the effects of a trade-diverting customs union that increases the welfare of a nation joining it.

See Figure 1 and compare it to Figure 10-2.

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10. Measure the net welfare gain of a nation joining a trade-diverting customs union that increases the welfare of the nation.

The net gain from the trade-diverting customs union shown in Figure 1 is given by C'JJ'+B'HH'-MJ'H'N. As contrasted with the case in Figure 10-2, however, the sum of the areas of the two triangles (measuring gains) is greater than the area the rectangle (measuring the loss). Thus, the nation would now gain from the formation of a custom union. Had we drawn the figure on graph paper, we would have been able to measure the net gain in monetary terms also.

11. What are the factors that determine whether a trade-diverting customs union leads to a net increase or decrease in the welfare of a member nation?

A trade-diverting customs union is more likely to lead to a welfare gain of a member nation (1) the smaller is the relative inefficiency of nation 3 with respect to nation 1, (2) the higher is the level of the tariff, and (3) the more elastic are Dx and Sx in nation 2. These can be seen by comparing Figure 10-2 in the text with Figure 1 on the next page.

12. Draw a figure showing what happens if country A forms a customs union with country B only, but the tariff-inclusive prices in country C are less than the free trade prices in country B. See Figure 2. The formation of the customs union has no effect.

13. Explain why the 1988 U.S.-Canada Free Trade Agreement created much less controversy in the United States than NAFTA which included Mexico.

NAFTA created much more controversy because the very low wages in Mexico led to great fears of large job losses in the U. S.

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14. Indicate the possible cost and benefit to the United States from the movement to a single unified market by the European Union at the beginning of 1993.

The possible cost to the U.S. from EU92 arose from the increased efficiency and competitiveness of the E.U. The benefit arose because a more rapid growth in the EU spills into a greater demand for American products, which benefits the U. S.

*= Answer provided at www.wiley.com/college/salvatore.

SUGGESTED ANSWERS TO PROBLEMS IN APPENDIX A10.1 Problem Starting from Figure 10.3, where Nation 2 produces at point F and consumes at point H', prove graphically that the smaller the relative inefficiency of Nation 3 is with respect to Nation 1, the more likely it is that the formation of a customs union between Nation 2 and Nation 3 will lead to a net welfare gain for Nation 2 (even though the customs union would be trade diverting).

Compare points B' and H' in Figure 10-3 with the corresponding points in Figure 3.

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CHAPTER 11: INTERNATIONAL TRADE AND ECONOMIC DEVELOPMENT

OUTLINE 11.1 Introduction 11.2 The Importance of Trade to Development 11.2a Trade Theory and Economic Development 11.2b Trade as an Engine of Growth 11.2c. The Contributions of Trade to Development 11.2d. International Trade and Endogenous Growth Theory 11.3 The Terms of Trade and Economic Development 11.3a The Various Terms of Trade Case Study 11-1: The East Asian Miracle of Growth and Trade Case Study 11-2: The Crisis in High-Performance Asian Economies (HPAEs) 11.3b Alleged Reasons for Deterioration in the Commodity Terms of Trade 11.3c Historical Movement in the Commodity and Income Terms of Trade 11.4 Export Instability and Economic Development 11.4a Causes and Effects of Export Instability Case Study 11-3: Change in Commodity Prices Over Time 11.4b Measurements of Export Instability and its Effect on Development 11.4c International Commodity Agreements 11.5 Import Substitution versus Export Orientation 11.5a Development Through Import Substitution Versus Exports 11.5b The Experience with Import Substitution Case Study 11-4: The Growth of Rich Countries, Globalizers and Non-Globalizers 11.5c Recent Trade Liberalization and Growth in Developing Countries Case Study 11-5: Manufactures in Total Exports of Selected Developing Countries 11.6 Current Problems Facing Developing Countries 11.6a Poverty in Developing Countries 11.6b The Foreign Debt Problem of Developing Countries Case Study 11-6: The Foreign Debt Burden of Developing Countries 11.6c Trade Problems of Developing Countries Case Study 11-7: Globalization and World Poverty

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Income Inequalities by Traditional and Purchasing-Power Parity (PPP) Measures

KEY TERMS Regions of recent settlement Engine of growth Vent for surplus Endogenous growth theory High-performanceAsian economies (HPAEs) Commodity, or net barter, terms of trade Income terms of trade Single factoral terms of trade Double factoral terms of trade Export instability Marketing boards International commodity agreements

Buffer stocks Export controls Purchase contracts Import substitution industrialization (ISI) Export-oriented industrialization Foreign debt Newly industrialized economies (NIEs) Export pessimism New International Economic order (NIEO) United Nations Conference on Trade and Development (UNCTAD)

LECTURE GUIDE 1. This is not a core chapter and I would skip it, except for section 6.

2. If I covered this chapter, I would present two sections in each of three lectures.

SUGGESTED ANSWERS TO PROBLEMS 1. Indicate all the ways in which international trade could retard development.

International trade could retard development by: • keeping the nation in primary production; • leading the nation to adopt excessive capital-intensive production techniques; • increasing the propensity to consume, thus reducing the nation's savings rate; • leading to foreign exploitation of natural resources; 2. Counter each of the criticisms in your answer to Problem 1 that international trade could retard economic development.

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Each of the criticisms that international trade can retard development given in the answer to problem 1 can by countered as follows: • As the availability of capital and technology increases, the nation can begin to export manufactured goods; • through appropriate taxes and subsidies the nation can avoid the use of excessive capital-intensive production techniques; • increased taxation can increase the rate of public savings; • taxation and regulation can reduce or eliminate foreign exploitation; 3. Draw a hypothetical production frontier for a developing nation exhibiting increasing costs. Have the horizontal axis measure primary commodities and the vertical axis measure manufactured goods.

Show on your figure the effect on the nation’s production frontier of an improvement in the technology of primary production.

An improvement in the technology of primary production results in a shift in the nation's transformation curve from Y1X1 to Y1X2 in Figure 1.

4. What effect is an improvement in the technology of primary production likely to have on the terms of trade of a developing country? Why? (Hint: See Chapter 7.)

An improvement in the technology of primary production is likely to lead to deterioration in the terms of trade as the developing nation exports more primary commodities.

5. Draw a figure showing how trade could be a vent for surplus.

A vent for surplus can be shown by a movement from point A inside the nation's production frontier without trade to point A' on the higher production frontier with growth and trade in Figure 2.

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*6. Taking the index of export prices, import prices, volume of exports, and productivity in the export sector in a developing nation to be all equal to 100 in 1980, in 2000 what would be: (a) The commodity terms of trade of this nation if the index of its export prices rises by 10 percent but the index of its import prices rises by 20 percent? (b) This nation’s income terms of trade if the index of export volume grows to 130 by 2000? (c) This nation’s single factoral terms of trade if its productivity index in the export sector rises to 140 by 2000? a) The nation's commodity terms of trade would be 91.7. b) The nation's income terms of trade would be 119.2. c) The nation's single factoral terms of trade would be 128.4. *7. Is the nation in Problem 6 better or worse off in 2000 as compared with 1980? Why? The nation of problem 6 will be better off in 2000 as compared with 1980 because its income and single factoral terms of trade rose. *8. Explain with the use of a graph how deteriorating terms of trade resulting from growth can make a developing nation worse off after growth than before.

Figure 7-6 in the text shows how deteriorating terms of trade resulting from growth can make a nation worse off after trade than before. This was called immiserizing growth in Chapter 7.

9. Draw a figure showing that when the supply of a commodity increases, its equilibrium price will fall by a greater amount the more price-inelastic is the demand curve for the commodity.

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Figure 3 shows that when the supply of a commodity increases, its equilibrium price will fall by a greater amount, the more price inelastic is the demand curve for the commodity.

10. Draw two figures showing that with a negatively inclined demand curve and a positively inclined supply curve, producers’ earnings fluctuate more with a shift in demand than with a shift in supply.

Figure 4 shows that with a negatively inclined demand curve and a positively inclined supply curve, producers' earnings fluctuate more with a shift in demand (Panel a) than with a shift in supply (Panel b).

11. With the use of a diagram, show how a buffer stock could lead either to an unmanageable stock or to the buffer authority running out of the commodity.

Figure 5 shows how a buffer stock could either lead to an unmanageable stock of the commodity or to the running out of the commodity. Specifically, if the buffer stock authority sets price above the long-run equilibrium price of the commodity, it will face an unmanageable stock of the

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commodity. On the other hand, if the buffer stock authority sets price below the long-run equilibrium level, then the buffer stock authority will run out of the commodity.

12. Why has the New International Economic Order demanded by developing countries not been established? Why is this no longer a hotly debated topic?

A New International Economic Order (NIEO) has not been established because industrial countries did not want to give up control over the present system and pay the economic costs of reforming it along the lines demanded by developing countries. The establishment of a NIEO is no longer a hotly debated topic because developed countries faced serious problems of their own during the 1980s and early 1990s in the form of slow growth and high unemployment. The NIEO was replaced by concerns about globalization in the 1990s.

13. In what way did the implementation of the Uruguay Round help developing nations? In what way did it not?

The Uruguay Round benefited developing countries by the reduction in trade protectionism on agricultural products and labor-intensive commodities. Although protectionism will be reduced, it will still remain relatively high in these products.

14. Explain why immiserizing growth does not seem to have occurred in most developing countries over the past three decades.

Immiserizing growth does not seem to have occurred in most globalizing developing countries despite some deterioration in their terms of trade because the volume of trade and their income terms of trade have increased substantially over the past three decades.

15. Explain the reason rich nations should and should not forgive all of the foreign debt of the poorest developing countries.

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Rich nations should forgive all of the foreign debt of the poorest developing countries because it is impossible for them to repay it or even service it. This, however, might encourage the poorest nations to continue to borrow and even use borrowed funds unwisely knowing that eventually their foreign debt might be forgiven.

*= Answer provided at www.wiley.com/college/salvatore.

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CHAPTER 12: INTERNATIONAL RESOURCE MOVEMENTS AND MULTINATIONAL CORPORATIONS OUTLINE 12.1 Introduction 12.2 Some Data on International Capital Flows Case Study 12-1: Fluctuation of Foreign Direct Investment Flows to the United States 12.3 Motives for International Capital Flows 12.3a Motives for International Portfolio Investments 12.3b Motives for Direct Foreign Investments to the United States Case Study 12-2: The Stock of Foreign Direct Investments Around the World 12.4 Welfare Effects of International Capital Flows 12.4a Effects on the Investing and Host Countries 12.4b Other Effects on the Investing and Host Countries 12.5 Multinational Corporations 12.5a Reasons for the Existence of Multinational Corporations 12.5b Problems Created by Multinational Corporations in the Home Country Case Study 12-3: The World's Largest Multinational Industrial Corporations Case Study 12-4: Employment of U.S. MNCs Abroad 12.5c Problems Created by Multinational Corporations in the Host Country 12.6 Motives for and Welfare Effects of International Labor Migration 12.6a Motives for International Labor Migration 12.6b Welfare Effects of International Labor Migration 12.6c Other Welfare Effects of International Labor Migration Case Study 12-5: British and Soviet Brain Drain Is U.S. Brain Gain Case Study 12-6: U.S. Immigration and Debate Over Immigration Policy Appendix: The Transfer Problem

KEY TERMS Portfolio investments Vertical integration Direct investments

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Multinational corporations (MNCs) Portfolio theory Transfer pricing

Risk diversification Brain drain Horizontal integration

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LECTURE GUIDE This is not a core chapter and I would skip it except for section 5 on multinational corporations and section 6 on immigration. Otherwise, I would present two sections in each of three classes.

SUGGESTED ANSWERS TO PROBLEMS 1. On a set of price–quantity axes show the effect of a capital outflow on the investing country.

See Figure 1.

In Figure 1, the outflow of capital is shown by the leftward and upward shift of the SK curve to S'K. This increases the return on capital until it is equal to that in the host or receiving country.

2. On a set of price–quantity axes show the effect of a capital inflow on the host or receiving country.

See Figure 2.

In Figure 2, the outflow of capital is shown by the rightward and downward shift of the SK curve to S'K. This reduces the return on capital until it is equal to that in the investing country.

3. Update Table 12.1 for the most recent year for which data are available.

The data to update Table 12-1 is found in the July issue of the most recent year of Business.

the Survey of Current

4. Update Table 12.2 for the most recent year for which data are available.

The data to update Table 12-2 is found in the July issue of the most recent year of Business.

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the Survey of Current

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5. Update Table 12.3 for the most recent year for which data are available.

The data to update Table 12-3 is found in the July issue of the most recent year of Business.

the Survey of Current

6. Update Table 12.4 for the most recent year for which data are available.

The data to update Table 12-4 is found in the July issue of the most recent year of Business.

the Survey of Current

*7. Determine whether the following statement is true or false and explain why: ‘‘The profitability of a portfolio of many securities can never exceed the yield of the highest-yield security in the portfolio, but it can have a risk lower than the lowest-risk security.’’

The Statement is true.

The profitability of a portfolio is equal to the weighted average of the yield of the securities included in the portfolio. Therefore, the profitability of a portfolio of many securities can never exceed the yield of the highest-yield security in the portfolio. The second part of the statement is also true if the portfolio includes securities for which yields are inversely correlated over time.

8. Draw a figure similar to Figure 12.2 showing equal gains in two nations as a result of capital transfers from Nation 1 to Nation 2.

See Figure 3. The gain of the investing country is EGR.

9. Draw a figure similar to Figure 12.2 showing greater gains for Nation 1 than for Nation 2 resulting from capital transfers from Nation 1 to Nation 2.

See Figure 4. The gain of the host or receiving country is ERM.

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10. What general principle can you deduce from your answer to the previous two problems and from Figure 12.1 as to the distribution of the total gains from international capital transfers between the investing and the host nation?

The general principle that can be deduced from the answers to the previous two problems and from Figure 12-1 is that the nation with the more rapidly declining VMPK curve gains more. With the VMPK curves declining at equal rates, both nations gain equal amounts.

11. Explain why the rate of return on U.S. direct investment in developing nations often exceeds the rate of return on investment on U.S. direct investments in developed nations.

The rate of return on U.S. direct investment in developing nations often exceeds the rate of return on investment on it investments in developed nations because of relative scarcity of capital and technology and lower wage rates in developing than in developed nations.

*12. Using Figure 12.2, explain why organized labor in the United States opposes U.S. investments abroad.

U.S. labor generally opposes U.S. investments abroad because they reduce the K/L ratio and the productivity and wages of labor in the United States.

*13. Using Figure 12.2, explain why labor in developing nations benefits from an inflow of foreign investments.

An inflow of foreign capital leads to an increase in the K/L ratio and in the productivity and wages of labor or employment in developing nations.

14. Update Table 12.6 for the most recent year for which data are available. How has the ranking of the world’s largest MNCs changed since 2006?

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The data to update Table 12-6 are found in the World Investment Report published yearly by the United Nations for the most recent year.

*= Answer provided at www.wiley.com/college/salvatore.

