International Economics Trade and Finance, 11th Edition International Student Version Solution Manua

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Solution Manual

Resource:

International Economics Trade and Finance

Edition:

11th Edition

Author(s):

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

Instructor’s Manual to Accompany

International Economics Eleventh Edition Dominick Salvatore

.

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

TABLE OF CONTENTS • Chapter 1: Introduction Page 1-1

PART ONE: INTERNATIONAL TRADE THEORY • Chapter 2: The Law of Comparative Advantage Page 2-1 • Chapter 3: The Standard Theory of International Trade Page 3-1 • Chapter 4: Demand and Supply, Offer Curves, and the Terms of Trade Page 4-1 • Chapter 5: Factor Endowments and the Heckscher-Ohlin Theory Page 5-1 • Chapter 6: Economies of Scale, Imperfect Competition, and International Trade Page 6-1 •

Additional Essays and Problems for Part One

PART TWO: INTERNATIONAL TRADE POLICY • Chapter 8: Trade Restrictions: Tariffs Page 8-1 • Chapter 9: Nontariff Trade Barriers and the New Protectionism Page 9-1 • Chapter 10: Economic Integration: Customs Unions and Free Trade Areas Page 10-1 • Chapter 11: International Trade and Economic Development Page 11-1 • Chapter 12: International Resource Movements and Multinational Corporations Page 12-1 •

Additional Essays and Problems for Part Two

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PART THREE: THE BALANCE OF PAYMENTS, FOREIGN EXCHANGE MARKETS, AND EXCHANGE RATES • Chapter 13: The Balance of Payments Page 13-1 • Chapter 14: Foreign Exchange Markets and Exchange Rates Page 14-1 • Chapter 15: Exchange Rate Determination Page 15-1 •

Additional Essays and Problems for Part Three

PART FOUR:OPEN ECONOMY MACROECONOMICS AND THE INTERNATIONAL MONETARY SYSTEM •

Chapter 16: The Price Adjustment Mechanisms with Flexible and Fixed Exchange Rates Page 16-1 •

Chapter 17: The Income Adjustment Mechanism and Synthesis of Automatic Adjustments Page 17-1 • Chapter 18: Open Economy Macroeconomics: Adjustment Policies Page 18-1 •

Chapter 19: Prices and output in an Open Economy: Aggregate Demand and Aggregate Supply Page 19-1 •

Chapter 20: Flexible versus Fixed Exchange Rates, The European Monetary System, and Macroeconomic Policy Coordination Page 20-1 • Chapter 21: The International Monetary System: Past and Present Page 21-1 •

Additional Essays and Problems for Part Four

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

INTRODUCTORY COMMENTS 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, the answer to the end-of-chapter problems, and a set of 12 to 18 multiple-choice questions with answers for each chapter.

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, 9, 13-18, 21. I would cover each of these 14 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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International Economics – 11th Edition

Instructor’s Manual

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 included can be used for quizzes or to be part of the midterm and final examinations. 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. At the end of each of the four parts of this Manual, there are also additional essays and problems with answers that can be used for class exams.

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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International Economics – 11th Edition

Instructor’s Manual

CHAPTER 1 *(Core Chapter) INTRODUCTION OUTLINE 1.1 The Globalization of the World Economy 1.1A We Live in a Global Economy Case Study 1-1: The Dell PCs, iPhones and iPads Sold in the U.S. Are Anything But American!

Case Study 1-2: What Is an "American" Car? 1.1B The Globalization Challenge Case Study 1-3: Is India’s Globalization Harming the United States?

1.2 International Trade and The Nation's Standard of Living Case Study 1-4: Rising Importance of International Trade to the United States 1.3 The International Flow of Goods, Services, Labor and Capital 1.3A The International Flow of Goods and Services: The Gravity Model 1.3B The International Flow of Labor and Capital Case Study 1-4: Major Net Exporters and Importers of Capital 1.4 International Economic Theories and Policies 1.4A Purpose of International Economic Theories and Policies 1.4B The Subject Matter of International Economics 1.5 Current International Economic Problems 1.6 Organization and Methodology of the Book 1.6A Organization of the Text 1.6B Methodology of the Text Appendix:

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

Key Terms Globalization Anti-globalization movement Interdependence Gravity model International trade theory International trade policy New protectionism

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Foreign exchange markets Balance of payments Adjustment in the balance of payments Microeconomics Macroeconomics Open economy macroeconomics International finance

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International Economics – 11th Edition

Instructor’s Manual

Lecture Guide 1.

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

The material in this chapter can be covered in two classes. I would utilize one class to cover Sections 1 to 3 and the second class to cover Sections 4 to 6. I would spend most of the second class on Section 3 on the major current international economic problems 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.

Answer to Problems 1.

a) International economic problems reported in our daily newspapers are likely to include: • • • • • • •

Slow growth and high unemployment in advanced economies; trade controversies between the United States, Europe, Japan, and China; excessive volatility of exchange rates; huge and unsustainable trade deficits of the United States; structural unemployment in advanced economies and insufficient restructuring in transition economies; deep poverty in many developing nations; resource scarcity, environmental degradation and climate changes

b) The effect of each of the above problems on the U.S. economy are: ● ● • • • • •

stagnant standard of living and economic suffering; increased protectionism and the danger of trade wars; discourages foreign trade and investments; can result in trade protectionism and/or deep dollar depreciation; reduces advanced countries' imports of goods and services from the rest of the world; can lead to political instability abroad that would adversely affect the U.S.; endangers future standard of living in the U.S. and abroad.

c) The effect of each of the current international economic problems can affect each of us, as follows: ● ●

•

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Can lose job and suffer financial losses; pay higher prices for imported products; great fluctuations in the price of imported products and cost of foreign travel;

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• • • • 2.

Instructor’s Manual

can lead you to support demands for trade protection; slower growth of wages and incomes; can lead to higher taxes to help poor countries; can result in higher taxes and price of fuel and other products.

a) Five industrial nations not mentioned are: France, Italy, Spain, Sweden, and Austria. b) See Table 1A. Note that, generally, smaller nations have higher percentages of imports and exports to GDP. The exception is Spain, which though economically smaller than Italy, has a smaller percentage of imports and exports to GDP than Italy.

Table 1A Economic Interdependence as Measured by Imports and Exports as a Percentage of GDP, 2010

Nation France Italy Spain Sweden Austria

Imports as a percent of GDP 27.7 28.5 28.4 44.1 50.5

Exports as a percent of GDP 25.4 26.7 26.2 49.9 55.3

Source: International Financial Statistics (Washington, D.C., IMF, November 2011).

3.

a) Five developing nations not mentioned in the text are: Brazil, Pakistan, Colombia, Morocco, and Tunisia. b) See Table 1B. Note that, once again, the smaller the nation, the greater is its economic interdependence.

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International Economics – 11th Edition

Instructor’s Manual

Table 1B Economic Interdependence as Measured by Imports and Exports as a Percentage of GDP, 2010

Nation Brazil Pakistan Peru Morocco Tunisia

Imports as a percent of GDP

Exports as a percent of GDP

12.1

11.2

19.0

12.9

22.8

25.78

39.5

28.6

47.9

45.0

Source: IFS (Washington, D.C., IMF, November 2011).

4.

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.

a) Mankiw’s Economics (6th., 2011) includes the following microeconomics topics: • • • • • • • • • • •

b)

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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;

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.

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c)

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Mankiw’s Economics (6th., 2011) 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; 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 trade off 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) Consumer demand theory predicts than when the price of a commodity rises (cet. par.), the quantity demanded of the commodity declines.

When the price of imports rises to domestic consumers, the quantity demanded of imports can be expected to decline (if everything else remains constant).

7.

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.

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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.

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.

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 8.

11.

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.

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 chapter for foreigners and so they would purchase a greater quantity of U.S. exports.

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Multiple-Choice Questions

1. Which of the following products are not produced at all in the United States? *a. Coffee, tea, cocoa b. steel, copper, aluminum c. petroleum, coal, natural gas d. typewriters, computers, airplanes 2. International trade is most important to the standard of living of: a. the United States *b. Switzerland c. Germany d. England 3. Over time, the economic interdependence of nations has: *a. grown b. diminished c. remained unchanged d. cannot say 4. A rough measure of the degree of economic interdependence of a nation is given by: a. the size of the nations' population b. the percentage of its population to its GDP *c. the percentage of a nation's imports and exports to its GDP d. all of the above 5. Economic interdependence is greater for: *a. small nations b. large nations c. developed nations d. developing nations 6. The gravity model of international trade predicts that trade between two nations is larger a. the larger the two nations b. the closer the nations c. the more open are the two nations *d. all of the above

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7. International economics deals with: a. the flow of goods, services, and payments among nations b. policies directed at regulating the flow of goods, services, and payments c. the effects of policies on the welfare of the nation *d. all of the above 8. International trade theory refers to: *a. the microeconomic aspects of international trade b. the macroeconomic aspects of international trade c. open economy macroeconomics or international finance d. all of the above 9. Which of the following is not the subject matter of international finance? a. foreign exchange markets b. the balance of payments *c. the basis and the gains from trade d. policies to adjust balance of payments disequilibria 10. Economic theory: a. seeks to explain economic events b. seeks to predict economic events c. abstracts from the many detail that surrounds an economic event *d. all of the above 11. Which of the following is not an assumption generally made in the study of international economics? a. two nations b. two commodities *c. perfect international mobility of factors d. two factors of production 12. In the study of international economics: a. international trade policies are examined before the bases for trade b. adjustment policies are discussed before the balance of payments c. the case of many nations is discussed before the two-nations case *d. none of the above

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13. International trade is similar to interregional trade in that both must overcome: *a. distance and space b. trade restrictions c. differences in currencies d. differences in monetary systems 14. The opening or expansion of international trade usually affects all members of society: a. positively b. negatively *c. most positively but some negatively d. most negatively but some positively 15. An increase in the dollar price of a foreign currency usually: a. benefit U.S. importers *b. benefits U.S. exporters c. benefit both U.S. importers and U.S. exporters d. harms both U.S. importers and U.S. exporters 16. Which of the following statements with regard to international economics is true? a. It is a relatively new field *b. it is a relatively old field c. most of its contributors were not economists d. none of the above

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CHAPTER 2 *(Core Chapter) THE LAW OF COMPARATIVE ADVANTAGE

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:

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

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Key Terms Basis for trade Gains from trade Pattern of trade Mercantilism Absolute advantage Laissez-faire Law of comparative advantage

Labor theory of value Opportunity cost theory Production possibility frontier 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 a adequately. In the first lecture, I would present Sections 1, 2, and 3. These are short s 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 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.

Answer to Problems 1.

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

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.

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International Economics – 11th Edition

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Instructor’s Manual

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 commodities.

3.

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.

a) The United States gains 1C. b) The United Kingdom gains 4C. c) 3C < 4W < 8C. d) The United States would gain 3C while the United Kingdom would gain 2C.

5)

a) The cost in terms of labor content of producing wheat is 1/4 in the United States a 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)

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.

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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.

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.

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) 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 2.3.

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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.

11.

See Figure 3 on page 15 and the discussion in the last paragraph of Section 2.6b in the text.

12.

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. d) 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.

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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

Nation B 2 1.5 3

C 3 2 2

Multiple-Choice Questions

1. The Mercantilists did not advocate: *a.free trade b. stimulating the nation's exports c. restricting the nations' imports d. the accumulation of gold by the nation 2. According to Adam Smith, international trade was based on: *a. absolute advantage b. comparative advantage c. both absolute and comparative advantage d. neither absolute nor comparative advantage 3. What proportion of international trade is based on absolute advantage? a. All b. most *c. some d. none

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4. The commodity in which the nation has the smallest absolute disadvantage is the commodity of its: a. absolute disadvantage b. absolute advantage c. comparative disadvantage *d. comparative advantage 5. If in a two-nation (A and B), two-commodity (X and Y) world, it is established that nation A has a comparative advantage in commodity X, then nation B must have: a. an absolute advantage in commodity Y b. an absolute disadvantage in commodity Y c. a comparative disadvantage in commodity Y *d. a comparative advantage in commodity Y 6. If with one hour of labor time nation A can produce either 3X or 3Y while nation B can produce either 1X or 3Y (and labor is the only input): a. nation A has a comparative disadvantage in commodity X b. nation B has a comparative disadvantage in commodity Y *c. nation A has a comparative advantage in commodity X d. nation A has a comparative advantage in neither commodity 7. With reference to the statement in Question 6: a Px/Py=1 in nation A b. Px/Py=3 in nation B c. Py/Px=1/3 in nation B *d. all of the above 8. With reference to the statement in Question 6, if 3X is exchanged for 3Y: a. nation A gains 2X *b. nation B gains 6Y c. nation A gains 3Y d. nation B gains 3Y 9. With reference to the statement of Question 6, the range of mutually beneficial trade between nation A and B is: a 3Y < 3X < 5Y b. 5Y < 3X < 9Y *c 3Y < 3X < 9Y d. 1Y < 3X < 3Y

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10. If domestically 3X=3Y in nation A, while 1X=1Y domestically in nation B: a. there will be no trade between the two nations b. the relative price of X is the same in both nations c. the relative price of Y is the same in both nations *d. all of the above 11. Ricardo explained the law of comparative advantage on the basis of: *a. the labor theory of value b. the opportunity cost theory c. the law of diminishing returns d. all of the above 12. Which of the following statements is true? a. The combined demand for each commodity by the two nations is negatively sloped b. the combined supply for each commodity by the two nations is rising stepwise c. the equilibrium relative commodity price for each commodity with trade is given by the intersection of the demand and supply of each commodity by the two nations *d. all of the above 13. A difference in relative commodity prices between two nations can be based upon a difference in: a. factor endowments b. technology c. tastes *d. all of the above 14. In the trade between a small and a large nation: a. the large nation is likely to receive all of the gains from trade *b. the small nation is likely to receive all of the gains from trade c. the gains from trade are likely to be equally shared d. we cannot say 15. The Ricardian trade model has been empirically *a. verified b. rejected c. not tested d. tested but the results were inconclusive

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Instructor’s Manual

*CHAPTER 3 (Core Chapter) THE STANDARD THEORY OF INTERNATIONAL TRADE

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 Study 3-1 Comparative Advantage of the Largest Advanced and Emerging Economies 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) Community indifference curves Marginal rate of substitution (MRS) Autarky Equilibrium relative commodity price in isolation

Equilibrium relative price with trade 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.

Answer to Problems 1.

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.

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.

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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.

a) See Figure 3. 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) 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 pretrade price than for Nation 2.

5.

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.

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 3-4 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 3-4, but this is shown in Chapter 4 with offer curves.

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Nation 2's demand curve for Nation 1's exports of commodity X could be derived from the right panel of Figure 3-4, as shown in Chapter 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 3-4.

7.

See Figure 6 on page 3-8.

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) 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.

a) See Figure 7. b) See Figure 8.

10.

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.

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.

See Figure 11

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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.

App. 1. 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.

App. 2. 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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Multiple-Choice Questions 1. A production frontier that is concave from the origin indicates that the nation incurs increasing opportunity costs in the production of: a. commodity X only b. commodity Y only *c. both commodities d. neither commodity 2. The marginal rate of transformation (MRT) of X for Y refers to: a. the amount of Y that a nation must give up to produce each additional unit of X b. the opportunity cost of X c. the absolute slope of the production frontier at the point of production *d. all of the above 3. Which of the following is not a reason for increasing opportunity costs: *a. technology differs among nations b. factors of production are not homogeneous c. factors of production are not used in the same fixed proportion in the production of all commodities d. for the nation to produce more of a commodity, it must use resources that are less and less suited in the production of the commodity 4. Community indifference curves: a. are negatively sloped b. are convex to the origin c. should not cross *d. all of the above 5. The marginal rate of substitution (MRS) of X for Y in consumption refers to the: a. amount of X that a nation must give up for one extra unit of Y and still remain on the same indifference curve *b. amount of Y that a nation must give up for one extra unit of X and still remain on the same indifference curve c. amount of X that a nation must give up for one extra unit of Y to reach a higher indifference curve d. amount of Y that a nation must give up for one extra unit of X to reach a higher indifference curve

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6. Which of the following statements is true with respect to the MRS of X for Y? a. It is given by the absolute slope of the indifference curve b. declines as the nation moves down an indifference curve c. rises as the nation moves up an indifference curve *d. all of the above 7. Which of the following statements about community indifference curves is true? a. They are entirely unrelated to individuals' community indifference curves b. they cross, they cannot be used in the analysis *c. the problems arising from intersecting community indifference curves can be overcome by the application of the compensation principle d. all of the above.

