Introduction to International Economics, 3rd Edition by Dominick Salvatore Solution Manual

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Solution Manual

Resource:

Introduction to International Economics

Edition:

3rd Edition

Author(s):

Dominick Salvatore

Salvatore’s Introduction to International Economics, 3rd Edition

Instructor’s Manual

*CHAPTER 1 (Core Chapter) INTRODUCTION OUTLINE 1.1 We Live in a Global Economy Case Study 1-1 The Dell and Other PCs Sold in the United States Are Anything But American!

Case Study 1-2 What Is an “American” Car? 1.2 The Globalization Challenge Case Study 1-3 Is India’s Globalization Harming the United States?

1.3 International Trade and the Nation’s Standard of Living Case Study 1-4 Rising Importance of International Trade to the United States 1.4 The International Flow of Labor and Capital Case Study 1-5 Major Net Exporters and Importers of Capital 1.5 The Subject Matter of International Economics 1.6 Current International Economic Problems 1.7 International Institutions and the World Economy 1.8 Organization of the Text Appendix: International Trade Data, Sources and Information A1.1 International Trade Data A1.2 Sources of Additional International Data and Information

KEY TERMS Globalization Anti-globalization movement Interdependence International trade policy Balance of payments Foreign exchange markets Adjustment in the Balance of Payments

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Microeconomics Macroeconomics Open-economy macroeconomics International finance World Trade Organization (WTO) International Monetary Fund (IMF) United Nations (UN)

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LECTURE GUIDE 1. As the first chapter of the book, the general aim here is simply to define the field of study of international economics and point out its importance in today's interdependent world.

2. The material in this chapter can be covered in three classes. I would utilize one class to cover Sections 1-2 and the second class for Sections 3-5. I would spend most of the third class on Section 6 to identify the major current international economic problems facing the United States and the world and to show how international economics can suggest ways to solve them.

This should greatly enhance students' motivation.

ANSWERS TO REVIEW QUESTIONS AND PROBLEMS 1. Globalization refers to the openness and the free exchange of goods, services, resources, technologies, moneys, and ideas around the world. The advantages of globalization are that it increases efficiency in production and leads to higher income for the nation’s workers.

Globalization often also makes available a greater range of cheaper and or better products to the nation’s consumers, and provides opportunities for higher returns a greater risk diversification to the nation’s investors. The disadvantages of globalization is that it often leads to job losses and lower wages for low-skilled labor in advanced nations and harm (i.e., it is a “brain drain” for) the nations of emigration. Financial globalization and unrestricted capital flows can also lead international financial crises. It is these disadvantages and negative aspects of globalization have given rise to a strong anti-globalization movement, which blames globalization for sacrificing human and environmental well-being to the corporate profits of multinationals.

2. International economic relations differ from interregional (i.e. within a country) economic relations in that nations usually impose some restrictions on the flow of goods, services, and factors across their borders, but not interregionally or internally (i.e., not across regions of the same nation). In addition, international flows are to some extent hampered by differences in language, customs, and laws. Furthermore, international flows of goods, services, and resources give rise to payments and receipts in foreign currencies, which change in value over time.

3. A rough measure of the economic relationship among nations, or their interdependence, is given by the ratio of their imports and exports of goods and services to their gross domestic product (GDP). The imports and exports as a percentage of GDP are much larger for small industrial and developing countries than they are for large countries.

4. The United States relies less on international trade for its high standard of living than most other nations because it is continental in size with immense natural and human resources. As such, it can produce with relative efficiency most of the products it needs. Contrast this to the position of a small nation, such as Switzerland, which can specialize and export only a small range of commodities and imports all the others. In general, the larger the nation the smaller .

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is its economic interdependence with the rest of the world.

5. Even though the United States relies only to a relatively small extent on international trade, a significant part of its high standard of living depends on it. The United States must import many commodities that it cannot produce and several needed minerals that it does have. More important quantitatively to its economic well-being, however, are the many commodities that the United States could produce domestically but only at relatively higher cost.

6. The immigration of skilled people benefits the United States because it raises the skill level, average income, and the growth rate of the nation. The cost arises from immigration of unskilled people and from the job competition which migrants provide to native workers.

7. Capital flows across national boundaries in search of higher returns and to diversify risks.

8. The major international economic problems facing the world today are: (1) slow growth and high unemployment in advanced nations after “the great recession”; (2) the rise of trade protectionism in advanced countries in a rapidly globalizing world; (3) excessive volatility and large disequilibria in exchange rates; (4) structural imbalances in advanced economies and insufficient restructuring in transition economies; (5) deep poverty in many developing countries, and (6) resource scarcity, environmental degradation, and climate change.

9. The most important economic international economic and political institutions are: (1) The World Trade Organization (WTO), which regulates international trade; (2) World Bank, which provides loans to developing countries for development programs aimed at reducing poverty; (3) International Monetary Fund (IMF), which oversees the conduct of international financial relations and provides borrowing facilities for member nations in temporary balance of payments difficulties; (4) United Nations (UN), which seeks to facilitate cooperation in international law, international security, economic development, social progress, and human rights issues.

10. The problems facing the world today affect the United States and you as an individual as follows: (1) Slow growth and high unemployment in advanced nations after “the great recession” means slower growth and higher unemployment for the United States than otherwise in our interdependent world and very likely less job opportunities and stagnant wages for you also.

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(2) Trade controversies between the United States, Europe, and Japan and emerging market economies, such as China, can result in trade restrictions or even trade wars, which would reduce the volume and the gains from trade and the flow of international investments and the benefits resulting from them. As an individual, you can be caught losing your job and a stagnant income.

(3) Excessive exchange rate volatility and misalignments discourage foreign trade and investments, reduce specialization in production and the benefits from trade, which means higher prices for your imported goods and services, more expensive travel.

(4) Structural imbalances (excessive and unsustainable trade and budget disequilibria) in advanced countries and insufficient restructuring in transition economies mean slower growth than possible as advanced nations try to eliminate or reduce their structural imbalances and transition economies redouble their efforts to complete the restructure of their economies. This also means possibly job opportunities for you and stagnant wages.

(5) Deep poverty in many developing nations in the world mean that the United States and other rich countries need to provide more foreign aid and open their markets more widely to the exports of the world’s poorest countries. This can result in your paying higher taxes and facing more job and income pressures.

(6) Resource scarcity, environmental degradation, and climate change means that the price of food and raw materials is likely to increase in the future and the United States and other countries need to spend more to protect the environment and prevent damaging climate change. All this means higher costs for all of us.

MULTIPLE-CHOICE QUESTIONS 1. Which of the following statements about globalization is false? a. it increase economic efficiency b. it cannot be avoided c. it benefits all people d. none of the above 2. The anti-globalization movement blames globalization for a. increasing income inequalities in the world b. child labor c. environmental pollution d. all of the above 3. The criticism of the anti-globalization movement is a. all wrong .

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b. all correct c. is only partly correct d. is impossible to answer 4. 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 5. International trade is most important to the standard of living of: a. the United States b. Switzerland c. Germany d. England 6. Over time, the economic interdependence of nations has: a. grown b. diminished c. remained unchanged d. cannot say 7. A rough measure of the degree of economic interdependence of a nation is given by: a. the size of the nations' population b. the ratio of its population to its GDP c. the ratio of a nation's imports and exports to its GDP d. all of the above 8. Economic interdependence is greater for: a. small nations b. large nations c. developed nations d. developing nations 9. 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 affecting international trade and finance on the welfare of the nation d. all of the above

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10. 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 11. 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 12. 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 13. 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 14. 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 15. 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) COMPARATIVE ADVANTAGE OUTLINE 2.1 Introduction 2.2 Mercantilists’ Views on Trade Case Study 2-1 Mercantilism Is Alive and Well in the Twenty-First Century 2.3 Trade Based on Absolute Advantage: Adam Smith 2.4 Trade Based on Comparative Advantage: David Ricardo 2.5 Gains from Trade with Comparative Advantage 2.6 Comparative Advantage with Money Case Study 2-2 The Petition of the Candlemakers 2.7 Comparative Advantage and Opportunity Costs Case Study 2-3 Labor Productivities and Comparative Advantage 2.8 Production Possibility Frontier with Constant Costs 2.9 Opportunity Costs and Relative Commodity Prices 2.10 Basis and Gains from Trade Under Constant Costs Appendix: Comparative Advantage with More than Two Commodities and Nations A2.1 Comparative Advantage with More than Two Commodities A2.2 Comparative Advantage with More than Two Nations KEY TERMS Basis for trade Gains from trade Pattern of trade 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

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LECTURE GUIDE 1. This is a long and crucial core chapter and may require four classes to cover adequately.

In the first lecture, I would present Sections 1-4 and assign review questions 1-3.

2. In the second lecture of Chapter 2, I would concentrate on Sections 5-6 and carefully explain the law of comparative advantage using simple numerical examples, as in the text. Both sections are crucial. Section 5 explains the law of comparative advantage and Section 6 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 lawyersecretary example should also render the law more immediately relevant to the student. I would also assign Problems 4-7.

3. In the third lecture, I would cover Sections 7-9 and assign Problems 8-10.

4. In the fourth lecture, I would Section 10 and go over problems 4-10. The appendixes could be made optional for the more enterprising students in the class.

ANSWERS TO REVIEW QUESTIONS AND PROBLEMS 1. The mercantilists believed that the way for a nation to become rich and powerful was to export more than it imported. The resulting export surplus would then be settled by an inflow of gold and silver and the more gold and silver a nation had, the richer and more powerful it was. Thus, the government had to do all in its power to stimulate the nation’s exports and discourage and restrict imports. However, since all nations could not simultaneously have an export surplus and the amount of gold and silver was fixed at any particular point in time, one nation could gain only at the expense of other nations. The mercantilists thus preached economic nationalism, believing that national interests were basically in conflict.

Adam Smith, on the other hand, believed that free trade would make all nations better off.

All of this is relevant today because many of the arguments made in favor of restricting international trade to protect domestic jobs are very similar to the mercantilists arguments made three or four centuries ago. That is why we can say that “mercantilism is alive and well in the twenty-first century”. Thus we have to be prepared to answer and demonstrate that these arguments are basically wrong.

2. According to Adam Smith, the basis for trade was absolute advantage, or one country being more productive or efficient in the production of some commodities and other countries being more productive in the production of other commodities.

The gains from trade arise as each country specialized in the production of the commodities in which it had an absolute advantage and importing those commodities in which the nation had an absolute disadvantage.

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Adam Smith believed in free trade and laissez-faire, or as little government interference with the economic system as possible. There were to be only a few exceptions to this policy of laissezfaire and free trade. One of these was the protection of industries important for national defense.

3. Ricardo’s law of comparative advantage is superior to Smith’s theory of absolute advantage in that it showed that even if a nation is less efficient than or has an absolute disadvantage in the production of all commodities with respect to the other nations, there is still a basis for beneficial trade for all nations.

The gains from trade arise from the increased production of all commodities that arises when each country specializes in the production of and exports the commodities of its comparative advantage and imports the other commodities.

A nation that is less efficient than others will be able to export the commodities of its comparative advantage by having its wages and other costs sufficiently lower than in other nations so as to make the commodities of its comparative advantage cheaper in terms of the same currency with respect to the other nations.

4. a. In case A, the United States has an absolute and a comparative 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. b. 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.

5. a. The United States gains 1C. b. The United Kingdom gains 4C.

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c. 3C < 4W < 8C. d. The United States would gain 3C while the United Kingdom would gain 2C. 6. a. The cost in terms of labor content of producing wheat is 1/4 in the United States and 1 in the United Kingdom, while the cost in terms of labor content of producing cloth is 1/3 in the United States and 1/2 in the United Kingdom. b. In the United States, Pw=$1.50 and Pc=$2.00. c. In the United Kingdom, Pw=£1.00 and Pc=£0.50.

7. 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.

8. Ricardo’s explanation of the law of comparative is unacceptable because it is based on the labor theory of value, which is not an acceptable theory of value.

The explanation of the law of comparative advantage can be based on the opportunity cost doctrine, which is an acceptable theory of value.

9. The production possibilities frontier reflects the opportunity costs of producing both commodities in the nation.

The production possibilities frontier under constant costs is a (negatively sloped) straight line.

The absolute slope of the production possibilities frontier reflects or gives the price of the commodity plotted along the horizontal axis in relation to the commodity plotted along the vertical axis.

10. 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. d. 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.

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Figure 1

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MULTIPLE-CHOICE QUETIONS 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 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

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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 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. The Ricardian trade model has been empirically a. verified b. rejected c. not tested d. tested but the results were inconclusive 13. The Ricardian model was tested empirically in terms of differences in a. relative labor productivities costs in various industries among nations b. relative labor costs in various industries among nations 2-7 .