SUGGESTED ANSWERS TO PROBLEMS IN APPENDIX Appendix: Problem A12.1 For the period from 1973 to 1980 (the time of the petroleum crisis), construct a table showing (a) the dollar price per barrel of Saudi Arabian petroleum exports, (b) the dollar value of the total exports of the nations belonging to the Organization of Petroleum Exporting Countries (OPEC), (c) the dollar value of the total imports of OPEC, and (d) the dollar value of U.S. petroleum imports. (Hint: Consult the 1981 issue of International Financial Statistics, published by the International Monetary Fund, in your library.)

See Table 1.

Table 1 (a) (b) (c) Year Petroleum Price OPEC Exports OPEC Imports (US $/barrel) (bill. $) (bill. $) 1973 2.7 39 20.1 1974 9.76 119.3 32.1 1975 10.72 109.8 51.3 1976 11.51 133 62.2 1977 12.4 146 83.8 1978 12.7 141.9 94.9 1979 16.97 208 101.6 1980 28.67 294.2 133.2 Source: International Financial Statistics, 1981 Yearbook.

Petroleum prices refer to Saudi Arabian prices

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(d) US Petroleum Imports (bill. $) 7.6 26.1 26.5 34.1 44.2 41.6 58.6 76.9

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*CHAPTER 13 BALANCE OF PAYMENTS (Core Chapter)

OUTLINE 13.1 Introduction 13.2 Balance of Payments Accounting Principles 13.2a Debits and Credits 13.2b Double-Entry Bookkeeping 13.3 The International Transactions of the United States Case Study 13-1: The Major Goods Exports and Imports of the United States 13.4 Accounting Balances and Disequilibrium in International Transactions 13.5 The Postwar Balance of Payments of the United States Case Study 13-2: The Major Trade Partners of the United States Case Study 13-3: The U.S. Trade Deficit with Japan Case Study 13-4: The Exploding U.S. Trade Deficit with China 13.6 The International Investment Position of the United States Case Study 13-5: The United States as a Debtor Nation Appendix:

A13.1 The IMF Method of Reporting International Transactions A13.2 The Case of the Missing Surplus

KEY TERMS Balance of payments Capital account Credit transactions Autonomous transactions Debit transactions Accommodating transactions Capital inflow

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Official reserve account Capital outflow Official settlements balance Double-entry bookkeeping Deficit in the balance of payments Unilateral transfers

Surplus in the balance of payments Statistical discrepancy International investment position Current account

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LECTURE GUIDE 1. In the first lecture, I would cover sections 1 and 2a. The average student usually finds the meaning of capital inflows and outflows particularly difficult to understand. Therefore, I would pay special care in presenting the material in section 2a. I would also assign problems 1 to 8.

2. In the second lecture, I would cover section 2b and go over problems 1-8.

I would present sections 3 and 4 in the third lecture, and stress the meaning and measurement of balance of payments deficits and surpluses.

Sections 5 and 6 (which are mostly descriptive and not difficult) could be left for students to do on their own so that the chapter could still be covered in three lectures.

SUGGESTED ANSWERS TO PROBLEMS 10. Update Table 13.1 for the most recent year.

11. Update Table 13.2 for the most recent year.

12. Update Table 13.3 for the most recent year.

13. Update Table 13.4 for the most recent year.

14. Update Table 13.5 for the most recent year. *1. Indicate how each of the following international transactions is entered into the U.S. balance of payments with double-entry bookkeeping: (a) A U.S. resident imports $500 worth of merchandise from a U.K. resident and agrees to pay in three months. (b) After the three months, the U.S. resident pays for his imports by drawing down his bank balances in London. (c) What is the net effect of transactions (a) and (b) on the U.S. balance of payments if they occur during the same year? a) The U.S. debits its current account by $500 (for the merchandise imports) and credits capital by the same amount (for the increase in foreign assets in the U.S.).

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b) The U.S. credits capital by $500 (the drawing down of its bank balances in London, a capital inflow) and debits capital by an equal amount (to balance the capital credit that the U.S. importer received when the U.K. exporter accepted to be paid in three months). c) The U.S. is left with a $500 debit in its current account and a net credit balance of $500 in its capital account.

2. Indicate how each of the following international transactions is entered into the U.S. balance of payments with double-entry bookkeeping: (a) The U.S. government gives a $100 cash balance in a U.S. bank to a developing nation as part of the U.S. foreign aid program. (b) The developing nation uses the $100 bank balance to import $100 worth of food from the United States. (c) What is the net effect of transactions (a) and (b) on the U.S. balance of payments if they occur during the same year? a). The U.S. debits unilateral transfers by $100 and credits capital by the same amount. b). The U.S. credits its current account by $100 and debits capital by the same amount. c). The debit of $100 in unilateral transfers and the credit of $100 in current account.

3. Indicate how the following transactions are entered into the U.S. balance of payments with double-entry bookkeeping: (a) The U.S. government gives $100 worth of food aid to a developing nation. (b) What is the difference in their effect on the balance of payments between transaction (a) in this problem, on the one hand, and the net result of transactions (a) and (b) in Problem 2, on the other? a). The same as 2a. b) The net result is the same, but the transaction in part a of this problem refers to "tied" aid while transactions a and b in problem 2 do not.

4. Indicate how the following transaction is entered into the U.S. balance of payments with double-entry bookkeeping: A U.S. resident purchases a $1,000 foreign stock and pays for it by drawing down her bank balances abroad.

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The U.S. debits capital account by $1,000 (for the purchase of the foreign stock by the U.S. resident) and also credits the capital account (for the drawing down of the U.S. resident bank balances abroad) by the same amount.

5. Indicate how the following transaction is entered into the U.S. balance of payments with double-entry bookkeeping: A U.S. resident receives a dividend of $100 on her foreign stock and deposits it into her bank account abroad.

The U.S. credits its current account by $100 and debits its capital account by the same amount. *6. Indicate how the following transaction is entered into the U.S. balance of payments with double-entry bookkeeping: A foreign investor purchases $400 of U.S. treasury bills and pays by drawing down his bank balances in the United States.

The U.S. credits its capital account by $400 (for the purchase of the U.S. treasury bills by the foreign resident) and debits its capital account (for the drawing down of the foreign resident's bank balances in the United States) for the by the same amount. *7. Indicate how the following transaction is entered into the U.S. balance of payments with double-entry bookkeeping: At maturity (during the same year), the foreign investor of Problem 6 receives $440 for the principal and interest earned and deposits these dollars in his bank account in his own nation.

The U.S. debits its current account by $40 for the interest paid, debits its capital account by $400 (for the capital outflow for the repayment of the repayment of the principal to the foreign investors by the U.S. borrower), and then credits its capital account by $440 (the increase in foreign holdings of U.S. assets, a credit).

8. Indicate how the following transaction is entered into the U.S. balance of payments with double-entry bookkeeping: (a) A U.S. commercial bank exchanges $800 worth of pounds sterling for dollars at the Federal Reserve Bank of New York. (b) What effect does this transaction have on the official settlements balance of the United States? a) The U.S. credits its capital account by $800 and debits its official reserves account by the same amount. b) The official settlements balance of the U.S. will improve (i.e., the U.S. deficit will fall or its surplus will rise) by $800.

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9. s (a) From Table 13.3, calculate the official settlements balance of the United States for each year from 1965 to 2008. (b) Why is this an appropriate measure for the U.S. balance-of-payments position until 1972, but not as appropriate since 1973? a) Year

Bal. Pay. $

1965 -1 1966 1967 1968 1969 1970 1971 1972 1973 1974

0 -3 2 2 -10 -30 -11 -6 -10

Year

Bal. Pay. $

Year

Bal. Pay. $

Year

Bal. Pay. $

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984

-6 -15 -37 -35 14 -8 -1 1 -5 0

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

5 -36 -54 -36 16 -32 -23 -44 -71 -45

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

($100) -134 -18 27 -53 -42 -23 -112 -280 -398

where values are in billions of dollars and a negative balance represents a deficit while a positive balance a surplus in the balance of payments. b) Because until 1972, we had a fixed exchange rate system, but from 1973 we had a managed floating exchange rate system. Under the latter, the balance of payments only measures the amount of official intervention in foreign exchange markets.

10. Update Table 13.1 for the most recent year.

See the July Issue of the Survey of Current Business for the most recent year.

11. Update Table 13.2 for the most recent year.

See the July Issue of the Survey of Current Business for the most recent year.

12. Update Table 13.3 for the most recent year.

See the July Issue of the Survey of Current Business for the most recent year.

13. Update Table 13.4 for the most recent year.

See the July and November Issues of the Survey of Current Business for the most recent year.

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14. Update Table 13.5 for the most recent year.

See the Balance of Payments Statistics Yearbook for the most recent year.

*= Answer provided at www.wiley.com/college/salvatore.

SUGGESTED ANSWERS TO PROBLEMS IN APPENDIX Problem A13.1 Indicate the major difference between the way the United States keeps its balance of payments (Table 13.1) and the International Monetary Fund method (Table 13.6).

The major difference between the way the United States keeps its balance of payments and the International Monetary Fund method is in the way they deal with international capital movements. The United States records international capital movements as increases in U.S.owned assets abroad and foreign-owned assets in the United States, subdivided into government and private. The International Monetary Fund includes international capital flows into a financial account, which is subdivided into direct investments, portfolio investments assets and liabilities, and other investment assets and liabilities.

See the table in April and October issue of the IMF's World Economic Outlook for the most recent year.

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*CHAPTER 14 FOREIGN EXCHANGE MARKETS AND EXCHANGE RATES (Core Chapter)

OUTLINE 14.1

Introduction

14.2 Functions of the Foreign Exchange Markets Case Study 14-1: The U.S. Dollar as the Major Vehicle Currency Case Study 14-2: The Birth of a New Currency: The Euro 14.3

Foreign Exchange Rates 14.3a Equilibrium Foreign Exchange Rates Case Study 14-3: Foreign Exchange Quotations 14.3b Arbitrage 14.3c The Exchange Rate and the Balance of Payments

14.4 Spot and Forward Rates, and Foreign Currency Swaps, Futures and Options 14.4a Spot and Forward Rates 14.4b Currency Swaps 14.4c Foreign Exchange Futures and Options Case Study 14-4: Quotations on Foreign Currency Futures and Options Case Study 14-5: Size, Currency and Geographical Distribution of the Foreign Exchange Market 14.5 Foreign Exchange Risks, Hedging, and Speculation 14.5a Foreign Exchange Risks 14.5b Hedging 14.5c Speculation 14.6 Interest Arbitrage and Efficiency of Foreign Exchange Markets 14.6a Uncovered Interest Arbitrage 14.6b Covered Interest Arbitrage 14.6c Covered Interest Arbitrage Parity 14.6d Covered Interest Arbitrage Margin 14.6e Efficiency of Foreign Exchange Markets Case Study 14-6: Local Currency and Dollar Stock Returns Around the World

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14.7 Eurocurrency Markets 14.7a Description and Size of Eurocurrency Markets 14.7b Reasons for the Development and Growth of the Eurocurrency Market Case Study 14-7: Size and Growth of the Eurocurrency Market 14.7c Operation and Effects of Eurocurrency Markets 14.7d Eurobond and Euronote Markets Case Study 14-8: Rising Competition in Global Banking Appendix

A14.1 Derivation of Formula for Covered Interest Arbitrage Margin

KEY TERMS Foreign exchange market Vehicle currency Seignorage Euro Exchange rate Depreciation Appreciation Cross Exchange rate Effective exchange rate Arbitrage Spot rate Forward rate Forward discount Forward premium Currency swaps Foreign exchange futures Foreign exchange options

Foreign exchange risk Hedging Speculation Stabilizing speculation Destabilizing speculation Interest arbitrage Uncovered interest arbitrage Covered interest arbitrage Covered interest arbitrage parity (CIAP) Covered interest arbitrage margin (CIAM) Efficiency of foreign exchange markets Eurocurrency Eurocurrency market Offshore deposits Eurobonds Euronotes

LECTURE GUIDE 1. This is one of the most important and challenging of the core chapters, and to cover it adequately requires five classes.

2. I would cover the first three sections in the first class, and spend one class on each of the remaining four sections.

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3. Students find hedging and speculation difficult. I would explain them slowly and very carefully. I would also assign and go over the problems in class.

4. Section 6 on interest arbitrage and the efficiency of foreign exchange markets is also difficult but very important and so I would cover it slowly and very carefully.

SUGGESTED ANSWERS TO PROBLEMS 1. From the following figure, determine (a) the equilibrium exchange rate between the dollar and the pound sterling and the equilibrium quantity of pounds with supply curve S£ and S'£ under a flexible exchange rate system. (b) If the United States wanted to maintain the exchange rate at $3 = £1 with supply curve S£, how much pound reserves would the U.S. central bank gain or lose per day? a. With supply curve of pounds S£, the equilibrium exchange rate is R=$2/£1 and the equilibrium quantity is Q=£40 million (point E in Figure 1) under a flexible exchange rate system. On the other hand with supply curve of pounds S’£, the equilibrium exchange rate would be R=$3/£1 and the equilibrium quantity would be Q=£20 million (point B in Figure 1).

b. If the United States wanted to maintain the exchange rate fixed at R=3 in Figure 1 with supply curve S£, the U.S. central bank would gain £40 million in reserves per day.

2. s(a) Redraw demand curve for pounds D£ and supply curve of pounds S£ as in the figure of Problem 1 and draw on it another supply curve for pounds (label it S∗£) that intersects D£ at $1 = £1 (label the point of intersection C). (b) Assuming a flexible exchange rate system, determine the equilibrium exchange rate and equilibrium quantity of pounds with S∗£.

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(c) If the United States wanted to maintain a fixed exchange rate of R = 1.5 with S∗£, indicate the amount of pound reserves that the U.S. central bank would gain or lose per day. a. See Figure 2.

b. With supply curve of pounds S*£, the equilibrium exchange rate would be R=$1/£1 and Q=£70 million under a flexible exchange rate system (see Figure 2). c. If the United States wanted to maintain a fixed exchange rate of R=1 in Figure 2 with S*£, the U.S. central bank would lose £50 million of reserves per day.

3. Assume the following exchange rates: $2 = £1 in New York ¥410 = £1 in London ¥200 = $1 in Tokyo Indicate how profitable triangular, or three point, arbitrage can take place.

Use $2 to purchase £1 in New York, use the £1 to purchase 410 yens in London, and use the 410 yens to purchase $2.05 in Tokyo, thus earning $0.05 in profit for each pound so transferred.

4. s(a) Identify the forces at work that will make the cross exchange rates consistent in currency arbitrage in the previous problem. (b) What are the consistent cross rates in Problem 3? a. The forces at work that will make the cross exchange rates consistent in currency arbitrage in the previous problem are as follows. The selling of pounds for yens in London will reduce the yen price of the pound in London until it is 400 yens to 1.

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b. The consistent cross rates in Problem 3 are: $2=£1=400 yens.

*5. Calculate the forward discount or premium for the following spot and three-month forward rates: (a) SR = $2.00/£1 and FR = $2.01/£1 (b) SR = $2.00/£1 and FR = $1.96/£1 a. The pound is at a three-month forward premium of 1c or 0.5% (or 2%/year) with respect to the dollar. b. The pound is at a three-month forward discount of 4c or 2% (or 8%/year) with respect to the dollar.

