Economics Homework

csht

EconomicsInternationalcopy.pdf

Home >Business & Finance homework help >Economics homework help >Economics Homework

International Economics

Sixteenth Edition

pug21774_fm_i-xxviii.indd ipug21774_fm_i-xxviii.indd i 12/8/14 8:59 PM12/8/14 8:59 PM

Final PDF to printer

ESSENTIALS OF ECONOMICS

Brue, McConnell, and Flynn

Essentials of Economics Third Edition

Mandel

Economics: The Basics Second Edition

Schiller

Essentials of Economics Ninth Edition

PRINCIPLES OF ECONOMICS

Colander

Economics, Microeconomics, and Macroeconomics Ninth Edition

Frank and Bernanke

Principles of Economics, Principles of Microeconomics, and Principles of Macroeconomics Fifth Edition

Frank and Bernanke

Brief Editions: Principles of Economics, Principles of Microeconomics, and Principles of Macroeconomics Second Edition

Karlan and Morduch

Economics, Microeconomics, and Macroeconomics First Edition

McConnell, Brue, and Flynn

Economics, Microeconomics, and Macroeconomics Twentieth Edition

McConnell, Brue, and Flynn

Brief Editions: Economics, Microeconomics, and Macroeconomics Second Edition

Miller

Principles of Microeconomics First Edition

Samuelson and Nordhaus

Economics, Microeconomics, and Macroeconomics Nineteenth Edition

Schiller

The Economy Today, The Micro Economy Today, and The Macro Economy Today Thirteenth Edition

Slavin

Economics, Microeconomics, and Macroeconomics Eleventh Edition

ECONOMICS OF SOCIAL ISSUES

Guell

Issues in Economics Today Seventh Edition

Sharp, Register, and Grimes

Economics of Social Issues Twentieth Edition

ECONOMETRICS

Gujarati and Porter

Basic Econometrics Fifth Edition

Gujarati and Porter

Essentials of Econometrics Fourth Edition

Hilmer and Hilmer

Practical Econometrics First Edition

MANAGERIAL ECONOMICS

Baye and Prince

Managerial Economics and Business Strategy Eighth Edition

Brickley, Smith, and Zimmerman

Managerial Economics and Organizational Architecture Sixth Edition

Thomas and Maurice

Managerial Economics Eleventh Edition

INTERMEDIATE ECONOMICS

Bernheim and Whinston

Microeconomics Second Edition

Dornbusch, Fischer, and Startz

Macroeconomics Twelfth Edition

Frank

Microeconomics and Behavior Ninth Edition

ADVANCED ECONOMICS

Romer

Advanced Macroeconomics Fourth Edition

MONEY AND BANKING

Cecchetti and Schoenholtz

Money, Banking, and Financial Markets Fourth Edition

URBAN ECONOMICS

O’Sullivan

Urban Economics Eighth Edition

LABOR ECONOMICS

Borjas

Labor Economics Seventh Edition

McConnell, Brue, and Macpherson

Contemporary Labor Economics Tenth Edition

PUBLIC FINANCE

Rosen and Gayer

Public Finance Tenth Edition

Seidman

Public Finance First Edition

ENVIRONMENTAL ECONOMICS

Field and Field

Environmental Economics: An Introduction Sixth Edition

INTERNATIONAL ECONOMICS

Appleyard and Field

International Economics Eighth Edition

King and King

International Economics, Globalization, and Policy: A Reader Fifth Edition

Pugel

International Economics Sixteenth Edition

The McGraw-Hill Series in Economics

pug21774_fm_i-xxviii.indd iipug21774_fm_i-xxviii.indd ii 12/8/14 8:59 PM12/8/14 8:59 PM

Final PDF to printer

International Economics

Sixteenth Edition

Thomas A. Pugel New York University

pug21774_fm_i-xxviii.indd iiipug21774_fm_i-xxviii.indd iii 12/8/14 8:59 PM12/8/14 8:59 PM

Final PDF to printer

INTERNATIONAL ECONOMICS: SIXTEENTH EDITION

2007. No part of this publication may be reproduced or distributed in any form or by any means, or stored in

a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not

limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the

United States.

This book is printed on acid-free paper.

1 2 3 4 5 6 7 8 9 0 DOC/DOC 1 0 9 8 7 6 5

ISBN 978-0-07-802177-0

MHID 0-07-802177-4

Senior Vice President, Products & Markets: Kurt L. Strand Vice President, General Manager, Products & Markets: Marty Lange Vice President, Content Design & Delivery: Kimberly Meriwether David Managing Director: James Heine Lead Product Developer: Michele Janicek Senior Product Developer: Christina Kouvelis Director of Marketing: Lynn Breithaupt Director, Content Design & Delivery: Linda Avenarius Senior Content Project Manager: Lisa Bruflodt Buyer: Laura M. Fuller Cover Image: Design Pics/Ryan Briscall Compositor: Laserwords Private Limited Printer: R. R. Donnelley

All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.

Library of Congress Cataloging-in-Publication Data

Pugel, Thomas A.

International economics/ Thomas A. Pugel.—Sixteenth edition.

pages cm

ISBN 978-0-07-802177-0 (alk. paper)

1. Commercial policy. 2. Foreign exchange. I. Title.

HF1411.L536 2016

337—dc23

2014040055

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does

not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not

guarantee the accuracy of the information presented at these sites.

www.mhhe.com

pug21774_fm_i-xxviii.indd ivpug21774_fm_i-xxviii.indd iv 12/9/14 6:49 PM12/9/14 6:49 PM

Final PDF to printer

In memory of my parents, Adele and Edmund, and my parents-in-law, Vivian and Freeman, with my deepest appreciation and gratitude for all that they did to benefit the generations that follow.

pug21774_fm_i-xxviii.indd vpug21774_fm_i-xxviii.indd v 12/8/14 8:59 PM12/8/14 8:59 PM

Final PDF to printer

About the Author

Thomas A. Pugel Thomas A. Pugel is Professor of Economics and Global Business at

the Stern School of Business, New York University, and a Fellow of

the Teaching Excellence Program at the Stern School. His research

and publications focus on international industrial competition and

government policies toward international trade and industry. Professor

Pugel has been Visiting Professor at Aoyama Gakuin University in

Japan and a member of the U.S. faculty at the National Center for

Industrial Science and Technology Management Development in China.

He received the university-wide Distinguished Teaching Award at New

York University in 1991, and twice he was voted Professor of the Year

by the graduate students at the Stern School of Business. He studied economics as

an undergraduate at Michigan State University and earned a PhD in economics from

Harvard University.

pug21774_fm_i-xxviii.indd vipug21774_fm_i-xxviii.indd vi 12/8/14 8:59 PM12/8/14 8:59 PM

Final PDF to printer

vii

Preface

International economics combines the excitement of world events and the incisiveness

of economic analysis. We are now deeply into the second great wave of globalization,

in which product, capital, and labor markets are becoming more integrated across

countries. This second wave, which began in about 1950 and picked up steam in the

1980s, has now lasted longer than the first, which began in about 1870 and ended with

World War I (or perhaps with the onset of the Great Depression in 1930).

As indicators of the current process of globalization, we see that international

trade, foreign direct investment, cross-border lending, and international portfolio

investments have been growing faster than world production. Information, data, and

rumors now spread around the world instantly through the Internet and other global

electronic media.

As the world becomes more integrated, countries become more interdependent.

Increasingly, events and policy changes in one country affect many other countries.

Also increasingly, companies make decisions about production and product develop-

ment based on global markets.

My goal in writing and revising this book is to provide the best blend of events

and analysis, so that the reader builds the abilities to understand global economic

developments and to evaluate proposals for changes in economic policies. The book

is informed by current events and by the latest in applied international research.

My job is to synthesize all of this to facilitate learning. The book

Combines rigorous economic analysis with attention to the issues of economic

policy that are alive and important today.

Is written to be concise and readable.

Uses economic terminology when it enhances the analysis but avoids jargon for

jargon’s sake.

I follow these principles when I teach international economics to undergraduates and

master’s degree students. I believe that the book benefits as I bring into it what I learn

from the classroom.

THE SCHEME OF THE BOOK The examples presented in Chapter 1 show that international economics is exciting

and sometimes controversial because there are both differences between countries and

interconnections among countries. Still, international economics is like other econom-

ics in that we will be examining the fundamental challenge of scarcity of resources—

how we can best use our scarce resources to create the most value and the most

benefits. We will be able to draw on many standard tools and concepts of economics,

such as supply and demand analysis, and extend their use to the international arena.

We begin our in-depth exploration of international economics with international

trade theory and policy. In Chapters 2–7 we look at why countries trade goods and

services. In Chapters 8–15 we examine what government policies toward trade would

bring benefits and to whom. This first half of the book might be called international

microeconomics.

pug21774_fm_i-xxviii.indd viipug21774_fm_i-xxviii.indd vii 12/8/14 8:59 PM12/8/14 8:59 PM

Final PDF to printer

viii Preface

Our basic theory of trade, presented in Chapter 2, says that trade usually results

from the interaction of competitive demand and supply. It shows how the gains that

trade brings to some people and the losses it brings to others can sum to overall

global and national gains from trade. Chapter 3 launches an exploration of what

lies behind the demand and supply curves and discovers the concept of comparative

advantage. Chapter 4 shows that countries have different comparative advantages for

the fundamental reason that people, and therefore countries, differ from each other

in the productive resources they own. Chapter 5 looks at the strong impacts of trade

on people who own those productive resources—the human labor and skills, the

capital, the land, and other resources. Some ways of making a living are definitely

helped by trade, while others are hurt. Chapter 6 examines how actual trade may

reflect forces calling for theories that go beyond our basic ideas of demand and sup-

ply and of comparative advantage. Chapter 7 explores some key links between trade

and economic growth.

Chapters 8–15 use the theories of the previous chapters to analyze a broad range

of government policy issues. Chapters 8–10 set out on a journey to map the border

between good trade barriers and bad ones. This journey turns out to be intellectu-

ally challenging, calling for careful reasoning. Chapter 11 explores how firms and

governments sometimes push for more trade rather than less, promoting exports

more than a competitive marketplace would. Chapter 12 switches to the economics

of trade blocs like the European Union and the North American Free Trade Area.

Chapter 13 faces the intense debate over how environmental concerns should affect

trade policy. Chapter 14 looks at how trade creates challenges and opportunities

for developing countries. Chapter 15 examines the economics of emigration and

immigration and the roles of global companies in the transfer of resources, including

technology, between countries.

The focus of the second half of the book shifts to international finance and

macroeconomics. In Chapters 16–21 we enter the world of different moneys, the

exchange rates between these moneys, and international investors and speculators.

Chapters 22–25 survey the effects of a national government’s choice of exchange-

rate policy on the country’s macroeconomic performance, especially unemployment

and inflation.

Chapter 16 presents the balance of payments, a way to keep track of all the eco-

nomic transactions between a country and the rest of the world. In Chapter 17 we

explore the basics of exchange rates between currencies and the functioning and

enormous size of the foreign exchange market. Chapter 18 provides a tour of the

returns to and risks of foreign financial investments. Exchange rates are prices, and

in Chapter 19 we look behind basic supply and demand in the foreign exchange

market, in search of fundamental economic determinants of exchange-rate values.

Chapter 20 examines government policies toward the foreign-exchange market, first

using description and analysis, and then presenting the history of exchange-rate

regimes, starting with the gold standard and finishing with the current mash-up of

different national policies. Well-behaved international lending and borrowing can

create global gains, but Chapter 21 also examines financial crises that can arise

from some kinds of foreign borrowing and that can spread across countries, a clear

downside of globalization.

pug21774_fm_i-xxviii.indd viiipug21774_fm_i-xxviii.indd viii 12/8/14 8:59 PM12/8/14 8:59 PM

Final PDF to printer

Preface ix

Chapter 22 begins our explication of international macroeconomics by develop-

ing a framework for analyzing a national economy that is linked to the rest of the

world through international trade and international financial investing. We use this

framework in the next two chapters to explore the macroeconomic performance of a

country that maintains a fixed exchange-rate value for its currency (Chapter 23) and

of a country that allows a floating, market-driven exchange-rate value for its currency

(Chapter 24). Chapter 25 uses what we have learned throughout the second half of the

book to examine the benefits and costs of alternatives for a country’s exchange-rate

policy. While rather extreme versions of fixed exchange rates serve some countries

well, the general trend is toward more flexible exchange rates.

In a few places the book’s scheme (international trade first, international finance

second) creates some momentary inconvenience, as when we look at the exchange-

rate link between cutting imports and reducing exports in Chapter 5 before we have

discussed exchange rates in depth. Mostly the organization serves us well. The under-

standing we gain about earlier topics provides us with building blocks that allow us to

explore broader issues later in the book.

CURRENT EVENTS AND NEW EXAMPLES It is a challenge and a pleasure for me to incorporate the events and policy changes that

continue to transform the global economy, and to find the new examples that show the

effects of globalization (both its upside and its downside). Here are some of the current

and recent events and issues that are included in this edition to provide new examples

that show the practical use of our international economic analysis:

• The euro crisis that began in Greece in 2010 spread to several other countries in

the euro area and during 2011–2012 seemed to threaten the continued existence of

the euro itself. Still, in the face of continued weak economic performance in the

euro area, Latvia adopted the euro at the beginning of 2014, bringing the number

of countries in the euro area to 18.

• Beginning in 2007 the United States rapidly expanded its production of natural gas

using horizontal drilling and hydraulic fracturing. A large number of U.S. firms

sought approval to export natural gas, but a U.S. law prohibits export unless it is in

the national interest. The U.S. government has been slow to act; as of mid-2014,

only one U.S. facility had received full approval to export.

• Immigration continues to be a hot issue. In 2014 Swiss voters approved limitations

on immigration into the country. Prime Minister Cameron pledged to greatly reduce

immigration into Britain by 2015. In 2013 the U.S. government again failed to pass

a revision of its immigration laws.

• Chinese government holdings of foreign exchange reserve assets reached $4 trillion

in mid-2014, the result of continued official intervention to prevent the exchange-

rate value of China’s currency from rising too quickly.

• Pressure from the growth of the countries’ exports led to rapidly rising wages for

workers in China and in India.

• After nearly two decades of negotiations, Russia joined the World Trade

Organization (WTO) in 2012.

pug21774_fm_i-xxviii.indd ixpug21774_fm_i-xxviii.indd ix 12/8/14 8:59 PM12/8/14 8:59 PM

Final PDF to printer

x Preface

• In 2013 the members of the WTO reached a new multilateral agreement on

trade facilitation, but in 2014 its implementation was held up by a single coun-

try, India.

• In response to rapidly growing imports, American steel producers sent a large

number of new complaints to the U.S. government, alleging dumping by foreign

producers and seeking hefty new antidumping duties.

• The WTO ruled that European governments had violated WTO rules by offering

massive subsidies to Airbus and that the U.S. government had violated WTO rules

by offering massive subsidies to Boeing. But, then, the situation seemed to reach

a stalemate.

• After approval from the U.S. Congress, the United States implemented free-trade

agreements with Colombia, South Korea, and Panama.

• In 2012, Venezuela became a member of MERCOSUR, the South American

regional trade area.

• Croatia joined the European Union in 2013 as its 28th member country.

• The first phase of the Kyoto Protocol was completed in 2012. For a number of

reasons, the effects were minor, and global warming continues as a major global

environmental challenge.

• Led by increases in international financial investments and computer-driven trad-

ing, the size of the foreign exchange market continued to grow, with trading of one

currency for another reaching $5 trillion per day in 2013. Foreign exchange trading has more than tripled since 2004.

• The market-driven exchange-rate value of the Japanese yen increased during the

week after a tsunami caused the nuclear disaster at Fukushima in 2011, prompting

a large official intervention in the foreign exchange market.

• Starting in 2008, the International Monetary Fund (IMF) rapidly expanded its lend-

ing to countries in crisis, with loans outstanding reaching $125 billion in mid-2014.

Most of these IMF loans are to advanced countries—Iceland, Greece, Ireland, and

Portugal—a sharp contrast to the lending to developing countries that had been

predominant since 1980.

• The United States pursued a third round of quantitative easing during 2012–2014 as

a continuation of unconventional monetary policy for an economy stuck in a liquid-

ity trap. In this third round, the Fed bought about $1.5 trillion of Treasury securities

and mortgage-backed securities, but this round seemed to have less effect on the

exchange-rate value of the U.S. dollar than did previous rounds.

IMPROVING THE BOOK: TOPICS In this edition I introduce and extend a number of improvements to the pedagogical

structure and topical coverage of the book.

• The euro crisis that began in 2010 and intensified in 2011 and 2012 has had

profound effects on the member countries of the euro area—the countries that

have replaced their national currencies with the euro in a monetary union.

pug21774_fm_i-xxviii.indd xpug21774_fm_i-xxviii.indd x 12/8/14 8:59 PM12/8/14 8:59 PM

Final PDF to printer

Preface xi

This edition interweaves the causes and impacts of the euro crisis across its

chapters. The overview of the euro crisis in Chapter 1 shows that it began in

different ways, as a fiscal crisis in Greece and as a burst housing-price bubble

in Ireland that led to a banking crisis. Portugal then had a debt-driven crisis, and

contagion spread the crisis pressures to Spain and Italy. The European Central

Bank needed to play a key role, and a new program announced in July 2012

and adopted in September was the turning point in addressing the worst of the

crisis. I then present discussions of important aspects of the crisis in a series of

new shaded Euro Crisis boxes, which join the other six series of boxes: Global Crisis, Focus on China, Global Governance, Focus on Labor, Case Studies, and Extensions. For the Euro Crisis series, the new box in Chapter 16 shows how attention to current account balances and net international investment positions

of the countries at the center of the crisis would have given signals of rising risk.

Chapter 18 has a combination of a Global Crisis and Euro Crisis box, which shows how a key parity relationship among interest rates and exchange rates

weakened under crisis conditions. The new box in Chapter 21 explains how the

euro crisis was actually three interrelated crises that reinforced each other—

sovereign debt or fiscal crisis, banking crisis, and macroeconomic crisis. While

the sovereign debt and banking crises have calmed, the macroeconomic perfor-

mance of the euro area remained very weak and Greece was in depression. The

concluding section of Chapter 25 examines the benefits and costs of European

monetary union, with special attention to fiscal policy. The euro area lacks area-

wide taxation and government spending, National fiscal policies have a double

edge, as both the principal remaining tool for national governments to address

their macroeconomic performance problems and a potential source of instability

that can threaten the entire union.

• The global financial and economic crisis that began in 2007 is the most important

global trauma of the past 70 years, and it was a major contributor to the onset of

the euro crisis. A new section of the text of Chapter 21 describes the global crisis,

including the start of the crisis as the result of losses on sub-prime mortgages in

the United States and on assets backed by these mortgages, and the terrible wors-

ening of the crisis in 2008 with the failure of Lehman Brothers. This discussion

of the global crisis also shows how the analysis of the series of financial crises

that hit developing countries during 1982–2002 helps us to understand the causes

and spread of the global crisis. The Global Crisis series of boxes examines other aspects of the crisis, including the collapse of international trade (Chapter 2),

the avoidance of new protectionism (Chapter 9), the use of quantitative easing

as nontraditional monetary policy once short-term interest rates are essentially

zero (Chapter 24), and the increased use of currency swaps among central banks

(Chapter 24).

• China continues its rise as a force in the global economy. The presentation of

China’s global role, including the series of boxes Focus on China, continues to be a strength of the text. Chapters 1 and 20 discuss the development of China’s

controversial policies toward the exchange-rate value of its currency. In the box in

Chapter 9, the presentation of China’s rising involvement in the dispute settlement

pug21774_fm_i-xxviii.indd xipug21774_fm_i-xxviii.indd xi 12/8/14 8:59 PM12/8/14 8:59 PM

Final PDF to printer

xii Preface

process at the World Trade Organization, both as a respondent (alleged violator)

and as a complainant, has been updated and rewritten. Among other recent cases,

the WTO ruled in 2014 that China’s restrictions on exports of rare earths were a

violation of its WTO commitments.

• A major strength of the book remains in-depth analysis of a range of trade

and trade-policy issues. The discussion of monopolistic competition and intra-

industry trade in Chapter 6 has been expanded to incorporate the conclusions

from research based on differences across firms in their cost levels. Opening to

international trade favors the survival and expansion of lower-cost firms. This dis-

cussion also includes an estimate of the global gains from greater product variety.

The section on trade embargoes in Chapter 12 has been revised, with a current

case, Iran, being used as the example of the effects of international sanctions on

the target country. Estimates of national factor endowments presented in Chapter 5

are completely updated and include better data on physical capital stocks and

more countries in total. Data on national intra-industry trade shares in Chapter 6

include new estimates for 2012.

• Chapter 13 on trade and the environment continues as a unique and powerful

treatment of issues of interest to many students. The discussion of global warm-

ing has been revised to incorporate data and projections from recent studies. The

discussion of the Kyoto Protocol has been updated to include the outcomes from

the first phase that ended in 2012 and the continued increase in global greenhouse

gas emissions.

• The box on the fiscal effects of immigration in Chapter 15 has been substan-

tially rewritten to incorporate the results of a recent Organization for Economic

Cooperation and Development study of the effects of immigrants on government

revenues and expenditures.

• In Chapter 18 a new section of text explains the definitions and uses of real

exchange rates and effective exchange rates. The four ways to measure the

exchange-rate value of a currency had previously been a box in the chapter, but the

increasing importance of these concepts motivated the shift to a text section.

• Chapter 21 has been substantially revised. It incorporates the global financial and

economic crisis into the text of the chapter and has a new box on the euro crisis.

Some other aspects of the chapter have been streamlined. The short subsections on

the Brazilian mini-crisis of 1999 and the Turkish crisis of 2001 have been removed,

as has one of the two boxes on the International Monetary Fund.

• I used the latest available sources to update the wide range of data and informa-

tion presented in the figures and text of the book. Among other updates, the book

offers the latest information on international trade in specific products for the

United States, China, and Japan; national average tariff rates; dumping and sub-

sidy cases; levels and growth rates of national incomes per capita; trends in the

relative prices of primary products; patterns of foreign direct investments broadly

and by major home country; rates of immigration into the United States, Canada,

and the European Union; the U.S. balance of payments and the U.S. international

pug21774_fm_i-xxviii.indd xiipug21774_fm_i-xxviii.indd xii 12/8/14 8:59 PM12/8/14 8:59 PM

Final PDF to printer

Preface xiii

investment position; the sizes of foreign exchange trading and foreign exchange

futures, swaps, and options; levels and trends for nominal exchange rates; effective

exchange-rate values for the U.S. dollar; evidence about relative purchasing power

parity; the exchange-rate policies chosen by national governments; the flows of

international financing to and the outstanding foreign debt of developing countries;

and gold prices.

NEW QUESTIONS AND PROBLEMS In this edition I provide additional opportunities for students to engage with the book’s

contents by adding new questions that students can use to build their facility in using

the concepts and analysis of international economics.

• Forty-eight new questions and problems have been added, two new questions and

problems to each of the chapters that have end-of-chapter materials. These new

questions and problems are targeted to cover chapter topics that were previously

underrepresented.

• A discussion question has been added at the end of each Case Study box, a total of

24 new questions that focus on the issues raised in the case studies.

FORMAT AND STYLE I have been careful to retain the goals of clarity and honesty that have made

International Economics an extraordinary success in classrooms and courses around the world. There are plenty of quick road signs at the start of and within chapters. The

summaries at the ends of the chapters offer an integration of what has been discussed.

Students get the signs, “Here’s where we are going; here’s where we have just been.”

I use bullet-point and numbered lists to add to the visual appeal of the text and to

emphasize sets of determinants or effects. I strive to keep paragraphs to reasonable

lengths, and I have found ways to break up some long paragraphs to make the text

easier to read.

I am candid about ranking some tools or facts ahead of others. The undeniable

power of some of the economist’s tools is applied repeatedly to events and issues

without apology. Theories and concepts that fail to improve on common sense are not

oversold.

The format of the book is fine-tuned for better learning. Students need to master

the language of international economics. Most exam-worthy terms appear in boldface in the text, with their definitions usually contiguous. The material at the end of each

chapter includes a listing of these Key Terms , and an online Glossary has definitions of each term. Words and phrases that deserve special emphasis are in italics.

Each chapter (except for the short introductory chapter) has at least 12 questions

and problems. The answers to all odd-numbered questions and problems are included

in the material at the end of the book. As a reminder, these odd-numbered questions

are marked with a ✦.

pug21774_fm_i-xxviii.indd xiiipug21774_fm_i-xxviii.indd xiii 12/8/14 8:59 PM12/8/14 8:59 PM

Final PDF to printer

xiv Preface

SUPPLEMENTS The following ancillaries are available for quick download and convenient access via

the Instructor Resource material available through McGraw-Hill Connect®.

• PowerPoint Presentations: Revised by Farhad Saboori of Albright College, the PowerPoint slides now include a brief, detailed review of the important ideas cov-

ered in each chapter, accompanied by relevant tables and figures featured within

the text. You can edit, print, or rearrange the slides to fit the needs of your course.

• Test Bank: Updated by Robert Allen of Columbia Southern University, the test bank offers well over 1,500 questions categorized by level of difficulty, AACSB

learning categories, Bloom’s taxonomy, and topic.

• Computerized Test Bank: McGraw-Hill’s EZ Test is a flexible and easy-to-use electronic testing program that allows you to create tests from book-specific items.

It accommodates a wide range of question types, and you can add your own ques-

tions. Multiple versions of the test can be created, and any test can be exported for

use with course management systems. EZ Test Online gives you a place to admin-

ister your EZ Test–created exams and quizzes online. Additionally, you can access

the test bank through McGraw-Hill Connect.

• Instructor’s Manual: Written by the author, the instructor’s manual contains chapter overviews, teaching tips, and suggested answers to the discussion ques-

tions featured among the case studies as well as the end-of-chapter questions and

problems. To increase flexibility, the Tips section in each chapter often provides the

author’s thoughts and suggestions for customizing the coverage of certain sections

and chapters.

DIGITAL SOLUTIONS

McGraw-Hill Connect® Economics

Less Managing. More Teaching. Greater Learning. McGraw- Hill’s Connect® Economics is an online assessment solution that connects students with the tools and resources they’ll need to

achieve success.

Shaded boxes appear in different font with a different right-edge format and two columns per page, in contrast to the style of the main text. The boxes are labeled by type and provide discussions of the euro crisis that began in 2010,

the global financial and economic crisis that began in 2007, the roles of the WTO and the IMF in global governance, China’s international trade and investment, labor issues, case studies, and extensions of the concepts presented in the text.

Box

pug21774_fm_i-xxviii.indd xivpug21774_fm_i-xxviii.indd xiv 12/8/14 8:59 PM12/8/14 8:59 PM

Final PDF to printer

Preface xv

McGraw-Hill’s Connect Economics Features Connect Economics allows faculty to create and deliver exams easily with selectable test bank items. Instructors can also build their own questions into the system for

homework or practice. Other features include:

Instructor Library The Connect Economics Instructor Library is your repository for additional resources to improve student engagement in and out of class. You can

select and use any asset that enhances your lecture. The Connect Economics Instructor Library includes all of the instructor supplements for this text.

Student Resources Any supplemental resources that align with the text for student use will be available through Connect.

Student Progress Tracking Connect Economics keeps instructors informed about how each student, section, and class is performing, allowing for more productive use

of lecture and office hours. The progress-tracking function enables you to

• Vie w scored work immediately and track individual or group performance with

assignment and grade reports.

• Access an instant view of student or class performance relative to learning

objectives.

• Collect data and generate reports required by many accreditation organizations,

such as AACSB.

Diagnostic and Adaptive Learning of Concepts: LearnSmart and SmartBook offer the first and only adaptive reading experience designed to change the way students

read and learn.

Students want to make the best use of their study time.

The LearnSmart adaptive self-study technology within

Connect Economics provides students with a seamless combination of practice, assessment, and remediation for every concept in the textbook. LearnSmart’s

intelligent software adapts to every student’s response and automatically delivers

concepts that advance students’ understanding while reducing time devoted to the

concepts already mastered. The result for every student is the fastest path to mas-

tery of the chapter concepts. LearnSmart

• Applies an intelligent concept engine to identify the relationships between concepts

and to serve new concepts to each student only when he or she is ready.

• Adapts automatically to each student, so students spend less time on the topics they

understand and practice more those they have yet to master.

• Provides continual reinforcement and remediation but gives only as much guidance

as students need.

• Integrates diagnostics as part of the learning experience.

• Enables you to assess which concepts students have efficiently learned on their

own, thus freeing class time for more applications and discussion.

pug21774_fm_i-xxviii.indd xvpug21774_fm_i-xxviii.indd xv 12/8/14 8:59 PM12/8/14 8:59 PM

Final PDF to printer

xvi Preface

Smartbook is an extension of LearnSmart—an adaptive eBook that helps students focus their study time more effec-

tively. As students read, Smartbook assesses comprehension and dynamically high-

lights where they need to study more.

For more information about Connect, go to connect.mheducation.com, or contact your local McGraw-Hill sales representative.

McGraw-Hill’s Customer Experience Group We understand that getting the most from your new technology can be challenging.

That’s why our services don’t stop after you purchase our products. You can e-mail

our Product Specialists 24 hours a day to get product-training online. Or you can

search our knowledge bank of Frequently Asked Questions on our support website.

For Customer Support, call 800-331-5094, or visit www.mhhe.com/support.

Create

McGraw-Hill Create™ is a self-service website that allows you to cre-

ate customized course materials using McGraw-Hill’s comprehensive,

cross-disciplinary content and digital products. You can even access

third-party content such as readings, articles, cases, videos, and more. Arrange the

content you’ve selected to match the scope and sequence of your course. Personalize

your book with a cover design and choose the best format for your students—eBook,

color print, or black-and-white print. And, when you are done, you’ll receive a PDF

review copy in just minutes!

CourseSmart

Go paperless with eTextbooks from CourseSmart and move light-years

beyond traditional print textbooks. Read online or offline anytime, any-

where. Access your eTextbook on multiple devices with or without an Internet connec-

tion. CourseSmart eBooks include convenient, built-in tools that let you search topics

quickly, add notes and highlights, copy/paste passages, and print any page.

pug21774_fm_i-xxviii.indd xvipug21774_fm_i-xxviii.indd xvi 12/9/14 6:55 PM12/9/14 6:55 PM

Final PDF to printer

xvii

Acknowledgments

I offer my deepest thanks to the many people whose advice helped me to improve

International Economics in its sixteenth edition. My first thanks are to Peter H. Lindert, my co author on several previous editions. I learned much from him about

the art of writing for the community of students who want to deepen their knowledge

and understanding of the global economy.

I love teaching international economics, and I am grateful to my students for the

many suggestions and insights that I have received from them. I thank my friends and

colleagues from other colleges and universities who took the time to e-mail me with

corrections and ideas for changes. I especially thank my faculty colleagues at the NYU

Stern School for information and suggestions. I am indebted to Natalia Tamirisa of

the International Monetary Fund for providing the data used in Figure 13.6, Carbon

Tax to Stabilize Atmospheric Carbon Dioxide; to Richard M. Levich of the NYU

Stern School of Business for providing data used in the box “Covered Interest Parity

Breaks Down” in Chapter 18; and to Ravi Balakrishnan and Volodymyr Tulin of the

International Monetary Fund for the data used in Figure 18.3, Uncovered Interest

Differentials: The United States against Germany and Japan, 1991–2005. I also thank

my brother, Michael Pugel, who shared with me his knowledge of technology issues

from his perspective as a patent attorney and electrical engineer.

I express my gratitude to the reviewers whose detailed and thoughtful comments

and critiques provided guidance as I wrote the sixteenth edition:

Adhip Chaudhuri, Georgetown University; Baizhu Chen, University of Southern

California; Tran Dung, Wright State University; Wei Ge, Bucknell University; Pedro

Gete, Georgetown University; Kirk Gifford, Brigham Young University; Nam Pham,

George Washington University; Courtney Powell-Thomas, Virginia Tech University;

Farhad Saboori, Albright College; George Sarraf, University of California–Irvine;

Paul Wachtel, New York University; Lou Zaera, Fashion Institute of Technology.

I remain grateful to the reviewers whose suggestions for improvements to the previ-

ous editions continued to redound to my benefit as I prepared the sixteenth:

Vera Adamchik, University of Houston–Victoria; Gregory W. Arbum, The

University of Findlay; Manoj Atolia, Florida State University; Mina Baliamoune,

University of North Florida; Michael P. Barry, Mount St. Mary’s University; Trisha

Bezmen, Old Dominion University; Frank Biggs, Principia College; Philip J.

Bryson, Brigham Young University; Philip E. Burian, Colorado Technical University

at Sioux Falls; James Butkiewicz, University of Delaware; Debasish Chakraborty,

Central Michigan University; Roberto Chang, Rutgers University; Shah Dabirian,

California State University Long Beach; Jamshid Damooei, California Lutheran

University; Manjira Datta, Arizona State University; Dennis Debrecht, Carroll

College; Carol Decker, Tennessee Wesleyan College; John R. Dominguez, University

of Wisconsin–Whitewater; Eric Drabkin, Hawaii Pacific University; Robert Driskill,

Vanderbilt University; Patrick M. Emerson, Oregon State University; Carole Endres,

Wright State University; Nicolas Ernesto Magud, University of Oregon; Hisham

Foad, San Diego State University; Yoshi Fukasawa, Midwestern State University;

John Gilbert, Utah State University; Chris Gingrich, Eastern Mennonite University;

pug21774_fm_i-xxviii.indd xviipug21774_fm_i-xxviii.indd xvii 12/9/14 6:55 PM12/9/14 6:55 PM

Final PDF to printer

xviii Acknowledgments

Amy Glass, Texas A&M University; Omer Gokcekus, Seton Hall University;

William Hallagan, Washington State University; Tom Head, George Fox University;

Barbara Heroy John, University of Dayton; Farid Islam, Woodbury School of

Business; Brian Jacobsen, Wisconsin Lutheran College; Geoffrey Jehle, Vassar

College and Columbia University; Jack Julian, Indiana University of Pennsylvania;

Ghassan Karam, Pace University; Vani V. Kotcherlakota, University of Nebraska

at Kearney; Quan Le, Seattle University; Kristina Lybecker, The Colorado

College; John Marangos, Colorado State University; John Mukum Mbaku, Weber

State University; John McLaren, University of Virginia; Michael A. McPherson,

University of North Texas; Matthew McPherson, Gonzaga University; Norman

C. Miller, Miami University; Karla Morgan, Whitworth College; Stefan Norrbin,

Florida State University; Joseph Nowakowski, Muskingum College; Rose Marie

Payan, California Polytechnic University; Harvey Poniachek, Rutgers University;

Dan Powroznik, Chesapeake College; Ed Price, Oklahoma State University; Kamal

Saggi, Southern Methodist University; Jawad Salimi, West Virginia University–

Morgantown; Andreas Savvides, Oklahoma State University; Philip Sprunger,

Lycoming College; John Stiver, University of Connecticut; William J. Streeter,

Olin Business School–Washington University in St. Louis; Kay E. Strong, Bowling

Green State University–Firelands; Kishor Thanawala, Villanova University; Victoria

Umanskaya, University of California-Riverside; Doug Walker, Georgia College

and State University; Dr. Evelyn Wamboye, University of Wisconsin–Stout;

Dave Wharton, Washington College; Elizabeth M. Wheaton, Southern Methodist

University; Jiawen Yang, George Washington University; Bassam Yousif, Indiana

State University Hamid Zangeneh, Widener University;

I offer my thanks and admiration to the great group at McGraw-Hill/Irwin who

worked with me closely in preparing this edition, including Michele Janicek, lead

product developer; Christina Kouvelis, senior product developer; Lisa Bruflodt, senior

project manager; and Sourav Majumdar, project manager at SPi Global.

My final acknowledgment is in remembrance of the late Charles P. Kindleberger,

who was one of my teachers during my graduate studies. He started this book over

60 years ago, and I strive to meet the standards of excellence and relevance that he

set for the book.

Thomas A. Pugel

pug21774_fm_i-xxviii.indd xviiipug21774_fm_i-xxviii.indd xviii 12/9/14 6:55 PM12/9/14 6:55 PM

Final PDF to printer

xix

1 International Economics Is Different 1

2 The Basic Theory Using Demand and Supply 13

3 Why Everybody Trades: Comparative Advantage 31

4 Trade: Factor Availability and Factor Proportions Are Key 47

5 Who Gains and Who Loses from Trade? 66

6 Scale Economies, Imperfect Competition, and Trade 88

7 Growth and Trade 117

8 Analysis of a Tariff 137

9 Nontariff Barriers to Imports 160

10 Arguments for and against Protection 192

11 Pushing Exports 222

12 Trade Blocs and Trade Blocks 252

13 Trade and the Environment 275

14 Trade Policies for Developing Countries 309

15 Multinationals and Migration: International Factor Movements 334

16 Payments among Nations 370

17 The Foreign Exchange Market 389

18 Forward Exchange and International Financial Investment 405

19 What Determines Exchange Rates? 433

20 Government Policies toward the Foreign Exchange Market 464

21 International Lending and Financial Crises 502

22 How Does the Open Macroeconomy Work? 539

23 Internal and External Balance with Fixed Exchange Rates 565

24 Floating Exchange Rates and Internal Balance 603

25 National and Global Choices: Floating Rates and the

Alternatives 628

APPENDIXES A The Web and the Library: International

Numbers and Other Information 655

B Deriving Production-Possibility Curves 659

C Offer Curves 664

D The Nationally Optimal Tariff 667

E Accounting for International Payments 673

F Many Parities at Once 677

G Aggregate Demand and Aggregate Supply in the Open Economy 680

H Devaluation and the Current Account Balance 690

SUGGESTED ANSWERS TO ODD-NUMBERED QUESTIONS AND PROBLEMS 694

REFERENCES 731

INDEX 743

Brief Contents

pug21774_fm_i-xxviii.indd xixpug21774_fm_i-xxviii.indd xix 12/8/14 8:59 PM12/8/14 8:59 PM

Final PDF to printer

Contents

Chapter 1 International Economics Is Different 1

Four Controversies 1

U.S. Exports of Natural Gas 1 Immigration 4 China’s Exchange Rate 5 Euro Crisis 7

Economics and the Nation-State 11

Factor Mobility 11 Different Fiscal Policies 12 Different Moneys 12

Chapter 2 The Basic Theory Using Demand and Supply 13

Four Questions about Trade 14

Demand and Supply 14

Demand 14 Consumer Surplus 16 Case Study Trade Is Important 17 Supply 18 Producer Surplus 19 Global Crisis The Trade Mini-Collapse of 2009 20 A National Market with No Trade 22

Two National Markets and the Opening

of Trade 22

Free-Trade Equilibrium 24 Effects in the Importing Country 25 Effects in the Exporting Country 27 Which Country Gains More? 27

Summary: Early Answers to the Four Trade

Questions 28

Key Terms 28

Suggested Reading

Suranovic (2000) discusses seven types of fairness and applies them to international

trade. He calls our one-dollar, one-vote metric “maximum benefit fairness.” Bems et al.

(2013) survey the causes of the 2009 trade collapse.

Questions and Problems

1. What is consumer surplus? Using real-world data, what information would you need

to measure consumer surplus for a product?

2. What is producer surplus? Using real-world data, what information would you need

to measure producer surplus for a product?

3. How can a country’s supply and demand curves for a product be used to determine the

country’s supply-of-exports curve? What does the supply-of-exports curve mean?

4. How can a country’s supply and demand curves for a product be used to determine the

country’s demand-for-imports curve? What does the demand-for-imports curve mean?

5. A tropical country can produce winter coats, but there is no domestic demand for these

coats. Explain how this country can gain from free trade in winter coats.

6. The United States exports a substantial amount of scrap iron and steel to Turkey,

China, Canada, and other countries. Why do some U.S. users of scrap iron and steel

support a prohibition on these exports?

7. Explain what is wrong with the following statement: “Trade is self-eliminating.

Opening up trade opportunities drives prices and costs into equality between coun-

tries. But once prices and costs are equalized, there is no longer any reason to trade

the product from one country to another, and trade stops.”

8. In 2012, the United States imported about 3.1 billion barrels of oil. Perhaps it would

be better for the United States if it could end the billions of dollars of payments to

foreigners by not importing this oil. After all, the United States can produce its own

oil (or other energy products that substitute for oil). If the United States stopped all

oil imports suddenly, it would be very disruptive. But perhaps the United States could

gain if it gradually restricted and then ended oil imports in an orderly transition. If we

allow time for adjustments by U.S. consumers and producers of oil, and we perhaps

are optimistic about how much adjustment is possible, then the following two equa-

tions show domestic demand and supply conditions in the United States:

Demand: P 5 364 2 48·Q D

Supply: P 5 4 1 40·Q S

where quantity Q is in billions of barrels per year and price P is in dollars per barrel.

a. With free trade and an international price of $100 per barrel, how much oil does the United States produce domestically? How much does it consume? Show the

demand and supply curves on a graph and label these points. Indicate on the graph

the quantity of U.S. imports of oil.

b. If the United States stopped all imports of oil (in a way that allowed enough time for orderly adjustments as shown by the equations), how much oil would be produced

in the United States? How much would be consumed? What would be the price of

oil in the United States with no oil imports? Show all of this on your graph.

c . If the United States stopped all oil imports, which group(s) in the United States would gain? Which group(s) would lose? As appropriate, refer to your graph in your answer.

✦

Chapter 2 The Basic Theory Using Demand and Supply 29

pug21774_ch02_013-030.indd 29pug21774_ch02_013-030.indd 29 10/16/14 10:27 PM10/16/14 10:27 PM

Final PDF to printer

9. Consider Figure 2.3, which shows free trade in motorbikes. Assume that consumers

in the United States shift their tastes in favor of motorbikes. What is the effect on the

U.S. domestic demand and/or supply curve(s)? What is the effect on the U.S. demand-

for-imports curve? What is the effect on the equilibrium international price?

10. Consider again Figure 2.3, which shows free trade in motorbikes. Assume that U.S.

productivity in producing motorcycles increases. What is the effect on the U.S.

domestic demand and/or supply curve(s)? What is the effect on the U.S. demand-for-

imports curve? What is the effect on the equilibrium international price?

11. Consider a two-country world. Each country has an upward-sloping national supply

curve for raisins and a downward-sloping national demand curve for raisins. With no

trade in raisins, the no-trade equilibrium price for raisins in one country would be

$2.00 per kilogram and the no-trade equilibrium price for raisins in the other coun-

try would be $3.20 per kilogram. If the countries allow free trade in raisins, explain

why $3.50 per kilogram cannot be the free-trade equilibrium world price for raisins.

In your answer, draw and refer to graphs of supply and demand curves for the two

national markets.

12. Consider a world in which everyone agrees that changes in consumers’ well-being are

more important than changes in producers’ well-being in analyzing the effects of free

trade in furniture. (This belief is a deviation from the one-dollar, one-vote metric.)

Does the importing country still gain from free trade in furniture? Does the exporting

country still gain from free trade in furniture?

13. The equation for the demand curve for writing paper in Belgium is

Q D 5 350 2 ( P /2) [or P 5 700 2 2 Q

D ]

The equation for the supply curve for writing paper in Belgium is

Q S 5 2200 1 5 P [or P 5 40 1 ( Q

S /5)]

a. What are the equilibrium price and quantity if there is no international trade? b. What are the equilibrium quantities for Belgium if the nation can trade freely with

the rest of the world at a price of 120?

c. What is the effect of the shift from no trade to free trade on Belgian consumer surplus? On Belgian producer surplus? What is the net national gain or loss for

Belgium?

14. Country I has the usual demand and supply curves for Murky Way candy bars. Country II

has a typical demand curve, too, but it cannot produce Murky Way candy bars.

a. Use supply and demand curves for the domestic markets and for the international market. Show in a set of graphs the free-trade equilibrium for Murky Way candy

bars. Indicate the equilibrium world price. How does this world price compare to

the no-trade price in Country I? Indicate how many Murky Ways are traded during

each time period with free international trade.

b. Show graphically and explain the effects of the shift from no trade to free trade on surpluses in each country. Indicate the net national gain or loss from free trade for

each country.

✦

30 Part One The Theory of International Trade

pug21774_ch02_013-030.indd 30pug21774_ch02_013-030.indd 30 10/16/14 10:27 PM10/16/14 10:27 PM

Final PDF to printer

Chapter Three

Why Everybody Trades: Comparative Advantage Chapter 2 examined international trade focusing on a single product. That analysis

helped answer some major questions about international trade but only indirectly

addressed some others. For an industry with expanding production, where do the addi-

tional resources come from? For a shrinking industry, what happens to the resources

no longer needed? If consumers increase or decrease the quantity demanded of one

product, what effect does this have on demand for other products?

Full analysis of international trade requires consideration of the entire economy.

Yet the entire economy is very complex—it consists of thousands of products and the

various resources needed to produce them. Fortunately, we can gain major insights by

considering an economy composed of just two products. For international trade, one

product can be exported and the other imported. This two-product economy captures

an essential feature of international trade: A country tends to be a net exporter of some

products and a net importer of others.

This chapter begins our examination of the general equilibrium of a two-product

economy. We focus on the first of our four basic trade questions: Why do countries

trade? In fact, why does everybody—every country as well as every person—find it

worthwhile to produce and export (sell) some things and to import (buy) other things?

We proceed in three steps:

1. We start with Adam Smith’s original explanation, which he developed as he battled

mercantilist thinking.

2. We then see that David Ricardo’s principle of comparative advantage allows us

to explain trade better than most people’s intuition and better than Adam Smith’s

original explanation.

3. We begin our development of tools for analyzing a two-product economy. The

production-possibility curve summarizes national production capabilities. We

can use it to show how trading based on comparative advantage can enhance the

well-being of a country.

pug21774_ch03_031-046.indd 31pug21774_ch03_031-046.indd 31 10/16/14 10:40 PM10/16/14 10:40 PM

Final PDF to printer

As you read this chapter, pay attention to the basic message: the power of com-

parative advantage. If you think that the framework is much too simple, don’t despair.

Subsequent chapters will build on the key insights of this chapter by adding more

realistic features to the economy.

ADAM SMITH’S THEORY OF ABSOLUTE ADVANTAGE

In the late 18th and early l9th centuries, first Adam Smith and then David Ricardo

explored the basis for international trade as part of their efforts to make a case for free

trade. Their writings were responses to the doctrine of mercantilism prevailing at the

time. (See the box “Mercantilism.”) Their classic theories swayed policymakers for a

whole century, even though today we view them as only special cases of a more basic,

and more powerful, theory of trade.

In his Wealth of Nations, Adam Smith promoted free trade by comparing nations to households. Every household finds it worthwhile to produce only some of the products

it consumes, and to buy other products using the proceeds from what the household

can sell to others. The same should apply to nations:

It is the maxim of every prudent master of a family, never to attempt to make at home what

it will cost . . . more to make than to buy. The tailor does not attempt to make his own

shoes, but buys them from the shoemaker . . .

What is prudence in the conduct of every private family, can scarce be folly in that of

a great kingdom. If a foreign country can supply us with a commodity cheaper than we

ourselves can make it, better buy it of them with some part of the product of our own

industry, employed in a way in which we have some advantage.

An example can show Smith’s reasoning. The two “countries” in the example

are the United States and the rest of the world. The two products are wheat and

cloth (perhaps broadly representing agricultural products and manufactured prod-

ucts). Each product is produced using one resource called labor. (Smith focused

on labor because he thought that all “value” was determined by and measured in

hours of labor. In this respect he was imitated by David Ricardo and Karl Marx,

who also believed that labor was the basis for all value. We don’t have to take this

literally—we can consider “labor” to be a bundle of resources used to produce

products.)

Suppose that the United States is better than the rest of the world at producing

wheat, and the rest of the world is better than the United States at producing cloth. It is

probably not a surprise that international trade can create benefits because the United

States can focus on producing what it does best (wheat) and export it, and the rest of

the world can focus on producing what it does best (cloth) and export it. Let’s look at

this more closely.

What do we mean by “better at producing”? We can indicate each country’s ability

to produce each product in one of two equivalent ways. First, we can measure labor productivity —the number of units of output that a worker can produce in one hour. Second, we can look at the number of hours that it takes a worker to produce one unit

of output—this is just the reciprocal of labor productivity. Here are some numbers for

our example:

32 Part One The Theory of International Trade

pug21774_ch03_031-046.indd 32pug21774_ch03_031-046.indd 32 10/16/14 10:40 PM10/16/14 10:40 PM

Final PDF to printer

Mercantilism was the philosophy that guided European thinking about international trade in the several centuries before Adam Smith pub- lished his Wealth of Nation s in 1776. Mercantilists viewed international trade as a source of major benefits to a nation. Merchants engaged in trade, especially those selling exports, were good— hence the name mercantilism . But mercantilists also maintained that government regulation of trade was necessary to provide the largest national benefits. Trade merchants would serve their own interests and not the national interest, in the absence of government guidance.

A central belief of mercantilism was that national well-being or wealth was based on national hold- ings of gold and silver (specie or bullion). Given this view of national wealth, exports were viewed as good and imports (except for raw materials not produced at home) were seen as bad. If a country sells (exports) more to foreign buyers than the for- eigners sell to the country (the country’s imports), then the foreigners have to pay for the excess of their purchases by shipping gold and silver to the country. The gain in gold and silver increases the country’s well-being, according to the mercantilist belief. Imports are undesirable because they reduce the country’s ability to accumulate these precious metals. Imports were also feared because they might not be available to the country in time of war. In addition, gold and silver accruing to the national rulers could be especially valuable in helping to maintain a large military for the country. Based on mercantilist thinking, governments (1) imposed an array of taxes and prohibitions designed to limit imports and (2) subsidized and encouraged exports.

Because of its peculiar emphasis on gold and silver, mercantilism viewed trade as a zero- sum activity—one country’s gains come at the expense of some other countries, since a surplus in international trade for one country must be a deficit for some other(s). The focus on promoting exports and limiting imports also provided major benefits for domestic producer interests (in both exporting and import-competing industries).

Adam Smith and economists after him pointed out that the mercantilists’ push for

more exports and fewer imports turns social priorities upside down. Here are the key points that refute mercantilist thinking:

• National well-being is based on the ability to consume products (and other “goods” such as leisure and a clean environment) now and in the future. Imports are part of the expanding national consumption that a nation seeks, not an evil to be suppressed.

• The importance of national production and exports is only indirect: They provide the income to buy products to consume. Exports are not desirable on their own; rather, exports are useful because they pay for imports.

• Trade freely transacted between countries gen- erally leads to gains for all countries—trade is a positive-sum activity.

In addition, even the goal of acquiring gold and silver can be self-defeating if this acquisi- tion expands the domestic money supply and leads to domestic inflation of product prices—an argument first expounded by David Hume even before Smith did his writing.

Although the propositions of the mercantilists have been refuted, and countries no longer focus on piling up gold and silver, mercantilist thinking is very much alive today. It now has a sharp focus on employment. Neo-mercantilists believe that exports are good because they create jobs in the country. Imports are bad because they take jobs from the country and give them to foreigners. Neo- mercantilists continue to depict trade as a zero-sum activity. There is no recognition that trade can bring gains to all countries (including mutual gains in employment as prosperity rises throughout the world). Mercantilist thinking, though misguided, still pervades discussions of international trade in countries all over the world.

DISCUSSION QUESTION Proponents of national competitiveness focus on whether our country is winning the battle for global market share in an industry. Is this a kind of mercantilist thinking? Why or why not?

Case Study Mercantilism: Older Than Smith—and Alive Today

Chapter 3 Why Everybody Trades: Comparative Advantage 33

pug21774_ch03_031-046.indd 33pug21774_ch03_031-046.indd 33 10/16/14 10:40 PM10/16/14 10:40 PM

Final PDF to printer

In the In the Rest United States of the World

Productivity: Units of cloth per labor hour 0.25 , 1.0 Units of wheat per labor hour 0.5 . 0.4 Labor hours to make: 1 unit of cloth 4.0 . 1.0 1 unit of wheat 2.0 , 2.5

In this numerical example, the United States has an absolute advantage in pro- ducing wheat because the U.S. labor productivity in wheat is higher than the rest of

the world’s labor productivity in wheat. Similarly, the rest of the world has an absolute

advantage in producing cloth.

If there is no trade, then each country will have to produce both products to satisfy

its demand for the products. If the countries then open to free trade, each can shift

its labor resources toward producing the good in which it has the absolute advantage.

Total world production increases. In the United States, shifting one hour of labor

results in a decrease of 0.25 unit of cloth and an increase of 0.5 unit of wheat. In the

rest of the world, shifting one hour of labor results in a decrease of 0.4 unit of wheat

and an increase of 1 unit of cloth. For each product, production using labor that has

high productivity replaces production using labor that has low productivity.

International trade makes these shifts in production possible even if consumers in

each country want to buy something different from what is produced in the country.

For instance, in the United States the apparent shortage of (or apparent excess demand

for) cloth (as cloth production decreases) is met by imports of cloth from the rest of

the world. The United States pays for these imports of cloth by exporting some of the

extra wheat produced.

Thus, Adam Smith showed the benefits of free trade by showing that global pro-

duction efficiency is enhanced because trade allows each country to exploit its abso-

lute advantage in producing some product(s). At least one country is better off with

trade, and this country’s gain is not at the expense of the other country. In many cases

both countries will gain from trade by splitting the benefits of the enhanced global

production.