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c. relative labor productivities and costs in various industries among nations d. none of the above 14. 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 15. 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

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*CHAPTER 3 (Core Chapter) THE STANDARD TRADE MODEL OUTLINE 3.1 Introduction 3.2 The Production Frontier with Increasing Costs 3.3 The Marginal Rate of Transformation 3.4 Community Indifference Curves 3.5 Equilibrium in Isolation 3.6 The Basis and the Gains from Trade with Increasing Costs 3.7 Equilibrium Relative Commodity Prices with Trade Case Study 3-1 Specialization and Export Concentration in Selected Countries 3.8 Terms of Trade Case Study 3-2 The Terms of Trade of the G-7 Countries Case Study 3-3 The Terms of Trade of Developed and Developing Countries 3.9 Specialization, Trade and Deindustrialization Case Study 3-4 Job Losses in High U.S. Import-Competing Industries Case Study 3-5 International Trade and Deindustrialization in the United States, the European Union, and Japan Appendix: The Equilibrium Relative Commodity Price with Trade and the Terms of Trade A3-1 The Equilibrium Relative Commodity Price with Trade, with Demand and Supply A3-2 Offer Curves and the Terms of Trade

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

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Equilibrium relative commodity prices with trade Incomplete specialization Terms of trade Deindustrialization Offer curve Reciprocal demand curve

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LECTURE GUIDE 1. In the first lecture of Chapter 3, I would cover Sections 1-5 and assign Review Question and Problems 1-3. Section 3 is the most difficult here and Section 5 is the most important, and so I would spend a bit more time covering them.

2. In the second lecture, I would cover Sections 6 and 7. Section 6 presents the basic trade model, and is essential for the student to master it completely. Section 7 derives the supply curve and the demand curves for the commodity from the production frontier and the community indifference curves. This is the most difficult section, but it is essential because it shows how the equilibrium-relative commodity price is determined with specialization in production and trade.

3. In the third lecture, I would cover the rest of the chapter, starting with Case Studies 3-1 and 3-2 and then going on to discuss the terms of trade. The last section on specialization, trade and deindustrialization is likely to be of great interest to the students and lead to a great deal of class discussion. I would make the Appendix optional for more advanced students in the class.

ANSWERS TO REVIEW PROBLEMS AND QUESTIONS 1. a.

Increasing opportunity costs arise because resources or factors of production are not homogeneous (i.e., all units of the same factor are not identical or of the same quality) and not used in the same fixed proportion or intensity in the production of all commodities.

This means that as the nation produces more of a commodity, it must utilize resources that become progressively less efficient or less suited for the production of that commodity. As a result, the nation must give up more and more of the second commodity to release just enough resources to produce each additional unit of the first commodity (i.e., it faces increasing costs).

b. In the real world, the production frontiers of different nations will usually differ because of differences in factor endowments and technology.

2. a. See Figure 1 on the next page. 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. 3. a. See Figure 2. b. Nation 1 has a comparative advantage in X and Nation 2 in Y. c. If the relative commodity price line in autarky has equal slope in both nations. This is rare.

4. a. See Figure 3. Points B and B’ are the production points in Nations 1 and 2, respectively, with specialization and trade and E and E’ are the consumption points. b. Nation 1 gains by the amount by which community indifference curve III (point E) is above indifference curve I (point A). Nation 2 gains to the extent that community indifference curve III’ (point E’) is above indifference curve I’ (point A).

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5. a. The equilibrium-relative commodity price in isolation is the relative price that prevails in the nation without trade or in autarky. b. The equilibrium-relative commodity price in isolation for the commodity plotted along the horizontal axis is given by the (absolute) slope of the tangent of the production frontier and the community indifference curve at the point of production and consumption in the nation in isolation. c. The nation with the lower equilibrium relative commodity price in isolation or autarky has a comparative advantage in the commodity measured along the commodity axis and a comparative disadvantage in the commodity measured along the vertical axis.

6. See Figure 4 on the next page.

Supply curve AFB for commodity X in Nation 1 (SX) in the left bottom panel is derived From production points AFB, respectively, at PA (not shown in the figure) < PF < PB on the production frontier of Nation 1 in the top panel. Nation 1’s demand curve AHE in the left bottom panel (DX) is derived, respectively, from tangency points of community indifferences and trade lines at points A, H and E in the top panel. SX and DX for Nation 2 in the right panel are derived in an analogous way.

From both bottom panels, we see that only at PB = PB’ would the quantity of exports of commodity X supplied by Nation 1 exactly match the quantity demanded of imports of commodity X of Nation 2. Thus, PB = PB’ is the equilibrium relative commodity prices with trade.

7. a. The reason for incomplete specialization under increasing costs is that as each nation specializes in the production of the commodity of its comparative advantage, the relative commodity price in each nation moves toward each other (i.e., become less unequal) until they are identical in both nations. At that point, it does not pay for either nation to continue to expand the production of the commodity of its initial comparative advantage. This occurs before either nation has completely specialized in production. b. Under constant costs, each nation specializes completely in production of the commodity of its comparative advantage (i.e., produces only that commodity). The reason is that since it pays for the nation to obtain some of the commodity of its comparative disadvantage from the other nation, then it pays for the nation to get all of the commodity of its comparative disadvantage from the other nation (i.e., to specialize completely in the production of the commodity of its comparative advantage).

8. See Figure 5.

Nations 1 and 2 have identical production frontiers (shown by a single curve) but different tastes (indifference curves). In isolation, Nation 1 produces and consumes at point A and Nation 2 at point A’. Since PA < PA’, Nation 1 has a comparative advantage in X and Nation 2 in Y.

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With trade, Nation 1 specializes in the production of X and produces at B, while Nation 2 specializes in Y and produces at B’ (which coincides with B). By exchanging BC = B’C’ of X for CE = C’E of Y with each other (see trade triangles BCE and B’C’E’), Nation 1 ends up consuming at E on indifference curve III (higher than indifference curve I at point A) and Nation 2 consumes at on indifference curve III’ (higher than indifference curve I’ at point A’).

9. 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 [(100-110)/110 = -0.09 =0.9%]. b. A deterioration in the terms of trade of the trade partner can be said to be unfavorable to the trade partner because the trade partner must pay a higher price for its imports in terms of its exports. c. 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.

10. It is true that Mexico's wages are much lower than U.S. wages (they are about one fifth of the average wage in the United States), 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.

MULTIPLE-CHOICE QUESTIONS 1. A production frontier that is concave 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

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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 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 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 8. 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 9. If actual 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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10. With free trade under increasing costs: a. neither nation will specialize completely in production if both nations are large 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 11. Which of the following statements is true? a. a nation’s demand curve of a commodity is derived from production points on the nation’s production frontier. b. a nation’s supply curve for a commodity is derived from community indifference curves and trade lines c. the price of the nation’s import commodity will fall as a result of international trade d. none of the above 12. At a relative commodity price above equilibrium a. the quantity demand of imports exceeds the quantity supplied of exports b. the relative price of the commodity will rise c. the commodity price will fall d. none of the above 13. 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 14. 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 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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*CHAPTER 4 (Core Chapter) THE HECKSCHER-OHLIN AND OTHER TRADE THEORIES

OUTLINE 4.1 Introduction 4.2 Factor Endowments and the Heckscher-Ohlin Theory 4.3 The Formal Heckscher-Ohlin Model Case Study 4-1 Relative Resource Endowments and the Comparative Advantage of Various Countries 4.4 Factor-Price Equalization and Income Distribution Case Study 4-2 Has International Trade Increased U.S. Wage Inequalities?

4.5 Empirical Tests of the Heckscher-Ohlin Theory 4.6 Economies of Scale and International Trade Case Study 4-3 The New International Economies of Scale 4.7 Trade Based on Product Differentiation Case Study 4-4 Growth of Intra-Industry Trade 4.8 Technological Gap and Product Cycle Models Case Study 4-5: The World’s Most Competitive Economies 4.9 Transportation Costs and International Trade 4.10 Environmental Standards and International Trade Appendix The Specific-Factors Model and Intra-Industry Trade Models A4.1 The Specific-Factors Model A4.2 A Model of Intra-Industry Trade

KEY TERMS Relative factor prices Heckscher–Ohlin (H–O) theory Heckscher–Ohlin (H–O) theorem Factor-proportions or factor-endowment theory Factor–price equalization theorem Stolper-Samuelson theorem Specific-factors model .

International economies of scale Differentiated products Intra-industry trade Technological gap model Product cycle model Transportation costs Nontraded goods and services 4-1

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Environmental standards Monopolistic competition

LECTURE GUIDE 1. This is one of the most important and difficult chapters in the book. It is also a long chapter and requires four lectures to cover adequately.

2. In the first lecture, I would cover sections 1-3. Section 3 is one of the most important sections in the book because it presents the H-O model. I would proceed slowly and carefully in explaining Figure 4.1 and compare it to the standard trade model of Figure 3.4.

3. In the second lecture, I would cover sections 4 and 5. Section 4 on the factor-price equalization theorem and income distribution is a difficult section. Case Study 4-2 should be of great interest to the students and give rise to a great deal of class discussion.

4. In third lecture, I would cover sections 6-7, paying a great deal of attention to section 7 on trade in differentiated products.

5. In fourth lecture, I would cover the rest of the chapter.

ANSWERS TO REVIEW QUESTIONS AND PROBLEMS 1.

a. The Heckscher–Ohlin (H-0) theorem postulates that a nation will export those commodities whose production requires the intensive use of the nation’s relatively abundant and cheap factor and import the commodities whose production requires the intensive use of the nation’s relatively scarce and expensive factor. In short, the relatively labor-rich nation exports relatively labor-intensive commodities and imports the relatively capital-intensive commodities. b. Heckscher and Ohlin identify the relative difference in factor endowments among nations as the basic determinant of comparative advantage and international trade. c. The H-O Theory represent an extension of the standard trade model because it explains the basis for comparative advantage (classical economists, such as Ricardo had assumed it) and examines the effect of international trade on factor prices and income distribution (which classical economists had left unanswered).

2. See Figure 1 on the next page. a. The factor–price equalization theorem postulates that international trade will bring about the equalization of the returns to homogeneous or identical factors across nations. b. The Stopler-Samuelson theorem postulates that free international trade reduces the real income of the nation’s relatively scarce factor and increases the real income of the nation’s relatively abundant factor.

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c. The specific-factors model postulates that the opening of trade (1) benefits the specific factor used in the production of the nation’s export commodity, (2) harms the specific factor used in the production of the nation’s import-competing industry, and (3) leads to an ambiguous effect (i.e., it may benefit or harm) the mobile factor. d. Trade acts as a substitute for the international mobility of factors of production in its effect on factor prices. With perfect mobility, labor would migrate from the lowwage nation to the high-wage nation until wages in the two nations are equalized.

Similarly, capital would move from the low-interest to the high-interest nation until the rate of interest was equalized in the two nations.

4. a. The Leontief paradox refers to the original Leontief’s finding that U.S. import substitutes were more K-intensive than U.S. exports. This was the opposite of what the H-O theorem postulated. b. The Leontief paradox was resolved by including human capital into the calculations and excluding industries based on natural resources. Recent research using data on many sectors, for many countries, over many years, and considering that countries could specialize in a particular subset or group of commodities that were best suited to their specific factor endowments, provides strong support for the H-O theorem. c. The Hecksher-Olhin theory remains the centerpiece of modern trade theory for explaining international trade today. To be sure, there are other forces (such as economies of scale, product differentiation, and technological differences across countries) that provide additional reasons and explanations for some international trade not explained by the basic H-O model. These other trade theories complement the basic H-O model in explaining the pattern of international trade in the world today.

5. International trade with developing economies, especially newly industrializing economies (NIEs), contributed in two ways to increased wage inequalities between skilled and unskilled workers in the United States during the past two decades. Directly, by reducing the demand for unskilled workers as a result of increased U.S. imports of labor-intensive manufactures and, indirectly, by speeding up the introduction of 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.

6. a. Economies of scale refer to the production situation where output grows proportionately more than the increase in inputs or factors of production. For example, output may more than double with a doubling of inputs. b. Even if two nations were identical in every respect, there is still a basis for mutually beneficial trade based on economies of scale. When each nation specializes in the production of one commodity, the combined total world output of both commodities will be greater than without specialization when economies of scale are present.

With trade, each nation then shares in these gains. c. The new international economies of scale refers to the increase in productivity resulting from firms purchasing parts and components from nations where they are made cheaper and better, and by establishing production facilities abroad .

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7. a. Product differentiation refers to products that are similar, but not identical. Intraindustry trade refers to trade in differentiated products, as opposed to inter-industry trade in completely different products. b. Intra-industry trade arises in order to take advantage of important economies of scale in production. That is, with intra-industry trade each firm or plant in industrial countries can specialize in the production of only one, or at most a few, varieties and styles of the same product rather than many different varieties and styles of a product and achieve economies of scale. c. With few varieties and styles, more specialized and faster machinery can be developed for a continuous operation and a longer production run. The nation then imports other varieties and styles from other nations. Intra-industry trade benefits consumers because of the wider range of choices (i.e., the greater variety of differentiated products) available at the lower prices made possible by economies of scale in production.