8. Which of the following is not true for a nation that is in equilibrium in isolation? *a. It consumes inside its production frontier b. it reaches the highest indifference curve possible with its production frontier c. the indifference curve is tangent to the nation's production frontier d. MRT of X for Y equals MRS of X for Y, and they are equal to Px/Py 9. If the internal Px/Py is lower in nation 1 than in nation 2 without trade: a. nation 1 has a comparative advantage in commodity Y b. nation 2 has a comparative advantage in commodity X *c. nation 2 has a comparative advantage in commodity Y d. none of the above 10. Nation 1's share of the gains from trade will be greater: a. the greater is nation 1's demand for nation 2's exports *b. the closer Px/Py with trade settles to nation 2's pretrade Px/Py c. the weaker is nation 2's demand for nation 1's exports d. the closer Px/Py with trade settles to nation 1's pretrade Px/Py 11. If Px/Py exceeds the equilibrium relative Px/Py with trade a. the nation exporting commodity X will want to export more of X than at equilibrium b. the nation importing commodity X will want to import less of X than at equilibrium c. Px/Py will fall toward the equilibrium Px/Py *d. all of the above

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12. With free trade under increasing costs: a. neither nation will specialize completely in production b. at least one nation will consume above its production frontier c. a small nation will always gain from trade *d. all of the above 13. Which of the following statements is false? a.The gains from trade can be broken down into the gains from exchange and the gains from specialization b. gains from exchange result even without specialization *c. gains from specialization result even without exchange d. none of the above 14. The gains from exchange with respect to the gains from specialization are always: a. greater b. smaller c. equal *d. we cannot say without additional information 15. Mutually beneficial trade cannot occur if production frontiers are: a. equal but tastes are not b. different but tastes are the same c. different and tastes are also different *d. the same and tastes are also the same.

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Instructor’s Manual

*CHAPTER 4 (Core Chapter) DEMAND AND SUPPLY, OFFER CURVES, AND THE TERMS OF TRADE 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 Advanced and Developing 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 Reciprocal demand curve Terms of trade

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Commodity or net barter terms of trade General equilibrium model

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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.

Answer to Problems 1. See Figure 1.

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

2. See Figure 2.

3. See Figure 3.

4. See Figure 4.

5. 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.

6. 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.

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7. a) See Figure 6 on page 34. 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 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. 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 e 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) 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 e 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.

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b) 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. See Figure 8 on page 36.

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 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.

See Figure 9 on page 36. 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. 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.

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 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.

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App. 3. See Figures 10 and 11.

App. 4. See Figure 12.

App. 5. 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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Multiple Choice Questions 1. Which of the following statements is correct? a. The demand for imports is given by the excess demand for the commodity b. the supply of exports is given by the excess supply of the commodity c. the supply curve of exports is flatter than the total supply curve of the commodity *d. all of the above 2. At a relative commodity price above equilibrium a. the excess demand for a commodity exceeds the excess supply of the commodity b. the quantity demanded of imports exceeds the quantity supplied of exports *c. the commodity price will fall d. all of the above 3. The offer curve of a nation shows: a. the supply of a nation's imports b. the demand for a nation's exports c. the trade partner's demand for imports and supply of exports *d. the nation's demand for imports and supply of exports 4. The offer curve of a nation bulges toward the axis measuring the nations a. import commodity *b. export commodity c. export or import commodity d. nontraded commodity 5. Export prices must rise for a nation to increase its exports because the nation: a. incurs increasing opportunity costs in export production b. faces decreasing opportunity costs in producing import substitutes c. faces decreasing marginal rate of substitution in consumption *d. all of the above 6. Which of the following statements regarding partial equilibrium analysis is false? a. It relies on traditional demand and supply curves b. it isolates for study one market *c. it can be used to determine the equilibrium relative commodity price but not the equilibrium quantity with trade d. none of the above

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7. Which of the following statements regarding partial equilibrium analysis is true? a. The demand and supply curve are derived from the nation's production frontier and indifference map b. It shows the same basic information as offer curves c. It shows the same equilibrium relative commodity prices as with offer curves *d. all of the above 8. In what way does partial equilibrium analysis differ from general equilibrium analysis? a. The former but not the latter can be used to determine the equilibrium price with trade b. the former but not the latter can be used to determine the equilibrium quantity with trade c. the former but not the latter takes into consideration the interaction among all markets in the economy *d. the former gives only an approximation to the answer sought.

9. If the terms of trade of a nation are 1.5 in a two-nation world, those of the trade partner are: a. 3/4 *b. 2/3 c. 3/2 d. 4/3 10. If the terms of trade increase in a two-nation world, those of the trade partner: *a. deteriorate b. improve c. remain unchanged d. any of the above 11. If a nation does not affect world prices by its trading, its offer curve: a. is a straight line b. bulges toward the axis measuring the import commodity *c. intersects the straight-line segment of the world's offer curve d. intersects the positively-sloped portion of the world's offer curve

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12. If the nation's tastes for its import commodity increases: a. the nation's offer curve rotates toward the axis measuring its import commodity b. the partner's offer curve rotates toward the axis measuring its import commodity c. the partner's offer curve rotates toward the axis measuring its export commodity *d. the nation's offer curve rotates toward the axis measuring its export commodity 13. If the nation's tastes for its import commodity increases: a. the nation's terms of trade remain unchanged *b. the nation's terms of trade deteriorate c. the partner's terms of trade deteriorate d. any of the above 14. If the tastes for a nation import commodity increases, trade volume: *a. increases b. declines c. remains unchanged d. any of the above 15. A deterioration of a nation's terms of trade causes the nation's welfare to: a. deteriorate b. improve c. remain unchanged *d. any of the above

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*CHAPTER 5 (Core Chapter) FACTOR ENDOWMENTS AND THE HECKSCHER-OHLIN THEORY 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 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: Classification of Major Product Categories in Terms of Factor Intensities Case Study 5-3: The Factor Intensity of Trade of Various Countries 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 Case Study 5-5: Has International Trade Increased U.S. Wage Inequalities?

5.5D The Specific-Factors Model 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 Case Study 5-7: Capital and Labor Requirements in U.S. Trade 5.6B Explanations of the Leontief Paradox and Other Empirical Tests of the H-O Model Case Study 5-8: The H-O Model With Skills and Land 5.6C Factor-Intensity Reversal

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Appendix:

Instructor’s Manual

A5.1 The Edgeworth Box Diagram for Nation 1 and Nation 2 A5.2 Relative Factor-Price Equalization A5.3 Absolute Factor-Price Equalization 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 abundance 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 1-8 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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Answer to Problems 1.

a) See Figure 1. b) The slope of the lines measuring K/L of each commodity in Nation 2 fall 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 rise 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.

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.

See Figure 3.

4.

See Figure 4 on page 46.

5.

See Figure 5.

6.

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. 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.

See Figure 6.

8.

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.

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Instructor’s Manual

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. 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.

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.

Internatioal 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 laborsaving 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) 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 factorintensity 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. importcompeting 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 natural-resource industries eliminated the paradox. 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.

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d) Factor-intensity reversal seems to be rather rare in the real world.

13.

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 factorintensity 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.

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 L-intensive 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.

15.

a) By allowing for different technologies and factor prices across countries, nontraded 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.

App. 2. See Figure 8.

App. 4. The effect of the opening of trade 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 is to increase Py/Px and to cause more L to be used in the production of Y. 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.

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App. 5. 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).

App. 6. 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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Multiple-Choice Questions 1. The H-O model extends the classical trade model by: a. explaining the basis for comparative advantage b. examining the effect of trade on factor prices *c. both a and b d. neither a nor b 2. Which is not an assumption of the H-O model a. the same technology in both nations b. constant returns to scale *c. complete specialization d. equal tastes in both nations

3. With equal technology nations will have equal K/L in production if: *a. factor prices are the same b. tastes are the same c. production functions are the same d. all of the above 4. We say that commodity Y is K-intensive with respect to X when: a. more K is used in the production of Y than X b. less L is used in the production of Y than X *c. a lower L/K ratio is used in the production of Y than X d. a higher K/L is used in the production of X than Y 5. When w/r falls, L/K a. falls in the production of both commodities *b. rises in the production of both commodities c. can rise or fall d. is not affected 6. A nation is said to have a relative abundance of K if it has a: a. greater absolute amount of K b. smaller absolute amount of L c. higher L/K ratio *d. lower r/w

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7. A difference in relative commodity prices between nations can be based on a difference in: a. technology b. factor endowments c. tastes *d. all of the above 8. In the H-O model, international trade is based mostly on a difference in: a. technology *b. factor endowments c. economies of scale d. tastes 9. According to the H-O model, trade reduces international differences in: a. relative but not absolute factor prices b. absolute but not relative factor prices *c. both relative and absolute factor prices d. neither relative nor absolute factor prices 10. According to the H-O model, international trade will: a. reduce international differences in per capita incomes b. increases international differences in per capita incomes *c. may increase or reduce international differences in per capita incomes d. lead to complete specialization 11. The H-O model is a general equilibrium model because it deals with: a. production in both nations b. consumption in both nations c. trade between the two nations *d. all of the above 12. The H-O model is a simplification of the a truly general equilibrium model because it deals with: a. two nations b. two commodities c. two factors of production *d. all of the above

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13. The Leontief paradox refers to the empirical finding that U.S. *a. import substitutes are more K-intensive than exports b. imports are more K-intensive than exports c. exports are more L-intensive than imports d. exports are more K-intensive than import substitutes 14. From empirical studies, we conclude that the H-O theory: a. must be rejected b. must be accepted without reservations *c. can be accepted while awaiting further testing d. explains all international trade 15. For factor reversal to occur, two commodities must be produced with: *a. sufficiently different elasticity of substitution of factors b. the same K/L ratio c. technologically-fixed factor proportions d. equal elasticity of substitution of factors

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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 Case Study 6-2 Job Loss Rates in U.S. Industries and Globalization *6.4 Imperfect Competition and International Trade 6.4A Trade Based on Product Differentiation Case Study 6-3: U.S. Intra-Industry Trade in Automotive Products Case Study 6-4: Variety Gains from International Trade 6.4B Measuring Intra-Industry Trade Case Study 6-5: Growth of Intra-Industry Trade Case Study 6-6: Intra-Industry Trade Indexes for G-20 Countries 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 6-7: The United States as the Most Competitive Economy 6.6 Transportation Costs, Environmental Standards, and International Trade 6.6A Transportation Costs and Nontraded Commodities 6.6B Transportation Costs and the Location of Industry 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, Outsourcing International economies of scale External economies Differentiated products ch06)

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

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

Footloose industries 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 4-9 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.

Answer to Problems: 1.

See Figure 1.

2.

See Figure 2.

3.

See Figure 3.

4.

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.

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

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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.

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 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) 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.

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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.

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.

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.

See Figure 5 on the previous page.

11.

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.

See Figure 6 on the previous page.

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.

13.

See Figure 7 on the next page.

P2 exceeds P1 by the relative cost of transporting one unit of commodity X from Nation 1 to Nation 2.

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See Figure 8.

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App. 1. 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.

App. 2. 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.

Multiple-Choice Questions: 1. Relaxing the assumptions on which the Heckscher-Ohlin theory rests: a. leads to rejection of the theory b. leaves the theory unaffected *c. requires complementary trade theories d. any of the above.

2. Which of the following assumptions of the Heckscher-Ohlin theory, when relaxed, leave the theory unaffected? a. Two nations, two commodities, and two factors b. both nations use the same technology c. the same commodity is L-intensive in both nations *d. all of the above 3. Which of the following assumptions of the Heckscher-Ohlin theory, when relaxed, require new trade theories? *a. Economies of scale b. incomplete specialization c. similar tastes in both nations d. the existence of transportation costs 4. International trade can be based on economies of scale even if both nations have identical: a. factor endowments b. tastes c. technology *d. all of the above ch06)

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5. A great deal of international trade: a. is intra-industry trade b. involves differentiated products c. is based on monopolistic competition *d. all of the above 6. The Heckscher-Ohlin and new trade theories explains most of the trade: a. among industrial countries b. between developed and developing countries c. in industrial goods *d. all of the above 7. The theory that a nation exports those products for which a large domestic market exists was advanced by: *a. Linder b. Vernon c. Leontief d. Ohlin 8. Intra-industry trade takes place: a. because products are homogeneous *b. in order to take advantage of economies of scale c. because perfect competition is the prevalent form of market organization d. all of the above 9. If a nation exports twice as much of a differentiated product that it imports, its intraindustry (T) index is equal to: a. 1.00 b. 0.75 *c. 0.50 d. 0.25 10. Trade based on technological gaps is closely related to: a. the H-O theory *b. the product-cycle theory c. Linder's theory d. all of the above ch06)

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11. Which of the following statements is true with regard to the product-cycle theory? a. It depends on differences in technological changes over time among countries b. it depends on the opening and the closing of technological gaps among countries c. it postulates that industrial countries export more advanced products to less advanced countries *d. all of the above 12. Transport costs: a. increase the price in the importing country b. reduces the price in the exporting country *c. both of the above d. neither a nor b.

13. Transport costs can be analyzed: a. with demand and supply curves b. production frontiers c. offer curves *d. all of the above 14. The share of transport costs will fall less heavily on the nation: *a. with the more elastic demand and supply of the traded commodity b. with the less elastic demand and supply of the traded commodity c. exporting agricultural products d. with the largest domestic market 15. A footloose industry is one in which the product: a. gains weight in processing b. loses weight in processing c. both of the above *d. neither a nor b.

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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: Growth in the Capital Stock per Worker of 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 7-2: Growth in 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 7-3: Growth and the Emergence of New Economic Giants 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 7-4: 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

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

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

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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.

Answer to Problems 1.

a) See Figure 1. b) See Figure 2 c) See Figure 3.

2.

See Figure 4.

3.

a) See Figure 5. b) See Figure 6. c) See Figure 7.

4.

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.

See Figure 8.

6.

See Figure 9.

7.

See Figure 10.

8.

See Figure 11.

9.

See Figure 12.

10.

See Figure 13.

11.

See Figure 14.

12.

See Figure 15.

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The United States has become the most competitive economy in the world since the early 1990’s, while the data in Table 7.2 refers to the 1965-1990 period.

App. 1a. See Figure 16.

1b. 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.

1c. Px/Py must rise (i.e., Py/Px must fall) as a result of growth only.

Px/Py will fall even more with trade.

2. 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.

3. 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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Multiple-Choice Questions 1. Dynamic factors in trade theory refer to changes in: a. factor endowments b. technology c. tastes *d. all of the above 2. Doubling the amount of L and K under constant returns to scale: a. doubles the output of the L-intensive commodity b. doubles the output of the K-intensive commodity c. leaves the shape of the production frontier unchanged *d. all of the above.

3. Doubling only the amount of L available under constant returns to scale: a. less than doubles the output of the L-intensive commodity *b. more than doubles the output of the L-intensive commodity c. doubles the output of the K-intensive commodity d. leaves the output of the K-intensive commodity unchanged 4. The Rybczynski theorem postulates that doubling L at constant relative commodity prices: a. doubles the output of the L-intensive commodity *b. reduces the output of the K-intensive commodity c. increases the output of both commodities d. any of the above 5. Doubling L is likely to: a. increases the relative price of the L-intensive commodity b. reduces the relative price of the K-intensive commodity *c. reduces the relative price of the L-intensive commodity d. any of the above 6. Technical progress that increases the productivity of L proportionately more than the productivity of K is called: *a. capital saving b. labor saving c. neutral d. any of the above

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7. A 50 percent productivity increase in the production of commodity Y: a. increases the output of commodity Y by 50 percent b. does not affect the output of X c. shifts the production frontier in the Y direction only *d. any of the above 8. Doubling L with trade in a small L-abundant nation: *a. reduces the nation's social welfare b. reduces the nation's terms of trade c. reduces the volume of trade d. all of the above 9. Doubling L with trade in a large L-abundant nation: a. reduces the nation's social welfare b. reduces the nation's terms of trade c. reduces the volume of trade *d. all of the above 10. If, at unchanged terms of trade, a nation wants to trade more after growth, then the nation's terms of trade can be expected to: *a. deteriorate b. improve c. remain unchanged d. any of the above 11. A proportionately greater increase in the nation's supply of labor than of capital is likely to result in a deterioration in the nation's terms of trade if the nation exports: a. the K-intensive commodity *b. the L-intensive commodity c. either commodity d. both commodities 12. Technical progress in the nation's export commodity: *a. may reduce the nation's welfare b. will reduce the nation's welfare c. will increase the nation's welfare d. leaves the nation's welfare unchanged

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13. Doubling K with trade in a large L-abundant nation: a. increases the nation's welfare b. improves the nation's terms of trade c. reduces the volume of trade *d. all of the above 14. An increase in tastes for the import commodity in both nations: a. reduces the volume of trade *b. increases the volume of trade c. leaves the volume of trade unchanged d. any of the above 15. An increase in tastes of the import commodity of Nation A and export in B: *a. will reduce the terms of trade of Nation A b. will increase the terms of trade of Nation A c. will reduce the terms of trade of Nation B d. any of the above

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ADDITIONAL ESSAYS AND PROBLEMS FOR PART ONE

1.