Smith’s reasoning was fundamentally correct, and it helped to persuade some

governments to dismantle inefficient barriers to international trade over the 100 years

after he wrote Wealth of Nations . Yet his argument failed to put to rest a fear that oth- ers had already expressed even before he wrote. What if our country has no absolute

advantage? What if the foreigners are better at producing everything than we are? Will

they want to trade? If they do, should we want to?

That fear existed in the minds of many of Smith’s English contemporaries, who

worried that the Dutch were more productive than they at making anything. The fear

reappears often. In the wake of World War II, many nations thought they could not

possibly compete with the highly productive Americans at anything and wondered

how they could gain from free trade. Today some Americans have the same fear in

reverse: Aren’t foreigners getting better at making everything that enters international

34 Part One The Theory of International Trade

pug21774_ch03_031-046.indd 34pug21774_ch03_031-046.indd 34 10/16/14 10:40 PM10/16/14 10:40 PM

Final PDF to printer

trade, and won’t the United States be hurt by free trade? We turn next to the theory

that first answered these fears and established a fundamental principle of interna-

tional trade.

RICARDO’S THEORY OF COMPARATIVE ADVANTAGE

David Ricardo’s main contribution to our understanding of international trade was to

show that there is a basis for beneficial trade whether or not countries have any abso-

lute advantage. His contribution is based on a careful examination of opportunity cost.

The opportunity cost of producing more of a product in a country is the amount of production of the other product that is given up. The opportunity cost exists because

production resources must be shifted from the other product to this product. (We

already used this idea in the discussion of absolute advantage, when we shifted labor

from producing one product to producing the other product.)

Ricardo’s writings in the early 19th century demonstrated the principle of comparative advantage: A country will export the goods and services that it can produce at a low opportunity cost and import the goods and services that it would

otherwise produce at a high opportunity cost.

The key word here is comparative, meaning “relative” and “not necessarily abso- lute.” Even if one country is absolutely more productive at producing everything and

the other country is absolutely less productive, they both can gain by trading with each

other as long as their relative (dis)advantages in making different goods are different.

Each country can benefit from trade by exporting products in which it has the greatest

relative advantage (or least relative disadvantage) and importing products in which

it has the least relative advantage (or the greatest relative disadvantage). Ricardo’s

approach is actually a double comparison—between countries and between products.

Ricardo drove home the point with a simple numerical example of gains from

trading two products (cloth and wine) between two countries (England and Portugal).

Here is a similar illustration, using wheat and cloth in the United States and the rest

of the world:

In the In the Rest United States of the World

Productivity: Units of cloth per labor hour 0.25 , 1.0 Units of wheat per labor hour 0.5 , 0.67 Labor hours to make: 1 unit of cloth 4.0 . 1.0 1 unit of wheat 2.0 . 1.5

Here, one country has inferior productivity in both goods. The United States has abso-

lute disadvantages in both goods—lower productivity or larger numbers of hours to

produce one unit of each good. What products (if any) will the United States export or

import? Can trade bring net national gains to both countries?

Chapter 3 Why Everybody Trades: Comparative Advantage 35

pug21774_ch03_031-046.indd 35pug21774_ch03_031-046.indd 35 10/16/14 10:40 PM10/16/14 10:40 PM

Final PDF to printer

As in the absolute-advantage case, we can begin by imagining the two countries

separately with no trade between them. Each country will have to produce both prod-

ucts to meet local demands for the two products. What will the product prices be in

each country? With no trade, the prices of the two products within each country will

be determined by conditions within each country. To keep our focus on real values

and activities, we are going to try to ignore money for as long as we can. Rather than

looking at money prices (dollars per cloth unit or dollars per wheat unit), we will use

the relative price —the ratio of one product price to another product price. It’s as if we are in a world without money, a world of barter between real products like wheat

and cloth. 1

Ricardo, like Smith, believed that, in competitive markets, product prices reflect the

costs of the labor needed to produce the products. With no trade, four hours of labor

in the United States could produce either 2 wheat units or 1 cloth unit. The price of

1 cloth unit is then 2 wheat units in the United States. (Two wheat units is also the

opportunity cost of producing cloth in the United States—product prices reflect costs.)

In the rest of the world, one hour of labor could produce 1 cloth unit or 2/3 wheat unit.

The price (and the opportunity cost) of a cloth unit is 0.67 wheat unit in the rest of

the world. Thus, within the two isolated economies, national prices would follow the

relative labor costs of cloth and wheat:

In the United States In the Rest of the World

With no international trade: Price of cloth 2.0 W/C 0.67 W/C Price of wheat 0.5 C/ W 1.5 C/ W

We will use the notation W to refer to wheat units and C to refer to cloth units. The relative price of cloth is measured as wheat units per unit of cloth ( W/C ), and the rela- tive price of wheat as C/W . Note that there is really only one ratio in each country because the price of wheat is just the reciprocal of the price of cloth.

Now let trade be possible between the United States and the rest of the world.

Somebody will notice the difference between the national prices for each good and

will try to profit from that difference. The principle is simple and universal: As long as

prices differ in two places (by more than any cost of transporting between the places),

there is a way to profit through arbitrage —buying at the low price in one place and selling at the high price in the other place.

Perhaps the first alert person will think of sending cloth to the United States in

exchange for U.S. wheat. Consider the arbitrage profit that the person could make.

She acquires cloth in the rest of the world, giving up 0.67 W for each cloth unit. She

1We keep money hiding in the wings throughout most of Chapters 2–15, allowing it to take center stage only in the more macroeconomic Chapters 16–25. Money appears briefly in the box later in this chapter titled “What If Trade Doesn’t Balance?” and again in Chapter 5, both times to help us think about how exchange rates relate to real prices like the “wheat units per unit of cloth” prices used here. Chapters 8–15 switch to what look like ordinary money prices, such as dollars per bicycle in Chapter 8. Even there, however, the prices do not have much to do with money. As in Chapter 2, the dollars are really units of all products other than the one being pictured (e.g., motorbikes).

36 Part One The Theory of International Trade

pug21774_ch03_031-046.indd 36pug21774_ch03_031-046.indd 36 10/16/14 10:40 PM10/16/14 10:40 PM

Final PDF to printer

then ships this cloth to the United States and sells it there for 2.0 W per cloth unit. To keep things simple, we will usually assume that the cost of transporting products

between the countries is zero. 2 Therefore, by buying low (at 0.67) and selling high (at

2.0), she can make an arbitrage profit of 1.33 W for each cloth unit that she exports from the rest of the world (and imports into the United States). Somebody else could

profit by acquiring wheat in the United States at the low price of 0.5 C per wheat unit, shipping the wheat to the rest of the world, and selling it for the higher price of 1.5 C per wheat unit.

The opening of profitable international trade will start pushing the two separate

national price ratios toward a new worldwide equilibrium. As people remove cloth

from the rest of the world by exporting it, cloth becomes more expensive relative to

wheat in the rest of the world. Meanwhile, cloth becomes cheaper in the United States,

thanks to the additional supply of cloth imported from the rest of the world. So, cloth

tends to get more expensive where it was cheap at first, and cheaper where it was more

expensive. (A similar process occurs for wheat.)

The tendencies continue until the two national relative prices become one world

equilibrium relative price. Normal trade on an ongoing basis will be conducted at this

equilibrium relative price.

What will the equilibrium international price be? We cannot say for sure without

knowing how strongly the two countries demand each of the two products. We do

know something—the equilibrium international price ratio must fall within the range

of the two price ratios that prevailed in each country before trade began:

2.0 W/C $ International price of cloth $ 0.67 W/C

or, equivalently,

0.5 C/W # International price of wheat # 1.5 C/W

Why? Consider what would happen if this were not true. For instance, consider an international price of only 0.4 W/C. At this low price of cloth, the rest of the world would want to import cloth and export wheat because the price of cloth on the inter-

national market is now below the cost of producing cloth at home (0.67 W/C ). No deal could be made, though. At this low cloth price the United States would also want to

import cloth and export wheat. No equilibrium is possible, and the cloth price would

be pushed up as a result of the excess demand for cloth. (Similar reasoning applies to

show the lack of an equilibrium if the cloth price is above 2 W/C .) The only way for the two sides to agree on trading is to have the cloth price somewhere in the range

0.67 to 2.0 W/C .

2The assumption of zero transport costs is relatively harmless. If transport costs are positive but not too large, they reduce the gains from trading but do not reverse any of our major conclusions. In addition, in a world with many products, high transport costs for some products could prevent any trade in those products. For instance, many services are nontraded products because the cost of getting the seller and buyer together is too high. (No Canadian or American would travel to China just to get a cheap haircut.) Yet other services can be and are traded at low cost, especially if the service is “transported” electronically. For instance, the author of this book recently completed consulting research for the European Union in which all communication, including the delivery of completed work, was conducted by e-mail and telephone.

Chapter 3 Why Everybody Trades: Comparative Advantage 37

pug21774_ch03_031-046.indd 37pug21774_ch03_031-046.indd 37 10/16/14 10:40 PM10/16/14 10:40 PM

Final PDF to printer

Suppose that the strengths of demand for the products, which we will examine

more closely in the next chapter, lead to an equilibrium international cloth price that

has the convenient value of 1 W/C . Then both countries gain from international trade. The United States gains:

• It produces a unit of wheat by giving up only 0.5 unit of cloth.

• It can export this wheat unit and receive 1 unit of cloth.

The rest of the world gains:

• It produces a unit of cloth by giving up only 0.67 unit of wheat.

• It can export this cloth unit and receive 1 unit of wheat.

How do absolute advantage and comparative advantage relate to each other? There

are two parts to the answer. First, Smith’s example of each country having an absolute

advantage in one product is also a case of comparative advantage. Our detailed analy-

sis of comparative advantage could be applied to the numerical example of absolute

advantage in the previous section.

Second, comparative advantage is more general and powerful. What matters is that

the two countries have different price ratios if there is no trade. A country will have a

comparative advantage even if it has no absolute advantage. The basis for trade and the

gains from trade arise from differences between the countries in opportunity costs of

the goods. In our numerical example of comparative advantage, the opportunity cost

of a unit of wheat within the United States (0.5 C/W ) is lower than this opportunity cost in the rest of the world (1.5 C/W ). The United States will export wheat, even though it has an absolute disadvantage in producing both wheat and cloth.

So is comparative advantage everything? Not exactly. While absolute advantage

does not determine the trade pattern in cases like this, it is a key to differences in liv-

ing standards. Having an absolute disadvantage in all products means that the country

is less productive than other countries are. Low-productivity countries have low real

wages and are poor countries. High-productivity countries have high real wages and

are rich countries. See the box titled “Absolute Advantage Does Matter.”

RICARDO’S CONSTANT COSTS AND THE PRODUCTION-POSSIBILITY CURVE

Ricardo’s numerical illustration succeeded in proving the principle of comparative

advantage. We can also show Ricardo’s comparative advantage using diagrams indi-

cating what each country can produce and consume.

Figure 3.1 pictures production, consumption, and trade for the United States and

the rest of the world. Let’s examine national production first. Each country can use its

resources (labor) to produce various amounts of the two products, wheat and cloth. To

show what a nation is capable of producing requires a curve (or line) that shows all of

these possibilities. For example, consider that the United States has 100 billion hours

of labor available during the year and that labor productivities are as shown in the

Ricardian numerical example (0.5 wheat unit per hour and 0.25 cloth unit per hour).

Then, the United States can make 50 billion wheat units per year if it produces only

38 Part One The Theory of International Trade

pug21774_ch03_031-046.indd 38pug21774_ch03_031-046.indd 38 10/16/14 10:40 PM10/16/14 10:40 PM

Final PDF to printer

The thick black lines are the production-possibility curves (ppc’s), showing what each nation

can produce. With no trade, each country’s consumption is limited by its ability to produce

so that consumption occurs at a point like S 0 in each country. With free trade, each country

specializes in producing only one good, at S 1 . Each country can reach its desirable levels of

consumption (consuming at a point like C ) by trading along the colored trade line.

Result: Both countries gain from trade. For each country, specializing and trading make it possible to consume more of both goods at C , relative to a no-trade point like S

0 on the ppc.

20 25

Wheat (billions of units per year)

United States

Cloth (billions of units per year)

0 50

Trade line

ppc

Rest of the World

100

0 100

Trade lineppc

S0 S1

FIGURE 3.1 The Gains from

Trade, Shown

for Ricardo’s

Constant-Cost

Case

wheat—or it can make 25 billion cloth units per year if instead it makes only cloth.

The United States can also produce a mix of wheat and cloth, say, 20 billion wheat

units and 15 billion cloth units. If we graph all of these points, we have the country’s

production-possibility curve (ppc), which shows all combinations of amounts of different products that an economy can produce with full employment of its resources

and maximum feasible productivity of these resources.

The thick black lines in Figure 3.1 are the ppc’s for the United States and the rest of

the world (assuming that the rest of the world also has 100 billion hours of labor avail-

able annually). Note that each is a straight line with a constant (negative) slope. This

slope indicates the cost of extra cloth, the number of wheat units each country would

have to give up to make each extra cloth unit. In this case, the cost is always 50/25 =

2 W/C for the United States, the same opportunity cost of cloth as in the numerical example. With no trade and competitive markets, this cost is also the relative price of

cloth in the United States. For the rest of the world the cost of extra cloth is 67/100 =

2/3 W/C . This is also the relative price of cloth in the rest of the world with competi- tive markets and no trade. The ppc’s in Figure 3.1 are drawn as straight lines to reflect

Ricardo’s belief that each labor-productivity value is constant. Constant productivi-

ties imply that the trade-off in production—the marginal or opportunity cost of each

good—is constant in each country.

We can use Figure 3.1 to restate Ricardo’s conclusions about the basis for trade

and the gains from trade. If neither country traded, each could consume and enjoy

Chapter 3 Why Everybody Trades: Comparative Advantage 39

pug21774_ch03_031-046.indd 39pug21774_ch03_031-046.indd 39 10/16/14 10:40 PM10/16/14 10:40 PM

Final PDF to printer

Focus on Labor Absolute Advantage Does Matter

If free trade is so good, why do so many people fear it? Activists and protesters have recently been complaining loudly that trade has bad effects on

• Workers in developing countries.

• Workers in the industrialized countries.

• The natural environment.

Analysis of absolute advantage and comparative advantage focuses on a resource called labor, so let’s focus on trade and workers. (Most of our examination of issues related to the natural envi- ronment is concentrated in Chapter 13.)

Can the classical analysis pioneered by Smith and Ricardo really tell us anything about current controversies? The most interesting case is the one presented in the text, in which one country (now call it the North) has an absolute advantage in the production of all products, and the other country (now call it the South) has an absolute disadvantage. Three prominent questions can be examined within this framework:

1. If labor in the North is so productive, will workers in the South be overwhelmed so that free trade makes the South poorer?

2. If wages in the South are so low, will work- ers in the North be overwhelmed so that free trade makes the North poorer?

3. Does trade lead to harm to and exploitation of workers in the South, as indicated by the low wages (and/or poor working conditions)?

The text has already answered the first ques- tion. The South will have a comparative advan- tage in some set of products, and production of these products will thrive in that country. The opening of trade will lead to reductions of jobs producing the products that are imported from the North, but these workers can shift to the expanding export-oriented industries. While there may be some transition costs borne by the workers who must shift from one industry to another, the South still gets the gains from trade—generally, it becomes richer, not poorer.

How is it that some products produced by (absolutely) low-productivity workers in the South can compete successfully? The answer must be that workers in the South have low wages. The cost of producing a unit of a product is the ratio between the wage rate paid to a worker and the productivity of the worker. Production cost can be low if wages are low, or if productiv- ity is high, and what really matters is the relation- ship between the two.

For the South’s comparative-advantage prod- ucts (the ones for which the productivity disad- vantage is smallest), the lower wages lead to low production costs and the ability to export success- fully. For the comparative-disadvantage products, the large productivity disadvantage is not offset by the lower wages, and these products are imported from the North.

But if wages in the South are low, how can products produced by high-wage workers in the North compete? The answer to this second ques- tion is the other side of the answer to the first. The North has comparative advantage in a set of products because in these products its (absolute) productivity advantage is the largest. Even with high wages, the cost of producing these products is low because the workers are highly productive. The North can successfully export these products because high productivity leads to low production costs. By using its comparative advantage (maxi- mizing its absolute productivity advantage), the North gets the gains from trade—generally it also becomes richer, not poorer.

But is this fair? Why should the workers in the North have high wages and the workers in the South have low wages? Does this show that the workers in the South are being exploited by trade? A big part of the answer to these ques- tions is that absolute advantage does matter . But it matters not for determining the trade pattern but rather for determining national wage levels and national living standards . Workers can receive high wages and enjoy high living standards if they are highly productive. Workers with low produc- tivity are paid low wages. (See the accompanying

40 Part One The Theory of International Trade

pug21774_ch03_031-046.indd 40pug21774_ch03_031-046.indd 40 10/16/14 10:40 PM10/16/14 10:40 PM

Final PDF to printer

figure for recent evidence for a number of coun- tries that shows how true this is.) The low wages in the South are the result of the low labor pro- ductivity, and wages in the South are going to be low with or without trade. Trade does not exploit these workers. In fact, because of the gains from trade, workers in the South can earn somewhat higher wages and have somewhat better living standards. Still, as long as productivity remains low in the South, workers in the South will remain relatively poor, even with free trade.

Is there anything we can do if we still think that it is unfair that workers in the South earn such low wages? Trade by itself is not the solu- tion (though it also is not the culprit). Some kind of government mandate to pay higher wages in

the South is also not the solution. Forcing higher wages would raise production costs, and this would just shrink some of the export-oriented industries that have productivity levels not much below the productivity levels in the North.

The true solution must be to find ways to increase the productivity of workers in the South. While Ricardo’s approach does not indicate what deter- mines labor productivity, we know some changes that would be desirable: increasing worker quality by enhancing education and health, upgrading production technologies and management prac- tices, and reforming or liberalizing restrictive and distortionary government policies. In short, abso- lute advantage matters—to raise wages and living standards, we need to raise productivity.

For the manufacturing sector of each of 63 countries, the average labor productivity and average wage are measured relative to the United States, for 2006. The figure shows that there is a strong tendency for the average wage to be higher in countries with higher average labor productivity. (For the curious, the outlier on labor productivity is Ireland.)

1.6

1.2

1.4

0.8

0.6

0.4

0.2

0 1.61.41.210.80.60.40.20

Average wage (relative to the United States)

Average Labor Productivity and Average Wage in Manufacturing, 2006

Average labor productivity (relative to the United States)

Sources: For 28 industrialized and other European countries, value added per hour and labor compensation per hour from EU KLEMS, Growth and Productivity Accounts, November 2009 Release. For 35 other developing countries, value added per employee and wage per employee from UNIDO, International Yearbook of Industrial Statistics, 2010. Based on Golub (1999).

Chapter 3 Why Everybody Trades: Comparative Advantage 41

pug21774_ch03_031-046.indd 41pug21774_ch03_031-046.indd 41 10/16/14 10:40 PM10/16/14 10:40 PM

Final PDF to printer

You may be struck by a contradiction between the spirit of the trade theory and recent head- lines about international trade.

The theory assumes that trade balances. In diagrams like Figure 3.1, the theory assumes equality between the market value of a country’s exports and the market value of its imports (both values calculated using the international price ratio). The balance seems guaranteed by the absence of money from the diagram, as noted in this chapter’s footnote 1. As long as countries are just bartering wheat for cloth, they must think U.S. wheat exports have exactly the same market value as U.S. cloth imports. Trade must balance.

Yet the news media have been announcing huge U.S. trade deficits every year since 1975. Imports of goods and services keep exceeding exports. (Conversely, Japan, Germany, and France have been running trade surpluses in most years since that time.) What’s going on? How can the basic theory of trade be so silent about the most newsworthy aspect of international trade flows? Isn’t the theory wrong in its statements about the reasons for trade or the gains from trade? Maybe Ricardo was too optimistic about every country’s having enough comparative advantage to bal- ance its overall trade.

These are valid questions, and they deserve a better answer than simply “Well, the model assumes balanced trade.” In later chapters, we will add details about how trade deficits and surpluses relate to exchange rates, money, and

finance. But the real answer is more fundamen- tal: The model is not really wrong in assuming balanced trade, even for a country that currently has a huge trade deficit or trade surplus!

Take the case of the U.S. trade deficit. It looks as though exports are always less than imports. Well, yes and no. Yes, the trade bal- ance (more precisely the “current-account” balance in Chapter 16) has stayed negative for many years. But a country with a current- account deficit pays for it by either piling up debts or giving up assets to foreigners. Such a country is exporting paper IOUs, such as bonds, that are a present claim on future goods and services. The value of these net exports of paper IOUs matches the value of the ordinary current- account deficit.

There is no need to add paper bonds to our wheat-and-cloth examples because the bonds are a claim on future wheat and cloth. Today the United States may be importing more cloth than it is exporting wheat, but this deficit is matched by the expected value of its net exports of extra wheat someday when it pays off the debt. Trade is expected to balance over the very long run. That expectation could prove wrong in the future: Maybe the United States will default on some of its foreign debts, or maybe price infla- tion (deflation) will make it give up less (more) wheat than expected. Still, today’s transactions are based on the expectation that trade will bal- ance in the long run.

Extension What If Trade Doesn’t Balance?

only combinations of wheat and cloth that are on (or below) its ppc, combinations

like those shown as S 0 in Figure 3.1. When trade is opened, each nation can trade at a

price between 2/3 and 2 W/C . Again, let us suppose that demand conditions make the free-trade price equal l W/C . Each country then specializes in producing only the good in which it has a comparative advantage, at point S

1 .

To show how each nation gains from trade at this price, we need to consider how

trade should be drawn on the diagram. When a nation sells its exports to get imports,

it ends up consuming a different set of goods. How different? In a diagram such as

Figure 3.1, the line connecting where a nation produces and where it consumes is

42 Part One The Theory of International Trade

pug21774_ch03_031-046.indd 42pug21774_ch03_031-046.indd 42 10/16/14 10:40 PM10/16/14 10:40 PM

Final PDF to printer

a line along which wheat trades for cloth at the world price ratio, l W/C . Two trade (or world price) lines are shown in Figure 3.1.

If the United States specializes in making only wheat, at S l , it can export wheat for

cloth imports at the world price ratio, moving along the trade line. Giving up wheat

and gaining cloth imports means moving southeast along the trade line. If the world

price is 1 W/C , the United States could consume anywhere along this thin colored line. Clearly, this is a better set of consumption options than if the United States did not

trade. For each point like S 0 , where the nation consumes what it produces, there are

better consumption points like C , where it can end up consuming more of everything by specializing and trading. The United States gains from trade. It is equally clear that

the rest of the world also gains from specializing in cloth production (at S l ) and trading

some of that cloth for wheat, moving northwest along its trade line to consume at some

point like C . Thus, Figure 3.1 is a different way to view the workings of comparative advantage with Ricardian constant costs.

This analysis is clear and powerful, but it also shows a serious shortcoming. The

constancy of marginal costs in Figure 3.1 leads us to conclude that each country

would maximize its gain by specializing its production completely in its comparative-

advantage good. 3

The real world fails to show total specialization. In Ricardo’s day, it may have been

reasonable for him to assume that England grew no wine grapes and relied on foreign

grapes and wines. However, even with cloth imports from England, the other country

in his example, Portugal, made most of its own cloth. Complete specialization is no

more common today. The United States and Canada continue to produce some of

their domestic consumption of products that they partially import—textiles, cars, and

furniture, for example. We take up the more realistic case of increasing marginal cost

and incomplete specialization in the next chapter.

Summary International trade occurs because product prices would differ if there were no trade. This chapter begins our analysis of theories emphasizing production-side differ-

ences between countries as the reason for product prices to differ without trade. In

Adam Smith’s theory of absolute advantage, each country exports the product in which the country has the higher labor productivity. David Ricardo’s principle of comparative advantage shows that beneficial trade can occur even if one country is worse (less productive) at producing all products.

The principle of comparative advantage is based on the importance of opportunity cost —the amount of other products that must be forgone to produce more of a particu- lar product. The principle states that a country will export products that it can produce

at low opportunity cost in return for imports of products that it would otherwise

produce at high opportunity cost.

3With constant costs, one of the two trading countries can fail to specialize completely only in the special case in which the international price ratio settles at the same price ratio prevailing in that country with no trade. In this case the country whose price ratio does not change is a “large” country and the other country is a “small” country. The large country continues to produce both goods with free trade because the small country cannot export enough to satisfy all demand for this product in the large country. Figure 3.1 assumes that the countries are of sufficiently similar “size” that both completely specialize in production.

Chapter 3 Why Everybody Trades: Comparative Advantage 43

pug21774_ch03_031-046.indd 43pug21774_ch03_031-046.indd 43 10/16/14 10:40 PM10/16/14 10:40 PM

Final PDF to printer

Suggested Reading

Irwin (1996) provides a good survey of thoughts about the advantages and disadvantages

of free trade, starting with the ancient Greeks and continuing through mercantilists,

Smith, Ricardo, and recent economic analysis. Bhagwati (2004) and Wolf (2004) analyze

and respond to the complaints and charges made by the critics of freer trade (and of

economic globalization more generally).

Questions and Problems

1. “According to Ricardo’s analysis, a country exports any good whose production

requires fewer labor hours per unit than the labor hours per unit needed to produce the

good in the foreign country. That is, the country exports any good in which its labor

productivity is higher than the labor productivity for this good in the foreign country.”

Do you agree or disagree? Why?

2. “For my country, imports are the good thing about international trade, whereas exports

are more like the necessary evil.” Do you agree or disagree? Why?

3. “Mercantilism recommends that a country should limit its exports, so that more of

the otherwise-exportable products are instead available for local consumption.”

Do you agree or disagree with this characterization of mercantilism’s message?

Explain.

4. Consider the two economies shown in Figure 3.1. When there is free trade, are we sure

that each country should specialize completely in producing only one of the products?

For instance, perhaps each country should shift along its production-possibility curve

only about halfway from the no-trade production point S 0 to the intercept point S

1 . If

the countries still traded with each other at the relative price of 1 W/C , would produc- ing at the halfway point be better or worse for each country (compared to completely

specializing at point S 1 )?

5. Consider the numerical example that we used to demonstrate the thinking of Adam

Smith (page 34). Assume that there is now no international trade. You are the first

person to notice the differences between the countries and the possibility of interna-

tional trade. How would you engage in arbitrage? How much can you profit from your

first small amount of arbitrage?

✦

We can picture a country’s production capabilities using a production-possibility curve (ppc) . Ricardo’s approach assumes constant marginal costs, so a country’s ppc is a straight line. We can use graphs with countries’ production-possibility curves to

illustrate why countries trade according to comparative advantage and to show that

both countries can gain by trading. Contrary to mercantilist thinking, trade is not a zero-sum game in which one country gains only when the other country loses.

Labor productivity

Mercantilism

Absolute advantage

Opportunity cost

Principle of comparative

advantage

Relative price

Arbitrage

Production-possibility

curve (ppc) Key Terms

44 Part One The Theory of International Trade

pug21774_ch03_031-046.indd 44pug21774_ch03_031-046.indd 44 10/16/14 10:40 PM10/16/14 10:40 PM

Final PDF to printer

6. Again, consider the numerical example that we used to demonstrate the thinking of

Adam Smith (page 34). When these countries open to free trade, is it possible that the free-trade equilibrium world relative price of cloth is 1.5 W/C ?

7. You are given the information shown in the table about production relationships in

Pugelovia and the rest of the world.

Inputs per Unit Inputs per Unit of Rice Output of Cloth Output

Pugelovia 75 100 Rest of the world 50 50

You make several Ricardian assumptions: These are the only two commodities, there

are constant ratios of input to output whatever the level of output of rice and cloth, and

competition prevails in all markets.

a. Does Pugelovia have an absolute advantage in producing rice? Cloth? b. Does Pugelovia have a comparative advantage in producing rice? Cloth? c. If no international trade were allowed, what price ratio would prevail between rice

and cloth within Pugelovia?

d. If free international trade is opened up, what are the limits for the equilibrium international price ratio? What product will Pugelovia export? Import?

8. Consider another Ricardian example, using standard Ricardian assumptions:

Labor Hours per Labor Hours per Bottle of Wine Kilogram of Cheese

Vintland 15 10 Moonited Republic 10 4

Vintland has 30 million hours of labor in total per year. Moonited Republic has

20 million hours of labor per year.

a. Which country has an absolute advantage in wine? In cheese? b. Which country has a comparative advantage in wine? In cheese? c. Graph each country’s production-possibility curve. Show the no-trade production

point for each country, assuming that with no trade Vintland consumes 1.5 million

kilos of cheese and Moonited Republic consumes 3 million kilos of cheese.

d. When trade is opened, which country exports which good? If the equilibrium international price ratio is ½ bottle of wine per kilo of cheese, what happens to

production in each country?

e. In this free-trade equilibrium, 2 million kilos of cheese and 1 million bottles of wine are traded. What is the consumption point in each country with free trade?

Show this graphically.

f. Does each country gain from trade? Explain, referring to your graphs as is appropriate.

✦

Chapter 3 Why Everybody Trades: Comparative Advantage 45

pug21774_ch03_031-046.indd 45pug21774_ch03_031-046.indd 45 10/16/14 10:40 PM10/16/14 10:40 PM

Final PDF to printer

9. The real wage is the purchasing power of one hour of labor. That is, for each product it

is the number of units of the product that a worker can buy with his earnings from one

hour of work. In a Ricardian model, for any product actually produced by the worker,

the worker is simply paid according to her productivity (units of output per hour). This

is then her real wage in terms of this product. In your answer to this question, use the

numerical example from the section on Ricardo’s theory of comparative advantage.

a. With no trade, what is the real wage of labor with respect to each good in the United States? In the rest of the world? Which country’s labor has the higher

“average” real wage?

b. With free trade and an equilibrium price ratio of 1 W/C , each country completely specializes. What is the real wage with respect to wheat in the United States? By

using international trade to obtain cloth, what is the new value of the real wage

with respect to cloth in the United States? What does this tell us about gains from

trade for the United States? What is the real wage with respect to cloth in the rest

of the world? By using international trade to obtain wheat, what is the new value

of the real wage with respect to wheat in the rest of the world? What does this tell

us about the gains from trade for the rest of the world?

c. With free trade, which country’s labor has the higher “average” real wage? In what sense does absolute advantage matter?

10. In your answer to this question, use the numerical example from the section on

Ricardo’s theory of comparative advantage. What is the effect on the pattern of trade

predicted by the Ricardian analysis if the number of labor hours required to make

a unit of wheat in the United States is reduced by half (that is, if its productivity

doubles)? Now return to the initial numbers. What is the effect on the pattern of trade

if instead the number of hours required to make a unit of cloth in the United States is

reduced by half (productivity doubles)?

11. Consider the international trade shown in Figure 3.1. Suppose that the equilibrium

international cloth price is 1.2 W/C, instead of 1 W/C. At the equilibrium international price of 1.2 W/C, does the United States probably gain more or less from free trade (than it would if, instead, the equilibrium international price is 1 W/C)? Does the rest of the world probably gain more or less? Explain, and refer to the figure’s graphs in

your explanation.

12. You know the following information about labor productivity (units of output per hour

of labor) in a country:

A worker can produce 8 units of product V in one hour.

A worker can produce 4 units of product Z in one hour.

a. With no international trade, what is the opportunity cost of product Z for this country?

b. The country now opens to free trade, and the equilibrium world price of product Z is 1.5 V/Z. In comparison with no trade, which product will the country shift toward producing more of?

c. For free trade with an equilibrium world price of product Z equal to 1.5 V/Z, is it possible that the labor productivities in the other country (the one that this country

trades with) are 6 units of product V per labor hour and 6 units of product Z per

labor hour? Why or why not?

✦

46 Part One The Theory of International Trade

pug21774_ch03_031-046.indd 46pug21774_ch03_031-046.indd 46 10/16/14 10:40 PM10/16/14 10:40 PM

Final PDF to printer

Chapter Four

Trade: Factor Availability and Factor Proportions Are Key Chapter 3 presented the powerful concept of comparative advantage in a simple setting

like the one that Ricardo first used. As we noted at the end of the chapter, a drawback

to Ricardo’s approach is the assumption of constant marginal opportunity costs. Many

industries incur rising, rather than constant, marginal opportunity costs. For instance,

efforts to expand U.S. wheat production would fairly quickly run into rising costs

caused by limits on (1) how much more land could be drawn into wheat production

and how suitable this additional land would be for wheat production, (2) the avail-

ability of additional workers willing and suitable to work on the farms, and/or (3) the

availability of seeds, fertilizers, and other material inputs.

This chapter presents the analysis of trade with increasing marginal costs of pro-

duction, an approach that is usually considered to be the standard modern theory of

trade. The first part of the chapter presents the development of tools to analyze the

general equilibrium of our two-product economy. First, we show that with rising mar-

ginal costs the production-possibility curve will have a bowed-out shape. Second, we

introduce community indifference curves to illustrate consumers’ decisions about how

much to buy of each of the two products. Third, we use these tools to show a country’s

economic situation with no trade and with free trade.

In the second half of the chapter we use this framework to explore the answers to

three of our four key questions about trade: the basis for trade, the gains from trade,

and the effects on production and consumption. The analysis shows that there are three

possible bases for trade. One possibility is that there are differences in the demands

for the products in the different countries. A second possibility is that differences in

technologies or resource productivities can create comparative advantage, just as they

did in Ricardo’s approach.

The chapter culminates in the presentation of the third possible basis for inter-

national trade. The Heckscher–Ohlin theory of trade emphasizes international dif-

ferences in the abundance of the factors of production (land, labor, skills, capital,

pug21774_ch04_047-065.indd 47pug21774_ch04_047-065.indd 47 11/3/14 6:10 PM11/3/14 6:10 PM

Final PDF to printer

and natural resources). Differences in factor availability are a source of comparative

advantage because there are also differences in the use of each factor in the production

of different products.

PRODUCTION WITH INCREASING MARGINAL COSTS

In the standard modern theory of international trade, economists replace the constant-

cost assumption used in the Ricardian approach with a more realistic assumption

about marginal costs. They assume increasing marginal costs: As one industry expands at the expense of others, increasing amounts of the other products must be

given up to get each extra unit of the expanding industry’s product.

A country’s production-possibility curve (ppc) shows the combinations of amounts of different products that a country can produce, given the country’s avail-

able factor resources and maximum feasible productivities. What does the ppc look

like with increasing marginal costs? It is “bowed out,” as shown in the top half of

Figure 4.1 . To see why a bowed-out ppc shows increasing marginal costs, consider

what happens to the marginal cost of producing an extra unit of cloth as we shift more

and more resources from wheat production to cloth production. When the economy is

producing only 20 billion units of cloth, the slope of the production-possibility curve

at point S 1 tells us that one extra cloth unit could be made each year by giving up

one unit of wheat. When 40 billion cloth units are being made each year, getting the

resources to make another cloth unit a year means giving up two units of wheat, as

shown by the steeper slope at point S 0 . To push cloth production up to 60 billion cloth

units per year requires giving up wheat in amounts that rise to three wheat units for

the last unit of cloth.

The increasing costs of extra cloth are also increasing costs of producing extra

wheat. When one starts from a cloth-only economy at point S 2 and shifts increasing

amounts of resources into growing wheat, the cost of an extra wheat unit rises (from

1/3 cloth unit at S 2 to 1/2 cloth unit at S

0 , 1 cloth unit at S

1 , and so forth).

The increasing marginal costs reappear in a familiar form in the lower half of

Figure 4.1. Here the vertical axis shows the marginal costs of extra cloth, which are the

slopes in the upper half of the figure. The resulting curve is a supply curve for cloth. The set of competitive U.S. cloth producers would use the marginal costs of producing

extra cloth to decide how much cloth to supply at each possible market price of cloth.

So, we have two ways to picture increasing marginal costs, the two-product bowed-

out ppc and the upward-sloping supply curve that focuses on one of these products.

What’s Behind the Bowed-Out Production-Possibility Curve? What information do we need to derive the production-possibility curve of each

country? Why are increasing-cost curves (bowed-out in shape) more realistic than

constant-cost (straight-line) production-possibility curves?

A country’s production-possibility curve is derived from information on both total

factor (resource) supplies and the production functions that indicate how factor inputs

can be used to produce outputs in various industries. In Appendix B we show how the

48 Part One The Theory of International Trade

pug21774_ch04_047-065.indd 48pug21774_ch04_047-065.indd 48 10/27/14 4:53 PM10/27/14 4:53 PM

Final PDF to printer

FIGURE 4.1 Production

Possibilities

under Increasing

Costs

Wheat (billions of units per year)

20 Cloth

(billions of units per year)

Cloth (billions of units per year)

0 60

2.0

Cost of an extra cloth unit (W/C)

3.0

0 60

1.0 Supply curve for cloth in the United States ( = opportunity-cost curve, or marginal-cost curve)

A. U.S. production- possibility curveS1: Slope =

1 W/C

S0: Slope = 2 W/C

S2: Slope = 3 W/C

B. Rising opportunity costs for producing cloth in the United States

Increasing opportunity costs can be shown in either of two equivalent ways: as changing slopes along

a bowed-out production-possibility curve or as an upward-sloping supply (or marginal-cost) curve.

Note: For the analysis of the production-possibility curve, we ignore the fact that the slopes of the

tangent lines are negative.

Chapter 4 Trade: Factor Availability and Factor Proportions Are Key 49

pug21774_ch04_047-065.indd 49pug21774_ch04_047-065.indd 49 10/27/14 4:53 PM10/27/14 4:53 PM

Final PDF to printer

production-possibility curves are derived under several common assumptions about

production functions in individual industries.

We can sketch the explanation for the realism of increasing costs (and the bowed-

out shape) even without a rigorous demonstration. The starting points are that

• There are several kinds of factor inputs (land, skilled labor, unskilled labor, capital,

and so forth).

• Different products use factor inputs in different proportions.

To stay with our wheat-and-cloth example, wheat uses relatively more land and less

labor than cloth, whether the yarn for the cloth comes from synthetic fibers or from

natural fibers such as cotton or silk.

This basic variation in input proportions can set up an increasing-cost (bowed-out)

production-possibility curve even if constant returns to scale exist in each industry. When

resources are released from cloth production and are shifted into wheat production, they

will be released in proportions different from those initially prevailing in wheat produc-

tion. The cloth industry will release a lot of labor and not much land. But wheat production

generally requires a lot of land and not much labor. To employ these factors, the wheat

industry must shift toward using more labor-intensive techniques. The effect is close to

that of the law of diminishing returns (which, strictly speaking, refers to the case of add-

ing more of one factor to fixed amounts of the others): Adding so much labor to slowly

changing amounts of land causes the gains in wheat production to decline as more and

more resources, mainly labor, are released from cloth production. Thus, fewer and fewer

extra units of wheat production are gained by each extra unit of lost cloth production.

What Production Combination Is Actually Chosen? Out of all the possible production points along the production-possibility curve, which

one point does the nation select? That depends on the price ratio that competitive firms

face. Suppose that the market price of cloth in terms of wheat is 2 W / C . If you are a competitive firm vying with other firms around you, you will see one of these three

conditions at any production point:

• If the opportunity cost of producing another unit of cloth is less than the 2 W / C that you can sell it for, then try to make more cloth (and take resources away from

wheat). Firms would react this way at a point like S 1 in Figure 4.1, where the oppor-

tunity cost is less (the slope of the ppc is flatter) than 2 W / C . • If the opportunity cost of producing another unit of cloth is more than the 2 W / C

that you can sell it for, then try to make less cloth (and shift resources into growing

wheat). Firms would react this way at a point like S 2 , where the opportunity cost is

greater (the slope of the ppc is steeper) than 2 W / C . • If the opportunity cost of producing another unit of cloth is equal to the 2 W / C that

you can sell it for, then you are producing the right amount. There is no reason to

shift any production between cloth and wheat. Firms would react this way at point S 0 .

By choosing to produce at S 0 (40 billion cloth and 50 billion wheat) when the

price is 2 W / C , firms end up maximizing the value of national production. The price is represented by a price line whose slope is 2 W / C . The price line with this slope is

50 Part One The Theory of International Trade

pug21774_ch04_047-065.indd 50pug21774_ch04_047-065.indd 50 10/27/14 4:53 PM10/27/14 4:53 PM

Final PDF to printer

tangent to the ppc at S 0 . 1 The tangent point is important. For the price shown by the

slope of the price line, you cannot increase the value of national production, measured

in either cloth units or wheat units, by moving to any other point on the production-

possibility curve. 2

What will happen if the relative price of cloth declines to 1 W / C ? With a lower price of cloth, we expect that cloth production will decrease. The resources released as cloth

production decreases are shifted into wheat production, and wheat output increases.

After a period of transition, during which resources are shifted from the cloth industry

to the wheat industry, the production point chosen by the country will shift to point S 1 .

The tangent line at S 1 has a slope of 1 W / C and represents a new price line. The pro-

duction combination chosen has less cloth (20) and more wheat (80).

COMMUNITY INDIFFERENCE CURVES

The production-possibility curve pictures the production side of a country’s economy.

To complete the picture of the economy, we need a way to depict the determinants of

demand for two products simultaneously.

For an individual, economists typically begin with the notion that each individual

derives well-being (or happiness or utility) from consuming various goods and ser-

vices. Figure 4.2 shows the usual way of relating an individual’s well-being to amounts

of two goods, again wheat and cloth, that the individual consumes. Instead of drawing

the level of well-being in a third dimension rising out of the printed page, economists

draw contours called indifference curves. An indifference curve shows the various combinations of consumption quantities (here wheat and cloth) that lead to the same

level of well-being or happiness. For example, the indifference curve I 0 shows that the

individual is indifferent between points A , B , and C , each of which gives the same level of well-being. That is, the individual would be equally happy consuming 80 units of

wheat and 20 units of cloth, or 40 of both, or 20 of wheat and 80 of cloth. Any consumption point below and to the left of I

0 is worse than A or B or C in the

eyes of this individual. Points above and to the right of I 0 are better. For example, point

D , on the better indifference curve I 1 , yields a higher level of happiness than A or B or C .

Point E , on I 2 , is even more preferred.

Each indifference curve is typically presumed to have a bowed shape, as shown

in the figure. The individual has an infinite number (a complete map) of indifference

curves, representing infinitesimally small differences in well-being and showing the

person’s preferences regarding various combinations of the products. Our diagrams

typically show only a small number of indifference curves from this complete map.

1 To make our descriptions less cluttered, we will consistently use positive values for the slopes of price lines (and similar lines like tangents to a ppc), even though the slopes are actually negative.

2 This can be seen by extending the 2 W / C price line from point S 0 to touch either axis in Figure 4.1. The

point where the extended line hits the horizontal axis is the value of the whole national production of wheat plus cloth, expressed as the amount of cloth that it could be traded for. Similarly, the point where the extended line hits the vertical axis is the value of the same national production, expressed in units of wheat. You can see that this value is greater when the nation produces at S

0 than when it produces at any other

point on the ppc, as long as the price (and the slope of a price line through this other point) is 2 W / C .

Chapter 4 Trade: Factor Availability and Factor Proportions Are Key 51

pug21774_ch04_047-065.indd 51pug21774_ch04_047-065.indd 51 10/27/14 4:53 PM10/27/14 4:53 PM

Final PDF to printer

Different combinations of consumption quantities that each would give the person the same

level of well-being are points on a single indifference curve. (Example: points A, B, and C on I

0 .) A consumption point that would give the person a higher level of well-being is on a higher

indifference curve. (Example: point E on I 2 is better than any point on I

1 .) If the budget constraint

is the dashed colored line, then the person would achieve his highest feasible well-being by

purchasing and consuming the consumption quantities shown by point D because indifference curve I

1 is the highest one that he can reach.

Units of wheat consumed

Units of cloth consumed

100

0 1004020

I0 I1 I2

Wo rse

Be tte

FIGURE 4.2 Indifference

Curves Relating

an Individual’s

Level of

Well-Being to

Consumption of

Two Goods

The actual consumption point chosen by the individual depends on the bud-

get constraint facing the person—the income that the individual has available to

spend on these products and the prices of the products. The budget constraint is

Y 5 P W · Q

W 1 P

C · Q

C , assuming that the individual spends all his income, Y , on the

two products wheat ( W ) and cloth ( C ). For given income and prices, the equation is a straight line showing combinations of cloth and wheat that the individual is able

to purchase with this income: Q W 5 ( Y / P

W ) – ( P

C / P

W ) · Q

C . The slope of this budget

constraint is the (negative of the) price ratio P C / P

W , the relative price of cloth, so

we usually refer to this budget constraint as a price line.

Given the budget constraint or price line, the individual chooses consumption to

be as well off as possible—to reach the highest feasible indifference curve. This is

the indifference curve that is just tangent to the price line. In Figure 4.2, the dashed

colored line shows the budget constraint for an individual who could purchase

100 wheat units if he spent all of his income on wheat ( Y / P W 5 100) and who faces the

52 Part One The Theory of International Trade

pug21774_ch04_047-065.indd 52pug21774_ch04_047-065.indd 52 10/27/14 4:53 PM10/27/14 4:53 PM

Final PDF to printer

relative price of cloth equal to 1.25 in the markets ( P C / P

W 5 1.25). Given this budget

constraint, the individual should choose to consume 50 wheat units and 40 cloth units

(at point D ). The consumer reaches the level of well-being shown by I 1 .

When exploring trade issues, we want to portray how the entire nation, not just one

individual, decides on consumption quantities and what this decision implies for the

economic well-being of the nation as a whole. Can we portray a large group of people

(like a country) as having a set of indifference curves? There are problems with this

portrayal, and we will discuss these in the next paragraph. Yet, a single set of indif-

ference curves for a group of people is remarkably useful as a tool for our analysis.

We will utilize community indifference curves, which purport to show how the economic well-being of a whole group depends on the whole group’s consumption of

products. In what follows, we look at sets of indifference curves like those in Figure 4.2

as if they were community indifference curves for thousands or millions of people.

We will use community indifference curves, along with the price line representing the

national budget (or income) constraint, as the basis for the choice of national quanti-

ties demanded and consumed of wheat and cloth.

Nonetheless, we must keep in mind that economic theory raises difficult questions

about community indifference curves. First, the shapes of individual indifference

curves differ from person to person. There is no completely clear way to “add up”

individuals’ indifference curves to obtain community indifference curves. Second, the

concept of national well-being or welfare is not well defined. How can we say whether

the community is better off with an average of 40 wheat units less and 40 cloth units

more? As a result of this change, usually some members of the community gain, while

others lose. Who can say that the increase in happiness of the one is greater than the

decrease in happiness of the other? Levels of happiness or well-being cannot be com-

pared from one person to another.

These are real difficulties. We will use community indifference curves because

they are convenient and neat. They are reasonable for depicting the basis for national

demand patterns for two products simultaneously. Under certain assumptions they

provide information on national well-being, but some caution is needed in using them

in this way. Higher national well-being, as shown by a higher community indifference

curve, does not mean that each person is actually better off.

PRODUCTION AND CONSUMPTION TOGETHER

Figure 4.3 summarizes information on the U.S. economy. The production capabilities

of the United States are shown by the bowed-out (increasing-cost) production-

possibility curve, and U.S. consumption preferences are shown by a map of commu-

nity indifference curves, of which three are shown.

Without Trade With no trade the United States must be self-sufficient and must find the combination

of domestically produced wheat and cloth that will maximize community well-being.

In this case, I 1 is the best (highest) indifference curve that the United States can

achieve. To reach I 1 , the United States must produce at S

0 on its production-possibility

curve. At this tangent point, the United States produces and consumes 40 billion units

Chapter 4 Trade: Factor Availability and Factor Proportions Are Key 53

pug21774_ch04_047-065.indd 53pug21774_ch04_047-065.indd 53 10/27/14 4:53 PM10/27/14 4:53 PM

Final PDF to printer

Wheat (billions of units per year)

0 4020

Price ratio = 2 W/C

Cloth (billions of units per year)

Without trade, the best an economy can do is to move to the production point that touches the

highest community indifference curve. This best no-trade point is S 0 , where the nation both

produces and consumes, reaching indifference curve I 1 .

FIGURE 4.3 Indifference

Curves and

Production

Possibilities

without Trade

of cloth and 50 billion units of wheat. The relative price of cloth in the United States

with no trade is 2 W / C . Point S

0 is the no-trade equilibrium for the United States. If, instead, the United

States found itself at any other point on the U.S. production-possibility curve, consum-

ers or producers would want to shift toward S 0 . To see this, consider the example in

which the economy begins at S 1 , with a price ratio set by the slope of the ppc (a relative

price of 1 W / C ). Consumers would find that this makes cloth look so cheap that they would rather buy more cloth than 20 billion units and less wheat than 80 billion units.

Producers will follow this change in demand and shift resources into cloth produc-

tion and out of wheat. The tendency to alter production will persist until the economy

produces and consumes at S 0 , the no-trade (or autarky) equilibrium.

With Trade To show the effects of opening the world to international trade, we examine the

economies of both countries. The left side of Figure 4.4 A shows the U.S. economy

(the same as in Figure 4.3). The right side shows the economy of the rest of the world.

54 Part One The Theory of International Trade

pug21774_ch04_047-065.indd 54pug21774_ch04_047-065.indd 54 10/27/14 4:53 PM10/27/14 4:53 PM

Final PDF to printer

Wheat

Cloth

0 6020

C1 S0

I2 I1 I2

2 W/C

A. With indifference curves and production-possibility curves

Price = 1 W/C

United States

Wheat

Cloth0

Rest of the World

Price of cloth (W/C)

Cloth

0 6020

DUS

B. With demand and supply curves

Price of cloth (W/C)

Cloth

1 0.67

0 10060 80

10060 80

Cloth imports

SUS

Cloth exports

1 W/C

Price = 0.67 W/C

There are two convenient ways to portray a free-trade equilibrium. The upper panel shows trade between two countries for two products, with each country producing at its point S

1 and

consuming at its point C 1 . The lower panel shows the same thing using supply and demand

curves that focus on one product (cloth).

FIGURE 4.4 Two Views of

Free Trade and

Its Effects

The no-trade equilibrium in each country is at point S 0 . With no trade the U.S. relative

price of cloth would be 2 W / C , while the relative price in the rest of the world would be 0.67 W / C .

As in previous examples, the difference in price ratios with no trade provides the

immediate basis for trade. With free trade the United States imports cloth from the rest

of the world and exports wheat to the rest of the world. This trade tends to decrease the

relative price of cloth in the United States and increase the relative price of cloth in the

rest of the world. With free trade (and assuming no transport costs), trade results in an

equilibrium international price ratio in the range of 0.67 W / C to 2 W / C . The price ratio for this free-trade equilibrium is the price that results in the quantity of wheat exported

by the United States being equal to the quantity of wheat imported by the rest of the

Chapter 4 Trade: Factor Availability and Factor Proportions Are Key 55

pug21774_ch04_047-065.indd 55pug21774_ch04_047-065.indd 55 10/27/14 4:53 PM10/27/14 4:53 PM

Final PDF to printer

The real world does in fact reveal the behavior portrayed in the diagrams and discussion of this chapter. Countries do react to the opening of trade in the ways predicted by diagrams like those in Figure 4.4.

A good example is China’s progression to becoming a major trading nation after the near- total isolation and self-sufficiency that Chairman Mao imposed between 1958 (at the start of the Great Leap Forward) and 1976 (the year of Mao’s death and the end of the Great Proletarian Cultural Revolution). Though China covers a huge geographic area, it is not a land-abundant coun- try. Rather, it is labor-abundant and land-scarce. True to the ancient Chinese saying “Many people, little land,” the country has about 19 percent of the world’s population but only about 10 percent of its farmable land. For such a labor-abundant country, this chapter’s theories would predict the following responses to the chance to trade with the rest of the world:

• China should export labor-intensive prod- ucts like clothing and import land-intensive products like wheat.

• China should shift resources out of produc- ing land-intensive products like wheat and into producing labor-intensive products like clothing.

• China’s production specialization should be incomplete. The country should go on pro- ducing some land-intensive products, though these should be a lower share of production than before.

• China should be a more prosperous country with trade than without trade. The theory even allows for the possibility that China could consume more of all goods, including both wheat and clothing.

All these predictions have been coming true in China since 1976. The trade pattern is what we would expect: China has become a strong

exporter of all sorts of manufactured products, including clothing, that take advantage of the country’s abundant labor supply. China has also turned to imports for a portion of its con- sumption of land-intensive products, including wheat.

All over China, people have noticed the shift of production out of agriculture and into export-oriented industry. For example, in the crowded countryside of Shandong province, vil- lages that once struggled with poor soil to grow wheat and corn for cities like Tianjin and Beijing have abandoned farming and now make furni- ture and pharmaceuticals. Even the relatively fer- tile villages of Jiangsu province, near the mouth of the Yangtse River, make textiles, steel, and other industrial goods. Similarly, in the south, Guangdong province used to send its rice north to Beijing. Now Guangdong, a leader in China’s rapid industrialization, consumes more rice than it produces, supplementing local crops with rice imports from Thailand.