8. a. According to the technological gap model, a firm exports a new product until imitators in countries take away its market. In the meantime, the innovating firm will have introduced a new product or process. b. The criticism of the technological gap model are that it does not explain the size of technological gaps and does not explore the reason for technological gaps arising in the first place, or exactly how they are eliminated over time. c. The five stages of the product cycle model are: the introduction of the product, expansion of production for export, standardization and beginning of production abroad through imitation, foreign imitators underselling the nation in third markets, and foreigners underselling the innovating firms in their home market as well.

9. See Figure 2 on page 25.

10. A nation with lower environmental standards can use the environment as a resource endowment or as a factor of production in attracting polluting firms from abroad and achieving a comparative advantage in the production of polluting goods and services.

This can lead to trade disputes with nations with more stringent environmental standards.

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. A nation is said to have a relative abundance of K if it has a: a. greater absolute amount of K .

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b. smaller absolute amount of L c. higher L/K ratio d. lower price of K in relation to the price of L 3. 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 4. 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 5. According to the H-O theory, trade reduces international differences in: a. commodity prices b. in factor prices c. both commodity and factor prices d. neither relative nor absolute factor prices 6. According to the Stolper-Samuelson theorem, international trade leads to a. reduction in the real income of the nation’s relatively abundant factor b. reduction in the real income of the nation’s relatively scarce factor c. increase in the real income of the nation’s relatively scarce factor d. none of the above 7. Which of the following is false with regard to the specific factors theorem, international trade a. harms the immobile factors that are specific to the nation’s export commodities or sectors b. harms the immobile factors that are specific to the nation’s import-competing commodities c. has an ambiguous effect on the nation’s mobile factors d. may benefit or harm the nation’s mobile factors 8. Perfect international mobility of factors of production a. leads to a reduction in international differences in the returns to homogenous factors b. acts as a substitute for international trade in its effects on factor prices c. operates on the supply of factors in affecting factor prices d. all of the above 9. The Leontief paradox refers to the empirical finding that U.S. a. import substitutes were more K-intensive than exports .

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b. exports were more L-intensive than imports c. exports were more K-intensive than import substitutes d. all of the above 10. From empirical studies, we conclude that the H-O theory: a. must be rejected b. must be accepted without reservations c. can generally be accepted d. explains all international trade 11. 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 12.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 13. 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 14. 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 15. Transport costs: a. increase the price in the importing country b. reduces the price in the exporting country c. falls less heavily on the nation with the more elastic demand and supply curves of the traded commodity d. all 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? (b) How much would the United States and Germany gain if 1 unit of beef is exchanged for 3 chips?

Ans. (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) 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 the figure below.

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.

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3. (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?

Ans. (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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4. Suppose that tastes change in Nation 1 (the L-abundant and L-cheap nation) so that consumers demand more of commodity X (the L-intensive commodity) and less of commodity Y (the Kintensive 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? Ans. (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. (c) 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). (d) 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 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.

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5. (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.

Ans. (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 5 (Core Chapter) TRADE RESTRICTIONS: TARIFFS OUTLINE 5.1 Introduction 5.2 Types of Tariffs Case Study 5-1 Average Tariff on Non-Agricultural Products in Major Developed Countries Case Study 5-2 Average Tariff on Non-Agricultural Products in Some Major Developing Countries 5.3 Effects of a Tariff in a Small Nation 5.4 Effect of a Tariff on Consumer and Producer Surplus 5.5 Costs and Benefits of a Tariff in a Small Nation Case Study 5-3 The Welfare Effects of Liberalizing Trade in Some U.S. Products Case Study 5-4 The Welfare Effects of Liberalizing Trade in Some EU Products 5.6 Costs and Benefits of a Tariff in a Large Nation 5.7 The Optimum Tariff and Retaliation 5.8 Theory of Tariff Structure Case Study 5-5 Rising Tariff Rates with Degree of Domestic Processing Case Study 5-6 Structure of Tariffs in the United States, EU, and Canada Appendix: Optimum Tariff and Retaliation with Offer Curves 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

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Revenue effect of a tariff Consumer surplus Rent or producer surplus Protection cost or deadweight loss of a tariff Terms of trade effect of the tariff Optimum tariff Prohibitive tariff Rate of effective protection

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LECTURE GUIDE 1. I would cover sections 1-4 in the first lecture. The most difficult part is Section 4 on 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 measuring the welfare effect of tariffs, I would explain these concepts very carefully.

2. I would cover sections 5-7 in the second lecture. These are the most difficult sections in the chapter and also the most important.

3. The theory of tariff structure (section 8) is also difficult and important. I found that the best way to explain it is by using the simple example in the text on the suit with and without imported inputs. This section is likely to generate a great deal of discussion about the trade relations between developed and developing nations. If you do not plan to cover optional Chapter 8 on growth and development, you could spend a bit more time on this topic here , even though it will come up again in Chapter 6.

ANSWERS TO REVIEW QUESTIONS AND PROBLEMS 1. a. See Figure 1 on the next page. b. Consumption is 70X, production is 50X and imports are 20X. c. The consumption effect is –30X, the production effect is +30X, the trade effect is –60X, and the revenue effect is $30 (see Figure 1).

2. a. The consumer surplus is $250 without and $l22.50 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), $22.50 represents the increase in production costs and another $22.50 represents the increase in rent or producer surplus (see Figure 1). c. The dollar value or the protection cost of the tariff is $45 (see Figure 1).

3. The dollar value or the protection cost of the tariff is $45 (see Figure 2).

4. The dollar value or the protection cost of the tariff is $45 (see Figure 3).

5. The optimum tariff is the tariff that maximizes the net benefit resulting from the improvement in the nation’s terms of trade against the negative effect resulting from reduction in the volume of trade.

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Fig 5.3

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6. a. When a nation imposes an optimum tariff, the trade partner’s welfare declines because of the lower volume of trade and the deterioration in its terms of trade. b. The trade partner is likely to retaliate and in the end both nations are likely to lose because of the reduction in the volume of trade.

7. Even when the trade partner does not retaliate when one nation imposes the optimum tariff, the gains of the tariff-imposing nation are less than the losses of the trade partner, so that the world as a whole is worse off than under free trade. It is in this sense that free trade maximizes world welfare.

8. a. The nominal tariff is calculated on the market price of the product or service. The rate of effective protection, on the other hand, is calculated on the value added in the nation. It is equal to the value of the price of the commodity or service minus the value of the imported inputs used in the production of the commodity or service. b. The nominal tariff is important to consumers because it determines by how much the price of the imported commodity increases. The rate of effective protection is important for domestic producers because it determines the actual rate of protection provided by the tariff to domestic processing.

9. a. Rates of effective protection in industrial nations are generally much higher than the corresponding nominal rates and increase with the degree of processing. b. The tariff structure of developed nations is of great concern for developing nations because it discourages manufacturing production in developing nations.

10. If a nation reduces the nominal tariff on the importation of the raw materials required to produce a commodity but does not reduce the tariff on the importation of the final commodity produced with the imported raw material, then the effective tariff rates will increase relative to the nominal tariff rate on the commodity.

MULTPLE-CHOICE QUESTIONS 1. Which of the following statements is incorrect? a. an ad valorem tariff is expressed as a percentage of the price 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 .

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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. The imposition of an optimum tariff by a small nation: a. improves its terms of trade b. reduces the volume of trade c. increases the nation's welfare d. none of the above 7. The optimum tariff for a small nation is: a. 100% b. 50% c. 0 d. depends on the elasticity of demand and supply for the import commodity in the nation 8. The imposition of an optimum tariff by a large nation: a. improves its terms of trade b. reduces the volume of trade .

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c. increases the nation's welfare d. all of the above 9. The imposition of an optimum tariff by a large nation: a. improves the terms of trade of the trade partner b. reduces the volume of trade c. increases the trade partner’s welfare d. all of the above 10. If two large countries impose an optimum tariff a. the welfare of the both nations decrease b. the welfare of the both nations increase c. the welfare of the larger nation will increase and that of the other nation decreases d. the welfare of the larger nation will decrease and that of the other nation increases 11. If one nation imposes an optimum tariff and the other nation does not retaliate a. the welfare of the first nation increases and that of the welfare of the second nation falls b. the welfare of the second nation increases and that of the welfare of the second nation falls c. the welfare of both nations fall d. the welfare of both nations increase 12. If one nation imposes an optimum tariff and the other nation does not retaliate a. the welfare of the first nation increases more than the fall in the welfare of the second nation b. the welfare of the first nation increases more than the fall in the welfare of the second nation c. the welfare of the second nation increases less than the fall in the welfare of the first nation d. the welfare of the first nation increases by the same amount as the fall in the welfare of the second nation 13. The nominal tariff is the tariff calculated on the a. price of the input used in the production of the commodity b. price of the commodity or service c. value added d. all of the above 14. The effective tariff rate is the tariff calculated on the a. price of the input used in the production of the commodity b. commodity or service .

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c. value added in the nation d. all of the above 15. If the nominal tariff on a commodity is higher than the nominal tariff on the imported input used in the production of the commodity, then the rate of effective protection is a. higher on the commodity than on the input b. lower on the commodity than on the imported input c. equal on the commodity and on the imported input d. any of the above

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*CHAPTER 6 (Core Chapter) NONTARIFF TRADE BARRIERS AND THE POLITICAL ECONOMY OF PROTETIONISM OUTLINE 6.1 Introduction 6.2 Import Quotas Case Study 6-1 Economic Effects of the U.S. Quota on Sugar Imports 6.3 Other Nontariff Trade Barriers Case Study 6-2 Voluntary Export Restraints on Japanese Automobiles to the United States 6.4 Dumping and Export Subsidies Case Study 6-3 Antidumping Investigations by G20 Members 6.5 The Political Economy of Protectionism Case Study 6-4 Agricultural Subsidies in Developed Nations Case Study 6-5 Pervasiveness of Nontariff Barriers 6.6 Outsourcing, Offshoring, and Fear of Globalization Case Study 6-6 Job Loss Rates in U.S. Industries and Globalization Case Study 6-7 Trade Protectionism Increased During the Financial Crisis 6.7 Strategic Trade and Industrial Policies Case Study 6-8 Economic Effects on the U.S. Economy from Removing all Import Restraints 6.7 History of U.S. Commercial Policy 6.8 The Uruguay Round Case Study 6-9 The Multilateral Rounds of Trade Negotiations 6.9 Outstanding Trade Problems and the Doha Round Appendix: Strategic Trade and Industrial Policies with Game Theory

KEY TERMS Quota Nontariff trade barriers (NTBs) New protectionism Voluntary export restraints (VERs) Technical, administrative, and other regulations International cartel Dumping Persistent dumping Predatory dumping Sporadic dumping Trigger-price mechanism .

Most-favored-nation principle Bilateral trade General Agreement on Tariffs and Trade (GATT) Multilateral trade negotiations Peril-point provisions Escape clause National security clause Trade Expansion Act of 1962 Trade adjustment assistance (TAP) Kennedy Round Trade Reform Act of 1974 6-1

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Export subsidies Export-Import Bank Foreign Sales Corporations Countervailing duties (CVDs) Scientific tariff Infant-industry argument Strategic trade policy Industrial policy Smoot–Hawley Tariff Act Trade Agreements Act of 1934

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Tokyo Round Trade and Tariff Act of 1984 Omnibus Trade and Competitiveness Act of 1988 Uruguay Round World Trade Organization (WTO) Trade promotion authority or fast track Doha Round Antiglobalization movement Game theory

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 1-3 in lecture 1. I would pay particular attention to Figure 6-1, which examines the partial equilibrium effects of an import quota. I would also clearly explain the difference between a regular import quota and a voluntary export restraint.

3. I would cover sections 4-6 in lecture 2. I would also clearly explain the meaning and importance of dumping and export subsidies, as well as the political economy of protectionism and outsourcing. The four case studies serve to highlight the theory and show the relevance of the theory in today's world.

4. The rest of the chapter can be covered in lecture 3. Strategic trade and industrial policies, the history of U.S. commercial policy, and the outstaying trade problems and the collapse of the Doha Round of trade negotiations should not be difficult to explain and can lead to a great deal of interesting class discussion.

ANSWERS TO REVIEW QUESTIONSAND PROBLEMS: 1. a. An import quota will increase the price of the product to domestic consumers, reduce the domestic consumption of the good, increase domestic production, and result in a protection or deadweight loss to the economy. b. The effects of an import quota are identical to those of an equivalent import tariff, except that with a quota the government does not collect a tariff revenue (unless it auctions off import quotas to the highest bidder). The import quota is also more restrictive than an equivalent import tariff because foreign producers cannot increase their exports by lowering their prices.