6. Calculate the forward discount or premium for the following spot and three-month forward rates: (a) SR = SF2/€1 and SF2.02/€1 where SF is the Swiss franc and € is the euro. (b) SR = ¥200/$1 and FR = ¥190/$1 a. The euro is at three-month forward premium of 1% (or 4%/year) with respect to the Swiss franc. b. The dollar is at three-month forward discount of 5% (or 20%/year) with respect to the yen.

7. Assume that SR = $2/£1 and the three-month FR = $1.96/£1. How can an importer who will have to pay £10,000 in three months hedge the foreign exchange risk?

The importer would have to purchase forward £10,000 pounds for delivery in three months at today's FR=$1.96/£1.

After three months (and regardless of what the spot rate is at that time), the importer would pay $19,600 and obtain the £10,000 he needs to make the payment.

8. For the given in Problem 7, indicate how an exporter who expects to receive a payment of £1 million in three months hedges the foreign exchange risk.

The exporter would have to sell forward £10,000 pounds for delivery in three months at today's FR=$1.96/£1.

After three months, the exporter will deliver the £10,000 and receive $19,600.

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*9. Assume that the three month FR = $2.00/£1 and a speculator believes that the spot rate in three months will be SR = $2.05/£1. How can a person speculate in the forward market?

How much will the speculator earn if he or she is correct?

The speculator can speculate in the forward exchange market by purchasing pounds forward for delivery in three months at FR=$2/£1.

If the speculator is correct, he will earn 5c per pound purchased.

10. If the speculator of Problem 9 believes that the spot rate in three months will be SR = $1.95/£1, how can he or she speculate in the forward market? How much will the speculator earn if he or she is correct? What will the result be if in three months SR = $2.05/£1 instead?

The speculator can speculate in the forward exchange market by selling pounds forward.

If the speculator is right, he will earn 5c per pound transferred.

If, on the other hand, SR=$2.05/£1, the speculator will lose 5c per pound. *11. If the positive interest rate differential in favor of a foreign monetary center is 4 percent per year and the foreign currency is at a forward discount of 2 percent per year, roughly how much would an interest arbitrageur earn from the purchase of foreign threemonth treasury bills if he or she covered the foreign exchange risk?

The interest arbitrageur will earn 2% per year from the purchase of foreign three-month treasury bills if he covers the foreign exchange risk.

12. For the given of Problem 11, indicate: (a) How much would an interest arbitrageur earn if the foreign currency were at a forward premium of 1 percent per year? (b) What would happen if the foreign currency were at a forward discount of 6 percent per year? a. If the foreign currency was instead at a forward premium of 1 percent per year, the interest arbitrageur would earn 5% per year. b. If the foreign currency was at a forward discount of 6 percent per year, it would pay for investors to transfer funds from the higher- to the lower-interest center and lose 4% interest but gain 6% from the foreign exchange transaction, for a net gain of 2% per year.

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13. With reference to Figure 14.4, explain (a) why there will be an arbitrage inflow at points B and B' and (b) the forces that tend to eliminate the net gain as arbitrage inflows continue. a. At point B, the loss of 1% per year from the forward premium on the foreign exchange transaction on the part of the foreign investor is more than made up by the 2% per year gain from the higher interest rate in our nation.

At point B', the 1% interest loss per year on arbitrage inflow into our nation is less than the 2% per year gain on the forward discount on currency transaction. b. As arbitrage inflow continues from point B, the positive interest differential in favor of our nation declines and the forward premium on the foreign currency increases.

From B', the interest differential in favor of the foreign country increases and the forward discount on the foreign currency decreases.

14. Explain why even when CIAP holds, investors in different monetary centers do not necessarily receive the same returns on their financial investments.

At CIAP, there is no further possibility from increasing returns over and above those that investors can achieve in their own country, but this does not mean that returns in the two countries are equalized.

As proof of this, we can see that in the example given at the end of Section 14.6d, annualized returns remain at 8 percent in London for British investors and are increased from 6 percent to 6.852 for American investors without considering transaction costs and 6.602 percent if we consider transaction costs of 1/4 of 1 percent investing in London. Thus, returns become less unequal as a result of CIA, but are not equalized!

*= Answer provided at www.wiley.com/college/salvatore.

SUGGESTED ANSWERS TO PROBLEMS IN APPENDIX Problem A14.1 Using the data on i, i∗, SR, and FR in the numerical example at the end of Section 14.6d, determine the dollar amount (principal plus interest) that a U.S. investor will get back by investing $100,000 for three months in (a) U.S. treasury bills or (b) EMU treasury bills with the foreign exchange risk covered. How would your answer to Part (b) differ if you estimated the CIAM as in Section 14.6b?

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a. The U.S. investor will get back ($200,000)(1.015) = $203,000. b. The U.S. investor will get back $203,000 + ($200,000)(0.00213) = $203,000 + $426 = $203,426. c. The U.S. investor will get back $205,000 + ($200,000)(0.0025) = $203,000 + $500 = $203,500, an overestimation of $74.

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*CHAPTER 15 EXCHANGE RATE DETERMINATION (Core Chapter) OUTLINE 15.1 Introduction 15.2 Purchasing-Power Parity Theory 15.2a Absolute Purchasing-Power Parity Theory Case Study 15-1: Absolute Purchasing-Power Parity in the Real World Case Study 15-2: Big McCurrencies 15.2b Relative Purchasing-Power Parity Theory Case Study 15-3: Relative Purchasing-Power Parity in the Real World 15.2c Empirical Tests of Purchasing-Power Parity 15.3 Monetary Approach to the Balance of Payments and Exchange Rates 15.3a Monetary Approach Under Fixed Exchange Rates 15.3b Monetary Approach Under Flexible Exchange Rates 15.3c Monetary Approach to Exchange Rate Determination Case Study 15-4: Monetary Growth and Inflation Case Study 15-5: Nominal and Real Exchange Rates, and the Monetary Approach 15.3d Expectations, Interest Differentials, and Exchange Rates Case Study 15-6: Interest Differentials, Exchange Rates, and the Monetary Approach 15.4 Portfolio Balance Model and Exchange Rates 15.4a Portfolio Balance Model 15.5b Extended Portfolio Balance Model 15.5c Portfolio Adjustments and Exchange Rates 15.5 Exchange Rate Dynamics 15.5a Exchange Rate Overshooting 15.5b Time Path to a New Equilibrium Exchange Rate Case Study 15-7: Exchange Rate Overshooting of the U.S. Dollar 15.6 Empirical Tests of the Monetary and Portfolio Balance Models and Exchange Rate Forecasting Case Study 15-8: The Euro Defies Forecasts During Its First Year Appendix:

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A15.1 Formal Monetary Approach Model A15.2 Formal Portfolio Balance Model

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KEY TERMS Purchasing-power parity (PPP) theory Absolute purchasing-power parity theory Law of one price Relative purchasing-power parity theory Balassa-Samuelson effect Monetary approach to the balance of payments Demand for money

Supply of money Monetary base Real exchange rate Portfolio balance approach Expected change in spot rate Risk premium Exchange rate overshooting

LECTURE GUIDE 1. This is another important and challenging core chapter.

2. Since the material in this chapter is rather challenging, five classes may be required to adequately cover it. I would use one class to cover each of sections 2-6.

3. Section 2 on the purchasing power-parity (PPP) theory is not too difficult and students will find Case Study 2 particularly interesting. The question of with respect to which currency the U.S. dollar is undervalued or overvalued can be very confusing to students because the table follows the British tradition of defining the exchange rate as the price of a unit of the domestic currency with respect to the foreign currency. Confusion can be avoided by keeping in mind that a negative sign in a value in the last column of the table means that the dollar is undervalued with respect to the currency of the foreign nation, while a positive sign refers to the dollar is overvalued.

4. Section 3 dealing with the monetary approach to the balance of payments and exchange rate determination is not too difficult, except for section 3d on expectations. The three case studies add real world relevance and stimulate students' interest.

5. Section 4 on the asset market or portfolio balance approach starts with a simple model with only the domestic and the foreign interest rate as the determinants of the demand for the domestic currency, the domestic bond, and the foreign bond, and then extends the model to include expected exchange rate changes, risk premium, real income, prices, and wealth as explanatory variables. Section 15.4c on portfolio adjustments and exchange rates brings it all together but is rather challenging.

6. Section 5 on exchange rate overshooting can be challenging for students, especially the reason for the overshooting.

7. In covering Section 6 on empirical testing of the monetary and portfolio balance models and exchange rate forecasting it is important to clearly point out to the students that even though

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empirical tests do not support the theories presented in the chapter, this does not mean that the theories are wrong or not useful.

SUGGESTED ANSWERS TO PROBLEMS 1. In 1973 the GDP deflator was 15.6 in the United Kingdom and 34.3 in the United States (with 1995 = 100). In 2001, it was 116.1 in the United Kingdom and 112.1 in the United States. The exchange rate was £0.4078 to the dollar in 1973 and £0.6944 to the dollar in 1998. (a) Calculate the rate of inflation in the United Kingdom minus the rate of inflation in the United States from 1973 to 2001 and compare it with the rate of depreciation of the British pound with respect to the U.S. dollar over the same time period. (b) Did the relative purchasing-power parity (PPP) theory hold between the United Kingdom and the United States between 1973 and 2001? Why? a.

The rate of inflation in Switzerland from 1973 to 1998 was: 101.3 - 46.6 = 54.7 = 0.739 or 73.9% (101.3+46.6)/2 74

On the other hand, the rate of inflation in the United States from 1973 to 1998 was: 107.0 – 29.2 = 77.8 = 1.142 or 114.2% (107.0+29.2)/2 68.1 Thus, the inflation rate in Switzerland minus the inflation rate in the United States from 1973 to 1998 was: 73.9% - 114.2% = -40.3% From 1973 to 1998, the Swiss franc appreciated with respect to the U.S. dollar from 3.1648 Swiss francs per dollar in 1973 to 1.4898 Swiss francs per dollar in 1998 or by 1.4898 - 3.1648 = -1.675 (1.4898+3.1648)/2 2.3273

=

-0.720 or -72.0%

b. The relative PPP theory did hold only to the extent that since the rate of inflation was lower in Switzerland than in the United States the Swiss franc appreciated with respect to the U.S. dollar between 1973 and 1998. But the percent appreciation of the Swiss franc with respect to the dollar was much greater than that predicted by the relative PPP. Note that in the above calculations, percentage changes were obtained by the average of the beginning and end values. You may want to ask the class to do the same when assigning this and the next problem so as to get the same answer.

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2. In 1973, the GDP deflator was 45.0 in Switzerland and 34.3 in the United States (with 1995 = 100). In 2001, it was 103.2 in Switzerland and 112.1 in the United States. The exchange rate of the Swiss franc was SF3.1648 per dollar in 1973 and 1.6876 in 2001. Did the relative PPP theory hold between Switzerland and the United States between 1973 and 2001? Why? The rate of inflation in Spain from 1973 and 1998 was: 107.5 – 10.1 (107.5+10.1)/2

= 97.4 58.8

= 1.656 or 165.6%

Thus the rate of inflation in Spain minus the rate of inflation in the United States (found in Problem 1a) is: 165.6% - 114.2% = 51.4% From 1973 to 1998, the Spanish peseta depreciated from 58.26 pesetas per dollar in 1973 to 149.40 pesetas to the dollar in 1998 or by: 149.40 - 58.26 = 91.14 = (149.40+58.26)/2 103.83

0.878 or 87.8%

Since Spain had an inflation rate 51.4 percent higher than the U.S. inflation rate and the Spanish peseta depreciated by 87.8 percent from 1973 and 1998, we can say that the relative PPP theory worked reasonably well between the United States and Spain during this period.

3. Suppose that the velocity of circulation of money is V = 5 and the nominal GDP of the nation is $200 billion. (a) What is the quantity of money demanded by the nation? (b) By how much will the quantity of money demanded rise if the nation’s nominal GDP rises to $220 billion? (c) What happens to the nation’s demand for money if its nominal GDP increases by 10 percent each year? a. Md=kPY=(1/V)(PY)=(1/5)(200)=$40 billion. b. If the nation's nominal GDP rises to $220 billion, Md=220/5=$44 billion. c. If the nation's nominal GNP increases by 10 percent each year, Md increases also by 10 per cent each year.

4. Suppose that the domestic credit created by the nation’s monetary authorities is $8 billion and the nation’s international reserves are $2 billion, and that the legal reserve requirement for the nation’s commercial banking system is 25 percent.

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(a) How much is the monetary base of the nation? (b) What is the value of the money multiplier? (c) What is the value of the total supply of money of the nation? a. Monetary base of the nation is, D+F=8+2=$10 billion. b. The value of the money multiplier is, m=1/LLR=1/0.25=4. c. The value of the nation's total money supply is Ms=m(D+F)=4(8+2)=$40 billion

5. Assuming fixed exchange rates, find the size of the deficit or surplus in the balance of payments of the nation described in (a) Problems 3a and 4a. (b) Problems 3b and 4b. (c) Problems 3c and 4c. a. Md=Ms and the nation is in balance of payments equilibrium. b. Md of $44 billion exceeds Ms of $40 by $4 billion. c. With m=4, there will be an inflow of money or international reserves from abroad of $1 billion to equate Ms to Md. Thus, the nation's balance of payments surplus will be equal to $1.

6. Explain how the balance-of-payments disequilibrium is corrected if monetary authorities do not change the domestic component of the nation’s monetary base: (a) In Problem 5b. (b) In Problem 5c. (c) What happens if monetary authorities completely sterilize, or neutralize, the balance-ofpayments disequilibrium with a change in the domestic component of the nation’s monetary base? How long can this go on?

The nation will face a continuous inflow of money or international reserves and balance of payments surplus of $1 billion, year in and year out. a. If monetary authorities do not change the domestic component of the nation's monetary base, the nation's balance of payments disequilibrium is corrected by a once-and-for-all inflow of money or international reserves of $1 billion. b. If monetary authorities do not change the domestic component of the nation's monetary base, the nation's balance of payments disequilibrium is corrected by a once-and-for-all inflow of money or international reserves of $1 billion.

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c. If monetary authorities completely sterilize, or neutralize, the balance-of-payments disequilibrium with a change in the domestic component of the nation's monetary base, the domestic component of the nation's monetary base will fall by an amount equal to the increase in the foreign component of the nation's monetary base so as to leave the monetary base unchanged. This could only go on until the domestic component of the nation's monetary base has dropped to zero.

*7. Suppose that a nation’s nominal GDP = 100, V = 4, and Ms = 30. Explain why this nation has a deficit in its balance of payments.

Md=100/4=25 falls short of Ms=30 and there will be an outflow of international reserves (a deficit in the nation's balance of payments).

8. Under the law of one price, the price of an internationally traded commodity in one nation in a two-nation world is equal to the exchange rate times the price of the same commodity in the other nation. Assuming that such a law holds, explain why, if the first nation would otherwise face no inflation at home, it will not be able to maintain in the long run both constant prices and a constant exchange rate in the face of inflation in the other nation.