Both public opinion and the available sta- tistics agree that the great majority of China’s population have gained purchasing power. Some Chinese do fear becoming dependent on imports of food. The fears seem to be greater in the government than in the population at large. The government in the 1990s decided to channel a larger share of taxpayers’ money into promoting agricultural production, to retard the shift away from being self-sufficient in food. Yet many are less worried. Wu Xiedong, leader of one of those Jiangsu villages that switched from growing grain to making tex- tiles and steel, is optimistic about the shift. As he put it in 1995, “As long as the present policy that allows farmers to go into industry doesn’t change, we will continue to grow very fast.” As for relying on imported food, Wu says, “America has lots of grain, right? If America buys my steel, I’ll buy America’s grain. Then we can all get rich.”*

Focus on China The Opening of Trade and China’s Shift Out of Agriculture

56 Part One The Theory of International Trade

pug21774_ch04_047-065.indd 56pug21774_ch04_047-065.indd 56 10/27/14 4:53 PM10/27/14 4:53 PM

Final PDF to printer

world, and the quantity of cloth exported by the rest of the world being equal to the

quantity of cloth imported by the United States.

For the conditions in each country shown by their production-possibility curves and

community indifference curves, the free-trade equilibrium occurs at a price ratio of

1 W / C . In the shift from no trade to free trade, producers in the United States respond to the lower relative price of cloth (and thus higher relative price of wheat) by reduc-

ing production of cloth and increasing production of wheat, shifting production from

point S 0 to S

1 . With production at S

1 , the United States can trade wheat for cloth with

the rest of the world at the price of 1 W / C . Consumption can be at any point along the price line that is tangent to the ppc at point S

1 (a line indicating a price ratio of

1 W / C ). Along this price line, the United States will consume at point C 1 , the tangent

point with the highest achievable community indifference curve I 2 .

In the rest of the world, the shift from no trade to free trade increases the relative

price of cloth. Producers respond by increasing production of cloth and decreasing

production of wheat from point S 0 to S

1 . The rest of the world can trade away from its

production point at the international equilibrium price ratio. Consumption can be at

any point along the price line tangent to the ppc at S 1 . Given this price line, the rest of

the world will consume at point C 1 .

At the international price ratio of 1 W / C , the United States is willing to export 40 billion units of wheat, the difference between the 80 produced domestically at point

S 1 and the 40 consumed domestically at point C

1 . The rest of the world wants to import

40 billion units of wheat, equal to the difference between the 55 consumed domestically

and the 15 produced domestically. At this price ratio, the United States wants to import

40 billion cloth units (60 consumed minus 20 produced domestically). The rest of the

world is willing to export 40 billion cloth units (100 produced minus 60 consumed

domestically). Thus, the international trade markets for both products are in equilibrium,

confirming that the price ratio of 1 W / C is the international equilibrium price ratio. The export–import quantities in each country can be summarized by the trade

triangles that show these quantities. The trade triangle for the United States is shown by the right triangle S

1 TC

1 , and that for the rest of the world C

1 TS

1 . International equi-

librium is achieved when these two trade triangles are the same size so that both sides

agree on the amounts traded.

China’s experience mirrors what happened earlier to Japan, Korea, Taiwan, and Hong Kong. All of these labor-abundant and land-scarce areas reacted to the opening of trade by shifting into labor-intensive industry and out of land- intensive agriculture, and all of them prospered.

* Note the “if” part of this statement. If U.S. policy blocked imports of industrial products from China, the Chinese would also reduce imports from the United States. The gains from trade then would be reduced.

Source: Source of the two quotes from Wu Xiedong: Wall Street Journal, March 10, 1995.

Chapter 4 Trade: Factor Availability and Factor Proportions Are Key 57

pug21774_ch04_047-065.indd 57pug21774_ch04_047-065.indd 57 10/27/14 4:53 PM10/27/14 4:53 PM

Final PDF to printer

We will generally assume that there is only one free-trade equilibrium international

price ratio for a given set of supply and demand conditions in each country. To see

why a price ratio other than 1 W / C generally will not be an international equilibrium, consider a price line flatter (making cloth even cheaper) than the price of 1 W / C . The United States would respond to such a price by producing above and to the left

of point S 1 and trading large volumes of wheat for cloth to consume out beyond C

1 .

The catch, however, is that the rest of the world would not want to trade so much at

a price ratio that makes its cloth cheaper than 1 W / C . This can be seen by finding the tangency of the new flat price line to the rest of the world’s production-possibility and

indifference curves on the right side of Figure 4.4A. The result of a price ratio making

cloth cheaper than 1 W / C is closer to S 0 , the no-trade point. With the rest of the world

willing to export only a small amount of cloth at such a price, the excess demand for

imported cloth by the United States would increase the relative price of cloth. The

price would return to the equilibrium unitary price shown in Figure 4.4 .

Demand and Supply Curves Again The community indifference curves also can be combined with the production-

possibility curves to plot out demand curves for cloth or wheat. A demand curve for

cloth shows how the quantity of cloth demanded responds to its price. To derive the

U.S. demand curve for cloth, start in Figure 4.4A with a price ratio and find how

much cloth the United States would be willing and able to consume at that price. At

2 W / C, the United States is willing and able to consume 40 billion cloth units a year (at S

0 ). At 1 W / C , the United States would consume 60 billion cloth units

(at C 1 ). These demand points could be replotted in Figure 4.4B, with the prices

on the vertical axis. Point S 0 above becomes point A below, point C

1 above

becomes point B below, and so forth. The same could be done for the rest of the world. (The demand-curve derivation is like that found in ordinary price-theory

textbooks, except that the nation’s income constraint slides along a production-

possibility surface instead of rotating on a fixed-income point.) In this way the

handy demand–supply framework can be derived from community indifference

curves and production-possibility curves. The international equilibrium focusing

on a single product (the approach discussed in Chapter 2 and shown in Figure 4.4B)

is therefore consistent with the general equilibrium approach using two products. 3

THE GAINS FROM TRADE

There are two ways to use a figure like Figure 4.4A to show that each nation gains

from international trade. First, trade allows each country to consume at a point ( C 1 )

that lies beyond its own ability to produce (its production-possibility curve). This is

a gain from trade as long as we view more consumption as desirable. It is the same

3 The theoretical literature on international trade often uses the indifference curves and production-possibility curve to derive an offer curve. An offer curve is a way of showing how a nation’s offer of exports for imports from the rest of the world depends on the international price ratio. A nation’s offer curve shows the same information as its export supply or import demand curve. Appendix C discusses how an offer curve can be derived and used.

58 Part One The Theory of International Trade

pug21774_ch04_047-065.indd 58pug21774_ch04_047-065.indd 58 11/3/14 6:10 PM11/3/14 6:10 PM

Final PDF to printer

demonstration of the gains from trade that we used for the Ricardian approach in

Chapter 3. Second, trade allows each country to achieve a higher community indif-

ference curve ( I 2 rather than I

1 with no trade). However, the use of community indif-

ference curves to show national gains from trade may hide the fact that opening trade

actually hurts some groups while bringing gains to others. We take up this issue of the

distribution of gains and losses in the next chapter.

How much each country gains from trade depends on the international price ratio

in the ongoing international trade equilibrium. As individuals we benefit from receiv-

ing high prices for the things that we sell (such as our labor services) and paying low

prices for the things that we buy. A similar principle applies to countries.

A country gains more from trade if it receives a higher price for its exports relative

to the price that it pays for its imports. For each country, the gains from trade depend

on the country’s international terms of trade, which are the price the country receives from foreign buyers for its export product(s), relative to the price that the

country pays foreign sellers for its import product(s).

In our example, the rest of the world exports cloth and imports wheat, so the terms

of trade for the rest of the world are the relative price of cloth. In Figure 4.4A we can

show that the rest of the world would gain more from trade if its terms of trade were

better—if the equilibrium international relative price of cloth were higher. Then the

international price line would be steeper than the line through S 1 and C

1 , and the rest

of the world could reach a community indifference curve higher than I 2 .

For the United States, its terms of trade are the relative price of wheat, its export good.

The United States would gain more from trade if the equilibrium relative price of wheat

were higher, resulting in a flatter international price line than the line through S 1 and C

1 .

Then the United States could reach a community indifference curve higher than I 2 .

TRADE AFFECTS PRODUCTION AND CONSUMPTION

Figure 4.4A shows that there are substantial effects on production quantities when

trade is opened. The opening has two types of implications for production. First,

within each country output expands for the product that the country exports—more wheat produced in the United States and more cloth produced in the rest of the world.

In each country, the growing industry expands by acquiring factor resources from the

other industry in the economy. The import-competing industry reduces its domestic

production—cloth in the United States and wheat in the rest of the world. Although

production shifts in each country, the countries do not (necessarily) specialize com-

pletely in producing their export product if the production-possibility curve is bowed

out because of increasing costs.

Second, the shift from no trade to free trade results in more efficient world produc- tion as each country expands output of the product in which it is initially the lower-

cost producer. In the particular case shown in Figure 4.4A, the efficiency gains show

up as an increase in world production of wheat (from 50 1 30 5 80 with no trade to

80 1 15 5 95 with trade), while world cloth production is unchanged at 120.

In each country, opening to trade also alters the quantities consumed of each

product, as the consumption point shifts from S 0 with no trade to C

1 with free trade.

Chapter 4 Trade: Factor Availability and Factor Proportions Are Key 59

pug21774_ch04_047-065.indd 59pug21774_ch04_047-065.indd 59 10/27/14 4:53 PM10/27/14 4:53 PM

Final PDF to printer

Consumer theory indicates that the quantity consumed of the importable product in

each country will increase. The relative price of the importable product declines in each

country, so consumers in the country buy more of it (a positive substitution effect).

Meanwhile, real income rises in each country (as a result of the gains from trade),

so consumers buy even more (a positive income effect). The quantity consumed of the

exportable product in each country could increase, stay the same, or decrease because of

opposing pressures from a negative substitution effect (resulting from the higher relative

price of the exportable good) and a positive income effect (as real income rises). In the

particular case shown in Figure 4.4A, the quantities consumed of the exportable product

actually decrease (50 to 40 for wheat in the United States and 80 to 60 for cloth in the

rest of world), but other outcomes for these two consumption quantities are possible.

WHAT DETERMINES THE TRADE PATTERN?

Our general view of national economies engaged in international trade is shown in

Figure 4.4A. The immediate basis for the pattern of international trade that we see

here is that relative product prices would differ between the two countries if there were

no trade. But why would product prices differ with no trade? They can differ because

• Production conditions differ—the relative shapes of the production-possibility

curves differ between the countries.

• Demand conditions differ—the relative shapes and positions of the community

indifference curves differ between the countries.

• Some combination of these two differences.

In our example the basis for the United States to import cloth could be that the

United States has a high demand for cloth, perhaps due to a harsh climate or fashion

consciousness. Although this kind of explanation may apply to a few products, most

analyses focus on production-side differences as the basis for no-trade price differ-

ences, assuming that demand patterns are similar for the countries.

Production-side differences can be a basis for the international trade pattern when the

relative shapes of the production-possibility curves differ. For instance, in Figure 4.4A,

the ppc for the United States is skewed toward production of wheat, and the ppc for the

rest of the world is skewed toward production of cloth. Why do we see these production-

side differences? There are two basic reasons.

First, the production technologies or resource productivities may differ between

countries. For instance, the United States may have superior technology to produce

wheat and somehow keep its secret from the rest of the world. The better technology

results in relatively high resource productivity in U.S. wheat production. This will

skew the U.S. production-possibility curve toward producing larger amounts of wheat,

resulting in a comparative advantage for the United States to produce and export wheat.

This type of comparative advantage was the basis for trade in the Ricardian approach.

Although technology or productivity differences can be a production-side basis

for comparative advantage, for the remainder of this chapter and in the next chapter,

we assume that they are not. Instead, we assume that both countries have access to

the same technologies for production and are capable of achieving similar levels of

resource productivity. This assumption is plausible if technology spreads internationally

60 Part One The Theory of International Trade

pug21774_ch04_047-065.indd 60pug21774_ch04_047-065.indd 60 10/27/14 4:53 PM10/27/14 4:53 PM

Final PDF to printer

because it is difficult for a country to keep its technology secret. (Issues related to

technology will be taken up in later chapters.)

The second reason that the relative shapes of the production-possibility curves can

differ is more subtle but has become the basis for the standard modern theory of com-

parative advantage. It is the Heckscher–Ohlin theory based on (1) differences across

countries in the availability of factor resources and (2) differences across products in

the use of these factors in producing the products.

THE HECKSCHER–OHLIN (H–O) THEORY

The leading theory of what determines nations’ trade patterns emerged in Sweden.

Eli Heckscher, the noted Swedish economic historian, developed the core idea in a

brief article in 1919. A clear overall explanation was developed and publicized in the

1930s by Heckscher’s student Bertil Ohlin. Ohlin, like Keynes, managed to combine

a distinguished academic career—professor at Stockholm and later a Nobel laureate—

with political office (Riksdag member, party leader, and government official during

World War II). Ohlin’s persuasive narrative of the theory and the evidence that seemed

to support it were later reinforced by another Nobel laureate, Paul Samuelson, who

derived mathematical conditions under which the Heckscher–Ohlin (H–O) prediction

was strictly correct. 4

The Heckscher–Ohlin theory of trade patterns says, in Ohlin’s own words,

Commodities requiring for their production much of [abundant factors of production]

and little of [scarce factors] are exported in exchange for goods that call for factors

in the opposite proportions. Thus indirectly, factors in abundant supply are exported

and factors in scanty supply are imported. (Ohlin, 1933, p. 92)

Or, more succinctly, the Heckscher–Ohlin theory predicts that a country exports the product (or products) that uses its relatively abundant factor(s) intensively and

imports the product (or products) that uses its relatively scarce factor(s) intensively.

To judge this plausible and testable argument more easily, we need definitions of

factor abundance and factor-use intensity. Consider labor:

• A country is relatively labor-abundant if it has a higher ratio of labor to other factors than does the rest of the world.

• A product is relatively labor-intensive if labor costs are a greater share of its value than they are of the value of other products.

The H–O explanation of trade patterns begins with a specific hunch as to why

product prices might differ between countries before they open trade. Heckscher and

Ohlin predicted that the key to comparative costs lies in factor proportions used in

4 Ohlin backed the H–O theory with real-world observation and appeals to intuition. Samuelson took the mathematical road, adding assumptions that allowed a strict proof of the theory’s main prediction. Samuelson assumed that (1) there are two countries, two goods, and two factors (the parsimonious “2 3 2 3 2” simplification); (2) factor supplies are fixed for each country, fully employed, and mobile between sectors within each country, but immobile between countries; (3) the consumption patterns of the two countries are identical; and (4) both countries share the same constant-returns-to-scale production technologies. The H–O predictions follow logically in Samuelson’s narrow case and seem broadly accurate in the real world. Our analysis in the text is based on Samuelson’s depiction of the theory.

Chapter 4 Trade: Factor Availability and Factor Proportions Are Key 61

pug21774_ch04_047-065.indd 61pug21774_ch04_047-065.indd 61 10/27/14 4:53 PM10/27/14 4:53 PM

Final PDF to printer

production. If cloth costs 2 W / C in the United States and less than 1 W / C elsewhere, it must be primarily because the United States has relatively less of the factors that

cloth uses intensively, and relatively more of the factors that wheat uses intensively,

than does the rest of the world.

Let land be the factor that wheat uses more intensively and labor be the factor that cloth uses more intensively. Let all costs be decomposable into land and labor costs

(e.g., it takes certain amounts of land and labor to make fertilizer for growing wheat

and certain other amounts of land and labor to make cotton inputs for cloth making).

The H–O theory predicts that the United States exports wheat and imports cloth

because wheat is land-intensive and cloth is labor-intensive and

(U.S. land supply)

(U.S. labor supply)

(Rest of world’s land supply)

(Rest of world’s labor supply) .

Under these conditions 5 with no international trade, land should rent more cheaply

in the United States than elsewhere because land is relatively abundant in the United

States and relatively scarce in the rest of the world. The cheapness of land cuts costs

more in wheat farming than in cloth making, so the United States is the lower-cost

producer of wheat. Conversely, the scarcity of labor should make the wage rate higher

in the United States than elsewhere, so cloth is relatively expensive to produce in the

United States. This, according to H–O, is why product prices differ in the direction

they do before trade begins. And, the theory predicts, it is the combination of the dif-

ference in relative factor endowments and the pattern of factor intensities that makes

the United States export wheat instead of cloth (and import cloth instead of wheat)

when trade opens up.

Summary The standard modern theory of trade is based on increasing marginal costs of producing more of a product, so that the production-possibility curve is bowed out. We can combine bowed-out production-possibility curves with community indifference curves to show how countries are affected by opening to trade.

Trade is positive-sum activity. The whole world gains from trade, and each country

is at least as well off with free trade as with no trade. The gains from trade for each

country can be demonstrated in two ways. First, trade allows the country to consume

beyond its own ability to produce—it allows consumption outside of its production-

possibility curve. Second, trade allows the country to reach a higher community indif-

ference curve, indicating that the country reaches a higher level of national economic

well-being.

The analysis provides key insights into the basis for the pattern of international

trade (what is exported and what is imported) by each country. While trade can be

5 Take care not to misread the relative factor endowment inequality. It does not say the United States has absolutely more land than the rest of the world. Nor does it say that the United States has less labor. In fact, the United States really has less of both. Nor does it say the United States has more land than it has labor—a meaningless statement in any case. (How many acres or hectares are “more than” how many hours of labor?)

Rather it is an inequality between relative endowments. Here are two correct ways of stating it: (1) There is more land per laborer in the United States than in the rest of the world and (2) the U.S. share of the world’s land is greater than its share of the world’s labor.

62 Part One The Theory of International Trade

pug21774_ch04_047-065.indd 62pug21774_ch04_047-065.indd 62 11/4/14 4:03 PM11/4/14 4:03 PM

Final PDF to printer

driven by differences in demand, most of our attention is on production-side differ-

ences. Production-side differences cause the countries’ production-possibility curves

to skew in different ways, reflecting different comparative advantages. One source

of production-side differences is differences in technologies or factor productivities.

The Heckscher–Ohlin (H–O) theory focuses on another important source of production-side differences. International differences in the shapes of bowed-out ppc’s

can occur because (1) different products use the factors of production in different pro-

portions and (2) countries differ in their relative factor endowments. The H–O theory

of trade patterns predicts that a country exports products that are produced with more

intensive use of the country’s relatively abundant factors in exchange for imports of

products that use the country’s relatively scarce factors more intensively.

Key Terms Increasing marginal costs

Production-possibility

curve (ppc)

Indifference curve

Community indifference

curves

Terms of trade

Heckscher–Ohlin

theory

Labor-abundant

Labor-intensive

Suggested Reading

For advanced technical surveys of the economic analysis of free trade, see Chapters 1–3,

7, and 8 of Jones and Kenen, Vol. I (1984). Ruffin (1988) improved the Ricardian model

of comparative advantage so that it generates the predictions of the Heckscher–Ohlin

model. He does so by interpreting productivity differences in the one-factor

Ricardian approach as differences in relative factor endowments. Chor (2010) examines

comparative advantage based on differences across countries in institutions (such as

security of contact enforcement and labor market regulations) that are more important to

some industries than to others.

Bernhofen and Brown (2005) find that the gains to Japan from its opening to trade in

the 19th century were equal to about 8 percent of its GDP at that time.

Questions and Problems

1. “According to the Heckscher–Ohlin theory, two countries that have the same production

technologies for the various products that they produce are unlikely to trade much with

each other.” Do you agree or disagree? Why?

2. “For a world in which international trade would be based only on the differences fea-

tured in the Heckscher–Ohlin theory, the shift from no trade to free trade is like a zero-

sum game.” Do you agree or disagree? Why?

3. The country of Pugelovia has an endowment (total supply) of 20 units of labor and

3 units of land, whereas the rest of the world has 80 units of labor and 7 units of land. Is

Pugelovia labor-abundant? Is Pugelovia land-abundant? If wheat is land-intensive and

cloth is labor-intensive, what is the Heckscher–Ohlin prediction for the pattern of trade

between Pugelovia and the rest of the world?

4. Explain how a supply curve can be obtained or derived from an increasing-cost

production-possibility curve. Use Figure 4.3 to derive the supply curve for cloth. For a

bit more challenge, use Figure 4.3 to derive the supply curve for wheat.

✦

Chapter 4 Trade: Factor Availability and Factor Proportions Are Key 63

pug21774_ch04_047-065.indd 63pug21774_ch04_047-065.indd 63 10/27/14 4:53 PM10/27/14 4:53 PM

Final PDF to printer

5. In your answer to this question, use a diagram like Figure 4.3, making it large enough

so that you can see the curves and quantities clearly. The no-trade point is as shown in

Figure 4.3, a price ratio of 2 W / C and 40 units of cloth demanded. Sketch the deriva- tion of the portion of the country’s cloth demand curve for cloth prices of 2 and below.

(To do this, examine a price of about 1.5, then 1.0, and then 0.5. In your analysis you

will need to show additional community indifference curves—ones that exist but are

not shown explicitly in Figure 4.3.)

6. Return to your answer for question 5. For prices below 2, which good does the country

export? Which good does it import? How does the quantity (demanded or needed)

of imports change as the price changes? What is happening to the country’s terms of

trade as the price declines? What is happening to the country’s well-being or welfare

as the price declines?

7. The country of Puglia produces and consumes two products, pasta ( P ) and togas ( T ), with increasing marginal opportunity costs of producing more of either product. With

no international trade the relative price of pasta is 4 T / P .

a. Show Puglia’s economy, using a graph with a production-possibility curve and community indifference curves.

b. Puglia now opens to international trade. With free trade the world relative price of pasta is 3 T / P . Which product will Puglia export? Which product will it import? On the same graph that you used for part a, show the free-trade equilibrium for Puglia.

c. Use your graph to explain whether or not Puglia gains from free trade.

8. Consider the rest of the world with free trade (production at S 1 and consumption at

C 1 ), as shown in the graph on the right in Figure 4.4A. The international relative price

of cloth now changes to 1.3 W / C .

a. Using a graph, show the effects of this change in the international relative price on production and consumption in the rest of the world.

b. Is this change in the international relative price an improvement or deterioration in the terms of trade of the rest of the world? According to your graph, does the rest

of the world gain or lose well-being? Explain.

9. Consider Figure 4.4A. According to the logic of the Heckscher–Ohlin theory, why

is the shape of the U.S. production-possibility curve different from the shape of the

production-possibility curve for the rest of the world?

10. In your answer to this question, use a diagram like Figure 4.3 and start from a no-trade

point like S 0 with a no-trade price ratio of 2 W / C . Now trade is opened and the country

can trade whatever it wants at an international price ratio of 1 W / C . (In your answers, you will need to picture additional community indifference curves that exist but are

not shown explicitly in Figure 4.3.)

a. Show that the country can gain from trade even if the country does not change its production point. (Production stays at point S

0 .) ( Hint: The price line with slope

of 1 will go through point S 0 but will not be tangent to the production-possibility

curve.)

b. Show that the country can gain even more from trade if it also adjusts the produc- tion point to its optimal position (given the price ratio of 1).

✦

64 Part One The Theory of International Trade

pug21774_ch04_047-065.indd 64pug21774_ch04_047-065.indd 64 10/27/14 4:53 PM10/27/14 4:53 PM

Final PDF to printer

c. What happens to the volume of trade as the country’s position shifts from that shown in part a to that shown in part b ?

11. Extending what you know about production-possibility curves, try to draw the

ppc for a nation consisting of four individuals who work separately. The four individu-

als have these different abilities:

Person A can make 1 unit of cloth or 2 units of wheat or any combination in

between (e.g., can make 0.5 cloth and 1 wheat by spending half time

on each).

Person B can make 2 cloth or 1 wheat or any combination in between.

Person C can make 1 cloth or 1 wheat or any combination in between.

Person D can make 2 cloth or 3 wheat or any combination in between.

What is the best they can all produce? That is, draw the ppc for the four of them. Try

it in these stages:

a. What is the most wheat they could grow if they spent all of their time growing wheat only? Plot that point on a cloth–wheat graph.

b. What is the most cloth they could make? Plot that point.

c. Now here’s the tricky part. Find the best combinations they could produce when producing some of both, where best means they could make that combination but could not make more of one good without giving up some of the other.

12. The world consists of two countries. One country (call it Hiland) has a strong legal

system for contract enforcement, and the other country (call it Loland) has a legal

system in which enforcement of contracts is uncertain, slow, and costly. In other basic

ways the two countries are quite similar.

For some final-goods industries, key material inputs into production are obtained

on spot markets, using short-lived purchasing agreements. For other final-goods

industries, key material inputs into production are best obtained through complicated,

longer-term contracts to assure steady availability of the inputs.

What do you predict about the pattern of trade in final goods between these two

countries? Why?

✦

Chapter 4 Trade: Factor Availability and Factor Proportions Are Key 65

pug21774_ch04_047-065.indd 65pug21774_ch04_047-065.indd 65 10/27/14 4:53 PM10/27/14 4:53 PM

Final PDF to printer

Chapter Five

Who Gains and Who Loses from Trade? If countries gain from opening trade, why do free-trade policies have so many

opponents year in and year out? The answer does not lie mainly in public ignorance

about the effects of trade. Trade does typically hurt some groups within any country. Many opponents of freer trade probably perceive this point correctly. A full analysis

of trade requires that we identify the winners and losers from freer trade. The chapter

on the analysis of supply and demand provided one look at these groups by focusing

on producers and consumers of a product. But this distinction is not completely valid.

People who are consumers also own and provide factor resources that are used in pro-

duction. Is there another useful way to examine the winners and losers?

A virtue of the Heckscher–Ohlin (H–O) theory of trade patterns is that it offers

realistic predictions of how trade affects the incomes of groups representing different

factors of production (e.g., landlords, workers). In each country international trade

divides society into gainers from trade and losers from trade because changes in rela-

tive product prices are likely to raise the rewards to some factors and lower the rewards

to others. A key purpose of this chapter is to show the implications of the Heckscher–

Ohlin theory for the incomes received by the different factors of production.

The Heckscher–Ohlin theory claims to provide powerful insights into the basis for

trade and the effects of trade, including the gains and losses for different production fac-

tors. How well does it actually fit the world’s trade? A second key purpose of the chap-

ter is to examine the empirical evidence on Heckscher–Ohlin. Does Heckscher–Ohlin

explain actual trade patterns? Does it identify the factors that gain and lose from trade?

WHO GAINS AND WHO LOSES WITHIN A COUNTRY

According to the Heckscher–Ohlin approach, trade arises from differences in the

availability of factor inputs in different countries and differences in the proportions in

which these factors are used in producing different products. Opening to trade alters

domestic production (for instance, from S 0 to S

1 in Figure 4.4A in the previous chapter).

There is expansion in the export-oriented sector (the one using the country’s abundant

factor intensively in production). There is contraction in the import- competing sector

(the one using the country’s scarce factor intensively). The changes in production have

one set of effects on incomes in the short run but another in the long run.

pug21774_ch05_066-087.indd 66pug21774_ch05_066-087.indd 66 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

Short-Run Effects of Opening Trade In the short run, laborers, plots of land, and other inputs are tied to their current lines of production. The demand for these factors, and therefore the incomes or returns

they earn, depend on the sector in which they are employed. Some people will enjoy

higher demand for the factors they have to offer because their factors are employed in

the sector that is attempting to expand its production. With the opening to free trade, the

expanding industries in our example are wheat in the United States and cloth in

the rest of the world. In the United States landlords in wheat-growing areas can charge

higher rents because their land is in strong demand. U.S. farmworkers in wheat-growing

areas are likely to get (temporarily) higher wages. Foreign clothworkers can also

demand and get higher wage rates. Foreign landlords in the areas raising cotton and

wool for cloth-making can also get higher rents.

Meanwhile, the sellers of factors to the declining industries—U.S. clothworkers,

U.S. landlords in areas supplying the cloth-making industry, foreign wheat-area land-

lords and farmhands—lose income through reduced demand and therefore reduced

prices for their services.

For the short run, then, gains and losses divide by output sector: All groups tied

to rising sectors gain, and all groups tied to declining sectors lose. One would expect

employers, landlords, and workers in the declining sectors to unite in protest.

The Long-Run Factor-Price Response In the long run, factors can move between sectors in response to differences in returns. Sellers of the same factor will eventually respond to the income gaps that

opened up in the short run. Some U.S. clothworkers will find better-paying jobs in

the wheat sector. As the supply of labor into the wheat sector increases, wages in the

wheat sector decline. As the remaining supply of labor to the cloth sector shrinks,

wages in the cloth sector increase. Some U.S. cotton- and wool-raising land will also

get better rents by converting to wheat-related production, bringing rents in different

areas back in line. Similarly, foreign farmhands and landlords will find the pay better

in the cloth-related sector. As the supplies of the factors to the two sectors change in

the long run, wages and rents in the cloth sector decrease, and wages and rents in the

wheat sector increase. The full process of the effects of opening trade on factor prices

in the long run is summarized in Figure 5.1 .

When the factors respond by moving to the better-paying sectors, will all wages and

rents be bid back to their pretrade levels? No, they will not. In the long run, wage rates

end up lower for all U.S. workers and higher for all foreign workers (each relative to its level with no trade). All land rents end up higher in the United States and lower in

the rest of the world (each relative to its level with no trade).

What drives this crucial result is the imbalance in the changes in factor supply and

demand. Wheat growing is more land-intensive and less labor-intensive than cloth

making. Therefore, the amounts of each factor being hired in the expanding sector

will not match the amounts being released in the other sector. The imbalances create

pressures for factor prices to adjust.

In the United States, for example, expanding wheat production creates demand for

a lot of land and very few workers, whereas cutting cloth production releases a lot of

Chapter 5 Who Gains and Who Loses from Trade? 67

pug21774_ch05_066-087.indd 67pug21774_ch05_066-087.indd 67 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

* At this point, the short-run effects come into play, but the economy continues to move toward the longer-run effects shown in the rest of this figure.

Crucial step— National factor markets change

For each unit of cloth sacrificed, many workers and a small amount of land laid off; extra wheat demands few workers and much land

For each unit of wheat sacrificed, much land and few workers laid off; extra cloth demands many workers and little land

Initial product prices:

Wheat cheap, cloth expensive

Wheat expensive, cloth cheap

Trade opens: wheat cloth

Product prices respond to trade

Pwheat up, Pcloth down

Pwheat down, Pcloth up

Production responds to product prices*

Produce more wheat Produce less cloth

Produce less wheat Produce more cloth

National factor prices respond

Wage rates fall and rents rise (in both sectors)

Wage rates rise and rents fall (in both sectors)

Product prices equalized between countries. Net gains for both countries but different effects on different groups. Winners: U.S. landowners, foreign workers. Losers: U.S. workers, foreign landowners

Long-run results:

In the United States In the Rest of the World FIGURE 5.1 How Free Trade

Affects Income

Distribution

in the Long

Run: The

Whole Chain of

Influence

workers and not so much land. 1 Something has to give. The only way the employment

of labor and land can adjust to the available national supplies is for factor prices to

change. The production shift toward land-intensive, labor-sparing wheat raises rents

and cuts wages throughout the United States in the long run. The rise in rents and the fall in wages both continue until producers come up with more land-saving and labor-

using ways of making wheat and cloth. Once they do, rents and wages stabilize—but

U.S. rents still end up higher and wages lower than before trade opened up. The same

kind of reasoning makes the opposite results hold for the rest of the world.

Trade, then, makes some people absolutely better off and others absolutely worse off

in each of the trading countries. The gainers and losers in the short run are somewhat

different from those in the long run because more adjustment can occur in the long run.

Figure 5.2 summarizes the discussion of winners and losers in the short and long runs.

1 This passage uses convenient shorthand that is quantitatively vague: “a lot of’’ land, “very few” workers, and so on. These should give the right impressions with a minimum of verbiage. For more precision about the implied inequalities, see the numerical example in the box “A Factor-Ratio Paradox.”

68 Part One The Theory of International Trade

pug21774_ch05_066-087.indd 68pug21774_ch05_066-087.indd 68 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

FIGURE 5.2 Winners and

Losers: Short

Run Versus

Long Run

Effects of Free Trade in the Short Run

(After product prices change and production attempts to respond, but before factors move between sectors)

In the United States In the Rest of the World

Landowners Laborers Landowners Laborers

In wheat Gain Gain Lose Lose In cloth Lose Lose Gain Gain

Effects of Free Trade in the Long Run

(After factors move between sectors in response to changes in factor demands, as shown in Figure 5.1)

In the United States In the Rest of the World

Landowners Laborers Landowners Laborers

In wheat Gain Lose Lose Gain In cloth Gain Lose Lose Gain

Reminder: The gains and losses to the different groups do not cancel out leaving zero net gain. In the long run,

both countries get net gains. In the short run, net national gains or losses depend partly on the severity of any

temporary unemployment of displaced factors.

THREE IMPLICATIONS OF THE H–O THEORY

The Heckscher–Ohlin model has three major implications for factor incomes. These

implications follow from the sort of analysis done in the previous section.

The Stolper–Samuelson Theorem The conclusion that opening to trade splits a country into specific gainers and los-

ers in the long run is an application of a general relationship called the Stolper– Samuelson theorem . 2 This theorem states that, given certain conditions and assumptions, including full adjustment to a new long-run equilibrium, an event that

changes relative product prices in a country unambiguously has two effects:

• It raises the real return to the factor used intensively in the rising-price industry.

• It lowers the real return to the factor used intensively in the falling-price industry.

2 Four important conditions and assumptions are needed for the Stolper–Samuelson theorem: (1) The country produces positive amounts of two goods (e.g., wheat and cloth) with two factors of production (e.g., land and labor) used in producing each good. One good (wheat) is relatively land-intensive; the other (cloth) is relatively labor-intensive. (2) Factors are mobile between sectors and fully employed overall in the economy. In addition, it is often assumed that total factor supplies (factor endowment sizes) are fixed, though this can be relaxed somewhat. (3) Competition prevails in all markets. (4) Production technology involves constant returns to scale (e.g., if all factors used in producing a product double, then output of the product doubles).

Chapter 5 Who Gains and Who Loses from Trade? 69

pug21774_ch05_066-087.indd 69pug21774_ch05_066-087.indd 69 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

Extension A Factor-Ratio Paradox

The effects of trade on factor use have their paradoxical side. By assumption, the same fixed amounts of factor supplies get reemployed in the long run. But everything else about factor use changes. To deepen understanding of several subtleties that help explain how trade makes gainers and losers, this box poses a paradox:

In one country, trade makes the land/labor ratio fall in both industries—but this ratio stays the same for the country as a whole. In the rest of the world, the same kind of paradox holds in the other direction: Trade makes the land/labor ratio rise in both industries—but this ratio again stays the same overall.

How, in the United States, could something that falls in both industries stay the same for the

two industries together? How, in the rest of the world, could it rise in both yet stay the same for the two together?

The explanation hinges on a tug-of-war that is only hinted at in the main text of this chapter. Here is what the tug-of-war looks like for the United States in our ongoing example. Trade shifts both land and labor toward the land- intensive wheat sector, yet rising rents and fall- ing wages induce both sectors to come up with more labor-intensive ways of producing. The two effects just offset each other and remain consis- tent with the same fixed total factor supplies.

Let’s look at a set of numbers illustrating how our wheat–cloth trade might plausibly change factor-use ratios in the United States and the rest of the world:

Here we have both the factor-ratio paradox and its explanation. In the United States the change in factor prices has induced both wheat producers and cloth producers to come up with production methods having lower land/labor ratios (more labor-intensive techniques). Yet the same fixed factor supplies are employed.

One can see that the key is the shift of U.S. output toward land-intensive wheat. If it had been

the only change, the national land/labor ratio would have risen. This is what induced the rise in rents and the fall in wages. The increase in the cost of land and the decrease in the cost of labor in turn induce firms to shift to more labor-intensive (less land-intensive) production techniques in both industries. (The same points apply in mirror image for the rest of the world.)

United States Rest of the World Before (with No Trade) Before (with No Trade)

Land Labor Land/Labor Land Labor Land/Labor Sector Output Use Use Ratio Output Use Use Ratio

Wheat 50 35 35 1.000 30 16 32 0.500 Cloth 40 18 65 0.277 80 18 160 0.113 Whole economy 53 100 0.530 34 192 0.177

After (with Free Trade) After (with Free Trade)

Land Labor Land/Labor Land Labor Land/Labor Sector Output Use Use Ratio Output Use Use Ratio

Wheat 80 48 64 0.750 (down) 15 9 12 0.750 (up) Cloth 20 5 36 0.139 (down) 100 25 180 0.139 (up) Whole economy 53 100 0.530 (same) 34 192 0.177 (same)

70 Part One The Theory of International Trade

pug21774_ch05_066-087.indd 70pug21774_ch05_066-087.indd 70 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

A shift from no trade to free trade is an event that changes product prices. For

instance, in our example, the opening of trade increases the relative price of wheat

in the United States. The Stolper–Samuelson theorem then predicts a rise in the real

income of the owners of land (the factor used intensively in producing wheat) and

a decline in the real income of the providers of labor (the factor used intensively in

producing cloth). In the rest of the world, the real income of labor increases and the

real income of landowners decreases.

Stolper and Samuelson showed that this result does not depend at all on how much

of each product is consumed by the households of landowners and laborers. The result

clashed with an intuition many economists had shared. It seemed, for instance, that if

U.S. laborers spent a very large share of their incomes on cloth, they could gain from

free trade by having cheaper cloth. Not so, according to the theorem. Opening trade

must enable one of the two factors to buy more of either good. It will make the other

factor poorer in its ability to buy either good.

Let’s use an example to see why. Under competition, the price of each product must

equal its marginal cost. In our wheat–cloth economy, price must equal the marginal

land and labor costs in each sector:

P wheat

5 Marginal cost of wheat 5 ar 1 bw

and

P cloth

5 Marginal cost of cloth 5 cr 1 dw

where the product prices are measured in the same units (e.g., units of a commodity,

or dollars), r is the rental rate earned on land, and w is the wage rate paid to labor. The coefficients a , b , c , and d are physical input/output ratios. These indicate how much land ( a and c ) or labor ( b and d ) is required to produce one unit of each good. The easiest case to consider is one where these input/output coefficients are constant.

Suppose that the price of wheat rises 10 percent and the price of cloth stays the

same. The higher price of wheat (and the resulting expansion of wheat production)

will bid up the return to at least one factor. In fact, it is likely to raise the rental rate for

land because growing wheat uses land intensively. So r rises. Now look at the equa- tion for the cloth sector. If r rises and the price of cloth stays the same, then the wage rate w must fall absolutely. The contraction of cloth production drives down the wage rate. Next take the fall of w back to the equation for the wheat sector. If w is falling and P

wheat is rising 10 percent, then r must be rising more than 10 percent to keep the

equation valid. So if wheat is the land-intensive sector,

P wheat

↑ by 10% and P cloth

steady means r ↑ more than 10% and w ↓.

Thus a shift in relative product prices brings an even more magnified response

in factor prices. The factor used intensively in production in the rising-price sector

has its market reward (e.g., r in our example) rise even faster than the product price rises. Therefore, its real return (its purchasing power with respect to either product)

rises. A factor used intensively in the other sector has its real purchasing power cut.

In our example, the lower wage rate means workers lose purchasing power with

respect to both the higher-priced wheat and the stable-priced cloth. The real wage

rate decreases.

Chapter 5 Who Gains and Who Loses from Trade? 71

pug21774_ch05_066-087.indd 71pug21774_ch05_066-087.indd 71 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

The same principle emerges no matter how we change the example (e.g., even if

we let the price of wheat stay the same and increase the price of cloth instead, so that

the real wage rate rises and the real rental rate declines, or even if we let producers

change the input/output coefficients a , b , c , and d in response to changes in r and w ). 3 The principle really just follows from the fact that price must equal marginal cost

under competition, both before and after trade (or some other event) has changed the

price ratio between wheat and cloth.

The Specialized-Factor Pattern The Stolper–Samuelson theorem uses only two factors and two products. Its results

are part of a broader pattern, one that tends to hold for any number of factors and

products.

• The more a factor is specialized, or concentrated, in the production of a product

whose relative price is rising, the more this factor stands to gain from the change

in the product price.

• The more a factor is concentrated into the production of a product whose relative

price is falling, the more it stands to lose from the change in product price.

This pattern should seem plausible. You may wonder whether it is meant as a pat-

tern for the short run, when factors are immobile, or for the long run. The answer

is both. Consider the issue of opening to free trade. The longer a factor continues

to be associated with producing exportables, the greater its stake in freer trade.

The longer it is associated with production threatened by imports, the more it

gains from limits on trade. In the extreme case, a factor that can be used only in

one sector has a lifelong or permanent stake in the price of that sector’s product.

A good example of such an immobile factor is farmland that is suited to growing

only one type of crop, so it has almost no alternative use. There is little difference

between the short run and the long run when it comes to this land. If the land is

of a type that will always be good only for growing an import-competing crop,

there is nothing subtle about the landowner’s stake in policies that keep out

imports of that crop.

The Factor-Price Equalization Theorem The same Heckscher–Ohlin trade model that leads to the Stolper–Samuelson result

also leads to an even more surprising prediction about the effects of trade on factor

prices in different countries. Beginning with a proof by Paul Samuelson in the late

1940s, the factor-price equalization theorem was established about the effect

3 For a numerical example, let both prices start at 100, let r and w both start at 1, and let a 5 40, b 5 60, c 5 25, and d 5 75. Let the price of wheat rise by 10 percent to 110. Your task is to deduce what values of r and w could satisfy the new wheat equation 110 5 40 r 1 60 w , while still satisfying the cloth equation 100 5 25 r 1 75 w . You should get that r rises to 1.5 and w falls to 5/6.

The text says that the result still holds even if a , b , c , and d change. To be more precise, the result still holds if a or c falls when r rises, or if b or d falls when w rises. These are the economically plausible directions of response, so the result holds in all plausible cases.

72 Part One The Theory of International Trade

pug21774_ch05_066-087.indd 72pug21774_ch05_066-087.indd 72 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

of trade on international differences in factor prices. 4 This theorem states that, given

certain conditions and assumptions, free trade equalizes not only product prices but

also the prices of individual factors between the two countries. To see what this means,

consider our standard example of free trade in cloth and wheat. The theorem predicts

that, even if factors cannot migrate between countries directly, with free trade

• Laborers (of the same skill level) earn the same wage rate in both countries.

• Units of land (of comparable quality) earn the same rental return in both countries.

This is a remarkable conclusion. It follows from the effects of opening trade on fac-

tor prices in each country. With no trade, workers in the United States, the labor-scarce

country, earn a high wage rate, and workers in the rest of the world (labor-abundant)

earn a low wage rate. The opening of trade results in a lowering of the wage rate in

the United States and a rise of the wage rate in the rest of the world (recall Figure 5.1).

If product prices are the same in the two countries with free trade, if production

technologies are the same, and if both countries produce both products (among other

necessary conditions), then the wage rate is also the same for the two countries with

free trade. (You might try to develop similar reasoning for land rents.)

The factor-price equalization theorem implies that laborers will end up earning the

same wage rate in all countries, even if labor migration between countries is not allowed.

Trade makes this possible, within the assumptions of the model, because the factors that

cannot migrate between countries end up being implicitly shipped between countries in

commodity form. Trade makes the United States export wheat and import cloth. Since

wheat is land-intensive and cloth is labor-intensive, trade is in effect sending a land-rich

commodity to the rest of the world in exchange for labor-rich cloth. It is as though each

factor were migrating toward the country in which it was scarcer before trade.

DOES HECKSCHER–OHLIN EXPLAIN ACTUAL TRADE PATTERNS?

The Heckscher–Ohlin approach to trade provides important insights, in theory, about

the gains from trade, the effects of trade on production and consumption, and the

effects of trade on the incomes of production factors. These insights are based on the

hunch by Heckscher and Ohlin about the basis for trade—why countries export some

products and import others. To know if the Heckscher–Ohlin theory actually is use-

ful, we must consider whether this hunch is right. Does it help to explain real-world

trade patterns?

The first formal efforts to test the H–O theory used the simple model of two fac-

tors of production and U.S. trade data. These tests failed to confirm the H–O theory.

4 The important conditions and assumptions needed for the factor-price equalization theorem include all four of those for the Stolper–Samuelson theorem (see footnote 2) and the following additional ones: (5) Both countries produce positive amounts of both goods with free trade. (Both are incompletely specialized in production.) (6) Trade is free of government restrictions or barriers to trade (like tariffs). (7) There are no transport costs. (8) The technologies available (or the production functions) are the same for both countries. (9) There are no factor-intensity reversals. (If wheat is the relatively land-intensive good in one country, then it is also the relatively land-intensive good in the other country.)

Chapter 5 Who Gains and Who Loses from Trade? 73

pug21774_ch05_066-087.indd 73pug21774_ch05_066-087.indd 73 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

(See the box “The Leontief Paradox.”) More recent tests recognize that more than

two types of production factors are relevant to the H–O explanation of trade patterns.

Economists have tested the H–O theory in several ways. Complete tests require infor-

mation on the factor endowments of different countries, international trade for various

products, and the factor proportions used in producing these products. The upshot of

these tests can be seen through a look at factor endowments and trade patterns.

Factor Endowments Figure 5.3 shows the shares of several countries in the “world” endowments of certain

factors of production. To recognize the patterns of relative abundance and scarcity here,

a country’s share of the world endowment of one factor should be compared to that

country’s shares of the world endowments of other factors. Physical (or nonhuman)

capital is relatively abundant in the industrialized countries, including the United States

and the five other countries shown specifically in the figure.

Highly skilled labor, represented here by those who have some college or a similar

post-secondary education (whether or not they graduated), is also relatively abundant in

the industrialized countries. This category includes scientists and engineers, a key input

into the research and development (R&D) that influences international competition in

high-technology goods.

Unskilled labor, represented here by those who have no formal education plus those

who have not completed primary school, is relatively scarce in the developed countries.

The developing countries show the opposite pattern of abundance and scarcity for physi-

cal capital, highly skilled labor, and unskilled labor. For medium-skilled labor, the interna-

tional contrasts are not nearly so sharp. Countries have them in shares that tend to be in the

middle of the abundance–scarcity spectrum, with China being an interesting exception.

FIGURE 5.3 Shares of the World’s Factor Endowments, 2010–2011

Physical Capital

Highly Skilled Labora

Medium- Skilled Laborb

Unskilled Laborc

Crop Land

Pasture Land Forestland

United States 16.8% 19.0% 3.9% 0.2% 11.1% 8.1% 7.9% Canada 1.4 1.5 0.6 0.1 3.3 0.5 8.1 Japan 7.5 6.1 2.2 0.4 0.3 0.0 0.7 Germany 4.2 1.9 1.8 0.4 0.8 0.2 0.3 France 3.6 1.5 1.2 0.5 1.3 0.3 0.4 United Kingdom 2.6 1.7 1.2 0.4 0.4 0.4 0.1 Other industrialized countries 16.8 9.5 5.9 1.6 6.6 13.1 7.0 China 18.3 12.9 27.8 15.7 8.6 12.8 5.5 Other developing countries 28.9 45.9 55.4 80.8 67.5 64.7 70.1

Notes: All values are approximations. The “world” refers to 138 countries (29 industrialized countries and 109 developing countries)

for which reasonable data are available. Physical capital and the land categories are for 2011, and the labor categories are for 2010.

a Adults who have some college (post-secondary education).

b Adults who have completed primary (first-level) education but have no college (post-secondary education).

c Adults who have not completed primary (first-level) education.

Sources: Physical capital (capital stock at current PPPs) from Feenstra, Inklaar, and Timmer (2013). Data on labor from Barro and Lee (2013), except four countries

from Cohen and Soto (2007). Data on land from World Bank, World Development Indicators .

74 Part One The Theory of International Trade

pug21774_ch05_066-087.indd 74pug21774_ch05_066-087.indd 74 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

What we now know about the mixtures of pro- ductive factors that make up the exports and imports of leading nations has been learned largely because Wassily Leontief was puzzled in the 1950s. Leontief, a Nobel Prize winner in economics, set off a generation of fruitful debate by following the soundest of scientific instincts: testing whether the predictions of a theory really fit the facts.

Leontief decided to test the Heckscher–Ohlin theory that countries will export products whose production requires more of the country’s abun- dant factors and import products whose produc- tion relies more on the country’s scarce factors. He assumed that the U.S. economy at that time was capital-abundant (and labor-scarce) relative to the rest of the world.

LEONTIEF’S K / L TEST Leontief computed the ratios of capital stocks to numbers of workers in the U.S. export and import-competing industries in 1947. This compu- tation required figuring out not only how much capital and labor were used directly in each of these several dozen industries but also how much capital and labor were used in producing the materials purchased from other industries. As the main pioneer in input–output analysis, he had the advantage of knowing just how to multiply the input–output matrix of the U.S. economy by vectors of capital and labor inputs, export values, and import values to derive the desired estimates of capital/labor ratios in exports and import- competing production. So the test of the H–O theory was set. If the United States was relatively capital-abundant, then the U.S. export bundle

should embody a higher capital/labor ratio ( K x / L

x )

than the capital/labor ratio embodied in the U.S. production that competed with imports ( K

m / L

m ).

Leontief’s results posed a paradox that puz- zled him and others: In 1947, the United States was exporting relatively labor-intensive goods to the rest of the world in exchange for rela- tively capital-intensive imports! The key ratio ( K

x / L

x )/( K

m / L

m ) was only 0.77 when H–O said it

should be well above unity. Other studies con- firmed the bothersome Leontief paradox for the United States between World War II and 1970.

BROADER AND BETTER TESTS The most fruitful response to the paradox was to introduce other factors of production besides just capital and labor. Perhaps, reasoned many econo- mists (including Leontief himself), we should make use of the fact that there are different kinds of labor, different kinds of natural resources, different kinds of capital, and so forth. Broader calculations of factor content have paid off in extra insights into the basis for U.S. trade. True, the United States was somewhat capital-abundant, yet it failed to export capital-intensive products. But the post-Leontief studies showed that the United States was also abundant in farmland and highly skilled labor. And the United States was indeed a net exporter of products that use these factors intensively, as H–O predicts.

DISCUSSION QUESTION When Leontief published his results, should econ- omists have abandoned Heckscher–Ohlin as a theory of international trade?

Case Study The Leontief Paradox

Figure 5.3 confirms what we know about the distribution of the world’s crop

land, pasture land, and forestland. These types of land are relatively concentrated

in North America and certain other developed and developing countries

(e.g., Australia, Argentina, Brazil). Europe and Japan are poorly endowed.

Although not shown in Figure 5.3, we do have some information on endowments of

natural resources in the form of fuels in the ground. Almost two-thirds of the proved

reserves of crude oil and of natural gas are in the countries of the Middle East. Proved

reserves of coal are more dispersed, with the United States, Russia, and Australia

Chapter 5 Who Gains and Who Loses from Trade? 75

pug21774_ch05_066-087.indd 75pug21774_ch05_066-087.indd 75 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

having a relative abundance. Unfortunately, we have limited data on other natural

resources (minerals and metal ores in the ground). Still, we can surmise some pat-

terns. Canada is relatively abundantly endowed, though the United States generally is

not. Certain countries, including Australia, Bolivia, Chile, Jamaica, and Zambia, are

endowed with abundance of various metal ores.

International Trade If Heckscher and Ohlin have given us the right prediction, the unequal distribution of

factors should be mirrored in the patterns of trade, with each country exporting those

goods and services that use its abundant factors relatively intensively.

International trade patterns are broadly consistent with the H–O prediction that

nations tend to export the products using their abundant factors intensively. Consider first

the United States. U.S. exports and imports for selected goods are shown in Figure 5.4 .

FIGURE 5.4 U.S.

International

Trade in

Selected

Products, 2012

Source: United

Nations, Statistics

Division, UN Comtrade Database .

A. Products Whose Trade Is Consistent with H–O Theory

Net Exports as U.S. Exports U.S. Imports a Percentage ($ billions) ($ billions) of Total Trade*

Wheat (041) 8.17 0.85 181 Corn (044) 9.71 1.02 181 Coffee (071) 1.28 7.26 270 Soybeans (2222) 24.74 0.35 197 Coal (321) 14.88 0.93 188 Crude petroleum (333) 2.40 321.86 299 Primary plastic materials (57) 34.49 13.80 143 Insecticides and herbicides (591) 3.31 0.89 158 Aircraft (792) 104.20 24.31 162 Clothing and accessories (84) 5.58 87.96 288 Shoes and other footwear (85) 1.33 24.86 290 Toys (8942) 0.96 11.55 285

B. Products Whose Trade Appears to Be Inconsistent with H–O Theory

Net Exports as U.S. Exports U.S. Imports a Percentage ($ billions) ($ billions) of Total Trade*

Pharmaceuticals (54) 44.59 68.66 221 Perfumes and cosmetics (553) 8.21 7.05 18 Iron and steel (67) 20.82 44.96 237 Automobiles (7812) 53.90 149.14 247 Medical instruments (872) 21.46 16.20 114

Note: Commodity numbers from the Standard International Trade Classification, revision 3, are shown in

parentheses.

* Net exports as a percentage of total trade equals exports of this product minus imports of this product, divided

by exports plus imports of this product. This percentage is an indicator of “revealed comparative advantage” in

the product.