2. By penciling in D”X in Figure 1, we can see that the effects of the import quota are: Px=$2.00 and consumption is 60X, of which 40X are produced domestically and 20X are imported; by auctioning off import licenses, the revenue effect would be $20.

3. The effects of an export quota of 20X are identical to those of an import quota of 20X or a 100 percent import tariff on commodity X, except that the revenue effect is collected by the .

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exporters, rather than by the domestic importers or their government.

4. a. An international cartel is an organization of suppliers of a commodity located in different nations (or it is a group of governments) that agrees to restrict output and the exports of the commodity with the aim of maximizing or increasing the total profits of its members.

Although domestic cartels are illegal in the United States and are restricted in Europe, the power of international cartels cannot easily be countered because they do not fall under the jurisdiction of any one nation. b. The most notorious of present-day international cartels is OPEC (Organization of Petroleum Exporting Countries), which, by restricting production and exports, succeeded in quadrupling the price of crude oil between 1973 and 1974. The economic power of OPEC declined during the 1980s and 1990s when many other nations (such as Russia, Mexico, Norway, the United Kingdom) encouraged by the sharp increase in prices started to extract and export petroleum.

5. a. Dumping refers to the export of a commodity at below cost or at a lower price than the commodity is sold domestically. b. Dumping is classified as persistent, predatory, and sporadic. Persistent dumping, or international price discrimination, refers to the continuous sale of the commodity at a higher price in the domestic market than internationally . The incentive for persistent dumping is the higher profits it provides to domestic producers.

Predatory dumping is the temporary sale of a commodity at below cost or at a lower price abroad than at home in order to drive foreign producers out of business, after which prices are raised to maximize profits. Sporadic dumping is the occasional sale of a commodity at below cost or at a lower price abroad than domestically in order to unload an unforeseen and temporary surplus of the commodity without having to reduce domestic prices. c. Dumping usually leads to trade restrictions as nations try to protect domestic producers from “unfair” foreign competition, even when the dumping is persistent and sporadic.

6. a. One fallacious argument is that trade restrictions are needed to protect domestic labor against cheap foreign labor. This argument is not valid because even if domestic wages are higher than wages abroad, domestic labor costs can still be lower if the productivity of labor is sufficiently higher domestically than abroad. If not, expensive-labor nations can still specialize in the production and export capital- and technology-intensive commodities. b. Another fallacious argument for protection is the scientific tariff. This is the tariff rate that would make the price of imports equal to domestic prices and (so the argument goes) allow domestic producers to meet foreign competition. However, this would eliminate international price differences and trade in commodities subject to such “scientific” tariffs.

7. a. The infant-industry argument postulates that temporary protection may be justified in order to allow a developing nation to develop an industry in which it has a potential comparative advantage. Temporary trade protection is then justified to establish and protect the domestic .

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industry during its “infancy” until it can grow and meet foreign competition. For this argument to be valid, however, protection must be temporary and the return in the grown-up industry must be sufficiently high to also offset the higher prices paid by domestic consumers of the commodity during the period of infancy. b. The infant-industry argument must be qualified in several important ways to be acceptable.

First, this argument is more justified for developing nations (where capital markets may not function properly) than for industrial nations. Second, it is usually difficult to identify which industry or potential industry qualifies for this treatment, and experience has shown that protection, once given, is difficult to remove. Third, and most important, what trade protection (say in the form of an import tariff) can do, an equivalent production subsidy to the infant industry can do better.

8. a. According to strategic industrial trade policy a nation can create a comparative advantage (through temporary trade protection, subsidies, tax benefits, and cooperative government– industry programs) in a high-technology field deemed crucial to future growth in the nation. b. There are also serious difficulties in carrying strategic industrial and trade policies. First, it is extremely difficult to pick winners (i.e., choose the industries that will contribute significantly to growth in the future). Second, if most leading nations undertake strategic trade policies at the same time, their efforts are largely neutralized. Third, when a country does achieve substantial success with a strategic trade policy, this comes at the expense of other countries (i.e., it is a beggar-thy-neighbor policy), which are, therefore, 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.

9. a. The main provisions of the Uruguay Round were the reduction of average tariffs on industrial goods from 4.7 percent to 3 percent, for quotas to be replaced by tariffs, and for antidumping and safeguards to be tightened. The agreement also called for the reduction in agricultural export subsidies and industrial subsidies, and for the protection of intellectual property. b. It was estimated that by 2005 the implementation of the Uruguay pound had increased world welfare by $73 billion, of which $58.3 billion of the gains went to developed countries and $19.2 billion to developing countries. The collapse of the Uruguay Round, however, would have been disastrous psychologically and could have led to the unrestrained proliferation of trade restrictions and destructive trade wars.

10. a. The major trade problems facing the world today are (1) the serious trade disputes among the many of the major advanced and emerging markets; (2) the high trade protectionism, especially in agriculture and textiles, which are of great importance to developing countries, and the abuse antidumping and safeguards; (3) the breaking up of the world into a few major trading blocks, and a serious anti-globalization movement that has come into existence. b. The Doha Round is needed to take up all of the above problems. However, as of the end of 2011 the Round had not been concluded because of disagreements on agricultural protectionism between developing and developed countries and among developed countries themselves. .

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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 quota d. all of the above 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 d. all of the above

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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. Trade protection in the United States is usually provided to: a. low-wage workers b. well-organized industries with large employment c. industries producing consumer products d. all of the above 12. 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

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13. 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 14. 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 15. 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

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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:

Fig 6.1

(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.

Ans. (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) 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.

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

Ans. (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.

3. (a) How can strategic trade policy justify trade protection? (b) What difficulties arise in carrying out a strategic trade policy?

Ans. (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. .

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(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-thyneighbor 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.

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*CHAPTER 7 (Core Chapter) ECONOMIC INTEGRATION OUTLINE 7.1 Introduction 7.2 Forms of Economic Integration 7.3 Trade Creation and Trade Diversion in Customs Unions 7.4 Dynamic Benefits from Customs Unions 7.5 The European Union Case Study 7-1 Economic Profile of EU, NAFTA, and Japan Case Study 7-2 Gains from the Single EU Market 7.6 The European Free Trade Association 7.7 The North-American Free Trade Agreement (NAFTA) 7.8 Attempts at Economic Integration Among Developing Countries Case 7-3 Economic Profile of Mercosur Case 7-4 Changes in Trade Pattern with Economic Integration 7.9 Economic Integration in Central and Eastern Europe and in the former Soviet Republics

KEY TERMS Economic integration Preferential trade arrangements Free trade area Customs union Common market (COMECON) Economic union Duty-free zones or free economic zones Trade creation Trade diversion Tariff factories European Union (EU) Variable import levies European Free Trade Association (EFTA)

Trade deflection European Economic Area (EEA) North American Free Trade Agreement (NAFTA) Southern Common Market (Mercosur) Council of Mutual Economic Assistance (CMEA) or State trading companies Centrally planned economies Bilateral agreements Bulk purchasing Central and Eastern European Countries (CEEC) Newly Independent States (NIS) Commonwealth of Independent States (CIS) Central European Free Trade Association (CEFTA) Baltic Free Trade Area (BFTA)

LECTURE GUIDE .

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1. I would cover sections 1-4 in the first class and sections 7-4 to 7-9 in the second class dealing with the European Union (EU), The European Free Trade Association, the North American Free Trade Agreement (NAFTA), and the Southern Common Market (Mercosur).

2. Case Studies 7-1 to 7-4 can be used for a very stimulating class discussion.

ANSWERS TO REVIEW QUESTIONS AND PROBLEM 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 tariff-inclusive price of $16 if Nation A imported commodity X from Nation B and $12 if Nation A imported commodity X from nation C. 2. 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. The formation by Nation A of a customs union with Nation B leads to trade creation only because Nation A replaces the 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 tariffinclusive 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 tariffinclusive price of $9. b. The formation by Nation A of a customs union with Nation B leads not only to trade creation but also to trade diversion because it replaces lower-cost 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. a. See Figure 1 below. b. The net gain from the trade-diverting customs union shown in Figure 1 is given by .

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C'JJ'+B'HH'-MJ'H'N. As contrasted with the case in Figure 7-1 in the text, however, the sum of the areas of the two triangles (measuring gains) is here 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.

6. A customs union that leads to both trade creation and trade diversion is more likely to lead to a net positive welfare gain of the nation joining the union (1) the smaller is the relative inefficiency of the union member in relation to the non-union member and (2) the higher is the level of the tariff imposed by the customs union on the non-union member.

7. The dynamic benefits resulting from the formation of a customs union are (1) increased competition, (2) economies of scale, (3) stimulus to investment, and (4) better utilization of economic resources. These are likely to be much more significant than the static benefits 8. See Figure 2 below. The formation of the customs union has no effect.

9. NAFTA created much more controversy because the very low wages in Mexico led to great fears of large job losses in the U. S. 10. 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.

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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 customs union creates trade when: 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. Trade diversion arises in a customs union if it: 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. Customs union usually results in: a. trade diversion only b. trade creation only c. both trade creation and trade diversion d. we cannot say 6. The formation of a customs union that leads only to trade creation and 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 .

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d. increase or decrease in the welfare of member and nonmember nations 7. A customs union that leads to both trade creation and trade diversion: 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 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. 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 10. 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 11. The benefit that the United States receives 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 12. 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 13. Which is a stumbling block to successful economic integration among groups of developing nations? .

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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 14. 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 15. The Members of Mercosur are: a. Brazil, Mexico, Argentina, and Colombia b. Argentina, Brazil, the United States and Peru c. Brazil, Argentina, Paraguay, Uruguay, and Venezuela d. Brazil, Chile, Peru and Canada

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CHAPTER 8 GROWTH AND DEVELOPMENT WITH INTERNATIONAL TRADE OUTLINE 8.1 Introduction 8.2 Growth and Development over Time 8.3 Trade Theory and Economic Development 8.4 The Contribution of Trade to Development Case Study 8-1 The East Asian Miracle of Growth and Trade 8.5 The Terms of Trade and Economic Development Case Study 8-2 Changes in Commodity Prices over Time 8.6 Immiserizing Growth 8.7 Export Instability and Economic Development 8.8 Import Substitution Versus Export Orientation Case Study 8-3 The Growth of Rich Countries, Globalizers and Nonglobalizers 8.9 Trade Liberalization and Growth in Developing Countries Case Study 8-4 Manufactures in Total Exports of Selected Developing Countries Case Study 8-5 The New Economic Giants 8.10 Current Problems Facing Developing Countries Case Study 8-6 The Foreign Debt Problem of Developing Countries KEY TERMS Balanced growth Engine of growth Regions of recent settlement Vent for surplus Endogenous growth theory High-performance Asian economies (HPAEs) Commodity, or net barter, terms of trade Income terms of trade Immiserizing growth Export instability Marketing boards

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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 Conferences on Trade and Development (UNCTAD)

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LECTURE GUIDE 1. This is not a core chapter and I would skip it, except for section 10.

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

ANSWERS TO REVIEW QUESTIONS AND PROBLEMS 1. a. International trade could retard development by: (1) keeping the nation in primary production; (2) leading the nation to adopt excessive capital-intensive production techniques; (3) increasing the propensity to consume, thus reducing the nation's savings rate; (4) leading to foreign exploitation of natural resources; b. Each of the above criticisms that international trade can retard development can by countered as follows: (1) As the availability of capital and technology increases, the nation can begin to export manufactured goods; (2) through appropriate taxes and subsidies the nation can avoid the use of excessive capital-intensive production techniques; (3) increased taxation can increase the rate of public savings; (4) taxation and regulation can reduce or eliminate foreign exploitation; 2. a. See Figure 1 on the next page b. See the top solid production frontier in Figure 2. c. See the dashed production frontier in Figure 3.

3. See Figure 4.

4. See Figure 5.

5. 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.

6. 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 is better off in 2010 than it was in 1980 because of its greater ability to import goods and services.

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7. a. Immiserizing growth can take place if the supply curve of the factor used in the nation’s export commodity increases so much as to cause such a large deterioration in the nation’s terms of trade (as the nation tries to export more of its commodity) that the nation reaches a lower indifference curve after growth than before growth. b. Immisering growth occurred rarely in the real world because the deterioration in the nations terms of trade is more than neutralized by increase in the volume of the nation’s exports (so that the nation’s terms of trade improve).

8. See Figure 6 on the previous page.

9. 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 establish ment 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. b. 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.

10. 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.