Assume that both the United States and Germany produce beef and computer chips with the following costs: United States (dollars) Unit cost of beef (B) Unit cost of computer chips (C)

2 1

Germany (marks) 8 2

a) What is the opportunity cost of beef (B) and computer chips (C) in each country? b) In which commodity does the United States have a comparative cost advantage?

What about Germany? c) What is the range for mutually beneficial trade between the United States and Germany for each computer chip traded? d) How much would the United States and Germany gain if 1 unit of beef is exchanged for 3 chips?

Answer a.

In the United States: the opportunity cost of one unit of beef is 2 chips; the opportunity cost of one chip is 1/2 unit of beef.

In Germany: the opportunity cost of one unit of beef is 4 chips; the opportunity cost of one chip is 1/4 unit of beef.

b.

The United States has a comparative cost advantage in beef with respect to Germany, while Germany has a comparative cost advantage in computer chips.

c.

The range for mutually beneficial trade between the United States and Germany for each unit of beef that the United States exports is 2C < 1B < 4C

d.

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Both the United States and Germany would gain 1 chip for each unit of beef traded.

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2. Given: (1) two nations (1 and 2) which have the same technology but different factor endowments and tastes, (2) two commodities (X and Y) produced under increasing costs conditions, and (3) no transportation costs, tariffs, or other obstructions to trade. Prove geometrically that mutually advantageous trade between the two nations is possible.

Note: Your answer should show the autarky (no-trade) and free-trade points of production and consumption for each nation, the gains from trade of each nation, and express the equilibrium condition that should prevail when trade stops expanding.)

Ans.: See Figure 1.

Nations 1 and 2 have different production possibilities curves and different community indifference maps. With these, they will usually end up with different relative commodity prices in autarky, thus making mutually beneficial trade possible.

In the figure, Nation 1 produces and consumes at point A and Px/Py=PA in autarky, while Nation 2 produces and consumes at point A' and Px/Py=PA'. Since PA < PA', Nation 1 has a comparative advantage in X and Nation 2 in Y. Specialization in production proceeds until point B in Nation 1 and point B' in Nation 2, at which PB=PB' and the quantity supplied for export of each commodity exactly equals the quantity demanded for import. Thus, Nation 1 starts at point A in production and consumption in autarky, moves to point B in production, and by exchanging BC of X for CE of Y reaches point E in consumption. E > A since it involves more of both X and Y and lies on a higher community indifference curve. Nation 2 starts at A' in production and consumption in autarky, moves to point B' in production, and by exchanging B'C' of Y for C'E' of X reaches point E'in consumption (which exceeds A').

At Px/Py=PB=PB', Nation 1 wants to export BC of X for CE of Y, while Nation 2 wants to export B'C' (=CE) of Y for C'E' (=BC) of X. Thus, PB=PB' is the equilibrium relative commodity price because it clears both (the X and Y) markets.

3.

Draw a figure showing: (1) in Panel A a nation's demand and supply curve for A traded commodity and the nation's excess supply of the commodity, (2) in Panel C the trade partner's demand and supply curve for the same traded commodity and its excess demand for the commodity, and (3) in Panel B the supply and demand for the quantity traded of the commodity, its equilibrium price, and why a price above or below the equilibrium price will not persist. At any other price, QD  QS, and P will change to P2.

Ans. See Figure 2.

The equilibrium relative commodity price for commodity X (the traded commodity exported by Nation 1 and imported by Nation 2) is P2 and the equilibrium quantity of commodity X traded is Q2.

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a) Identify the conditions that may give rise to trade between two nations. b) What are some of the assumptions on which the Heckscher-Ohlin theory is based? c) What does this theory say about the pattern of trade and effect of trade on factor prices?

Answer: a)

Trade can be based on a difference in factor endowments, technology, or tastes between two nations. A difference either in factor endowments or technology results in a different production possibilities frontier for each nation, which, unless neutralized by a difference in tastes, leads to a difference in relative commodity price and mutually beneficial trade. If two nations face increasing costs and have identical production possibilities frontiers but different tastes, there will also be a difference in relative commodity prices and the basis for mutually beneficial trade between the two nations. The difference in relative commodity prices is then translated into a difference in absolute commodity prices between the two nations, which is the immediate cause of trade.

b)

The Heckscher-Ohlin theory (sometimes referred to as the modern theory – as opposed to the classical theory - of international trade) assumes that nations have the same tastes, use the same technology, face constant returns to scale (i.e., a given percentage increase in all inputs increases output by the same percentage) but differ widely in factor endowments. It also says that in the face of identical tastes or demand conditions, this difference in factor endowments will result in a difference in relative factor prices between nations, which in turn leads to a difference in relative commodity prices and trade. Thus, in the Heckscher-Ohlin theory, the international difference in supply conditions alone determines the pattern of trade. To be noted is that the two nations need not be identical in other respects in order for international trade to be based primarily on the difference in their factor endowments.

c)

The Heckscher-Ohlin theorem postulates that each nation will export the commodity intensive in its relatively abundant and cheap factor and import the commodity intensive in its relatively scarce and expensive factor. As an important corollary, it adds that under highly restrictive assumptions, trade will completely eliminate the pretrade relative and absolute differences in the price of homogeneous factors among nations. Under less restrictive and more usual conditions, however, trade will reduce, but not eliminate, the pretrade differences in relative and absolute factor prices among nations. In any event, the Heckscher-Ohlin theory does say something very useful on how trade affects factor prices and the distribution of income in each nation. Classical economists were practically silent on this point.

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5. consumers demand more of commodity X (the L-intensive commodity) and less of commodity Y (the K- intensive commodity). Suppose that Nation 1 is India, commodity X is textiles, and commodity Y is food. Starting from the no-trade equilibrium position and using the Heckscher-Ohlin model, trace the effect of this change in tastes on India's (a) relative commodity prices and demand for food and textiles, (b) production of both commodities and factor prices, and (c) comparative advantage and volume of trade. (d) Do you expect international trade to lead to the complete equalization of relative commodity and factor prices between India and the United States? Why? Answer: a.

The change in tastes can be visualized by a shift toward the textile axis in India's indifference map in such a way that an indifference curve is tangent to the steeper segment of India's production frontier (because of increasing opportunity costs) after the increase in demand for textiles. This will cause the pretrade relative commodity price of textiles to rise in India.

b.

The increase in the relative price of textiles will lead domestic producers in India to shift labor and capital from the production of food to the production of textiles. Since textiles are L-intensive in relation to food, the demand for labor and therefore the wage rate will rise in India. At the same time, as the demand for food falls, the demand for and thus the price of capital will fall. With labor becoming relative more expensive, producers in India will substitute capital for labor in the production of both textiles and food.

Even with the rise in relative wages and in the relative price of textiles, India still remains the L-abundant and low-wage nation with respect to a nation such as the United States. However, the pretrade difference in the relative price of textiles between India and the United States is now somewhat smaller than before the change in tastes in India. As a result the volume of trade required to equalize relative commodity prices and hence factor prices is smaller than before. That is, India need now export a smaller quantity of textiles and import less food than before for the relative price of textiles in India and the United States to be equalized.

Similarly, the gap between real wages and between India and the United States is now smaller and can be more quickly and easily closed (i.e., with a smaller volume of trade).

c.

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Since many of the assumptions required for the complete equalization of relative commodity and factor prices do not hold in the real world, great differences can be expected and do in fact remain between real wages in India and the United States. Nevertheless, trade would tend to reduce these

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differences, and the H-O model does identify the forces that must be considered to analyze the effect of trade on the differences in the relative and absolute commodity and factor prices between India and the United States.

4.

(a) Explain why the Heckscher-Ohlin trade model needs to be extended. (b) Indicate in what important ways the Heckscher-Ohlin trade model can be extended. (c) Explain what is meant by differentiated products and intra-industry trade.

Anwer: a.

The Heckscher-Ohlin trade model needs to be extended because, while generally correct, it fails to explain a significant portion of international trade, particularly the trade in manufactured products among industrial nations.

b.

The international trade left unexplained by the basic Heckscher-Ohlin trade model can be explained by (1) economies of scale, (2) intra-industry trade, and (3) trade based on imitation gaps and product differentiation.

c.

Differentiated products refer to similar, but not identical, products (such as cars, typewriters, cigarettes, soaps, and so on) produced by the same industry or broad product group. Intra-industry trade refers to the international trade in differentiated products.

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*CHAPTER 8 (Core Chapter) TRADE RESTRICTIONS: TARIFFS OUTLINE 8.1 Introduction 8.2 Partial Equilibrium Analysis of a Tariff Case Study 8-1: Average Tariff on Nonagricultural Products in Major Developed Countries Case Study 8-2: Average Tariff on Nonagricultural 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:

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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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Answer to Problems 1.

a) Consumption is 70Y, production is 10Y and imports are 60Y (see Figure 1 on the next page). 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.

a) The consumer surplus is $245 without and $l80 with the tariff (see Figure 1). 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.

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

4.

a) g = 0.4 - (0.5)(0.4) = 0.4 - 0.2 = 0.2 = 40% 1.0 - 0.5 0.5 0.5

5.

a) g=60% b) g=80% c) g=0 d) g=20%

6.

a) g=70% b) See the first paragraph of section 8.3b.

7.

See Figure 2.

8.

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.

Py/Px rises for domestic producers and consumers. As production of Y (the Kintensive 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.

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.

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International Economics – 11th Edition

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Instructor’s Manual

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International Economics – 11th Edition

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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.

See Figure 3 on the previous page.

13.

See Figure 4.

14.

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

App. 1. 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.

App. 2a. 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.

App. 3. See Figure 5 (on the next page).

App. 4. See Figure 6.

App. 5. 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.

App. 6a. See Figure 7. 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.

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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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International Economics – 11th Edition

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Instructor’s Manual

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Multiple-choice Questions 1. Which of the following statements is incorrect? a. An ad valorem tariff is expressed as a percentage of the value of the traded commodity b. a specific tariff is expressed as a fixed sum of the value of the traded commodity. c. export tariffs are prohibited by the U.S. Constitution *d. The U.S. uses exclusively the specific tariff 2. A small nation is one: a. which does not affect world price by its trading b. which faces an infinitely elastic world supply curve for its import commodity c. whose consumers will pay a price that exceeds the world price by the amount of the tariff *d. all of the above 3. If a small nation increases the tariff on its import commodity, its: a. consumption of the commodity increases b. production of the commodity decreases c. imports of the commodity increase *d. none of the above 4. The increase in producer surplus when a small nation imposes a tariff is measured by the area: *a. to the left of the supply curve between the commodity price with and without the tariff b. under the supply curve between the quantity produced with and without the tariff c. under the demand curve between the commodity price with and without the tariff d. none of the above.

5. If a small nation increases the tariff on its import commodity: *a. the rent of domestic producers of the commodity increases b. the protection cost of the tariff decreases c. the deadweight loss decreases d. all of the above 6. Which of the following statements is incorrect with respect to the rate of effective protection? a. for given values of ai and ti, g is larger the greater is t b. for a given value of t and ti, g is larger the greater is ai c. g exceeds, is equal to or is smaller than t, as ti is smaller than, is equal to or is larger than t *d. when aiti exceeds t, the rate of effective protection is positive

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7. With ai=50%, ti=0, and t=20%, g is: *a. 40% b. 20% c. 80% d. 0 8. The imposition of an import tariff by a small nation: *a. increases the relative price of the import commodity for domestic producers and consumers b. reduces the relative price of the import commodity for domestic producers and consumers c. increases the relative price of the import commodity for the nation as a whole d. any of the above is possible 9. The imposition of an import tariff by a small nation: a. increases the nation's welfare *b. reduces the nation's welfare c. leaves the nation's welfare unchanged d. any of the above is possible 10. According to the Stolper-Samuelson theorem, the imposition of a tariff by a nation: a. increases the real return of the nation's abundant factor *b. increases the real return of the nation's scarce factor c. reduces the real return of the nation's scarce factor d. any of the above is possible 11. The imposition of an import tariff by a nation results in: a. an increase in relative price of the nation's import commodity b. an increase in the nation's production of its importable commodity c. reduces the real return of the nation's abundant factor *d. all of the above 12. The imposition of an import tariff by a nation can be represented by a rotation of the: *a. nation's offer curve away from the axis measuring the commodity of its comparative advantage b. the nation's offer curve toward the axis measuring the commodity of its comparative advantage c. the other nation's offer curve toward the axis measuring the commodity of its comparative advantage d. the other nation's offer curve away from the axis measuring the commodity of its comparative advantage

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13. The imposition of an import tariff by a large nation: a. increases the nation's terms of trade b. reduces the volume of trade c. may increase or reduce the nation's welfare *d. all of the above

14. The imposition of an optimum tariff by a large nation: a. improves its terms of trade b. reduces the volume of trade c. increases the nation's welfare *d. all of the above

15. The optimum tariff for a small nation is: a. 100% b. 50% *c. 0 d. depends on elasticities

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International Economics – 11h Edition

Instructor’s Manual

*CHAPTER 9 (Core Chapter) NONTARIFF TRADE BARRIERS AND THE NEW PROTECTIONISM 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 States 9.3B Technical, Administrative, and Other Regulations 9.3C International Cartels 9.3D Dumping Case Study 9-3: Antidumping Measures in Force in 2007 9.3E Export Subsidies Case Study 9-4: Agricultural Subsidies in Developed Nations Case Study 9-5: The Pervasiveness of Nontariff Barriers 9.3F Analysis of Export Subsidies 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 9-6: 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 9.6E The 1984 and 1988 Trade Acts

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9.7 The Uruguay Round and Outstanding Trade Problems 9.7A The Uruguay Round Case Study 9-7: Gains from the Uruguay Round Case Study 9-8: The Multilateral Rounds of Trade Negotiations 9.7B Outstanding Trade Problems Case Study 9- 9: 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

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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

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Lecture Guide: 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 9-2 (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.

Answer to Problems: 1.

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 he nation as a whole. The second is very difficult to achieve.

2.

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.

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.

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

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5.

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

6.

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.

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.

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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International Economics – 11h Edition

Instructor’s Manual

9.

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.

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

11.

a) The monopolist should charge P1=$4 in the domestic market and P2=$3 in Figure 9-5 in Appendix A9.2.

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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.

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

13.

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. *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.

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

App. 1. See Figure 3 on page 90.

App. 2. 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.

App. 3. 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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Multiple-choice Questions: 1. An import quota: a. increases the domestic price of the imported commodity b. reduces domestic consumption c. increases domestic production *d. all of the above 2. An increase in the demand of the imported commodity subject to a given import quota: a. reduces the domestic quantity demanded of the commodity *b. increases the domestic production of the commodity c. reduces the domestic price of the commodity d. reduces the producers' surplus 3. Adjustment to any shift in the domestic demand or supply of an importable commodity occurs: a. in domestic price with an import quota b. in the quantity of imports with a tariff c. through the market mechanism with an import tariff but not with an import *d. all of the above

quota

4. An international cartel refers to: a. dumping *b. an organization of exporters c. an international commodity agreement d. voluntary export restraints 5. The temporary sale of a commodity at below cost or at a lower price abroad in order to drive foreign producers out of business is called: *a. predatory dumping b. sporadic dumping c. continuous dumping d. voluntary export restraints 6. The type of dumping which would justify antidumping measures by the country subject to the dumping is: *a. predatory dumping b. sporadic dumping c. continuous dumping

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d. all of the above 7. A fallacious argument for protection is: a. the infant industry argument b. protection for national defense *c. the scientific tariff d. to correct domestic distortions 8. Which of the following is true with respect to the infant-industry argument for protection: a. it refers to temporary protection to establish a domestic industry b. to be valid, the return to the grown-up industry must be sufficiently high also to repay for the higher prices paid by domestic consumers of the commodity during the infancy period c. is inferior to an equivalent production subsidy to the infant industry *d. all of the above 9. Which of the following is false with respect to strategic trade policy? a. it postulates that a nation can gain by an activist trade policy *b. it is practiced to some extent by most industrial nations c. it can easily be carried out d. all of the above 10. Industrial policy refers to: a. an activist policy by the government of an industrial country to stimulate the development of an industry b. the granting of a subsidy to a domestic industry to stimulate the development of an industry c. the granting of a subsidy to a domestic industry to counter a foreign subsidy *d. all of the above 11. Game theory refers to: *a. a method of choosing the optimal strategy in conflict situations b. the granting of a subsidy to correct a domestic distortion c. the theory of tariff protection d. none of the above 12. Trade protection in the United States is usually provided to: a. low-wage workers b. well-organized industries with large employment

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c. industries producing consumer products *d. all of the above 13. The most-favored-nation principle refers to: *a. extension to all trade partners of any reciprocal tariff reduction negotiated by the U.S. with any of its trade partners b. multilateral trade negotiation c. the General Agreement on Tariffs and Trade d. the International Trade Organization 14. On which of the following principles does GATT rest? a. nondiscrimination b. elimination of nontariff barriers c. consultation among nations in solving trade disputes *d. all of the above 15. Which of the following was not negotiated under the Uruguay Round? a. reduction of tariffs on industrial goods b. replacement of quotas with tariffs c. reduction of subsidies on industrial products and on agricultural exports *d. liberalization in trade in most services

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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 344 10.6E Economic Integration in Central, Eastern Europe & Former Soviet Republics

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)

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)

Baltic States Free Trade Area (BAFTA)

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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10-2

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

Answers to Problems: 1.