According to the monetary approach, inflation in the second nation is caused by excessive money creation there. As a result, either the first nation's exchange rate has to appreciate to keep its balance of payments in equilibrium or its monetary base will rise (so that inflation will spread to nation 1).

*9. Suppose that the interest rate is i = 10% in New York and i∗ = 6% in Frankfurt, the spot rate is SR = $1/€1 today and is expected to be $1.01/€1 in three months. (a) Indicate why the condition for uncovered interest parity (UIP) is satisfied. (b) Explain what would happen if there was a change in expectations so that the spot rate in three months became $1.02/€ and the interest rate differential remained unchanged. a) The condition for uncovered interest parity is given by i-i*=EA, where EA is the expected appreciation of the pound. That is, since the spot rate of SR=$2.02/£1 in three months is 1% (4% on an annual basis) higher than SR=$2.00/£1 today, the condition for UIA is satisfied because 6%-10% = 4% (with all percentage rates expressed on an annual basis). b) If the spot rate is expected to be SR=$2.04/£1 in three months, the pound would be expected to appreciate by 2% for the three months (8% on an annual basis). Investors would now earn more by investing in London than by investing in New York and the condition for UIA would no longer be satisfied. As more dollars are exchanged for pounds to increase investments in London, the actual spot rate will increase from SR=$2.00/£1 to SR=$2.02/£1. This will leave only an expected appreciation of the pound of about 4% per year (the same as before the change in expectations). This is obtained by comparing the new higher spot rate of SR=$2.02/£1 today with the new expected spot rate of SR=$2.04/£1 in three months, so as to return to UIA parity.

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10. s(a) What is the difference between the expected change in the exchange rate and the forward discount or forward premium on the foreign currency? (b) When would the expected change in the exchange rate equal the forward discount or forward premium on the foreign currency? a) The expected change in the exchange rate is part of the uncovered interest parity (UIP) condition (see Equation 15-8). Here investors face a foreign exchange risk in purchasing foreign bonds. On the other hand, the forward discount or premium is part of covered interest arbitrage condition (see Equation 14-1) and investors do not face any foreign exchange risk in purchasing foreign bonds. b) If the actual change in the exchange rate were always exactly equal to the expected change in the exchange rate, then the expected change in the exchange rate would be equal to the forward discount.

11. Suppose that individuals and firms in a nation are holding the desired proportion of their wealth in foreign bonds to begin with. Suppose that there is then a once-and-for-all decrease in the exchange rate (i.e., the domestic currency appreciates and the foreign currency depreciates). What is the adjustment that the simple portfolio balance model presented in Section 15.4a postulates?

The depreciation of the foreign currency means that the domestic-currency value of foreign bonds has decreased and the nation's residents now hold less of their wealth in foreign bonds than they want. They will, therefore, purchase more foreign bonds. This is stock adjustment that leads to a once-and-for-all increase in the quantity purchased of the foreign currency (to purchase the foreign bonds), which, in turn, leads to an appreciation of the foreign currency that neutralizes in part the original depreciation of the foreign currency.

*12. Discuss the portfolio adjustment for an increase in expected domestic inflation under flexible exchange rates using the extended or portfolio balance model presented in Section 15.4b.

According to the portfolio balance approach, an increase in the expected rate of inflation in the nation would lead to the expectation that the domestic currency will depreciate and the foreign currency will appreciate under flexible exchange rates. In terms of the extended portfolio balance model, this means that the expected appreciation of the foreign currency (EA) increases. The rise in EA will lead to a reduction in the demand for money balances (M) and the domestic bond (D) and an increase in the demand for the foreign bond (F) by domestic residents (see Equations 15-10 to 15-12). This leads to a depreciation of the domestic currency as domestic residents exchange the domestic for the foreign currency in order to purchase the foreign bond and to other changes in all other variables of the model until equlibrium is reestablisehd in all the markets simultaneously.

13. Using the extended asset market or portfolio balance model presented in Section 15.4b examine the portfolio adjustment resulting from an increase in the supply of the foreign bond because of the foreign government budget deficit.

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The increase in the supply of the foreign bond because of a foreign government's budget deficit increases the risk premium on holdings of foreign bonds by home-country residents. This reduces the right-hand side of the UIP condition (Equation remaining equal, this leads to a depreciation of the foreign currency and appreciation of the domestic currency as investors switch from foreign to domestic bonds.

Furtheremore, if inflation expectations abroad increase because of the budget deficit, this will reinforce the tendency of the foreign currency to depreciate and domestic currency to appreciate. The depreciation of the foreign currency will then make foreign bonds cheaper to home-country residents and this induces them to buy more of them. Portfolio adjustments will continue until equilibrium is reestablished in all markets simultaneously.

14. Explain the exchange rate dynamics of the dollar resulting from an unanticipated increase in the money supply by the EMU central bank.

The unanticipated increase in the money supply by the U.K. central bank, will lead to an immediate reduction in the British interest rate and a magnified depreciation of the pound (appreciation of the dollar). Over time, as prices and interest rates rise in the United Kingdom, the pound appreciates (dollar depreciates) so as to remove its undervaluation (overvaluation) in order to reach its new long-run equilibrium level.

*= Answer provided at www.wiley.com/college/salvatore.

SUGGESTED ANSWERS TO PROBLEMS IN APPENDIX Problem A15.1 Suppose that the values obtained by estimating Equation (15A-8) for a particular nation over a specified period of time are a = b = c = 1 and gu = gi = gm = 0.

Suppose also that at the beginning of the period of the analysis, D = 100 and F = 20 in this nation and during the period of the analysis gP = 10% and gY = 4% and the nation’s monetary authorities increase D from 100 to 110. Estimate the value of this nation’s international reserves (F) at the end of the period under fixed exchange rates.

At the beginning of the period: H = D + F = 100 + 20 = 120 and F/H = 20/120 and D/H = 100/120 Over the period of the analysis: gD = (10/100)100=10% Rewriting (19A-8) and substituting the values of the problem into it, we get: (F/H)gF = agP + bgY + gu – cgr – gm - (D/H)gD (20/120)gF = 0.1 + 0.04 + 0 – 0 – 0 - (100/120)(0.1) (20/120)gF = 0.140 - 0.083

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(20/120)gF = 0.057 gF = (120/20)(0.057) gF = 0.342 Since F=20 at the beginning of the period of the analysis and grows by 34.2% over the period of the analysis, F = 20 + 20(0.342) = 20 + 6.84 = 26.84 at the end of the period of the analysis.

Problem A15.2 Using the portfolio balance model presented earlier, examine the effect on the exchange rate of (a) an increase in the domestic money supply and (b) a once-and-forall depreciation of the domestic currency. a. An increase in Ms increases the domestic demand for the foreign bond and increases R (i.e., the domestic currency depreciates). This is the same result postulated by the monetary approach. b. A once-and-for-all depreciation of the domestic currency increases the domestic-currency value of the foreign bond (i.e., confers a capital gain to the nation's residents). If they previously held the desired proportion of their wealth in foreign bonds, they would be holding more of the foreign bond than they want after the depreciation. As a result, they would sell some of their holdings of the foreign bond to purchase more of the domestic bonds and the domestic money. This will cause an appreciation of the domestic currency, which will neutralize in part the previous depreciation. The process ends when equilibrium is simultaneously reestablished in all three markets.

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*CHAPTER 16 THE PRICE ADJUSTMENT MECHANISM WITH FLEXIBLE AND FIXED EXCHANGE RATES (Core Chapter)

OUTLINE 16.1 Introduction 16.2 Adjustment with Flexible Exchange Rates 16.2a Balance-of-Payments Adjustment with Exchange Rate Changes 16.2b Derivation of the Demand Curve for Foreign Exchange 16.2c Derivation of the Supply Curve for Foreign Exchange 16.3 Effect of Exchange Rate Changes on Domestic Prices and the Terms of Trade Case Study 16-1: Currency Depreciation and Inflation in Developing Countries 16.4 Stability of Foreign Exchange Markets 16.4a Stable and Unstable Foreign Exchange Markets 16.4b The Marshall-Lerner Condition 16.5 Elasticities in the Real World 16.5a Elasticity Estimates 16.5b The J-Curve Effect and Revised Elasticity Estimates Case Study 16-2: Estimated Price Elasticities in International Trade Case Study 16-3: Effective Exchange Rate of the Dollar and the U.S. Current Account Balance Case Study 16-4: Dollar Depreciation and the U.S. Current Account Balance Case Study 16-5: Exchange Rates and Current Account Balances During the European Financial Crisis of the Early 1990s 16.5c Currency Pass-Through Case Study 16-6: Exchange Rate Pass-Through to Import Prices in Industrial Countries 16.6 Adjustment Under the Gold Standard 16.6a The Gold Standard 16.6b The Price-Specie-Flow Mechanism Appendix:

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A16.1 The Effect of Exchange Rate Changes on Domestic Prices A16.2 Derivation of the Marshall-Lerner Condition

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A16.3 Stability of Foreign Exchange Markets Once Again A16.4 Derivation of the Gold Points and Gold Flows Under the Gold Standard

KEY TERMS Devaluation Dutch disease Stable foreign exchange market Unstable foreign exchange market Marshall-Lerner condition Elasticity pessimism Identification problem J-curve effect Pass-through effect

Gold standard Mint parity Gold export point Gold import point Price-specie flow mechanism Quantity theory of money Rules of the game of the gold standard Currency board

LECTURE GUIDE 1. This is an important and challenging core chapter.

2. I would cover sections 1 and 2 in the first lecture. My experience is that students find particularly difficult the derivation of the demand and supply curves for foreign exchange. Therefore, I would explain the material in sections 16.2a and 16.2b very carefully and slowly. I would also assign problems 1 to 6.

3. I would cover sections 3 and 4 in the second lecture and pay special attention to section 16.4b. I would also assign problems 7 to 9.

4. In the third lecture, I would present sections 5 and 6 and assign problems 10 to 15.

SUGGESTED ANSWERS TO PROBLEMS *1. From the negatively sloped demand curve and the positively sloped supply curve of a nation’s tradeable commodity (i.e., a commodity that is produced at home but is also imported or exported), derive the nation’s demand curve of imports of the tradeable commodity for below-equilibrium prices. (Hint: See Figure 4.1.)

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The nation's demand curve for imports is derived by the horizontal distance of the nation's supply curve from the nation's demand curve of the tradable commodity at each price below the equilibrium level of the tradable commodity. See Figure 1 on the next page.

*2. For the same given as in Problem 1, derive the supply curve of exports of the tradeable commodity for above-equilibrium prices.

The nation's supply curve for exports is derived by the horizontal distance of the nation's demand curve from the nation's supply curve of the tradable commodity at each price above the equilibrium level of the tradable commodity. See Figure 2.

3. Draw a figure similar to the left-hand panel of Figure 16.2, but with DM vertical. Explain why D€ would also be vertical.

A depreciation of the dollar shifts DM downward vertically and leaves PM (in pounds) and the quantity of imports unchanged (see Figure 3).

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4. Draw a figure similar to the right-hand panel of Figure 16.2, but with SX vertical.

Explain why S€ would also be vertical.

A depreciation of the dollar shifts SX downward vertically and leaves PX (in the quantity of exports unchanged (see Figure 4).

pounds) and

5. Draw a figure similar to the left-hand panel of Figure 16.2 but with DM steeper (less elastic) than in Figure 16.2 and explain why D€ would be steeper (less elastic) than in Figure 16.1.

A depreciation of the dollar reduces the quantity demanded of pounds by less when DM is inelastic (point B in Figure 5) than when DM is elastic (point C).

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6. Draw a figure similar to the right-hand panel of Figure 16.2 but with SX steeper (less elastic) than in Figure 16.2 and explain why S€ would be steeper (less elastic) than in Figure 16.1 if DX is price elastic in the relevant range.

A depreciation of the pound increases the quantity supplied of pounds by less when SX is inelastic (point B in Figure 6) than when SX is elastic (point C).

*7. Explain why SM and DX are horizontal for a small nation.

SM is infinitely elastic for a small nation because a small nation can demand any quantity of imports without affecting its price; similarly, DX is infinitely elastic because a small nation can sell any amount of its export good without having to reduce its price.

8. Explain why the balance of payments of a small nation always improves with a devaluation or depreciation of its currency.

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The balance of payments of a small nation always improves with a depreciation or devaluation of its currency because the small nation's quantity demanded of pounds always falls (unless DM is vertical) and the quantity supplied of pounds always rises.

9. Draw a figure similar to Figure 16.2 but referring to an unstable foreign exchange market.

See the two panels of Figure 7.

Panel A shows that a devaluation or depreciation of the nation's currency results in downward shift in DM and, by itself, results in a reduction in the quantity demanded of the foreign currency by the nation and thus to an improvement in the nation's balance of payments (trade).

Panel B shows that a devaluation or depreciation of the nation's currency results in a downward shift in SX which, by itself, leads to a net reduction in the quantity of foreign currency earned by the nation through exports and to a worsening of the nation's balance of payments (trade).

Since the reduction in the foreign exchange earnings of the nation exceeds the reduction in the demand for foreign currency by the nation (compare the shaded areas in the two panels of Figure 7), the nations balance of payments (trade) worsens as a result of the devaluation or depreciation, indicating an unstable foreign exchange market.

10. In what way can the United States be said to have a trade problem with Japan?

Although trade need not be balanced bilaterally or even multilaterally (with international private capital flows), the United States can be said to have a trade deficit with Japan because of the size

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of this trade deficit and the fact that it has persisted for such a long time despite the sharp depreciation of the dollar with respect to the yen during the past decade.

11. Since the U.S. trade deficit with Japan has not been reduced as a result of the sharp depreciation of the dollar with respect to the yen during the 1990s, can we conclude that the trade or elasticity approach to balance-of-payments adjustment does not work?

Explain.

Even though the U.S. trade deficit with Japan has not been reduced as a result of the sharp depreciation of the dollar with respect to the yen during the past 10 years, we cannot conclude that the trade or elasticity approach to balance of payments adjustment does not work. The U.S. trade deficit with Japan seems to respond only with a lag of several years to exchange-rate changes. In addition other forces may have overwhelmed the effect of a depreciation of the dollar with respect to the yen. For example, if Japan is in the contractionary part of the business cycle while the United States at an expansionary part of the cycle, the U.S. trade deficit with Japan may increase because Japan demands fewer American products while the United States demands more Japanese products, despite the depreciation of the dollar vis-avis the yen.

12. Suppose that under the gold standard the price of 1 ounce of gold is set at $35 by U.S. monetary authorities and at £14 by the U.K. monetary authorities. What is the relationship between the dollar and the pound? What is this called?

Since $35=1 ounce of gold = £14, the dollar price of £ or the exchange rate (R=$/£) is fixed at $35/14=$2.50. Thus, fixing the price of gold in terms of national currencies under the gold standard establishes a fixed relationship or exchange rate between any two currencies. This is the mint parity.

13. If to ship any amount of gold between New York and London costs 1 percent of the value of the gold shipped, define the U.S. gold export point or upper limit in the exchange rate between the dollar and the pound (R = $/£). Why is this so?