MULTIPLE-CHOICE QUESTIONS: 1. If only the supply of labor increases in a nation, the nation’s production frontier shifts: a. only along the axis measuring the L-intensive commodity b. only along the axis measuring the K-intensive commodity c. more along the axis measuring the L-intensive commodity d. in the same proportion along both axes 2. 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 .

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d. all of the above 3. International trade was an engine of growth for the: a. 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 6. The nation's commodity terms of trade times the quantity index of its export sector gives the nation's a. income terms of trade b. commodity terms of trade c. factoral terms of trade d. all of the above 7. When a nation's commodity terms of trade deteriorate and its income terms of trade improve, the nation's welfare: a. falls b. rises c. remains unchanged d. any of the above 8. Immizerising growth refers to a: a. decrease in the commodity terms of trade and increase in the income terms of trade b. a decrease in the welfare of a nation with growth c. a decrease in the income terms of trade and an increase in welfare d. any of the above.

9. Developing nations often experience wildly fluctuating export prices for their primary .

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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. Empirical studies have found that, in general, 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. The policy of import substitution was most vigorously followed by: a. large developing nations during the 1980'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 12. 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.

13. 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.

14. Those nations that liberalized trade during the past decade .

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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 15. 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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CHAPTER 9 INTERNATIONAL RESOURCE MOVEMENTS AND MULTINATIONAL CORPORATIONS OUTLINE 9.1 Introduction 9.2 Types of Foreign Investments 9.3 Data on International Capital Flows Case Study 9-1 Fluctuations in Foreign Direct Investment to the United States 9.4 Motives for International Portfolio Investments 9.5 Motives for Direct Foreign Investments Case Study 9-2 The Stock of Foreign Direct Investments Around the World 9.6 Effects of International Capital Flows on Investing and Host Countries 9.7 Reasons for the Existence of Multinational Corporations Case Study 9-3 The World’s Largest Non-Petroleum Industrial Multinational Corporations 9.8 Problems Created by Multinational Corporations in the Home Country Case Study 9-4 Employment of U.S. MNCs Abroad 9.9 Problems Created by Multinational Corporations in the Host Country 9.10 Motives and Welfare Effects of International Labor Migration Case Study 9-5 U.S. Immigration and Debate over Immigration Policy Appendix : Analysis of Effects of International Capital Flows and Migration A9.1 Analysis of Effects of International Capital Flows on Investing and Host Countries A9.2 Analysis of Effects of International Labor Migration

KEY TERMS Portfolio investments Direct investments Portfolio theory Risk diversification Horizontal integration

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Vertical integration Multinational corporations (MNCs) Transfer pricing Brain drain

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LECTURE GUIDE: This is not a core chapter and I would skip it except for sections 9.7 to 9.9 on multinational corporations and section 9.10 on immigration. Otherwise, I would present two sections in each of three classes.

ANSWERS TO REVIEW QUESTIONS AND PROBLEMS: 1. International trade can be regarded as a substitute for the movements of productive resources in the sense that a relatively capital-abundant and labor-scarce country, such as the United States, could either export capital-intensive commodities or export capital itself, and either import labor-intensive products or allow the immigration of workers from countries with plentiful labor supplies. The opposite is the case for a relatively capital-poor and laborabundant developing country.

2. a. Portfolio investments, such as the purchase of bonds, are purely financial assets and take place primarily through banks and investment funds. b. Direct investments are real investments in factories, capital goods, land, and inventories where both capital and management are involved and the investor retains control over use of the invested capital. International direct investments are usually undertaken by multinational corporations.

3. a. The basic motives for international portfolio investments are yield maximization and risk diversification. Risk diversification is also necessary to explain two-way capital flows. b. Direct foreign investments are also undertaken for yield maximization and risk diversification but require additional explanations. These are (1) to exploit abroad some unique production knowledge or managerial skill (horizontal integration), (2) to gain control over a foreign source of a needed raw material or a foreign marketing outlet (vertical integration), (3) to avoid import tariffs and other trade restrictions and/or to take advantage of production subsidies, (4) to enter a foreign market to share in its profits, (5) to acquire a foreign firm in order to avoid future competition, or (6) because of unique ability to obtain financing.

4. 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 cannot 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.

5. a. The share of national income going to labor decreases while that going to capital increases in the investing nation.

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b. The increase in the share of national income going to capital increases more than the fall in the relative share going to labor. Therefore, the investing nation as a whole benefits (i.e., it average national income increases). The nation receiving the foreign capital will also experience a net increase in average national income.

6. Some of the alleged problems created by multinational corporations in the home country are the export of domestic jobs, erosion of the home nation’s technological advantage, avoidance of domestic taxes through transfer pricing, and reduced government control over the domestic economy.

7. a. Host countries complain multinational corporations operating in the nation lead to a loss of sovereignty and domestic research activity, tax avoidance, the utilization of inappropriate technology, and most benefits flowing to the home nation. b. Host countries try to minimize the alleged harmful effects of multinationals operating in the country by and increase the possible benefits in a variety of ways. Some nations, such as Canada, impose higher taxes on foreign affiliates with less than 25 percent Canadian interest. Other nations, such as India, specify the sectors in which direct foreign investments are allowed and set rules to regulate their operation. Some developing nations allow only joint ventures (i.e., local equity participation) and set rules for the transfer of technology and the training of domestic labor, impose limits on the use of imported inputs and the remission of profits, set environmental regulations, and so on.

8. The data to update Table 9.6 are found in the World Investment Report published yearly by the United Nations for the most recent year.

9. 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.

10. a. International labor migration can occur for economic and non-economic reasons. When the decision to migrate is economic, it can be evaluated in terms of costs and benefits just as any other investment in human and physical capital. b. International migration tends to increases real wages in the nation of emigration and to reduce them in the nation of immigration, at least in the short run. This is why U.S. labor generally opposes immigration. Over time, however, migration is likely to benefit both the nation of emigration and the nation of immigration because of the better utilization of world labor.

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m: 1. Portfolio investments refer primarily to: a. direct investments b. bonds c. liquid assets d. short-term assets 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 2009 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 2009 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 .

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b. to maximize profits and diversify risks c. to stimulate development d. to avoid tariffs 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 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 .

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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

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ADDITIONAL ESSAYS AND PROBLEMS FOR PART THREE 1. (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. (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.

2. (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.

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(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.

3. 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 the 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. .

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*CHAPTER 10 (Core Chapter) BALANCE OF PAYMENTS OUTLINE 10.1 Introduction 10.2 The Balance of Payments: Definition and Use 10.3 Balance-of-Payments Accounting Principles: Credits and Debits 10.4 Double-Entry Bookkeeping 10.5 The International Transactions of the United States Case Study 10-1 The Major Goods Exports and Imports of the United States 10.6 Accounting Balances and Disequilibrium in International Transactions 10.7 Measuring Deficits or Surpluses in the Balance of Payments 10.8 The Postwar Balance of Payments of the United States Case Study 10-2 The Major Trade Partners of the United States Case Study 10-3 The U.S. Trade Deficit with Japan Case Study 10-4 The Exploding U.S. Trade Deficit with China 10.9 The International Investment Position of the United States Case Study 10-5 The United States as a Debtor Nation

KEY TERMS Balance of payments Credit transactions Debit transactions Capital inflow Capital outflow Double-entry bookkeeping Unilateral transfers Statistical discrepancy

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Current account Capital account Deficit in the balance of payments Official reserve account Surplus in the balance of payments Official settlements balance Autonomous transactions Accommodating transactions International investment position

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LECTURE GUIDE: 1. In the first lecture, I would cover sections 1-4. The average student usually finds the meaning of financial inflows and outflows particularly difficult to understand. Therefore, I would pay special care in presenting the material in section 3. I would also assign problems 1-8.

2. In the second lecture, I would over problems 1-8 and cover sections 5-7 and stress the meaning and measurement of balance of payments deficits and surpluses.

3. In the third lecture, I would cover sections 8 and 9. Case studies 10-2 to 10-5 are likely to provide interesting class discussion.

ANSWERS TO REVIEW QUESTIONS AND PROBLEMS: 1. a. The U.S. debits its current account by $500 (for the merchandise imports) and credits financial by the same amount (for the increase in foreign assets in the U.S.). b. The U.S. credits financial by $500 (the drawing down of its bank balances in London, a capital inflow) and debits financial 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). c. 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 the financial account by the same amount. b. The U.S. credits its current account by $100 and debits financial account 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. b. The net result is the same, but the transaction in part a of this problem refers to "tied" aid while transactions a and b in problem 2 do not.

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

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

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

10. a. The benefit that the United States received from becoming a net debtor nation is that the United States utilized foreign capital to finance some of its investments (thus allowing it to grow faster) and some of its public consumption (public debt) without the need to increase interest rates, which would have slowed growth. b. The risk that the United States faces in becoming a net debtor nation is that foreigners may suddenly stop investing in the United States and financing the public debt. That would cause a financial crisis in the United States and a sharp increase in interest rates.

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. financial 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 .

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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. financial d. official reserves 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 financial 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. financial 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) .

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10. When a U.S. resident (1) purchases a foreign treasury bill and pays by (2) drawing down his bank balances abroad: a. debits short-term capital 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 the short-term financial account and debits official reserves 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. 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 13. Accommodating items are: a. transactions in official reserve assets b. the items below the line c. needed to balance international transactions d. all of the above 14. 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 15. Which of the following statements is correct with regard to the United Stated becoming a net debtor nation a. it allowed the United States to grow faster b it helped finance some of the U.S. budget deficits c. it created the risk that foreigners may suddenly withdraw their investments in the U.S. .

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d. all of the above.

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*CHAPTER 11 (Core Chapter) THE FOREIGN EXCHANGE MARKET AND EXCHANGE RATES

OUTLINE 11.1 Introduction 11.2 Functions of the Foreign Exchange Market Case Study 11-1 The U.S. Dollar as the Dominant International Currency Case Study 11-2 The Birth of a New Currency: The Euro 11.3 Equilibrium Exchange Rates 11.4 Cross Exchange Rates, Effective Exchange Rates, and Arbitrage Case Study 11-3 Foreign Exchange Quotations Case Study 11-4 The Effective Exchange Rate of the Dollar 11.5 The Exchange Rate and the Balance of Payments 11.6 Spot and Forward Exchange Rates 11.7 Foreign Exchange Futures and Options 11.8 Foreign Exchange Risks 11.9 Hedging 11.10 Speculation 11.11 Interest Arbitrage Case Study 11-5. Eurocurrency or Offshore Financial Market

KEY TERMS Foreign exchange market Euro Exchange rate Depreciation Appreciation Cross exchange rates Effective exchange rate Arbitrage Spot rate Forward rate Forward discount Forward premium Foreign exchange futures Foreign exchange option

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Foreign exchange risk Hedging Speculation Stabilizing speculation Destabilizing speculation Interest arbitrage Uncovered interest arbitrage Covered interest arbitrage Eurocurrency Eurocurrency market Offshore deposits Eurobonds Euronotes

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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 Sections 11.1 to 11.3 in the first class, Sections 11.4 and 11.5 in the second, Sections 11.6 and 11.7 in the third, Sections 11.8 to 11.10 in the fourth, and 11.11 in the fifth.

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 11.11 on interest arbitrage is also challenging but very important and so I would take a whole class period to cover it slowly and carefully.

ANSWERS TO REVIEW QUESTIONS AND PROBLEMS: 1. a. The equilibrium exchange rate would be $1.50 = €1. b. The equilibrium quantity demand and supplied of euros would be €100 million.

2. a. The equilibrium exchange rate would be $0.50 = €1. b. The equilibrium quantity demand and supplied of euros would be €350 million.

3. a. The United States would have a surplus in its balance of payments. b. The surplus would be €350 million (HC in Figure 11.1).

4. 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.

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

6. The exporter would have to sell forward £1 million for delivery in three months at today’s FR=$1.96/£1.

After three months, the exporter will deliver the £1 million and receive $1,960,000.

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

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for delivery in three months at FR=$2/£1.

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

8. a. The speculator can speculate in the forward exchange market by selling pounds forward. b. If the speculator is right, he will earn 5c per pound transferred. c. If, on the other hand, SR=$2.05/£1, the speculator will lose 5c per pound.

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

10.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.

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 euro 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 euro d. none of the above 4. A shortage of euros with flexible exchange rates results in:

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a. a depreciation of the euro 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. a flexible exchange rate 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=$1.99/€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 euros 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 10. If the three-month FR=$1/€1 and a speculator anticipates that SR=$1.03/€1 in three months, he can earn a profit by: a. selling euros forward b. purchasing euros forward .