76 Part One The Theory of International Trade

pug21774_ch05_066-087.indd 76pug21774_ch05_066-087.indd 76 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

The United States is relatively abundant in crop land, and it tends to be a net exporter

(exports exceed imports) of temperate-zone agricultural products, such as wheat, corn,

and soybeans. The United States is an importer of tropical-zone agricultural products

like coffee. The United States has abundant endowments of some natural resources, such

as coal, and tends to be a net exporter of these resource products. It is a net importer

(imports exceed exports) of many other natural resource products, such as petroleum,

which are found more abundantly in some other countries.

The United States is relatively abundant in skilled labor, including scientists and

engineers employed in R&D, and tends to be a net exporter of products that are skilled-

labor-intensive or technology-intensive, including primary plastic materials, insecti-

cides and herbicides, and aircraft. Less-skilled labor is relatively scarce in the United

States, so the country is a net importer of less-skilled-labor-intensive products like

clothing, shoes, and toys. (The United States is also a major net exporter of business

services—for instance, marketing, management, accounting, and consulting—reflecting

the abundance of skilled labor that is important in producing these services.)

The pattern of U.S. trade in some other goods appears to be inconsistent with H–O.

Five of these are shown in Figure 5.4. The United States is a net importer of steel and

automobiles. The United States both exports and imports large amounts of pharma-

ceuticals, perfumes and cosmetics, and medical instruments. Factor proportions do not

seem to be able to explain U.S. trade patterns for these products. In the next chapter,

we will examine other theories that may explain them.

The trade pattern of Japan is also broadly consistent with H–O. Land and natural

resources are scarce in Japan, which is crucially dependent on imports of agricultural,

fishing, forestry, and mineral products. Without trade, Japan would be a far poorer

country. Japan has relatively abundant skilled labor (including scientists and engi-

neers) and tends to export skilled-labor-intensive manufactured products. Although

Japan 60 years ago was a net exporter of less-skilled-labor-intensive products, the

country now is a net importer of these products, a pattern consistent with its current

relative scarcity in less-skilled labor.

Canada is relatively abundant in natural resources and tends to export primary

products. Even its exports of manufactures tend to be intensive in natural resources

used as important inputs into the manufacturing process. Examples include fertilizers,

nonferrous metals, wood products, and paper.

The trade patterns of developing countries largely follow the H–O theory. For a closer

look at the trade of one developing country, see the box “China’s Exports and Imports.”

In general, trade patterns fit the H–O theory reasonably well but certainly not perfectly. 5

5 A comprehensive test by Bowen, Leamer, and Sveikauskas (1987) measured the ability of factor endowments and U.S. input–output patterns to predict the net factor flows through trade in 1967. Out of 324 cases, defined by 12 factors and 27 countries, H–O correctly predicted the sign of net exports in 61 percent of the cases. This share was better than a coin flip, but only modestly so. The results of testing by Trefler (1995) indicate that all three of the bases for trade noted in Chapter 4 may be important for explaining actual trade—namely, factor endowment differences, technology differences, and a demand bias toward consuming domestically produced products. The magnitudes of the technology differences that Trefler finds are similar to the differences in labor productivity shown on the horizontal axis of the figure in Chapter 3’s box on absolute advantage (p. 40). Research by Davis and Weinstein (2001), Schott (2003), and Trefler and Zhu (2010) includes further refinements and shows that factor endowment differences are an important part of predicting trade patterns.

Chapter 5 Who Gains and Who Loses from Trade? 77

pug21774_ch05_066-087.indd 77pug21774_ch05_066-087.indd 77 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

WHAT ARE THE EXPORT-ORIENTED AND IMPORT-COMPETING FACTORS?

The link of factor endowments to international trade patterns emphasized in the H–O

theory also suggests, through the logic of the Stolper–Samuelson theorem, the effects

of trade on factor groups’ incomes and purchasing power. National policymakers need

to know which factor groups are likely to gain and lose from liberalizing trade. The

policymakers can then anticipate different groups’ views on trade or plan ahead for

ways to compensate groups that are harmed, if society wishes to do so.

The U.S. Pattern Figure 5.5 shows the factor content of U.S. exports and of U.S. imports competing

with domestic production. Overall, labor incomes account for a greater share of the

value of U.S. exports than of the value of U.S. imports. This reflects two facts. First,

the number of jobs associated with U.S. exports is about the same as the number asso-

ciated with an equal value of imports. (See the box “U.S. Jobs and Foreign Trade.”)

Second, the average skill and pay levels are higher on the export side. In fact, it seems

wise to divide labor into at least two types—skilled and unskilled—as in Figure 5.5.

Skilled labor in the United States is an export-oriented factor, while unskilled labor

is an import-competing factor. Farmland is another export-oriented factor. Physical

capital (as suggested by the Leontief paradox) and mineral rights generally are import-

competing factors.

Note: Vertical distances are meant to give rough impressions of factor-content proportions in U.S. exports

and the set of outputs that would replace the U.S. imports that compete with domestic products.

FIGURE 5.5 A Schematic

View of the

Factor Content

of U.S. Exports

and Competing

Imports Unskilled labor

Skilled labor

Capital (plant, equipment, and inventories)

Farmland rents

Unskilled labor

Skilled labor

Mineral rights

Factor content of each $1 million of exports

Factor content of each $1 million of competing imports

78 Part One The Theory of International Trade

pug21774_ch05_066-087.indd 78pug21774_ch05_066-087.indd 78 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

The Canadian Pattern Canada, by contrast, implicitly exports and imports the factor mixtures sketched

in Figure 5.6 . One clear similarity to the U.S. pattern is that both countries are net

exporters of the services of farmland through their positions as major grain exporters.

Another similarity is that Canada is a net importer of unskilled labor. In contrast to

the United States, Canada is a net importer of labor overall and a slight net exporter of

nonhuman capital. Finally, Canada is a heavy net exporter of mineral-rights services

through its exports of both the minerals extracted from the ground and manufactured

products made with these minerals.

Patterns in Other Countries The patterns of factor content have also been roughly measured for other countries.

Two such results deserve quick mention here.

The factor content of oil-exporting countries is not surprising. They explicitly export mineral rights in large amounts, of course. The less populous oil exporters, par-

ticularly the oil nations of the Arabian peninsula, also export capital services through

the foreign investment of much of their financial wealth. The same countries implicitly

import just about every other factor: all human factors and farmland.

The oil-importing developing countries implicitly import capital and human skills as well as oil. They export unskilled labor, the services of agricultural land,

and minerals other than oil. This pattern has important implications for the dis-

tributional effects of trade. For many developing countries, lower-income groups

selling unskilled labor or working small farm plots have the greatest positive stake

FIGURE 5.6 The Factor

Content of

Canada’s

Exports and

Competing

Imports Unskilled labor

Skilled labor

Capital

Farmland and forests

Unskilled labor

Skilled labor

Factor content of each $1 million of exports

Factor content of each $1 million of competing imports

Mineral rights

Chapter 5 Who Gains and Who Loses from Trade? 79

pug21774_ch05_066-087.indd 79pug21774_ch05_066-087.indd 79 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

Focus on China China’s Exports and Imports

One of the most striking features of the global economy is the rise of China as a trading force after it opened to international trade beginning in the 1970s. China accounted for less than 1 percent of international trade in 1980. Its exports and imports have grown rapidly, so that by 2012 China’s trade averaged over 9 percent of world trade.

Many media stories and commentators make it sound as though China is a ruthless mercantilist trader, focused on exporting its way to economic success. But the actual evidence is quite different. China is much closer to fitting our presumption that changes in export values roughly match changes in import values, so that trade is close to being balanced over time. The figure on the next page shows the paths of the value of exports and value of imports for China during 1976–2012. The rapid growth is evident. It is also clear that the value of exports almost exactly equaled the value of imports up to about 1996. While exports and imports continued to grow rapidly, exports exceeded imports by a moderate amount each year from 1996 to 2004. Then the gap increased to about $350 billion in 2008, before declining to about $230 billion in 2012. Still, with generally

rapid growth in both exports and imports, China’s trade expansion is closer to the textbook model of balanced overall trade than it is to an export-only mercantilism.

What does China trade? Do the patterns across export and import products match with what the Heckscher–Ohlin theory predicts? As shown in Figure 5.3, China is relatively abundant in medium-skilled labor, and it is relatively scarce in forestland, crop land, and highly skilled labor. Although it is not shown in this figure, we also know that China is relatively scarce in most natural resources in the ground.

The table below lists some representative prod- ucts in China’s international trade in 2012.

As is true for other countries, much but not all of China’s international trade is consistent with the Heckscher–Ohlin theory. First, the theory predicts that China will be a net importer of land-intensive agricultural products like soybeans. Second, the theory predicts that China will be a net importer of natural resources like metal ores and crude petro- leum. Third, the theory predicts that China will be a net importer of skilled-labor-intensive manu- factured products like metalworking machinery,

China’s Exports China’s Imports ($ billions) ($ billions)

Soybeans (2222) 0.3 35.0 Metal ores (28) 0.5 158.7 Crude petroleum (333) 2.2 220.8 Metalworking machinery (73) 6.9 18.2 Computers (752) 169.4 35.1 Audio equipment (763) 20.0 10.1 Electronic microcircuits (7764) 54.3 192.7 Aircrafts (792) 1.6 17.6 Clothing and accessories (84) 159.6 4.5 Shoes and other footwear (85) 46.8 1.8 Toys (8942) 11.5 0.3 Vegetables (054 and 056) 10.6 2.7 Textiles and leather machinery (724) 4.7 4.6

Note: Commodity numbers from the Standard International Trade Classification, revision 3, are shown in parentheses.

Source: United Nations, Statistics Division, UN Comtrade Database .

80 Part One The Theory of International Trade

pug21774_ch05_066-087.indd 80pug21774_ch05_066-087.indd 80 11/4/14 3:49 PM11/4/14 3:49 PM

Final PDF to printer

electronic microcircuits, and aircrafts. Fourth, the theory predicts that China will be a net exporter of lower-skilled-labor-intensive products like cloth- ing, footwear, and toys.

But then we are left with a fifth group that appears superficially puzzling. Why is China a net exporter of such products as computers and audio equipment? Here we must be careful to note that the part of the production process that occurs in China is mainly the assembly of these products, and the assembly processes use lower- skilled labor intensively. Essentially, China is a net importer of the materials and components that go into these products (as well as importing the product designs and the machinery used in pro- duction). China’s production focuses on using its

abundant less-skilled and medium-skilled work- ers to assemble the final products, which are then exported.

While much of China’s international trade does match with the Heckscher–Ohlin theory, there are some products that do not, including vegetables and textile machinery, as shown at the bottom of the listing.

Overall, China fits our textbook stories re- mark ably well. First, its trade has been roughly balanced—the value of exports has roughly equaled the value of imports, even though both are growing rapidly. Second, much of its pat- tern of net exports and net imports of different products is just what Heckscher and Ohlin would predict.

Source: World Bank, World Development Indicators.

400

800

1,200

1,600

2,000

2,400 1 9 7 6

1 9 8 1

1 9 8 6

1 9 9 1

1 9 9 6

2 0 0 1

2 0 0 6

2 0 1 1

Exports of goods and services

B il li o

n s

o f

U .S

. d

o ll a rs

Imports of goods and services

China: Value of Exports and Value of Imports, 1976–2012

Chapter 5 Who Gains and Who Loses from Trade? 81

pug21774_ch05_066-087.indd 81pug21774_ch05_066-087.indd 81 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

in foreign trade because their products are the exportable ones. Restrictions on

international trade can widen the income gaps between rich and poor in devel-

oping countries. We examine trade issues for developing countries in depth in

Chapter 14.

DO FACTOR PRICES EQUALIZE INTERNATIONALLY?

Perhaps the most remarkable conclusion of the Heckscher–Ohlin theory is that trade

can equalize the price of each factor of production across countries. The factor-

price equalization theorem is more than just remarkable. It is also clearly wrong in

the strong form in which it is stated. Even the most casual glance at the real world

shows that factor prices are not fully equalized across countries. For example,

the same labor skill does not earn the same real pay in all countries. Machine

operators do not earn the same pay in Mexico or India as in the United States or

Canada. Neither do hair stylists. Given the large number of assumptions—some of

them not realistic—that are necessary to prove the strong form of the factor-price

equalization theorem, it is not surprising that the real world is not fully consistent

with the theorem. For instance, in the real world governments do impose barriers

to free trade, and technologies (or production functions) are not exactly the same

in all countries.

Does a weaker form of the theorem work? That is, does trade tend to make prices

for a factor more similar across countries than they would be with no trade? In our

ongoing example, with no trade the return to land (the abundant factor) in the United

States would be low, and the return to land (the scarce factor) in the rest of the world

would be high. Opening to trade increases the return to land in the United States and

reduces the return to land in the rest of the world—an example of a tendency toward international factor-price equalization.

That is exactly what happened before World War I: As Europe expanded its trade

with land-rich America and Australia, the high land rents in Europe tended to stagnate

while the low land rents of America and Australia shot up, reducing the global inequal-

ity of land rent. More recently, we see this tendency toward equalization in the rise of

wages in China and India. As China has integrated into world trade and expanded its

exports of less-skilled, labor-intensive manufactured goods, increases in demand for

less-skilled workers has led to real wages for a typical factory worker rising at about

10 percent per year since the early 2000s, narrowing the wage gap between China and

the industrialized countries. In India, the growth of export-oriented production of busi-

ness services (sometimes referred to as offshore outsourcing) has also affected wages

in the past decade or so. Worker compensation in business services in India had been

about one-fifth the compensation for comparably skilled workers in the United States.

By 2013 compensation in India had risen to about three-fifths. Although we still do

not see full factor-price equalization in the real world, there appear to be tendencies

toward equalization.

82 Part One The Theory of International Trade

pug21774_ch05_066-087.indd 82pug21774_ch05_066-087.indd 82 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

The U.S. Congress has sometimes come close to passing comprehensive bills to slash U.S. imports through tariffs or other barriers. These attempts have been defended as necessary to protect U.S. jobs. Does more trade mean fewer U.S. jobs? Does less trade mean more U.S. jobs? Economists have developed a relatively clear and surprising answer.

Consider general restrictions that reduce U.S. imports across the board. Such restrictions are likely to result in no increase in U.S. jobs at given wage rates! This is because (1) reducing U.S. imports also tends to reduce U.S. exports and (2) the average job content of U.S. exports is about equal to that of U.S. imports.

There are four reasons to think that reducing imports reduces exports. First, exports use import- able inputs. If these imports are not so readily available, U.S. exports become less competitive. Second, foreigners who lose sales to us cannot buy so much from us. As foreigners lose income from exports to us, they buy less of many things, including less of our exports. Third, foreign gov- ernments may retaliate by increasing their own protection against imports. U.S. exports decline as they face additional foreign barriers.

Fourth, cutting our imports may create pres- sures for changes in exchange rates. We will discuss exchange rates further in Chapters 17–25. Here we depart briefly from barter trade to recognize that most trade is paid for with national curren- cies. Reducing demand for imports also reduces demand for foreign currencies used to pay for the imports. If the foreign currencies then lose value— thus increasing the exchange-rate value of the U.S. dollar—the higher dollar value tends to make U.S. goods more expensive to foreign buyers. In response they buy less of our exports.

The combination of these four effects results in roughly a dollar-for-dollar cut in exports if imports are cut. If both exports and imports are cut, the effect on U.S. jobs then depends on whether more jobs are created in the expanding import- competing industries than are lost in the declining- export industries. Estimates from different studies vary somewhat. Overall, the studies indicate that

the net change in total jobs would probably be small if U.S. imports and U.S. exports decreased by the same amount. (In addition, the average wage rate tends to be higher in export industries.)

If a sweeping cut in imports would probably not increase jobs much, why would labor groups favor such import cuts? The largest lobbyist for protec- tion against imports is the American Federation of Labor–Congress of Industrial Organizations (AFL– CIO). The goods-sector membership of this orga- nization is concentrated in industries that are more affected by import competition than is the economy (or labor) as a whole. It is practical for the AFL–CIO to lobby for protectionist bills that would defend the jobs of AFL–CIO members and their wages even if these bills would cost many jobs and wages outside of this labor group. To understand who is pushing for protection, it is important to know whose incomes are most tied to competition from imports.

This discussion refers to a general restriction against U.S. imports. Selective barriers against specific imports would alter the net effect on U.S. jobs. For instance, studies of existing U.S. barriers, which are selective, show that they are most restrictive on goods having a higher-than- average jobs content, especially in less-skilled jobs categories. Thus, existing U.S. import bar- riers may bring some increase in U.S. jobs, even though raising new barriers against all imports probably would not increase U.S. jobs.

We conclude by noting that the validity of focusing on jobs gained and lost through trade is itself debatable. Jobs gained or lost through changes in international trade are themselves a small part of overall changes in jobs in the economy. Many different sources of pressure for change, including shifts in demand and changes in technologies, result in changes in the number and types of jobs in the country. A well-functioning economy is dynamic—employment shifts between sectors to reallocate workers (and other resources) to their highest-value uses. While there are disrup- tions in the short run, the reallocations are crucial to economic growth.

Focus on Labor U.S. Jobs and Foreign Trade

Chapter 5 Who Gains and Who Loses from Trade? 83

pug21774_ch05_066-087.indd 83pug21774_ch05_066-087.indd 83 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

This chapter examines the effects of trade on income distribution. Combining these

insights with the basic view of trade offered in Chapters 2, 3, and 4, we can summarize

by answering the four basic questions about trade introduced at the start of Chapter 2.

1. Why do countries trade? Supply and demand conditions differ between coun-

tries because production conditions and consumer tastes differ. The main theories

emphasize differences in production conditions rather than in tastes. Ricardo argued

that trade is profitable because countries have different comparative advantages in pro-

ducing different goods. His examples stressed differences in resource productivities.

The Heckscher–Ohlin theory agrees that comparative advantages in production are the

basis for trade, but H–O explains comparative advantage in terms of underlying differ-

ences in factor endowments. Each country tends to export those goods that intensively

use its relatively abundant factors of production. The evidence is that the Heckscher–

Ohlin theory explains a good part of the world’s actual trade patterns reasonably well,

but that some important aspects of trade patterns do not square easily with H–O.

2. How does trade affect production and consumption in each country? In the

country importing a good, it will raise consumption and lower production of that good.

In the exporting country, it will raise production of that good, but in the general case

we cannot say for sure what happens to the quantity consumed of that good. With the

exception of the latter conclusion, these answers are unchanged since Chapter 2.

3. Which country gains from trade? Both countries gain. Trade makes every nation

better off in the net national sense defined in Chapter 2. Each country’s net national

gains are proportional to the change in its price from its no-trade value, so the country

whose prices are disrupted more by trade gains more. (Later chapters will show how

an already-trading nation can be made worse off by trading more, but some trade is

better than no trade at all.)

4. Within each country, who are the gainers and losers from opening trade? This

chapter has concentrated on this fourth question. Its answers go well beyond those

summarized at the end of Chapter 2.

In the short run, with factors unable to move much between sectors, the gainers and losers are defined by the product sector, not by what factors of production the people are

selling. The gainers are those who consume imported goods and produce exportable goods.

Those who lose are the producers of import-competing goods and consumers of exportable

goods. So far, the answer remains close to the answer given at the end of Chapter 2.

In the long run, when factors can move between sectors and the economy achieves full employment, the division between gainers and losers looks different. Application

of the general Stolper–Samuelson theorem to the case of opening trade shows that

• If you make your living selling a factor that is relatively abundant in your country,

you gain from trade (by receiving a higher real income), regardless of what sector

you work in or what goods you consume. Examples are scientists and grain-area

landowners in the United States and less-skilled laborers in China.

• If you make your living selling a factor that is relatively scarce in your country,

you lose from trade (by receiving a lower real income), regardless of what sector

you work in or what goods you consume. Examples are less-skilled laborers in the

United States and scientists and grain-area landowners in China.

Summary: Fuller Answers to the Four Trade Questions

84 Part One The Theory of International Trade

pug21774_ch05_066-087.indd 84pug21774_ch05_066-087.indd 84 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

A corollary of these long-run effects on different groups’ fortunes is that trade

can reduce international differences in how well a given factor of production is paid.

A factor of production (for instance, less-skilled labor) tends to lose its high reward in

countries where it was scarce before trade and to gain in countries where it was abun-

dant before trade. Under certain conditions the factor-price equalization theorem holds: Free trade in products will equalize a factor’s rate of pay in all countries, even

if the factor itself is not free to move between countries. Those conditions for perfect

equalization are not often met in the real world, but there is real-world evidence that

opening trade tends to make factor prices less unequal between countries.

Key Terms

Short run

Long run

Stolper–Samuelson

theorem

Factor-price

equalization theorem

Suggested Reading

For excellent surveys of empirical tests of trade theories, see Deardorff (1984), Leamer

and Levinsohn (1995), and Davis and Weinstein (2003). Tough tests of the Heckscher–

Ohlin theory appear in Bowen, Leamer, and Sveikauskas (1987); Trefler (1993, 1995);

Davis and Weinstein (2001); Schott (2003); and Trefler and Zhu (2010).

Hanson (2012) discusses the role of comparative advantage in the trade of developing

countries. Explorations of the effects of trade (and other aspects of globalization) on the

earnings of different groups in developing countries include Goldberg and Pavcnik (2007);

Gonzaga, Menezes Filho, and Terra (2006); and Robertson (2007). O’Rourke et al. (1996) and

O’Rourke and Williamson (1994) explore factor price convergence in the late 19th century.

Questions and Problems

1. As a result of the North American Free Trade Agreement (NAFTA), the United

States and Canada shifted toward free trade with Mexico. According to the Stolper–

Samuelson theorem, how is this shift affecting the real wage of unskilled labor in

Mexico? In the United States or Canada? How is it affecting the real wage of skilled

labor in Mexico? In the United States or Canada?

2. “The factor-price equalization theorem indicates that with free trade the real wage

earned by labor becomes equal to the real rental rate earned by landowners.” Is this

correct or not? Why?

3. “Opening up free trade does hurt people in import-competing industries in the short

run. But in the long run, when people and resources can move between industries,

everybody ends up gaining from free trade.” Do you agree or disagree? Explain.

4. One of your relatives suggests to you that our country should stop trading with other

countries because imports take away jobs and lower our national well-being. How

would you try to convince him that this is probably not the right way to look at

international trade and its effects on the country?

5. The empirical results that Leontief found in his tests are viewed as a paradox. Why?

6. Consider our standard model of the economy, with two goods (wheat and cloth) and

two factors (land and labor). A decrease now occurs in the relative price of wheat.

✦

Chapter 5 Who Gains and Who Loses from Trade? 85

pug21774_ch05_066-087.indd 85pug21774_ch05_066-087.indd 85 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

What are the short-run and long-run effects on the earnings of each of the following:

Labor employed in the wheat industry? Labor in the cloth industry? Land used in the

wheat industry? Land in the cloth industry?

7. In shipbuilding there are two types of ships. Producing basic bulk-carrying ships is

labor intensive. Production of complex ships, including the largest container ships

and very deepwater oil-drilling ships, depends more on technical skills and design

capabilities. Both China and South Korea have large shipbuilding industries. China’s

factor endowments are shown in Figure 5.3, and comparable data for South Korea,

reading across the columns, are 2.3%, 2.6%, 0.7%, 0.1%, 0.1%, 0.0%, 0.0%, and

0.2%. If China exports mostly basic bulk-carrying ships and South Korea exports

mostly complex ships, is this pattern consistent with the Heckscher–Ohlin theory?

8. Indian exports of computer software development services have grown rapidly since

the early 2000s. In the early 2000s the cost to employ programmers in India was about

half the cost of programmers with comparable skills in the United States. In 2013 the

cost in India was about two-thirds the cost in the United States. What trade theory or

theories help us to understand the change?

9. In the long run in a perfectly competitive industry, price equals marginal cost and

firms earn no economic profits. The following two equations describe this long-

run situation for prices and costs, where the numbers indicate the amounts of each

input (labor and land) needed to produce a unit of each product (wheat and cloth):

P wheat

5 60 w 1 40 r

P cloth

5 75 w 1 25 r

a. If the price of wheat is initially 100 and the price of cloth is initially 100, what are the values for the wage rate, w , and the rental rate, r ? What is the labor cost per unit of wheat output? Per unit of cloth? What is the rental cost per unit of wheat?

Per unit of cloth?

b. The price of cloth now increases to 120. What are the new values for w and r (after adjustment to the new long-run situation)?

c. What is the change in the real wage (purchasing power of labor income) with respect to each good? Is the real wage higher or lower “on average”? What is the

change in the real rental rate (purchasing power of land income) with respect to

each good? Is the real rental rate higher or lower “on average”?

d. Relate your conclusions in part c to the Stolper–Samuelson theorem.

10. You are given the following input cost shares in the corn and vehicle industries for the

country of Pugelovia:

For Each Dollar of

Overall Corn Output Vehicle Output National Income

Total labor input $0.60 $0.59 $0.60 Total land input 0.15 0.06 0.10 Total capital input 0.25 0.35 0.30 $1.00 $1.00 $1.00

✦

86 Part One The Theory of International Trade

pug21774_ch05_066-087.indd 86pug21774_ch05_066-087.indd 86 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

Suppose that a change in demand conditions in the rest of the world raises the price of

corn relative to vehicles, so producers in Pugelovia try to expand production of corn

in order to export more corn.

a. If all factors are immobile between the corn and vehicle sectors, who gains from this change? Who loses?

b. If all factors are freely mobile between the corn and vehicle sectors, who gains from this change? Who loses?

11. From the following information calculate the total input shares of labor and capital in

each dollar of cloth output:

For Each Dollar of

Cloth Synthetic Fiber Cotton Fiber Output Output Output

Direct labor input $0.50 $0.30 $0.60 Direct capital input 0.20 0.70 0.40 Synthetic fiber input 0.10 0.00 0.00 Cotton fiber input 0.20 0.00 0.00 All inputs $1.00 $1.00 $1.00

Cloth is the only product that this country exports. The total input share of labor in

producing $1.00 of import substitutes in this country is $0.55, and the total input share

of capital is $0.45. Is this trade pattern consistent with the fact that this country is

relatively labor-abundant and capital-scarce?

12. Consider the following data on some of Japan’s exports and imports in 2012, mea-

sured in billions of U.S. dollars:

Product Japanese Exports Japanese Imports

Food (0) 3.7 64.2 Metal ores (28) 6.5 39.7 Crude petroleum (333) 0.0 153.1 Pharmaceuticals (54) 4.0 24.3 Soaps and cleaners (554) 1.2 0.8 Iron and steel (67) 43.8 10.1 Automobiles (7812) 97.3 10.9 Aircraft (792) 3.9 7.3 Clothing and accessories (84) 0.6 33.9 Shoes and other footwear (85) 0.1 5.9 Medical instruments (872) 2.8 6.0

Note: Commodity numbers from the Standard International Trade Classification are shown in parentheses.

For which of these products do Japan’s exports and imports appear to be consistent

with the predictions of the Heckscher–Ohlin theory? Which appear to be inconsistent?

✦

Chapter 5 Who Gains and Who Loses from Trade? 87

pug21774_ch05_066-087.indd 87pug21774_ch05_066-087.indd 87 10/27/14 7:00 PM10/27/14 7:00 PM

Final PDF to printer

Chapter Six

Scale Economies, Imperfect Competition, and Trade According to our standard theories of comparative advantage, countries should trade

to exploit the relative cost differences that arise from differences in factor endow-

ments and differences in technology and productivity. As we discussed in the previous

chapter, much international trade conforms to this predicted pattern. Industrialized

countries trade with developing countries. Countries with substantial reserves of oil

trade with countries that lack crude in the ground.

However, another part of international trade does not conform. According to

comparative advantage, countries that are similar should trade little with each other.

Industrialized countries are similar to each other in many aspects of their relative

factor endowments (physical capital, skilled labor, unskilled labor) and also in their

technologies and technological capabilities. Yet, they trade extensively with each

other. About two-thirds of the exports of industrialized countries are shipped to other

industrialized countries, and about one-third of total world trade is industrialized

countries trading with each other.

According to our standard theories of comparative advantage, each country should

export some products (if the country has a relative cost advantage) and import other

products (if the country has a relative cost disadvantage). Much trade is in this form.

For instance, a country that exports large amounts of oil usually does not also import

much oil, but rather it imports other products like machinery. But, again, another part

of international trade does not conform. For instance, much of the trade of an indus-

trialized country is two-way trade in which the country both exports and imports the

same or very similar products.

To understand why industrialized countries trade so much with each other, and why

they have so much two-way trade in very similar products, we need to extend our models

of trade beyond standard comparative advantage, with its assumption of perfect competi-

tion. In this chapter we will incorporate additional important features of rivalry in actual

global markets, features that represent aspects of imperfect competition.

We begin by reviewing what we need to know about scale economies, in which

large size leads to lower per-unit costs of production. Scale economies play an impor-

tant role in departures from perfect competition. Then we look carefully at intra-

industry trade—two-way trade in which a country both exports and imports the same

or very similar products.

pug21774_ch06_088-116.indd 88pug21774_ch06_088-116.indd 88 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

With these concepts in hand, we turn to the main task of the chapter, the develop-

ment of three theories that add to our understanding of trade. Each theory is based on

a type of market structure that differs from perfect competition, specifically:

• Product differentiation and monopolistic competition.

• Dominance of large firms in global oligopoly.

• Clustering of firms to exploit cost advantages of locating close to each other.

Each of these theories applies to industries with specific characteristics. As you will

see, each adds to our ability to answer the four major questions about trade.

SCALE ECONOMIES

For types of imperfect competition that are the focus of this chapter, scale economies

play an important role. But what are scale economies? Where do they come from?

We are entering new territory because our standard theory of international trade has

assumed constant returns to scale.

Consider how cost changes as a firm alters the amount that it wants to produce,

assuming that the firm can make full or long-run adjustments of all factor inputs and

that factor prices are constant. Total cost increases if the firm wants to produce more,

so the proportionate changes in total cost and output quantity are the key issues. With

constant returns to scale , input use and total cost rise in the same proportion as output increases. For an industry such as production of basic clothing items, produc-

tion is probably very close to constant returns to scale.

What is the implication for average cost , which is total cost divided by the number of units produced? For constant returns to scale, total cost and output go up by the

same proportion, so average cost (the ratio between them) is constant (or steady). Here

is a simple example of constant returns to scale. If a firm wants to double output, it

must double all the inputs that it uses. If input prices are constant, then total cost also

doubles. If both total cost and output double, then average cost is unchanged.

Of course, constant returns to scale are not the only possibility. In fact, we believe

that for many industries there is a range of output for which scale economies exist. With

scale economies , output quantity goes up by a larger proportion than does total cost, as output increases. If output quantity expands faster than total cost increases, then the

average cost of producing a unit of output decreases as output increases. (Remember,

we are assuming all useful long-run adjustments are made to vary the production inputs

as the output quantity changes, and we are assuming that input prices are constant.)

Figure 6.1 shows how scale economies affect average costs. The basic data for

total cost that would be incurred to produce each of several different levels of output

are shown toward the bottom of the figure, and the average cost for each of these

output levels can be computed as total cost divided by output quantity. According to

Figure 6.1, if the output level for this time period is only 25,000 units, the average

cost for producing these units would be $26 per unit. If, instead, the output level is

50,000 units, the average cost would be $23 per unit, and for 75,000 units the average

cost would be $21 per unit. For the output level of 100,000 units, the average cost

would be $20 per unit. For output levels up to 100,000 units, scale economies can

Chapter 6 Scale Economies, Imperfect Competition, and Trade 89

pug21774_ch06_088-116.indd 89pug21774_ch06_088-116.indd 89 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

Output quantity 25,000 50,000 75,000 100,000

Total cost $650,000 $1,150,000 $1,575,000 $2,000,000

Scale economies exist for the range of production up to 100,000 units, so average cost is declining

as output increases in this range.

Cost per unit ($ per unit)

21 Average cost

25 50 75 100 Quantity (thousands per year)

FIGURE 6.1 Scale

Economies

be achieved, so average cost declines as output increases. (For output levels above

100,000, constant returns to scale apply, and the average cost curve is a flat line.)

Internal Scale Economies Where do scale economies come from? There are actually two types of scale econo-

mies. First, scale economies can be internal to the individual firm. The actions and

decisions of the individual firm itself result in internal scale economies . A larger firm may have a lower average cost for a number of different reasons. Here are a few

examples. (1) There are often up-front costs before any production occurs. For instance,

the cost of designing and developing a new large civilian aircraft is often close to

$10 billion. As more planes of this model can be produced, the average cost of each

airplane will be lower because the up-front fixed development cost is spread over the

larger number of planes. (2) There are sometimes advantages to using large, special-

ized capital equipment that operates at high volume. Bottling or canning beer achieves

lowest cost per unit using high-speed automated filling and sealing machines, but use

of such a machine is economical only if it can be run to produce more than a thousand

bottles or cans per minute. (3) Tanks, vats, and pipes are a source of scale economies in

producing chemicals. The cost of this type of input is based largely on its surface area,

but its contribution to output is based on the volume that it contains. As size increases,

volume increases proportionately more than surface area.

Scale economies that are internal to the firm can drive an industry away from textbook-perfect competition because they drive individual firms to be larger than the

(very) small firms that populate perfectly competitive industries. But how far away?

This depends on the size or extent of the scale economies. How large does a firm

have to be to achieve all or most of the available scale economies? For instance, in

Figure 6.1 low average cost is achieved at an output size of 100,000 units. And how

90 Part One The Theory of International Trade

pug21774_ch06_088-116.indd 90pug21774_ch06_088-116.indd 90 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

large is the unit-cost penalty for smaller output levels? In Figure 6.1 the average cost

penalty for a scale of 50,000 units, compared with lowest average cost at 100,000

units, is about 15 percent (5 (23 2 20)/20). The answers to these questions are impor-

tant for the type of structure that arises on the seller side of the market.

If scale economies are modest or moderate, then there is room in the industry for a

large number of firms. If, in addition, products are differentiated, then we have a mild

form of imperfect competition called monopolistic competition, a type of market structure in which a large number of firms compete vigorously with each other in

producing and selling varieties of the basic product. Because each firm’s product is

somewhat different, each firm has some control over the price that it charges for its

product. This contrasts with the perfectly competitive market structure used in stan-

dard trade theory. With perfect competition, each of the industry’s many small firms

produces an identical commodity-like product, takes the market price as given, and

believes that it has no direct control or influence on this market price.

If scale economies are substantial over a large range of output, then it is likely that a

few firms will grow to be large in order to reap the scale economies. If a few large firms

dominate the global industry, perhaps because of substantial scale economies, then we

have an oligopoly. The large firms in an oligopoly know that they can control or influ- ence prices. A key issue in an oligopoly is how actively these large firms compete with

each other. If they do not compete too aggressively, then it is possible for the firms to

earn economic (or pure) profit, profit greater than the normal return to invested capital.

In a later section of this chapter, we present in-depth analysis of how we can use

monopolistic competition to better understand the drivers and implications of interna-

tional trade. We then take a look at the role of oligopoly in international trade.

External Scale Economies The second type of scale economies is external to any individual firm. External scale economies are based on the size of an entire industry within a specific geographic area. The average cost of the typical firm producing the product in this area declines as

the output of the industry (all the local firms producing this product) within the area is larger. External economies explain the clustering of the production of some products in specific geographic areas. What are the sources of external scale economies? There

are several possibilities.

External economies can arise if concentration of an industry’s firms in a geographic

area attracts greater local supplies of specialized services for the industry or larger pools

of specialized kinds of labor required by the industry. One reason that filmmaking firms

cluster in Hollywood (and in Mumbai, formerly Bombay, India, known as Bollywood)

is that a deep pool of workers skilled in the various aspects of filmmaking and a range

of companies providing special services to facilitate filmmaking are available in these

locations. (You can also see the self-reinforcing aspect of external scale economies—if

you want to break into films and filmmaking, or to offer services to film companies,

you know where you need to go.) External economies can also result as new knowl-

edge about product and production technology (or other useful business information)

diffuses quickly among firms in the area, through direct contacts among the firms or as

skilled workers transfer from firm to firm. Knowledge diffusion is rapid and personnel

are continually shifting among the high-technology computer, software, semiconductor,

and related firms in Silicon Valley. Other examples of clustering driven by external scale

Chapter 6 Scale Economies, Imperfect Competition, and Trade 91

pug21774_ch06_088-116.indd 91pug21774_ch06_088-116.indd 91 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

economies include banking and finance in London and in New York City; stylish cloth-

ing, shoes, and accessories in Italy; and watches in Switzerland.

The final section of this chapter examines how external scale economies add to our

ability to analyze international trade.

INTRA-INDUSTRY TRADE

According to our basic theories of comparative advantage, if a country trades in a

product, it should either mostly export the product (based on its relatively low produc-

tion costs) or mostly import the product (as a result of its relatively high production

costs). We would see only inter-industry trade , in which a country exports some products in trade for imports of other, quite different products.

While much trade is inter-industry, especially in agricultural products and other pri-

mary products, there is also substantial intra-industry trade (IIT )—two-way trade in which a country both exports and imports the same or very similar products (product

varieties that are such close substitutes that they are classified within the same indus-

try). Figure 6.2 provides some examples of product categories in which the United

States engages in intra-industry trade. For example, for each of perfumes and cosmet-

ics, the amount that the United States exports is close to the amount that it imports.

We can quantify the relative importance of IIT in a country’s trade in a product by

splitting the total trade (the sum of exports plus imports) into two components. The

first component is net trade , the difference between exports and imports of that product. Net trade is not intra-industry trade. Rather, net trade shows the product’s

importance in the country’s inter-industry trade, in which some products are (net)

exported and other products are (net) imported. In measurement we often use the con-

vention that net trade is a positive value if the country is a net exporter of the product,

and it is a negative value if the country is a net importer of the product. (The “positive”

and “negative” are not value judgments, just ways of measuring.)

Intra-industry trade is then the other component of the country’s total trade in the

product, the amount of trade in which the country is both exporting and importing

in the same product category. There are two equivalent ways to measure the amount

of a country’s intra-industry trade in a product. First, it is equal to twice the value of

the smaller of exports or imports (capturing the amount of exporting of the product

that is matched by the same amount of importing of the product). Second, IIT is the

part of total trade in the product (exports plus imports) that is not net trade. Using

this latter approach,

IIT 5 ( X 1 M ) 2 | X 2 M |

where X is the value of exports of the product and M is the value of imports of the product. Furthermore, we often want to compare the importance of IIT across different

products or different countries. Because the total amount of trade in a product differs

naturally for different products or different countries, we can measure the relative importance of intra-industry trade as a share of total trade in the product:

IIT share 5 Total trade

IIT 5

(X 1 M) 2 |X 2 M|

(X 1 M) 5 1 2

|X 2 M| (X 1 M)

92 Part One The Theory of International Trade

pug21774_ch06_088-116.indd 92pug21774_ch06_088-116.indd 92 11/4/14 4:10 PM11/4/14 4:10 PM

Final PDF to printer

U.S. Exports (X)

($ millions)

U.S. Imports (M)

($ millions)

Total Trade (X 1 M)

($ millions)

Net Trade (X 2 M)

($ millions)

Intra-Industry Trade

($ millions)

IIT Share

(percentage)

Perfumes (55310) 1,723 1,962 3,684 (2)239 3,445 93.5 Cosmetics (55320) 3,710 3,058 6,768 (1)651 6,117 90.4 Household clothes washing

machines (77511) 205 308 512 (2)103 410 79.9 Electronic microcircuits (77640) 33,483 27,490 60,973 (1)5,993 54,979 90.2 Automobiles (78120) 53,901 149,142 203,042 (2)95,241 107,802 53.1 Photographic cameras (88111) 323 134 456 (1)189 267 58.6 Books and brochures (89219) 2,414 1,712 4,126 (1)701 3,425 83.0

FIGURE 6.2 Intra-Industry Trade for the United States, Selected Products, 2012

The values of these various measures are shown in Figure 6.2. For these seven

products, over half of U.S. total trade in the product is IIT.

How Important Is Intra-Industry Trade? How large is intra-industry trade in general? It is more important for trade in manufac-

tured products than it is for trade in agricultural products and other primary products,

so let’s focus on nonfood manufactured products. Figure 6.3 shows the average share

of IIT in the nonfood manufactures trade of six industrialized countries. The estimates

are based on dividing the sector into over 1,300 different products. To develop the

estimates, the IIT share is calculated for each of these products, and then the weighted average is calculated across all these products (using the country’s total trade in the product as weights, so that products with more total trade receive more weight in the

overall average). 1 The fine level of product detail is necessary so that we have mean-

ingful, narrowly defined industries. We try to avoid biasing the measurement of IIT

1 We can show the formula for this weighted average of IIT shares. To be clear, let us add the subscript i to the value for each product’s exports and imports, to emphasize that we are averaging over a number of different product categories.

Weighted average of IIT shares 5 S i 33 (Xi 1 Mi)S

i (X

i 1 M

i ) 4 · (IIT share) i 4

In this formula, the first (ratio) term is the proportionate weight for each product category, and the second term is the calculated IIT share for that product category.

For each product, intra-industry trade is the difference between total trade and (the absolute value of) net trade. The IIT share is intra-

industry trade as a percentage of total trade.

The numbers in parentheses are the 5-digit code, Standard International Trade Classification, Revision 3.

Source: Data on exports and imports from United Nations, Commodity Division, UN Comtrade Database.

Chapter 6 Scale Economies, Imperfect Competition, and Trade 93

pug21774_ch06_088-116.indd 93pug21774_ch06_088-116.indd 93 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

FIGURE 6.3 Average

Percentage

Shares of Intra-

Industry Trade

in the Country’s

Total Trade

in Nonfood

Manufactured

Products

Country 1989 2005 2012

United States 55.3 58.3 63.6 Canada 54.3 63.2 55.4 Japan 27.8 41.2 38.0 Germany 62.6 67.5 67.2 France 71.3 73.9 71.5 United Kingdom 69.0 71.7 71.6

For trade in nonfood manufactured goods (SITC 5 through 8), intra-industry trade is more than half of overall

trade for most industrialized countries. The estimates are based on over 1,300 different individual product

categories (the 5-digit level of the SITC, Revision 2).

Source: Authors’ calculations, based on data for 1989 and 2005 from Organization for Economic Cooperation and Development,

SourceOECD ITCS International Trade by Commodity Database, and data for 2012 from United Nations, Commodity Division, UN Comtrade Database .

upward, which could happen if we instead used broad product categories in which

we would be (mistakenly) finding IIT when a country exports “apples” and imports

“oranges” (if the too-broad product category was “fruit”). 2

As we can see in Figure 6.3, the importance of IIT rose from 1989 to 2005 for these

six countries. The increase was especially large for Japan. In this aspect of its trade,

Japan is still different from most other industrialized countries, but it is less different

than it used to be. After 2005, the importance of IIT has roughly plateaued, except for

the continued increase in U.S. IIT. For five of these six countries, IIT is more than half

of total trade in nonfood manufactured products.

We know from other studies that IIT is more prevalent where trade barriers and

transport costs are low, as within preferential-trade areas like the European Union.

In Figure 6.3, the average IIT shares are particularly high for the three European

countries. Furthermore, IIT is more characteristic of the (high-income) industri-

alized countries, and average IIT shares tend to be lower for the (low-income)

developing countries. For instance, for China’s trade in 1992, the average IIT share

for its trade in nonfood manufactures was 20.9 percent. Even this difference has nar-

rowed for developing countries like China that have been integrating into the global

economy. By 2004, the average share of IIT in China’s trade in nonfood manufactured

products had risen to 41.1 percent, and it was 39.2 percent in 2012.

What Explains Intra-Industry Trade? Why do we see so much intra-industry trade? There are several reasons. Some mea-

sured IIT probably reflects trade driven by comparative advantage. For instance, a

product category may still be too broad, so that it includes different products that are

produced using different production methods. Within a category, for instance, the United

States may export specific products that are produced using skilled labor intensively

2 In the analysis of intra-industry trade, a well-defined product category consists of product varieties viewed as close substitutes by consumers and produced using similar factor proportions. The latter is needed to conform to the definition of an industry stressed in the Heckscher–Ohlin theory of comparative advantage. Although we cannot prove that each of these over 1,300 product categories meets this definition, it seems unlikely that the categories generally are too broad.

94 Part One The Theory of International Trade

pug21774_ch06_088-116.indd 94pug21774_ch06_088-116.indd 94 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

and import other specific products that are produced using unskilled labor intensively.

As another example, for some agricultural products, IIT measured over a year may

reflect seasonal comparative advantages. The United States exports cherries in July but

imports cherries in January.

Much intra-industry trade is driven by something other than comparative advan-

tage, and the leading explanation focuses on the role of product differentiation — consumers view the varieties of a product offered by different firms in an industry as

close but not perfect substitutes for each other. We can see the role of differentiation

for the products shown in Figure 6.2. Product differentiation is rampant in perfumes

and cosmetics, with strong brand names, exotic packaging, and wide-ranging claims

for effectiveness and high quality. For clothes washing machines, brands from outside

the United States, including Miele, Bosch, LG, Samsung, and Haier, compete with

Whirlpool, Maytag, GE, and other U.S. brands. In integrated circuits there is differen-

tiation by specific circuit design as well as by functional specification, with U.S. firms

like Intel, Texas Instruments, and Micron battling with foreign firms like Toshiba,

Samsung, and Infineon. The range of automobile models on offer is obviously very

large. For cameras, consumers can choose from a range of brand names (including

Canon, Sony, Samsung, Leica, Polaroid, and GE) and models that differ by features

and quality. Books are inherently differentiated by title and author.

Product differentiation easily can be a basis for trade. Some buyers in a country pre-

fer varieties of the product produced in a foreign country, so they want to import the

product. The foreign varieties are not necessarily cheaper than the varieties produced

by local firms. Rather, each foreign variety has different characteristics, and these buy-

ers find the foreign varieties’ characteristics to be desirable. At the same time, some

foreign buyers prefer varieties produced by firms in this country, and these firms are

able to export to the foreign country. Even if there are no relative cost differences of

the type emphasized by theories of comparative advantage, there is international trade.

And much of it can be intra-industry trade, with a country exporting and importing

different variants of the same basic product.

Yet, it is not only product differentiation at work in this explanation. Taken to the

extreme, each of us would want to buy the unique product variant that exactly matches

our personal preference. This would be different from anyone else’s exact variant, so

the product variant would be completely customized to our own individual taste. But we

know that this is not the case for the products shown in Figure 6.2. Each has a limited

number of variants. The customization is limited. What limits the number of variants,

and the amount of customization? The answer is some form of internal scale economy,

so that there is a cost advantage to producing larger amounts of a specific variant.

MONOPOLISTIC COMPETITION AND TRADE

To understand why we see so much intra-industry trade, we need a model of trade

driven by product differentiation and scale economies. Product differentiation is a

deviation from the assumption of a homogeneous product, one of the standard assump-

tions used in the analysis of perfect competition, so we are entering the realm of

imperfect competition. Our analysis is based on a mild form of imperfect competition

Chapter 6 Scale Economies, Imperfect Competition, and Trade 95

pug21774_ch06_088-116.indd 95pug21774_ch06_088-116.indd 95 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

called monopolistic competition. Edward Chamberlain pioneered this analysis in the

1930s, and Paul Krugman received a Nobel Prize in 2008 that cited his work in apply-

ing the model to international trade.

Monopolistic competition describes an industry with three main characteristics. First,

for a general type of product, each of a number of firms produces a variant that consum-

ers view as unique, so the product offering of each firm is differentiated from the product offerings of other firms. Consumers’ perceptions of differences may be based on brand-

ing, physical characteristics, quality, effectiveness, or anything else that matters to the

consumers. Each firm has some monopoly power based on its established production of

its unique variety. At the same time, the variants of different firms are close substitutes

for each other, so we analyze them together as part of a market for the general product.

Second, there are some internal scale economies in producing a product variant. Third, there is easy entry and exit of firms in the long run (and the long run arrives rather quickly).

The third characteristic, easy entry and exit, is the same assumption used in perfect

competition. This characteristic is powerful. Consider a firm that has a highly successful

product variant and earns large economic profits. If entry is easy, other firms can readily

introduce similar imitation or “me-too” variants to try to gain some of the profits. In the

process, the sales and profits of the first firm decrease. In the long run, the typical firm

in a monopolistically competitive industry earns zero economic profit (a normal rate of

return on invested capital) for the same reason (easy entry and exit) that the typical firm

in a perfectly competitive market earns zero economic profit in long-run equilibrium.

For our discussion here we will use automobiles as our running example of an industry

that has many of the characteristics of monopolistic competition. It is like monopoly in

that each firm produces unique models of cars, known by their brand names, so that the

firm has some control over the price that it charges for each model. A Toyota Camry is

somewhat different from a Honda Accord or a Volkswagen Passat. It is like competition

because there are a fairly large number of producers, and there is entry of new producers

into any segment of the market that looks attractive in terms of sales and profits. Chrysler

pioneered the minivan segment with the Plymouth Voyager and Dodge Caravan. Once

other firms saw how successful these models were, they developed and introduced their

own minivans, including the Ford Windstar and the Toyota Sienna. In addition, new

companies enter the market, for example, Kia and Hyundai from South Korea and, more

recently, the emerging auto firms like Chery from China.

Let’s look specifically at the product compact cars, with such models as the Ford

Focus and the Honda Civic, and use our standard approach of comparing no trade with

free trade. What would production and consumption of compact cars look like in a

country if there were no international trade? What will change in the country (and in

the world) if the country opens to trade with the rest of the world? Here in the text we

will focus the analysis at the market or general product level. The box “The Individual

Firm in Monopolistic Competition” provides a look at a firm producing a specific vari-

ant of the product (e.g., Ford and its Focus).

We would like to picture the entire market for compact cars, but this is challenging.

There are a number of firms each producing its own unique model of a compact car.

We will need to use a somewhat different approach from standard supply–demand

analysis. In fact, it turns out to be useful to picture not the total quantity of compact

cars produced and consumed but rather the total number of variants (or models) pro- duced and consumed.

96 Part One The Theory of International Trade

pug21774_ch06_088-116.indd 96pug21774_ch06_088-116.indd 96 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

The Market with No Trade Figure 6.4 shows what is happening in a monopolistically competitive national (say,

U.S.) market for compact cars with no trade. The picture is built in three pieces, cor-

responding to the three key characteristics of monopolistic competition.

First, consider the price curve P. For buyers the models are differentiated. Still, as more compact car models are available in the market, consumers have access to more

and closer substitutes for any one model. The demand for any one model becomes

more price-elastic. As there are more models, each firm loses some pricing power

as the market becomes more rivalrous. The price that the typical firm (e.g., Ford) can

charge for its model (e.g., Focus) decreases as the number of models available in the

market increases. The price curve P is downward sloping. Second, consider the unit cost curve UC

NUS . Each firm could achieve internal scale

economies and lower average cost if it could produce more units of its model. Yet, given the overall size of U.S. market demand for compact cars, an increase in the

number of models produced means that the typical individual model will be produced

at a smaller level of output. This crowding of models in the market reduces the ability

of each firm to achieve scale economies. In fact, an increase in the number of models

would drive scale economies “in reverse”—average cost would increase as the scale of

production for the typical model decreased. The unit cost curve UC NUS

slopes upward.

Note that a unit cost curve like UC NUS

is not the same as the individual firm’s average

We can picture a monopolistically competitive market by showing how price and unit (or average)

cost vary with the number of varieties (models) that firms are selling in the market. With more models

on offer, price falls because buyers have more alternative models from which to choose. With more

models on offer, average cost increases because each firm will produce at a smaller scale. With no trade

the unit cost curve is UC NUS

. In long-run equilibrium, the typical firm earns zero economic profit, so the

market equilibrium is determined by the intersection of the price curve and the unit cost curve. In the

no-trade equilibrium the number of different models is 10, and the typical price is $19,000 per car.

FIGURE 6.4 The U.S.

Market for

Compact Cars,

No Trade

P = Price

UC NUS = Unit cost

Number of models

Price and cost per car (thousand of dollars)

Chapter 6 Scale Economies, Imperfect Competition, and Trade 97

pug21774_ch06_088-116.indd 97pug21774_ch06_088-116.indd 97 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

cost curve (an average cost curve like the one shown in Figure 6.1). Rather, the unit

cost curve is based on how the number of models affects where each firm can position

itself on its individual average cost curve.

Third, easy entry and exit means that the typical firm earns zero economic profit on its model. Zero economic profit means that price equals unit (or average) cost, so

the long-run equilibrium for the U.S. market for compact cars with no trade is at point

A, the intersection of the price curve P and the unit cost curve UC NUS

.3 In the no-trade

equilibrium, 10 different models are produced and sold in the U.S. market, each at a

price of $19,000 per car.

Opening to Free Trade The top panel of Figure 6.5 pictures the world with no trade as two separate national

markets for compact cars. The U.S. market with no trade is the same as that shown in

Figure 6.4. The market in the rest of the world is assumed to be somewhat larger, so

the no-trade unit cost curve UC Nf

for the rest of the world is somewhat farther to the

right than is the no-trade unit cost curve for the United States UC NUS

. In the no-trade

zero-profit equilibrium for the rest of the world, at point B the number of models is somewhat larger, 12 models, and the price is somewhat lower, $18,500. (One subtle

note—the price curve is the same in both national markets because the overall size of

the market does not directly influence consumers’ buying decisions.)