Since to ship $2.50 worth of gold from New York to London costs 1% or 2.5c, the U.S. gold export point or upper limit of the exchange rate equals $2.50 plus 2.5c or $2.525. The reason for this is that no U.S. resident would pay more than $2.525 to obtain £1, since he could buy $2.50 worth of gold from the U.S. treasury, ship it to the United Kingdom at a cost of 2.5c and sell it to the U.K. treasury for £1. Thus, under the gold standard, the exchange rate of the pound can never rise above (and the dollar depreciate past) the U.S. gold export point of $2.525.

14. Define the U.S. gold import point or the lower limit in the exchange rate (R = $/£). Why is this so?

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Similarly, the exchange rate can never fall below (and the dollar appreciate past) the U.S. gold import point of $2.475. The reason for this is that no U.S. resident would accept less than $2.475 for each pound sold, since he could always buy a pound worth of gold from the U.K. treasury at the fixed price, import this gold into the United States at a cost of 2.5c, and resell it to the U.S. treasury for $2.50. Thus, the U.S. resident can get pounds at $2.475 ($2.50 minus 2.5c) and would not accept less in selling them. Note that the shipping cost of gold includes not only the transportation cost but also all other handling charges, insurance, and the interest foregone while the gold is in transit.

*= Answer provided at www.wiley.com/college/salvatore.

SUGGESTED ANSWERS TO PROBLEMS IN APPENDIX Problem A16.1 From Figure 16.7, calculate the U.S. terms of trade before and after the 20 percent depreciation or devaluation of the dollar. How do your results compare with those obtained in Section 16.3?

N=($PX/$PM)=($4/$2)=2 or 200%.

The results is the same as that obtained in section 16.2b, where PX and PM were both measured in pounds.

Problem A16.2 Explain why a depreciation or devaluation of a small country’s national currency is not likely to affect its terms of trade. (Hint: Refer to the statement of Problem 9.)

A depreciation or devaluation of a small country's national currency is not likely to affect its terms of trade because DM and SX are infinitely elastic or horizontal for a small nation, and a depreciation or a devaluation of its currency would leave PM and PX unchanged when measured in terms of either the domestic or the foreign currency.

Problem A16.3 Determine from Figure 16.8 the exchange rate and the size of the deficit or surplus in the U.S. balance of payments under the gold standard and under a flexible exchange rate system if D£ shifts to D'£, and S£ shifts to S'£ at the same time.

The fact that an unstable foreign exchange market eventually becomes stable for large enough exchange rate changes is not of practical importance because such large changes in exchange rates would be very inflationary and are usually outside most nations' experience of actual exchange rate changes.

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*CHAPTER 17 THE INCOME ADJUSTMENT MECHANISM AND SYNTHESIS OF AUTOMATIC ADJUSTMENTS (Core Chapter) OUTLINE 17.1 Introduction 17.2 Income Determination in a Closed Economy 17.2a Determination of the Equilibrium National Income in a Closed Economy 17.2b The Multiplier in a Closed Economy 17.3 Income Determination in a Small Open Economy 17.3a Import Function Case Study 17-1: Income Elasticity of Imports and Exports in the Leading Industrial Countries 17.3b Determination of Equilibrium National Income in a Small Open Economy 17.3c Graphical Determination of the Equilibrium National Income Case Study 17-2: Savings, Investments, and the Current Account Balance in the Leading Industrial Nations 17.3d Foreign-Trade Multiplier 17.4 Foreign Repercussions Case Study 17-3: Growth in United States and Abroad, and U.S. Current Account Deficits Case Study 17-4: Growth and Current Account Balance in Developing Countries 17.5 Absorption Approach Case Study 17-5: Effect of the Asian Financial Crisis of the Late 1990s on OECD Countries 17.6 Monetary Adjustments and Synthesis of Automatic Adjustments 17.6a Monetary Adjustments 17.6b Synthesis of Automatic Adjustments Case Study 17-6: Interdependence in the World Economy 17.6c Disadvantages of Automatic Adjustments Appendix:

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A17.1 Derivation of Foreign Trade Multipliers with Foreign Repercussions A17.2 The Transfer Problem Once Again

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KEY TERMS Closed economy Equilibrium level of national income (YE) Desired or planned investment Marginal propensity to consume (MPC) Consumption function Saving function Marginal propensity to save (MPS) Investment function Multiplier (k)

Import function Marginal propensity to import (MPM) Average propensity to import (MPM) Income elasticity of imports (ny) Export function Foreign trade multiplier (k') Foreign repercussions Absorption approach Synthesis of automatic adjustments

LECTURE GUIDE 1. In the first lecture on Chapter 17 (a core chapter), I would cover sections 1 and 2 and assign problems 1 to 4. Section 2 is a review of principles of economics but my experience is that the average student needs it to clearly understand the material in the rest of the chapter.

2. In the second lecture, I would cover sections 3 and 4 and assign problems 3 to 8. Most other texts do not deal with foreign trade multipliers in any great detail because of the difficulty of deriving them. However, their meaning and use is important and they can still be discussed without deriving them (their derivation is in section A17.1 of the appendix, which can be made optional for the best and most eager students in the class).

3. In the third lecture, I would cover sections 5 and 6 and assign problems 9 to 14. These two sections are very important and difficult.

SUGGESTED ANSWERS TO PROBLEMS 1. Given C = 100 + 0.8Y and autonomous investment I = 100, draw a figure showing the equilibrium level of national income.

See Figure 1.

The equilibrium level of national income is YE = 1,000 and is given by point E at which the C+I function crosses the 45° line.

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2. For the given in Problem 1: (a) Write the equation of the saving function. (b) Draw a figure showing the equilibrium level of national income in terms of desired saving and investment. a. S=-100+0.2Y. The saving function is obtained by subtracting vertically the consumption function from the 45˚ line b. See Figure 2.

The equilibrium level of national income is YE = 1,000 and is given by point E at which the positivelysloped S function crosses the horizontal I function.

3. Starting from the given and figure of Problem 1, and assuming that autonomous investment expenditures increase from I = 100 to I' = 200, draw a figure in terms of total expenditures showing the new equilibrium level of national income.

See Figure 3.

The new equilibrium level of national income is YE = 1,500 and is given by point E' at which the new C+I' function crosses the 45° line.

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4. Starting from the given and figure of Problem 2, and assuming that autonomous investment expenditures increase from I = 100 to I' = 200: (a) Draw a figure in terms of desired saving and investment showing the new equilibrium level of national income. (b) Determine the value of the multiplier. a. See Figure 4.

The new equilibrium level of national income is YE = 1,500 and is given by point E' at which the S function crosses the new I' function.

b. k=1/MPS=1/(1/5)=5.

*5. Given C = 100 + 0.8Y, M = 150 + 0.20Y, I = 100, and X = 350: (a) Determine YE algebraically. (b) Show the determination of YE graphically as in the top panel of Figure 17.3. a. S(Y)+M(Y)=-100+0.2Y+150+0.2Y=50+0.4Y I+X=100+350=450 50+0.4Y=450; therefore, YE=400/0.4=1000.

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b. See Figure 5.

The equilibrium level of national income is YE = 1,000 and is given by point E at which the positivelysloped S+M function crosses the horizontal I+X function.

*6. For the same given as in Problem 5, show the determination of YE graphically as in the bottom panel of Figure 17.3.

See Figure 6.

The equilibrium level of national income is YE = 1,000 and is given by point E at which the negativelysloped X-M function crosses the positively-sloped S-I function.

7. Starting with the algebraic and graphical results of Problems 5 and 6, determine algebraically and determine graphically the effect on YE of an autonomous: (a) Increase in X of 200. (b) Increase in I of 200. (c) Increase in X and I of 200. a. I+X'=100+350+200=650

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50+0.4Y=650; therefore, YE'=1500 At YE'=1500, M=150+0.2Y=150+(0.2)(1500)=450 X'-M=550-450=100 See Figure 7.

b. I'+X=650 YE'=1500 X-M=350-450=-100 See Figure 8.

c. X'+I'=550+300=850 50+0.4Y=850 therefore, YE"=2000 At YE"=2000, M=150+0.2Y=150+(0.2)(2000)=550 X'-M=550-550=0 See Figure 9 on page 155.

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8. Starting with the algebraic and graphical results of Problems 5 and 6, determine algebraically and determine graphically the effect on YE of an autonomous: (a) Decrease in S of 100. (b) Decrease in M of 100. (c) Decrease in S and M of 100. a. S'(Y)+M(Y)=-200+0.2Y+150+0.2Y=-50+0.4Y I+X=100+350=450 -50+0.4Y=450 therefore, YE'=1250 At YE'=1250, M=150+0.2Y=150+(0.2)(1250)=400 X-M=350-400=-50 S See Figure 10.

b. S(Y)+M'(Y)=-100+0.2Y+50+0.2Y=-50+0.4Y -50+0.4Y=450 therefore, YE'=1,250 at YE'=1250, M'=50+0.2Y=50+(0.2)(1,250)=300

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X-M'=350-300=50 (see Figure 11).

c. S'(Y)+M'(Y)=-200+0.2Y+50+0.2Y=-150+0.4Y -150+0.4Y=450 therefore, YE"=1500 at YE"=1500, M'=50+0.2Y=50+(0.2)(1500)=350 X-M'=350-350=0 (see Figure 12).

*9. Assuming that Nations 1 and 2 are both large, and starting from the equilibrium level of national income and equilibrium in the trade balance in Nation 1, and given that MPS1 = 0.20, MPS2 = 0.15, MPM1 = 0.20, and MPM2 = 0.10, find the change in the equilibrium level of national income and the trade balance in Nation 1 for: (a) An autonomous increase in the exports of Nation 1 of 200 that replaces domestic production in Nation 2. (b) An autonomous increase in investment of 200 in Nation 1.

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a.

K"=

1 = 1 = 1 = 1.88 MPS1+MPM1+MPM2(MPS1/MPS2) 0.20+0.20+0.10(0.20/0.15) 0.533

YE=(X)(k")=(200)(1.88)=376 M=(YE)(MPM1)=(376)(0.20)=75.2 S=(YE)(MPS1)=(376)(0.20)=75.2 X=S+ M=75.2+75.2=150.4 so that X-M=75.2=Nation 1's trade surplus. b. k* =

1+MPM2/MPS2 MPS1+MPM1+MPM2(MPS1/MPS2)

=

1+0.10/0.15

= 1.667 = 3.13

0.533

0.533

YE=(I)(k*)=(200)(3.13)=626 M=(YE)(MPM1)=(626)(0.20)=125.2 S=(YE)(MPS1)=(626)(0.20)=125.2 200+X=125.2+125.2 and X=50.4 so that X-M=50.4-125.2=-74.8

10. Do the same as in Problem 9 for an autonomous increase in investment of 200 in Nation 2. k**=

MPM2/MPS2 = MPS1+MPM1+MPM2(MPS1/MPS2)

0.10/0.15 0.533

=

0.67 = 1.25 0.533

YE=(I*)(k**)(200)(1.25)=250 M=(YE)(MPM1)=(250)(0.20)=50=S X=S+M =100 X-M=5

11. Do the same as in Problem 9 for the numerical example in Section 17.4. k**=

0.5 = 0.95 0.53

YE=(I*)(k**)=(200)(0.95)=190 M=(YE)(MPM1)=(190)(0.15)=28.5=S X=S+M=57 X-M=28.5

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12. Starting from your graphical results of Problem 7b, show graphically the effect on YE and on X −M of a depreciation of the nation’s currency from a position of full employment and a trade deficit.

The X-M function would shift up as in Figure 9 without full employment. With full employment, the depreciation will result in inflation and a return to the condition of Figure 8 (i.e., the X-M function would shift up and then down to its original position), unless domestic absorption is somehow reduced.

13. Under what conditions would Equation (17-8) not hold in the real world?

One reason is that the government sector is not included. Another reason is if the nation is not in equilibrium.

14. Identify the advantages of automatic over policy adjustments to correct a trade disequilibrium.

The advantages of automatic over policy adjustment to correct a trade disequilibrium are: (1) adjustment begins to operate even before the problem is recognized; (2) there are no possibilities of policy mistakes; and, (3) the adjustment will continue until the trade disequilibrium is entirely eliminated.

On the other hand, adjustment policies can only be enacted after the problem is recognized. There are then delays to enact policies and for them to have effect. Thus, by the time adjustment policies become effective the nation may not longer face the problem or may face the opposite problem. Wrong policies can also be adopted.

*= Answer provided at www.wiley.com/college/salvatore.

SUGGESTED ANSWERS TO PROBLEMS IN APPENDIX Problem A17.1 (a) Starting from Equation (17A-2), derive k"_ for Nation 1 in the same way that k∗ and k∗∗ were derived. (b) What is the value of the foreign trade multiplier with foreign repercussions for Nation 1 if the autonomous increase in the exports of Nation 1 represents entirely an increase in expenditures in Nation 2? a.

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I + m*Y* = sY + mY I* + mY = s*Y* + m*Y* X + m*Y* = sY - mY -X + mY = (s*+m*)Y* -X + mY = Y* s* + m* X + m*(-X + mY) = sY + mY

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s* + m* X + -m*X + m*mY = (s + m)Y s* + m+ s*X + m*X - m*X + m*mY = (s + m)(s* + m*)Y s*X + m*mY = (s + m)(s* + m*)Y s*X = [(s + m) (s* + m*) - m*m]Y X = [ ] Y s* Y = s* = 1 X ss* + mm* + ms* + m*s - m*m s + m + m*s/s* b. k" =

1 s+m that is, k" is already a foreign repercussion.

Problem A17.2 Discuss how the transfer arising from the sharp increase in petroleum prices during the 1970s was accomplished. What happened during the 1980s?

Most petroleum exporting nations, notably Saudi Arabia, Libya, and Kuwait could not spend all of their petroleum earnings on increased imports from petroleum importing countries during the 1970s. Most unspent earnings were used for portfolio purchases in the developed nations, especially in the U.S., through the Eurodollar market. At the same time, most oil-importing nations deflated their economies to reduce their oil bill and balance of payments difficulties. The sharp decline in petroleum since 1981completely eliminated the excess earnings of most OPEC nations so that the transfer problem disappeared.