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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 London under covered interest arbitrage can take place if the interest differential in favor of London is: a. smaller than the forward discount on the pound b. equal to the forward discount on the pound c. larger than the forward discount on the pound 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 higher interest rate is usually at a a. forward discount b. forward premium c. covered interest arbitrage parity d. any of the above

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*CHAPTER 12 (Core Chapter) EXCHANGE RATE DETERMINATION OUTLINE 12.1 Introduction 12.2 Overview of Exchange Rate Determination 12.3 Trade or Elasticity Approach 12.4 Purchasing-Power Parity Theory Case Study 12-1 Absolute Purchasing Power in the Real World Case Study 12-2 Big MacCurrencies Case Study 12-3 Relative Purchasing Power in the Real World 12.5 The Monetary Approach to Exchange Rates Case Study 12-4 Nominal and Real Exchange Rates, and the Monetary Model 12.6 Asset or Portfolio Model of Exchange Rates 12.7 Exchange Rate Dynamics Case Study 12-5 Exchange Rate Overshooting of the U.S. Dollar 12.8 Exchange Rate Forecasting Case Study 12-6 The Euro Exchange Rate Defies Forecasting

KEY TERMS Trade or elasticity approach Purchasing-power parity (PPP) theory Absolute purchasing-power parity theory Law of one price Relative purchasing-power parity theory

Monetary model of exchange rates Nominal exchange rate Real exchange rate Asset or portfolio model of exchange rates Exchange rate overshooting

LECTURE GUIDE 1. This is another important and challenging core chapter. I would cover 2 sections in each of four classes.

2. Section 2 is a crucial section because it provides an overview of exchange rate determination.

3. Section 3 briefly examines the elasticity or trade approach to exchange rate determination.

This is a simple introduction to what will be examined in detail in Chapter 13.

4. Section 4 on the purchasing power-parity (PPP) theory is not too difficult and students will find .

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Case Study 2 particularly interesting.

5. Section 5 and section 6 examine, respectively, how exchange rates are determined according to the monetary and the asset or portfolio model. These are, of course, simplified version of the models that are fully developed in Chapter 15 of my more advanced International Economics text (10th ed., Wiley, 2010).

6. Section 7 on exchange rate overshooting can be challenging for students, especially the reason for the overshooting.

7. In covering Section 8 on empirical testing of the monetary and asset market or portfolio balance models and exchange rate forecasting it is important to clearly point out to students that even though empirical tests do lens much support the theories presented in the chapter, this does not mean that the theories are wrong or useless.

ANSWERS TO REVIEW QUESTIONS AND PROBLEMS 1. If economic growth increased in the EMU but not in the United States, the EMU would demand more U.S. exports and supply more euros to the United States, and this would lead to a reduction in the dollar/euro exchange rate (appreciation of the dollar).

2. If the price level increased in the United States less than in the EMU, the United States would find imports from the EMU more expensive while the EMU would find U.S. exports cheaper. This will reduce the U.S. demand for euros (the U.S. demand curve for euros shifts down and to the left) but increase the U.S. supply of euros (the U.S. supply curve for euros shifts down and to the right). Both of these effects would lead to a reduction in the dollar/euro exchange rate (dollar appreciation).

3. If the interest rate increased in the United States but remained unchanged in the European Monetary Union (EMU), both the United States and the EMU would demand fewer euros. This would reduce the U.S. demand and increase the U.S. supply of euros and lead to a decline in the dollar/euro exchange rate (the dollar to appreciate).

4. If the expectation suddenly arises that the dollar will appreciate, U.S. and EMU investors would buy dollars with euros, now that the dollar is cheap in the anticipation of selling dollars for euros (and thus earn a profit) after the dollar appreciates. This would reduce the U.S. demand and increase the U.S. supply of euros, both of which cause a decrease in the dollar/euro exchange rate (an appreciation of the dollar).

5. If growth, inflation, and interest rates increase in the United States but not in the European Monetary Union, the effect on the dollar/euro exchange rate depends on the net effect of these changes on the U.S. demand and supply curve.

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a. The absolute purchasing-power parity theory postulates that the equilibrium exchange rate between two currencies is equal to the ratio of the price levels in the two nations, so that a given commodity would have the same price in the two countries when expressed in terms of the same currency (the law of one price).

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The absolute PPP theory would hold only if there were no transportation costs, tariffs or other obstructions to the free flow of trade; if all commodities were traded internationally; and if no structural changes (such as wars) took place in the United States and the EMU. Since these assumptions do not hold in the real world, the absolute version of the PPP cannot be taken seriously. Whenever the purchasing-power parity theory is used, it is usually in its relative formulation. b. The relative purchasing-power parity theory postulates that the percentage change in the exchange rate is equal to the difference in the percentage change in the two countries' general price levels (as long as there are no changes in transportation costs, obstructions to trade, ratio of traded to nontraded goods, and in the structure of the two economies). c. Empirical tests indicate that relative purchasing power-parity (PPP) holds reasonably well only in the long run.

7. a. The rate of inflation in the United Kingdom from 1973 to 2003 was:

On the other hand, the rate of inflation in the United States from 1973 to 2003 was:

Thus, the inflation rate in the United Kingdom minus the inflation rate in the United States from 1973 to 2003 was: 154.0% - 122.5 = 31.5% From 1973 to 2003, the British pound depreciated with respect to the U.S. dollar from £0.4304 to the dollar in 1973 and £0.5975 per dollar in 2003 or by

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 problem, so that students would get as to get the same answer as given above. b. The relative PPP theory did hold because the rate of inflation was higher in the United Kingdom than in the United States by almost the exact percentage by which the pound depreciated with respect to the dollar from 1973 to 2003.

8. a. According to the monetary model, an increase in the nation’s money supply leads to a proportionate increase in prices and depreciation of the nation’s currency in the long run, as postulated by the PPP theory. This means that the nominal and real exchange rates of the nation’s currency should move together by the same percentage over time. .

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b. Empirical tests do not lend much support to the monetary model of exchange rates. One reason for this is that the monetary approach does not include all of the factors that affect the exchange rate.

9. a. The asset or portfolio model postulates that an increase in a nation's money supply leads to an immediate decline in the interest rate in the nation and to a shift from domestic bonds to the domestic currency and to foreign bonds. The shift from domestic to foreign bonds causes an immediate depreciation of the home currency as individuals and firms exchange domestic for foreign currency in order to purchase more foreign bonds. b. The asset or portfolio model of exchange rates differs from the monetary model by postulating that the exchange rate is determined in the process of equilibrating or balancing the stock or total demand and supply of financial assets (of which money is only one, as in the monetary approach) in each country. It also brings trade explicitly into the analysis. d. Although theoretically superior to the monetary approach, empirical tests do not lend much support to the asset or portfolio model of exchange rates either.

10. The asset or portfolio model postulates that an increase in a nation's money supply leads to an immediate decline in the interest rate and shift from domestic to foreign bonds. This causes an immediate depreciation of the nation’s currency. Over time, this leads to a trade surplus and an appreciation of the domestic currency, which neutralizes part of its original depreciation, thus explaining the exchange rate overshooting often observed in the real world.

MULTIPLE-CHOICE QUESTIONS: 1. If growth increased in the United States but not in the European Monetary Union (EMU) the dollar would: a. depreciate b. appreciate c. the dollar/euro exchange rate would remain unchanged d. any of the above 2. If growth increased in the in the European Monetary Union (EMU) but not in the United States, the dollar would: a. depreciate b. appreciate c. the dollar/euro exchange rate would remain unchanged d. any of the above 3. A more rapid increase in prices in the United States than in the European Monetary Union (EMU) would lead to a. a decrease in the U.S. demand for euros and an increase in the U.S. supply of .

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euros b. an increase in the U.S. demand and supply of euros c. a decrease in the U.S. demand and supply of euros d. an increase in the U.S. demand for euros and a decrease in the U.S. supply of euros 4. A faster price increase in the United States than in the European Monetary Union (EMU) will lead to a. a dollar depreciation b. a dollar appreciation c. the dollar/euro exchange rate to remain unchanged d. any of the above 5. An increase in the interest rate in the United States but not in the European Monetary Union would lead to a. an increase in the U.S. demand for euros and a decrease in the U.S. supply of euros b. an increase in the U.S. demand and supply of euros c. a decrease in the U.S. demand and supply of euros d. a decrease in the U.S. demand for euros and an increase in the U.S. supply of euros 6. An increase in the interest in the United States but not in the European Monetary Union (EMU) will lead to a. a dollar depreciation b. a dollar appreciation c. the dollar/euro exchange rate to remain unchanged d. any of the above 7. The expectation that the U.S. will appreciate in the future would lead to a. a decrease in the U.S. demand for euros and an increase in the U.S. supply of euros b. an increase in the U.S. demand for euros and a decrease in the U.S. supply of euros c. an increase in the U.S. demand and supply of euros d. a decrease in the U.S. demand and supply of euros 8. The expectation that the U.S. will appreciate in the future would lead to a. a dollar depreciation b. a dollar appreciation c. the dollar/euro exchange rate to remain unchanged d. any of the above 9. An increase in the U.S. growth rate, inflation, and interest rate relative to the European Monetary Union (EMU) would lead to a. a dollar depreciation b. a dollar appreciation .

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c. the dollar/euro exchange rate to remain unchanged d. any of the above 10. 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 11. 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 percentage change in the exchange rate over a period of time is equal to the difference in the percentage 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 12. 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 13. According to the monetary model, an increase in the nation’s supply of money leads to: a. a depreciation of the foreign currency b. an appreciation of the domestic currency c. depreciation of the domestic currency d. depreciation of both the foreign and domestic currencies 14. The asset market or portfolio model: a. can be regarded as an extension of the monetary model b. deals with money and other domestic and foreign financial assets c. can more readily be extended than the monetary model to deals with the real sector d. all of the above 15. According to the asset market or portfolio model, an expected appreciation of the foreign currency leads to:

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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 with flexible exchange rates? 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 all the entries in the balance of payments are included (including 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 zero would the nations' balance of payments be in equilibrium. b. If total debits exceed total credits in the current and financial 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 financial 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 financial 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 fromand 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 flexible exchange rate system because 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. 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.

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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 three-month foreign 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 three-month foreign 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. 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 fall 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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*CHAPTER 13 (Core Chapter) AUTOMATIC ADJUSTMENTS WITH FLEXIBLE AND FIXED EXCHANGE RATES OUTLINE 13.1 Introduction 13.2 Adjustment with Flexible Exchange Rates 13.3 Stability of the Foreign Exchange Market Case Study 13-1 Price Elasticities in International Trade Case Study 13-2 Effective Exchange Rate of the Dollar and the U.S. Current Account Balance 13.4 Adjustment with Fixed Exchange Rates: The Gold Standard 13.5 Income Determination in a Closed Economy 13.6 Income Determination in an Open Economy Case Study 13-3 Income Elasticity of Imports Case Study 13-4 Savings, Investments, and Current Account Balance in the Leading Industrial Nations 13.7 Foreign Repercussions 13.8 Absorption Approach 13.9 Synthesis of Automatic Adjustments with Flexible and Fixed Exchange Rates Case Study 13-5 Interdependence in the World Economy KEY TERMS Stable foreign exchange market Unstable foreign exchange market Marshall–Lerner condition J-curve effect Pass-through effect Gold standard Mint parity Gold export point Gold import point Rules of the game of the gold standard

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Price-specie-flow mechanism Equilibrium level of income Multiplier (k) Foreign trade multiplier (k’) Foreign repercussions Absorption approach Synthesis of automatic adjustments Quantity theory of money

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

2. I would cover sections 1-3 in the first lecture, paying particular attention to Figures 13.1 and 13.2. I would explain the J-curve and the pass-through effect with Case Study 2 on the effective exchange rate of the dollar and the U.S. current account balance.

3. In the second lecture I would cover Sections 4-6. Section 4 deals with the gold standard and it is important because other fixed exchange rate systems operate (or are supposed to operate) in a similar way. Section 5 is a review of Keynesian economics from principles of economics, but my experience is that students need this review very much. Section 6 deals with open economies which is, of course, one of the major aims of the chapter.

4. In the third lecture, I would cover the remainder of the chapter. Section 7 examines foreign repercussions without presenting foreign trade multipliers with foreign repercussions because they are very complex and unnecessary for understanding the importance of foreign repercussions. Section 8 deals with the absorption approach and is very important because it provides synthesis of the automatic price and income adjustment mechanisms. Section 9 then provides overview of automatic adjustments under flexible and fixed exchange rates, including their disadvantages.

ANSWER TO REVIEW QUESTIONS AND PROBLEMS: 1. a. A depreciation is inflationary because the country needs more of its currency to purchase each unit of the foreign currency. Therefore, even if the foreign price of a foreign good remains unchanged, it will cost more for the nation to purchase in terms of the domestic currency. b. If the nation’s demand and supply curve of the foreign currency are inelastic, a depreciation will not be feasible to correct a deficit in the nation’s balance of payments because the depreciation will be very inflationary (and thus create an inflation problem for the nation, which may worse than its balance-of-payments deficit problem).