If the world is now opened to trade, two things will happen:

• First, Ford (and other U.S. automakers) can export their models to foreign consumers

because some buyers in the rest of the world find that they prefer the U.S. car models.

• Second, automakers in the rest of the world can export their models (for instance,

Hyundai Elantra, Mazda3, and Mini Cooper) to the United States because some

U.S. buyers prefer these foreign models.

Essentially, with free trade, the world becomes one market, as shown in the bot-

tom panel of Figure 6.5. With the larger size of the overall global market for com-

pact cars, rather than the two separated national markets with no trade, the unit cost

curve for the world UC W

is farther to the right than either the no-trade U.S. curve

UC NUS

or the no-trade curve for the rest of the world UC Nf

. (The world price curve is

the same as that shown for the no-trade national markets.) The free-trade equilibrium

for the world is at point E. The price of the typical car model is competed down to

3 We can see why the intersection of the two curves is the long-run equilibrium by considering what would happen if the number of varieties is (temporarily) different from that shown by the intersection. Consider the price curve and the unit cost curve in Figure 6.4. If the number of models on offer is, say, 7, then the price of the typical model (shown by the height of the P curve for 7 models) is greater than the unit cost for the typical model (shown by the height of the UC

NUS curve). Firms are earning substantial

economic profits on these 7 models, and the profits will attract the introduction of new, similar models by rival firms. As the total number of models on offer increases, the typical price falls and typical unit cost increases. The process continues until we have 10 models on offer. With 10 models, price equals unit cost, and there is no more incentive to introduce additional similar models. If, instead, the number of models begins at 14, the unit cost exceeds price. Each firm earns an economic loss, and some firms decide to exit by ceasing production of their models. The total number of models on offer decreases. The typical price increases, and the typical unit cost decreases, so the loss decreases. The market again is heading toward the zero profit (and zero loss) equilibrium at 10 models.

98 Part One The Theory of International Trade

pug21774_ch06_088-116.indd 98pug21774_ch06_088-116.indd 98 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

$17,000 and 18 different models will be offered for sale to consumers. For each coun-

try, some of these 18 models will be produced locally and some will be imported.

Also, some of the country’s production of its models will be exported.

Basis for Trade What is the basis for Ford and each of the other firms in the United States to export

their models of compact cars to the rest of the world? At first glance, it could be scale

economies. But internal scale economies stem from engineering realities common to

all auto producers. Auto firms in the rest of the world can achieve similar scale econo-

mies, so there may be no comparative advantage.

P = Price

Price and cost per car (thousands of dollars)

Number of models

UC W = Unit cost

18.5

P = Price P = Price

A B

Price and cost per car (thousands of dollars)

A. No trade, national markets

United States

Number of models

UC NUS = Unit cost

UC Nf = Unit cost

Rest of world

B. Free-trade equilibrium for the world

FIGURE 6.5 Markets for

Compact Cars,

No Trade and

Free Trade

With no trade, each country must produce the models of compact cars that it consumes. With no

trade, the size of each market is limited, so the unit cost curves are UC NUS

and UC Nf

. With no trade,

the United States produces and consumes 10 different models, with a typical price of $19,000

per car, and the rest of the world produces and consumes 12 different models, with a typical

price of $18,500 per car. With free trade, the world market is large (the combination of the two

national markets), so the unit cost curve is UC W

. Consumers in both countries now have access to

18 models, and the typical price declines to $17,000 per car.

Chapter 6 Scale Economies, Imperfect Competition, and Trade 99

pug21774_ch06_088-116.indd 99pug21774_ch06_088-116.indd 99 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

Extension The Individual Firm in Monopolistic Competition

100 Part One The Theory of International Trade

The analysis of monopolistic competition in the text focuses on the market for a type of differen- tiated product and examines the number of vari- ants or models and the price of a typical variant. We can also picture what is happening to an indi- vidual firm—say, Ford—and its unique model— say, the Focus. By analyzing an individual firm in a monopolistically competitive market, we add depth to the analysis. We can better understand both the effects of entry and how the number of models is linked to the price of the typical model.

FROM MONOPOLY TO MONOPOLISTIC COMPETITION Consider Ford and its model the Focus. We pre- sume that moderate scale economies are of some importance, so the (long-run) average cost (AC) curve for producing the Focus is downward slop- ing, as shown in the graphs in this box. If average cost is falling, then we know that marginal cost is less than average cost. The exact shape of the marginal cost (MC) curve depends on production technology, and a reasonable shape for the MC curve is shown in the graphs.

To get started on the analysis, let’s assume that the Ford Focus is the only compact car model offered in this market, so Ford has a pure monopoly. The demand for the Focus as the only compact car is strong, with the demand curve D

shown in the graph on the left at the top of the facing page. We assume that Ford sets one price to all buyers of the Focus during a period of time. Then, the marginal revenue for selling another car during this time period is less than the price the buyer pays for this car because Ford must lower the price to all other buyers to sell this one additional car. The marginal revenue curve (MR

0 )

is below the corresponding demand curve D 0 .

How will Ford use its monopoly power to maxi- mize its profit? Profit is the difference between revenue and cost, so Ford should produce and sell all units for which marginal revenue exceeds mar- ginal cost. Maximum profit occurs when marginal revenue equals marginal cost, at point F in the graph, so Ford should produce and sell 1.2 million cars per year. Using the demand curve at point G, Ford should set a price of $31,000 per car to sell

the 1.2 million cars. The price of $31,000 per car exceeds the average cost of producing 1.2 million cars, shown in the graph as $15,000 per car. Ford earns total economic profit of $19.2 billion (equal to $16,000 per car times 1.2 million cars).

Will this high profit last? Other firms can see Ford’s sales and its high profit. If entry is easy, then other firms will offer new, similar models. Here comes the competition part of monopolistic com- petition. As other firms offer similar models, some of what had been demand for the Focus is lost as some buyers shift to the new rival models. In addi- tion, the increased availability of close substitutes probably increases the price elasticity of demand for the Focus. As a result of the entry of new com- peting models, the demand curve for the Focus shifts down and becomes somewhat flatter. If entry of new models is easy, then this process continues as long as there are positive profits that continue to attract entry. Entry stops only when economic profit is driven to zero, for Ford and its Focus (and for other firms producing competing models).

The graph on the top right side shows both the initial demand curve D

0 for the Focus monop-

oly and the new shrunken and flatter demand curve D

1 for the Focus after the entry of rival

models. The Focus is still a unique model, and Ford still has some pricing power (the demand curve D

1 is still downward sloping). However,

the best that Ford can do in the new long- run equilibrium of this monopolistically com- petitive market is to operate at point J. Ford sells 0.8 million cars at a price of $19,000 per car. Price equals average cost, and Ford earns zero economic profit.

FROM NO TRADE TO FREE TRADE Assume that the monopolistic competition equilib- rium for Ford shown in the top right-hand graph is part of the U.S. market equilibrium with no trade. What happens to Ford and its Focus when the U.S. market is opened to free trade with the rest of the world? Ford can now export Focuses to foreign buyers, and Ford faces new competi- tion from imports of foreign models. Essentially, with free trade Ford is now part of a larger and more competitive world market for compact cars.

pug21774_ch06_088-116.indd 100pug21774_ch06_088-116.indd 100 11/3/14 6:20 PM11/3/14 6:20 PM

Final PDF to printer

With even more substitute models now available, demand for the Ford Focus becomes even more price elastic. And in the new long-run monopo- listically competitive equilibrium with free trade, Ford still earns zero economic profit.

The graph at the right shows both the no-trade equilibrium for Ford and the new free-trade equilibrium. The new demand curve D

2 shows the combined U.S. and foreign

demand for the Focus with free trade. In com- parison with the no-trade demand curve D

1 ,

the free-trade D 2 is somewhat flatter because

of the larger number of competing models that are available (both U.S. and foreign mod- els). In the new free-trade zero-profit equilib- rium, the price of the Ford Focus is down to $17,000 per car, and Ford produces and sells 1 million cars per year, some to U.S. buyers and some to foreign buyers. With price equal to average cost at point L, Ford earns zero eco- nomic profit.

Price and cost per car

(thousands of dollars per car)

Price and cost per car

(thousands of dollars per car)

Quantity (millions of cars)

19 15

1.2 0.8

MR0

F MC

MR1 Quantity (millions of cars)

Pure Monopoly Shift to Monopolistic Competition

Price and cost per car

(thousands of dollars per car)

Quantity (millions of cars)No Trade to Free Trade

1.00.8

D2 D1

MR2

AC K

L J

19 17

Chapter 6 Scale Economies, Imperfect Competition, and Trade 101

pug21774_ch06_088-116.indd 101pug21774_ch06_088-116.indd 101 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

Rather, in this setting a country’s trade is based on product differentiation.

• The basis for exporting is the domestic production of unique models demanded by

some consumers in foreign markets.

• The basis for importing is the demand by some domestic consumers for unique

models produced by foreign firms.

• Intra-industry trade in differentiated products can be large, even between countries

that are similar in their general production capabilities.

Scale economies play a supporting role, by encouraging production specialization for

different models. Firms in each country produce only a limited number of varieties of

the basic product. 4

In addition to intra-industry trade, this product may also have some net trade—that

is, the United States may be either a net exporter or a net importer of compact cars.

The basis for the net trade can be comparative advantage.

Figure 6.6 provides an example of how net trade and intra-industry trade can coexist.

We modify the world that we used in previous chapters slightly, so the two products are

wheat and compact cars. Wheat is relatively land-intensive in production, and compact

cars are relatively labor-intensive in production. Wheat is assumed to be a commod-

ity, with no product differentiation, and compact cars are differentiated by model. The

United States is relatively land-abundant and labor-scarce. Here is the pattern of trade

that we predict. First, the Heckscher–Ohlin theory explains net trade, with the United

States being a net exporter of wheat ($40 billion) and net importer of compact cars (also

$40 billion, equal to the difference between the $30 billion of U.S. exports and the $70

billion of U.S. imports). Second, intra-industry trade is driven by product differentia-

tion. For the commodity wheat, there is no intra-industry trade. For compact cars, dif-

ferentiated by models, there is $60 billion of intra-industry trade, equal to the difference

between the $100 billion of total trade in compact cars and the $40 billion of net trade.

The share of intra-industry trade in total compact car trade is 60 percent ($60 billion of

intra-industry trade as a percentage of the $100 billion of total trade).

Once we recognize product differentiation and the competitive marketing activities

that go with it (for instance, styling, advertising, and service), net trade in an indus-

try’s products can also reflect other differences between countries and their firms. Net

trade in a product can be the result of differences in international marketing capabili-

ties. Or it can reflect shifting consumer tastes, given the history of choices of which

specific varieties are produced by each country. For instance, Japanese firms focused

on smaller car models, and they benefited from a consumer shift toward smaller cars

in the United States following the oil price shocks of the 1970s. Japanese auto pro-

ducers also marketed their cars skillfully and developed a reputation for high quality

at reasonable prices. Japan developed large net exports in automobile trade with the

United States during the 1970s and 1980s. Some of this was the result of comparative

cost advantages, but another part was the result of focusing on smaller cars at the right

time and skillful marketing.

4 Product differentiation and the limited number of varieties produced in each country can also provide a base for examining the pattern of trade between different pairs of countries. See the box “The Gravity Model of Trade.”

102 Part One The Theory of International Trade

pug21774_ch06_088-116.indd 102pug21774_ch06_088-116.indd 102 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

Gains from Trade Product differentiation, monopolistic competition, and intra-industry trade add major

insights into the national gains from trade and the effects of trade on the well-being of

different groups in the country. A major additional source of national gains from trade

is the increase in the number of varieties of products that become available to consum- ers through imports, when the country opens to trade. For instance, the economic well-

being of U.S. consumers increases when they can choose to purchase an automobile

not only from the domestic models such as the Ford Focus but also from imported

foreign models such as the Mini Cooper because some may prefer the Mini Cooper.

How large might the gains from greater variety be? Broda and Weinstein (2006)

look at very detailed data on imports into the United States during 1972 to 2001

to develop an estimate. They conclude that the number of imported varieties more

than tripled during this time period. They use estimates of how different the new

varieties are to determine how much U.S. consumers gained from access to the new

varieties. (The more different, the more the gain.) By 2001 the gain to the United

States was about $260 billion per year, close to an average gain of $1,000 per per-

son. Feenstra (2010) estimated that, as of 1996, the greater product variety obtained

through international trade increased world well-being by an amount equal to about

12.5 percent of global GDP. If that 12.5 percent is still roughly correct, the increase

in world well-being currently is about $10 trillion per year.

These national gains from greater variety accrue to consumers generally. They

can be added to trade’s other effects on the well-being of different groups within the

country. Two additional insights result.

First, the opening (or expansion) of trade has little impact on the domestic distribu-

tion of factor income if the (additional) trade is intra-industry. Because extra exports

occur as imports take part of the domestic market, the total output of the domestic

industry is not changed much. There is little of the inter-industry shifts in production

U.S. exports ROW imports

ROW imports

ROW exports

U.S. exports

U.S. imports

Wheat $40 billion

Compact cars

$30 billion

Compact cars

$70 billion

United States

Rest of world

The United States has net exports of wheat of $40 billion and net imports of compact cars of $40 billion. There is also substantial intra-industry trade in compact cars, with the IIT share equal to 60 percent of total trade in compact cars.

FIGURE 6.6 Net Trade and

Intra-Industry

Trade

Chapter 6 Scale Economies, Imperfect Competition, and Trade 103

pug21774_ch06_088-116.indd 103pug21774_ch06_088-116.indd 103 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

that put pressures on factor prices (recall the discussion in Chapter 5). Instead, with

the expansion of intra-industry trade, all groups can gain from the additional trade

because of gains from additional product variety. A good example is the large increase

of trade in manufactured goods within the European Union during the past half-

century. Much of the increase was expansion of intra-industry trade, so the rapid

growth of trade actually led to few political complaints.

Second, gains from greater variety can offset any losses in factor income resulting

from interindustry shifts in production that do occur. Groups that appear to lose real

income as a result of Stolper–Samuelson effects will not lose as much; and they could

actually believe that their well-being is enhanced overall if they value the access to

greater product variety that trade brings. For instance, many people would be willing

to give up a few dollars of annual income to continue to have numerous models of

imported automobiles available for purchase.

Research pioneered by Melitz (2003) and Bernard et al. (2003) indicates yet

another source of additional gains from trade, assuming (realistically) that firms in

each country differ somewhat by cost levels (or quality levels) for their product mod-

els. With no trade, firms with different levels of cost can coexist, with lower-cost firms

having lower prices and larger market shares. When the country opens to trade in this

type of product, the increased global competition causes the demand curve facing a

typical firm to become flatter and the typical price declines. In the more competi-

tive global market, high-cost (or low-quality) national firms cannot compete and go

out of business. Lower-cost firms can compete and export, so their production levels

increase. Thus, opening to trade favors the survival and expansion of firms with lower

cost levels (or higher levels of product quality).

We see a new way in which international trade drives national production toward

firms with low opportunity costs. For comparative advantage trade (Ricardian or

Heckscher–Ohlin), the restructuring is across different industries. For monopolistic

competition trade, the restructuring is across firms of differing capabilities within

the industry.

OLIGOPOLY AND TRADE

Monopolistic competition is a mild form of imperfect competition, but still one that

has large implications for international trade. Oligopoly, the second type of imperfect

competition examined in this chapter, is a stronger form. Some important industries

in the world are dominated by a few large firms. Two firms, Boeing and Airbus,

account for nearly all the world’s production of large commercial aircraft. Three

firms, Sony, Nintendo, and Microsoft, design and sell most of the world’s video game

consoles. Three firms, Companhia Vale do Rio Doce (CVRD), Rio Tinto, and BHP

Billiton, mine more than half of the world’s iron ore. Such concentration of produc-

tion and sales in a few large firms is a major deviation from one of the assumptions

of perfect competition, that there are a large number of small firms competing for

sales in the market.

An industry in which a few firms account for most of the world’s produc-

tion is a global oligopoly. (In the extreme, one firm would dominate the global

104 Part One The Theory of International Trade

pug21774_ch06_088-116.indd 104pug21774_ch06_088-116.indd 104 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

market—a global monopoly. Microsoft in operating systems for personal computers

is an example.) How does global oligopoly (or monopoly) alter our understanding

of international trade? We focus here on two aspects. First, there are implications of

substantial scale economies for the pattern of trade. Second, there are implications

of oligopoly (or monopoly) pricing for the division of the global gains from trade. 5

Substantial Scale Economies Exploiting substantial internal scale economies is an explanation for why a few large firms come to dominate some industries. If substantial scale economies exist over a

large range of output, then production of a product tends to be concentrated in a few

large facilities in a few countries, to take full advantage of the cost-reducing benefits

of the scale economies. (In the extreme, production would be in one factory in a single

country.) These countries will then tend to be net exporters of the product, while other

countries are net importers. An example is the large civilian aircraft industry. Boeing

concentrates most of its aircraft production in the United States, and Airbus concen-

trates most of its aircraft production in Western Europe.

Why do we see this pattern of producing-exporting countries and importing coun-

tries? History matters. Firms initially chose these production locations for a number

of reasons. One prominent reason usually was comparative advantage—the compa-

nies could achieve low-cost production with access to required factor inputs at these

locations.

However, even if a location initially was consistent with comparative advantage,

cost conditions can change over time. Yet, the previously established pattern of pro-

duction and trade can persist even if other countries could produce more cheaply. To

see why, start with the fact that the established locations are already producing at

large scale and have fairly low costs because they are achieving scale economies. Now

consider the potential new location. The shifting comparative advantage can provide

the new location with lower cost based on factor prices and factor availability, but

that source of cost advantage may not be enough. To be competitive on costs with the

established locations, the production level at this new location would also have to be

large enough to gain the cost benefits of most of the scale economies. This may not

be possible without an extended period of losses because (1) the increase in quantity

supplied would lower prices by a large amount or (2) established firms in other loca-

tions may fight the entrant using (proactive) price cuts or other competitive weapons.

With the risk of substantial losses, production in this potentially lower-cost location

may fail to develop.

Oligopoly Pricing Each large firm in an oligopoly knows that it is competing with a few other large

firms. It knows that any action that it takes (such as lowering its price, increasing its

5 Other economic issues related to monopoly and oligopoly are taken up elsewhere in the book. A domestic monopoly in a competitive world market is examined in Chapter 9. Chapter 11 shows that one reason for dumping is international price discrimination by a firm with market power. Use of game theory to examine decision-making in an oligopoly is also presented in Chapter 11. The activities and stability of international cartels are explored in Chapter 14.

Chapter 6 Scale Economies, Imperfect Competition, and Trade 105

pug21774_ch06_088-116.indd 105pug21774_ch06_088-116.indd 105 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

Extension The Gravity Model of Trade

Another way of looking at international trade is to examine total exports and total imports between pairs of countries. That is, for a coun- try like Australia, which countries does it export to and which countries does it import from? Australia exports mainly primary products, including coal and iron ore. The top 10 destina- tion countries for its exports in 2012, in order from the largest down, were China, Japan, South Korea, India, the United States, Taiwan, New Zealand, Singapore, Britain, and Malaysia. Australia imports mainly manufactured prod- ucts, including automobiles, machinery, and computers, as well as crude and refined petro- leum. The top 10 source countries, again starting with the largest, were China, the United States, Japan, Singapore, Germany, Thailand, South Korea, Malaysia, New Zealand, and Britain.

In looking at these lists, we can note three things. The first is that they are mostly the same countries in the two lists. Eight of the top 10 are the same. The second is that many of these coun- tries, including the United States, Japan, China, Britain, and Germany, have large economies. The third is that New Zealand is in both lists. Although New Zealand has a small economy, it is geographically close to Australia.

When we look at other countries, we see simi- lar patterns for their major trading partners. Such observations have led to the development of the gravity model of trade, so called because it has similarity to Newton’s law of gravity, which states that the force of gravity between two objects is larger as the sizes of the two objects are larger, and as the distance between them is smaller.

The gravity model of international trade pos- its that trade flows between two countries will be larger as

• The economic sizes of the two countries are larger.

• The geographic distance between them is smaller.

• Other impediments to trade are smaller.

In statistical analysis of data on trade between pairs of countries, the gravity model explains the patterns very well. Let’s look at what we know and learn about each of these determinants.

ECONOMIC SIZE Our theory of trade based on product differ- entiation and monopolistic competition can explain why the economic sizes of the coun- tries matter. Consider first differences across the importing countries. Using basic demand analysis, we expect that an importing country that has a larger national income will buy (as imports) more of the product varieties pro- duced in other countries. Now consider dif- ferences across the exporting countries. If the exporting country has a larger overall produc- tion capability, then it will have the resources to produce a larger number of varieties of the products. With more varieties offered to foreign buyers, it will sell more (as exports) to these foreigners.

Economic size is usually measured by a coun- try’s gross domestic product (GDP), which rep- resents both its production capability and the income that is generated by its production. Consider Australia’s trade with the United States and Canada. U.S. GDP is about nine times that of Canada, and Australia trades about nine times as much with the United States as it does with Canada. In statistical analysis, the elasticity of trade values with respect to country size (GDP) is usually found to be about 1 (so that, for instance, a country with twice the GDP tends to do twice the trade with a particular partner country, other things being equal).

DISTANCE Most obviously, distance shows the importance of a cost that we have generally ignored in our theoretical analysis, the cost of transporting goods internationally. It costs more to transport goods longer distances. Consider Australia’s

106 Part One The Theory of International Trade

pug21774_ch06_088-116.indd 106pug21774_ch06_088-116.indd 106 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

trade with New Zealand and Ireland, the lat- ter a country that is over seven times as far from Australia as is New Zealand. Even though Ireland’s GDP is larger than that of New Zealand, Australia’s trade with Ireland is only one-ninth that of its trade with New Zealand. (Not all of this huge trade difference is due to the large difference in distances because Australia and New Zealand also have a preferential trade agreement, but much of the difference is due to distance.)

In statistical analysis, a typical finding is that a doubling of distance between partner countries tends to reduce the trade between them by one-third to one-half. This is actually a surprisingly large effect, one that cannot be explained by the monetary costs of transport alone because these costs are not that high. This finding has led us to think about other reasons why distance matters.

One set of reasons is that countries that are closer tend to have more similar cultures and a greater amount of shared history, so the costs of obtaining information about closer trade part- ners are lower. Another set of reasons focuses on risk. Shipping things a longer distance, especially by ocean transport, takes a longer time. The longer time for shipment could lead to greater risks that the goods would be physically damaged or deteriorate. In addition, there is a greater risk that conditions could change in the import- ing country. For instance, the styles that are in fashion could change, or the importer could go bankrupt.

OTHER IMPEDIMENTS Government policies like tariffs can place impedi- ments to trade, as we will discuss in Chapter 8, and the gravity model can show how these reduce trade between countries. Perhaps the most remarkable finding from statistical analysis using the gravity model is that national bor- ders matter much more than can be explained

by government policy barriers. Even for trade between the United States and Canada, this border effect is very large.

A series of studies (starting with McCallum [1995] and including Anderson and van Wincoop [2003]) have used the gravity model to examine inter-provincial trade within Canada, interstate trade within the United States, and interna- tional trade between Canadian provinces and U.S. states. As usual, province and state GDPs are important, as are distances between them. The key finding is that there is also an astounding 44 percent less international trade than there would be if the provinces and states were part of the same country. This extremely large border effect exists even though any government bar- riers are generally very low, and it is not easy to see what the other impediments could be. There’s something about the national border. For Canada, the result is that provinces trade much more with each other and much less with U.S. states.

The gravity model has been used to examine the effects of many other kinds of impediments (or removal of impediments) to trade. Let’s con- clude with a sampling of some of the results:

• Countries that share a common language trade more with each other.

• Countries that have historical links (for example, colonial) trade more with each other.

• A country trades more with other countries that are the sources of large numbers of its immigrants.

• Countries that are members of a preferential trade area trade more with each other.

• Countries that have a common currency trade more with each other.

• A country with a higher degree of govern- ment corruption, or with weaker legal en- forcement of business contracts, trades less with other countries.

Chapter 6 Scale Economies, Imperfect Competition, and Trade 107

pug21774_ch06_088-116.indd 107pug21774_ch06_088-116.indd 107 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

advertising, or introducing a new product model) is likely to provoke reactions from

its rivals. We can model this interdependence as a game. (Here we just give a flavor of

this kind of analysis. We use game theory more formally in Chapter 11.)

Consider an example. Picture price competition between two dominant large firms

as a choice for each firm between competing aggressively (setting a low price) or

restraining its competition (setting a high price). The outcome of the game depends

on which strategy each firm chooses. The best outcome for the two firms together is

usually to restrain their price competition. They both can charge high, monopoly-like

prices and earn substantial economic profits. However, if they cannot cooperate with

each other, then the play of the game may result in both competing aggressively, and

each earning rather low profits. To see why, imagine what could happen if one firm

decides to restrain its competition and to set a high price. The other firm often has

an incentive to compete by setting a lower price because it can increase its sales so

much that it earns even more profit than it would earn by also setting a high price.

The high-price firm loses sales and may earn very low profits. Both know the other is

likely to act this way, so neither is willing to set a high price. Both compete aggres-

sively with low prices, and both earn low profits. They are caught in what is called a

prisoners’ dilemma . The firms can attempt to find a way out of the dilemma by cooperating to restrain

their competition. The cooperation may be by formal agreement (though such a cartel

arrangement is illegal in the United States and many other countries). The cooperation

could be tacit or implicit, based on recognition of mutual interests and on patterns of

behavior established over time. If they can cooperate, then they can both earn high

profits. But the cooperation is often in danger of breaking down because each firm

still has the incentive to cheat by lowering its price, to try to earn even higher profit.

Although game theory does not say for sure what is the outcome of this kind of

game, it does highlight that cooperating with rivals is possible (though not assured) in

an oligopoly. Firms in an oligopoly can earn economic profits, and these profits can

be substantial if competition is restrained.

Pricing matters for the division of the global gains from trade. To see this, focus

on export sales by the oligopoly firms. If the oligopoly firms compete aggressively on

price, then more of the gains from trade go to the foreign buyers and less is captured

by the oligopoly firms. If, instead, the oligopoly firms can restrain their price competi-

tion, then the oligopoly firms can earn large economic profits on their export sales. If

a firm located in a country can charge high prices on its exports and earn high profits

on its export sales, there are two related effects. First, the high export prices enhance

the exporting country’s terms of trade. Second, the high profits add to the exporting

country’s national income by capturing some of what would have been the consumer

surplus of foreign buyers. More of the gains from trade go to the exporting country

(or, perhaps more precisely, to the country or countries of the owners of the oligopoly

firms), and less to the foreign buyers.

Putting all of this together, we see that the current pattern of national production

locations for a global oligopoly may be somewhat arbitrary, and that the small number

of countries that have the industry’s production may obtain additional gains from trade

if the firms in these countries can earn substantial economic profits on their exports.

The national gain from having high-profit oligopoly firms in a country is a basis for

108 Part One The Theory of International Trade

pug21774_ch06_088-116.indd 108pug21774_ch06_088-116.indd 108 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

national governments to try to establish local firms in the oligopoly industry or to

expand the industry’s local production and exporting. These issues are taken up further

in the discussions of infant industry policy in Chapter 10 and of strategic trade policy

in Chapter 11.

EXTERNAL SCALE ECONOMIES AND TRADE

Now let’s turn to examine an industry that benefits from substantial external scale economies, as our third form of market structure that deviates from the standard

case of perfect competition. External scale economies exist when the expansion

of the entire industry’s production within a geographic area lowers the long-run

average cost for each firm in the industry in the area. External scale economies are

also called agglomeration economies, indicating the cost advantages to firms that

locate close to each other. As noted in the section on scale economies earlier in

the chapter, examples of industries and locations that benefit from external scale

economies include filmmaking in Hollywood, computer and related high-tech

businesses in Silicon Valley, watch-making in Switzerland, and financial services

in London.

To focus on the effects of external scale economies, we will conduct our formal analysis using the assumption that a large number of small firms exist in the industry

in each location. That is, we assume that there are no (or only modest) internal scale economies, so that an individual firm does not need to be large to achieve low cost. We then have a case in which substantial external scale economies coexist with a highly

competitive industry.

If expansion of an industry in a location lowers cost for all firms in that location,

then new export opportunities (or any other source of demand growth) can have dra-

matic effect. Figure 6.7 pictures a national semiconductor industry that is competi-

tive, but characterized by external scale economies. There is an initial equilibrium at

point A , with many firms competing to sell 40 million units at $19 a unit. Here the usual short-run supply and demand curves ( S

1 and D

1 ) intersect in the usual way. The

upward-sloping national supply curve is the sum of each small individual firm’s view

of its own costs. Each firm operates at given levels of industry production, which it

cannot by itself affect very much. It reacts to a change in price according to its own

upward-sloping supply curve, which is also its own upward-sloping marginal cost

curve. The sum of these individual-firm supply curves is shown as national supply

curve S 1 .

What is new in the diagram is the coexistence of the upward-sloping short-run

national supply curve S 1 with the downward-sloping long-run average cost curve,

which includes the cost-reducing effects of the external scale economies. The national

industry’s downward-sloping average cost curve comes into play when demand shifts.

To bring out points about international trade, let us imagine that opening up a new

export market shifts overall demand from D l to D

2 . Each firm would respond to the

stronger demand by raising output. If each national firm acted alone and affected

only itself, the extra demand would push the market up the national supply curve S l

to a point like B . The new export business raises the national industry’s output, here

Chapter 6 Scale Economies, Imperfect Competition, and Trade 109

pug21774_ch06_088-116.indd 109pug21774_ch06_088-116.indd 109 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

Results:

• In industries that can reap external economies (e.g., knowledge spillovers from firm to firm),

a rise in demand triggers a great expansion of supply and lowers costs and price.

• Therefore, increasing trade brings gains to all consumers (home-country and foreign alike) as

well as to the exporting producers.

• Corollary: Among nations having the same initial factor endowments, cost curves, and demand

curves, whichever nation moved first to capture its export market would gain a cost advantage

in this product.

Quantity (million units per year)

Price ($ per unit)

6040 46

D1 D2 S1 = Sum of individual firms’ supply curves

(MC curves), which do not include external economies

Industry’s average costs, including external economies

FIGURE 6.7 External

Economies

Magnify an

Expansion in

a Competitive

Industry

initially from 40 at point A to 46 at point B . The increase in industry output brings additional external economies. For instance, there could be more development and

exchange of useful information, which raises productivity and cuts costs through-

out the national industry. This means, in effect, a sustained rightward movement of

the national industry short-run supply curve, for instance, to S 2 in the new long-run

equilibrium.

To portray the cost-cutting more conveniently than with multiple shifts of the

supply curve, we can follow the national industry’s long-run average cost curve,

including external economies. The external economies lead to a decline in average

cost as national industry output expands. As Figure 6.7 is drawn, we imagine that

demand and supply expansion catch up with each other at point C , the new long-run equilibrium.

What are the welfare effects of the opening of trade for an industry with external

economies? Producers of the product in an exporting country tend to gain producer

surplus as a result of the expansion of industry output, although the decline in price

will mitigate the gain. Producers in importing countries lose producer surplus.

Consumers in the importing countries gain consumer surplus as price declines and

their consumption increases. Consumers in the exporting country also gain consumer

surplus as price declines and consumption quantity increases. Here is a definite

contrast to the standard case (e.g., Figure 2.4), where local buyers suffer from price

increases on goods that become exportable with the opening of trade.

110 Part One The Theory of International Trade

pug21774_ch06_088-116.indd 110pug21774_ch06_088-116.indd 110 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

What explains the pattern of trade that emerges in industries subject to external

scale economies? Many of the issues are similar to those raised with respect to sub-

stantial internal scale economies. With no trade, each country must produce for its

own consumption. If trade is opened, production tends to be concentrated in a small number of locations. Clusters of firms in some locations will expand production, as shown in Figure 6.7, and countries with these locations will export the product. In

other countries, production will shrink or cease, and these countries will import the

product.

It is not easy to predict which locations will expand and which will shrink or

cease production. Sometimes it appears to be luck, with firms in one location decid-

ing to expand at the right time to take the lead. Swiss watch-making seems roughly

to fit. Or the size of the domestic market with no trade may be important if the

larger domestic market permits domestic firms to be low-cost producers when trade

is opened. Hollywood seemed to benefit from the early large size of the U.S. market

for films. Or a push from government policy may be important. Early in its devel-

opment Silicon Valley benefited from selling to the U.S. government for defense

and aerospace applications. The outcome is analogous to the production of pearls.

Which oysters produce pearls depends on luck or outside human intervention. An

oyster gets its pearl from the accidental deposit of a grain of sand or from a human’s

introducing a grain of sand.

The external-economies case is one in which a lasting production advantage in

an industry can be acquired by luck or policy even if there are no differences in

countries’ initial comparative advantages. The production locations and pattern of

trade tend to persist even if other locations are potentially lower-cost. Other loca-

tions cannot easily overcome the scale advantages of established locations. As we

also noted for the case for substantial internal scale economies, the government of

an importing country may conclude that there is a basis for infant-industry poli-

cies that nurture the local development of the industry, an issue that we explore

in Chapter 10.

This chapter examined several theories that have broadened our answers to the four major questions about trade. The theories focus on

• Product differentiation and monopolistic competition. • Substantial internal scale economies and global oligopoly. • External scale economies.

According to the standard trade theory emphasizing comparative advantage, the

similarity of industrialized countries in factor endowments and technological capa-

bilities suggests little reason for trade among them. Yet we observe the opposite.

Trade among industrialized countries represents a third of world trade. Furthermore,

an increasing fraction of world trade consists of intra-industry trade (IIT), in which a country both exports and imports items in the same product category. A

challenge for trade theory is to explain why we have so much IIT and whether the

standard model’s conclusions about the gains from trade and the effects of trade

still hold.

Summary: How Does Trade Really Work?

Chapter 6 Scale Economies, Imperfect Competition, and Trade 111

pug21774_ch06_088-116.indd 111pug21774_ch06_088-116.indd 111 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

Much IIT involves trade in differentiated products—exports and imports of differ-

ent varieties of the same basic product. Monopolistic competition , a mild form of imperfect competition, provides a good basis for understanding intra-industry trade.

Firms producing their own varieties are able to export to some consumers in foreign

markets even as they face competition from imports of varieties produced by foreign

firms. Net trade in these differentiated products may still be based on comparative advantage.

Another fact is that some industries are dominated by a few large firms. Global

oligopoly can arise when there are substantial scale economies internal to each firm. These large firms choose production locations to maximize their profits, and compara-

tive advantages are likely to be prominent in such location decisions. Over time, the

conditions may change, but, because of the scale advantages of the established places,

the production locations and the trade pattern do not necessarily change.

Some other industries, while competitively populated by a large number of firms,

also tend to concentrate in a few production locations because of scale economies

that are external to the individual firm. External scale economies depend on the size

of the entire industry in the location. It can be difficult to predict or explain which

production locations prosper. Home market size, luck, and government policy may

affect which country locations capitalize on the external economies.

Thinking about imperfect competition and scale economies also adds to our

understanding of the gains from trade and the effects of trade on different groups. It

does not contradict the main conclusions of the standard competitive-market analysis

of Chapters 2 through 5. Rather, it broadens the set of conditions under which we

see gains from trade, with some changes in how any gains or losses are distributed

among the groups. Figure 6.8 summarizes gains and losses for three kinds of trade:

FIGURE 6.8 Summary of

Gains and

Losses from

Opening Up

Trade in Three

Cases

* In monopolistic competition that results in intra-industry trade (IIT), producers are both exporters and import-competing

at the same time. If trade is mostly or completely IIT, then the effects on producers as a group tend to be small.

Note: The gains and losses to producers and consumers in all cases refer to changes in producer surplus and

consumer surplus in the short run. In the long run, these gains and losses shift to the factors most closely

tied to the export or import-competing industries (according to the Stolper–Samuelson theorem).

Kinds of Trade

Standard Monopolistic External Competition Competition (IIT)* Economies Group (Chapters 2–5) (This Chapter) (This Chapter)

Exporting country Gain Gain Gain Export producers Gain * Gain Export consumers Lose Gain Gain Importing country Gain Gain Gain Import-competing producers Lose * Lose Import consumers Gain Gain Gain Whole world Gain Gain Gain

112 Part One The Theory of International Trade

pug21774_ch06_088-116.indd 112pug21774_ch06_088-116.indd 112 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

the standard competitive trade of Chapters 2 through 5 plus two of the three kinds of

trade analyzed in this chapter. Oligopoly is not included because we do not have a

single generally accepted model.

Relative to standard competitive trade, both trade based on monopolistic com-

petition and trade based on external economies provide additional benefits to con-

sumers, especially consumers of exportable products. In the case of monopolistic

competition, the additional gains come from (1) access to greater product variety and

(2) a tendency for additional competition to lower product prices. In the case of exter-

nal economies, gains to consumers in the exporting country arise from the decline

in the price for the good as the local industry expands and achieves greater external

economies. Relative to standard competitive trade, trade based on monopolistic

competition has less of an impact on producing firms and factor incomes because

firms under pressure from import competition also have the opportunity to export

into foreign markets.

Although not portrayed fully in Figure 6.8, global oligopoly (or monopoly) also

has implications for well-being. Trade allows firms to concentrate production in a

few locations, achieving scale economies that lower costs. Furthermore, a global oli-

gopoly (or monopoly) firm can charge high prices and earn large economic profits on

its export sales. In comparison with standard competitive trade, these high profits on

exports alter the division of the global gains from trade, with more of the gains going

to export producers and the exporting country.

Where does the theory of trade patterns stand?

The standard model of Chapters 2 through 5 has the virtue of breadth, allowing

for both demand-side differences and production-side differences between coun-

tries to explain trade. The Heckscher–Ohlin variant of the standard model makes

the stronger assertion that the explanation can focus on cross-country differences

in the endowments of a few main factors used in production. This has the scientific

virtue of giving more testable and falsifiable predictions than the broadest standard

model (of which it is a special case). But, as we saw in Chapter 5, the tests of the

Heckscher–Ohlin model give it only a middling grade. It is only part of the explana-

tion of trade patterns.

Our ability to predict (explain) trade patterns is improved if we add technol-

ogy differences and models based on scale economies and imperfect competition.

Technology differences can be a basis for comparative advantage. We will explore

in depth the relationship between technological progress and trade in the next

chapter.

The monopolistic-competition model suggests that product differentiation can

be a basis for both exporting and importing different variants, or models, of a

type of product. Economic models based on substantial scale economies (internal

or external) indicate that production tends to be concentrated at a small number

of locations, but they do not precisely identify which specific countries will be

the production locations. Historical luck and early government policy may have a

major impact on the current production locations.

Chapter 6 Scale Economies, Imperfect Competition, and Trade 113

pug21774_ch06_088-116.indd 113pug21774_ch06_088-116.indd 113 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

Key Terms

Constant returns

to scale Scale economies Internal scale economies

Monopolistic

competition Oligopoly External scale economies

Inter-industry trade Intra-industry trade (IIT) Net trade Product differentiation

Suggested Reading

Intra-industry trade is measured and interpreted by Grubel and Lloyd (1975), Greenaway

and Milner (1986), and Brülhart (2009).

In his Nobel Prize acceptance speech, Krugman (2009) summarizes the role of scale

economies in international trade analysis. Ottaviano and Puga (1998) survey analyses of

external scale economies and the “new economic geography.” Helpman (1999) surveys

empirical testing of traditional and alternative trade theories. Antweiler and Trefler (2002)

find that scale economies are important to understanding trade in at least one-third of

the industries that they study. Helpman (2011, Chapters 4 and 5) provides an accessible

survey of research on monopolistic competition in international trade. Melitz and Trefler

(2012) summarize what we know about the gains from trade for monopolistically

competitive industries with firms that differ by cost or quality. Bernard et al. (2007)

survey research about firms that export.

Questions and Problems

1. “According to the Heckscher–Ohlin theory, countries should engage in a lot of intra-

industry trade.” Do you agree or disagree? Why?

2. Scale economies are important in markets that are not perfectly competitive. What is

the key role of scale economies in the analysis of markets that are monopolistically

competitive? What is the key role in oligopoly?

3. “Once we recognize that product differentiation is the basis for much international

trade, there are likely to be more winners and fewer losers in a country when the coun-

try shifts from no trade to free trade.” There may be several reasons why this statement

is true. What are the reasons? Explain each briefly.

4. A country is the only production site in the world for hyperhoney infinite pasta, a

wonderful product produced using a delicate, highly perishable extract obtainable

from some trees that grow only in this country. Beyond a very small size, there are

no internal or external scale economies—production is essentially constant returns to

scale. Furthermore, there is no domestic demand for this product in the country, so

all production will be exported. The country’s government has the choice of forming

the pasta-producing industry either as a monopoly or as a large number of small pasta

producers that will act as perfect competitors. What is your advice to the country’s

government about which market structure to choose for the pasta industry?

5. “External scale economies are an influence on the pattern of international trade because

they affect the number of varieties of a product that are produced in a country.” Do you

agree or disagree? Why?

6. The world market for large passenger jet airplanes is an oligopoly dominated by two

firms: Boeing in the United States and Airbus in Europe.

a. Explain why the market equilibrium might involve either a low price for airplanes or a high price for airplanes.

b. From the perspective of the well-being of the United States (or Europe), why might a high-price equilibrium be desirable?

✦

114 Part One The Theory of International Trade

pug21774_ch06_088-116.indd 114pug21774_ch06_088-116.indd 114 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

c. What price outcome is desirable for Japan or Brazil? Why? d. If the outcome is the high-price equilibrium, does Japan or Brazil still gain from

importing airplanes? Explain.

7. A monopolistically competitive industry exists in both Pugelovia and the rest of the

world, but there has been no trade in this type of product. Trade in this type of product

is now opened.

a. Explain how opening trade affects domestic consumers of this type of product in Pugelovia.

b. Explain how opening trade affects domestic producers of this type of product in Pugelovia.

8. You are a consumer of a product that your country imports. There is an increase in

demand in the rest of the world for this type of product. You are wondering if this

change will be good or bad for you (in your role as consumer of this product). Is it possible

that your conclusion depends on whether (a) the product is undifferentiated and has a

perfectly competitive market (so the standard model of Chapters 2–5 applies) or (b) the

product is differentiated and has a monopolistically competitive market (so the model

of this chapter applies)? Explain.

9. The global market for household dishwashers is monopolistically competitive. It is

initially in a free-trade equilibrium, with 40 models offered, and a price of $600 for a

typical dishwasher. In your answer use a graph like that shown in Figure 6.5. There is

now a permanent increase in global demand for dishwashers generally, so the global

market size increases by about 15 percent. Show graphically the effect on the number

of dishwasher models offered, after the global market has adjusted to a new long-run

equilibrium. Explain the process of adjustment to this new long-run equilibrium.

10. Return to the scenario described in Question 9, the initial free-trade equilibrium for

dishwashers and the increase in global demand. In your answer use a graph like those

shown in the box “The Individual Firm in Monopolistic Competition.”

a. Show graphically and explain whether the typical individual firm earns an economic profit or a loss in the short run just after the general increase in global demand occurs.

b. Show graphically and explain the situation for the typical individual firm when the global market has adjusted to its new long-run equilibrium.

11. Here are data on Japanese exports and imports, for 2012, for the same seven products shown for U.S. trade in Figure 6.2:

Japanese Japanese Exports Imports Product ($ millions) ($ millions)

Perfumes (55310) 3 234 Cosmetics (55320) 1,291 1,183 Household clothes washing machines (77511) 3 967 Electronic microcircuits (77640) 27,997 17,456 Automobiles (78120) 97,276 10,882 Photographic cameras (88111) 11 26 Books and brochures (89219) 96 251

✦

Chapter 6 Scale Economies, Imperfect Competition, and Trade 115

pug21774_ch06_088-116.indd 115pug21774_ch06_088-116.indd 115 11/4/14 4:11 PM11/4/14 4:11 PM

Final PDF to printer

a. For each product for Japan, calculate the IIT share. b. The weighted average of IIT shares for these seven products for 2012 for the

United States (using the data from Figure 6.2) is 63.1 percent. For Japan for these

seven products for 2012, what is the weighted average of the IIT shares? Which

country has relatively more IIT in these seven products?

12. There are a small number of firms that make electric railroad locomotives. In 2012

world exports of electric railroad locomotives (SITC revision 3 number 79111) totaled

about $1 billion. Germany exported $448 million (45 percent of the total), China

exported $390 million (39 percent of the total), and Switzerland exported $78 million

(8 percent of the total). Which economic model or theory from this chapter is most likely

to explain these facts about the patterns of world trade and world production? Why?

13. Production of a good is characterized by external scale economies. Currently there

is no trade in the product, and the product is produced in two countries. If trade is

opened in this product, all production will be driven to occur in only one country.

a. With free trade, why would production occur only in one country? b. Does opening trade bring gains to both countries? Explain.

14. You are an adviser to the Indian government. Until now, government policy in India

has been to severely limit imports into India, resulting also in a low level of Indian

exports. The government is considering a policy shift to much freer trade.

a. What are the three strongest arguments that you can offer to the Indian government about why the policy shift to freer trade is desirable for India?

b. Which groups in India will be the supporters of the policy shift toward freer trade? Which groups will be the opponents?

✦

116 Part One The Theory of International Trade

pug21774_ch06_088-116.indd 116pug21774_ch06_088-116.indd 116 10/27/14 5:54 PM10/27/14 5:54 PM

Final PDF to printer

Chapter Seven

Growth and Trade The world keeps changing, and trade responds. Real investments expand countries’

stocks of physical capital. Population growth (including immigration) adds new mem-

bers to the labor force. Education and training expand labor skills. Discoveries of

resource deposits change our estimates of countries’ endowments of natural resources.

Land reclamation and other shifts in land use can alter the amount of land available

for production. New technologies improve capabilities to produce goods and services.

New products enter the market. Consumer tastes change, altering demands for various

products. Each of these forces affects trade patterns.

The Heckscher–Ohlin theory is a snapshot of the international economy during a

period of time. We can also use the H–O model to show the effects of changes over

time. In a way we have already done this in previous chapters—the shift from no trade

to free trade is an example of one kind of change that can occur over time.

This chapter focuses on changes in productive capabilities. These production-side

changes are usually called economic growth (although we can also consider cases of decline). There are two fundamental sources of long-run economic growth:

• Increases in countries’ endowments of production factors (e.g., physical capital,

labor, and land).

• Improvements in production technologies (and other intangible influences on

resource productivity).

In this chapter we will analyze the implications of economic growth, especially

the implications for international trade flows and national economic well-being or

welfare. Our analysis focuses on “before” and “after” pictures, with the after picture

showing the economy after it fully adjusts (in the long run) to the growth that we are

analyzing.

Some of the growth effects explored here will agree with common intuition, but

some will not. In particular, we will discover two odd effects of growth. First, an

increase in a country’s endowment of only one of its production factors actually causes

national production of some products to decline. This result is the basis for concerns

that discovering and extracting new deposits of natural resources such as oil can retard

a country’s industrial development. Second, it is possible that expanding a country’s

ability to make the products that it exports can actually make the country worse off.

This perverse outcome could be of concern to a country that is a large exporter of

a primary commodity such as coffee beans or copper ore.

117

pug21774_ch07_117-136.indd 117pug21774_ch07_117-136.indd 117 10/27/14 6:18 PM10/27/14 6:18 PM

Final PDF to printer

These surprising results are part of this chapter’s tour of the variety of ways in

which economic growth can affect trade and national well-being. The chapter also

examines links between technology and trade, including technology differences as

a basis for comparative advantage, the cycle of innovation of new technologies and

diffusion of these technologies internationally, and the impact that openness to inter-

national trade can have on economic growth.

BALANCED VERSUS BIASED GROWTH

Growth in a country’s production capabilities, whether from endowment increases or

technology improvements, shifts the country’s production-possibility curve outward.

As the ppc shifts out, we are interested in knowing the effects on

• The general shape of the production-possibility curve.

• The specific production quantities for the different products, if product prices

remain the same (as their pregrowth values).

The three panels in Figure 7.1 represent different possibilities for types of growth

experienced by the United States. The first case, Figure 7.1A, is balanced growth, in which the ppc shifts out proportionately so that its relative shape is the same. In

this case, growth would result in the same proportionate increase in production of all

products if product prices remain the same. For instance, before the growth, produc-

tion is at point S 1 , 80 wheat and 20 cloth, and the relative price of cloth is 1 W/C . As a

result of growth the ppc shifts out. At the same relative price (implying another price

line parallel to the one through S 1 ), the country would produce at point S

2 , 112 wheat

and 28 cloth. Balanced growth could be the result of increases in the country’s endow-

ments of all factors by the same proportion. Or it could be the result of technology

improvements of a similar magnitude in both industries.

With biased growth the expansion favors producing proportionately more of one of the products. In this case the shift in the production-possibility curve will be

skewed toward the faster-growing product. Figure 7.1B shows growth that is biased

toward producing more cloth. If the relative product price remains unchanged, produc-

tion quantities do not change proportionately. For instance, with production initially at

point S 1 , growth biased toward cloth shifts production to a point like S

3 if the relative

price remains at 1 W/C . Cloth production increases from 20 to 40 units. Wheat pro- duction in this case remains unchanged at 80. Other examples of this type of biased

growth could have wheat production either growing somewhat (but by less than the

percent increase in cloth production) or decreasing below 80.

Figure 7.1C shows growth that is biased toward wheat production. The ppc shift

is skewed toward wheat. At the relative price of 1 W/C , the production point would shift from S

1 to a point like S

4 . In this example, wheat production increases from 80

to 130 and cloth production remains unchanged. In other specific examples of growth

biased toward wheat, cloth production might either increase by a lesser percentage

than wheat production increases or decrease.

118 Part One The Theory of International Trade

pug21774_ch07_117-136.indd 118pug21774_ch07_117-136.indd 118 10/27/14 6:18 PM10/27/14 6:18 PM

Final PDF to printer

Before growth, the United States produces at point S 1 and consumes at point C

1 . Balanced growth expands the

ppc in a uniform or neutral way. Biased growth expands the ppc in a way skewed toward one good or the other.

If the price ratio remains unchanged, then production growth (to points S 2 , S

3 , S

4 ) increases national income and

increases consumption of both goods (points C 2 , C

3 , C

4 ). By altering production and consumption, growth may

change the country’s willingness to trade (the size of its trade triangle). For balanced growth and for growth

biased toward wheat, the case of increased willingness to trade is shown. For growth biased toward cloth,

the case of less willingness to trade is shown.

FIGURE 7.1 Balanced and Biased Growth

Cloth

130

0 9020

Cloth

0 7220

48 40

40 60

A. Balanced Growth

Cloth

112

0 8420

S1 S1S1

C2 C3

Wheat Wheat Wheat

28 60

B. Growth Biased toward Cloth Production

C. Growth Biased toward Wheat Production

Biased growth arises when the country’s endowments of different factors grow

at different rates, or when improvements in production technologies are larger in

one of the industries than in the other. A specific example of unbalanced growth in

factor endowments is the situation in which one factor grows but the other factor is

unchanged. A specific example of different rates of technology improvement is the

situation in which technology in one industry is improving but technology in the other

industry is not changing. 1

1 The case in which technology in one industry is improving but no other production-side growth is occurring actually looks a little different from the graphs in Figure 7.1B and C. For instance, growth biased toward cloth could occur if only cloth production technology is improving. In this case the ppc shifts out in a manner that is skewed toward cloth, and the ppc intercept with the wheat axis does not change . This wheat intercept shows no production of cloth, so the better cloth technology does not expand the production capability. The rest of the ppc shifts out, as any cloth production benefits from the improved cloth technology. A similar reasoning applies to an improvement only in wheat technology. In this case the ppc intercept with the cloth axis does not change, but the rest of the ppc shifts out.

Chapter 7 Growth and Trade 119

pug21774_ch07_117-136.indd 119pug21774_ch07_117-136.indd 119 10/27/14 6:18 PM10/27/14 6:18 PM

Final PDF to printer

GROWTH IN ONLY ONE FACTOR

The case in which only one factor is growing has important implications, summarized

in the Rybczynski theorem: In a two-good world, and assuming that product prices are constant, growth in the country’s endowment of one factor of production, with the

other factor unchanged, has two results:

• An increase in the output of the good that uses the growing factor intensively.

• A decrease in the output of the other good. 2

To see the logic behind this theorem, consider the case in which only labor is grow-

ing. The most obvious place in which to put the extra labor to work is in the labor-

intensive industry—cloth in our ongoing example. Thus, it is not surprising that cloth

production increases.

With the production techniques in use, increasing cloth production requires not

only extra labor but also some amount of extra land. But the amount of land avail-

able in the country (the country’s land endowment) did not grow. The cloth sector

must obtain this extra land from the wheat sector. Wheat production decreases as

the amount of land used to produce wheat declines. (In addition, as wheat produc-

tion declines, it releases both land and labor, all of which must be reemployed

into cloth production. Therefore, the proportionate expansion of cloth production

will actually be larger than the proportion by which the overall labor endowment

grows.)