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 tariffinclusive price of $16 if Nation A imported commodity X from Nation B and $12 if Nation A imported commodity X from nation C.

2. 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 tradecreating 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.

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. 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.

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

6.

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.

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10-3

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

7.

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

8.

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.

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

10.

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.

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 seen by comparing Figure 10-2 in the text with Figure 1 on the next page.

12.

See Figure 2. The formation of the customs union has no effect.

13.

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

14.

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

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International Economics – 11th Edition

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Instructor’s Manual

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

Multiple-choice Questions:

1. Which of the following statements is correct? *a. In a customs union, member nations apply a uniform external tariff b. in a free-trade area, member nations harmonize their monetary and fiscal policies c. within a customs union there is unrestricted factor movement d. a customs union is a higher form of economic integration than a common market 2. A customs union that allows for the free movement of labor and capital among its member nations is called a: a. preferential trade arrangement b. free-trade area *c. common market d. all of the above 3. A trade-creating customs union is one where: a. lower-cost imports from outside the customs union are replaced by higher-cost imports from a union member *b. some domestic production in a member nation is replaced by lower-cost imports from another member nation c. trade among members increases but trade with nonmembers decreases d. trade among members decreases while trade with nonmembers increases 4. A trade-diverting customs union: a. increases trade among union members and with nonmember nations b. reduces trade among union members and with nonmember nations *c. increases trade among members but reduces trade with non-members d. reduces trade among union members but increases it with nonmembers 5. A trade-diverting customs union results in: a. trade diversion only b. trade creation only *c. both trade creation and trade diversion d. we cannot say

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10-6

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

6. The formation of a trade-creating customs union where all economic resources of member nations are fully employed before and after the formation of the customs union leads to an: *a. increase in the welfare of member and nonmember nations b. increase in the welfare of member nations only c. increase in the welfare of nonmember nations only d. increase or decrease in the welfare of member and nonmember nations 7. A trade-diverting customs union: a. increases the welfare of member and nonmember nations b. reduces the welfare of member and nonmember nations c. increases the welfare of member nations but reduces that of nonmembers *d. reduces the welfare of nonmembers and may increase or reduce that of members 8. A trade-diverting customs union is more likely to lead to trade creation: a. the lower are the pre-union trade barriers of the member countries *b. the lower are the customs union's barriers on trade with the rest of the world c. the smaller is the number of countries forming the customs union and the smaller their size d. the more complementary rather than competitive are the economies of the nations forming the customs union 9. The theory of customs union is a special case of the theory of: a. effective protection *b. the second best c. the product cycle d. comparative advantage 10. Which is not a dynamic benefit from the formation of a customs union? a. increased competition b. economies of scale c. stimulus to investment *d. trade creation 11. The formation of the EU resulted in: a. trade creation in industrial and agricultural products b. trade diversion in industrial and agricultural products *c. trade creation in industrial products and trade diversion in agricultural products d. trade diversion in industrial products and trade creation in agricultural products (ch10)

10-7

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

12. The benefit that the United States is likely to receive from NAFTA: *a. increasing competition in product and resource markets b. greater technical innovation c. improvements in its terms of trade d. all of the above 13. The benefit that Mexico is likely to receive from NAFTA: a. greater export-led growth b. encouraging the return of flight capital c. more rapid structural change *d. all of the above 14. Which is a stumbling block to successful economic integration among groups of developing nations? a. benefits are not evenly distributed among nations b. many developing nations are not willing to relinquish part of their newly-acquired sovereignty to a supranational community body, as required for successful economic integration c. the complementary nature of their economies and competition for the same world markets for their agricultural exports *d. all of the above 15. The formation of a free trade area among the countries of Eastern Europe is advocated in order to: a. restore trade trading *b. retain the traditional trade links that can be justified on market principles c. reduce the need for structural change d. none of the above

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10-8

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

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 Case Study 11-1: The East Asian Miracle of Growth and Trade 11.3 The Terms of Trade and Economic Development 11.3a The Various Terms of Trade 11.3b Alleged Reasons for Deterioration in the Commodity Terms of Trade 11.3c Historical Movement in the Commodity and Income Terms of Trade Case Study 11-2: Change in Commodity Prices Over Time 11.4 Export Instability and Economic Development 11.4a Causes and Effects of Export Instability 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 Experience with Import Substitution Case Study 11-3: The Growth of Rich Countries, Globalizers and Non-Globalizers 11.5c Trade Liberalization and Growth in Developing Countries Case Study 11-4: 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 11-5: The Foreign Debt Burden of Developing Countries 11.6c Trade Problems of Developing Countries Case Study 11-6: Globalization and World Poverty Appendix:

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

11-1

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

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.

Answer to Problems: 1.

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.

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.

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.

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.

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 on the previous page.

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International Economics – 11th Edition

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Instructor’s Manual

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International Economics – 11th Edition

6.

Instructor’s Manual

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.

The nation of problem 6 will be better off in 2010 as compared with 1980 because its income and single factoral terms of trade rose.

8.

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.

Figure 3 on the previous page 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.

Figure 4 on the next page 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.

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 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.

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.

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.

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11-4

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

14.

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.

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.

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International Economics – 11th Edition

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Instructor’s Manual

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

Multiple-choice Questions:

1. According to traditional trade theory, a developing nation should export the commodity: a. of its comparative advantage b. that it can produce relatively more efficiently c. intensive in the nation's relatively abundant factor *d. all of the above 2. Which of the following is false with respect to traditional trade theory? a. it can incorporate changes in factor endowments and technology b. it leads to the best allocation of resources at any point in time *c. it is a dynamic theory d. it is based on comparative advantage 3. According to Nurkse, international trade was an engine of growth for: *a. the regions of recent settlements during the 19th century b. regions of recent settlements during the 20th century c. developed nations during the 19th century d. developed nations during the 20th century 4. Trade cannot be an engine of growth for today's developing nations because: a. the income elasticity for many of their exports is less than 1 b. the development of synthetic substitutes c. technical advances reduced the raw-material content of many products *d. all of the above 5. If the price of a nation's exports and imports both rise, the nation's commodity terms of trade: a. improve b. deteriorate c. remain unchanged *d. any of the above

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11-7

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

6. The nation's commodity terms of trade times the productivity index in its export sector gives the nation's a. income terms of trade b. double factoral terms of trade *c. single factoral terms of trade d. barter terms of trade 7. When a nation's commodity terms of trade deteriorate and its single factoral terms of trade improve, the nation's welfare: a. falls *b. rises c. remains unchanged d. any of the above 9. Developing nations often experience wildly fluctuating export prices for their primary products because of: a. inelastic and stable demand and supply b. elastic and unstable demand and supply *c. inelastic and unstable demand and supply d. elastic and stable demand and supply 10. MacBean found that the export instability faced by developing nations was: *a. not very large and did not seriously interfere with development b. very large and seriously interfered with development c. very large but did not seriously interfere with development d. not very large but seriously interfered with development 11. Supporting the price of a commodity by buying it when its price is low is: *a. a buffer stock b. a purchase contract c. an export control d. a marketing board

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11-8

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

12. The policy of import substitution was most vigorously followed by: a. large developing nations during the 1970's *b. large developing nations during the 1960's c. small developing nations during the 1970's d. small developing nations during the 1960's 13. What is the advantage of a policy of import substitution? a. setting up an industry to replace imports minimizes risk of failure because the market for the product already exists in the nation as evidenced by the nation's imports of the commodity b. It is easier for developing nations to protect their domestic market against foreign competition than to force developed nations to lower their trade barriers against their manufactured exports c. foreign firms are induced to establish tariff factories to overcome the tariff wall of developing nations *d. all of the above.

14. Which are is not an advantage of export-oriented industrialization? a. It overcomes the smallness of the domestic market and allows developing nations to take advantage of economies of scale *b. domestic industries grow accustomed to protection and have an incentive to become more efficient c. production of manufactured goods for export requires and stimulates efficiency throughout the economy d. the expansion of manufactured exports is not limited by the size of the domestic market 15. Those nations that liberalized trade during the past decade *a. grew faster than those that did not b. grew more slowly than those that did not c. grew at about the same rate as those that did not d. any of the above 16. Which of the following is not part of the demand for a NIEO? a. the establishment of international commodity agreements *b. preferential access for the manufactured exports of developed nations c. removal of the agricultural trade barriers in developed nations d. increasing the yearly flow of foreign aid to developing nations

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11-9

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

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 Non-Petroleum 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: U.S. Immigration and Debate Over Immigration Policy Appendix: The Transfer Problem Key Terms Portfolio investments Direct investments Portfolio theory Risk diversification Horizontal integration

Ch12_Salvatore 11e.doc

Vertical integration Multinational corporations (MNCs) Transfer pricing Brain drain

12-1

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

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.

Answer to Problems: 1.

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.

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.

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

4.

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

5.

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

6.

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

7.

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.

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

9.

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

10.

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.

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International Economics – 11th Edition

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Instructor’s Manual

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

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.

11.

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.

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.

12.

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.

App. See Table 1.

Table 1 Year

1973 1974 1975 1976 1977 1978 1979 1980

(a)

(b)

(c)

Petroleum Price (US $/barrel) 2.7 9.76 10.72 11.51 12.4 12.7 16.97 28.67

OPEC Exports (bill. $) 39 119.3 109.8 133 146 141.9 208 294.2

OPEC Imports (bill. $) 20.1 32.1 51.3 62.2 83.8 94.9 101.6 133.2

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

Source: International Financial Statistics, 1981 Yearbook.

Petroleum prices refer to Saudi Arabian prices

Multiple-choice Questions:

1. Portfolio investments refer primarily to: a. direct investments *b. bonds c. liquid assets d. short-term assets

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

2. Direct investments usually involve the transfer of: a. capital b. technology c. management *d. all of the above 3. Which of the following is not true with regard to direct investments? a. U.S. direct investments abroad and foreign direct investments in the U.S. grew very rapidly from 1950 to 2007 b. the amount of U.S. direct investments abroad is similar to the amount of foreign direct investments in the U.S. *c. U.S. direct investments in Canada are higher than in Europe d. U.S. private holdings of foreign long-term securities grew very rapidly from 1950 to 2007 4. Two-way international capital flows can be explained by the desire to: a. earn higher yields abroad b. avoid tariffs *c. diversify risks d. all of the above 5. Portfolio theory tells us that by investing in securities with yields that are inversely related over time: a. a given yield can be obtained at a smaller risk b. a higher yield can be obtained for the same level of risk c. a two-way capital flow may be required to achieve a balanced portfolio *d. all of the above 6. The reason the residents of a nation do not borrow from other nations and themselves undertake real investments in their own nation is that: *a. multinationals want to retain control over their own technology b. banks do not want to lend to foreigners c. vertical integration is not possible for foreigners d. multinationals want to avoid horizontal integration 7. Which is not a reason for private foreign direct investments? a. horizontal and vertical integration b. to maximize profits and diversify risks *c. to stimulate development d. to avoid tariffs

Ch12_Salvatore 11e.doc

12-5

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

8. Which of the following is not a beneficial effect of direct investments on the investing country: *a. the transfer of technology b. higher profits c. risk diversification d. avoids the possible loss of export markets 9. Foreign direct investment benefits the host nation because it: a. increases the K/L ration b. increases the productivity of labor c. increases per capita income *d. all of the above 10. U.S. labor generally *a. opposes U.S. investments abroad b. favors U.S. investments abroad c. is indifferent to U.S. investments abroad d. we cannot say without additional information 11. Labor in developing countries generally a. opposes an inflow of foreign direct investments from abroad *b. favors an inflow of foreign direct investments from abroad c. is indifferent to foreign direct investments from abroad d. we cannot say without additional information 12. Owners of capital in developing countries generally *a. oppose an inflow of foreign direct investments from abroad b. favor an inflow of foreign direct investments from abroad c. are indifferent to foreign direct investments from abroad d. we cannot say without additional information 13. The basic reason for the existence of MNC is the: *a. competitive advantage of a global network of production and distribution. b. incentives provided by the investing nation c. incentives provided by the host nation d. imperfections of international capital markets

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

14. Transfer pricing refers to: a. risk diversification b. the pricing of the technology transferred *c. the artificial overpricing of components shipped to an affiliate in a higher tax nation d. portfolio theory 15. The brain drain refers to the transfer of: a. technology from developed to developing nations b. skilled labor and professionals from developed to developing nations c. unskilled labor from developing to developed nations *d. skilled labor and professionals from less advanced to more advanced nations

ADDITIONAL ESSAYS AND PROBLEMS FOR PART TWO 1.

From the following figure, in which Dc and Sc refer, respectively to the domestic demand and supply curves of cloth, and SF and SF+T refer, respectively, to the world supply curve of cloth under free trade and with a 50% import tariff imposed by the nation on the importation of cloth, determine:

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

(a)

the consumption, production effect, and the trade effect of the tariff.

(b)

the reduction in consumer surplus, the increase in producer surplus or rent, the tariff revenue, and the protection cost or deadweight loss to the economy as a result of the tariff.

Answ. (a) The consumption effect is equal to BR=-20c; the production effect is equal to GN=20C; therefore, the trade effect is equal to -(BR+GN)=-40c. (b)

2.

The reduction in consumer surplus is FJHB=$90; the increase in producer surplus is FJMG=$30; the revenue effect is NMHR=$40; the protection cost or deadweight loss to the economy is equal to the sum of the area of triangles GMN and BHR or $20.

(a) Explain why and under what conditions the infant-industry argument for an import tariff is valid. (b) How must this argument be qualified?

Answ. (a) The infant-industry argument for tariffs is generally valid, especially for less developed countries (LDCs). It holds that an LDC may have a potential comparative advantage in a particular commodity, say textiles, but that because its initial production costs are too high (due to lack of know-how and the initial small level of output), this industry cannot be established or grow in the LDC in the face of foreign competition. An import tariff is then justified to help the LDC establish the industry and protect it during its "infancy," until the industry has grown in size and efficiency and is able to meet foreign competition. At that time, the tariff is to be removed. (b) In order for the infant-industry argument to be valid, not only must the tariff eventually be removed and the "grown up" industry be able to compete with foreign firms without protection, but the extra return in the industry (after the removal of the protection) must be high enough to justify the costs involved during the period of protection. These costs arise because the commodity is produced domestically rather than imported for less. It may also be difficult a priori to determine which industry or potential industry qualifies for this treatment, and to eventually remove the tariff once it is imposed. Economists also agree that what a tariff can do here, a direct subsidy to the infant industry can do better. This is because a subsidy can be varied so as to provide the infant industry with the same degree of protection as an equivalent import tariff but without distorting relative prices and domestic consumption. However, a subsidy requires revenue, rather than generating it as the tariff does.

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Dominick Salvatore

International Economics – 11th Edition

3.

(a) (b)

Instructor’s Manual

How can strategic trade policy justify trade protection?

What difficulties arise in carrying out a strategic trade policy?

Answ. (a) According to strategic trade policy, a nation can create a comparative advantage through temporary trade protection in such fields as semiconductors, computers, telecommunications, and other industries that are deemed crucial to future growth in the nation. These high-technology industries are subject to high risks, require large scale production to achieve economies of scale and give rise to extensive external economies when successful. Strategic trade policy suggests that by encouraging such industries, the nation can enhance its future growth prospects. This is similar to the infant-industry argument in developing nations, except that it is advanced for industrial nations to acquire a comparative advantage in crucial high-technology industries. Most nations do some of this.

Indeed, some economists would go so far as to say that a great deal of the postwar industrial and technological success of Japan is due to its strategic industrial and trade policies. (b) There are three serious difficulties in carrying out strategic trade policy. First, it is extremely difficult to pick winners (i.e., choose the industries that will provide large external economies in the future) and devise appropriate policies to successfully nurture them. Second, since most leading nations undertake strategic trade policies at the same time, their efforts are largely neutralized so that the potential benefits to each may be small. Third, when a country does achieve substantial success with strategic trade policy, this comes at the expense of other countries (i.e., it is a beggar-thy-neighbor policy) and so other countries are likely to retaliate. Faced with all these practical difficulties, even supporters of strategic trade policy grudgingly acknowledge that free trade is still the best policy, after all.

4. (a)

Why do you think that the United States supported economic integration in Europe after World War II?

(b)

What direct or indirect evidence can you give to conclude that U.S. support for economic integration in Europe did in fact result in the hope-for outcome?

(c)

What are the major economic disputes between the United States and Europe about these days? What dangers do they create?