2. Even if a nation’s trade deficit does not fall as a result of a depreciations of the nation’s currency, this does not mean that the trade or elasticity approach to balance-of-payments adjustment does not work. Without the depreciation, the nation’s trade deficit could have been much greater. Furthermore, a nation’s balance of payments depends on many other factors, such as the rate of growth and the savings rate of a nation in relation to its trade partners’.

3. a. A depreciation of a nation’s currency from a position of full employment will lead to excess demand in the nation (as the nation tries to produce more exports and import substitutes) and inflation unless domestic absorption (consumption and investments) are somehow reduced. b. Domestic absorption is reduced if the depreciation of the nation’s currency (1) redistributes income from wages to profits (since profits earners usually have a higher marginal propensity to save than wage earners), (2) increases in domestic prices and reduces wealth, and hence expenditures in the nation, and (3) leads to inflation which pushes people into higher tax brackets and results in reduced consumption. .

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4. 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 45o line.

5. a. S = -100 + 0.2Y. The saving function is obtained by subtracting vertically the consumption function from the 45o 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.

6. a. See Figure 3 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/s = 1/0.2 = 5.

7. S+M = -100+0.2Y + 150+0.2Y = 50+0.4Y I+X = 100+350 = 450 50+0.4Y = 450; therefore, YE=400/0.4=1000.

8. See Figure 4.

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.

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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 5 on the next page.

b. I'+X=650 YE'=1500 X-M=350-450=-100 See Figure 6.

c. X'+I'=550+300=850 50+0.4Y=850 therefore, YE"=2000 At YE"=2000, M=150+0.2Y=150+(0.2)(2000)=550 X'-M=550-550=0 See Figure 7.

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MULTIPLE-CHOICE QUESTIONS: 1. The more elastic is a nation's demand and supply of foreign exchange the: a. larger is the depreciation required to correct a deficit of a given size in the nation's balance of payments b. smaller is the 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. none of the above 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. demand and supply curves for the nation’s imports in terms of the foreign currency d. demand and supply curves for the nations’ exports in terms of the foreign currency 3. 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 4. 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 5. 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 6. 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 .

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is prevented from moving outside the gold points by gold shipments d. all of the above 7. 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 8. 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 9. If MPS=0.2 and MPM=0.3, the foreign trade multiplier is: a. 5 b. 3.3 c. 3 d. 2 10. 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 11. 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 12. 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 13. The improvement in a nation's balance of trade and payments resulting from a depreciation .

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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 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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*CHAPTER 14 (Core Chapter) ADJUSTMENT POLICIES OUTLINE 14.1 Introduction 14.2 National Objectives and Policies 14.3 Policies to Achieve Internal and External Balance with Fixed but Changeable Exchange Rates 14.4 Effect of Monetary Policy on Internal and External Balance Under Fixed Exchange Rates 14.5 Effect of Fiscal Policy on Internal and External Balance Under Fixed Exchange Rates 14.6 Policy Mix for Internal and External Balance Under Fixed Exchange Rates Case Study 14-1 Relationship between U.S. Current Account and Budget deficits 14.7 Effect of Monetary and Fiscal Policies on Internal Balance Under Flexible Exchange Rates 14.8 Correcting Unemployment with Inflation Case Study 14-2 Effect of U.S. Monetary Policy 14.9 Policy Mix in the Real World Case Study 14-3 U.S. Monetary and Fiscal Policies During the Past decade Case Study 14-4 The U.S. Recession Would Have Been Deeper Without Strong Fiscal and Monetary Action 14.10 Direct Controls Case Study 14-5 Direct Controls on International Transactions Around the World

KEY TERMS Internal balance External balance Expenditure-changing policies Expenditure-switching policies

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Trade controls Exchange controls Multiple exchange rates

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LECTURE GUIDE: 1. This is one of the most important and challenging chapter.

2. In the first class, I would cover Sections 14.1 to 14.3. The objective of nations in Section 14.2 is likely to generate a great deal of class discussion. What needs to be pointed out is that in a course of international economics, we can only deal explicitly only with the objectives of full employment with price stability and equilibrium in the balance of payments.

3. What needs also to be pointed out is that, at least initially, we will deal only demand-pull inflation, where prices being to rise only after the economy has reached full employment. This type of inflation arises from excess aggregate demand and, as such, it is the opposite of recession of unemployment. This is the type of inflation which advanced economies are more likely to face today than in the 1970s and 1980s.

4. Finally, students need to clearly understand why nations have generally been unwilling to change their exchange rate even when faced with large and persistent (fundamental) balance of payments disequilibrium, so that they are then forced to try to achieve internal and external balance only with fiscal and monetary policies.

5. In the second class, I would cover Sections 14.4 to 14.6. These deal with the effectiveness of monetary and fiscal policies under fixed exchange rates. It is crucial here to explain well why monetary policy is ineffective while fiscal policy is effective. This will reconnect the student with the material covered in Chapter 13.

6. The most difficult part in the explanation of why fiscal policies are relatively more effective in correcting the internal imbalance while monetary policy is relatively more effective in correcting the external imbalance.

7. In the third class, I would cover the remainder of the chapter dealing with correcting unemployment with inflation, the policy mix in the real world, and direct controls. These topics as well as the case studies in these sections are also likely to generate a great deal of class discussion.

ANSWER TO REVIEW QUESTIONS AND PROBLEMS: 1. Nations need policies to adjust a balance-of-payments disequilibrium when they are large and persistent. If they do not, they will run out of international reserves under a fixed exchange rate system or will face a continuously depreciating currency, which is inflationary.

2. a. The most important economic goals or objectives of nations are (1) internal balance, (2) external balance, (3) a reasonable rate of growth, (4) an equitable distribution of income, and (5) adequate protection of the environment.

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b. In a course in international economics, we deal primarily with the objectives of internal and external balance. On the two, internal balance is clearly more important to the citizens and, thus to the government, of the nation.

3. a. To achieve internal balance the nation can use expenditure-changing policies (i.e., fiscal and monetary policy) while to achieve external balance, the nation can use expenditureswitching policies (devaluation or revaluation). b. Expenditure-changing policies operate to increase production and income in the nation to correct recession and unemployment and to reduce production and income to correct inflation. On the other hand, expenditure-switching policies increase the demand for nation’s exports and reduce the nation’s demand for imports to correct a balance of payments deficit and work in the opposite direction to correct a surplus.

4. a. When the nation faces a recession and a balance of payments deficit and the nation is not willing to change the exchange rate, the nation should use expansionary fiscal policy to correct the internal imbalance and contractionary monetary policy to correct the balance of payments deficit. b. By increasing government expenditures and/or reducing taxes, expansionary fiscal policy increases domestic production and income, and cures the recession. Contractionary monetary policy reduces the money supply and increases the rate of interest in the nation.

This attracts financial inflows and improves the nation’s capital account. The increase in the interest rate also reduces domestic investments and income, and thus imports, so that the current account of the nation also improves. c. Although there seems to be a conflict between the expansionary fiscal policy and the contractionary monetary policy, they will still work to correct the internal and external imbalances. The reason is that fiscal policy is relatively more effective in dealing with the internal imbalance while monetary policy is relatively more efficient in correcting the external imbalance. Because of this, these two opposing policies do not neutralize each other, but leave a net effect on the target toward which the policy is directed.

5. a. The “assignment rule” refers to directing a policy toward the objective toward which it is relatively more efficient. This is internal balance for fiscal policy and external balance for monetary policy. b. It is important to follow the assignment rule because, if is not followed, the policies will increase rather than reduce or eliminate the internal and external imbalances.

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6. Monetary is policy completely ineffective to achieve internal balance with perfect international financial mobility under fixed exchange rates because trying to cure a recession using monetary policy would lead to a balance of payments deficit, which the nation must cover out of its international reserves. Otherwise, the currency depreciates and the nation would have to abandon the fixed exchange rate system. But intervening in the foreign exchange market to purchase the domestic currency with its international reserves, however, reduces the nation’s money supply and eliminates all of the increase in the money supply of the expansionary monetary policy.

7 a. If the nation operates with flexible exchange rates and international financial mobility is not perfect, then the nation should use expansionary monetary policy to correct the recession.

Fiscal policy will not be effective in the short run because an expansionary fiscal policy will increase production and income but it will also increase the interest rate in the nation and lead to a financial inflow, which causes an appreciation of the nation’s currency thus dampening the increase in production and income from the expansionary fiscal policy. b. With perfect international financial mobility, monetary policy will become all-powerful, while fiscal policy becomes completely ineffective in the short run.

8. a. To correct a recession and a balance of payments deficit when the nation also faces inflation, the nation could use fiscal policy to correct the recession, contractionary monetary policy to correct inflation, and leave to flexible exchange rate the function of correcting the deficit in the nation’s balance of payments and keeping it in equilibrium. b. If the nation operates with a fixed exchange rate, the nation will have to devalue its currency to correct the balance of payments deficit. One (much less preferable) alternative would be to use price and wage controls.

9. The difficulties in using policies is that it may take time to decide on them and then for them to operate or bring about results, by the time this occurs, the problem may have been resolved, so that the policy will actually create instability. Then, here is the possibility of adopting the wrong policies.

Automatic adjustments do not have these problems, but they have shortcomings of their own.

Thus, the relative advantages and disadvantages of automatic adjustments relative to adjustment policies must be evaluated, and these may depend on the particular type of country and situation in which the country finds itself.

10. a. The advantage of direct controls is that they operate on the balance of payments item that is creating a problem. Alternative policies may also not be readily available. b. The disadvantage of direct controls is that they interfere with the efficient operation of markets and usually result in great inefficiency.

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MULTIPLE-CHOICE QUESTIONS: 1. The most important economic objective of advanced 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: a. one policy b. two policies c. three policies d. cannot say 3. To correct a recession and a balance of payments deficit a nation usually requires: a. contractionary fiscal and monetary policies and a devaluation b. contractionary fiscal and monetary policies and a revaluation c. expansionary fiscal and monetary policies and a devaluation d. expansionary fiscal and monetary policies and a revaluation 4. To correct inflation and a balance of payments surplus a nation usually requires a: a. contractionary fiscal and monetary policies and a devaluation b. contractionary fiscal and monetary policies and a revaluation c. expansionary fiscal and monetary policies and a devaluation d. expansionary fiscal and monetary policies and a revaluation 5. To correct a recession and a balance of payments surplus a nation requires: a. expansionary fiscal and monetary policies and a devaluation b. expansionary fiscal and monetary policies and a revaluation c. contractionary fiscal and monetary policy and either a devaluation or a revaluation d. expansionary fiscal and monetary policy and either a revaluation or a devaluation 7. To inflation and correct a balance of payments deficit a nation requires: a. contractionary fiscal and monetary policies and a devaluation b. expansionary fiscal and monetary policies and a devaluation c. contractionary fiscal and monetary policy and either a devaluation or a revaluation d. expansionary fiscal and monetary policy and either a devaluation or a revaluation

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8. During the 1950s and 1960s nation were a. unwilling to devalue b. unwilling to revalue c. devaluation was regarded as a sign of failure d. all of the above 9. With fixed exchange rates a. fiscal policy is effective and monetary policy is not b. monetary policy is effective but fiscal policy is not c. both fiscal and monetary policy are about equally effective d. neither fiscal no monetary policy is effective 10. With flexible exchange rates a. fiscal policy is effective and monetary policy is not b. monetary policy is effective but fiscal policy is not c. both fiscal and monetary policy are about equally effective d. neither fiscal no monetary policy is effective 11. Fixed exchange rates and perfect financial mobility a. makes fiscal policy completely ineffective b. makes monetary policy very effective c. makes fiscal policy very effective d. increases the effectiveness of both fiscal and monetary policy 12. With flexible exchange rates and perfect capital mobility 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 a recession and a balance of payments deficits with flexible exchange rates and imperfect financial 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. When inflation occurs before full employment is reached, the nation faces the following targets: a. full employment and equilibrium in the balance of payments b. full employment, balance of payments equilibrium, and an equitable distribution of income c. full employment, price stability, and balance of payments equilibrium d. full employment, price stability ,and an equitable distribution of income .

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15. Direct controls refer to: a. tariffs, quotas, and other quantitative restrictions on the flow of international trade b. restrictions on international financial flows c. multiple exchange rates d. all of the above

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 a 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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(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 demand-increasing 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 financial 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.