Figure 7.2 shows the effects of this growth in the labor endowment. As a result of

the growth, the ppc shifts out at all points. Even if the country produced wheat only,

the extra labor presumably could be employed in wheat production to generate some

extra wheat output. However, the outward shift in the ppc is biased toward more cloth

production, the industry in which labor is the more important production factor. If the

relative price is initially 1 W/C and remains unchanged, then growth shifts production from point S

1 to a point like S

5 on the new ppc. Cloth production increases from 20 to

35, and wheat production decreases from 80 to 74.

The Rybczynski theorem suggests that development of a new natural resource,

such as oil or gas in Canada or Britain, may retard development of other lines

of production, such as manufactures. (See the box “The Dutch Disease and

Deindustrialization.”) Conversely, rapid accumulation of new capital and worker

skills can cause a decline in domestic production of natural resource products and

make the country more reliant on imported materials. This happened to the United

States in the 1800s. The United States shifted from being a net exporter to a net

importer of minerals as it grew relative to the rest of the world. One of the causes of

this shift was the rapid growth of production of manufactured goods as the United

States accumulated skills and capital.

2 The other important conditions and assumptions include (1) the country produces positive amounts of both goods before and after growth, with both factors used in producing each good; (2) factors are mobile between sectors and fully employed; and (3) the technology of production is unchanged. Rybczynski (1955) also explored the changes in the terms of trade that are likely to accompany factor growth, as we will do subsequently in this chapter. (You may abbreviate his name as “Ryb” when answering exam questions.)

120 Part One The Theory of International Trade

pug21774_ch07_117-136.indd 120pug21774_ch07_117-136.indd 120 10/27/14 6:18 PM10/27/14 6:18 PM

Final PDF to printer

Growth in one production factor, with the other factor not growing, results in strongly biased growth.

If only labor grows, the ppc shifts out in a way that is biased toward more cloth production. If the price ratio

remains the same, the actual production point shifts from S 1 to S

5 . The Rybczynski theorem indicates that

cloth production increases and wheat production decreases.

FIGURE 7.2 Single-Factor

Growth: The

Rybczynski

Theorem

Cloth0 20

74 S5

Wheat

3 An alternative assumption is that one of the two goods is inferior, so that quantity demanded of this inferior good would decrease as income increases. While this case is possible, it would complicate the discussion without adding major insights.

CHANGES IN THE COUNTRY’S WILLINGNESS TO TRADE

Growth alters a country’s capabilities in supplying products. Growth also alters the

country’s demand for products, for instance, by changing the income that people in the

country have to spend. As production and consumption change with growth, a coun-

try’s willingness to or interest in engaging in international trade can change. That is,

even if the relative price between two products stays constant, the country could either

• increase its willingness to trade (it could want to export and import more) or

• decrease its willingness to trade (it could want to export and import less).

To analyze this further, we assume as usual that both goods are normal goods, so

that an increase in income (with product prices unchanged) increases the quantities

demanded of each of the goods. 3

Chapter 7 Growth and Trade 121

pug21774_ch07_117-136.indd 121pug21774_ch07_117-136.indd 121 10/27/14 6:18 PM10/27/14 6:18 PM

Final PDF to printer

4 We could also reach the same conclusions by focusing on changes in the quantities of cloth produced and consumed. In the order presented in the text, consumption of cloth would increase by more than production increases, so that desired imports increase, or consumption would rise by less, so that desired imports would decline. Of course, it is also possible that the quantities produced and consumed of cloth would increase by equal amounts (as would those for wheat), in which case the trade triangle and the country’s willingness to trade would not change.

We can examine changes in the country’s willingness to trade in each of the three

cases of growth shown in Figure 7.1. In each graph the change in willingness can be

shown by the change in the size of the trade triangle. The trade triangle is a handy

way to summarize willingness to trade because it shows how much the country wants

to export and import. Before the growth occurs we presume that the country was at a

free-trade equilibrium with production at S 1 and consumption at C

1 . The trade triangle

connecting S 1 and C

1 shows exports of 40 wheat and imports of 40 cloth.

Consider first the case of balanced supply-side growth (Figure 7.1A). As we showed

previously, production shifts to S 2 with growth. Proportionate expansion of production

means that wheat production increases by 32 and cloth by 8. With the relative price

constant, the price line shifts out. The country has more income and expands its con-

sumption quantities for both products. However, this by itself is not enough to indicate

the change in the country’s willingness to trade. Here are the two major possibilities:

• If the consumption of wheat increases by less than 32, then the quantity of wheat

available for export will increase. The size of the trade triangle and the country’s

willingness to trade will increase.

• If the consumption of wheat expands by more than 32, then the quantity of wheat

available for export will decrease. The size of the trade triangle and the country’s

willingness to trade will decrease. 4

The changes in the consumption quantities depend on the tastes of the consumers

in the country. Tastes are summarized by the shapes of the community indifference

curves and the specific community indifference curve that is tangent to the postgrowth

price line. The case actually shown in Figure 7.lA has the new community indifference

curve tangent to the new price line at point C 2 , so that the quantities consumed expand

proportionately to 56 wheat and 84 cloth. In this case, the increase in wheat consump-

tion (16) is less than the increase in wheat production (32), so the trade triangle and

the country’s willingness to trade expand.

Suppose next that growth is biased toward cloth, the imported product, as shown

in Figure 7.lB. Production shifts to S 3 with growth, raising cloth production with no

change in wheat production. More wheat is consumed (as the consumption point shifts

to a point like C 3 ),so there is less wheat available for export. In this case, the trade

triangle and the country’s willingness to trade shrink. A similar analysis applies to the

growth shown in Figure 7.2, growth even more biased toward cloth production.

If the growth is sufficiently biased toward producing more of the good that is

initially imported, the country’s pattern of trade could reverse itself, making the

country an exporter of cloth and an importer of wheat. For example, as noted

at the end of the previous section, the United States shifted from exporting to

importing minerals since the late 1800s. There is nothing immutable about the trade

pattern—comparative advantage and disadvantage can reverse over time.

122 Part One The Theory of International Trade

pug21774_ch07_117-136.indd 122pug21774_ch07_117-136.indd 122 10/27/14 6:18 PM10/27/14 6:18 PM

Final PDF to printer

Developing a new exportable natural resource can cause problems. One, discussed later in this chapter, is the problem of “immiserizing growth”: If you are already exporting and your export expansion lowers the world price of your exports, you could end up worse off. A second is the appar- ent problem called the Dutch disease, in which new production of a natural resource results in a decline in production of manufactured products (deindustrialization).

For the Netherlands, the origin of the disease was the development of new natural gas fields under the North Sea. It seemed that the more the Netherlands developed its natural gas production, the more depressed its manufacturers of traded goods became. Even the windfall price increases that the two oil shocks offered the Netherlands (all fuel prices skyrocketed, including that for natural gas) seemed to add to industry’s slump. The Dutch disease has been thought to have spread to Britain, Norway, Australia, Mexico, and other countries that have newly developed natu- ral resources.

The main premise of this fear is correct: Under many realistic conditions, the windfall of a new natural resource does indeed erode profits and production in the manufactured goods sector. Deindustrialization occurs for the same reason that underlies the Rybczynski theorem intro- duced in this chapter: The new sector draws production resources away from the manufac- turing sector. Specifically, to develop output of the natural resource, the sector must hire labor away from the manufacturing sector, and it must obtain capital that otherwise would have been invested in the manufacturing sector. Thus, the manufacturing sector contracts.

Journalistic coverage of the link between natural resource development and deindustri- alization tends to discover the basic Rybczynski effect in a different way. The press tends to notice that the development of the exportable natural resource causes the nation’s currency to rise in value on foreign exchange markets because of the increased demand for the coun- try’s currency as foreign buyers pay for their purchases. A higher value of the nation’s cur- rency makes it harder for its industrial firms to compete against foreign products whose price is now relatively lower. To the manufacturing sector this feels like a drop in demand, and the sector contracts. The foreign exchange market, in gravitating back toward the original balance of trade, is producing the same result we would get from a barter trade model: If you export more of a good, you’ll end up either export- ing less of another good or importing more. Something has to give so that trade will return to the same balance as before.

Even though the Dutch disease does lead to some deindustrialization, it is not clear that this is really a national problem. Merely shifting resources away from the manufacturing sector into the production of natural resources is not necessarily bad, despite a rich folklore assum- ing that industrial expansion is somehow key to prosperity. The country usually gains from devel- oping production of its natural resources, as long as this growth does not tip into the realm of the immiserizing.

DISCUSSION QUESTION Why do many real-world examples of Dutch disease originate from developments in energy products?

Case Study The Dutch Disease and Deindustrialization

Finally, consider growth that is biased toward wheat, as shown in Figure 7.1C.

The country’s demand for cloth increases as consumption shifts to a point like C 4 ,

so it wants to import more. The strong growth of wheat production also increases

the amount available for export. The trade triangle expands, showing the country’s

greater willingness to trade.

Chapter 7 Growth and Trade 123

pug21774_ch07_117-136.indd 123pug21774_ch07_117-136.indd 123 10/27/14 6:18 PM10/27/14 6:18 PM

Final PDF to printer

EFFECTS ON THE COUNTRY’S TERMS OF TRADE

Changes in a country’s willingness to trade can alter the country’s terms of trade if

the country is large enough for its trade to have an impact on the international equi-

librium. In turn, any change in the country’s terms of trade affects the extent to which

the country benefits from its growth.

In this section we first examine the case of a small country, one whose trade does not affect the international price ratio. We then examine the case of a large country, one whose trade can have an impact on the relative international price ratio (that is, an

effect on the price the country receives for its exports, the price it pays for its imports,

or both). Note that the definitions of small country and large country are based on the ability of the country to have a noticeable effect on one or more international prices.

Even a country that we think of as having a small economy can be a large country.

For instance, Ghana (which is a relatively small country, overall) is a major exporter

of cocoa. A reasonable change in its export supply (say, an increase in its export sup-

ply by 10 percent due to an improvement in farming practices) would affect world

cocoa prices. On the other hand, even a country that we think of as having a large

economy (for instance, Japan) can be a small country for many products (examples

would be milk and cheese), in the sense that reasonable changes in its own production

or demand have no discernible effect on the world price of the product.

Small Country If a country is small (that is, a price-taker in world markets), then its trade has no impact

on the international price ratio (the country’s terms of trade). The graphs shown in

Figure 7.1 represent the full analysis of growth by the small country. In each of these

cases the country gains from its growth in the sense that it reaches a higher community

indifference curve (at point C 2 , C

3 , or C

4 , depending on the type of growth).

Large Country If a country is large, a change in its willingness to trade affects the equilibrium inter-

national price ratio. Consider first the case in which growth reduces the country’s

willingness to trade at any given price, as shown in Figure 7.3 (which reproduces the

ppc shift of Figure 7.1B). The reduction in the country’s demand for imports reduces

the relative price of the import good (or the reduction in the country’s supply of

exports increases the relative price of the export good). This change in the equilibrium

international price is an improvement in the country’s terms of trade. In this case, the

country gets two benefits from growth:

• The production benefit from growth as the ppc shifts out.

• The benefit from improved terms of trade as it receives a better price for its exports

relative to the price that it has to pay for its imports.

In Figure 7.3 the improved terms of trade are shown in a flatter price line (a lower

relative price of cloth, the import good). In response, the country shifts its production

point to S 6 on the new ppc and decides to consume at a point C

6 . If, instead, there were

124 Part One The Theory of International Trade

pug21774_ch07_117-136.indd 124pug21774_ch07_117-136.indd 124 10/27/14 6:18 PM10/27/14 6:18 PM

Final PDF to printer

A large country can gain in two ways from an expanding ability to produce the import-competing

good—here, cloth. In addition to the gains from being able to produce more (already shown

in Figure 7.1B), it can improve its terms of trade. By demanding fewer imports (a decreased

willingness to trade), it makes cloth cheaper on world markets. After growth, the relative price of

cloth declines to 2/3 W/C in the example shown. The country’s remaining imports cost less. Thus, the country gains more from growth, as consumption shifts from C

1 to C

6 because the price line

becomes flatter.

FIGURE 7.3 Growth

Biased toward

Replacing

Imports in a

Large Country

Cloth0 20

54 C6

26.7

Price = 1 W/C

Price = 2/3 W/C

Wheat

no change in the terms of trade, with this ppc growth the country would reach the level

of well-being associated with the community indifference curve through C 3 (48 wheat

and 72 cloth) in Figure 7.1B. So, the actual improvement in the terms of trade permits

the country to reach the higher level of well-being associated with the community

indifference curve through C 6 (54 wheat and 82 cloth) in Figure 7.3.

Consider next the case in which growth increases the country’s willingness to

trade. The increase in the country’s demand for imports increases the relative price

of the import good (or the increase in the country’s supply of exports reduces the

relative price of the export good). This change in the equilibrium international price

ratio is a deterioration in the country’s terms of trade. In this case the overall effect

on the country’s well-being is not clear. Growth brings a production benefit, but the

country is hurt by the subsequent decline in its terms of trade. (It receives a lower

price for its export products relative to the price that it pays for its import products.)

If the terms of trade do not decline by too much, then the country gains overall from

growth, but not by as much as it would if the terms of trade did not change. However,

if the adverse movement is large, a surprising outcome is possible.

Chapter 7 Growth and Trade 125

pug21774_ch07_117-136.indd 125pug21774_ch07_117-136.indd 125 10/27/14 6:18 PM10/27/14 6:18 PM

Final PDF to printer

FIGURE 7.4 Immiserizing

Growth in a

Large Country

A large country actually could be made worse off by an improvement in its ability to produce the products it exports. Such a perverse case of immiserizing growth is shown here. By expanding its

ability to produce wheat, its export good, the large country increases its supply of exports (expands

its willingness to trade). This drives down the relative price of wheat in world markets. Looked at

the other way, this causes an increase (here a tripling) of the relative price that it must pay for its

imports of cloth. The decline in the country’s terms of trade is so bad, in this case, that it outweighs

the benefits of the extra ability to produce. Consumer enjoyment is lower at C 7 than at the initial

consumption point C 1 .

Cloth0 20

Price = 1 W/C

5537

Price = 3 W/C

Wheat

Immiserizing Growth What happens if the terms of trade decline a great deal in response to growth in the

country’s ability to produce its export good? If the terms of trade decline substantially,

the country’s well-being could fall. (Or, in the in-between case, the country’s well-

being could be unchanged.) The possibility of a decline in well-being is shown in

Figure 7.4 , in which a large improvement in wheat-production technology results in a

shift in the ppc that is strongly skewed toward expanding wheat production.

For a relatively steep price line (showing a large decline in the country’s terms of

trade), the country’s production is at point S 7 on the new ppc and its consumption at

point C 7 . The level of well-being for C

7 is less than that for point C

1 before growth.

This possibility is a remarkable result, first analyzed carefully by Jagdish Bhagwati.

It is called the possibility of immiserizing growth : Growth that expands the coun- try’s willingness to trade can result in such a large decline in the country’s terms of

trade that the country is worse off.

126 Part One The Theory of International Trade

pug21774_ch07_117-136.indd 126pug21774_ch07_117-136.indd 126 10/27/14 6:18 PM10/27/14 6:18 PM

Final PDF to printer

Three conditions seem crucial for immiserizing growth to occur:

1. The country’s growth must be strongly biased toward expanding the country’s sup-

ply of exports (increasing its willingness to trade), and the increase in export supply

must be large enough to have a noticeable impact on world prices.

2. The foreign demand for the country’s exports must be price inelastic, so that an

expansion in the country’s export supply leads to a large drop in the international

price of the export product.

3. Before the growth, the country must be heavily engaged in trade, so that the welfare

loss from the decline in the terms of trade is great enough to offset the gains from

being able to produce more.

Countries that export a diversified selection of export products do not seem to be at

much risk of experiencing immiserizing growth. A developing country that relies on

one or a few primary products (agricultural or mineral products) is more at risk. For

example, consider a country like Zambia that relies on a mineral ore (e.g., copper) for

most of its export revenues. A discovery that leads to the opening of several new large

mines would increase its ore exports and greatly reduce the international price of this

ore. As a result of the decline in the price, the country could be worse off. For instance,

the money value of Zambia’s exports of copper ore could decline (if the price falls

more than the export quantity increases), and Zambia then could not afford to import

as much as before the growth.

It may seem foolish for a nation to undergo an expansion that makes itself worse off.

But remember that the expansion would be undertaken, both in the model and in the real

world, by individual competitive firms, each of which might profit individually from its

own expansion. Individual rationality can sometimes add up to collective irrationality.

The possibility of immiserizing growth offers large countries a policy lesson that

transcends the cases in which it actually occurs. By itself, the case of immiserizing

growth is probably just a curious rarity. Even for large countries the necessary condi-

tions listed above are not likely to be met very often. Yet a larger point emerges from

Figures 7.3 and 7.4.

Any effect of growth in the national economy on the terms of trade affects the national gains from encouraging that growth. Suppose that the government is debating which

industries to favor with tax breaks or subsidies and has to choose between encourag-

ing import-replacing industries and encouraging export-expanding ones. In Figure 7.3

we found that the country reaped greater benefits if its expansion of import-competing

capabilities causes a drop in the price of imports. By contrast, in Figure 7.4, expanding

export industries is less beneficial because it lowers the relative price of exports. This

is true whether or not the bad terms-of-trade effect is big enough to outweigh the gains

from being more productive. So a large country has reason to favor import-replacing

industries over export industries: If other things are truly equal, why not favor industries that turn world prices in your favor rather than against you? 5 We return to this point when

discussing trade policy for developing countries in Chapter 14.

5 Remember, however, that the whole reason for favoring import replacement here relates to turning international prices in this nation’s favor. For the world as a whole, there can be no such gain and no immiserizing growth. One country’s gains (losses) from changes in the terms of trade equal another country’s losses (gains).

Chapter 7 Growth and Trade 127

pug21774_ch07_117-136.indd 127pug21774_ch07_117-136.indd 127 10/27/14 6:18 PM10/27/14 6:18 PM

Final PDF to printer

TECHNOLOGY AND TRADE

This chapter’s discussion of biased growth can be linked to the general discussion

of the basis for comparative advantage presented in Chapter 4. As we noted there,

comparative advantage skews countries’ capabilities for producing various products.

In presenting the Heckscher–Ohlin theory, we spent much time discussing differences

in factor endowments as the basis for comparative advantage.

Another basis for comparative advantage is differences in production technologies

available in the various countries. Technology differences tend to skew production in

each country toward producing the product(s) in which the country has the relatively

better technology (that is, the technology of greatest advantage or least disadvantage).

Technology-based comparative advantage can arise over time as technological

change occurs at different rates in different sectors and countries. For instance, improve-

ments in the production technology used in the wheat industry in the United States over

time would skew U.S. production capabilities toward producing larger amounts of

wheat. The U.S. ppc would shift out in a way biased toward wheat production (as in

Figure 7.1C). These technology improvements could include improved farming prac-

tices or better seed varieties. If the technology for wheat production is not improving

in a comparable manner in the rest of the world, then the United States can develop a

comparative advantage in wheat based on its relative technology advantage in wheat.

In some ways this technology-based explanation is an alternative that competes

with the H–O theory. Technology differences can become an important cause (some-

times the dominant cause) of the pattern of trade in specific products. For instance, the

fact that the United States became a net importer of steel products in the early 1960s

can be explained in part by the adoption of newer production technologies for steel in

Japan and other countries.

In other ways technology differences can be consistent with an H–O view of the

world, at least one using an extended and dynamic H–O approach. To see this, we

must consider the question of where the technological improvements come from.

Some technological improvement happens by chance or through the unusual efforts

of individuals. However, most industrially useful new technology now comes from

organized efforts that we call research and development (R&D). This R&D is done largely by businesses and focuses on improvements in production technologies

for existing products and on new production technologies for new or improved prod-

ucts. Products or industries in which R&D is relatively important—such as aircraft,

semiconductors, and pharmaceuticals—are usually called high technology. Ongoing (and costly) R&D within these high-tech industries can create an ongoing stream of

new and improved technology over time.

The most obvious link to the H–O theory is the national location of R&D itself.

R&D is a production activity that is intensive in highly skilled labor—scientists and

engineers in particular. Most of the world’s R&D is done in the industrialized coun-

tries that have an abundance of this type of labor. Another factor of importance is

capital willing to take the substantial risks involved in financing R&D investments.

The relative abundance of venture capital (outsiders’ purchase of ownership in new businesses) in the United States is the basis for a U.S. advantage, while other countries

like Japan depend more on internal funding of R&D within their large corporations.

128 Part One The Theory of International Trade

pug21774_ch07_117-136.indd 128pug21774_ch07_117-136.indd 128 10/27/14 6:18 PM10/27/14 6:18 PM

Final PDF to printer

The national location of production using the new technology, which is what is

shown explicitly in our ppc graph, is not so clear-cut. It seems reasonable that the first

use in production could be in the same country in which the R&D was done. However,

technology can spread internationally. This international spread or “trade” in technol-

ogy is called diffusion. New technology is difficult to keep secret, and other countries have an incentive to obtain the technology improvements. Indeed, the creator of the

new technology has the incentive to apply it in production in the national location(s)

in which the new technology is most suitable (and therefore most profitable). H–O

theory suggests that the suitable location matches the factor proportions of production

using the new technology to the factor endowments of the national location.

Individual Products and the Product Cycle One effort to find a pattern in these technology activities is the product cycle hypothesis, first advanced by Raymond Vernon. When a product is first invented (born), it still must be perfected. Additional R&D is needed, and production is often

in small amounts by skilled workers. In addition, the major demand is mostly in the

high-income countries because most new products are luxuries in the economist’s

sense. Close communication is needed between the R&D, production, and marketing

people in the producing firm. All this suggests that both R&D and initial production

are likely to be in an advanced developed country.

Over time, the product and its production technology become more standardized

and familiar (mature). Factor intensity in production tends to shift away from skilled

labor and toward less-skilled labor. The technology diffuses and production locations

shift into other countries, eventually into developing countries that are abundant in

less-skilled labor.

Trade patterns change in a manner consistent with shifting production locations.

The innovating country is initially the exporter of the new product, but it eventually

becomes an importer. Although it is dynamic and emphasizes additional consider-

ations like demand and communication, many aspects of this product cycle hypothesis

are consistent with H–O theory.

The product cycle hypothesis does fit the experience of products in many industries

in the past century. Laptop computers are an example. Computer firms in the United

States and Japan began R&D to design small, portable computers in the 1970s and

early 1980s. The firms planned to meet expected demand by businesspeople and

researchers in the United States and other high-income countries. Several early models

were produced in the United States and Japan, and R&D continued. In the late 1980s

and early 1990s, IBM, Toshiba, Texas Instruments, and other U.S. and Japanese firms

introduced better models, with production in the United States and Japan, and some

of this production was exported to buyers in other countries. As the components of

the laptops became standardized, and as competition among sellers intensified through

the 1990s, firms shifted much of the assembly production of laptops, first to Taiwan

and later to China, to reduce production costs. In the process, the initial innovating

countries became importers.

Nonetheless, the usefulness of the product cycle hypothesis is limited for sev-

eral reasons. These have to do with the unpredictable lengths or progression of the

phases of the cycle. In many industries—especially high-tech industries—product

Chapter 7 Growth and Trade 129

pug21774_ch07_117-136.indd 129pug21774_ch07_117-136.indd 129 10/27/14 6:18 PM10/27/14 6:18 PM

Final PDF to printer

and production technologies are continually evolving because of ongoing R&D.

Rejuvenation or replenished youthfulness is important. In addition, international dif-

fusion often occurs within multinational (or “global”) corporations. In this case, the

cycle can essentially disappear. New technology developed by a multinational cor-

poration in one of its research facilities in a leading developed country can be trans-

ferred within the corporation for its first production use in affiliates in other countries,

including its affiliates in developing countries.

Openness to Trade Affects Growth So far, most of the discussion in this chapter has looked at how growth in production

capabilities can affect international trade. Clearly, growth can have a major impact

on international trade. There is also likely to be an impact in the other direction,

from trade to growth. Openness to international trade can have an impact on how

fast a country’s economy can grow—how fast its production capabilities are growing

over time.

We can gain insights into this relationship by considering how openness to trade

can affect the technologies that the country can use. As we noted previously, in the

discussion of the product life cycle, there are two sources of new technology for a

country: technology developed domestically and technology imported from foreign

countries. If a country closes itself to international trade, it probably also cuts itself

off from this second source of new technology. By failing to absorb and use new

technologies developed in other countries, this closed country is likely to grow more

slowly. Looked at in the other way, countries that are open to international trade (and

international exchanges more generally) can grow faster. Let’s consider more closely

the reasons for this relationship. (We might also note that the relationship is actually

complex, so none of these reasons is completely straightforward. We will focus on

generally positive effects, without providing the caveats that may apply.)

Trade provides access to new and improved products. For our production-side anal-

ysis, capital goods are an important type of input into production that can be imported.

Trade allows a country to import new and improved machinery, which “embodies”

better technology that can be used in production to raise productivity. The foreign

exporters can also enhance the process, for instance, by advising the importing firms

on the best ways to use the new machines. Paul Romer, one of the pioneers of “new

growth theory,” has estimated that the gains from being able to import unique foreign

capital goods that embody new technology can be much larger than the traditional

gains from trade highlighted in Chapters 2–4.

More generally, openness to international activities leads the firms and people of

the country to have more contact with technology developed in other countries. This

greater awareness makes it more likely that the country will gain the use of the new

foreign-developed technology, through purchase of capital goods or through licensing

or imitation of the technology.

Openness to international trade can also have an impact on the incentive to

innovate. Trade can provide additional competitive pressure on the country’s firms.

The pressure drives the firms to seek better technology to raise their productivity

to build their international competitiveness. Trade also provides a larger market in

which to earn returns to innovation. If sales into foreign markets provide additional

returns, then the incentive to innovate increases, and firms devote more resources to

R&D activities.

130 Part One The Theory of International Trade

pug21774_ch07_117-136.indd 130pug21774_ch07_117-136.indd 130 11/3/14 6:25 PM11/3/14 6:25 PM

Final PDF to printer

Focus on Labor Trade, Technology, and U.S. Wages

Americans have reason to worry about trends in real wages since the early 1970s. One major trend has been a rising gap between the wages of relatively skilled workers and the wages of less-skilled workers. For instance, from the mid- 1970s to the early 2010s, the ratio of the aver- age wage of college graduates to that of high school graduates increased by about 30 percent. Many less-skilled workers have seen their wages decline in real (purchasing power) terms.

Meanwhile, the importance of international trade increased dramatically for the United States. The ratio of the sum of exports and imports to total national production (GDP) close to tripled from the early 1970s to the early 2010s. (Recall the data shown in the box “Trade Is Important” in Chapter 2, pages 18–19.) Do we see here the effects on U.S. wages of a “race to the bottom” driven by rising imports? More precisely, is this the Stolper–Samuelson theorem at work, as rising trade alters the returns to scarce and abundant factors in the United States?

Given the political implications of the trend toward greater wage inequality, economists have studied it carefully. While increasing trade pre- sumably has had some effect on wage rates through the Stolper–Samuelson effect, econo- mists have generally concluded that trade has not been the main culprit.

For the Stolper–Samuelson theorem to be the main culprit—the predominant effect—at least two other things should be true. First, the changes in factor prices should result from changes in product prices. Specifically, a decline in the relative price of less-skilled-labor-intensive goods should be behind the decline in the relative wages of less-skilled workers. Second, and more subtly, the change in the relative wage should induce indus- tries to become more intensive in their use of the now cheaper less-skilled labor. (See the box “A Factor-Ratio Paradox” in Chapter 5, page 70.)

Neither of these two things appears to have occurred. Research on U.S. manufacturing indus- tries indicates that there is no clear trend in the relative international price of manufactured goods that use less-skilled labor intensively. The data also show that most manufacturing industries became

more intensive in their use of skilled labor and less intensive in less-skilled labor.

The lack of change in the relative prices of traded goods and the rising skill intensity of production are not consistent with the Stolper– Samuelson effect. The implication is that changes in international trade prices are not the pre- dominant cause of the rising wage inequality. Other economists have concluded similarly that changes in the trade flows themselves (imports and exports) are not the predominant cause.

If not trade, then what? Most researchers have concluded that the major driving force changing demands for skilled and unskilled labor has been technological change. In fact, technological change may be pressuring relative wages in two ways.

First, technological progress has been faster in industries that are more intensive in skilled labor. As the cost and prices of some skill-intensive products decline, and the quality of these products is improved, demand for the products increases. As demand shifts toward skill-intensive products and their production increases, the demand for skilled labor expands, increasing the relative wage of skilled labor.

Second, the technological progress that has occurred within individual industries appears to be biased in favor of using more skilled labor. This bias increases demand for skilled labor even more, reinforcing the pressure for an increase in wage inequality. We see this bias in the shift toward greater use of computers generally and in the shift toward computer-controlled flexible manufactur- ing systems in manufacturing specifically.

The United Kingdom has also experienced ris- ing wage inequality between skilled and unskilled workers, though the change is not as large as in the United States. In most other countries in Western Europe and in Canada, these pressures seem to have played themselves out somewhat differ- ently. Labor market institutions like high minimum wages have prevented wage rates for less-skilled workers from declining so much. Instead, unem- ployment has increased since the early 1970s and has remained high. While inequality of earnings has not increased so much in Canada and Western Europe, unemployment, especially among the less skilled, has become a serious problem.

Chapter 7 Growth and Trade 131

pug21774_ch07_117-136.indd 131pug21774_ch07_117-136.indd 131 11/3/14 6:25 PM11/3/14 6:25 PM

Final PDF to printer

Openness to international trade thus can enhance the technology that a country can use,

both by facilitating the diffusion of foreign-developed technology into the country and by

accelerating the domestic development of technology. Furthermore, these increases in the

current technology base can be used to develop additional innovations in the future. This

is a key insight of the new growth theory mentioned above, which posits that economic

policies and activities influence the growth rate. The current technology base provides a

source of increasing returns over time to ongoing innovation activities. The growth rate

for the country’s economy (and for the whole world) increases in the long run.

Do we have clear evidence that openness to trade actually increases a country’s

economic growth? Jakob Madsen (2007) found that international trade in products

has spurred international diffusion of technologies among industrialized countries,

and that foreign technologies acquired through this diffusion have been the source of most productivity growth since 1870 in these industrialized countries. More broadly,

many studies have used statistical analyses to examine the correlation between open-

ness to international activities and national economic growth rates. For example,

Estevadeordal and Taylor (2013) show that countries that reduced barriers to imports

of capital goods and intermediate inputs grew by about 1 percent more per year since

1990 (than did countries that did not lower such barriers).

The preponderance of evidence favors a positive relationship. These studies do not

absolutely prove that openness leads to increased growth, for two reasons. First, the

positive correlation does not prove the direction of causation. Second, it is difficult

to disentangle the effects of international openness from the effects of other govern-

ment policies that can also increase economic growth, including policies that reform

government taxation and spending, policies that strengthen the rule of law and protect

private property generally, and less distorted exchange-rate policies.

Still, the evidence broadly is consistent with the proposition that international

openness is good for long-run national economic growth, and there is no convincing

evidence that openness to trade leads to slower long-run growth. We will take up the

issue of trade and growth again in Chapter 14, when we discuss developing countries.

Summary Economic growth (expansion of a country’s production capabilities) results from increases in the country’s endowments of factors of production or from technological

improvements. Balanced growth shifts the country’s production-possibility curve outward in a proportionate manner. If the product price ratio is unchanged, produc-

tion of each product increases proportionately. Consumption of both products also

increases. This alters the country’s trade triangle and its willingness to trade unless the

increases in quantities produced and consumed are equal. For instance, if the growth in

production quantity of the exportable product exceeds the growth in its consumption

quantity, then the trade triangle and the willingness to trade increase.

Biased growth shifts the ppc outward in a manner that is skewed toward one product. If the product price ratio is unchanged, production of this product expands,

but production of the other product increases by a lesser proportion, stays the same,

or declines. The Rybczynski theorem states that a kind of very biased growth, in which the endowment of only one factor is growing, results in a decrease in produc-

tion by the sector that is not intensive in the growing factor. The Dutch disease is

132 Part One The Theory of International Trade

pug21774_ch07_117-136.indd 132pug21774_ch07_117-136.indd 132 12/5/14 6:25 PM12/5/14 6:25 PM

Final PDF to printer

Key Terms

Economic growth

Balanced growth

Biased growth

Rybczynski theorem

Dutch disease

Small country

Large country

Immiserizing growth

Research and development

(R&D)

Diffusion

Product cycle hypothesis

a real-world example. In the Dutch case the endowment growth was the discovery of

natural gas deposits. Shifting labor and capital to the extraction of this gas led to a

decline in the country’s manufacturing sector.

If growth is biased toward producing more of the import-competing product, the

country’s trade triangle and its willingness to trade tend to shrink. If growth is biased

toward producing more of the exportable product, the country’s trade triangle and its

willingness to trade tend to expand.

The trade of a small country has no impact on international prices. The analysis of growth in a small country is straightforward because its growth does not alter its

terms of trade.

The trade of a large country does have an impact on international prices. If growth results in a large country becoming less willing to trade, then the relative

price of the country’s export product increases. In this case, growth benefits the coun-

try both by expanding its production capabilities and by improving its terms of trade.

If growth results in a large country becoming more willing to trade, then the relative

price of its export product decreases. This deterioration in the terms of trade reduces

the benefits to the country of growing productive capabilities. Indeed, it is possible

that, if the terms of trade decline substantially, the country could be worse off after

growing—a possibility called immiserizing growth. The relationship of technology to the shape of the ppc indicates that differences in

technology between countries can be a basis for trade. In some ways, this technology

explanation competes with the Heckscher–Ohlin theory. The technology explanation of

trade is that countries export products in which they have relative technology advantages.

In other ways, technology differences can be linked to H–O. For instance, the research and development that leads to new technologies tends to be located in countries that are well endowed with the highly skilled labor (e.g., scientists and engineers) that

is needed to conduct the R&D. The product cycle hypothesis is an attempt to offer a dynamic theory of technology and trade by emphasizing that the location of produc-

tion of a product is likely to shift from the leading developed countries to developing

countries as the product moves from its introduction to maturity and standardization.

Openness to international trade can also influence the rate of economic growth

by affecting the rate at which the country’s production technology is improving.

With international openness, diffusion of new foreign technology into the country increases because of imports of capital goods that embody the foreign technology,

or licensing or imitation of the foreign technology. Innovation by domestic firms

increases because of competitive pressure and the greater returns available through

foreign sales. Empirically, most studies find a positive relationship between the inter-

national openness of a country and the long-run economic growth rate of that country.

Chapter 7 Growth and Trade 133

pug21774_ch07_117-136.indd 133pug21774_ch07_117-136.indd 133 10/27/14 6:18 PM10/27/14 6:18 PM

Final PDF to printer

Suggested Reading

A classic theoretical study of the effects of technological progress on a country’s

economy and trade (using techniques similar to those presented in Appendix B) is

Findlay and Grubert (1959). The product cycle hypothesis of trade is put forth in Vernon

(1966), but doubts are voiced by Vernon himself (1979). Slaughter (2000), Lawrence

(2008, chapter 3), and Haskel et al. (2012) survey the effects of trade and other influences

on rising wage inequality. Anderson and Smith (2000) and Heitger and Stehn (2003)

examine the effects of trade on wages in Canada and Germany, respectively.

Van den Berg and Lewer (2007) examine both theories and empirical evidence about

how trade affects growth. Grossman and Helpman (1995) provide a technical survey of

theories of the relationships between technology and trade. Romer (1994) and Rivera-

Batiz and Romer (1991) present technical discussions of the effects of trade openness

on growth. Keller (2004) offers a technical survey of economic research on international

technology diffusion.

When you feel that you are nearing mastery of the theoretical material in Chapters 2

through 7, give yourself a test by looking at the first 10 paradoxes in Magee (1979). First

look at Magee’s listing of the paradoxes on his pages 92–93; then try to prove or explain

them before looking at the answers.

1. Pugelovia’s growth has been oriented toward expansion of its export industries. How do

you think Pugelovia’s terms of trade have been changing during this time period?

2. “An increase in the country’s labor force will result in an increase in the quantity pro-

duced of the labor-intensive good, with no change in the quantity produced of the other

good.” Do you agree or disagree? Why? In your answer, use the logic of the Rybczynski

theorem.

3. A number of Latin American countries export coffee and import other goods. A long-

term drought now reduces coffee production in the countries of this region. Assume that

they remain exporters of coffee. Explain why the long-term drought in the region might

lead to an increase in the region’s well-being or welfare. What would make this gain in

well-being more likely?

4. “A country whose trade has almost no impact on world prices is at great risk of

immiserizing growth.” Do you agree or disagree? Why?

5. Why does the Heckscher–Ohlin theory predict that most research and development

(R&D) activity is done in the industrialized countries?

6. If every new product goes through a product cycle, will the technological initiator (e.g.,

the United States or Japan) eventually develop chronic overall “trade deficits”?

7. Explain the effect of each of these on the shape and position of the country’s

production-possibility curve:

a. A proportionate increase in the total supplies (endowments) of all factors of production.

b. New management practices that can be used in all industries to improve productivity by about the same amount in all industries.

c. New production technology that improves productivity in the wheat industry, with no effect on productivity in the cloth industry.

✦

Questions and Problems

134 Part One The Theory of International Trade

pug21774_ch07_117-136.indd 134pug21774_ch07_117-136.indd 134 10/27/14 6:18 PM10/27/14 6:18 PM

Final PDF to printer

8. Which of the following can lead to a reversal of the country’s trade pattern (that is, a shift in which a previously exported good becomes an imported good or a previously

imported good becomes an exported good)? Consider each separately. Explain each.

a. Growth in the country’s total supply (endowment) of the factor that is initially scarce in the country.

b. International diffusion of technology. c. Shifting tastes of the country’s consumers.

9. A free-trade equilibrium exists in which the United States exports machinery and

imports clothing from the rest of the world. The goods are produced with two fac-

tors: capital and labor. The trade pattern is the one predicted by the H–O theory. An

increase now occurs in the U.S. endowment of capital, its abundant factor.

a. What is the effect on the shape and position of the U.S. production-possibility curve?

b. What is the effect on the actual production quantities in the United States if the product price ratio is unchanged? Explain.

c. What is the effect on the U.S. willingness to trade? d. Assuming that the U.S. growth does affect the international equilibrium price ratio,

what is the direction of the change in this price ratio?

e. Is it possible that U.S. national well-being declines as a result of the endowment growth and the resulting change in the international price ratio? Explain.

10. A free-trade equilibrium exists in a two-region, two-product world. The United States

exports food and imports clothing. A long-term drought now occurs in East Asia.

a. What is the effect on East Asia’s willingness to trade? b. Assuming that each region is large enough to influence international prices, how

does East Asia’s drought affect the equilibrium international price ratio?

c. Show on a graph and explain the effect of all this on the following in the United States: (1) quantities produced of food and clothing, (2) quantities consumed of food and clothing, (3) U.S. well-being.

d. Which group in the United States is likely to gain real income in the long run as a result of all this? Which group in the United States is likely to lose real income?

11. A free-trade equilibrium exists in which the United States exports food and imports

clothing. U.S. engineers now invent a new process for producing clothing at a lower

cost. This process cannot be used in the rest of the world.

a. What is the effect on the U.S. production-possibility curve? b. What is the effect on the U.S. willingness to trade? (Assume that the United States

remains an importer of clothing.)

c. Assuming that the change in the United States is large enough to affect international prices, will the equilibrium international price of clothing rise or will it fall?

12. Continue with the scenario of question 11—the new process in the United States and

the resulting change in the international equilibrium price ratio. Focus now on effects

in the rest of the world.

a. Show graphically and explain the effect on quantities produced, quantities con- sumed, and well-being in the rest of the world.

b. Explain as precisely as possible why well-being changes in the rest of the world.

✦

Chapter 7 Growth and Trade 135

pug21774_ch07_117-136.indd 135pug21774_ch07_117-136.indd 135 10/27/14 6:18 PM10/27/14 6:18 PM

Final PDF to printer

136 Part One The Theory of International Trade

13. A country is initially in a free-trade equilibrium, in which it is producing 40 units of

wheat and 64 units of cloth. The country exports cloth and imports wheat. Growth

now occurs in the country’s production capabilities. If product prices are unchanged, the country will shift to producing 50 units of wheat and 80 units of cloth.

a. What kind of growth is this? b. The growth of the country actually causes a change in product prices. In the

new free-trade equilibrium, the country actually produces 52 units of wheat and

77 units of cloth. Explain what has happened to result in the change from the initial

equilibrium to this new equilibrium.

14. Country B is a small country that allows free trade with the rest of the world. There

are two products, oats and newts. Country B initially can produce oats, but initially it

cannot produce newts because it lacks the production technology for newts. Country B

consumes some of both oats and newts. (In your graph for Country B, place oats on

the horizontal axis and newts on the vertical axis.)

a. Use a graph to show the initial free-trade equilibrium for Country B. (Choose a reasonable free-trade equilibrium international price ratio.) What is the quantity

exported and the quantity imported?

b. Now the technology for producing newts diffuses to Country B. Country B then can produce both products, with an increasing cost of trade-off in production.

Show on your graph how this changes Country B’s production possibilities.

c. Let’s examine the new free-trade equilibrium for Country B. Assume that in the new free-trade equilibrium, Country B produces positive amounts of both products. Which

of the following is possible? Country B exports oats and/or Country B imports oats.

For each case that you think is possible, show it on your graph and use your graph

to explain why it is possible.

d. In the initial situation (before the technology diffuses), what was the key driver of the trade pattern? In the new situation (after the technology diffuses), what is the

key driver of the trade pattern?

15. During the 1950s both North Korea and South Korea were mostly closed to inter-

national trade. Both were very poor and had low rates of growth of production (or

income) per person.

Since the 1960s, North Korean government policy has continued to permit almost

no international trade (and very limited contact with the outside world). In contrast,

the South Korean government adopted a number of policy changes, including al-

lowing more international trade with the rest of the world. Between 1970 and 2012,

production per person in North Korea stagnated, while production per person in South

Korea increased by more than eight times.

You have been asked to make the case that trade policies and technologies probably

were important contributors to the difference in growth rates between North Korea

and South Korea since the 1960s. What will you say?

✦

pug21774_ch07_117-136.indd 136pug21774_ch07_117-136.indd 136 11/3/14 6:26 PM11/3/14 6:26 PM

Final PDF to printer

Chapter Eight

Analysis of a Tariff Most economists favor letting nations trade freely, with few tariffs or other barriers to

trade. Indeed, economists have tended to be even more critical of trade barriers than

have other groups in society, even though economists have taken great care to list the

exceptional cases in which they feel trade barriers can be justified. Such agreement

among economists is rare. Why should they agree on this one issue?

The striking consensus in favor of free trade is based primarily on a body of eco-

nomic analysis demonstrating that there are usually net gains from freer trade, both

for nations and for the world. The main task of this chapter and Chapters 9–14 is to

compare free-trade policies with a wide range of trade barriers, barriers that do not

necessarily shut out all international trade. It is mainly on this more detailed analysis

of trade policies that economists have based their view that free trade is generally bet-

ter than partial restrictions on trade, with a list of exceptions. This analysis makes it

easier to understand what divides the majority of economists from groups calling for

restrictions on trade.

To see what is lost or gained by putting up barriers to international trade, let us take

a close look at the effects of the classic kind of trade barrier, a tariff on an imported

product. This chapter spells out who is likely to gain and who is likely to lose from a

tariff and explains conditions under which a nation could end up better off from a tariff.

A tariff, as the term is used in international trade, is a tax on importing a good or service into a country, usually collected by customs officials at the place of entry.

Tariffs come in two main types. A specific tariff is stipulated as a money amount per unit of import, such as dollars per ton of steel bars or dollars per eight-cylinder

two-door sports car. An ad valorem (on the value) tariff is a percentage of the esti- mated market value of the goods when they reach the importing country. We will not

pay much attention to this distinction because it makes almost no difference to our

conclusions.

Tariff rates have been declining, but they are still important. Indeed, only one

country in the world, Singapore, has almost no tariffs. (In addition, two autonomous

customs areas, Hong Kong and Macau, have no tariffs.)

For the industrialized countries, average tariff rates in the 1930s were about

60 percent, in the aftermath of the infamous Smoot-Hawley tariffs that the United

States enacted in 1930 and the increased rates adopted by other countries in response

to the higher U.S. tariffs. Negotiated agreements since then have dropped most tariffs

on nonagricultural products in these countries to very low levels. The key role of the

General Agreement on Tariffs and Trade (GATT), which is now folded into the World

137

pug21774_ch08_137-159.indd 137pug21774_ch08_137-159.indd 137 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

Global Governance WTO and GATT: Tariff Success

138 Part Two Trade Policy

During the past 65 years, governments of industrialized countries reached a series of global agreements that have reduced tariffs on their nonagricultural imports to very low levels. How did they accomplish this remarkable reduction? And what is the position of the developing countries in the process? To answer these questions, we take up the topic of global governance —practices and institutions that condition how national govern- ments interact with each other—with a focus on international economic issues like trade.

GATT TO WTO The story began during World War II, when the United States, Britain, and the other allies started to discuss how to ensure that the economic system worked better after the war than it had before the war. For trade, the goal was to find a way to avoid the virulent protectionism that had taken hold in many countries in the early 1930s. The United States, Britain, and their allies expected the key institution to be the International Trade Organization. However, it never came into existence because of opposition, led by members of the U.S. Congress, to what many viewed as the excessive breadth of the organization’s proposed charter.

Instead, a “provisional” accord, the General Agreement on Tariffs and Trade (GATT), became the key institution. The GATT was signed in 1947 by 23 countries and focused squarely on international trade issues. The number of countries in the GATT rose to 38 in 1960, 77 in 1970, 84 in 1980, and 99 in 1990. A new global agreement in the early 1990s led to the creation of the World Trade Organization (WTO) in January 1995. The WTO, which subsumes and expands on the GATT, is now the organiza- tion that oversees the global rules of government policies toward international trade and provides the forum for negotiating global agreements to improve these rules.

The WTO (like the GATT before it) espouses three major principles:

• Reductions of barriers to trade.

• Nondiscrimination, often called the most- favored nation ( MFN) principle.

• No unfair encouragement for exports.

As of early 2014 the WTO had 159 member coun- tries, including Russia, which joined in 2012. In addition, 24 countries have been negotiating to become members. The WTO’s headquarters are in Geneva, Switzerland.

NEGOTIATIONS LOWER TARIFFS In the first decades of its existence the GATT focused on tariffs. In recent decades other (“non- tariff”) barriers have received more attention, and these are taken up in the next chapter.

Under the GATT, member countries pursued eight rounds of multilateral trade negotiations to lower barriers. The first five rounds focused on reductions in tariff rates, using item-by- item negotiations in which the largest trading countries agreed to mutual reductions and then extended these new lower tariffs to all members, following the MFN nondiscrimination principle. This meant that the negotiations were conducted among the largest industrial countries. In addi- tion, it was quickly recognized that lowering barriers to trade in agricultural products would be fraught with controversy, so the negotiations focused on nonagricultural products.

The first round, Geneva 1947, achieved sub- stantial tariff reductions (for instance, the aver- age U.S. tariff rate was reduced by 21 percent). The next three rounds, Annecy 1949, Torquay 195021951, and Geneva 1956, achieved mod- est new reductions, as did the Dillon Round (196021961), which also took up the creation of a common external tariff schedule for the newly formed European Economic Community (now the European Union).

To accomplish more substantial tariff reduc- tions, the Kennedy Round (196321967) shifted the process so that the industrialized countries began with an agreement to use a formula to lower all nonagricultural tariffs and then negoti- ated limited exceptions in which some products had lesser tariff cuts. This innovation worked—the average tariff reduction was 38 percent for non- agricultural imports into industrialized countries. The Tokyo Round (197321979) and the Uruguay Round (198621994) continued the process using formulas for cuts, with negotiated exceptions.

pug21774_ch08_137-159.indd 138pug21774_ch08_137-159.indd 138 11/4/14 4:19 PM11/4/14 4:19 PM

Final PDF to printer

Chapter 8 Analysis of a Tariff 139

Industrialized countries’ nonagricultural tariffs fell by an average of 33 and 38 percent, respectively.

DEVELOPING COUNTRIES While the industrialized countries have negoti- ated tariff reductions, what has been the role of developing countries? Of the 23 founding members of GATT, 13 were developing countries, and now most WTO members are developing countries. However, until recently, developing countries played little role in the multilateral trade negotiations. Because they were seldom major exporters or importers of specific non- agricultural products, they were not active in the negotiations of the first five rounds. In the Kennedy Round there was formal recognition that developing countries did not need to offer tariff cuts even though they benefited from the tariff reductions by the industrialized countries. The Tokyo Round continued the approach, for- malizing “special and differential” treatment for developing countries. In fact, most develop- ing countries had not even agreed to maximum bound tariffs for most products, so they were free to raise their tariffs if they wanted to.

While the developing countries benefited from the tariff reductions by industrialized coun- tries, they were not able to influence how the industrialized countries were lowering tariffs because they were not involved in the give-and- take of negotiating over mutual reductions. Industrialized countries shied from lowering tar- iffs on “sensitive” products, which were often the labor-intensive nonagricultural products that were the most promising products for expanding developing countries’ manufactured exports.

In the 1980s many developing countries shifted toward a more outward-oriented strat- egy for development (see Chapter 14 for further discussion). Many unilaterally lowered their tariff rates. They also became more involved in the negotiations of the Uruguay Round, although ultimately the conclusion of the round still was dominated by negotiations among the indus- trialized countries, especially the United States and the European Union. As part of the Uruguay Round, many developing countries agreed to

adopt bound rates for most of their tariffs, though these bound rates often remain above their actual rates. For example, Mexico has now bound most of its rates, but Mexico’s average actual tariff rate of 8 percent is well below its average bound rate of 36 percent.

RECENT PROGRESS Under the WTO, reduction of tariff barriers continues. First, a special negotiation led to the Information Technology Agreement of 1996. Each country adopting the agreement (initially 29 countries) commits to eliminate tariffs on imports of information technology goods (com- puters, telecommunications equipment, semi- conductors, semiconductor manufacturing equipment, and related instruments and parts) and software. By 2014, 78 countries had adopted the agreement, so that 97 percent of global trade in these information technology products is (or soon will be) tariff-free.

Second, the developing countries that have joined the WTO since 1995 have generally low- ered their actual tariff rates as a condition for joining and accepted bound rates equal to or very close to their actual rates. For instance, the average tariff rate of China, which joined the WTO in 2001, fell from 17 percent in 2000 to 11 percent in 2003. Third, reducing tariffs is an important part of the agenda for the current Doha Round of trade negotiations, a topic that will be examined further in the next chapter.

Overall, the liberalization procedures set up under the GATT and continued under the WTO have been remarkably successful in low- ering industrialized countries’ tariffs on non- agricultural products. In part the multilateral negotiations have succeeded because each coun- try’s government is able to defend its tariff- cutting “concessions” against the protests of domestic protectionists as the price the country must pay to give its exporters better access to other markets. This mercantilist logic is bad economics—we know instead that imports are something the country gains and exports are something the country gives up—but the logic seems to be useful politics.

pug21774_ch08_137-159.indd 139pug21774_ch08_137-159.indd 139 11/4/14 4:19 PM11/4/14 4:19 PM

Final PDF to printer

Trade Organization (WTO), as a forum for these multilateral trade negotiations is

described in the box “WTO and GATT: Tariff Success.”

In 2012, tariff rates averaged 2.4 to 4.2 percent on nonagricultural products

imported into the United States, Canada, the European Union, and Japan. But tar-

iffs on some individual nonagricultural products are much higher, up to 55 percent

in the United States, 25 percent in Canada, 26 percent in the European Union, and

463 percent in Japan. Tariff rates for agricultural products are higher for many indus-

trialized countries, with average tariffs of 5 percent for the United States (highest rate

350 percent), average 16 percent for Canada (highest 551 percent), average 13 percent

for the European Union (highest 605 percent), and average 17 percent for Japan (high-

est 692 percent).

Average tariff rates are higher in most developing countries. For example, for

China, in 2012 the average tariff rate on nonagricultural imports was 9 percent, with a

maximum rate of 50 percent, and the average tariff rate on agricultural imports was 16

percent, with a high rate of 65 percent. For Mexico, the average and maximum tariff

rates were 6 and 50 percent for nonagricultural products and 21 and 254 percent for

agricultural products.

A PREVIEW OF CONCLUSIONS

Our exploration of the pros and cons of a tariff will be detailed enough to warrant list-

ing its main conclusions here at the outset. This chapter will discuss how

• A tariff almost always lowers world well-being.

• A tariff usually lowers the well-being of each nation, including the nation imposing

the tariff.

• The “nationally optimal” tariff discussed near the end of this chapter is a possible

exception to the case for free trade. When a nation can affect the prices at which it trades

with foreigners, it can gain from its own tariff. (The world as a whole loses, however.)

• A tariff absolutely helps those groups tied closely to the production of import sub-

stitutes, even when the tariff is bad for the nation as a whole.

You may wish to review these conclusions after we have completed the analysis of

import barriers in this chapter.