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CHAPTER 18 OPEN-ECONOMY MACROECONOMICS: ADJUSTMENT POLICIES

OUTLINE *18.1 Introduction Case Study 18-1: Government, Private Sector, and Current Account Balances in the G-7 Countries *18.2 Internal and External Balance with Expenditure-Changing and Expenditure-Switching Policies 18.3 Equilibrium in the Goods Market, in the Money Market, and in the Balance of Payments 18.4 Fiscal and Monetary Policies for Internal and External Balance with Fixed Exchange Rates 18.4a Fiscal and Monetary Policies from External Balance and Unemployment 18.4b Fiscal and Monetary Policies from External Deficit and Unemployment 18.4c Fiscal and Monetary Policies with Elastic Capital Flows 18.4d Fiscal and Monetary Policies with Perfect Capital Mobility Case Study 18-2: Relationship Between U.S. Current Account and Budget Deficits 18.5 The IS-LM-FE Model with Flexible Exchange Rates 18.5a IS-LM-FE Model with Flexible Exchange Rates and Imperfect Capital Mobility Case Study 18-3: Effect of U.S. Fiscal Policy in the United States and Abroad 18.5b IS-LM-FE Model with Flexible Exchange Rates and Perfect Capital Mobility Case Study 18-4: Effect of Monetary Policy in the U.S. and Other OECD Countries *18.6 Policy Mix and Price Changes 18.6a Policy Mix and Internal and External Balance 18.6b Evaluation of the Policy Mix with Price Changes 18.6c Policy Mix in the Real World Case Study 18-5: U.S. Monetary and Fiscal Policies in the 1980s and Early 1990s *18.7 Direct Controls 18.7a Trade Controls 18.7b Exchange Controls Case Study 18-6: Direct Controls on International Transactions Around the World 18.7c Other Direct Controls and International Cooperation

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Instructor’s Manual

A18.1 Derivation of the IS Curve A18.2 Derivation of the LM Curve A18.3 Derivation of the FE Curve A18.4 Mathematical Summary

KEY TERMS Internal Balance External balance Expenditure-changing policies Expenditure-switching policies Principle of effective market classification IS curve LM curve

Transaction demand for money Speculative Demand for money BP curve Phillips curve Exchange controls Multiple exchange rates

LECTURE OUTLINE 1. This is one of the most important and challenging of the chapters. Sections 1-2 and 6-7 are core sections and should be covered in any international economics course. Sections 3-5 introduce the IS-LM-BP model and may be skipped if intermediate macroeconomics is not a requirement for the course. This is up to the Instructor, however.

2. In the first lecture, I would cover sections 1 and 2 and assign problems 1-3. The most important and difficult part here is the Swan diagram. If students are to know anything about economic policies to correct internal and external imbalances, this is it.

3. Sections 3-5 require two classes to be covered adequately if students had intermediate macroeconomics. Otherwise, it would take three classes, or they can be skipped. If sections 3-5 are covered, I would assign problems 4-11 and go over some of these in class to make sure that students fully understand the model and the policies that can be used to correct internal and external imbalances.

4. I would cover section 6 in the next class and assign problems 12-14. The most important aspect of this section is the explicit recognition of price stability as the third important objective of nations and the problems that this creates with the policies at hand to achieve internal and external balance completely. I would also cover Case Studies 18.1-18-3.

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5. I would leave section 7 for students to cover by themselves. The section is important but mostly descriptive and students to read it on their own and bring questions to class.

SUGGESTED ANSWERS TO PROBLEMS *1. Indicate the expenditure-changing and expenditure-switching policies required to achieve external and internal balance simultaneously for points C1, C4, C7, and C10 in the following figure (similar to Figure 18.1).

Point C1 C4 C7 C10

Change in D increase increase decrease decrease

Change in R devalue revalue revalue devalue

2. Indicate the expenditure-changing and expenditure-switching policies required to achieve external and internal balance simultaneously for points C2, C5, C8, and C11, in the figure for Problem 1.

Point C2 C5 C8 C11

Change in D increase none decrease none

Change in R none revalue none devalue

3. Indicate the expenditure-changing and expenditure-switching policies required to achieve external and internal balance simultaneously for points C3, C6, C9, and C12, in the figure for Problem 1.

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Point C3 C6 C9 C12

Change in D increase decrease decrease increase

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Change in R revalue revalue devalue devalue

4. From the following figure (similar to Figure 18.2): (a) Indicate whether the nation faces a deficit or surplus in its balance of payments at YE = 1000. (b) Determine the size of the deficit or surplus that the nation faces at YE = 1000 if its marginal propensity to import is MPM = 0.15 and there are no foreign repercussions.

a. The nation faces a surplus at YE=1,000 because P is below point E. b. At YE=1,000 and with a MPM=0.15, the nation faces a surplus of (200)(0.15)=30.

5. Show how the nation in Problem 4 can reach full employment with external balance by using the appropriate mix of fiscal and monetary policies.

The nation of problem 4 can reach full employment with external balance with the expansionary fiscal policy that shifts IS upward until it crosses the BP line at point F and the tight monetary policy that shifts LM upward until it also crosses the BP line at point F. 6. Draw on graph paper a figure similar to Figure 18.4, but without the broken curves IS' and LM' and assuming that the full employment level of national income is YF = 1200.

Indicate on your figure the appropriate mix of fiscal and monetary policies required for the

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nation to achieve simultaneously internal and external balance under a fixed exchange rate system.

The nation requires the expansionary fiscal that shifts the IS curve up until it crosses the BP curve at point F and the tight monetary policy that shifts up the LM curve until it crosses the BP curve at point F. See Figure 1.

7. Repeat Problem 6 for the assumption that the full-employment level of national income is YE = 1000.

If the full-employment level of national income is YE=1,000, the nation requires the expansionary fiscal policy that shifts the IS curve up until it crosses the BP curve at point B' and the tight monetary policy that shifts up the LM curve until it crosses the BP curve at point B'.

See Figure 2.

8. Draw on graph paper a figure similar to Figure 18.2, but interchanging the labels of the LM and BP curves so that the BP curve is now flatter than the LM curve.

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(a) Show on your graph the appropriate mix of fiscal and monetary policies required by the nation to reach full employment with external balance. (b) How does the required policy mix in this case differ from that required for the case shown in Figure 18.2 discussed in Section 18.4? a. If the BP curve were flatter than the LM curve, the nation would require the expansionary fiscal policy that shifts the IS curve up until it crosses the PB curve at point F and the easy monetary policy that shifts down the LM curve until it crosses the BP curve at point F. See Figure 3.

b. When the BP curve is flatter than the LM curve, the nation requires an easy rather than a tight monetary policy to achieve internal and external balance simultaneously.

9. Explain what would happen in Problem 8 if international capital flows were perfectly elastic.

With perfectly elastic international capital flows, the BP line would be horizontal and monetary policy would be completely ineffective. The nation could reach internal and external balance with the appropriate expansionary fiscal policy only.

10. Starting from point E in Figure 18.8, draw a figure showing how the nation could reach internal and external balance with flexible exchange rates by using an expansionary fiscal rather than an easy monetary policy.

Starting from point E in Figure 18-8 in the text, the nation could use the fiscal policy that shifts the IS curve to IS', intersecting the LM curve at point Z (see Figure 4). Since point Z is to the right of the BP curve, the nation will have a deficit in its balance of payments. With flexible exchange rates, the nation's currency depreciates and so the BP curve shifts to the right. This induces a leftward shift in the LM curve to LM', such that curve IS" and LM' intersect on the BP

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curve at point E'. Since at point E' the nation still faces unemployment, the nation would need to apply additional doses of expansionary fiscal policy until all three markets are in equilibrium at the full-employment level of national income of YF = 1500.

*11. Starting from point E in Figure 18.8, draw a figure showing how the nation could reach internal and external balance with flexible exchange rates by using an expansionary fiscal rather than an easy monetary policy if capital mobility is large and the BP curve is to the right of point Z in Figure 18.8.

Starting from point E in Figure 18-8 in the text, the nation could use the fiscal policy that shifts the IS curve to IS' (see Figure 5), intersecting the LM curve at point Z. Since point Z is now to the left of the BP curve, the nation will have a surplus in its balance of payments. With flexible exchange rates, the nation's currency appreciates and so the BP curve shifts to the left. This induces a leftward shift in the IS curve to IS" and a rightward shift in the LM curve to LM', such that curve IS" and LM' intersect on the BP curve at point E'. Since at point E' the nation still faces unemployment, the nation would need to apply additional doses of expansionary fiscal policy until all three markets are in equilibrium at the full-employment level of national income of YF = 1500.

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*12. Indicate the type of fiscal and monetary policies required to reach point F in the following figure (similar to Figure 18.10) for points C3, C6, C9, and C12.

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Point C3 C6 C9 C12

Fiscal Policy expansionary contractionary contractionary expansionary

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Monetary Policy easy easy tight tight

13. Indicate the type of fiscal and monetary policies required to reach point F in the figure for Problem 10 for points C1, C5, C7, and C11.

Point C1 C5 C7 C11

Fiscal Policy expansionary contractionary contractionary expansionary

Monetary Policy tight easy easy tight

14. Indicate the type of fiscal and monetary policies required to reach point F in the figure for Problem 10 for points C4, C8, and C10.

Point C4 C8 C10

Fiscal Policy none contractionary none

Monetary Policy easy none tight

*= Answer provided at www.wiley.com/college/salvatore.

SUGGESTED ANSWERS TO PROBLEMS IN APPENDIX Problem A18.1 Trace (i.e., pencil in) in each of the four panels of Figure 18.11 the effect of an expansionary fiscal policy that increases government expenditures (G) from 0 to 50.

Assume that the government changes the money supply as it pursues this expansionary fiscal policy in such a way as to keep the interest rate unchanged. Assume also that the open-economy multiplier for the nation is k' = 2.5 (as in Section 17.3d under the assumption that the nation is small enough that there are no foreign repercussions).

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Draw in panel IV of Figure 18-11 the I(i)+X+G function 50 units to the left of I(i)+X, and draw in panel I the IS' function 125 units on the right of IS [the S(Y)+M(Y) function remains unchanged]. Draw a dashed rectangle with corners (Y=1125, i=10%) on the IS' line, (Y=1125, leakages=500) on the S(Y)+M(Y) line, (injections=500, leakages=500) on the 45 degree line, and (injections=500, i = 10%) on the I(i)+X+G line. S increases by (Y)(MPS)=(125)(0.25, from section 17.3c) = 31.25, M increases by (Y)(MPM)=(125)(0.15)=18.75 for a total increase in leakages of 50 equal to the increase in injections of G=50.

Problem A18.2 Starting from point E on the LM curve in panel I, trace (i.e., pencil in) in each of the four panels of Figure 18.12 the effect of (a) an easy monetary policy that increases the nation’s money supply by 100, on the assumption that the entire increase in the money supply will be held for transaction purposes, and (b) a depreciation that shifts the MT function down by 200 in panel II, on the assumption that monetary authorities keep MS at 800. (c) What happens if instead monetary authorities increase MS by 200 to MS = 1000 in part (b)?

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a. Draw in panel III of Figure 18-12 the MS' line 100 units to the left of MS, in panel IV the ML' line 100 units to the right of ML, and in panel I the LM' line 500 units to the right of LM (the MT line in panel II remains unchanged). Draw a dashed rectangle with corners (Y=1250, i=8%) on the LM' line, (Y=1250, MT=500) on the MT line, (ML=400, MT=500) on the MS' line, and (ML=400, i=8%) on the ML' line. b. Xerox Figure 18-12 and draw in panel II the MT' line 500 units to the left of MT, and in panel I the LM" line 500 units to the left of LM (the MS and ML lines remain unchanged). Draw a dashed rectangle with corners (Y=500, i=10%) on the LM" line, (Y=500, MT=400) on the MT' line, (ML=400, MT=400) on the MS line, and (ML=400, i=10%) on the ML line. c. YE=1000, MT=600 leaving ML=400 at i=10%. LM" shifts back to LM. Problem A18.3 Starting from point E on the BP curve in panel I, trace (i.e., pencil in) in each of the four panels of Figure 18.13 the effect of a depreciation or devaluation that shifts the X −M function up by 50 in panel II.

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Draw in panel II of Figure 18-13 the (X-M)' line 50 units above X-M, and in panel I the BP' line 4 units below BP (the SC line in panel IV remains unchanged). Draw a dashed rectangle with corners (YE=1000, i=6%) on the BP' line, (YE=1000, X-M=50) on the (X-M)' line, (SC=-50, XM=50) on the 45 degree line, and (SC=-50, i=6%) on the SC line.

Problem A18.4 Use the above three equations to trace the effects of (a) a contractionary fiscal policy, (b) a tight monetary policy, and (c) an appreciation or revaluation of the nation’s currency. a. The reduction in G* causes YE to fall by the reduction in G* times the multiplier. The fallin YE induces a total fall in S and M equal to the fall in G* (graphically, this can be shown by the opposite changes from those described in App. 1 above). b. The reduction in MS* causes i to rise and ML and MT to fall. These effects are generally the opposite of those described in App. 2a above. c. An appreciation or revaluation causes X to fall and M to rise (see equation 18A-1), MT to fall (see equation 18A-2), and TB to deteriorate (see equation 18A-3).

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CHAPTER 19 PRICES AND OUTPUT IN AN OPEN ECONOMY: AGGREGATE DEMAND AND AGGREGATE SUPPLY OUTLINE 19.1 Introduction 19.2 Aggregate Demand, Aggregate Supply, and Equilibrium in a Closed Economy 19.2a Aggregate Demand in a Closed Economy 19.2b Aggregate Supply in the Long Run and in the Short Run 19.2c Short-Run and Long-Run Equilibrium in a Closed Economy Case Study 19-1: Deviations of Short-Run Outputs from the Natural Level in the U.S. 19.3 Aggregate Demand in an Open Economy Under Fixed and Flexible Exchange Rates 19.3a Aggregate Demand in an Open Economy Under Fixed Exchange Rates 19.3b Aggregate demand in an Open Economy Under Flexible Exchange Rates 19.4 Effect of Economic Shocks and Macroeconomic Policies on Aggregate Demand in Open Economies with Flexible Prices 19.4a Real-Sector Shocks and Aggregate Demand 19.4b Monetary Shocks and Aggregate Demand 19.4c Fiscal and Monetary Policies and Aggregate Demand in Open Economies 19.5 Effect of Fiscal and Monetary Policies in Open Economies with Flexible Prices Case Study 19.2: Central Bank Independence and Inflation in Industrial Countries 19.6 Macroeconomic Policies to Stimulate Growth and to Adjust to Supply Shocks 19.6a Economic Policies for Growth 19.6b Economic Policies to Adjust to Supply Shocks Case Study 19.3: Petroleum Shocks and Stagflation in the United States Case Study 19.4: Actual and Natural Unemployment Rate, and Inflation in the U.S. Case Study 19.5: Actual and Natural Unemployment Rate, and Inflation in the U.S.

KEY TERMS Aggregate demand curve (AD) Aggregate supply curve (AS) Long-run aggregate supply curve (LRAS) Natural level of output (YN)

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Short-run aggregate supply curve (SRAS) Expected prices Stagflation

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LECTURE GUIDE 1. This is not a core chapter and I would omit it in a one-semester undergraduate course in international economics.

2. If I were to cover this chapter, I would cover two sections in each of three lectures and assign the end-of-chapter problems.

SUGGESTED ANSWERS TO PROBLEMS 1. Using an IS–LM diagram, show graphically how a reduction in the general price level in a nation results in a movement down the aggregate demand curve.

See Figure 1.

2. Using an IS–LM diagram, show graphically that for a given LM curve, the flatter is the IS curve, the flatter or more elastic is the aggregate demand curve.

See Figure 2.

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3. Using an IS–LM diagram, show the effect of an easy monetary policy on the aggregate demand curve.

See Figure 3.

4. Using an IS–LM diagram, show the effect of an expansionary fiscal policy on the aggregate demand curve.

See Figure 4.