Answ. (a) The United States supported economic integration in Europe to foster and Strengthen democratic systems in Europe after World War II, resist communism, and to promote peaceful coexistence among European countries, especially Germany and France, which were once bitter enemies.

Ch12_Salvatore 11e.doc

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

(b)

Evidence that U.S. support for economic integration in Europe achieved its goals is provided by the fact that the members of the European Union have strong democratic governments and economies, communist regimes have collapsed in Eastern Europe and the Soviet Union, and Germany and France are so closely integrated economically that a future armed conflict between them is practically nil.

(c)

The major economic disputes between the United States and Europe (the European Union) today are about trade protection in agriculture and some services as well as subsidies that the European Union provides to some of its industries, such as Airbus Industrie. These disputes could degenerate into trade wars that would harm both the European Union and the United States.

(a)

Why did large developing nations generally follow a policy of import substitution as a strategy for growth during the 1950s, 1960s, and 1970s?

Why was this not generally possible for small developing nations?

(b)

Why was the policy of import substitution generally a failure?

(c)

Why did developing nations that switched from a policy of import substitution to a policy of export promotion generally grow faster during the past decade?

Answ. (a)

Large developing nations generally followed a policy of import substitution during the 1950s, 1960s, and 1960s because their large domestic market allowed them to reap many of the benefits economies of scale in production even without international trade. On the other hand, small developing nations generally did not have the choice of industrializing through import substitution because their small domestic market would have made production costs unacceptably high.

(b)

the policy of import substitution was generally a failure even in large developing nations because once protection was granted to a domestic industry in order to encourage it establishment and growth, it becomes practically impossible to remove the protection. This led to inefficiencies and higher costs in the developing country even for unprotected industries that use the output of protected industries as intermediate products or inputs in their production processes.

(c)

The developing countries that switched from a policy of import substitution to export promotion generally grew faster than those developing countries that did not make that switch because production for export and international competition stimulated efficiency throughout the economy and resulted in domestic prices more closely reflecting the true opportunity costs of commodities and inputs.

5.

Ch12_Salvatore 11e.doc

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Dominick Salvatore

International Economics – 11th Edition

6.

Instructor’s Manual

One of the most significant international economic developments of the postwar period is the proliferation of multinational corporations (MNCs). These are firms that own, control or manage production facilities in several countries. With regard to MNCs, explain (a) the reason for their existence; (b) some of the alleged problems that they create for the home country; (c) some of the alleged problems that they create for the host country.

Answ. (a) The basic reason for the existence of MNCs is the competitive advantage that they have over other forms of economic organization based on economies of scale in production, financing, research and development (R&D), and in gathering market information, resulting from a global network of production and distribution. Today, MNCs account for about 25% of world output, and the trade between then parent firms and their foreign affiliates accounts for about one-third of world trade in manufactured goods. (b) The most controversial of the alleged harmful effects of MNCs on the home country is the loss of domestic jobs resulting from foreign direct investments.

However, it must be pointed out that the home country may have lost some of these jobs anyway to foreign competitors. A related problem stems from the export of advanced technology. Countering this harmful effect, however, is the tendency of MNCs to concentrate their R&D in the home country. Finally, easy accessibility of MNCs to the international capital market reduces the effectiveness of domestic monetary policy. (c) Host countries have even more serious complaints against MNCs. First is the alleged domination by the MNC of the hosts' economy. The largest MNCs have yearly sales greater than the GNP of all but a handful of nations. It is further alleged that MNCs absorb local savings and local entrepreneurial talent, use excessive K-intensive production techniques that are inappropriate for developing nations and do not train local labor. Most of these complaints are to some extent true especially for host LDCs and have led these nations to regulate foreign direct investments in order to mitigate the harmful effects and increase the possible benefits.

Ch12_Salvatore 11e.doc

12-11

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

*CHAPTER 13 (Core Chapter) BALANCE OF PAYMENTS 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 the Balance of Payments 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

Key Terms Balance of payments Credit transactions Debit transactions Financial inflow Financial outflow Double-entry bookkeeping Unilateral transfers Statistical discrepancy Current account

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Capital account Financial account Official settlements balance Official reserve account Deficit in the balance of Payments Surplus in the balance of payments Autonomous transactions Accomodating transactions International investment position

13-1

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

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.

Answers to Problems: 1. a.

The U.S. debits its current account by $500 (for the merchandise imports) and credits its financial account by the same amount (for the increase in foreign assets in the U.S.).

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

The U.S. is left with a $500 debit in its current account and a net credit balance of $500 in its financial account.

2. 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. a.

The same as 2a.

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.

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

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

5.

The U.S. credits its current account by $100 and debits its financial account by the same amount.

6.

The U.S. credits its financial account by $400 (for the purchase of the U.S. treasury bills by the foreign resident) and debits its financial account (for the drawing down of the foreign resident's bank balances in the United States) for the by the same amount.

7.

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

8. a.

The U.S. credits its financial 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.

9. a.

Year

Bal. Pay. $

Year

Bal. Pay. $

Year

Bal. Pay. $

Year

1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976

-1 0 -3 2 2 -10 -30 -11 -6 -10 -6 -15

1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1988 1989

-37 -35 14 -8 -1 1 -5 0 5 -36 -54 -36

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

16 -32 -23 -44 -71 -45 -$100 -134 27 -53 -43 -23

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Bal. Pay. $ -112 -280 -401 -273 -490 -481 -550 -428 -348

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.

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

11.

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

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

12.

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

13.

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

14.

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

App. 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. Compare Table 13.1 with Table 13.6

Multiple-choice Questions: 1. Which of the following is false? a. A credit transaction leads to a payment from foreigners b. A debit transaction leads to a payment to foreigners *c. A credit transaction is entered with a negative sign d. Double-entry bookkeeping refers to each transaction entered twice.

2. Which of the following is a debit? a. The export of goods b. The export of services *c. Unilateral transfers given to foreigners d. Capital inflows 3. Financial inflows: a. refer to an increase in foreign assets in the nation b. refer to a reduction in the nation's assets abroad c. lead to a payment from foreigners *d. all of the above 4. When a U.S. firm imports goods to be paid in three months the U.S. credits: a. the current account b. unilateral transfers *c. the financial account d. official reserves

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13-4

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

5. The receipt of an interest payment on a loan made by a U.S. commercial bank to a foreign resident is entered in the U.S. balance of payments as a: a. credit in the financial account *b. credit in the current account c. credit in official reserves d. debit in unilateral transfers 6. The payment of a dividend by an American company to a foreign stockholder represents: a. a debit in the U.S. financial account b. a credit in the U.S. financial account c. a credit in the U.S. official reserve account *d. a debit in the U.S. current account 7. When a U.S. firm imports a good from England a pays for it by drawing on its pound sterling balances in a London Bank, the U.S. debits its current account and credits its: a. official reserve account b. unilateral transfers account c. services in its current account *d. financial account 8. When the U.S. ships food aid to a developing nation, the U.S. debits: *a. unilateral transfers b. services c. the financial account d. official reserves 9. When the resident of a foreign nation (1) sells a U.S. stock and (2) deposits the proceeds in a U.S. bank, the U.S.: a. credits the financial account for (1) and debits the financial account for (2) b. credits the current account and debits the financial account c. debits the financial account and credits official reserves *d. debits the financial account for (1) and credits the financial account for (2) 10. When a U.S. resident (1) purchases foreign treasury bills and pays by (2) drawing down his bank balances abroad, the U.S.: a. debits short-term financial account and credits official reserves *b. debits the financial account for (1) and credits the financial account for (2) c. debits official reserves and credits the financial account d. credits short-term financial account and debits official reserves

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

11. From the U.S. point of view, drawing on (reducing) foreign bank balances in a New York bank represents a: a. financial inflow *b. financial outflow c. outflow of official reserves d. debit in the current account 12. Which is not an official reserve asset of the U.S.? a. U.S. holdings of Special Drawing Rights b. The U.S. reserve position in the International Monetary Fund *c. Foreign official holdings of U.S. dollars d. Official holdings of foreign currencies by U.S. monetary authorities 13. The financial account of the U.S. includes: a. the change in U.S. assets abroad and foreign assets in the U.S. *b. the change in U.S. assets abroad and foreign assets in the U.S., other than official reserve assets c. all financial assets d. all but current account transactions 14. Accommodating transactions are: a. transactions in official reserve assets b. transactions to balance autonomous transactions c. needed to balance international transactions *d. all of the above 15. Which of the following is false? *a. a net debit balance in the current and financial accounts measures the surplus in the nation's balance of payments b. a balance of payments deficit must be settled by a net credit in the official reserve account c. a deficit in the balance of payments can be measured by the excess of credits over debits in the official reserve account d. a net debit balance in the official reserve account refers to a surplus

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13-6

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

*CHAPTER 14 (Core Chapter) FOREIGN EXCHANGE MARKETS AND EXCHANGE RATES 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 Foreign Exchange Swaps 14.4c Foreign Exchange Futures and Options Case Study 14-4: 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 Case Study 14-5: Carry Trade 14.6b Covered Interest Arbitrage 14.6c Covered Interest Arbitrage Parity 14.6d Covered Interest Arbitrage Margin 14.6e Efficiency of Foreign Exchange Markets 14.7 Eurocurrency Markets 14.7a Description and Size of Eurocurrency Markets Case Study 14-6: Size and Growth of the Eurocurrency Market 14.7b Reasons for the Development and Growth of the Eurocurrency Market 14.7c Operation and Effects of Eurocurrency Markets 14.7d Eurobond and Euronote Markets Appendix

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A14.1 Derivation of Formula for Covered Interest Arbitrage Margin

14-1

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

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 Foreign exchange futures Foreign exchange options Foreign exchange risk

Hedging Speculation Stabilizing speculation Destabilizing speculation Interest arbitrage Uncovered Interest arbitrage Foreign exchange swaps Carry Trade 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.

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.

Answers to Problems: 1. 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 on the next page) 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).

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14-2

Dominick Salvatore

International Economics – 11th Edition

b.

Instructor’s Manual

2. a.

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.

See Figure 2 on the next page.

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.

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

5. 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. 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.

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Dominick Salvatore

International Economics – 11th Edition

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Instructor’s Manual

14-4

Dominick Salvatore

International Economics – 11th Edition

7.

Instructor’s Manual

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.

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.

9.

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.

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.

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

12. 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.

13. 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.

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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.

14-5

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

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

14. a. 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!

App.1a. 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.

Multiple-choice Questions: 1. Which is not a function of the foreign exchange market? a. to transfer funds from one nation to another b. to finance trade *c. to diversify risks d. to provide the facilities for hedging 2. An increase in the pound price of the dollar represents: *a. an appreciation of the dollar b. a depreciation of the dollar c. an appreciation of the pound d. a devaluation of the dollar 3. A change from $1=€1 to $2=€1 represents *a. depreciation of the dollar b. an appreciation of the dollar c. a depreciation of the pound

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

d. none of the above 4. A shortage of pounds under a flexible exchange rate system results in: a. a depreciation of the pound *b. a depreciation of the dollar c. an appreciation of the dollar d. no change in the exchange rate 5. An effective exchange rate is a: a. spot rate b. forward rate c. flexible exchange rates *d. weighted average of the exchange rates between the domestic currency and the nation's most important trade partners 6. The exchange rate is kept within narrow limits in different monetary centers by: a. hedging *b. exchange arbitrage c. interest arbitrage d. speculation 7. If SR=$1/€1 and the three-month FR=$0.99/€1: *a. the euro is at a three-month forward discount of 1% b. the euro is at a forward discount of 1% per year c. the euro is at a three-month forward premium of 1% d. the dollar is at a three-month forward discount of 1% 8. Hedging refers to: a. the acceptance of a foreign exchange risk *b. the covering of a foreign exchange risk c. foreign exchange speculation d. foreign exchange arbitrage 9. A U.S. importer scheduled to make a payment of €100,000 in three months can hedge his foreign exchange risk by: a. purchasing $100,000 in the forward market for delivery in three months b. selling €100,000 in the spot market for delivery in three months *c. purchasing €100,000 in the forward market for delivery in three months d. selling €100,000 in the spot market for delivery in three months

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14-7

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

10. If the three-month FR=$1/€1 and a speculator anticipates that SR=$1.02/€1 in three months, he can earn a profit by: a. selling euros forward *b. purchasing euros forward c. selling dollars forward d. purchasing dollars forward 11. Destabilizing speculation refers to the: *a. sale of the foreign currency when the exchange rate falls or is low b. purchase of the foreign currency when the exchange rate falls or is low c. sale of the foreign currency when the exchange rate rises or is high d. all of the above 12. A capital outflow from New York to Frankfurt under covered interest arbitrage can take place if the interest differential in favor of Frankfurt is: a. smaller than the forward discount on the euro b. equal to the forward discount on the euro *c. larger than the forward discount on the euro d. none of the above.

13. According to the theory of covered interest arbitrage, if the interest differential in favor of the foreign country exceeds the forward discount on the foreign currency, there will be a: a. capital inflow under covered interest arbitrage *b. capital outflow under covered interest arbitrage c. no capital flow under a covered interest arbitrage d. any of the above 14. When the interest differential in favor of the foreign country is equal to the forward premium on the foreign currency, we: a. are at covered interest arbitrage parity *b. are not at covered interest arbitrage parity c. may or may not be at covered interest arbitrage parity d. we cannot say without additional information 15. The currency of the nation with the lower interest rate is usually at a *a. forward premium b. forward discount c. covered interest arbitrage parity d. any of the above

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14-8

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

*CHAPTER 15 EXCHANGE RATE DETERMINATION 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: The Big and the Law of One Price 15.2B Relative Purchasing-Power Parity Theory 15.2C Empirical Tests of Purchasing-Power Parity Case Study 15-3: Relative Purchasing-Power Parity in the Real World

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 15.3D Expectations, Interest Differentials, and Exchange Rates Case Study 15-4: Monetary Growth and Inflation Case Study 15-5: Nominal and Real Exchange Rates, and the Monetary Approach 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 15.4B Extended Portfolio Balance Model 15.4C 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 Exchange Rate Defies Forecasting Appendix:

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A15.1 Formal Monetary Approach Model A15.2 Formal Portfolio Balance Model and Exchange Rates

15-1

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

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.

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Dominick Salvatore

International Economics – 11th Edition

7.

Instructor’s Manual

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

Answer to Problems 1. a.

The rate of inflation in Switzerland from 1973 to 1998 was: 101.3 - 46.6 (101.3+46.6)/2

=

54.7 74

=

0.739 or 73.9%

On the other hand, the rate of inflation in the United States from 1973 to 1998 was: 107.0 – 29.2 (107.0+29.2)/2

=

77.8 68.1

=

1.142 or 114.2%

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 (1.4898+3.1648)/2

b.

=

-1.675 2.3273

=

-0.720 or -72.0%

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.

2.

The rate of inflation in Spain from 1973 and 1998 was: 107.5 – 10.1 (107.5+10.1)/2

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=

97.4 58.8

=

1.656 or 165.6%

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

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 (149.40+58.26)/2

=

91.14 103.83

=

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. 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. 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. a. b.

Md=Ms and the nation is in balance of payments equilibrium.

Md of $44 billion exceeds Ms of $40 by $4 billion.

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.

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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.

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

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.

c.

If monetary authorities completely sterilize, or neutralize, the balance-ofpayments 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.

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.

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.(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.

10. (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.

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

(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.

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.

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.

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 homecountry 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 equilbrium is reestablished in all markets simultaneously.

14.

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.

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

App. 1.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 (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.