THE EFFECT OF A TARIFF ON DOMESTIC PRODUCERS

Intuition suggests that domestic producers that compete against imports will benefit

from a tariff. If the government places a tax on imports of the product, the domestic

price of the imported product will rise. Domestic producers can then expand their own

production and sales, raise the price they charge, or both. The tariff, by taxing imports

to make imports less competitive in the domestic market, should make domestic pro-

ducers better off.

The demand and supply analysis of a tariff agrees with our intuition. It goes beyond

intuition, though, by allowing us to calculate just how much a tariff benefits domestic

producers.

140 Part Two Trade Policy

pug21774_ch08_137-159.indd 140pug21774_ch08_137-159.indd 140 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

We begin with a demand2supply view of the U.S. market for bicycles without any

tariff. For most of this chapter, we deal with the simple case in which our nation is a

competitive “price-taker” in the world markets for the products we trade. This is the

same small country that we defined in the previous chapter. For a small country, the price that the country must pay the foreign sellers is not affected by how much the

small country imports of the product.

In the free-trade situation shown in Figure 8.1 , bicycles are imported freely at the

given world price of $300. At this price consumers buy S 0 bikes a year from domestic

suppliers and import M 0 bikes a year, buying a total of D

0 5 S

0 1 M

0 bikes. To use illus-

trative numbers, let’s say that consumers buy D 0 5 1.6 (million bikes a year), domestic

producers make S 0 5 0.6, and the remaining M

0 5 1.0 are imported.

Recall that producer surplus is the amount that producers gain from being able to sell bikes at the going market price. Graphically, producer surplus is the area above

the supply curve and below the market price line. Let’s review why this is producer

surplus.

The supply curve tells us, for each possible quantity supplied, the lowest price that

will draw out another bike produced and supplied. This is true because the supply

curve indicates the marginal cost of each additional unit. A competitive producer will

supply an additional unit as long as the price (the extra revenue) covers the marginal

(or extra) cost. Thus, according to the supply curve S d in Figure 8.1, some firm is will-

ing to supply the very first bike for $210 (at point A ). This firm receives the market price of $300, bringing a net gain (producer surplus) of $90 on this first unit.

FIGURE 8.1 The U.S.

Market for

Bicycles with

Free Trade

If the world price is $300 per bike, with free trade the country’s consumers buy

1.6 million bikes, and its local firms produce 0.6 million bikes, so 1.0 million

bikes are imported. With free trade domestic producer surplus is area CBA and domestic consumer surplus is area FEC.

Quantity (millions of bikes per year)

540

Price ($ per bike)

300

S0 = 0.6 D0 = 1.6

210

Imports M0 = 1.0

World priceE

C B

A Dd (domestic demand curve)

Sd (domestic supply curve)

Chapter 8 Analysis of a Tariff 141

pug21774_ch08_137-159.indd 141pug21774_ch08_137-159.indd 141 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

Similarly, as we go up the supply curve from point A toward point B , we find that the vertical distance between the supply curve and the price of $300 shows the gains

that producers are getting on each additional unit.

By summing the gain on each unit supplied, we see that producers receive the area

of triangle CBA as producer surplus—the amount by which the price exceeds the incremental costs, unit by unit. We might immediately think that this is a measure of

profit, and much or all of it could be profit. But it is possible that other resources used

in production may also share in the producer surplus. For instance, the expansion of

quantity produced could drive up wage rates for the type of labor used in the industry

because the industry increases its demand for this labor.

Now imagine a tariff of 10 percent on imported bikes. 1 Because this is a small coun-

try, foreign exporters insist on continuing to receive $300 for each bike they export. So

the 10 percent tariff is $30 per bike, and this amount is passed on to consumers. The domestic price of imported bikes rises to $330.

When the tariff is imposed, domestic producers can also raise the price that they

charge for their bikes. If domestic and imported bikes are perfect (or very close)

substitutes, then domestic producers raise their price to $330. When the tariff drives

the domestic market price to $330, domestic firms respond by raising their output

and sales, as long as the higher price exceeds the marginal cost of supplying the

extra units.

Figure 8.2 shows the same bicycle market introduced in Figure 8.1. When the tariff

is imposed, domestic producers expand output by 200,000 units, from S 0 to S

1 . Each

of these units from S 0 to S

1 is now profitable for some domestic firm to produce. The

marginal cost of each of these units is between $300 and $330, which is less than the

new, tariff-inclusive price of $330.

With the tariff in place, domestic producer surplus is area g 1 a , the area below the new $330 price line and above the domestic supply curve. As a result of the

tariff, domestic producer surplus increases by area a , which equals $21 million per year. We can think of this as composed of two pieces. First, the rectangular part of

area a covering the first 0.6 million bikes reflects the higher price received on units that are supplied even if there is no tariff. Second, the triangle at the right-hand end

of area a reflects the additional producer surplus earned on the extra 0.2 million bikes supplied.

THE EFFECT OF A TARIFF ON DOMESTIC CONSUMERS

Intuition also suggests that buyers of a good imported from abroad will be hurt

by a tariff. Domestic consumers end up paying a higher price, buying less of

the product, or both. Again, we can use demand and supply analysis to calculate the

consumer loss.

1 The U.S. bicycle example is realistic in some ways. The Bicycle Manufacturers Association at times lobbied Congress for higher bicycle tariffs to stem import competition, but to no avail. Imports have now claimed over 90 percent of the U.S. market for bicycles.

142 Part Two Trade Policy

pug21774_ch08_137-159.indd 142pug21774_ch08_137-159.indd 142 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

FIGURE 8.2 The Effect

of a Tariff

on Domestic

Producers

The $30 tariff on imports allows domestic producers to expand their production from S 0 to S

1 .

The $30 bike tariff gives domestic producers extra surplus on all the bikes they would have

produced even without the tariff (an extra $30 3 S 0 ) plus smaller net gains on additional

sales [gain equaling ½ 3 $30 3 ( S 1 2 S

0 )].

Shaded area a = Producer’s gain from tariff = $21 million

Quantity (millions of bikes per year)

540

Price ($ per bike)

300

210

330 Domestic price with tariff

World price Tariff

Sd (domestic supply curve or marginal cost curve)

Dd (domestic demand curve)

S0 = 0.6 S1 = 0.8 D0D1

First, let’s return to the free-trade situation (before the tariff is imposed) shown

in Figure 8.1. With free trade domestic consumers buy D 0 bikes at the world price

of $300. Recall that consumer surplus is the amount that consumers gain from being able to buy bikes at the going market price. Graphically, consumer surplus is

the area below the demand curve and above the market price line. To see this, recall

that the demand curve tells us the highest price that some consumer is willing to

pay for each additional bike. Thus, according to the demand curve in Figure 8.1,

some consumer is willing to pay $540 for the first bike (at point F ). This consumer can buy the bike at the market price of $300, so the consumer receives a net gain

(consumer surplus) of $240 on that first unit. As we go down the demand curve from

point F to point E , we find that the vertical distances between the demand curve and the world price of $300 show us the bargains that these consumers are getting.

These consumers pay less for bikes than the maximum amount they would have

been willing to pay. By summing the net gain on each unit purchased, we see that

the entire area ( FEC ) between the demand curve and the $300 price line tells us the total amount of consumer surplus.

Now the government imposes a tariff of 10 percent on imported bikes. Figure 8.3

shows the consumers’ view of the bicycle market with the tariff. The tariff raises the

price that consumers must pay for bikes (both imported and domestically produced)

to $330.

Chapter 8 Analysis of a Tariff 143

pug21774_ch08_137-159.indd 143pug21774_ch08_137-159.indd 143 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

FIGURE 8.3 The Effect

of a Tariff

on Domestic

Consumers

An import tariff of $30 raises the price that domestic consumers must pay for imported and

domestic bikes. Quantity demanded falls from D 0 to D

1 . The tariff costs consumers both the

full $30 on every bike they continue to buy (a loss of $30 3 D 1 ) and the net enjoyment on

bikes they would have bought at the lower tariff-free price but do not buy at the higher

price including the tariff [an additional loss of ½ 3 $30 3 ( D 0 2 D

1 )].

Quantity (millions of bikes per year)

540

300

210

Sd (domestic supply curve)

E 330

Tariff

a b c d

Price ($ per bike)

Domestic price with tariff

World price

Dd (domestic demand curve)

S0 S1 D1 = 1.4 D0 = 1.6

Shaded area = Cost of the tariff to consumers = $45 million

By raising the price to $330, the tariff forces consumers who were buying the

1.6 million bikes to make a decision:

• Some will continue to buy bikes, paying $30 more per bike.

• Some will decide that a bike is not worth $330 to them, so they will not buy at the

higher price.

In Figure 8.3, quantity demanded falls from D 0 to D

1 , a decrease of 0.2 million bikes.

The net loss to consumers is the shaded area a 1 b 1 c 1 d because consumer surplus declines from triangle FEC to triangle FGH. Area a 1 b 1 c is the loss of $30 per bike of consumer surplus for those who continue to buy bikes at the higher price. Area d is the loss of consumer surplus for those who stop buying bikes. In our example, the

consumer surplus loss is $45 million per year.

What domestic consumers lose from the tariff (here $45 million) is larger than what

domestic producers gain ($21 million). The reason is straightforward: Producers gain

the price markup on only the domestic output, while consumers are forced to pay the

same price markup on both domestic output and imports. Figures 8.2 and 8.3 show

this clearly for the bicycle example. The tariff brings bicycle producers only area

144 Part Two Trade Policy

pug21774_ch08_137-159.indd 144pug21774_ch08_137-159.indd 144 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

a in gains, but it costs consumers this same area a plus areas b 1 c 1 d . As far as the effects on bicycle consumers and bicycle producers alone are concerned, the tariff is

definitely a net loss.

THE TARIFF AS GOVERNMENT REVENUE

The effects of a tariff on the well-being of consumers and producers do not exhaust its

effects on the importing country. As long as the tariff is not so high as to prohibit all

imports, it also brings revenue to the country’s government. This revenue equals the

unit amount of the tariff times the volume of imports with the tariff. In Figure 8.3 the

total government revenue from collecting the tariff is area c , equal to $18 million per year (the tariff of $30 times the imports of M

1 5 0.6 million).

The country’s government could do any of several things with the tariff revenue.

The revenue could be used to pay for extra government spending on socially worth-

while projects. It could be matched by an equal cut in some other tax, such as the

income tax. Or it could just become extra income for greedy government officials.

Although what form the tariff takes can certainly matter, the central point is that this

revenue accrues to somebody within the country. It counts as an element of national

gain to be weighed in with the consumer losses and producer gains from the tariff. 2

THE NET NATIONAL LOSS FROM A TARIFF

By combining the effects of the tariff on consumers, producers, and the government,

we can determine the net effect of the tariff on the importing country as a whole.

The first key step is to impose a social value judgment. How much do you really

care about each group’s gains or losses? If one group gains and another loses, how

big must the gain be to outweigh the other group’s loss? To make any overall judg-

ment, you must first decide how to weigh each dollar of effect on each group. That is

unavoidable. Anybody who expresses an opinion on whether a tariff is good or bad

necessarily does so on the basis of a personal value judgment about how important

each group is.

The basic analysis uses the one-dollar, one-vote metric: Every dollar of gain or loss is just as important as every other dollar of gain or loss, regardless of who the gainers or losers are . Let’s use this measure of well-being here just as we did in Chapter 2. Later we discuss what difference it would make if we chose to weigh one

group’s dollar stakes more heavily than those of other groups.

If the one-dollar, one-vote metric is applied, then a tariff like the one graphed in

Figures 8.2 and 8.3 brings a clear net loss to the importing country and to the world

as a whole. Figure 8.4 shows the same bicycle example. We have seen that the dol-

lar value of the consumer losses exceeds the dollar value of the producer gains from

2 We note a possible exception. Part of the tariff could be used up as real resource costs of administering and enforcing the tariff, so this amount would not represent a national gain.

Chapter 8 Analysis of a Tariff 145

pug21774_ch08_137-159.indd 145pug21774_ch08_137-159.indd 145 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

For a small importing country, a tariff brings a net national loss. What it costs consumers is greater than what it

brings producers plus the government’s tariff revenue. The two reasons for the net loss are summarized in areas b and d . Area b (the production effect) represents the loss from making at higher marginal cost what could have been bought for less from foreign exporters. Area d (the consumption effect) represents the loss from discouraging import consumption that is worth more than what the nation would pay the foreign exporters.

FIGURE 8.4 The Net National Loss from a Tariff in Two Equivalent Diagrams

Quantity (millions of bikes per year)

Price ($ per bike)

300

330 Tariff

A. The U.S. Market for Bicycles B. The Market for U.S. Bicycle Imports

Quantity imported (millions of bikes per year)

Demand curve for imports Dm = Dd – Sd

c b + d

M1 = 0.6

M0 = 1.0

ΔM = 0.4

M0 = 1.0

0.6 1.40.8 1.6

Consumers lose Area a + b + c + d = $45 million (loss) Producers gain Area a = $21 million Government collects Area c in tariff revenue = $18 million Net national loss from the tariff = Area b + d = $6 million

the tariff. We have also seen that the country’s government gains some tariff revenue.

The left side of Figure 8.4 makes it clear that the dollar value of what the consumers

lose (area a 1 b 1 c 1 d ) exceeds even the sum of the producer gains (area a ) and the government tariff revenues (area c ). The net national loss from the tariff is area b plus area d .

The same net national loss can be shown in another way. The right side of Figure 8.4

shows the market for imports of bicycles. We can derive our demand curve for imports

of bicycles by subtracting the domestic supply curve from the domestic demand curve

for bicycles at each price (horizontally). That is, for each possible price, the quantity

demanded of imported bicycles equals the domestic quantity demanded minus the domestic quantity supplied at that price.

146 Part Two Trade Policy

pug21774_ch08_137-159.indd 146pug21774_ch08_137-159.indd 146 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

We can use the right side of Figure 8.4 to show some of the same information that

is shown on the left side. With free trade, the price of imports is $300. The country

imports M 0 bikes. With the imposition of the tariff, the domestic price of imported

bikes rises to $330. The country then imports only M 1 bikes. The government collects

tariff revenue equal to area c . The net national loss from the tariff is shown on the right side as the area of triangle

b 1 d . To see that this triangle has the same area as the sum of the areas of the two triangles b and d on the left side, consider the heights and bases of the triangles. All of the triangles have the same height (the tariff per unit). The base of triangle b is the reduction in imports that are replaced by domestic production. The base of triangle

d is the import reduction that results from the lower domestic consumption. The two bases add up to the total reduction in imports, the base of triangle b 1 d . With the same height and combined bases, the sum of the areas of triangles b and d equals the area of triangle b 1 d .

The net national loss from the tariff shown in Figure 8.4 is not hard to estimate

empirically. The key information we need consists only of the amount of the tariff

per unit and the estimated volume by which the tariff reduces imports, D M . The usual way of arriving at this information is to find out the percent price markup

the tariff represents, the initial dollar value of imports, and the percent elasticity,

or responsiveness, of import quantities to price changes. It is handy, and perhaps

surprising, that the net national loss from the tariff can be estimated just using

information on imports, as on the right side of Figure 8.4, without even knowing

the domestic demand and supply curves. In our bicycle example, the net loss b 1 d equals $6 million.

Why is there a net loss? What economic logic lies behind the geometric finding that

the net national loss equals areas b 1 d ? With a little reflection, we can see that these areas represent gains from international trade and specialization that are lost because

of the tariff.

Area d , sometimes called the consumption effect of the tariff, shows the loss to consumers in the importing nation based on the reduction in their total consumption of

bicycles. They would have been willing to pay prices above $300 and up to $330 to get

the extra 200,000 bicycles. These extra 200,000 bicycles would have cost the nation

only $300 a bike in payments to foreign sellers. Yet the tariff discourages them from

buying these bicycles. Area d is a deadweight loss because what the consumers lose in area d , nobody else gains. Area d is the inefficiency for those consumers squeezed out of buying bicycles because the tariff artificially raises the domestic price.

Area b is a welfare loss based on the fact that some consumer demand is shifted from imports to more expensive domestic production. The tariff raises domestic

production from 0.6 to 0.8 million bikes at the expense of imports. The domestic sup-

ply curve (which also shows the marginal cost of domestic production) is assumed to

be upward sloping. Each extra bicycle costs more and more to produce, rising from a

resource cost of $300 up to a cost of $330. The domestic resource cost of producing

these bicycles is more than the $300 price at which the bicycles are available from

foreign suppliers. This extra cost of shifting to more expensive home production,

called the production effect of the tariff, is represented by area b . Like area d , it

Chapter 8 Analysis of a Tariff 147

pug21774_ch08_137-159.indd 147pug21774_ch08_137-159.indd 147 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

Extension The Effective Rate of Protection

To gain more understanding of how much pro- tection is given to domestic producers by a coun- try’s tariffs, we need to take a closer look at how products are produced. We are interested in how tariffs affect domestic “value added” in an indus- try. Value added is the amount that is available to make payments to the primary production factors in the industry. That is, value added is the sum of wages paid to labor, the rents paid to landowners, and the profits and other returns to the owners and providers of capital.

In addition to these primary factors, firms also use various kinds of components and material inputs in production. This is more important than it sounds. It means that many tariffs matter to the industry, not just the tariff on the product it produces. Specifically, firms in a given industry are affected by tariffs on their purchased inputs as well as by the tariff on the product they sell. Firms producing bicycles, for example, would be hurt by tariffs on metal tubing or bicycle tires. This complicates the task of measuring the effect of the whole set of tariffs on an individual indus- try’s firms.

To give these points their due requires a detailed portrayal of supply2demand interac- tions in many markets at once. To cut down on the elaborate details, economists have developed a simpler measure that does part of the job. The measure quantifies the effects of the whole tariff structure on one industry’s value added per unit of output without trying to estimate how much its output, or other outputs and prices, would change. The effective rate of protection of an individual industry is defined as the percentage by which the entire set of a nation’s trade barri- ers raises the industry’s value added per unit of output.

The effective rate of protection for the indus- try can be quite different from the percent tariff paid by consumers on its output (the “nominal” rate of protection). This difference is brought out clearly by the example on the facing page.

What are the effects of a 10 percent tariff on bicycle imports and a 5 percent tariff on imports of tubing, tires, and all other material and component inputs into the bicycle industry? The 10 percent tariff on bicycles by itself raises their price and the value added by the bicycle industry by $30 per bike, as before. The 5 percent tariff on material and component inputs costs the bicycle industry $11 per bike by raising the prices of these inputs. The two sets of tariffs together would raise the industry’s unit value added by only $19 per bike. But this extra $19 represents a protection of value added (incomes) in the bicycle industry of 23.8 percent of value added, not just 10 percent or less, as one might have thought from a casual look at the nominal tariff rates themselves.

This example illustrates two of the basic points brought out by the concept of effective rate of protection:

• A given industry’s incomes, or value added, will be affected by trade barriers on its inputs as well as trade barriers on its output.

• The effective rate of protection will be greater than the nominal rate when the industry’s output is protected by a higher rate than the tariff rates on its inputs.

We add three other insights. First, if the tariff rates on the inputs are the same as the tariff rate on the output, then this rate is also the effective rate of protection. (Try this by modifying our example by using a 5 percent tariff on bicycles.) Second, the effective rate of protection can be negative. The tariff structure can penalize value added in the industry. (Try this using a 2 percent tariff on bicycles.) Third, export producers are penalized with something like negative effective protection if their costs are increased by tariffs on the inputs they use in production. (Try this by changing our example to one in which the country’s bicycle producers try to sell to foreign buyers at the world price of $300 per bike.)

148 Part Two Trade Policy

pug21774_ch08_137-159.indd 148pug21774_ch08_137-159.indd 148 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

To see who is getting protected by trade barriers, it helps (1) to distinguish an industry and its suppliers and (2) to

look at the effects of the whole set of barriers, not just the one directly protecting the industry. In this case, the

tariff on bicycles helps the domestic bike industry, but the tariffs on the material and component inputs the

bicycle industry buys hurt it. The net result in this case is an “effective rate of protection” of 23.8 percent.

Unit value added (v) = 80

Unit value added (v') = 99

Unit cost of material and component inputs = $220

Illustrative calculation of an effective rate of protection

Unit cost of material and component inputs = $231

With free trade

With 10% tariff on bicycles, 5% tariff on inputsUnit value

(price) of a bicycle

= $300

220

0 0

231 220

10% tariff on bicycles

5% tariff on inputs

$330

300

Effective rate of protection for bicycle industry 5 v' 2 v

v 5 $99 2 $80

$80 5 23.8%

is a deadweight loss. It is part of what consumers pay, but neither the government

nor bicycle producers gain it. It is the amount by which the cost of drawing domestic

resources away from other uses exceeds the savings from not paying foreigners to sell

us the 200,000 extra units.3

The basic analysis of a tariff identifies areas b and d as the net national loss from a tariff only if certain assumptions are granted. One key assumption is the

one-dollar, one-vote metric. Use of this measure implies that consumers’ losses

of areas a and c were exactly offset, dollar for dollar, by producers’ gain of area a and the government’s collection of area c . That is what produced ( b 1 d ) as the net loss for the nation. Suppose that you personally reject this metric. Suppose,

for example, that you think that each dollar of gain for the bicycle producers

3 The text of this chapter focuses on tariffs, which are taxes or duties on imports. Some countries also impose duties on exports, and the box “They Tax Exports, Too” examines their effects.

Chapter 8 Analysis of a Tariff 149

pug21774_ch08_137-159.indd 149pug21774_ch08_137-159.indd 149 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

Case Study They Tax Exports, Too

Nearly all governments impose tariffs (taxes) on some imports into their countries. Most govern- ments do not impose additional taxes (duties) on their exports. Still, WTO rules allow countries to impose export taxes. In the mid-2000s about half of WTO member countries did have some duties on their exports. Typically, this is a developing country (e.g., Argentina, Russia) imposing duties on its exports of one or more agricultural or other primary products. Why would some coun- tries impose extra taxes on their exports? What effects do export taxes have? Let’s start with the effects because understanding the effects pro- vides clues to the reasons.

Consider a small exporting country, one whose supply of exports has essentially no effect on world prices of its exports. The figure shows the country and the world price P

0 . If there is no export tax,

the country produces the quantity S 0 , consumes

the quantity D 0 , and exports the difference, S

0 2

D 0 . Now the country’s government imposes an

export tax equal to T dollars per unit exported (a rate that reduces but is not high enough to completely eliminate exports of this product). What changes (and what does not change)?

For a small country, the world price P 0 does

not change. So, after the government collects the tax, domestic producers receive revenue net of tax on their exports of only (P

0 2 T). These

producers will try to shift some sales to local consumers, who initially are willing to pay more. But as competitive domestic producers strive to make more domestic sales, the domestic price is also driven down to (P

0 2 T ). At the new price

of (P 0 2 T ) received for both domestic sales

and exports, the country’s quantity produced falls to S

1 , quantity consumed increases to D

1 ,

and quantity exported decreases to (S 1 2 D

1 ).

Well-being changes, for groups within the country and for the country overall. Consumers gain surplus of area g 1 h, producers lose surplus of area g 1 h 1 j 1 k 1 n, the gov- ernment gains export tax revenue equal to area k, and the country suffers deadweight

losses equal to areas j and n. Area j is the inef- ficiency of domestic overconsumption of the product—the units from D

0 to D

1 are worth less

to domestic consumers than the P 0 price that

the country would receive from foreign buyers if instead these units were exported. Area n is the inefficiency of national underproduction of the product—the units from S

1 to S

0 cost

the country less to produce than the price P 0

that foreign buyers would be willing to pay for them if they were produced and exported.

As you can see, the effects of an export tax for a small country are analogous to the effects of an import tariff for a small country. What about a large exporting country that imposes an export tax? This case is also analo- gous, and you may want to try to draw the graph yourself. The large exporting country has national monopoly power in the world market. It can use an export tax to limit its export supply and drive up the world price of the product. The country benefits from the higher world price for its export product, and there is a nationally optimal export tax that could maximize its net gains from enhanc- ing its terms of trade in this way (assum- ing that the rest of the world is passive).

Why do we see some countries using export taxes (and other restrictions on exports)? The analy- sis provides insights. First, the country’s government may use export taxes, as it would use any other tax, to raise revenue for the government. Second, the country’s government may use export taxes to benefit local consumers of the product. The local consumers could be households. For example, in reaction to the increases in world food prices dur- ing 2007–2008, a number of countries (including Thailand, Vietnam, and India) increased export taxes or otherwise restricted exports of agricultural products like rice and sugar to keep local food prices low. Or the local consumers could be firms in other industries that use this product as an input into their production. The export tax artificially lowers their production costs and encourages the

150 Part Two Trade Policy

pug21774_ch08_137-159.indd 150pug21774_ch08_137-159.indd 150 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

expansion of these user industries. Third, for a large country, the country’s government may be using the export tax to gain national well-being at the expense of foreign buyers.

Are export taxes a good idea? For the first two reasons (more revenue or lower domestic prices), the government is achieving some other objec- tive at the cost of the deadweight losses. For the third reason (exploiting national monopoly

power), the country is risking retaliation by for- eign countries, and the export tax is reducing global efficiency.

DISCUSSION QUESTION In March 2012 the Indian government prohibited the export of cotton. What are the possible rea- sons for this export ban? Which one or two seem to be the most plausible reasons?

n Sd

Units

$/Unit

D1 S0S1

P0 – T

is somehow more important to you than each dollar of consumer loss, perhaps

because you see the bicycle consumers as a group society has pampered too much.

If that is your view, you will not accept areas b and d as the net national loss from the tariff. The same basic analysis of the tariff is still useful to you, however. You

can stipulate how much more weight you put on each dollar of effect on bicycle

producers than on each dollar for consumers. Then you can apply your own dif-

ferential weights to each group’s dollar stake to see whether the net effect of the

tariff is still negative.

Chapter 8 Analysis of a Tariff 151

pug21774_ch08_137-159.indd 151pug21774_ch08_137-159.indd 151 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

THE TERMS-OF-TRADE EFFECT AND A NATIONALLY OPTIMAL TARIFF

It is time to relax a key assumption we have been making. So far, this chapter has used

the small-country assumption: We have assumed that the importing nation, here the

United States, cannot affect the world price of the imported good. In particular, the

tariff on bicycle imports did not affect the world price of bicycles, which stood fixed

at $300, tariff or no tariff.

The small-country assumption is often valid. Many individual nations as importers

have small shares of world markets for individual commodities. Any feasible change

in a small country’s demand for imports is so small that it has (almost) no effect on

the big world market. For instance, if Costa Rica reduced its demand for imported

bicycles by imposing a tariff, the effect on the world market would be imperceptible.

Costa Rican importers would still have to pay foreign suppliers the same world price

if they wanted to buy any of their bicycles. Similarly, Singapore could not expect to

force foreign sellers of rice to supply it more cheaply. Any attempt to do so would

simply prove that Singapore was a price-taker on the world market by causing rice

exporters to avoid Singapore altogether, with little effect on the world rice price.

Yet in other cases a nation has a large enough share of the world market for one of

its imports that the country’s buying can affect the world price unilaterally. A nation

collectively can have this monopsony power even in cases in which no individual buyer within the nation has it. For example, the United States looms large in the

world auto market. If the U.S. government imposes a tariff on imported autos, the

reduction in U.S. demand for foreign autos would have noticeable adverse effects on

foreign exporters. In the face of lower U.S. demand, those exporters would fight to

maintain sales by reducing their export prices. The United States probably has the

same monopsony power to some extent in the world markets for many other goods.

A nation with such power over foreign selling prices could exploit this advantage with

a tariff on imports. Let’s look at a case in which a large country can affect the world price of a good it imports, just by imposing a tariff. In this case, the tariff has a terms-of- trade effect. Recall that in earlier chapters we defined the terms of trade as the ratio of the international prices of our exports to the international prices of our imports.

Suppose that the United States (now a large country) imposes a small tariff on bicy-

cles. Imposing the tariff makes the price paid by U.S. consumers exceed the price paid

to foreign suppliers. Now, however, the tariff is likely to lower the foreign price a bit

as well as raise the domestic price a bit. To see why the foreign export price decreases,

we need to watch what happens to the marginal costs of foreign exporters. Here is one

way to think of the process:

• The United States imports fewer bicycles because the tariff increases the domestic

price, so foreign firms export fewer and produce fewer.

• By removing demand pressure on foreign production, the marginal cost at the

smaller level of foreign production is lower. (We will see that this is a movement

down and to the left along the foreign export supply curve.)

• With lower marginal cost and weak demand, foreign firms will compete and lower

their export price.

152 Part Two Trade Policy

pug21774_ch08_137-159.indd 152pug21774_ch08_137-159.indd 152 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

The lowering of the price paid to foreign suppliers of U.S. imports (an improve-

ment in the U.S. terms of trade) is what makes it possible for the United States to gain

as a nation from its own tariff. To be sure, there is still a loss in economic efficiency for

the world. By discouraging some imports that would have been worth more to buyers

than the price being paid to cover the foreign seller’s costs—and by shifting some pro-

duction to higher-cost domestic producers—the tariff still has its costs. And the United

States bears part of these inefficiency costs. But as long as the tariff is small, for the

United States its part of those costs is outweighed by the gains from continuing most

of the previous imports at a lower price paid to foreign exporters. So, for tariff rates

that are not too high, the United States as a nation is better off than with free trade.

Figure 8.5 shows the effects of a rather small tariff, in this case $6 per bicycle. As

in Figure 8.4, the left side of Figure 8.5 shows the market for bicycles in the United

States, and the right side shows the market for bicycle imports into the United States.

Because the United States is a large country relative to foreign export capacity, the

foreign supply-of-exports curve slopes upward (instead of being flat at a given world

price, as it would be in Figure 8.4B).

With free trade, the market for bicycle imports clears at the price of $300, and the

United States imports 1 million bikes. If the U.S. government then imposes a tariff of

$6 per bike, the tariff drives a wedge of $6 between the price that foreign exporters receive

and the price that U.S. buyers of imports pay. Even with this tariff wedge, the market still

must clear. The quantity of exports (from the supply-of-exports curve) must equal the

quantity of imports (from the demand-for-imports curve), given the $6 difference in price.

In Figure 8.5B, the $6 tariff drives up the domestic price of imports to $303 and

lowers the price charged by foreign exporters to $297. The quantity traded declines

by a small amount, to 0.96 million bikes. We can use these conclusions to show in

Figure 8.5A what is happening in the U.S. market for bikes. If the domestic price rises

to $303, the domestic quantity produced rises to 0.62 million bikes and the domestic

quantity demanded declines to 1.58 million bikes.

What is the effect of the tariff on the national well-being of the United States?

Consumer surplus decreases by area a 1 b 1 c 1 d , and producer surplus increases by area a . The government collects tariff revenue equal to area c 1 e (the tariff of $6 per unit times 0.96 million units imported). Who really pays the tariff? For a large country, domestic consumers still pay part of the tariff, area c . The new wrinkle for a large importing country is that foreign exporters also pay part of the tariff (area e ) because they lower their export price when the tariff is imposed. If foreigners pay part

of our taxes, then this is a gain to the importing country (though not to the world as

a whole).

What is the overall effect on the importing country if it imposes a small tariff?

The importing country still loses areas b and d , the triangles of inefficiency that we also saw for the small-country case. This small loss is easily outweighed by the gain

of area e , the part of the tariff that is absorbed by foreign exporters when they lower their export price. For a suitably small tariff imposed by a large importing country, the importing country gains national well-being because area e is larger than areas b and d . For tariff rates that are not too high, the United States is better off than with free trade. In the case of a $6 tariff, the net gain to the United States is $2.82 million,

which is the gain of area e ($2.88 million) minus the loss of area b 1 d ($0.06 million).

Chapter 8 Analysis of a Tariff 153

pug21774_ch08_137-159.indd 153pug21774_ch08_137-159.indd 153 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

If the foreign export supply curve slopes up, an importing country collectively has some power over the price that it pays foreigners for its imports, even if individual importers have no such power. The importing country can exploit

this monopsony power. Here, the United States imposes a relatively small tariff of $6 per bike imported. The United

States has a net gain in well-being equal to area e minus areas b and d .

Quantity (millions of bikes)

Price ($ per bike)

297

303

300 297

303 300

375

225

Tariff

A. The National Market for Bicycles B. The Market for Bicycle Imports

d c

b a

Quantity (millions of bikes)

U.S. demand for imports Dm = Dd – Sd

Foreign export supply Sx to the United Statesc

b + d

M1 = 0.96 �M = 0.04

M0 = 1.0

1.6 0.961.580.620.6 1.0

FIGURE 8.5 A Large Country Imposes a Small Tariff

If a small tariff works for the nation with power over prices, higher tariffs work

even better—but only up to a point. To see the limits to a nation’s monopsony power,

we can start by noting that a prohibitive tariff cannot be optimal . Suppose that the United States were to put a tariff on bicycle imports that was so high as to make

all imports unprofitable. A tariff of over $150 a bike in Figure 8.5 would drive the

price received by foreign suppliers below $225. Foreign suppliers would decide not

to sell any bicycles to the United States at all. Lacking any revenues earned partly

at the expense of foreign suppliers, the United States would find itself saddled with

nothing but the loss of all gains from international trade in bicycles.

Is there a “best” tariff rate for the large importing country to impose, if it is purely

driven by its own national well-being? The answer is yes, assuming that the rest of the

world is passive. This best tariff is called the nationally optimal tariff, the tariff that creates the largest net gain for the country imposing it. For a large country, this

optimal tariff lies between no tariff and a prohibitively high one.

The optimal tariff can be derived in the same way as the optimal price reduction for

any monopsonist, any buyer with market power. Appendix D derives the formula for

the optimal tariff rate. It turns out that the optimal tariff rate, measured as a fraction

154 Part Two Trade Policy

pug21774_ch08_137-159.indd 154pug21774_ch08_137-159.indd 154 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

The large importing country in theory can gain the most by imposing an

optimal tariff. Here the nationally optimal tariff is $50 per bike, and the

importing country gains area e 2 area b 1 d . The foreign country is harmed, losing areas e and f , and it may retaliate. Even without retaliation, the world is worse off because of the nationally optimal tariff. The global inefficiency

equals area b 1 d and area f .

Price ($ per bike)

300

275

325

375

225

Quantity (millions of bikes)

U.S. demand for imports Dm = Dd – Sd

Foreign export supply Sx to the United States

e f

b + d

0.67 1.0

FIGURE 8.6 The Nationally

Optimal Tariff

of the price paid to foreigners, equals the reciprocal of the price elasticity of foreign

supply of our imports.

It makes sense that the lower the foreign supply elasticity, the higher our optimal

tariff rate. The more inelastically foreigners keep to supplying a nearly fixed amount

to us, the more we can get away with exploiting them. Conversely, if their supply is

infinitely elastic (the small-country case), facing us with a fixed world price, then we

cannot get them to accept lower prices. If their supply elasticity is infinite, our own

tariff hurts only us, and the optimal tariff is zero.

Figure 8.6 shows an optimal tariff for a large country. The nation gains the price

reduction on foreign bicycle imports, represented by area e . This considerably exceeds what the nation loses by reducing its imports of bicycles (area b 1 d ). The national gain, e 2 b 2 d , is greater than the national gain at any other tariff rate. 4

For the world as a whole, however, the nationally optimal tariff is still unambigu-

ously bad. What the nation gains is less than what foreigners lose from our tariff.

Figure 8.6 shows this. The United States gains area e only at the expense of foreign suppliers, dollar for dollar, leaving no net effect on the world from this redistribu-

tion of income through the price change. But foreign suppliers suffer more than that.

4 As Figure 8.6 is drawn, the tariff rate does fit the optimal-tariff formula. The rate equals $50/$275, or about 18.2 percent. The elasticity of foreign supply works out to be 5.5 at this point on the foreign supply curve, so the tariff rate of about 18.2 percent is the reciprocal of 5.5.

Chapter 8 Analysis of a Tariff 155

pug21774_ch08_137-159.indd 155pug21774_ch08_137-159.indd 155 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

They also lose area f in additional surplus on the exports discouraged by the tariff. Therefore, the world loses areas b 1 d and f . This large triangle (the shaded area in Figure 8.6) is a loss of part of the global gains from trade. Above the level of imports

of 0.67 million a year (and up to 1.0 million), U.S. consumers value foreign bicycles

more highly than it costs foreign suppliers to make and sell them. The tariff may be

nationally optimal, but it still means a net loss to the world.

Even for large nations, it might be unwise to levy what looks like an optimal tariff.

Even if individual foreign suppliers cannot fight back, their governments can. Foreign

governments may retaliate by putting up new tariff barriers against our exports.

Knowing this, even large countries like the United States restrain the use of their

power in individual import markets.

Summary A tariff is a tax on imports. It redistributes well-being from domestic consumers of the product to domestic producers and the government, which collects the tariff rev-

enue. For a small country (one that cannot affect world prices), a tariff on imports lowers national well-being. It costs consumers more than it benefits producers and the

government.

To reinforce your understanding of these basic effects of a tariff on well-being,

imagine how you might describe each of them to legislators who are considering a

tariff law. Remember what this performance in the policy arena requires. You have

to speak in language that is clear to a wide audience. You can’t use any diagram or

equation—no legislator will be impressed by such abstractions. You can, however, use

the following concise verbal descriptions to explain each of the key effects shown by

lettered areas in Figures 8.2 through 8.4:

1. “By raising the price on strictly domestic sales, a tariff redistributes incomes from

consumers to producers. The amount redistributed is the price increase times the

average quantity of domestic sales.” (This describes area a .)

2. “A tariff shifts some purchases from foreign products to home products. This costs

more resources to make at home than to buy abroad.” (This describes area b , the production effect. )

3. “A tariff makes consumers pay tax revenue directly to the government.” (This

describes area c .)

4. “A tariff discourages some purchases that were worth more than they cost the

nation.” (This describes area d , the consumption effect. ) 5. “Both by shifting some purchases toward costly home products and by discour-

aging some purchases worth more than they cost the nation, the tariff costs the

nation as a whole. The cost equals one-half the tariff amount times the drop in our

imports.” (This describes area b 1 d , the net national loss.)

The effects of tariffs on producer interests are further clarified by the concept of

the effective rate of protection, which measures the percent effect of the entire tariff structure on the value added per unit of output in each industry. This concept

incorporates the point that incomes in any one industry are affected by the tariffs on

many products.

156 Part Two Trade Policy

pug21774_ch08_137-159.indd 156pug21774_ch08_137-159.indd 156 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

When a country as a whole can affect the price at which foreigners supply imports,

the country has monopsony power. For such a large country, a positive tariff can increase national well-being because the tariff has a beneficial terms-of-trade effect. The nationally optimal tariff yields the largest possible gain. However, this tariff is optimal only if foreign governments do not retaliate with tariffs on our

exports. With or without retaliation, the nationally optimal tariff is still bad for the

world as a whole.

The World Trade Organization (WTO) was formed in 1995 as the successor to the General Agreement on Tariffs and Trade (GATT). The WTO oversees the global rules of government policies toward trade and provides a forum for negotiat-

ing global agreements to reduce barriers to trade. Beginning as the GATT, created

in 1947, rounds of multilateral trade negotiations have been especially successful in

reducing the tariffs that industrialized countries impose on their imports of nonagri-

cultural goods.

Key Terms

Tariff Specific tariff

Ad valorem tariff

General Agreement on

Tariffs and Trade (GATT)

World Trade Organization

(WTO)

Small country

Producer surplus

Consumer surplus

One-dollar, one-vote

metric

Consumption effect

Production effect

Effective rate of

protection

Monopsony power Large country Terms-of-trade effect Nationally optimal tariff

Suggested Reading

For summary information on countries’ tariffs, see the annual World Tariff Profiles issued by the World Trade Organization. Greenaway and Milner (2003) discuss the concept

of the effective rate of protection and its uses. Broda et al. (2008) provide a technical

empirical analysis that finds support for optimal-tariff influences on tariff rates in

countries that are not members of the WTO. Organization for Economic Cooperation and

Development (2010) surveys export taxes and other restrictions.

Questions and Problems

1. What is the minimum quantitative information you would need to calculate the net

national loss from a tariff in a small price-taking country?

2. “A tariff on imports of a product hurts domestic consumers of this product more than it

benefits domestic producers of the product.” Do you agree or disagree? Why?

3. What is the production effect of a tariff? How would you describe it in words, without

reference to any diagram or numbers? How would you show it on a diagram, and how

would you compute its value?

4. What is the consumption effect of a tariff? How would you describe it in words, without

reference to any diagram or numbers? How would you show it on a diagram, and how

would you compute its value?

✦

Chapter 8 Analysis of a Tariff 157

pug21774_ch08_137-159.indd 157pug21774_ch08_137-159.indd 157 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

5. You have been asked to quantify the effects of removing a country’s tariff on sugar.

The hard part of the work is already done: Somebody has estimated how many pounds

of sugar would be produced, consumed, and imported by the country if there were no

sugar duty. You are given the information shown in the table.

Situation with Estimated Situation Import Tariff without Tariff

World price $0.10 per pound $0.10 per pound Tariff $0.02 per pound 0 Domestic price $0.12 per pound $0.10 per pound Domestic consumption (billions of pounds per year) 20 22 Domestic production (billions of pounds per year) 8 6 Imports (billions of pounds per year) 12 16

Calculate the following measures:

a. The domestic consumers’ gain from removing the tariff. b. The domestic producers’ loss from removing the tariff. c. The government tariff revenue loss. d. The net effect on national well-being.

6. Suppose that Canada produces 1.0 million bicycles a year and imports another 0.4 mil-

lion; there is no tariff or other import barrier. Bicycles sell for $400 each. Parliament

is considering a $40 tariff on bicycles like the one portrayed in Figures 8.2 through

8.4. What is the maximum net national loss that this could cause Canada? What is the

minimum national loss if Canada is a small country that cannot affect the world price?

( Hint: Draw a diagram like Figure 8.4 and put the numbers given here on it. Next, imagine the possible positions and slopes of the relevant curves.)

7. As in Question 5, you have been asked to quantify the effects of removing an import duty;

somebody has already estimated the effects on the country’s production, consumption, and

imports. This time the facts are different. The import duty in question is a 5 percent tariff on

imported motorcycles. You are given the information shown in the table.

Current Situation Estimated Situation with 5 Percent Tariff without Tariff

World price of motorcycles $2,000 per cycle $2,050 per cycle Tariff at 5 percent $100 per cycle 0 Domestic price $2,100 per cycle $2,050 per cycle Number of cycles purchased domestically per year 100,000 105,000 Number of cycles produced domestically per year 40,000 35,000 Number of cycles imported per year 60,000 70,000

✦

158 Part Two Trade Policy

pug21774_ch08_137-159.indd 158pug21774_ch08_137-159.indd 158 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

Chapter 8 Analysis of a Tariff 159

Calculate the following:

a. The consumer gain from removing the duty. b. The producer loss from removing the duty. c. The government tariff revenue loss. d. The net effect on the country’s well-being.

Why does the net effect on the country as a whole differ from the result in Question 5?

8. For the international trade market for bicycles shown in Figure 8.5, demonstrate that a

rather large tariff, for instance, a tariff that resulted in imports of 0.33 million bicycles,

would not be an optimal tariff for the importing country.

9. This problem concerns the effective rate of protection. With free trade, each dollar

of value added in the domestic cloth-making industry is divided as follows: 40 cents

value added, 30 cents for cotton yarn, and 30 cents for other fibers. Suppose that a

25 percent ad valorem tariff is placed on cloth imports and a l/6 tariff (16.7 percent)

goes on cotton yarn imports. (There is no tariff on imports of other fibers.) Work out

the division of the tariff-ridden unit value of $1.25 (the free-trade unit cloth value of

$1 plus the cloth tariff) into value added, payments for cotton, and payments for other

fibers. Then calculate the effective rate of protection.

10. What is the formula for the nationally optimal tariff? What is the optimal tariff if the

foreign supply of our imports is infinitely elastic?

11. “A good way to understand why a large country can gain by imposing a tariff is that

the country gets foreigners to pay some of its taxes.” Do you agree or disagree? Why?

12. A small country has a straight-line, upward-sloping domestic supply curve and a

straight-line, downward-sloping domestic demand curve for one of its key export

products. The world price for this product is $150 per ton. The country currently has

an export tax of $10 per unit, and it exports 10 million tons per year.

The country’s government is considering reducing its export tax to $5 per ton ,

and it asks you to determine if this will reduce by half the inefficiency caused by the

export tax. Use a graph to conduct your analysis and provide your response.

✦

pug21774_ch08_137-159.indd 159pug21774_ch08_137-159.indd 159 10/27/14 6:08 PM10/27/14 6:08 PM

Final PDF to printer

Chapter Nine

Nontariff Barriers to Imports Protecting domestic producers against import competition

• Clearly helps those producers.

• Harms domestic consumers of the products.

• Probably hurts the importing nation as a whole.

• Almost surely hurts the world as a whole.

So it is with a typical tariff barrier, and so it is with other kinds of barriers against

imports that we will analyze in this chapter. In fact, as tariff rates have declined in

industrialized countries and many developing countries, the use of other barriers to

provide protection to domestic producers has increased.

The major purpose of this chapter is to examine various kinds of nontariff barriers

to imports and their effects. We also look at how large are deadweight losses from

protection, in relation to the size of the whole national economy or to the extra pro-

ducer benefits created by the protection. In addition, we continue our examination of

the activities of the World Trade Organization, first in a box that looks at WTO rules

about nontariff barriers and at the current Doha Round of multilateral trade negotia-

tions, and then in a section at the end of the chapter that examines how trade disputes

between countries can be resolved.

TYPES OF NONTARIFF BARRIERS TO IMPORTS

A nontariff barrier (NTB) to imports is any policy used by the government to reduce imports, other than a simple tariff on imports. Nontariff barriers can take many

forms, including import quotas, discriminatory product standards, buy-at-home rules

for government purchases, and administrative red tape to harass importers of foreign

products.

An NTB reduces imports through one or more of the following direct effects:

• Limiting the quantity of imports.

• Increasing the cost of getting imports into the market.

• Creating uncertainty about the conditions under which imports will be permitted.

160

pug21774_ch09_160-191.indd 160pug21774_ch09_160-191.indd 160 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

Figure 9.1 provides a listing of major types of NTBs and indicates the main way that

each affects imports. Although antidumping duties and countervailing duties are not

listed in the figure, they are also often considered NTBs. Because governments claim

that they impose these kinds of measures in response to unfair practices by foreign

exporters, we defer an in-depth discussion of antidumping and countervailing duties to

Chapter 11. Here we will examine carefully several types of NTBs, listed in Figure 9.1.

How much protection do NTBs provide? Kee et al. (2009) estimate that NTBs are

more important than tariffs in restricting world trade. One way to summarize the size

of NTBs on a product is to estimate the equivalent tariff that would lead to the same

reduction in import quantity as does the set of NTBs. (We will see explicitly what this

means when we analyze the import quota in the next section.) Using this approach,

Type Description Direct Effect(s)

Import quota Quantitative limit on imports Quantity

Voluntary export restraint (VER) Quantitative limit on foreign exports Quantity (based on threat of import restriction)

Tariff quota Allows imports to enter the country Quantity (if the tariff for at a low or zero tariff up to a specified potential imports above the quantity; imposes a higher tariff on specified quantity is so high imports above this quantity that it is prohibitive, so that there are no imports above the specified quantity)

Government procurement Laws and government rules that favor Quantity (for instance, an local products when the government outright prohibition) is the buyer Cost of importing (for instance, special procedures for imports)

Local content and Require specified use of local labor, Quantity mixing requirements materials, or other products

Technical and product Discriminate against imports by writing Cost (to conform to standards standards or enforcing standards in a way that or demonstrate compliance) adversely affects imports more than Uncertainty (if approval domestic products procedures are unclear)

Advance deposit Requires some of the value Cost (forgone interest) of intended imports to be deposited with the government and allows the government to pay low or zero interest on these deposits

Import licensing Requires importers to apply for and Cost (of application procedure) receive approval for intended imports Uncertainty (if timing of, or basis for, approval is unclear)

Other customs procedures Affect the amount of tariff duties Cost (classification of product, owed or the quota limit applied; Uncertainty valuation of product, procedures can be slow or costly procedures for clearing)

FIGURE 9.1 Major Types of NTBs

Chapter 9 Nontariff Barriers to Imports 161

pug21774_ch09_160-191.indd 161pug21774_ch09_160-191.indd 161 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

and averaging across products, Kee et al. estimate that the country’s NTBs create pro-

tection against imports that is the equivalent of an average tariff of 5.5 percent for the

United States, 3.0 percent for Canada, 9.6 percent for the European Union, 8.5 percent

for Japan, 6.4 percent for China, and 13.9 percent for Mexico.

The World Trade Organization has rules that try to limit the use of nontariff bar-

riers, and it serves as a forum for negotiations to reduce NTBs. The first box of this

chapter, “The WTO: Beyond Tariffs,” describes the role of the WTO (and the GATT

before it) in areas that extend outside its traditional focus on reducing tariffs on

nonagricultural goods. Pressures for tariff and nontariff barriers to imports usually

rise during recessions. The second box, “Dodging Protectionism,” examines how

the world managed to limit new import barriers that could have made the global

financial and economic crisis worse.

THE IMPORT QUOTA

The best-known nontariff barrier is the import quota (or just quota), a limit on the total quantity of imports of a product allowed into the country during a period of time

(for instance, a year). One way or another, the government gives out a limited num-

ber of licenses to import the quota quantity legally and prohibits importing without a

license. As long as the quota quantity is less than the quantity that people would want

to import without the quota, the quota has an impact on the market for this product.

There are several reasons why protectionists and government officials may favor

using a quota instead of a tariff. For instance,

• A quota ensures that the quantity of imports is strictly limited; a tariff would allow

the import quantity to increase if foreign producers cut their prices or if our domestic

demand increases.

• A quota gives government officials greater power. As we will see below, these officials

often have administrative authority over who gets the import licenses under a quota

system, and they can use this power to their advantage (for instance, by taking bribes).

Note that these are not arguments showing that an import quota is in the national interest.

Let’s compare the quota to a tariff as a way of impeding imports. A tariff increases

the domestic price of the imported product and reduces the quantity imported. A quota

reduces the quantity imported. Does a quota also increase the domestic price of the

imported product? We will see that the answer is yes. In fact, we will see that, in most

ways, the effects of a quota are the same as the effects of a tariff that leads to the same

quantity of imports as the quota, if markets are perfectly competitive.

As we did with the analysis of the tariff, we begin our analysis of the quota with

the small-country case and then proceed to the large-country case. Our analysis in

the text assumes that all relevant markets are highly competitive. (The Extension box

“A Domestic Monopoly Prefers a Quota” examines an alternative case.)

Quota versus Tariff for a Small Country The effects of a quota on bicycles are portrayed in Figure 9.2 for a small importing

country facing a given world price of $300 per bicycle. Recall that a country is “small”

162 Part Two Trade Policy

pug21774_ch09_160-191.indd 162pug21774_ch09_160-191.indd 162 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

A quota cuts off the supply of imports by placing an absolute limit ( Q Q ) on what can be bought from abroad.

Under the competitive conditions shown here, the effects of an import quota are the same as those of a tariff that

cuts imports just as much (with the possible exception of who gets shaded area c ). To see this, compare the prices, quantities, and areas a , b , c , and d shown here with those shown in Figure 8.4.

Quantity (millions of bikes per year)

Price ($ per bike)

330

300

A. The U.S. Market for Bicycles B. The Market for Bicycle Imports

b d

a c 330

300 c

Quantity (millions of bikes per year)

Dm = Dd – Sd

b + d

Sd + QQ

Quota

QuotaShaded rectangle c = markup revenues

Domestic price with quota

World price

Domestic price with quota

World price

1.61.40.80.6 1.00.6

FIGURE 9.2 The Effects of an Import Quota under Competitive Conditions, Small Importing Country

Chapter 9 Nontariff Barriers to Imports 163

if its decisions about how much to import of a product have no effect on the going

world price of the product. That is, the foreign supply of exports to this small coun-

try is infinitely elastic at this price. In our example in Figure 9.2, the country would

import 1.0 million bikes per year with free trade. The government then imposes a

quota that limits imports to a smaller quantity, say, 0.6 million bikes per year.

The quota alters the available supply of bicycles within the importing country.

For all domestic prices at or above the world price, the total (domestic plus import)

supply within the country equals the domestic supply curve plus the fixed quota

quantity ( Q Q ) of imports. At the domestic price of $300 there would be excess

demand for bicycles in the importing country. The market in the importing country

will clear only at the higher domestic price of $330, as shown by the intersection

of the total available supply curve ( S d 1 Q

Q ) and the domestic demand curve ( D

d )

on the left side of Figure 9.2. At the domestic price of $330, the domestic quantity

supplied is 0.8 million, the quantity imported is the quota quantity of 0.6 million,

and the domestic quantity demanded is 1.4 million. (We can see the same effect on

domestic price by using the country’s demand-for-imports curve shown in the right

side of the figure. If the quota limits imports to 0.6 million, then the demand for

imports indicates a price of $330.)

pug21774_ch09_160-191.indd 163pug21774_ch09_160-191.indd 163 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

The box “WTO and GATT: Tariff Success” in Chapter 8 introduced the World Trade Organization (WTO), which in 1995 subsumed the General Agreement on Tariffs and Trade (GATT). That box documented the success of the rounds of multilateral trade negotiations in reducing the tariffs imposed by industrialized countries on most nonagricultural goods. We now turn to examine three ways in which the WTO tries to go beyond tariffs on non- agricultural goods:

• As tariffs have declined, the use of nontariff import barriers has increased. How have the WTO and the GATT tried to limit and reduce nontariff barriers?