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*CHAPTER 15 (Core Chapter) FLEXIBLE VERSUS FIXED EXCHANGE RATES, EUROPEAN MONETARY SYSTEM, AND MACROECONOMIC POLICY COORDINATION OUTLINE 15.1 Introduction 15.2 Fixed Versus Flexible Rates: An Overview 15.3 The Case for Flexible Exchange Rates 15.4 The Case for Fixed Exchange Rates Case Study 15-1 Macroeconomic Performance under Fixed and Flexible Exchange Rate Regimes 15.5 Optimum Currency Areas 15.6 European Monetary System and Transition to Monetary Union Case Study 15-2 Maastricht Convergence Indicators 15.7 The Creation of the Euro, the European Central Bank, and the Common Monetary Policy Case Study 15-3 Benefits and Costs of the Euro 15.8 Currency Board Arrangements and Dollarization Case Study 15-4 Argentina’s Currency Board Arrangements and Crisis 15.9 Adjustable Pegs, Crawling Pegs, and Managed Floating Case Study 15-5 Exchange Rate Arrangements of IMF Members 15.10 International Macroeconomic Policy Coordination

KEY TERMS Freely floating exchange rate system or clean Euro float European Central Bank (ECB) Optimum currency area or bloc Currency board arrangements (CBAs) European Monetary System (EMS) Dollarization European Currency Unit (ECU) Adjustable peg system European Monetary Cooperation Fund (EMCF) Crawling peg system European Monetary Institute (EMI) Managed floating exchange rate system or dirty Maastricht Treaty float Growth and Stability Pact (GSP) International macroeconomic policy European Monetary Union (EMU) coordination

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LECTURE GUIDE 1. This chapter (non-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, currency board arrangements, dollarization, and international macroeconomic cooperation. It is an important chapter but if time is short , I would omit it, except for sections 15.7 to 15.10.

2. If I were to cover the entire chapter, I would cover sections 1 to 4 in the first lecture, section 5 to 7 in the second lecture, and sections 8-10 in the third lecture.

ANSWERS TO REVIEW QUESTIONS AND PROBLEMS 1. (a) The advantages of a fixed exchange rate system are lower uncertainty, the belief that speculation is more likely to be stabilizing, and being less inflationary. Advocates of flexible exchange rates disagree. They point out that destabilizing speculation is less likely to occur when exchange rates adjust continuously than when they are prevented from doing so until a large discrete adjustment can no longer be avoided. They do admit, however, that flexible exchange rates are more likely to be inflationary and to lead to greater exchange rate volatility. (b) Whether flexible or fixed exchange rates are better depends, to a large extent, on the nation involved and the conditions under which it operates. In general, a fixed exchange rate is preferable if disturbances are predominantly monetary (such as inflation), while a flexible exchange rate is preferable if disturbances are predominantly real (such as a change in technology) and originate abroad.

2. See the figure below.

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3. (a) An optimum currency area involves permanently fixed exchange rates as well as common monetary and fiscal policies among its members. There are no such implications for countries which are connected only by fixed exchange rates. (b) The main advantages of an optimum currency area for a nation are greater price stability and thus stimulating the specialization in production and the flow of trade and investments among member nations. An optimum currency area also encourages producers to view the entire area as a single market and to benefit from greater economies of scale in production. (c) The requirements for a well-functioning optimum currency area are a great deal of labor mobility, structural similarities, and willingness to closely coordinate their fiscal and other policies.

4. The benefits on EMU countries from the adoption of the euro are: (1) elimination of the need to exchange currencies among euro-area members; (2) elimination of exchange rate volatility among the currencies of participating countries; (3) more rapid economic and financial integration of participating nations; (4) participation in determining EMU’s monetary policy; (5) greater economic and budgetary discipline; (6) seignorage from the use of the euro; (7) reduced cost of borrowing in international financial markets; and (8) increased economic and political importance in international affairs. The most serious problem created by the adoption of the euro for the participating countries arises from being unable to conduct an independent monetary policy.

5. (a) Under a fixed exchange rate system, the nation fixes the exchange rate and intervenes in the foreign exchange market to keep the exchange rate within narrowly defined limits. (b) Under a currency board arrangement, the nation rigidly fixes the exchange rate and its central bank loses its ability of conducting an independent monetary policy by allowing the nation’s supply to increase or decrease only in response to balance-of-payments surpluses or deficits. (c) With dollarization the nation adopts another nation’s currency as its legal tender.

6. Under a crawling peg system, nations change their exchange rates by small amounts at frequent specified intervals. This avoids destabilizing speculation that often arises under an adjustable peg system where nations change their exchange rates reluctantly and only when forced by market conditions, thus generating destabilizing speculation.

7. (a) Under a managed exchange rate system or dirty floating, monetary authorities intervene in foreign exchange markets to smooth out excessive exchange rate volatility. (b) The policy of leaning against the wind operates by a nation’s monetary authorities selling the foreign currency on the foreign exchange market to reduce the depreciation of the national currency and purchasing the foreign currency to reduce the appreciation of the national currency. (c) The major advantage of a managed floating exchange rate system with respect to a freely floating exchange rate is that it limits exchange rate volatility. The main advantage with respect to a fixed exchange rate system is that it corrects a balance of payments .

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disequilibrium by exchange rate changes rather than requiring changes in all internal prices in the nation.

8. A flexible exchange rate does 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 more expensive, thus preventing the importation of inflation from abroad.

In an integrated world financial market, however, inflationary policies by one nation will lower its interest rates and lead to capital outflows. Unless the trade partner is able to continuously sterilize its 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.

9. In a non-cooperative equilibrium, each nation is likely to follow a loose fiscal policy but a tight monetary policy in order to keep its interest rates up (thereby attracting foreign capital and keeping the international value of its currency high and 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 stimulate long-run growth.

10. (a) International macroeconomic policy coordination among the leading industrial countries is useful because it allows the adoption of some beneficial policies that a nation would not undertake alone. For example, with a worldwide recession, each nation may hesitate to stimulate its economy to avoid a deterioration of its trade balance. Through a coordinated simultaneous expansion of all nations, however, output and employment can increase in all nations without any of them suffering deterioration in its trade balance. (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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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. 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 4. Most economists believe that under "normal conditions" speculation: a. is stabilizing b. is destabilizing c. is neither stabilizing nor destabilizing d. seldom occurs 5. 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 6. Which of the following statements is correct with respect to flexible exchange rates? a. they insulate the domestic economy from external shocks 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

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7. 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 economic policies d. all of the above 8. 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 9. 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 10. The exchange rate system where a nation rigidly fixes the exchange rate of its currency to that of a trade partner and the nation gives up control over its money supply is called: a. adjustable peg b. currency board arrangement c. monetary union d. dollarization 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 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 .

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c. constantly d. we cannot say 13. The policy of changing par values by small pre-announced 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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*CHAPTER 16 (Core Chapter) THE INTERNATIONAL MONETARY SYSTEM: PAST, PRESENT, AND FUTURE OUTLINE 16.1 16.2 16.3 16.4 16.5

Introduction Meaning of International Monetary System The Gold Standard and the Interwar Experience The Bretton Woods System Operation and Evolution of the Bretton Woods System Case Study 16-1 Macroeconomic Performance Under Different Exchange Rate Regimes 16.6 U.S. Balance-of-Payments Deficits and Collapse of the Bretton Woods System 16.7 Operation of the Present International Monetary System 16.8 Problems with the Present Exchange Rate Arrangements and Proposals for Reforms 16.9 Financial Crises in Emerging Market Economies Case Study 16-2 The Anatomy of a Currency Crisis: The Collapse of the Mexican Peso Case Study 16.3 Chronology of Economic Crises in Emerging Markets: From Thailand to Argentina 16.10 The Global Financial Crisis Case Study 16.4 The Global Financial Crisis and Great Recession 16.11 Other Current International Economic Problems Case Study 16-5 Trade Imbalances of the Leading Advanced Countries KEY TERMS International monetary system Adjustment Liquidity Confidence International Monetary Fund (IMF) Bretton Woods System Intervention currency Fundamental disequilibrium Currency convertibility International Bank for Reconstruction and Development (IBRD or World Bank) International Development Association (IDA) International Finance Corporation Gold tranche Credit tranches Net IMF position General Arrangements to Borrow (GAB) .

Stadby aggangements Swap arrangements Special Drawing Rights (SDRs) Dollar shortage Seigniorage Dollar standard Smithsonian Agreement Dollar glut Jamaica Accords Benign neglect First credit tranche New Arrangements to Borrow (NAB) IMF conditionality Dollar overhang Substitution account Target zones Global financial crisis Group of Twenty (G-20) 16- 1

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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 the recent global financial crisis and proposals for reforms of the international monetary system..

2. I would cover Sections 16-1 to 16-4 in the first lecture, Sections 16-5 to 16-8 in the second lecture, and the rest of the chapter in the third lecture.

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, as well as the recent global financial crisis. Indeed, this will also serve a summary review of the course for the final.

ANSWERS TO REVIEW QUESTIONS AND PROBLEMS 1.

(a) The primary goal of nations today is internal balance, while during the heyday of the gold standard nations gave priority to external balance. The gold standard days were also characterized by much greater price flexibility than today. Furthermore, London was then the undisputed center of international trade and finance and as a result there were no destabilizing international capital flows, as frequently occur today between the different international monetary centers. (b) The reestablishment of the gold standard today would require the reestablishment of all the conditions that made for its smooth operation from 1880 until 1914. Nations would have to place priority on external over internal balance and give up their use of monetary policy. They would have to eliminate domestic restrictions on price flexibility (i.e., abolish price ceilings, minimum wages, interest restrictions, etc.), and reestablish the supremacy of one international monetary center (New York, Tokyo, or London) so as to avoid destabilizing capital flows among the international monetary centers in existence today.

Needless to say, this is impossible.

2.

(a) 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 IMF in any one year. (b) Today, the nation would pay 25 percent of its quota in SDRs or in currencies of other members selected by the IMF, and the rest in their own currency. Under the new rules in operation today, the nation can borrow a maximum of up to 50 percent of its quota in any one year plus additional amounts under the various programs to facilitate borrowing that the IMF has put in place over the years.

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3. (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.

4. 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.

5. (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.

6.

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.

7. (a) The fundamental reason for the Mexican currency crisis was that Mexico relied on keeping an overvalued exchange rate that would lead to a trade deficit and thus a capital inflow to help finance investments and growth. This worked fine until the middle of 1994 when investors began to doubt Mexico’s ability to repay foreign loans and thus withdrew their capital. This caused the international value of the Mexican pesos to fall sharply (i.e., to depreciate very heavily with respect to the dollar), inflation and interest rates to rise sharply, and the nation to plunge into deep recession. (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 increasing the amount that it could borrow in order to provide financial .

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assistance to those nations that do face a serious financial crisis.

8.

(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. (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.

9. (a)

All the economic crises in emerging market economies during the past decade 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 six emerging market crises: Mexico in 1994-5, SouthEast Asia in 1997-1999, Russia in summer 1998, Brazil in 1999, Turkey in 2001, and Argentina in 2002.

(b) Proposed solutions to avoid future crises in emerging market economies include: (1) Avoid over-borrowing of short-term funds (2) increased transparency in financial relations, (3) strengthening emerging markets’ banking and financial system, and (4) greater private sector involvement in rescue programs.

10. (a) The crisis that started in the U.S. housing sector in 2007 as a result as a result of banks giving huge amounts of (subprime) loans or mortgages to individuals and families who could not afford them. When many individual and families defaulted on their loans, U.S. banks fell into a deep crisis. (b) The crises spread from the United States to other advanced economies because many of their banks committed even more excesses than U.S. banks and faced even bigger housing bubbles than the United States. The crisis spread to emerging market economies because advanced economies cut drastically their imports from foreign direct investments to emerging market economies. (c) The crisis resulted in the deepest recession of the postwar period in most advanced economies, emerging and other developing economies. Growth resumed in most countries in 2010, but it was very slow in most advanced economies as evidenced by the persistent high unemployment, unsustainable budget deficits, and rapidly rising national debts. Most emerging and other developing economies fared better, with rapid growth and better fiscal conditions.

11. The problems arising from present exchange rate arrangements discussed above are closely related to other serious economic problems facing the world today. These are: .

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(1) slow growth and high unemployment in advanced economies after the great recession, (2) trade protectionism in advanced countries in the context of a rapidly globalizing world, (3) large structural imbalances in the United States and insufficient restructuring in transition economies of Central and Eastern Europe, (4) deep poverty in many developing economies, and (5) resource scarcity, environmental degradation, and climate change

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 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 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 .

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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 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? .

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Instructor’s Manual

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 14. Which of the following statements is false with regard to 12 countries of the European monetary Union: a. they have adopted a single currency b. they have established a single central bank c. they conduct a common fiscal policy d. they conduct a single monetary policy 15. Which of the following was not a cause of the recent global financial crisis a. financial regulations were not adequate b. the financial regulations that existed were not applied c. exchange rates were too stable d. greed and fraud 16. 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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ADDITIONAL ESSAYS AND PROBLEMS FOR PART FOUR 1. 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.

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 are very limited in the European Monetary Union as compared, for example, with the United States.

2. 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 freely-flexible exchange rate system is 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 grossly misaligned exchange rates. This 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.

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