App. 2 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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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

Multiple-choice Questions: 1. Which is correct with respect to the absolute PPP theory? a. It postulates that the exchange rate between two currencies is equal to the ratio of the price levels in the two nations b. it does not take into consideration transportation costs or other obstructions to the flow of international trade c. can be very misleading *d. all of the above 2. The relative purchasing power-parity theory postulates that: a. The equilibrium exchange rate is equal to the ratio of the price level in the two nations *b. the change in the exchange rate over a period of time should be proportional to the relative change in the price level in the two nations over the same time period c. the change in the exchange rate over a period of time should be proportional to the absolute change in the price level in the two nations over the same time period d. the exchange rate at a period of time should be proportional to the relative prices in the two nations 3. The relative PPP theory gives better results: *a. in the long run than in the short run b. when structural changes take place c. the greater is the level of commodity aggregation d. in tests including developed and developing countries 4. The monetary approach to the balance of payments: a. views the balance of payments as an essentially monetary phenomenon b. rests on the purchasing power-parity theory c. postulates that money plays the crucial role in the long run both as a disturbance and adjustment in the nation's balance of payments *d. all of the above 5. If a nation's money GDP is 100 and the velocity of circulation of money is 4, the quantity demanded of money in the nation is: a. 20 *b. 25 c. 50 d. 100

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

6. The monetary base of the nation refers to the: a. domestic credit created by the nation's monetary authorities or the domestic assets backing of the nation's money supply b. international reserves of the nation *c. domestic credit created by the nation's monetary authorities or the domestic assets backing of the nation's money supply plus the international reserves of the nation d. legal reserve requirements in the nation 7. If the legal reserve requirement of the nation is 25%, the money multiplier in the nation is: a. 2 *b. 4 c. 5 d. 6 8. According to the monetary approach to the balance of payments, a deficit in the nation's balance of payments results from: *a. an excess in the nation's stock of money supply that is not eliminated or corrected by the nation's monetary authorities b. an excess in the stock of money demanded in the nation that is not satisfied by domestic monetary authorities c. an excess in the stock of money demanded in the other nation that is not satisfied by the other nation's monetary authorities d. an excess of imports over exports in the nation 9. If the increase in a nation's money supply grows less rapidly than its GNP, the nation will face a: a. once-and-for-all balance of payments deficit b. once-and-for-all balance of payments surplus c. continuous balance of payments deficit *d. continuous balance of payments surplus 10. According to the monetary approach to the balance of payments a non-reserve currency nation: *a. has no control over its money supply in the long-run under fixed exchange rates b. has no control over its money supply in the short-run under fixed exchange rates c. has no control over its money supply in the long-run under flexible exchange rates d. retains complete control over its money supply in the long-run

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15-9

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

11. According to the monetary approach to the balance of payments, a surplus nation will have to give up in the long-run its goal of: a. price stability b. fixed exchange rate *c. price stability or fixed exchange rate d. price stability and fixed exchange rate 12. Which of the following statements is true with respect to the monetary approach to the balance of payments: a. the interest differential in favor of the dollar equals the expected rate of appreciation of the euro b. the interest differential in favor of the dollar equals the expected rate of depreciation of the dollar c. the interest differential in favor of the pound equals the expected rate of depreciation of the pound *d. all of the above 13. The monetary approach assumes that the following assumption holds: *a. domestic and foreign bonds are perfect substitutes b. covered interest arbitrage holds c. expectations do not affect the future spot exchange rate. d. the risk premium is positive 14. The portfolio balance approach: a. can be regarded as an extension of the monetary approach b. deals with money and other domestic and foreign financial assets c. can more readily be extended than the monetary approach to deals with the real sector *d. all of the above 15. According to the portfolio balance approach, an increase in the expected appreciation of the foreign currency leads domestic residents to increase: a. the demand for domestic money b. the demand for the domestic bond *c. the demand for the foreign bond d. the risk premium

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

16. According to the portfolio balance approach, a reduction in the risk premium on the foreign bond leads domestic residents to increase the demand for the: a. domestic money b. domestic bond *c. foreign bond d. all of the above 17. According to the portfolio balance approach, an increase in domestic real income or GDP leads domestic residents to increase the demand for the: *a domestic money b. domestic bond c. foreign bond d. all of the above 18. According to the portfolio balance approach, an increase in domestic wealth leads domestic residents to increase the demand for the: a. domestic money b. domestic bond c. foreign bond *d. all of the above 19. Which of the following is false with regard to exchange rate dynamics: a. seeks to explain exchange rate fluctuations over time *b. results because the real sector adjusts instantaneously to disturbances c. in the short run, the exchange rate overshoots its long-run equilibrium d. results from the stock adjustment in financial assets 20. An unexpected increase in the U.S. money supply leads to: a. an immediate reduction in the U.S. interest rate b. an immediate larger dollar depreciation c. a gradual appreciation of the dollar over time *d. all of the above

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15-11

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

ADDITIONAL ESSAYS AND PROBLEMS FOR PART THREE 1. (a) If, for every debit or credit in the balance of payments, an offsetting credit or debit, respectively, of an equal amount is entered, how can a nation have a deficit or a surplus in the balance of payments? (b) How is a deficit of a surplus in the balance of payments measured? (c) Why are the concepts and measurement of deficit or surplus not appropriate under a flexible exchange rate system? (d) What is the difference between a disequilibrium and a deficit in the balance of payments?

Answ. (a) We have seen that because of double-entry bookkeeping, total credits always equal total debits when the three accounts are summed (including the allocation of SDRs and the statistical discrepancy). However, the deficit or surplus is measured by summing all items in the balance of payments except those in the nation's official reserve account. Only if the net balance on the nation's official reserve account were account were zero would the nations' balance of payments be in equilibrium. (b)If total debits exceed total credits in the current and capital accounts (including the statistical discrepancy), the net debit balance measures the deficit in the nation’s balance of payments. The deficit must be settled (under a fixed exchange rate system) with an equal net credit balance in the official reserve account. On the other hand, if total credits exceed total debits in the current and capital accounts (and the statistical discrepancy), the net credit balance measures the surplus in the nation's balance of payments. This surplus must be settled (under a fixed exchange rate system) with an equal net debit balance in the official reserve account.

All transactions in the current and capital accounts are called autonomous items because they take place for business or profit motive (except unilateral transfers) and are independent of balance of payments considerations. On the other hand, the items in the official reserve account are called accommodating items because they result from and are needed to balance international transactions. Thus, a deficit in a nation's balance of payments is given either by the net debit balance in the nation's autonomous items or by an equal net credit balance in the nation's accommodating items. The opposite is true for a surplus. (c) The concept and measurement of deficit or surplus in the balance of payments are not very appropriate under a freely flexible exchange rate system because of the tendency for a deficit to occur would be prevented by a depreciation of the nation's currency. Under a managed floating exchange rate system, part of the deficit would be corrected by a depreciation of the nations' currency and part would be financed by a net credit balance in the nation's official reserve account.

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

(d) A disequilibrium refers to an actual or potential deficit. A nation has a potential deficit whenever it imposes import or other restrictions specifically designed to suppress an actual or open deficit. Then the nation is also in disequilibrium.

2.

(a) If the positive interest rate differential in favor of a foreign monetary center is 3 percent per year and the foreign currency is at a forward discount of 1 percent per year, roughly how much would an interest arbitrageur earn from the purchase of foreign three-month treasury bills if he covers the foreign exchange risk? (b) How much would an interest arbitrageur earn if the foreign currency were instead at a forward premium of 1 percent per year? (c) What would happen if the foreign currency were at a forward discount of 3 percent per year?

Answ. (a) The interest arbitrageur will earn 2% per year from the purchase of foreign three- month treasury bills if he covers the foreign exchange risk. (b) If the foreign currency was instead at a forward premium of 1 percent per year, the interest arbitrageur would earn 4% per year. (c) If the foreign currency was at a forward discount of 3 percent per year, it would pay for investors to transfer funds from the higher- to the lower-interest center and lose 2% interest but gain 3% from the foreign exchange transaction, for a net gain of 2% per year.

3.

Explain why according to monetarists (a) nations retain control over their money supply under a flexible exchange rate system but not under a fixed exchange rate system, (b) nations could not sterilize continuous money outflows or inflows under a fixed exchange rate system in order to retain control over their money supply.

Answ. (a) According to monetarists, balance of payments disequilibria are corrected by exchange rate changes without any international flow of money or reserves under a flexible exchange rate system. Thus, the nation retains control over its money supply in the long run. For example, if a nation in balance of payments equilibrium increases its money supply (easy monetary policy), its currency would depreciate and absorb the excess supply of money, without any outflow of money or reserves from the nation. Thus, the increase in the nation's money supply would be retained in the nation. On the other hand, if the nation reduced its money supply (tight monetary policy), the excess demand for money would be eliminated by an appreciation of the nation's currency, without any inflow of money or reserves from the nation. As a result, the nation's attempt to reduce its money supply would succeed.

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

Under a fixed exchange rate system, the attempt of a nation to increase its money supply and conduct easy monetary policy would simply lead to an outflow of the excess supply of money in the long run, while a nation's attempt to reduce its supply of money and conduct tight monetary policy would simply lead to an outflow of money or reserves. As a result, non-reserve currency nations have little or no control over their money supply in the long run under a fixed exchange rate system. (b) A deficit nation could not sterilize continuous international money flows in the long run under a fixed exchange rate system because the nation would run out of international reserves. On the other hand, a surplus nation would run out of domestic assets backing the nation's money supply. In the long run, a surplus nation would either have to give up its goal of domestic price stability or revalue its currency. This is, in fact, what happened in Germany during the 1960s, when the large inflow of reserves led to some domestic inflation and a revaluation of the mark in 1961 and 1969.

4.

Discuss (a) the exchange dynamics of the dollar resulting from an unanticipated reduction of the U.S. money supply and (b) indicate the final long-run equilibrium interest rate, price index, and exchange rate as compared with the original equilibrium position.

Answ. (a) The unanticipated reduction in the U.S. money supply leads to an immediate increase in the U.S. interest rate and a magnified (i.e., a larger percentage) appreciation of the dollar. Over time, prices and interest rates in the United States all and the dollar depreciates so as to remove the excessive appreciation that took place at the time the U.S. money supply was reduced. (b) At the new long-run equilibrium level, the U.S. interest rate is the same as it was before the reduction of the U.S. money supply. The U.S. price index will be lower by the same percentage by which the U.S. money supply was reduced. The exchange rate will also be lower (i.e., the dollar will have appreciated) by the same percentage by which the U.S. money supply was reduced.

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

*CHAPTER 16 (Core Chapter) THE PRICE ADJUSTMENT MECHANISM WITH FLEXIBLE AND FIXED EXCHANGE RATES 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 During the Asian Crisis 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 16.5C Currency Pass-Through Case Study 16-2: Estimated Price Elasticities in International Trade Case Study 16-3: Other Estimated Price Elasticities in International Trade Case Study 16-4: Effective Exchange Rate of the Dollar and the U.S. Current Account Balance Case Study 16-5: Dollar Depreciation and the U.S. Current Account Balance Case Study 16-6: Exchange Rates and Current Account Balances During the European Financial Crisis of the Early 1990s Case Study 16-7: 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 A16.3 Derivation of the Gold Points and Gold Flows Under the Gold Standard

16-1

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

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.

Answer to Problems: 1.

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.

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.

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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Dominick Salvatore

International Economics – 11th Edition

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Instructor’s Manual

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

4.

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

5.

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).

6.

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.

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.

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.

See the two panels of Figure 7 on page 156.

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.

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Dominick Salvatore

International Economics – 11th Edition

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Instructor’s Manual

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International Economics – 11th Edition

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Instructor’s Manual

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

10.

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 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.

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 seem 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.

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.

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.

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.

App. 1 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.

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

App. 2 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.

App. 3 If D£ shifts to D'£ and S£ shifts to S'£ in Figure 16-8, the exchange rate R would be R=$4.86/£1 and the balance of payments would be in equilibrium both under the gold standard and under a flexible exchange rate system.

Multiple-choice Questions: 1. The more elastic is a nation's demand and supply of foreign exchange the: a. larger is the devaluation or depreciation required to correct a deficit of a given size in the nation's balance of payments *b. smaller is the devaluation or depreciation required to correct a deficit of a given size in the nation's balance of payments c. less feasible is a flexible exchange rate system d. less feasible is a devaluation as a policy to correct a deficit in the nation's balance of payments 2. A nation's demand curve for foreign exchange is derived from the: a. foreign demand curve for the nations' exports b. nation's supply curve of exports *c. domestic demand curve for imports and the foreign supply curve for the nation's imports d. foreign demand curve and the domestic supply curve for the nation's exports 3. A depreciation of a nation's currency shifts: a. down its supply curve of imports in terms of the foreign currency b. up its demand curve of imports in terms of the foreign currency *c. down its demand curve of imports in terms of the foreign currency d. down its demand curve of imports in terms of the domestic currency 4. When a nation's demand curve for imports in terms of the foreign currency is vertical: *a. the nation's demand curve for the foreign currency has zero elasticity b. the nation's demand for the currency is elastic c. the nation's supply of the currency is vertical d. the other nation's demand for the nation's currency has zero elasticity

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International Economics – 11th Edition

Instructor’s Manual

5. A depreciation of a nation's currency shifts: a. down its supply curve of exports in terms of the domestic currency *b. down its supply curve of exports in terms of the foreign currency c. down its demand curve for exports in terms of the foreign currency d. up its supply curve of imports in terms of the foreign currency 6. When a nation's demand curve for exports in terms of the foreign currency is inelastic: *a. the nation's supply curve of the foreign currency is negatively inclined b. the nation's supply curve of the foreign currency is vertical c. the nation's demand curve for the foreign currency is negatively inclined d. the other nation's supply curve of the nation's currency is negatively inclined 7. For a small nation: a. the foreign supply of exports is horizontal b. the domestic demand for imports is horizontal *c. the foreign demand for its exports is horizontal d. the foreign supply of exports is vertical 8. A depreciation of the nation's currency causes its terms of trade to: a. deteriorate b. improve c. remain unchanged *d. any of the above 9. A depreciation of a nation's currency is: *a. inflationary for the nation b. deflationary for the nation c. deflationary for the trade partner d. any of the above 10. The foreign exchange market is stable when: a. The demand curve of foreign exchange is negatively inclined and the supply curve of foreign exchange is positively inclined b. the supply curve of foreign exchange is negatively inclined and less elastic than the demand curve c. the sum of the absolute values of the elasticity of the nation's demand of imports and the foreign demand for the nation's exports is greater than one *d. all of the above

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International Economics – 11th Edition

Instructor’s Manual

11. The United States has a trade problem with Japan because the U.S. trade deficit with Japan: a. is very large b. has persisted for a long time c. did not seem to decline when the dollar depreciated sharply with respect to the yen *d. all of the above 12. The mint parity refers to the: a. gold export point b. gold import point c. equilibrium exchange rate *d. ratio of the price of a unit of gold in terms of the currency of two nations 13. Under the gold standard: a. each nations defines the price of gold in terms of its currency and then stands ready to buy and sell any amount of gold at that price b. there is a fixed relationship between any two currencies called the mint parity c. the exchange rate is determined by demand and supply between the gold points and is prevented from moving outside the gold points by gold shipments *d. all of the above 14. Which of the following statements is not true with regard to the price-specie-flow mechanism: a. relies on the quantity theory of money b. requires that nations allow their money supply to rise when the nation has a surplus in its balance of payments and to fall when the nation has a deficit *c. requires that the price elasticity of demand for imports and exports be equal to zero d. it was introduced by David Hume to show the futility of the mercantilists' prescription that a nation should attempt to continuously accumulate gold 15. A currency board refers to the case where: a. the central bank sterilizes changes in the money supply resulting from balance of payments disequilibria *b. the money supply of the nation is backed by 100 percent international reserves c. the nation operates under flexible exchange rates d. the nation retains firm control over its money supply

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International Economics – 11th Edition

Instructor’s Manual

*CHAPTER 17 (Core Chapter) THE INCOME ADJUSTMENT MECHANISM AND SYNTHESIS OF AUTOMATIC ADJUSTMENTS 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 17.3B Determination of Equilibrium National Income in a Small Open Economy Case Study 17-2: Private Sector and the Current Account Balances in the G-7 Countries 17.3C Graphical Determination of the Equilibrium National Income 17.3D Foreign-Trade Multiplier Case Study 17-3: Growth in United States and the World, and U.S. Current Account Deficits Case Study 17-4: Growth and Current Account Balance in Developing Countries 17.4 Foreign Repercussions Case Study 17-5: Effect of the Asian Financial Crisis of the Late 1990s on OECD Countries 17.5 Absorption Approach 17.6 Monetary Adjustments and Synthesis of Automatic Adjustments 17.6A Monetary Adjustments 17.6B Synthesis of Automatic Adjustments 17.6C Disadvantages of Automatic Adjustments Case Study 17-6: Interdependence in the World Economy Appendix:

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

Key Terms Closed economy Equilibrium level of national income (YE) Desired or planned investment Marginal propensity to consume (MPC) Consumption function (ch17)

Import function Marginal propensity to import (MPM) Average propensity to import (MPM) Income elasticity of imports (ny) Export function 17-1

Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

Saving function Marginal propensity to save (MPS) Investment function Multiplier (k)

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 s 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.

Answer to Problems: 1.

See Figure 1 on the next page.

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.

2. 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 positively-sloped S function crosses the horizontal I function.

3.

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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International Economics – 11th Edition

4. a.

Instructor’s Manual

See Figure 4 on the next page.

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. 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.

b. See Figure 5.

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

6.

See Figure 6.

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

7. a.

I+X'=100+350+200=650 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 on page 155.

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

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c.

Instructor’s Manual

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.

8. 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 on page 157.

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 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).

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9. a.

K"=

1 MPS1+MPM1+MPM2(MPS1/MPS2)

Instructor’s Manual

=

1 0.20+0.20+0.10(0.20/0.15)

=

1 0.533

=

1.88

=

1.667 0.533

=

0.67 0.533

=

1.25

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/MPS)

=

(1+0.10)/0.15 0.533

3.13

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. k**=

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

=

0.10/0.15 0.533

=

YE=(I*)(k**)(200)(1.25)=250 M=(YE)(MPM1)=(250)(0.20)=50=S (ch17)

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International Economics – 11th Edition

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X=S+M =100 X-M=5 11. k**=

0.5 0.53

=

0.95

YE=(I*)(k**)=(200)(0.95)=190 M=(YE)(MPM1)=(190)(0.15)=28.5=S X=S+M=57 X-M=28.5 12.