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*5. Explain why an unexpected increase in prices in the face of sticky wages (i.e., wages that do not immediately increase in the same proportion as prices) can explain an upward sloping short-run aggregate supply curve.

An unexpected increase in prices in the face of sticky wages means that real wages temporarily fall. This leads firms to hire more workers and thus increase output in the short run. In the long-run, however, money wages fully adjust to (i.e., increase in the same proportion as) the increase in prices. As a result, real wages return to their previous higher level, firms reduce employment to their original lower level, and the nation's output returns to its lower long-run natural level, but at the new higher price level.

*6. Suppose that the original long-run and short-run equilibrium in the economy of Figure 19.3 were at point C where the AD' curve crosses LRAS and SRAS' curves. Explain why a downward shift in the aggregate demand curve from AD' to AD would result in a temporary reduction in output and a permanent reduction in price.

Starting from point C in Figure 19-3, an unexpected decrease in aggregate demand from AD' to AD causes prices to fall and firms to temporarily reduce their output, giving the new short-run equilibrium point where the AD' curve intersects the SRAS' curve. In the long run, however, as expected prices fall to match actual prices, the short-run aggregate supply curve shifts down by the amount of the price reduction (i.e., from SRAS' to SRAS) and defines new long-run equilibrium point E at the natural level of output YN, but lower price level of PE. Another way of saying this is that at point to the left of the LRAS curve, actual prices are lower than expected prices. Expected prices then fall and this shifts the SRAS curve downward until expected prices are equal to the lower actual prices, and the economy returns to its long-run natural level of output equilibrium.

7. Explain in terms of labor market imperfections how a downward shift in the aggregate demand curve would result in a temporary reduction in output and a permanent reduction in price.

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An unexpected decrease in aggregate demand causes prices to fall. If wages are sticky and do not immediately fall in the same proportion as the fall in prices, real wages will temporarily increase. This leads firms to hire fewer workers and thus reduce output in the short run. In the long-run, however, money wages fully adjust to (i.e., fall in the same proportion as) the fall in prices. As a result, real wages return to their previous lower level, firms increase employment to their original higher level, and the nation's output returns to its higher long-run or natural level, but at the new higher lower level.

8. Explain how equilibrium in the goods and money markets and in the balance of payments would be reached if the LM' curve in the left panel of Figure 19.5 intersected the IS' curve below the BP' curve for an economy operating under fixed exchange rates.

If the LM' curve intersected the IS' curve at a point below the BP' curve in the left panel of Figure 19-5, the interest rate in the nation would be lower than required for balance of payments equilibrium. The nation would then have a deficit in its balance of payments. Under a fixed exchange rate system, the deficit in the nation's balance of payments would result in an outflow of international reserves and thus a reduction in the nation's money supply, which would shift up the LM' curve sufficiently to intersect the IS' curve on the BP' curve, so that the nation would be simultaneously in equilibrium in the goods and money markets and in the balance of payments, as at point E".

9. Draw a figure similar to the left panel of Figure 19.6 showing how equilibrium in the goods and money markets and in the balance of payments would be reached if the LM' curve intersected the IS' curve below the BP' curve for an economy operating under flexible exchange rates.

See Figure 5.

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10. Examine the effect on the nation’s aggregate demand curve of an autonomous worsening of a nation’s trade balance under fixed exchange rates.

Starting from equilibrium in the goods and services sector, in the monetary sector, and in the balance of payments, an autonomous worsening of the nation's trade balance at unchanged domestic prices, causes the IS and BP curves to shift to the left and opens a deficit in the nation's balance of payments under fixed exchange rates. This leads to a leftward shift of the LM curve and a reduction in national income. Thus, the nation's aggregate demand curve shifts to the left.

11. Do the same as for Problem 10 for flexible exchange rates.

With flexible exchange rates, the autonomous worsening of the nation's trade balance at unchanged domestic prices, causes the IS and BP curves to shift to the left (just as in the case of fixed rates). Now, however, the tendency of the nation's balance of payments to go into deficit leads to a depreciation of the nation's currency and a deterioration in the nation's trade balance, so that the BP and IS curves shift to the left, back to their original position along the unchanged LM curve. Thus, the nation returns to the original equilibrium position and point on its original aggregate demand curve.

*12. Explain why the usefulness of expansionary fiscal policy or easy monetary policy to correct a recession depends on how flexible domestic prices are downward.

Expansionary fiscal policy under fixed exchange rates or easy monetary policy under flexible rates can correct a recession but only the expense of higher prices or inflation. If prices are flexible downward in the nation, however, the recession can be corrected automatically and in a relatively short time by falling domestic prices, which would stimulate the domestic and foreign demand for the nation's goods and services. If domestic prices are sticky or not too flexible downward, however, relying on market force (i.e., falling prices in the nation) to automatically correct the recession may take too long, and this may justify the use of expansionary fiscal or monetary policies.

13. With reference to Figure 19.12, determine what would happen if the monetary policy that shifts the nation’s aggregate demand curve to the right to AD' in order to adjust to stagflation also leads to growth that keeps the nation’s long-run aggregate supply curve at LRAS in the long run.

The nation would reach the long-run equilibrium point where the AD' curve crosses the unchanged LRAS curve. The SRAS curve would also shift and cross the LRAS curve at the same point. The nation's natural level of output and employment would then be the same as before the supply (petroleum) shock, but prices would be higher.

14. Is the concept of the natural rate of unemployment useful in view of the data presented in Case Study 19-4?

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The concept of the natural rate of unemployment is useful as long as no structural changes take place in the economy. When structural changes do occur (and globalization may just be such a structural change), then the rate of natural unemployment will change. With globalization the natural rate of unemployment may well be 5 percent or lower in the United States today.

*= Answer provided at www.wiley.com/college/salvatore.

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CHAPTER 20 FLEXIBLE VERSUS FIXED EXCHANGE RATES, THE EUROPEAN MONETARY SYSTEM, AND MACROECONOMIC POLICY COORDINATION OUTLINE 20.1 Introduction 20.2 The Case for Flexible Exchange Rates 20.2a Market Efficiency 20.2b Policy Advantages 20.3 The Case for Fixed Exchange Rates 20.3a Less Uncertainty 20.3b Stabilizing Speculation 20.3c Price Discipline Case Study 20-1: Macroeconomic Performance Under Fixed and Flexible Rates Regimes 20.4 Optimum Currency Areas and the European Monetary System 20.4a Optimum Currency Areas 20.4b European Monetary System Case Study 20-2: The 1992-3 Currency Crisis in the European Monetary System 20.4c Transition to Monetary Union Case Study 20-3: Maastricht Convergence Indicators 20.4d Creation of the Euro Case Study 20-4: Benefits and Costs of the Euro 20.4e European Central Bank and Common Monetary Policy 20.5 Exchange Rate Bands, Adjustable Pegs, Crawling Pegs, and Managed Floating 20.5a Exchange Rate Bands 20.5b Adjustable Peg Systems 20.5c Crawling Pegs 20.5d Managed Floating Case Study 20-5: Exchange Rate Arrangements of IMF Members 20.6 International Macroeconomic Policy Coordination Appendix: Exchange Rate Arrangements

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KEY TERMS Freely floating exchange rate system Optimum currency area or block European Monetary System (EMS) European Currency Unit (ECU) European Monetary Cooperation Fund (EMCF) Exchange Rate Mechanism (ERM) Leaning against the wind Managed floating exchange rate system International macro policy coordination

European Monetary Union Euro European Central Bank (ECB) Adjustable peg system Crawling peg system European Monetary Institute (EMI) Dirty floating Maastricht Treaty Growth and Stability Pact (GSP)

LECTURE GUIDE 1. This chapter (not a core chapter) brings together for the most part material scattered throughout previous chapters on the question of fixed versus flexible exchange rates. But it also examines the European Monetary System and international macroeconomic cooperation. It is an important chapter but because of the time constraint, I would omit it in a one-semester undergraduate course in international economics, except for section 20.4 on the European Union and the short section on international macroeconomic policy coordination.

2. If I were to cover this chapter, I would cover sections 1 to 3 in the first lecture, section 4 in the second lecture, and sections 5 and 6 in the third lecture and assigning the end of chapter problems.

SUGGESTED ANSWERS TO PROBLEMS *1. Suppose that the price of a commodity is $3.50 in the United States and €4 in the European Monetary Union and the actual exchange rate between the dollar and the euro is R = $1/€1, but, the equilibrium exchange rate R' = $0.75/€1. (a) Will the United States import or export this commodity? (b) Does the United States have a comparative advantage in this commodity? a. The U.S. will export the commodity because at R=2, P=$7 in the U.S. and P=$8 in the U.K. b. The U.S. has a comparative disadvantage in this commodity at the equilibrium exchange rate.

*2. Explain why monetary policy would be completely ineffective under a fixed exchange rate system and perfectly elastic international capital flows.

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Under a fixed exchange rate system and perfectly elastic international capital flows, the attempt on the part of the nation to reduce its money supply (tight monetary policy) tends to increase interest rates in the nation and attract capital inflows. This frustrates the attempt on the part of the nation's monetary authorities to reduce the nation's money supply. On the other hand, the attempt of the nation's monetary authorities to increase the money supply of the nation will be frustrated by the tendency of the nation's interest rate to fall, resulting in a capital outflow that would leave the nation's money supply unchanged (see section 17.4c).

3. Draw a figure similar to Figure 20.1, but showing that for given shifts in the nation’s supply curve of foreign exchange, the exchange rate would fluctuate less when the demand for foreign exchange is elastic than when it is inelastic.

See Figure 1.

Figure 1 shows that for a shift in the supply of pounds from S to S' and S*, the exchange rate fluctuate more when the demand curve for pounds is more inelastic (D*) then when it is more elastic (D).

4. Draw a figure similar to Figure 20.2 showing the fluctuation in the exchange rate over the business cycle without speculation, with stabilizing speculation, and with destabilizing speculation when there is no long-run trend in the exchange rate over the cycle.

See Figure 2.

Curve A shows the fluctuation in the exchange rate over the business cycle without speculation; curve B shows the fluctuation in the exchange over the business cycle with stabilizing speculation, while curve C shows the fluctuation in the exchange rate over the business cycle with destabilizing speculation.

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5. Do the same as in Problem 4 but assuming an implicit appreciating trend of the dollar over the business cycle.

See Figure 3.

*6. Explain the difference between an optimum currency area and a fixed exchange rate system.

An optimum currency area involves permanently fixed exchange rates as well as common monetary and fiscal policies among its members. Thus, an optimum currency area resembles a single economic entity and monetary union. There are no such implications for countries which are connected only by fixed exchange rates.

7. Explain why (a) a single central bank and currency for the countries of the European Union mean that its members can no longer have an independent monetary policy and (b) there is no such thing as an exchange rate among member nations. a. With a single central bank and currency the member nations of the European Union can no longer print money and thus each member no longer has the wherewithal to conduct monetary policy. The original central bank of each member nation now assumes functions similar to that of the federal reserve banks in the Federal Reserve System in the United States. That is, they affect the community-wide monetary policy only through their participation in central bank deliberations and decisions. b. With a single currency, of course, there are no such things and exchange rates among the member nations' currencies, just as there are no exchange rates for the dollar among the states of the United States.

Or better, the exchange rate is permanently fixed at 1:1.

8. Indicate the benefits and costs that are likely to arise for the EU member countries from the establishment of a single currency.

The benefits that the EU would get from establishing a single currency are: eliminating the costs involved in exchanging currencies, eliminating the risk of exchange fluctuations and currency crises, inducing

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nations to adopt more appropriate economic policies and being able, as a community, to withstand better external shocks. The costs results from the inability of nations to change their exchange rate and to tailor monetary and fiscal policies to their specific national needs.

9. Indicate the difference among (a) a fixed exchange rate system, (b) a currency board arrangement, and (c) dollarization. a. Under a fixed exchange rate system a nation rigidly fixes the exchange rate and prevents it

from changing by losing or accumulating international reserves. b. Under a currency board arrangement (CBA), the nation rigidly fixes the exchange rate and its

central bank loses its ability to conduct an independent monetary policy by allowing the nation’s supply of money to increase or decrease only in response to its balance of payments deficits or surpluses. c. With dollarization a nation adopts another nation’s currency as its legal tender.

10. Starting with the exchange rate of R = $2/€1, draw a figure showing the exchange rate under a crawling peg system with the nation appreciating its currency by 1 percent at the end of each month for three months, with an allowed band of fluctuation of 1 percent above and below the par value.

See Figure 4.

11. Starting with the solid line (curve A) showing the fluctuation in the exchange rate over the business cycle in the absence of speculation in Figure 20.2, draw a figure showing the fluctuation in the exchange rate over the cycle (under a managed floating exchange rate system and no speculation) with a policy of leaning against the wind that eliminates about one-half of the fluctuation in the exchange rate.

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See the dashed curve in Figure 5.

12. A flexible exchange rate system will insulate the economy from international disturbance and therefore eliminate the need for international policy coordination. True or false? Explain.

It is true that flexible exchange rates tend to insulate the economy from international disturbances. For example, the tendency of a nation to follow inflationary policies will result in a depreciation of its currency. This means that the trade partner's currency will appreciate, making its imports cheaper and thus preventing the importation of inflation from abroad.

In an integrated world capital market, however, inflationary policies by one nation will lower its interest rates in the nation and will lead to capital outflows. Unless the trade partner is able to continuously sterilize these capital inflows, inflationary pressures will spread to it also. These inflationary pressures can be avoided by international policy coordination. Thus, international policy coordination is useful also under a flexible exchange rate system because in a world of unrestricted international capital flows flexible exchange rate do not insulate nations completely from their partner's policies.

13. Explain how game theory can be used to examine international macroeconomic policy coordination.

Game theory is a method for examining the effect of a given policy or course of action on a nation or other economic unit for each possible response by another nation or other economic unit. Game theory can thus be used to show that a cooperative equilibrium can be better for (i.e., can increase the welfare of) each nation or economic unit than if each tries to maximize its welfare independently.

14. Explain why each nation might pursue a loose fiscal policy and a tight monetary policy in the absence of international policy coordination but the opposite with policy coordination.

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In a noncooperative equilibrium, each nation is likely to follow a loose fiscal policy but a tight monetary policy in order to keep its interest rates up and thereby attract foreign capital and keep the international value of its currency high, so as to keep import prices low. However, when all nations do this their efforts will be self-defeating and interest rates will be higher than with a cooperative equilibrium. High interest rates will reduce long-term growth for all nations. With a cooperative equilibrium, on the other hand, nations will use restrictive fiscal and easy monetary policies. This will keep interest rates low and thus stimulate long-run growth.