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.

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

14.

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.

App. 1a.

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*

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

App. 2. 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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Multiple-choice Questions: 1. In order to isolate the income adjustment mechanism, we assume that: a. the nation operates under a fixed exchange rate system b. all prices, wages, and interest rates are constant c. the nation operates at less than full employment *d. all of the above 2. The marginal propensity to consume measures: a. the ratio of imports to income b. the ratio of income to imports *c. the change in imports over the change in income d. the change in income over the change in imports 3. The income elasticity of imports is given by: a. the percentage change in income over the percentage change in imports b. the change in imports over the change in income *c. the marginal propensity to import over the average propensity to import d. the average propensity to import over the marginal propensity to import 4. The equilibrium level of national income in an open economy is given by: a. I + X = S + M b. X - M = S - I c. I + (X-M) = S *d. all of the above 5. If MPS=0.2 and MPM=0.3, the foreign trade multiplier is: a. 5 b. 3.3 c. 3 *d. 2 6. When S exceeds I, an open economy has a trade balance: *a. surplus b. deficit c. equilibrium d. any of the above (ch17)

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7. The S-I function rises because: a. rising I are subtracted from constant S *b. constant I are subtracted from rising S c. rising I are subtracted from rising S d. constant I are added to falling S 8. An autonomous fall in M from a condition of equilibrium in national income and in the trade balance results in the nation's income: a. rising and its trade balance turning to deficit b. falling and its trade balance turning into surplus *c. rising and its trade balance turning into surplus d. rising and the trade balance remaining in equilibrium 9. An autonomous increase in S from a condition of equilibrium in national income and in the trade balance results in the nation's income: a. rising and its trade balance turning into surplus *b. falling and its trade balance turning into surplus c. falling and its trade balance turning into deficit d. rising and its trade balance turning into deficit 10. The foreign trade multiplier of nation 1 is largest: a. when there are no foreign repercussions b. with foreign repercussions for an autonomous increase in nation 1's X that replace domestic production in nation 2 *c. with foreign repercussions for an autonomous increase in I in nation 1 d. with foreign repercussions for an autonomous increase in I in nation 2 11. By itself, the automatic income adjustment mechanism is likely to bring about: *a. incomplete adjustment b. complete adjustment c. perverse adjustment d. any of the above

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12. A depreciation of a deficit nation's currency from a condition of full employment: *a. may improve the nation's trade balance b. will improve the nation's trade balance c. will leave the nation's trade balance unchanged d. will cause a deterioration in the nation's trade balance 13. The improvement in a nation's balance of trade and payments resulting from a depreciation of its currency is: a. reinforced by the induced fall in imports *b. partly neutralized by the induced rise in imports c. partly neutralized by the induced fall in imports d. any of the above.

14. In the real world, the automatic income, price, and interest adjustment mechanisms, if allowed to operate, are likely to: a. reinforce each other but still result in incomplete adjustment *b. reinforce each other and result in complete adjustment c. work at cross purposes from each other and result in incomplete adjustment d. work at cross purposes from each other and result in perverse adjustment 15. A benefit of automatic adjustment mechanisms is that they: a. avoid the possibility of policy mistakes b. avoid the time lags associated with adjustment policies c. begin to operate as soon as balance of payments disequilibria develop *d. all of the above

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International Economics – 11th Edition

Instructor’s Manual

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 Case Study 18-3: Effect of U.S. Fiscal Policy in the United States and Abroad 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 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 Case Study 18-6: Deeper U.S. Recession without Strong Fiscal and Financial Measures 18.7 Direct Controls 18.7A Trade Controls 18.7B Exchange Controls 18.7C Other Direct Controls and International Cooperation Case Study 18-7: Direct Controls on International Transactions Around the World Appendix:

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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

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International Economics – 11th Edition

Instructor’s Manual

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.

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.

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International Economics – 11th Edition

Instructor’s Manual

Answer to Problems: 1.

Point C1 C4 C7 C10

Change in D increase increase decrease decrease

Change in R devalue revalue revalue devalue

2.

Point C2 C5 C8 C11

Change in D increase none decrease none

Change in R none revalue none devalue

3.

Point C3 C6 C9 C12

Change in D increase decrease decrease increase

Change in R revalue revalue devalue devalue

4. 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.

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.

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.

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. 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.

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b.

9.

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Instructor’s Manual

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.

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.

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10.

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 on the next page). 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 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 in the text, the nation could use the fiscal policy that shifts the IS curve to IS' (see Figure 5 on the next page), 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.

12.

Point C3 C6 C9 C12

Fiscal Policy expansionary contractionary contractionary expansionary

Monetary Policy easy easy tight tight

13.

Point C1 C5 C7 C11

expansionary contractionary contractionary expansionary

tight easy easy tight

Point C4 C8 C10

Fiscal Policy none contractionary none

Monetary Policy easy none tight

14.

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International Economics – 11th Edition

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App. 1 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

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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.

App. 2a 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.

App. 2b 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.

App. 2c YE=1000, MT=600 leaving ML=400 at i=10%. LM" shifts back to LM.

App. 3 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, X-M=50) on the 45 degree line, and (SC=-50, i=6%) on the SC line.

App. 4a 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).

App. 4b 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.

App. 4c An appreciation or revaluation causes X to fall and M to rise (see equation 18A1), MT to fall (see equation 18A-2), and TB to deteriorate (see equation 18A-3).

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International Economics – 11th Edition

Instructor’s Manual

Multiple-choice Questions: 1. The most important economic objective of industrial nations is: a. external balance *b. internal balance c. a reasonable rate of growth d. an equitable distribution of income 2. In order to achieve internal and external balance simultaneously, a nation must usually use at least: a. one policy *b. two policies c. three policies d. cannot say 3. Points below internal balance line YY in the Swan diagram indicate: a. a balance of payments deficit b. a balance of payments surplus *c. unemployment d. inflation 4. To correct a balance of payments deficit and unemployment a nation requires a: a. devaluation and expansionary fiscal and monetary policies b. devaluation and contractionary fiscal and monetary policies *c. devaluation and either expansionary or contractionary fiscal and monetary policies d. revaluation and either expansionary or contractionary fiscal and monetary policies 5. To correct a balance of payments deficit and inflation a nation requires a: a. devaluation and expansionary fiscal and monetary policies b. devaluation and contractionary fiscal and monetary policies *c. devaluation or revaluation and contractionary fiscal and monetary policies d. revaluation and either expansionary or contractionary fiscal and monetary policies 6. To correct a balance of payments surplus and unemployment a nation requires a: a. devaluation and expansionary fiscal and monetary policies b. devaluation and contractionary fiscal and monetary policies *c. devaluation or revaluation and expansionary fiscal and monetary policies d. revaluation and either expansionary or contractionary fiscal and monetary policies

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International Economics – 11th Edition

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7. To correct a balance of payments surplus and inflation a nation requires a: a. devaluation and expansionary fiscal and monetary policies b. devaluation and contractionary fiscal and monetary policies *c. devaluation and either expansionary or contractionary fiscal and monetary policies d. revaluation and either expansionary or contractionary fiscal and monetary policies

8. The IS curve is negatively inclined because: a. the higher is the rate of interest the smaller is the quantity of money demanded for speculative purposes b. higher rates of interest lead to greater capital flows *c. at lower interest rates the levels of investment and national income are higher d. at lower interest rates the level of national income is lower

9. If the BP curve is above the point of intersection of the IS and LM curves, the nation will: *a. have a balance of payments deficit at that level of income b. have a balance of payments surplus at that level of income c. be in recession d. face inflation

10. To correct unemployment from a condition of external balance, a nation will usually have to use: a. expansionary fiscal policy only b. easy monetary policy only c. expansionary fiscal policy and easy monetary policy *d. expansionary fiscal policy and tight monetary policy

11. To achieve external balance and correct a recession, a nation will always have to use tight monetary policy if at the full employment level of national income the nation's BP curve is: *a. above the LM curve b. below the LM curve c. steeper than the LM curve d. above the IS curve

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International Economics – 11th Edition

Instructor’s Manual

12. In a world of perfectly elastic international capital flows and fixed exchange rates: a. fiscal policy is completely ineffective *b. monetary policy is completely ineffective c. both fiscal and monetary policies are completely ineffective d. both fiscal and monetary policies are effective

13. To correct unemployment and a balance of payments deficits with flexible exchange rates and imperfect capital mobility: a. both fiscal and monetary policies are required b. fiscal policy is required c. monetary policy is required *d. either monetary or fiscal policy is required 14. To correct a balance of payments surplus and inflation a nation requires: a. expansionary fiscal policy and easy monetary policy b. contractionary fiscal policy and tight monetary policy *c. contractionary fiscal policy and easy monetary policy d. expansionary fiscal policy and tight monetary fiscal policy 15. To correct a balance of payments deficit and inflation a nation requires: a. contractionary fiscal policy and easy monetary policy b. contractionary fiscal policy and tight monetary policy c. expansionary fiscal policy and tight monetary policy *d. any of the above depending on the level of inflation and the size of the initial deficit 16. Direct controls refer to: a. tariffs, quotas, and other quantitative restrictions on the flow of international b. restrictions on international capital flows c. multiple exchange rates *d. all of the above

trade

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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 Case Study 19.3: Inflation Targeting – A New Approach to Monetary Policy 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 19.4: Petroleum Shocks and Stagflation in the United States Case Study 19.5: Actual and Natural Unemployment Rate, and Inflation in the U.S. Case Study 19.6: 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) Short-run aggregate supply curve (SRAS) Expected prices Inflation targeting Stagflation

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International Economics –11th Edition

Instructor’s Manual

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.

Answer to Problems 1.

See Figure 1.

2.

See Figure 2.

3.

See Figure 3.

4.

See Figure 4.

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5.

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.

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 longrun 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.

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.

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.

See Figure 5.

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10.

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.

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.

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.

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International Economics –11th Edition

Instructor’s Manual

13.

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.

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.

Multiple-Choice Questions 1. In general, as the economy expends or contracts over the business cycle *a. prices change b. prices remain unchanged except in a recession c. prices remain unchanged until the economy reaches full employment d. all of the above 2. The aggregate demand curve (AD) for closed economy is derived from the a. IS curve b. LM curve c. FE curve *d. IS and LM curves 3. A reduction in the general price level with a constant money supply is shown by a a. leftward shift in the LM curve *b. movement down along a given aggregate demand curve c. rightward shift in the aggregate supply curve d. a rightward shift in the IS curve 4. An increase in the money supply with constant prices leads to a a. leftward shift in the LM curve b. movement along a given aggregate demand curve *c. rightward shift in the aggregate demand curve d. rightward shift in the IS curve

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International Economics –11th Edition

Instructor’s Manual

5. An increase in government expenditures leads to a. a rightward shift in the IS curve b. a rightward shift in the AD curve c. an increase in the level of national income *d. all of the above 6. A nation's output in the short-run can a. exceed its natural level b. fall short of its natural level c. equal to its natural level *d. any of the above 7. Which of the following statements is false? a. a nations' natural level of output can increase as a result of growth b. imperfection in product markets can lead to temporary deviations in a nation's output from its long-run natural level *c. sticky wages cannot lead to temporary deviations in a nation's output from its long-run natural level d. none of the above.

8. Output in the short run exceeds the natural level of output if expected prices *a. exceed actual prices b. are lower than actual prices c. are equal to actual prices d. any of the above 9. The aggregate demand curve (AD) for an open economy is derived from the a. IS curve b. LM curve c. BP curve *d. all of the above 10. The aggregate demand curve for an open economy under fixed exchange rates is a. less elastic than if the economy were closed *b. more elastic than in the economy were closed c. more elastic than in the economy operated with flexible exchange rates d. all of the above

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International Economics –11th Edition

Instructor’s Manual

11. An autonomous improvement in the nation's trade balance under fixed exchange rates will cause the nation's aggregate demand curve to *a. shift to the right b. shift to the left c. remain unchanged d. any of the above 12. An autonomous short-term capital outflow under flexible exchange rates causes the nation's aggregate demand curve to *a. shift to the right b. shift to the left c. remain unchanged d. any of the above 13. With high short-term international capital flows, fixed exchange rates, and flexible prices a. monetary policy is effective *b. fiscal policy is effective c. both fiscal and monetary policies are effective d. neither fiscal policy nor monetary policies are effective 14. Which of the following statements is false? a. expansionary fiscal or monetary policy can increase the nation's output temporarily above its natural level b. expansionary fiscal or monetary policy can used to correct a recession but only at the expense of higher prices in the nation *c. a recession cannot be eliminated automatically even if domestic prices are flexible downward d. when prices are not flexible downward inflation may be less costly that recession 15. Which of the following statements is false with regard to the effect of macroeconomic policies? a. they generally cause shifts in the aggregate demand curve b. they can possibly increase long-run growth c. they can help correct supply shocks that increases production costs but only at the expense of even higher inflation *d. they always cause shifts in the long-run aggregate supply curve

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International Economics – 11th Edition

Instructor’s Manual

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 Rgimes 20.3D The Open-Economy Trilemma 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 20.4E European Central Bank and Common Monetary Policy Case Study 20-4: Benefits and Costs of the Euro Case Study 20-5: The Euzone Crisis 20.5 Currency Board Arrangements and Dollarizatin 20.A Currency Board Arrangements 20.B Dollarization Case Study 20-6: Argentina Currency Board Arrangements and Crisis 20.6 Exchange Rate Bands, Adjustable Pegs, Crawling Pegs, and Managed Floating 20.6A Exchange Rate Bands 20.6B Adjustable Peg Systems 20.6C Crawling Pegs 20.6D Managed Floating Case Study 20-7: Exchange Rate Arrangements of IMF Members 20.7 International Macroeconomic Policy Coordination

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International Economics – 11th Edition

Instructor’s Manual

Appendix: Exchange Rate Arrangements 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 Trilemma

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.

Answers to Problems: 1. a. b.

The U.S. will export the commodity because at R=2, P=$7 in the U.S. and P=$8 in the U.K. The U.S. has a comparative disadvantage in this commodity at the equilibrium exchange rate.

2.

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.

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).

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4.

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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.

See Figure 3 on the previous page.

6.

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. (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.

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 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. (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.

See Figure 4.

11.

See the dashed curve in Figure 5.

12.

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.

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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.

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.

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 longrun growth.

15. (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.

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App. 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 likelyhood, 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, was installed to keep the currencies of these four countries from fluctuating to widely, in anticipation of their joining the euro.

Multiple-choice Questions: 1. An alleged advantage of flexible over fixed exchange rates is: *a. market efficiency b. stabilizing speculation c. price discipline d. all of the above 2. Flexible exchange rates: a. enhance the effectiveness of fiscal policy b. reduce the effectiveness of fiscal policy *c. enhance the effectiveness of monetary policy d. reduce the effectiveness of monetary policy 3. Under a flexible as compared to a fixed exchange rate system: *a. a nation can more easily achieve its desired inflation-unemployment tradeoff b. it is more difficult for a nation to achieve its desired inflation-unemployment tradeoff c. it is more difficult for a nation to achieve internal balance d. it is more difficult for a nation to achieve external balance 4. Everything else being the same, the volume of trade is likely to be: a. larger under a flexible than under a fixed exchange rate system *b. larger under a fixed than under a flexible exchange rate system c. equal under a flexible and fixed exchange rate system d. any of the above 5. Most economists believe that under "normal conditions" speculation: *a. is stabilizing b. is destabilizing c. is neither stabilizing nor destabilizing d. seldom occurs

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International Economics – 11th Edition

Instructor’s Manual

6. Price discipline is: *a. greater under a fixed than under a flexible exchange rate system b. greater under a flexible than under a fixed exchange rate system c. about the same under a fixed as under a flexible exchange rate system d. is unrelated to the type of exchange rate system 7. Which of the following statements is correct with respect to flexible exchange rates? a. they insulate the domestic economy from external shocks much more than fixed exchange rates b. they are particularly attractive to nations subject to large external shocks c. they provide less stability to an open economy subject to large internal shocks *d. all of the above 8. The formation of an optimum currency area is more likely to be beneficial: a. the smaller is the mobility of resource among the various nations of the optimum currency area b. the smaller are the structural similarities of member nations *c. the more willing are member nations to closely coordinate their fiscal, monetary, and other policies d. all of the above 9. The European Monetary System is or resembles a: *a. fixed exchange rate system b. a managed exchange rate system c. a crawling peg system d. a freely flexible exchange rate system 10. The European Monetary Union: a. has a common currency b. has a single central bank c. conducts a common monetary policy *d. all of the above 11. If the band of allowed fluctuation under a fixed exchange rate system is made very wide, the system will resemble: *a. a flexible exchange rate system b. the gold standard c. an adjustable peg d. a crawling peg

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12. A fixed exchange rate system without a band of allowed fluctuation would require the nation's monetary authorities to intervene in the foreign exchange market: a. never b. seldom *c. constantly d. we cannot say 13. The policy of changing par values by small preannounced amounts at frequent intervals until the equilibrium exchange rate is reached is called: *a. crawling peg b. adjustable peg c. managed float d. dirty float

14. The policy of intervention in the foreign exchange market to smooth out short-run fluctuations in exchange rates is called: a. crawling peg b. adjustable peg *c. leaning against the wind d. managed float

15. International macroeconomic policy coordination has become more useful and essential in recent decades because: a. the interdependence among countries has increased b. the volume of trade has grown more rapidly than GNP c. of the large increase in international capital flows *d. all of the above

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Instructor’s Manual

*CHAPTER 21 (Core Chapter) THE INTERNATIONAL MONETARY SYSTEM: PAST, PRESENT, AND FUTURE 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: 1950-2011

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Key Terms International monetary system Adjustment Liquidity Confidence International Monetary Fund (IMF) Bretton Woods System Intervention currency Fundamental disequilibrium Currency convertibility Smithsonian Agreement Dollar glut International Development Association (IDA) International Finance Corporation (IFC) Gold tranche Credit tranche Super gold tranche International Bank for Reconstruction and Development (IBRD or World Bank)

General Arrangements to Borrow (GAB) Net IMF position Standby arrangements Swap arrangements Special Drawing Rights (SDRs) Dollar shortage Roosa bonds Seignorage Dollar standard Substitution account Dollar overhang Jamaica Accords Benign neglect First credit tranche IMF conditionality Group of Twenty Subprime Mortgage Crisis Original sin

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.

Answers to Problems: 1. a.

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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.

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Dominick Salvatore

International Economics – 11th Edition

b.

2.

Instructor’s Manual

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.

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.

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.

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.

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.

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.

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).

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Dominick Salvatore

International Economics – 11th Edition

7. a.

Instructor’s Manual

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. 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.

9.

Under the Bretton Woods system, the dollar was truly an international currency. From about the mid-sixties until the collapse of the system in 1971, however, foreigners became progressively more reluctant to hold dollars as the amount of officially foreignheld 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. 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.

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. 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 (ch21)

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

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. b. The IMF proposed to avoid the recurrence of a Mexican-style currency crisis by setting up an early-warning 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. 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. 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 19945, South-East Asia in 1997-1999, 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.

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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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International Economics – 11th Edition

Instructor’s Manual

App. a. See Table 1 below. 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, declined to 0.24 in 1995, it rose to 0.76 in 2009, and it was 0.68 in 2011.

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)

International Reserves

1 2 Imports 3 Reserves/Imports

International Reserves

1 2 Imports 3 Reserves/Imports

1950

1955

1960

1965

1970

1975

1980

1985

48.0

53.6

60.7

71.3

95.8

299.0

776.6

679.6

60.1

92.1

123.9

183.3

313.5

875.2

2,014.7

1,964.6

0.80

0.58

0.49

0.39

0.31

0.34

0.3

0.35

1990

1995

2000

2005

2008

2009

2010

2011

908.3

1,227.4

2,367.2

4,879.1

8,298.7

9,545.1

10,907.2

12,260.0

3,530.7

5,187.4

6,572.2

10,655.8

16,304.0

12,516.1

15,169.8

17,964.8

0.26

0.24

0.36

0.47

0.51

0.76

0.72

0.68

Source: Table 21-6 in the text and IMF, International Financial Statistics Yearbook, 1985, 2002, 2011, and March 2012.

Multiple -Choice Questions: 1. Which of the following statements about the gold standard is true? a. London was the undisputed center of international trade and finance b. international trade and international capital flows were mostly unrestricted c. International liquid capital flows were mostly stabilizing *d. all of the above (ch21)

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

2. Balance of payments adjustment under the gold standard is now believed to have occurred primarily through: a. the price-specie-flow mechanism b. gold shipments *c. stabilizing short-term capital flows and changes in national incomes d. free trade 3. The interwar period was characterized by: a. the operation of the gold standard *b. chaotic conditions in international trade and finance c. free trade d. stabilizing international capital flows 4. The Bretton Woods System was a: a. gold standard b. managed floating exchange rate system *c. gold-exchange standard d. crawling peg system 5. On which of the following principles was the Bretton Woods System based on? a. Fixed exchange rates b. Currency convertibility c. Free trade *d. All of the above 6. The Bretton Woods System: *a. allowed nation to change their par values when facing fundamental disequilibrium b. allowed nations to change their par values when facing a temporary disequilibrium c. did not allow nations to change their par exchange rates under any circumstance d. allowed only deficit nations to change their par values, but not surplus nations 7. Which of the following did not represent an evolution of the Bretton Woods System? a. General Arrangements to Borrow *b. managed floating c. standby arrangements d. Special Drawing Rights

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

8. Which of the following was a primary cause of the U.S. balance of payments deficits during the late 1960s?: a. Capital outflows b. Domestic inflation c. Increased foreign competition *d. All of the above 9. During the 1960s the U.S. attempted to correct its balance of payments deficits by: *a. ad hoc measures b. devaluing the dollar c. deflating the economy d. restricting imports 10. The immediate cause for the collapse of the Bretton Woods System was: a. the expectation that the United States would soon be forced to devalue the dollar b. the massive flight of liquid capital from the United States c. the attempt by three small European central banks to convert part of their dollar holdings into gold at the Fed *d. all of the above 11. The fundamental cause for the collapse of the Bretton Woods System was: a. lack of confidence b. inadequate liquidity *c. lack of an adequate adjustment mechanism d. all of the above 12. The present international monetary system is a: a. gold standard b. flexible exchange rate system *c. managed exchange rate system d. a target zone system 13. Which of the following is false with regard to the present international monetary system? *a. Special Drawing Rights are the primary reserve asset b. Monetary authorities intervene in foreign exchange markets to smooth out excessive short-run fluctuations in exchange rates c. It was forced on the world by the collapse of the Bretton Woods System d. It was formally recognized in the Jamaica Accords

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

14. Which of the following statements is false with regard to 11 countries of the European monetary Union: a. They have adopted a single currency *b. They have established a single central bank c. Conduct a common fiscal policy d. Conduct a single monetary policy 15. Which is one of the most serious international economic problems facing the world today? a. Large volatility and disequilibria in exchange rates and frequent crises in emerging markets b. The rise of protectionism in developed countries and the high structural unemployment in Western Europe c. The restructuring problems of Eastern Europe and the former Soviet Union and the deep poverty of some of the poorest developing countries *d. All of the above

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

ADDITIONAL ESSAYS AND PROBLEMS FOR PART FOUR

1.

Explain the meaning of the J-curve effect and exactly how it works.

Answ. The J-curve effect refers to the deterioration in a nation's trade balance that may result immediately after a devaluation or depreciation of its currency. Only with the passage of time, the nation's trade balance is likely to improve. This is due to the tendency of the domestic-currency price of imports to rise faster than export prices soon after the devaluation or depreciation, with quantities initially not changing very much. With import prices rising faster than export prices and with export and import quantities not changing very much, this means that the nation's expenditures on imports initially increases more than its earning from exports. As a result, the nation's trade balance is likely to deteriorate soon after it devalues or allows its currency to depreciate.

Over time, the quantity of exports rises and the quantity of imports falls and export prices catch up with import prices, so that the initial deterioration in the nation's trade balance is halted and then reversed. Economists have called this tendency of a nation's trade balance to first deteriorate before improving as a result of a devaluation or depreciation in the nation's currency the J-curve effect. The reason is that when the nation's net trade balance is plotted on the vertical axis and time is plotted on the horizontal axis, the response of the trade balance to devaluation or depreciation looks like the curve J.

2.

Suppose that a nation is at full employment without inflation but has a deficit in its balance of payments. (a) Explain why a depreciation of the nation's currency will not correct the deficit unless real output rises or domestic expenditures (absorption) fall. (b) How can the nation's output rise as a result of the depreciation? (c) How can domestic absorption fall automatically as a result of the depreciation? (d) How can the government help reduce domestic absorption and make the devaluation effective?

Answ. (a) A depreciation of the nation's currency stimulated the nation's exports and its production of import substitutes. Unless real output can somehow be expanded and/or domestic absorption reduced, however, this will lead to excess aggregate demand. The resulting inflation will then wipe out the price advantage of the devaluation and the deficit will remain uncorrected. (b) Even if the nation is already at full employment, a depreciation of the nation's currency could lead to higher real national output through the better utilization and the more economic allocation of existing resources. Though possible, this is by no means certain or sufficient. Thus, for a depreciation to be effective, domestic absorption must fall.

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

(c) Domestic absorption can fall automatically as the nation's currency depreciates because of a real cash balance effect, money illusion, and redistributive effect. The real cash balance effect operates as follows: When a nation's currency depreciates, domestic prices rise; if the money supply remains constant, real cash balances fall and can be replenished only by reducing consumption or absorption. The money illusion cuts absorption if consumers spend less when prices rise, even though their income has also risen. Finally, absorption falls if the depreciation redistributes income to consumers with higher marginal propensities to save. These effects, however, may be inoperative or insufficient. (d) The government can help reduce domestic absorption (and allow the depreciation to be effective) by adopting expenditure-switching or demand policies

3.

Suppose a nation faces domestic unemployment and a surplus in its balance of payments. (a) Explain in detail the expenditure-changing policies required to cure the unemployment. (b) What would happen to the nation's external balance? Why? Answ. (a) Domestic unemployment can be corrected with expenditure- or demandincreasing policies. These refer to expansionary fiscal and monetary policies.

Expansionary fiscal policy refers to an increase in government expenditures and/or a reduction in taxes. A reduction in taxes leads to an increase in consumption which, as for an increase in government expenditures, results in a multiple expansion in national income. On the other hand, easy monetary policy refers to an increase in the money supply and reduction in interest rates. These stimulate investment and also result in a multiple expansion of national income. (b) If domestic unemployment was accompanied by a surplus in the nation's balance of payments, the expansion in national income (to eliminate unemployment) induces a rise in imports, and the reduction in interest rates (from the easy monetary policy) may lead to a larger short-term capital outflow (or reduced inflow), both of which reduce the surplus. Sometimes the original surplus could even turn into a deficit.

This is more likely to occur when the original surplus is small, unemployment is large (so that strongly expansionary fiscal and monetary policies are needed), the marginal propensity to import is high, domestic prices rise as the economy approaches full employment, and capital movements readily respond to the fall in the interest rate. Only rarely and by coincidence will the elimination of unemployment also lead to complete external balance.

4.

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Explain why according to monetarists (a) nations retain control over their money supply under a flexible exchange rate system but not under a fixed exchange rate system, (b) nations could not sterilize continuous money outflows or inflows under a fixed exchange rate system in order to retain control over their money supply.

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

(a) According to monetarists, balance of payments disequilibria are corrected by exchange rate changes without any international flow of money or reserves under a flexible exchange rate system. Thus, the nation retains control over its money supply in the long run. For example, if a nation in balance of payments equilibrium increases its money supply (easy monetary policy), its currency would depreciate and absorb the excess supply of money, without any outflow of money or reserves from the nation.

Thus, the increase in the nation's money supply would be retained in the nation. On the other hand, if the nation reduced its money supply (tight monetary policy), the excess demand for money would be eliminated by an appreciation of the nation's currency, without any inflow of money or reserves from the nation. As a result, the nation's attempt to reduce its money supply would succeed.

Under a fixed exchange rate system, the attempt of a nation to increase its money supply and conduct easy monetary policy would simply lead to an outflow of the excess supply of money in the long run, while a nation's attempt to reduce its supply of money and conduct tight monetary policy would simply lead to an outflow of money or reserves. As a result, non-reserve currency nations have little or no control over their money supply in the long run under a fixed exchange rate system. (b) A deficit nation could not sterilize continuous international money flows in the long run under a fixed exchange rate system because the nation would run out of international reserves. On the other hand, a surplus nation would run out of domestic assets backing the nation's money supply. In the long run, a surplus nation would either have to give up its goal of domestic price stability or revalue its currency.

This is, in fact, what happened in Germany during the 1960s, when the large inflow of reserves led to some domestic inflation and a revaluation of the mark in 1961 and 1969.

5.

Explain what are the benefits and costs for a European nation contemplating joining the European Monetary Union.

Answ. There are some major benefits that the nation can expect to get from joining the monetary union. The nation will no longer have to exchange its currency for that of the other union members and, of course, will no longer have to worry about exchange rate volatility or misalignments with respect to other members. The nation can expect greater and faster economic and financial integration with the other union members and to participate in deciding union wide monetary and other policies. The nation will also be able to undertake domestic policies that are important for its future growth and wellbeing, but which would be political impossible if the nation remained outside the union. The nation will also share in the seigniorage that results from issuing the currency, face lower borrowing costs, and share in the political importance of belonging to a large economic and monetary union.

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

The most serious problem resulting from joining the monetary union is that the nation will lose complete control over its money supply and exchange rates. As result, in case of a recession, the nation cannot adopt an expansionary monetary policy and/or allow its currency to depreciate (so as to stimulate exports and discourage imports and thus stimulate domestic production). It is true that in a world of open capital markets, the nation would have limited monetary and exchange rate policy independence, but by joining the monetary union it loses all monetary and exchange rate policy independence.

This is a serious shortcoming because labor mobility out of the nation in recession and fiscal redistribution in favor of the nation n are very limited in the European Union as compared, for example, with the United States.

6.

Explain why the establishment of a freely-flexible exchange rate system is unlikely today.

Answ. Under a freely flexible exchange rate system, exchange rates are determined exclusively by the forces of demand and supply without any foreign exchange market intervention on the part of monetary authorities. Under such a self-adjusting system, the need for international reserves would virtually disappear and monetary authorities could devote most of their energies to achieve internal balance. At least, this is how a freelyflexible exchange rate system was supposed to operate. In reality, huge international capital flows rob the nation of most of its monetary independence. Huge international capital flows are also likely to lead to excessive volatility of exchange rate. Exchange rates could also become grossly misaligned for long periods of time. This would seriously distort the pattern of world trade and specialization. As a result, it is rather unlikely that the present managed exchange rate system will evolve in a truly freely flexible exchange rate system. Indeed, it is more likely that more restrictions will be imposed in the future on exchange rate fluctuations.

7. Discuss the causes and effects of the recent global financial crisis in view of what you learned in this course.

The recent global financial crisis had four basic causes: (1) financial regulations were not adequate, especially in the investing banking sector, (2) the financial regulations that did exist were not applied, (3) greed (profits at all costs by bankers and other financial specialists), and (4) fraud (e.g. Madoff’s Ponzi scheme involving $65 billion). The crisis resulted in the “great recession”(the deepest of the post war period) in advanced economies and in many emerging market economies in 2009. Table 16-5 shows that in 2009 real GDP fell by 2.5 percent in the United States, 4.1 percent in the Euro Area, 4.9 percent in the U.K., and 5.2 percent in Japan among advanced economies in the G-20. It fell by 7.9 percent in Russia, 6.5 percent in Mexico, and 4.7 percent in Turkey in 2009 (China and India only suffered a slow-down from the very rapid growth of previous years) among emerging market economies in the G-20. Growth resumed in 2010 in most countries, but remained anemic in advanced economies, as opposed to most emerging market economies.

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Dominick Salvatore

International Economics – 11th Edition

Instructor’s Manual

Growth of Real GDP in Advanced Countries and Emerging Market Economies in the G20, 2009 and 2010 ADVANCED NATION OR AREA

GROWTH IN 2009

GROWTH IN 2010

United States

-2.6

2.6

Euro Area

-4.1

Germany

EMERGING MARKET ECONOMY

GROWTH IN 2009

GROWTH IN 2010

China

9.1

10.5

1.7

India

5.7

9.7

-4.7

3.3

Russia

-7.9

4.0

France

-2.5

1.6

Brazil

-0.2

7.5

Italy

-5.0

1.0

Indonesia

4.5

6.0

United Kingdom

-4.9

1.7

Mexico

-6.5

5.0

Japan

-5.2

2.8

Argentina

0.9

7.5

Korea

0.2

6.1

Turkey

-4.7

7.8

Canada

-2.5

3.1

S. Arabia

0.6

3.4

Australia

1.0

3.0

S. Africa

-1.8

3.0

Sources: IMF, World Economic Outlook, October 2010; D. Salvatore, “The Financial Crisis: Causes, Effects, Policies and Prospects,” Journal of Politics and Society, April 2010, pp. 7-16 and D. Salvatore, “The Financial Crisis: Predictions, Reforms, Prospects,” The Journal of Economic Asymmetries, Winter 2010, pp. 1-22.

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