15. (a) Review the experience with international macroeconomic policy coordination among the leading industrial countries during the past two decades. (b) What conclusion can you reach regarding the possibility of much greater international macroeconomic policy coordination among the leading industrial countries of the world today? a. There have been four episodes of significant international macroeconomic policy coordination among the leading industrial nations during the past three decades. The first occurred in 1978 when Germany was induced to stimulate its economy and play as "locomotive" and stimulate growth in other leading industrial countries also. The effort ended when Germany, fearing inflation, stooped stimulating its economy. The second was the Plaza Agreement in September of 1985 when the United States, Japan, Germany, France, and the United Kingdom met at the Plaza Hotel in New York to engineer a "soft landing" for the overvalued dollar. This effort was regarded as successful but the markets were already lowering the value of the dollar. The third case is represented by the Louvre Accord in February 1987, when the leading industrial nations agreed on implicit target zones for the exchange rates among the leading currencies. This agreement, however, became inoperative soon after it was reached. The fourth case is evidenced by the coordinated quick monetary response on the part of the United States, Germany, and Japan to October 1987 worldwide equity-market crash. b. International macroeconomic policy coordination to date has been episodic and limited in scope and it is unlikely that it will be very different in the future.

*= Answer provided at www.wiley.com/college/salvatore.

SUGGESTED ANSWERS TO PROBLEMS IN APPENDIX Problem A20.1 What kind of exchange rate arrangement did the nations of the European Union adopt on January 1, 1999?

On Janaury 1, 1999, 11 of the 15 members of the European Union adopted the euro as their common currency. Britain, Sweden, and Denmark decided not to join from the start, but retained the option to join later. Greece was not admitted because of its inability to meet most of the Maastricht criteria. The likelihood, however, is that all four will join the euro by July 2002, when the euro is to completely replace the currencies of the participating nations. In the meantime, a new exchange rate mechanism, the ERM II,

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was installed to keep the currencies of these four countries from fluctuating to widely, in anticipation of their joining the euro.

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*CHAPTER 21 THE INTERNATIONAL MONETARY SYSTEM: PAST, PRESENT, AND FUTURE (Core Chapter)

OUTLINE 21.1 Introduction 21.2 The Gold Standard and the Interwar Experience 21.2a The Gold Standard Period (1880-1914) 21.2b The Interwar Experience 21.3 The Bretton Woods System 21.3a The Gold-Exchange Standard (1947-1971) 21.3b Borrowing from the International Monetary Fund 21.4 Operation and Evolution of the Bretton Woods System 21.4a Operation of the Bretton Woods System 21.4b Evolution of the Bretton Woods System Case Study 21-1: Macroeconomic Performance under Different Exchange Regimes 21.5 U.S. Balance of Payments Deficits and Collapse of the Bretton Woods System 21.5a U.S. Balance of Payments Deficits 21.5b Collapse of the Bretton Woods System 21.6 The International Monetary System: Present and Future 21.6a Operation of the Present System 21.6b Current IMF Operation 21.6c Problems with Present Exchange Rate Arrangements 21.6d Proposals for Reforming Present Exchange Rate Arrangements 21.6e Financial Crises in Emerging Market Economies Case Study 21-2: The Anatomy of a Currency Crisis: The Collapse of the Mexican Pesos Case Study 21-3: Chronology of Economic Crises in Emerging Markets: From Asia to Argentina Case Study 21-4: The Financial Crisis in the United States and Other Advanced Countries 21.6f Other Current International Economic Problems Case Study 21-5: Trade Imbalances Among the Leading Industrial Nations Appendix: International Reserves: 1950-2008

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KEY TERMS International monetary system General Arrangements to Borrow (GAB) Adjustment Net IMF position Liquidity Standby arrangements Confidence Swap arrangements International Monetary Fund (IMF) Special Drawing Rights (SDRs) Bretton Woods System Dollar shortage Intervention currency Roosa bonds Fundamental disequilibrium Seignorage Currency convertibility Dollar standard Smithsonian Agreement Substitution account Dollar glut Dollar overhang International Development Association (IDA) Jamaica Accords International Finance Corporation (IFC) Benign neglect Gold tranche First credit tranche Credit tranche IMF conditionality Super gold tranche International Bank for Reconstruction and Development (IBRD or World Bank)

LECTURE GUIDE 1. This core chapter examines the operation of the international monetary system from the gold standard to the present managed exchange rate system, using the theoretical analyses of the previous chapters as background. It also examines proposals for reforms.

2. I would cover two sections in each of three lectures and assign the end-of-chapter problems.

3. I would use each lecture to show the relevance and importance of the analysis of previous chapters in analyzing and evaluating the operation of the various adjustment mechanisms discussed throughout the semester. Indeed, this will also serve a summary review of the course for the final.

SUGGESTED ANSWERS TO PROBLEMS *1. Explain: (a) How economic conditions today differ from those prevailing under the gold standard period. (b) Why the different economic conditions today would make the reestablishment of a smoothly working gold standard impossible.

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a. The primary goal of nations today is internal balance, while during the heyday of the gold standard nations gave priority to external balance. The gold standard days were also characterized by much greater price flexibility than today. Furthermore, London was then the undisputed center of international trade and finance and as a result, there were no destabilizing international capital flows, as frequently occur today between the different International monetary centers. b. The reestablishment of the gold standard today would require the reestablishment of all the conditions that made for its smooth operation from 1880 until 1914. Nations would have to place priority on external over internal balance and give up their use of monetary policy. They would have to eliminate domestic restrictions on price flexibility (i.e., abolish price ceilings, minimum wages, interest restrictions, etc.), and reestablish the supremacy of one international monetary center (New York, Tokyo, or London) so as to avoid destabilizing capital flows among the international monetary centers in existence today. Needless to say, this is impossible.

2. With respect to a nation with a $100 million quota in the IMF, indicate how the nation was to pay in its quota to the IMF and the amount that the nation could borrow in any one year under the original rules. How are the rules different today?

The nation was to pay 25% of its quota ($25 million) in gold and the remainder in the nation's currency.

Under the original rules, the nation could borrow no more than 25% of its quota ($25 million for this nation) from the Fund in any one year.

Today, the nation would pay 25 percent of its quota in SDRs or in currencies of other members selected by the Fund, with their approval, and the rest in their own currency. Under the new rules in operation today, the nation can borrow a maximum of up to 150 percent of its quota in any one year under the various programs to facilitate borrowing that the Fund has put in place over the years.

3. Explain the procedure whereby the nation of Problem 2 borrowed the maximum amount allowed from the IMF for the first year under the original rules.

In order to borrow $25 million, the nation of problem 2 would pay into the Fund another $25 million of its currency. The nation would then receive an equal amount of a reserve currency (usually dollars). The nation could borrow this so-called this gold (now, the reserve or first credit) trance automatically.

4. Explain the procedure whereby the nation of Problem 2 borrowed the maximum amount allowed from the IMF in each year after it had already borrowed the maximum amount allowed in the first year under the original rules.

The nation of problem 2 could continue to borrow $25 million in each of the four subsequent years under the original rules. During each year, the nation would deposit an additional $25 million of its currency with the Fund in exchange for an equal amount of a reserve currency.

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After 5 years, the nation will have borrowed a total of 125% of its quota under the original rules so that the Fund would hold 200% of the nation's quota in the nation's currency (75% deposited when the nation joined the Fund and 125% from borrowing). With each additional amount borrowed, the Fund imposes more conditions and supervision.

5. With regard to the nation of Problem 2, explain how and when the nation was to repay its loan to the IMF under the original rules.

The nation was to repay its loan by "repurchasing" its currency from the Fund with other convertible currencies approved by the Fund, until the Fund once again held no more than 75% of the nation's quota in the nation's currency. The fund allows repayment to be made in currencies of which the Fund holds no more than 75% of the issuing nation's quota. Repayment was originally to be made within 3 to 5 years.

6. Explain what happens if the nation of Problem 2 (call it Nation A) stops borrowing after the first year, but before it repays its loan, another nation borrows $10 of Nation A’s currency from the IMF. Nation A will only have to repay $15 million (for the Fund to hold no more than 75% of nation A's quota in nation A's currency).

*7. (a) Explain how a nation could attempt to discourage large destabilizing international capital inflows under the Bretton Woods system by intervening in the forward market. (b) Can the same be done under the present international monetary system? a. The nation could attempt to discourage large destabilizing international capital flows by purchasing the foreign currency forward to reduce the forward discount or increase the forward premium on the foreign currency. b. The same is true today, except that today exchange rates can fluctuate much more than under the Bretton Woods System and capital moves much more freely internationally than under the old Bretton Woods System, so that the policy of intervening in the forward market is likely to be much less effective.

*8. (a) Explain how a nation could attempt to discourage large destabilizing international capital inflows under the Bretton Woods system by intervening in the spot market. (b) Can the same be done under the present international monetary system? a. The nation could attempt to discourage large destabilizing international capital flows by purchasing the foreign currency in the spot market. This tends to appreciate the foreign currency and discourage international capital inflows. b. The same is true today, except that today exchange rates can fluctuate much more than under the Bretton Woods System and capital moves much more freely internationally than under the old Bretton Woods System, so that the policy of intervening in the spot market is likely to be much less effective.

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9. Explain the role of the dollar under the Bretton Woods system.

Under the Bretton Woods system, the dollar was truly an international currency. From about the midsixties until the collapse of the system in 1971, however, foreigners became progressively more reluctant to hold dollars as the amount of officially foreign-held dollars became progressively higher than U.S. gold reserves. Some other "strong" currencies such as the German mark also began to be widely held as international reserves. But the dollar remained by far the most widely-held international currency.

10. Explain with respect to the Bretton Woods system: (a) The immediate cause of its collapse. (b) The fundamental cause of its collapse. a. The immediate cause of the collapse of the Bretton Woods system was the demand on the part of some European central banks to convert some of their dollar holdings into gold. Had the United States done so, others would have demanded gold for dollars, soon exhausting all U.S. gold reserves. Thus on August 15, 1971, the U.S. suspended the convertibility of dollars into gold. This put the world on a pure paper (dollar) standard. b. The fundamental cause of the collapse of the Bretton Woods system was the lack of an adequate adjustment mechanism as nations were very reluctant to change their par value when in fundamental disequilibrium. They relied instead on a web of ad hoc measures which in the end became unwieldy and inadequate for the task.

11. Explain briefly the operation of the present international monetary system.

The present international monetary system is a managed floating exchange rate system with nations intervening in the foreign exchange markets to smooth out excessive fluctuations in exchange rates. Thus, there is still a need for international reserves. The dollar (without any backing to gold) remains the most important international currency.

12. (a) Explain the fundamental reason for the Mexican currency crisis of December 1994. (b) How does the International Monetary Fund propose to avoid the recurrence of similar crises in the future? a. The fundamental reason for the Mexican currency crisis was that Mexico relied on keeping an overvalued exchange rate that would lead to a trade deficit and thus a capital inflow to help finance investments and growth. This worked fine until the middle of 1994 when investors began to doubt Mexico’s ability to repay foreign loans and thus withdrew their capital. This caused the international value of the Mexican pesos to fall sharply (i.e., to depreciate very heavily with respect to the dollar), inflation and interest rates to rise sharply, and the nation to plunge into deep recession.

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b. The IMF proposed to avoid the recurrence of a Mexican-style currency crisis by setting up an earlywarning system for developing countries to provide accurate and timely financial data so that investors can anticipate problems before they become crises and by negotiating a doubling to $47 billion of the amount that it could borrow under the (New) General Agreement to Borrow in order to provide financial assistance to those nations that do face a serious financial crisis.

13. With regard to the Mexican crisis of December 1994, indicate the lesson that it provides (a) for developing countries relying heavily on short-term capital inflows and (b) on how to deal with a currency crisis once it starts. a. The Mexican currency and financial crisis taught developing nations that they cannot rely excessively on short-term capital inflows (which can as quickly flow in as flow out) to finance growth and development. They should instead try to increase domestic savings and encourage long-term capital inflows. Second, in the face of a financial crisis, it is better to deal with the crisis quickly and decisively. b. Another lesson from the Mexican crisis is that when a currency and financial crisis does hit, it is best to nip it in the bud and take immediate and bold action to overcome it. For example, if Mexico had devalued the pesos in April or even September 1994 when its international reserves were still plentiful, the crisis would probably not have been as deep and serious as it became.

14. (a) Explain the fundamental causes of the economic crises in emerging markets in the second half of the 1990s. (b) What is being proposed to avoid similar crises in the future? a. All the economic crises in emerging market economies during the second half of the 1990s started with a massive withdrawal of short-term liquid funds at the first sign of financial weakness in the nation.

Foreign investors poured funds into many emerging markets during the 1990s in order to take advantage of high returns and to diversify their portfolio after these nations liberalized their capital markets, but they quickly got out of the country as soon as they began to fear that an economic crisis was imminent. This was the case in each of the four emerging market crises: Mexico in 1994-5, South-East Asia in 19971999, Russia in summer 1998, and Brazil in 1999. b. Proposed solutions to avoid future crises in emerging market economies include: Avoid over borrowing of short-term funds (2) increased transparency in financial relations, (3) strengthening emerging markets’ (4) banking and financial system, and (5) greater private sector involvement in rescue programs.

15. Identify the most significant international economic problems facing the world today.

The most important international monetary problems facing the world today are: (1) trade protectionism in advanced countries; (2) large exchange rate volatility and disequilibria, (3) frequent economic crises in emerging market economies (4) job insecurity and stagnant wages in the United States and other advanced countries (5) high structural unemployment and slow growth in Europe and stagnation in Japan (6) restructuring challenges of transition economies, and (7) deep poverty in many developing countries..

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*= Answer provided at www.wiley.com/college/salvatore.

SUGGESTED ANSWERS TO PROBLEMS IN APPENDIX Problem A21.1 (a) Calculate the ratio of the total dollar value of international reserves (with gold measured at market values) to the total dollar value of world imports in 1950, 1955, 1965, 1970, 1980, 1985, 1990, 1995, 2000 and from 2001 to 2008. (b) What can you say about the change in international liquidity over the years? (c) Why may international liquidity be excessive under the present international monetary system? a. See Table 1. b. International liquidity measured by the ratio of the dollar value of international reserves (with gold reserves measured at market values) to the total dollar value of world imports declined over the years from 0.80 in 1950 to 0.31 in 1970, it rose to 0.35 in 1985, and then it ranged from 0.24 in 1995 and 0.32 in 2002, and it was 0.30 in 2008 c. While there is still a need for international reserves under the present system, it is much smaller than it was under the Bretton Woods system. Thus, there seems to be an excess of liquidity in the world today.

Table 1 International Reserves and Trade (in billions of dollars at year-end with gold at market value) 1950 1955 1960 1965 1970 1975 1980 1985 International 1 Reserves 48.0 53.6 60.7 71.3 95.8 299.0 776.6 679.6 2 Imports 60.1 92.1 123.9 183.3 313.5 875.2 2,014.7 1,964.6 3

Reserves/Imports

0.8

0.58

0.49

0.39

0.31

0.34

0.3

1990

1995

2000

2005

2006

2007

2008

1 2

International Reserves Imports

908.3 3,530.7

1,227.4 5,187.4

1,752.6 6,573.7

3

Reserves/Imports

0.26

0.24

0.27

0.35

3,279.1 3,732.8 4,456.3 4,883.1 10,650.5 12,243.7 14,094.7 16,265.0 0.3

0.32

0.31

0.30

Source: Table 21-6 in the text and IMF, International Financial Statistics Yearbook, 1985, 2002, and 2009.

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