• The birth of the WTO in 1995 coincided with efforts to push trade rules and trade liberal- ization into new areas. What are these new areas, and what are the agreements?

• The current round of trade negotiations, the Doha Round, is an ambitious effort to push fur- ther, but as of late 2014 there had been modest progress. What are the key objectives of the Doha Round, and why the lack of progress?

NONTARIFF BARRIERS The original GATT of 1947 included provisions that limited countries’ use of some barriers to imports other than tariffs. Most important was a prohibition on the use of import quotas on non- agricultural goods. Countries complied by remov- ing such quotas—another major success for the GATT. The agreement also stated that any gov- ernmental rules and regulations should not dis- criminate against imports; imports and domestic products should be treated equally, often called “national treatment.” In addition, the agreement included provisions for national governments to take actions against foreign dumping using anti- dumping measures and against export subsidies using countervailing measures, topics that we will take up in Chapter 11.

As tariffs declined and NTBs (other than quotas) rose in importance, the GATT members

began to discuss NTBs more seriously. Yet, nego- tiations have had less success in reducing NTBs. The protective effects of NTBs are harder to mea- sure, so it is harder to get negotiated agreement on what constitutes an international exchange of “comparable” NTB reductions.

The Kennedy Round (1963–1967) included some NTB negotiations but the results were slim—one voluntary code on dumping and antidumping procedures. The Tokyo Round (1973–1979) made some progress and resulted in six voluntary codes on NTBs, covering customs valuation, import licens- ing procedures, government procurement, product standards and similar technical barriers, subsidies and countervailing measures, and dumping and antidumping measures. However, the codes had only modest effects in limiting or reducing NTBs.

The Uruguay Round (1986–1994) was more ambitious. The agreements from this round cre- ated the WTO, addressed a number of NTBs, and required that all countries joining the new WTO accept nearly all the NTB agreements. The Uruguay Round agreements also gave the new WTO a much stronger process for resolving dis- putes between countries about NTB and other trade issues. (Dispute settlement will be discussed in the final section of this chapter.)

The Uruguay Round agreements on NTBs are far-ranging and include new or revised codes on customs valuation, import licensing, import procedures, safeguards (temporary increased protection against import surges), subsidies, and dumping. Codes on technical standards estab- lished two rules to reduce the use of standards as subtle NTBs. Standards and regulations should not restrict imports more than the minimum necessary to achieve their legitimate objectives, and standards about food safety should be based on scientific evidence. Another major outcome was that governments agreed to phase out the global web of voluntary export restraints on textiles and clothing (a topic taken up in a case study later in this chapter). In addition, governments agreed to end the use of most

Global Governance The WTO: Beyond Tariffs

164 Part Two Trade Policy

pug21774_ch09_160-191.indd 164pug21774_ch09_160-191.indd 164 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

other VERs, and they agreed to limit their use of domestic content requirements.

NEW AREAS The Uruguay Round agreement established WTO rules to cover three areas that had received almost no attention in previous rounds. First, the treatment of agricultural goods was shifted to be similar to that of industrial goods. Tariffs (and tariff-rate quotas) have replaced many agricul- tural import quotas and other NTBs. In addition, governments agreed to limits on their domestic subsidies to agricultural production and to some reductions of their export subsidies for agri- cultural products. Overall, the effects of these changes have been modest. For instance, the new tariffs were usually set high enough that there has been little increase in total trade.

Second, the agreement on “trade-related intellectual property” created global rules requiring protections of patents, copyrights, and trademarks. The purpose is to get all govern- ments behind efforts to prevent counterfeiting of branded products and pirating of technology, software, music, and films.

Third, the Uruguay Round established a new set of rules, the General Agreement on Trade in Services. Many countries limit international trade in services with legal red tape or with outright bans on foreign providers. This new agreement provides a framework for efforts to liberalize trade in services, although it contained little in the way of actual liberalizations. Subsequently, there was some progress. In 1997, 69 countries reached an agreement to open up national markets for basic telecommunications services, and 70 coun- tries reached an agreement to remove restrictions in banking, financial services, and insurance.

THE DOHA ROUND The effort to launch a new round of multilateral trade negotiations in the late 1990s was turbulent in two ways. First, the WTO, with its broader mandate, became a focal point for protests against globalization. Second, the governments

of the member countries had difficulty agreeing on what the new round should accomplish, a challenge because decision making in the WTO is generally by consensus.

Since the late 1990s protests have swirled around meetings of the WTO and other inter- national organizations. Many groups have been involved, including human-rights activists, envi- ronmentalists, consumer-rights advocates, orga- nized labor (unions), anti-immigration groups, animal-rights activists, and anarchists. It is not easy to summarize their positions toward the WTO, but prominent complaints and demands, some of them contradictory with others, have included:

• That the WTO is too powerful, undemocratic, and secretive and should be abolished or greatly reined in.

• That the WTO should expand the use of its powers to achieve goals other than free trade, especially such goals as environmental protec- tion and better wages and working conditions in developing countries.

• That the WTO is the tool of big business and that freer trade benefits corporations and capitalists while hurting the environment, local cultures, and workers.

After failing to begin the new round at the WTO ministerial conference in Seattle in 1999, the next conference was in Doha, Qatar, in 2001. Developing countries believed that they had not received a fair deal in the Uruguay Round. They incurred substantial costs by accepting the manda- tory NTB rules and the mandatory protections of intellectual property, but their benefits of greater access to export markets in the industrialized coun- tries were limited by the slow end to the VERs on clothing and textiles and by the lack of actual liber- alization of agricultural trade. Developing country governments pushed for a “development round” and vowed to be more active in the negotiations.

After much wrangling at the 2001 meet- ing, the ministers agreed on the agenda and

—Continued on next page

Chapter 9 Nontariff Barriers to Imports 165

pug21774_ch09_160-191.indd 165pug21774_ch09_160-191.indd 165 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

These effects on domestic price and quantities should sound familiar. They are the

same as the effects of the 10 percent tariff shown in Figures 8.2 through 8.4. For a

competitive market, the effects of a quota on price, quantities, and well-being are the

same as those of an equivalent tariff, with one possible exception. Here are the effects

that are the same. In comparison with free trade:

• The quota results in a higher price and larger production quantity, so domestic

producers gain surplus equal to area a . • With the higher price and smaller consumption quantity, domestic consumers lose

surplus equal to area a 1 b 1 c 1 d . • Area b is a loss to the country. The quota induces domestic producers to increase

production from 0.6 to 0.8 million. The marginal costs of producing these addi-

tional bicycles at home rise up to $330 (along S d ), when these additional bicycles

instead could be purchased from foreign exporters for only $300.

• Area d is also a loss to the country. The quota reduces quantity consumed from 1.6 million to 1.4 million. The consumer surplus lost on these bicycles is not a gain

to anyone else.

Therefore, the quota creates the same two deadweight losses ( b 1 d ), as does the tariff. This leaves rectangular area c , the “possible exception” to the equivalence. With a

tariff, area c is government tariff revenue. With a quota, what is it? Who gets it?

launched the Doha Round of trade negotiations. Each of the major players (the United States, the European Union, and the developing countries) compromised to reach the consensus. Key ele- ments of the ambitious agenda include substan- tial liberalization of agricultural trade, reductions of tariffs on nonagricultural goods, liberalization of trade in services, provision of assured access by developing countries to low-cost medicines to protect public health, and refinement of rules governing various NTBs. (In a separate agree- ment reached in 2003, developing countries gained the right to import cheap generic versions of patented drugs in health emergencies.)

The Doha Round negotiations have been intermittent and mostly unproductive for more than a decade. A meeting in July 2008 seemed to make progress but collapsed when some developing countries, led by India and China, demanded a “safeguard” process that would

allow them to easily increase tariffs on imports of agricultural products if and when such imports increased.

In December 2013 the WTO members reached a multilateral trade agreement about trade facilitation, a small part of the Doha agenda. Countries agreed to lower costs and to accept binding standards for customs and border proce- dures. Most of the benefits from the agreement will go to developing countries. However, in mid-2014 India blocked the process to adopt the agreement.

Discussions about other aspects of the Doha agenda have continued, but progress has remained elusive. The United States has resisted meaningful cuts in its agricultural subsidies. The European Union has sought to limit lowering its barriers to agricultural imports. India, Brazil, and other developing countries have been unwilling to reduce tariffs and to open up service sectors.

166 Part Two Trade Policy

pug21774_ch09_160-191.indd 166pug21774_ch09_160-191.indd 166 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

Global Crisis Dodging Protectionism

If this bill is enacted into law, we will have a renewed era of prosperity . . .

Representative Willis Hawley, Republican of Oregon, June 1930

The global crisis that began in 2007 was the worst global economic crisis since the Great Depression of the 1930s. Protectionism played a key role in the Great Depression, but fortunately history did not repeat itself.

As the Great Depression began in 1929, the U.S. Congress was debating a bill to increase U.S. tariffs. The notorious Smoot-Hawley tariff bill was passed in June 1930. By itself, its tariff increases were not that large, adding several percentage points to average U.S. tariffs. But it did not lead to prosperity. Rather, other countries retaliated against the United States by enacting similar tariff increases. The aver- age world tariff rose from 9 percent in 1929 to 20 percent in 1933. By 1933 world trade had fallen to only one-third its 1929 level. While much of this decline was the decrease in trade that accompanies macroeconomic reductions in national production and income levels, at least one-quarter of the decline was due to the rapid rise in protectionism around the world. Protectionism did not cause the Great Depression, but it did make it longer and worse than it otherwise would have been.

As the global crisis of the 2000s deepened, some countries again resorted to forms of protec- tionism. What happened, and how did we avoid a repeat of the 1930s? There were no widespread increases in tariffs (or in antidumping duties, which we will discuss in Chapter 11), although a few countries, Russia, Argentina, and Turkey, did increase tariffs by an average of about one percentage point. Overall, global tariff increases explain very little of the trade decline described in the box “The Trade Mini-Collapse of 2009” in Chapter 2. A number of countries increased non- tariff barriers to trade:

• Some imposed tougher import licensing; for example, Argentina shifted to discretionary licensing for imports of car parts, televisions, shoes, and some other items.

• Some enacted more complicated customs pro- cedures; for example, Indonesia limited im- ports of clothes, shoes, toys, and some other goods to only five ports of entry.

• Some adopted new product standards that blocked some imports; for example, China against certain European foods and beverages and India against Chinese toys.

• Some placed new “buy domestic” requirements on government spending as part of fiscal stimu- lus efforts; for example, new “Buy American” rules in the U.S. stimulus bill passed in 2009.

Still, overall the new protectionist measures were modest. The WTO estimated that less than 1 per- cent of world trade was affected.

Three forces were at work to limit increases in import barriers. First, world leaders did not want to repeat the experience of the 1930s. For example, in November 2008, at the meeting of the Group of 20 (G-20) major countries, leaders of these countries formally declared that they committed to “refrain from raising new barriers to investment or to trade in goods and services.” Second, the WTO as a strong multilateral organi- zation reinforced the resolve, through its agreed principles and rules and through its monitoring and reporting of trade policy developments. Third, in many countries the government policy response was focused more on bailouts (for example, financial institutions) and subsidies to domestic firms (for example, auto producers) than on directly limiting imports. Such subsidies can distort trade, but the subsidies did not lead to widespread policy retaliation or destruction of trade. Fortunately for the world, after the mini- trade collapse of late 2008 and 2009, world trade bounced back.

Chapter 9 Nontariff Barriers to Imports 167

pug21774_ch09_160-191.indd 167pug21774_ch09_160-191.indd 167 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

Ways to Allocate Import Licenses The quota license to import is a license to buy the product from foreign suppliers at

the world price of $300 and resell these units at the domestic price of $330. The quota

results in a price markup (or economic rent) of $30 per unit imported. For all units

imported with the quota, the markup totals to rectangular area c . Who gets this rectangle of price markup? That depends on how the licenses to

import the quota quantity are distributed. Here are the main ways to allocate import

licenses: 1

• The government allocates the licenses for free to importers using a rule or process

that involves (almost) no resource costs.

• The government auctions off the licenses to the highest bidders.

• The government allocates the licenses to importers through application and selec-

tion procedures that require the use of substantial resources.

Let’s look at each of these, examining who gets area c and whether this affects our view of the inefficiency of the quota.

Fixed Favoritism Import licenses adding up to the total quota can be allocated for free on the basis

of fixed favoritism, in which the government simply assigns the licenses to firms (and/or individuals) without competition, applications, or negotiation. In this case the

importers lucky enough to receive the import licenses will get area c . Each of them should be able to buy from some foreign exporter(s) at the world price (playing differ-

ent foreign exporters off against each other if any one of them tries to charge a higher

price). The importers can resell the imports at the higher domestic price. The price

difference is pure profit ($30 per bike in our example). Area c is then a redistribu- tion of well-being from domestic consumers in the importing country to the favored

importers with the quota licenses. Using the one-dollar, one-vote metric, this method

of allocating the quota licenses does not create any additional inefficiency (as long as

no resources are used up in allocating the quota rights).

One common way of fixing the license recipients and amounts is to give the

licenses to firms that were doing the importing before the quota was imposed, in

the same proportion to the amounts that they had previously been importing. This

is how the U.S. government ran its oil import quotas between 1959 and 1973.

Licenses to import were simply given to companies on the basis of the amount of

oil they had imported before 1959. There is a political reason for allocating import

licenses in this way. The importers generally will be hurt by the imposition of a

quota, and they would then be a group opposing the quota. However, if they receive

1 There is a fourth way that the quota licenses might be distributed. The importing country government could allocate the licenses to the exporting firms (or to others in the exporting country). In this case (but not in the three cases shown in the text), the exporters ought to be able to raise their export price, so this fourth case is essentially the same as that of the voluntary export restraint discussed in the next major section of this chapter.

168 Part Two Trade Policy

pug21774_ch09_160-191.indd 168pug21774_ch09_160-191.indd 168 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

Chapter 9 Nontariff Barriers to Imports 169

the valuable quota licenses, they are much less likely to oppose the quota. Although

they will have a lower volume of import business, the importing that they do will

be very profitable.

Auction The government can run an import license auction, selling import licenses on a competitive basis to the highest bidders. Would someone be willing to pay something

to buy a quota license? Yes, because the right to acquire imports at the low world price

and sell these imports at the higher domestic price is valuable. How much would some

individuals be willing to pay in a competitive auction? An amount very close to the

price difference—in our example, an amount very close to $30 per bike. If the winning

bids in the auction are very close to this price difference, who gets area c ? The govern- ment gets (almost all of ) it, in the form of auction revenues. In this case, the auction

revenues to the government will be (almost) equal to the revenues that the government

would instead collect with the equivalent tariff.

Public auctions of import licenses are rare. They were used in Australia, New

Zealand, and Colombia in the 1980s. In New Zealand, once or twice a year the gov-

ernment auctioned the rights to import over 400 different goods. For a sample of these

auctions for which data are available, the bidders paid, on average, about 20 percent

of the world price to acquire the quota licenses. The quotas for these products were

equivalent to an average tariff of about 20 percent.

There is an informal variant of a quota auction that is probably more prevalent.

Corrupt government officials can do a thriving business by selling import licenses

“under the table” to whoever pays them the highest bribes. As with other forms of

corruption, this variant of the auction entails some social costs that go beyond eco-

nomic market inefficiency. Persistent corruption can cause talented persons to become

bribe-harvesting officials instead of pursuing productive careers. Public awareness of

corruption also raises social tensions over injustice in high places.

Resource-Using Procedures Instead of holding an auction, the government can insist that firms (and/or individuals)

that want to acquire licenses must compete for them in some way other than simple

bidding or bribing. Resource-using application procedures include allocating quota licenses on a first-come, first-served basis; on the basis of demonstrating need

or worthiness; or on the basis of negotiations. With first-come, first-served allocation,

those seeking the licenses use resources to try to get to and stay at the front of the line.

An example of allocation by worthiness is awarding quota licenses for materials or com-

ponents based on how much production capacity firms have for producing the products

that use these inputs. This approach encourages resource wastage because it causes firms

to overinvest in production capacity in the hope of obtaining more quota licenses. An

example of resource wastage from negotiation is the time and money spent on lobbying

with government officials to press each firm’s case for receiving quota licenses.

What amount of resources would be used by firms seeking quota licenses? It would

be rational for the firms to use resources up to the value of the licenses themselves—that

is, up to the value of area c . Using resources in this way is privately sensible for each

pug21774_ch09_160-191.indd 169pug21774_ch09_160-191.indd 169 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

Extension A Domestic Monopoly Prefers a Quota

The analysis of an import quota presented in the text presumes that the domestic industry in the importing country is highly competitive. With perfect competition we saw that the effect of the quota on domestic producer surplus is the same as the effect of a tariff that results in the same quantity of imports. In this case the domes- tic industry would not have a strong preference between the quota and the equivalent tariff.

Domestic industries are often highly com- petitive, but not always. Especially for a small country, in some industries no more than one or two domestic firms can achieve scale economies in production if they are selling only to local consumers. This would be true for industries like automobiles or steel.

If the domestic industry is a monopoly, would the monopoly have a preference between a tariff and a quota? The answer is yes. The monopoly prefers the quota (even if the monopoly does not get any of the price markup on the imports them- selves). Let’s look at this more closely. (We assume that the importing country is a small country, but the same idea holds for the large-country case.)

The domestic monopoly would like to use its market power to set the domestic price to maximize its profits. But with free trade the world price becomes the domestic price. Imports entering the country at the world price prevent the domestic monopoly from charging a higher price than the world price. If it did try to charge a higher price, most consumers would just buy imports. Free trade is a good substitute for national antitrust or antimonopoly policy.

If the country’s government imposes a tariff, the domestic price rises to be the world price plus the tariff. The pricing power of the monopoly is still severely limited. If the monop- oly tries to charge more than this tariff-inclusive price, again most consumers would just buy imports. Domestic consumers can buy as much of the imported product as they wish, as long as they are willing to pay the tariff-inclusive price. They will not pay more for the locally produced product.

If instead the country’s government imposes a quota, the whole game changes. No matter how high the monopoly raises its domestic

Price

Quantity0

Domestic demand curve

World price

Marginal cost curve of sole domestic producer

Even with the tariff the domestic producer is a price-taker

a b c d P1 P0

S0 D0S1 D1

Tariff

Tariff, domestic monopoly.

170 Part Two Trade Policy

pug21774_ch09_160-191.indd 170pug21774_ch09_160-191.indd 170 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

price, imports cannot exceed the quota quan- tity. Domestic consumers cannot just shift to imports because there is a strict limit on how much they can import. The marginal source of more of the product is now the domestic monopoly. After allowing for the quota quan- tity of imports, the domestic monopoly can set the domestic price to maximize its profits. In comparison to a tariff that results in the same quantity of imports, the domestic monopoly prefers an import quota because the monopoly can set a higher price and garner larger profits. However, these higher profits come at a cost to the importing country as a whole. If the domes- tic industry is a monopoly, the quota causes a larger net national loss.

A pair of graphs for the domestic monopoly can highlight the differences between the tar- iff and the quota. The figure on the previ- ous page shows the case of the tariff. With free trade at the world price P

0 , the monopo-

list cannot charge a price higher than P 0 , so

the monopoly produces all units for which its marginal costs are less than this free-trade price. The tariff raises the domestic price to P

1 , but

the monopolist cannot charge a higher price than this tariff-inclusive price. The monopolist increases production from S

0 to S

1 and increases

its profits by area a. Imports with the tariff are M

1 . The net loss in national well-being because

of the tariff equals area b 1 d. The figure below shows what happens if this

same M 1 quantity of imports is instead set as a

quota. With the fixed quota quantity of imports, the monopoly views its market as domestic demand less this quota quantity (for all prices above the world price P

0 ). That is, the monopoly

faces the downward-sloping net demand curve (the domestic demand curve minus the quota quantity). Using the net demand curve, the monopoly can determine the marginal revenue from lowering price to sell additional units. The monopoly maximizes profit when marginal rev- enue equals marginal cost, producing and selling quantity S

2 and charging price P

2 .

In comparison with the tariff, the monopoly uses the quota to increase the product price ( P

. P 1 ), to reduce the quantity that it produces

and sells ( S 2 , S

1 ), and to increase its profit. The

monopoly prefers the quota, but the monopoly’s

Import quota, domestic monopoly.

Price

Quantity0

Domestic demand curve

Marginal revenue curve

Quota = M1

Marginal cost curve of the sole domestic producer

Net national loss = areas b + d (as with a tariff) plus the shaded area due to the exercise of monopoly power

Domestic total demand curve

Net demand curve faced by monopoly

b d

P2 P1

S2 S1

World price = P0

—Continued on next page

Chapter 9 Nontariff Barriers to Imports 171

pug21774_ch09_160-191.indd 171pug21774_ch09_160-191.indd 171 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

individual firm seeking to get the economic rents created by the licenses. But, from the

point of view of the entire country, these resources used up in the rent-seeking activi- ties are being wasted (compared to the other two ways of allocating quota licenses or compared to having no quota at all).

Resource-using procedures encourage rent-seeking activities, and some or all of

area c is turned into a loss to society by wasting productive resources. The inefficiency of the quota is greater than area b 1 d because it also includes some of area c . In this case the quota is worse than the equivalent tariff in its effects on net national

well-being.

Quota versus Tariff for a Large Country Figure 9.3 shows the effects of a quota for a country whose import demand for this

product is large enough to affect world prices. A large country faces an upward-sloping

foreign supply-of-exports curve. With free trade, the country would import 1.0 million

bicycles per year and the world price would be $300 per bicycle. The government then

imposes an import quota that reduces the import quantity to 0.8 million bicycles. By

looking at the right-hand side of Figure 9.3, we see the effects of the quota on prices.

Domestic import buyers will pay $315 per bicycle if the import quantity is limited to

0.8 million. Foreign exporters will compete among themselves to make this limited

amount of export sales, and they will bid the export price down to $285.

We can use these prices and the left-hand side of Figure 9.3 to see what is hap-

pening in the domestic market for the country that is importing bicycles. When the

domestic price increases to $315, domestic quantity supplied increases to 0.7 million

and domestic quantity consumed decreases to 1.5 million.

If we compare a quota to its equivalent tariff for the large-country case (by

comparing Figure 9.3 to Figure 8.5), we reach the same general conclusion

for the large-country case that we reached for the small-country case. With the

same exception of who gets the price markup from the quota (area c 1 e in the large-country case), the effects of the quota are the same as those of the equivalent

gain comes with some additional social cost. In comparison with the tariff, the economic inefficiency of the quota is larger. The nation as a whole loses not only area b 1 d but also the shaded area. The shaded area is the addi- tional social loss from unleashing the monopoly’s power to restrict production and raise prices. Additional consumers are squeezed out of the market, and they suffer an additional loss of consumer surplus that is not a gain for any other group.

We can combine this conclusion with the con- clusions reached in the text. For the nation as a whole, at best the quota is no worse than an equivalent tariff as a way of impeding imports. The import quota is worse than the tariff in two cases:

• If quota licenses are allocated through resource-using application and selection procedures.

• If a dominant domestic firm can use the quota to assert its monopoly pricing power.

172 Part Two Trade Policy

pug21774_ch09_160-191.indd 172pug21774_ch09_160-191.indd 172 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

Under the competitive conditions shown here, the effects of an import quota are the same as those of a tariff that

cuts imports just as much (with the possible exception of who gets shaded area c 1 e ).

Quantity (millions of bikes per year)

Price ($ per bike)

315

300 285

315 300 285

A. The National Market for Bicycles B. The Market for National Bicycle Imports

a c e

c e

Quantity (millions of bikes per year)

Dm = Dd – Sd

Sxb + d

Sd + QQ

Quota

QuotaShaded rectangle c + e = Markup revenues

Domestic price

New export price

World price

1.61.50.70.6 1.00.8

FIGURE 9.3 The Effects of an Import Quota under Competitive Conditions, Large Importing Country

tariff. If the quota licenses can be distributed with minimal resource costs, then the

effect on net national well-being of the import quota is the gain of area e less the loss of area b 1 d .

If the exporters are passive, then a large country can gain net national well-being

by imposing an import quota, and there is an optimal quota that maximizes the gain in

national well-being. The nationally optimal quota is 0.67 million bicycles per year, the

same quantity of imports that results from the optimal tariff shown in Figure 8.6. The

cautions for the use of an optimal quota are the same as those for the optimal tariff.

The quota hurts the foreign country, and the foreign country may choose to retaliate.

Even if the foreign country does not retaliate, the quota causes worldwide inefficiency.

In comparison with free trade, the loss in world well-being is area b 1 d plus area f in the right-hand side of Figure 9.3.

VOLUNTARY EXPORT RESTRAINTS (VERs)

A voluntary export restraint (VER) is an odd-looking trade barrier in which the importing country government compels the foreign exporting country to agree “volun-

tarily” to restrict its exports to this country. The export restraint usually requires that

foreign exporting firms act as a cartel, restricting sales and raising prices. Yes, that’s

right—through the VER the importing country actually gives foreigners monopoly

power, forces them to take it, and calls their compliance voluntary!

Chapter 9 Nontariff Barriers to Imports 173

pug21774_ch09_160-191.indd 173pug21774_ch09_160-191.indd 173 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

VERs have been used by large countries as a rear-guard action to protect their

industries that are having trouble competing against a rising tide of imports. Beginning

in the late 1960s the United States, the European Union, and Canada used VERs to

limit imports while avoiding the embarrassment of imposing their own import quo-

tas or raising their own tariffs, as such actions would violate their commitment to

the international rules of the WTO. The countries most often forced to restrict their

exports have been Japan, Korea, and the transition countries of Central and Eastern

Europe. The box “VERs: Two Examples” describes both Japan’s limit of car exports

to the United States in the 1980s and the pervasive set of export quotas in textiles and

clothing for almost half a century. Agricultural goods, steel, footwear, and electronics

are other products that often have been restricted by VERs.

The graphical analysis of a VER is very similar to that of an import quota. For

instance, we can use Figure 9.2 to show the effects of a VER for a small importing

country. The amount Q Q is now the export quota imposed by the VER. (Similarly, the

graphs showing the effects of the VER for a large importing country would be nearly

identical to Figure 9.3.)

Consider the small importing country shown in Figure 9.2. The two key differences

between a VER (or any other form of export quota) and an import quota are the effect on the export price and who gets area c, the price markup or economic rent created by the quantitative limit on trade. Recall that with an import quota the quota rights to

import are given to importers. If foreign export supply is competitive, these importers

should be able to buy at the world price ($300 in our bicycle example) and sell these

imports domestically at the higher price ($330). The price markup (area c ) stays within the importing country.

With the VER, the exporting country’s government usually distributes to its producers

licenses to export specified quantities. The export producers should realize that there is

much less incentive to compete among themselves for export sales. Instead, they should

act as a cartel that has agreed to limit total sales and to divide up the market. Faced with

limited export quantity (0.6 million bikes in Figure 9.2), the exporters should charge the

highest price that the market will bear. The export price rises to $330, the highest price that import demanders will pay for this quantity. Therefore, the foreign exporters now get area c as additional revenue on the VER-limited quantity of exports. 2

For the importing country, how does the cost of a VER compare to either an import quota or free trade? In comparison to an import quota (which uses minimal resources to administer), the VER causes a loss of area c . This is the amount paid to the for- eign exporters rather than kept within the importing country. It is a national loss due

to a deterioration in the importing country’s terms of trade (the higher price paid to

foreign exporters) because of the VER. In comparison to free trade, the net loss to the importing country because of the VER is area b 1 c 1 d . The VER may be a

2 I learned of an interesting variation on this effect from one of my students a number of years ago. I noticed that each time I saw him outside of class he was driving a different expensive car. I complimented him on this, and he said that his family in India was doing very well. When I asked what they did, he said that they owned some of the VER rights to export clothing from India to countries like the United States. He said that his family actually did not bother to make clothing; instead they simply rented the export rights to local clothing manufacturers. Thus, his family did very well by getting some of area c created by the clothing VERs.

174 Part Two Trade Policy

pug21774_ch09_160-191.indd 174pug21774_ch09_160-191.indd 174 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

politically attractive way of offering protection to an import-competing industry, but

it is also economically expensive for the importing country. (In addition, note that for the world as a whole the net loss in comparison to free trade is only area b 1 d . Area c is a transfer from consumers in the importing country to producers in the exporting country, so it is not a loss to the whole world.)

There is another important effect of the VER. For many products foreign producers

can adjust the mix of varieties or models of the product that they export, while remain-

ing within the overall quantitative limit. Usually, the profit margin on higher-quality

varieties is larger, so the exporters shift toward exporting these varieties (a process called

“quality upgrading”). As the Japanese firms implemented the VER on their auto exports

to the United States, one part of their strategy was to shift the mix of models exported,

away from basic subcompact cars (like the Honda Civic) and toward larger, fancier mod-

els (like the Honda Accord and eventually the Acura line). (In this auto case, there was

one more notable effect. To avoid the sales limits created by the VER, Japanese automo-

bile firms set up assembly operations in the United States. More generally, any import

protection can serve as an incentive for direct investment into the importing country by

the thwarted foreign exporters. We examine foreign direct investment in Chapter 15.)

OTHER NONTARIFF BARRIERS

In addition to quotas and VERs, there are many other kinds of nontariff import barri-

ers. Indeed, we should be impressed with governments’ creativity in coming up with

new ways to discriminate against imports. Let’s look more closely at three other NTBs

from the vast toolkit used against imports. (The box “Carrots Are Fruit, Snails Are

Fish, and X-Men Are Not Humans” provides more examples of creativity.)

Product Standards If you are looking for rich variety and imagination in import barriers, try the panoply

of laws and regulations pertaining to product quality, including those enforced in the

names of health, sanitation, safety, and the environment. Such standards can be noble

efforts to enhance society’s well-being, by addressing market failures that lead to

unsafe conditions and environmental degradation.

Standards that accomplish these goals need not discriminate against imports. But,

if a government is determined to protect local producers, it can always write rules that

can be met more easily by local products than by imported products. For instance, the

standards can be tailored to fit local products but to require costly modifications to

foreign products. Or the standards can be higher for imported products or enforced

more strictly. Or the testing and certification procedures can be more costly, slower, or

more uncertain for foreign products. Here are some examples to illustrate the

ingenuity of the standard-setters.

In an obvious effort to protect domestic ranchers, the U.S. government in the

past has found hidden health hazards in the way beef cattle are raised in Argentina.

Similarly, the European Union (EU) has banned imports of beef from cattle that have

received growth hormones, claiming that it is responding to public concerns about

health dangers. The United States asserts that this is actually protection of European

Chapter 9 Nontariff Barriers to Imports 175

pug21774_ch09_160-191.indd 175pug21774_ch09_160-191.indd 175 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

Case Study VERs: Two Examples

Voluntary export restraints provide for rich inter- play between economics and politics. Let’s look at two examples. In the first, the United States forced one key exporter, Japan, to limit its exports of auto- mobiles. In the second, a small VER, again between the United States and Japan, grew to become a wide-ranging set of export limits that covered many textile and clothing products, involved many countries, and lasted for decades.

AUTO VER: PROTECTION WITH INTEGRITY? Before the mid-1970s import totals of automobiles into the United States were minuscule. Then, in the late 1970s sales of Japanese-made automo- biles accelerated in the United States. American buyers were looking for smaller cars in the wake of substantial increases in the price of oil. Japanese manufacturers offered good-quality smaller cars at attractive prices. Japanese cars were capturing a rapidly growing share of the U.S. auto market, U.S. production of cars was declining, American autoworkers were losing their jobs, and the U.S. auto companies were running low on profits.

In early 1981 the protectionist-pressure tacho- meter was in the red zone. Japanese auto exports were caught in the headlights, with Congress ready to impose strict import quotas if necessary. Ronald Reagan, the new U.S. president, had a problem. In March 1981, his cabinet was discuss- ing auto import quotas. Reagan’s autobiography later explained his thinking at that moment:

As I listened to the debate, I wondered if there might be a way in which we could maintain the integrity of our position in favor of free trade while at the same time doing something to help Detroit and ease the plight of thousands of laid-off assembly workers . . .

I asked if anyone had any suggestions for striking a balance between the two positions. [Then–Vice President] George Bush spoke up: “We’re all for free enterprise, but would any of us find fault if Japan announced without any request from us that they were going to volun- tarily reduce their exports of autos to America?”*

A few days later Reagan met with the Japanese foreign minister.

Foreign Minister Ito . . . was brought into the Oval Office for a brief meeting . . . I told him that our Republican administration firmly opposed import quotas but that strong sentiment was building in Congress among Democrats to impose them.

“I don’t know whether I’ll be able to stop them,” I said. “But I think if you voluntarily set a limit on your automobile exports to the country, it would probably head off the bills pending in Congress and there wouldn’t be any mandatory quotas.” *

The Japanese government got the message and “voluntarily” agreed to make sure that Japanese firms put the brakes on their exports to the United States. Maximum Japanese exports to the United States for each of the years 1981 through 1983 were set at a quantity of 1.8 million vehicles per year, about 8 percent less than what they had exported in 1980. As total automobile sales in the United States increased substantially after the 1981–1982 recession, the export limit was raised in 1984 to 2 million and in 1985 to 2.3 million. The export restraint continued to exist until 1994, but from 1987 on actual Japanese exports to the United States were less than the quota quantity. By 1987 Japanese firms were producing large numbers of cars in factories that they had recently built in the United States.

As a result of the VER, the profits of U.S. auto companies increased, as did production and employment in U.S. auto factories. What did the VER cost the United States? One study estimated that the VER cost U.S. consumers $13 billion in lost consumer surplus and that it imposed a net loss to the United States of $3 billion. Other esti- mates of these costs are even higher. “Protection with integrity” does not come cheap.

TEXTILES AND CLOTHING: A MONSTER In 1955, a monster was born. In the face of rising imports from Japan, the U.S. government convinced the Japanese government to “voluntarily” limit

176 Part Two Trade Policy

pug21774_ch09_160-191.indd 176pug21774_ch09_160-191.indd 176 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

Japan’s exports of cotton fabric and clothing to the United States. In the late 1950s, Britain followed by compelling India and Pakistan to impose VERs on their clothing and textile exports to Britain. The VERs were initially justified as “temporary” restraints in response to protectionist pleas from import-competing firms that they needed time to adjust to rising foreign competition. But the mon- ster kept growing.

The 1961 Short-Term Arrangement led to the 1962 Long-Term Arrangement. In 1974, the Multifibre Arrangement extended the scheme to include most types of textiles and clothing. The trade policy monster became huge. A large and rising number of VERs, negotiated country by country and product by product, limited exports by developing countries to industrialized countries (and to a number of other developing countries).

The monster even had its own growth dynamic. A VER is, in effect, a cartel among the export- ing firms. As they raise their prices, the profit opportunity attracts other, initially unconstrained suppliers. Production of textiles and clothing for export spread to countries such as Bangladesh, Cambodia, Fiji, and Turkmenistan. As these coun- tries became successful exporters, the importing countries pressured them to enact VERs to limit their disruption to the managed trade.

The developing countries that were con- strained by these VERs pushed hard during the Uruguay Round of trade negotiations to bring this trade back within the normal WTO rules (no quantitative limits, and any tariffs to apply equally to all countries—most favored nation treatment, rather than bilateral restrictions). The Agreement on Textiles and Clothing came into force in 1995 and provided for a 10-year period during which all quotas in this sector would be ended. On January 1, 2005, after almost a half century of life, the monster mostly died.

We say “mostly” because for a few more years a small piece of the monster lived on. As part of its accession agreement to the World Trade Organization, China accepted that other countries could impose China-specific “safe- guards” if its rising exports of textiles or cloth-

ing harmed import-competing producers. As the United States phased out VERs, the U.S. government imposed such safeguards on some imports from China. By late 2005 a comprehen- sive agreement limited imports of 22 types of products from China. Similarly, the European Union imposed safeguard limits on imports from China on 10 types of products. Then, the monster finally took its last breaths. The EU limits expired at the end of 2007 and the U.S. limits expired at the end of 2008. (Still, we do not have free trade in textiles and clothing because many countries continue to have rela- tively high import tariffs in this sector. But the web of VERs has ended.)

Consumers are the big winners from the liber- alization. Prices generally fell by 10 to 40 percent when the VERs ended. Another set of winners is countries, including China, India, and Bangladesh, that have strong comparative advantage in textiles and clothing but whose production and exports had been severely constrained by the VERs. On the other side, with rising imports, textile and cloth- ing firms and workers in the United States and other industrialized countries have been harmed. Another set of losers is those developing coun- tries, apparently including Korea and Taiwan, that do not have comparative advantage in textile and clothing production but that had become producers and exporters of textiles and clothing because the VERs had severely restricted the truly competitive countries. (This shows another type of global production inefficiency that resulted from the VERs.) These uncompetitive countries lost the VER rents that they had been receiving, and their industries shrank as those in countries such as China expanded.

DISCUSSION QUESTION In late 1981, your father went to a Honda dealer in his home state and paid about $1,000 more for a Civic than he would have paid the year before. Why?

* Ronald Reagan (1990), pp. 253–254 and 255. Emphasis in the original.

Chapter 9 Nontariff Barriers to Imports 177

pug21774_ch09_160-191.indd 177pug21774_ch09_160-191.indd 177 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

Case Study Carrots Are Fruit, Snails Are Fish, and X-Men Are Not Humans

178 Part Two Trade Policy

Governments have shown perhaps their greatest trade-policy creativity when deciding in what cat- egories different imported goods belong. Their decisions are by no means academic. The stakes are high because an import that falls into one category can be allowed into the country duty- free, whereas the same import defined as falling into a related category is subject to a high tariff or banned altogether.

You can bet that if definitions matter so much to trade policy, there will be intense lob- bying over each product’s official definition. Protectionists will insist that an imported product be defined as belonging to the category with the high import barrier, but importing firms will demand that it be put in the duty-free category. When such strong pressures are brought on gov- ernment, don’t always expect logic in the official definitions.

Some of the resulting rules are bizarre. For example, here are two included in regulations passed by the European Union (EU) in 1994:

• Carrots are a fruit. This definition allows Portugal to sell its carrot jam throughout Western Europe without high duties.

• The land snail, famously served in French res- taurants, is a fish. Therefore, European snail farmers can collect fish farm subsidies.

The U.S. government has similarly bent the rules. In the early 1990s Carla Hills, then the U.S. trade representative, was compelled to call the same car both American and “not American.” She told the Japanese government that car exports from U.S. factories owned by Japanese firms to Japan were Japanese, not American. They did not count when the U.S. government examined the size of American car exports to Japan. At the same time, she told European governments that the cars exported to Europe from these same Japanese-owned factories in the United States were American, so they were

not subject to European quotas on Japanese car imports.

With even greater ingenuity private firms have changed the look and the names of their products to try to get around each set of official definitions. For instance, a VER on down-filled ski parkas led to the innovation of two new products that were not subject to VERs. One product was a down-filled ski vest that had one side of a zip- per on each armhole. The other product was a matched pair of sleeves, with one side of a zipper at the top of each sleeve. Once the two prod- ucts were imported “separately,” the distributor knew what to do.

As another example, Subaru once imported pickup trucks with two flimsy “rear seats” bolted to the truck bed to avoid the U.S. tariff of 25 percent on “regular” pickup trucks. To avoid the same 25 percent U.S. duty, Ford imports vans from Turkey as “passenger wagons” because the vans have both rear side windows and rear seats. Once past customs Ford removes and trashes the rear windows and seats, replaces the windows with metal panels, and sells them as small com- mercial delivery vans.

In some cases it is a U.S. judge that makes the call. In 2001, a judge ruled that cheap chil- dren’s Halloween costumes (think Scream) were “fancy dress apparel,” not the “flimsy festive articles” that the U.S. Customs Service had long considered them. The suit was a victory for the U.S. producer, Rubie’s Costume Company, that brought it. Rather than entering duty-free, imported costumes (that competed with Rubie’s) would be subject to a tariff up to 32 percent and be covered by the VERs on clothing. Trick or treat?

In 2003, another U.S. judge studied opposing legal briefs and more than 60 action figures, both heroes and villains. Among her conclusions were that the X-Men were not humans, nor were many of the others. She was not just play- ing around: Toys that depict humans are dolls,

pug21774_ch09_160-191.indd 178pug21774_ch09_160-191.indd 178 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

subject to 12 percent import tariffs, but toys that depict nonhumans are just toys, subject to a 7 percent tariff.

Such games have been played with great frequency over the definitions of products. As long as definitions mean money gained or lost, products will be defined in funny ways.

DISCUSSION QUESTION During your foreign travel in South Asia, you acquired an expensive, elaborately woven textile, size 1 meter by 2 meters. At customs as you are returning home, the official asks if it is a rug or a decorative wall hanging. What do you reply?

beef producers because the scientific evidence indicates that beef from cattle that

receive growth hormones is safe and poses no risk to human health.

The EU requires that foreign facilities producing dairy products and many other

animal products be approved as meeting EU public health standards. But it has not

devoted many resources to the approval process, leading to waits of months for simple

approvals. Health regulations set by the Mexican government require inspection and

approval of factories making herbal and nutritional products that are sold in Mexico.

However, for a number of years the Mexican authorities were unable to inspect facto-

ries in other countries.

The U.S. government has complained that Japan’s procedures for approving phar-

maceuticals and medical devices is slow. For instance, the Japanese government often

requires clinical trials on Japanese patients, even though such trials simply duplicate

those completed successfully in other countries. Since the mid-1990s, South Korea

has imposed many new standards for automobiles, including a unique antipinch

requirement for electric windows and a unique emissions standard, that are costly for

foreign automakers to meet. In addition, in May 2006 the Korean tax authority took

actions implying that owners of foreign cars would be more likely to be subject to

tax audits. Automobile imports into Korea are remarkably low.

Product standards usually do not raise tariff or tax revenues for the importing coun-

try’s government. On the contrary, enforcing these rules uses up government resources

(and businesses must use resources to meet the standards). The standards can bring a

net gain in overall well-being to the extent that they truly protect health, safety, and

the environment. Yet it is easy for governments to disguise costly protectionism in

virtuous clothing.

Domestic Content Requirements A domestic content requirement mandates that a product produced and sold in a country must have a specified minimum amount of domestic production value,

in the form of wages paid to local workers or materials and components produced

within the country. Domestic content requirements can create import protection at

Chapter 9 Nontariff Barriers to Imports 179

pug21774_ch09_160-191.indd 179pug21774_ch09_160-191.indd 179 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

two levels. They can be a barrier to imports of the products that do not meet the con-

tent rules. And they can limit the import of materials and components that otherwise

would have been used in domestic production of the products. For instance, local

content requirements for automobiles, used by Malaysia and other countries, force

local auto manufacturers to use more domestically produced automobile components

and parts (for instance, sheet metal or seat covers). If the domestic content require-

ment is set high enough, it can force domestic production of such expensive parts as

engines or transmissions.

A closely related NTB, sometimes called a mixing requirement, stipulates that an importer or import distributor must buy a certain percentage of the product locally.

For instance, the Philippine government has required that certain retail stores in the

country must source at least 30 percent of their inventory in the Philippines. Such

mixing requirements have also been used to restrict imports of foreign entertainment.

Canada has imposed “Canada time” requirements on radio and TV stations, forcing

them to devote a certain share of their air time to songs and shows recorded in Canada.

Similarly, the EU, led by France, has waged a sustained war against American enter-

tainment, partly by stipulating that minimum percentages of various forms of enter-

tainment must be from domestic studios.

Like product standards, domestic content and mixing requirements do not generate

tariff or tax revenue for the government. The gains on the price markups are captured

by the protected home-country sellers of the protected products. These requirements

create the usual deadweight losses because the protected local products are less

desired or more costly to produce.

Government Procurement Governments are major purchasers of goods and services. One estimate is that gov-

ernment purchases of products that could be traded internationally amount to close

to one-tenth of all product sales in the industrialized countries. Government procure-

ment practices can be a nontariff barrier to imports if the purchasing processes are

biased against foreign products, as they often are. In many countries the govern-

ments buy relatively few imported products and instead buy mostly locally produced

products.

In the United States, the Buy America Act of 1933 is the basic law that mandates

that government-funded purchases favor domestic products. For different types of

purchases the bias takes different forms, including prohibitions on buying imports,

local content requirements, and mandating that domestic products be purchased unless

imported products are priced much lower (for instance, at least one-third lower). More

than half of the states and many cities and towns also have “Buy American” or “buy

local” rules for purchases by their governments.

Many other countries have similar rules and practices. For instance, in Japan

the U.S. government has complained that the Japanese government has limited

foreign sales of telecommunications products and services to the government and

government-owned companies by using both standards that are biased toward local

products and short time periods for bidding. In India the government requires that

the computers it purchases have a minimum proportion of locally produced compo-

nents. In Greece the specifications for the goods and services that the government

180 Part Two Trade Policy

pug21774_ch09_160-191.indd 180pug21774_ch09_160-191.indd 180 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

plans to buy are often vague and tend to favor local suppliers. It also appears that

the Greek government informally favors Greek and other EU firms when making

purchasing decisions.

HOW BIG ARE THE COSTS OF PROTECTION?

We have examined the effects of tariffs and nontariff barriers to imports. How impor-

tant are these effects? Are the costs large or small? Large or small relative to what?

We’ll look first at their importance for the whole national economy, and then at their

size in relation to producer benefits from the protection.

As a Percentage of GDP One popular way of weighing the importance of any economic cost or benefit is to

see whether it is a big part of the national economy, which we usually measure by

the value of domestic production (gross domestic product, or GDP). Surprisingly, our

basic theory indicates that the costs of protection for a typical industrialized country

may be small, even if we ignore any favorable changes in the country’s terms of trade

(the small-country assumption).

Consider a diagram like Figure 8.4B. For a small country that imposes a tariff, area

b 1 d , the net national loss from the tariff, equals one-half the tariff per unit times the reduction in the import quantity. Using this equality and some mathematical manipu-

lation, we can write the expression for the net national loss as a percentage of GDP: 3

Net national loss

from the tariff

GDP 5 ½ 3 Tariff rate 3

Percent reduction

in import quantity 3

Import value

GDP

A similar expression applies to a product affected by an import quota or some

other nontariff barrier. (The percentage increase in domestic price that results from

the NTB replaces the tariff rate.) Furthermore, we can use this expression to examine

the effect of all tariffs and nontariff barriers imposed by the country. (Roughly, we get

this expression if we add up all the losses for all products protected against imports.)

3 Here is how we get this formula. Our analysis of tariffs in Chapter 8 indicates that the net national loss (a money amount) is the area of the triangle b 1 d (or the sum of the two triangles b and d ). Recalling that the area of a triangle is equal to one-half of the product of the base (the change in imports as the result of the tariff) and height (the tariff money amount per unit, which is equal to the percentage tariff rate times the import price):

Net national loss from the tariff 5 ½ · (Reduction of import quantity) · (Tariff rate · Import price)

Then, divide the first term in parentheses on the right side of the equation by the import quantity (so it becomes reduction in import quantity divided by import quantity, which is the percent reduction in import quantity, stated in decimal form) and multiply the second term by the import quantity (so we obtain import price times import quantity, which is import value, as part of the expression). We then have:

Net national loss from the tariff 5 ½ · (Percent reduction of import quantity) · (Tariff rate · Import value)

Now divide both sides of the equation by the money value of GDP and rearrange terms to obtain the expression in the text.

Chapter 9 Nontariff Barriers to Imports 181

pug21774_ch09_160-191.indd 181pug21774_ch09_160-191.indd 181 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

How large is the loss? Suppose, for example, that a nation’s import tariffs are all

10 percent and that they cause a 20 percent reduction in import quantities. Suppose

that total imports affected by these tariffs are 20 percent of GDP. In this realistic case,

the net national loss from all tariffs on imports equals ½ 3 0.10 3 0.20 3 0.20, or

only 0.2 percent of GDP! The net national loss from import protection is not likely

to be large for a country that has rather low tariff levels and that is not that dependent

on imports. The cost of protection is now relatively small for industrialized countries

because the governments of these countries have cooperated to lower their trade barriers

so much during the past half-century. (We also note that that 0.2 percent of U.S. GDP

is about $34 billion, an amount that most of us would not think to be absolutely small.)

However, we also know that estimates based on this simple calculation can under-

estimate the costs of protection as a share of GDP. Here are five ways in which the

true cost is probably bigger than the calculation above shows:

• Foreign retaliation. If our country has introduced barriers, other governments may retaliate by putting new barriers against our exports. The true costs would be higher

than any shown in the diagram or the calculation above. The costs would be much

higher in the event of a trade war, in which each side counterretaliates with still

higher import barriers.

• Enforcement costs. Any trade barrier has to be enforced by government officials. That is costly because the people enforcing the trade barrier could have been productively

employed elsewhere. Part of the revenues collected by the government (area c in our diagram) is the waste of society’s resources used to enforce the barrier. This is a

loss to the country, not just a pure redistribution from consumers to the government.

• Rent-seeking costs. Local firms seeking protection may use techniques such as lob- bying that also use resources. If this is the case, then part of the producer surplus

created by protection (area a in our diagram) is also a loss due to wasted resources, rather than a pure redistribution from consumers to producers. In addition, firms

and individuals may use resources to try to claim the tariff revenues or the price

markup on the quota quantity of imports, another reason that some of area c could be a national loss due to wasted resources.

• Rents to foreign producers. VERs encourage foreign exporters to raise their export prices. This is a third reason that some or all of area c could be a loss to the import- ing country.

• Innovation. Protection can mute the incentive to innovate new technology because there is less competitive pressure. In addition, protection can cause a loss to

national well-being because it reduces the number of varieties of products available

in the domestic market.

For any or all of these reasons, the cost of protection could be noticeably larger than the

estimates from the simple calculations above, but it is not easy to say how much larger.

As the Extra Cost of Helping Domestic Producers The political reason for import barriers is often to enhance the incomes of a threat-

ened domestic industry. How much does it cost society for each dollar of additional

producer surplus for the protected industries?

182 Part Two Trade Policy

pug21774_ch09_160-191.indd 182pug21774_ch09_160-191.indd 182 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

To see how much it might cost society to create a dollar of protected income,

let’s return to the calculation that led to our conclusion that import barriers cost only

0.2 percent of GDP. In this case, the tariffs gave domestic producers a 10 percent

hike in the price of their products. If the threatened industries were 25 percent of

GDP, then their gains in producer surplus, as a percentage of GDP, would be close to

10 percent times 25 percent, or 2.5 percent of GDP. Every dollar transferred to provide

income for the protected industries also costs society an additional 8 cents (equal to

0.2 divided by 2.5) in deadweight losses. Thus, every dollar of protected income costs

the rest of society $1.08 (the $1.00 transferred plus the extra loss of $0.08), even in

this example in which the level of protection is moderate.

INTERNATIONAL TRADE DISPUTES

Each country’s government sets its own trade policies, but these policies also have

effects on other countries. With regularity policies enacted by one country incite

complaints from other countries that the policies are harmful or unfair. We mentioned

this issue at the end of the previous chapter. If one country enacts an optimal tariff,

the benefits to this country come at the expense of other countries, who are worse

off because their terms of trade decline and their firms lose export opportunities.

These other countries should complain and may take actions in response. Disputes

about nontariff barriers are at least as likely. NTBs raised by one country hurt other

countries, just as tariffs would. In addition, actions that one country takes for some

other reason (for instance, the adoption of rigorous product standards to protect public

health) can be viewed as unfair trade barriers by other countries.

How an international trade dispute is resolved is important to the countries involved

and to the world. If other countries respond by raising their own barriers in retaliation,

then the world is worse off, and it is likely that most or all of the countries involved are

worse off because they are mutually losing some of the gains from trade. If, instead,

negotiations and diplomacy lead the countries to find a resolution that removes

offending trade restrictions, then the world benefits, as countries move closer to free

trade. The trick is how to avoid the first outcome and make the second more likely.

Countries’ governments can informally discuss and negotiate with each other, but

institutions and rules also matter. From its inception in 1947, the General Agreement

on Tariffs and Trade had a mechanism for hearing disputes in which a member

believed that another member had taken actions that violated a GATT rule or obliga-

tion. However, the resolution process had a major shortcoming—any GATT member,

including the country that had the dispute ruling go against it, could block adoption

of a ruling. As rulings were blocked, frustration with the system grew. This led to

movement in two directions. First, the United States adopted a law that promoted its

right to seek its own resolution if other countries were using unfair trade practices.

Then, as part of the Uruguay Round agreements, the newly created World Trade

Organization was given a stronger dispute resolution process.

America’s “Section 301”: Unilateral Pressure As the U.S. government became frustrated with the shortcomings of the GATT dispute

resolution process, it enacted Section 301 of the Trade Act of 1974, which gives the

Chapter 9 Nontariff Barriers to Imports 183

pug21774_ch09_160-191.indd 183pug21774_ch09_160-191.indd 183 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

Focus on China China in the WTO

After 15 years of complex and sometimes difficult negotiations, China became a member of the WTO in late 2001. To become a member, a country must gain acceptance from all WTO members (an example of WTO decision making by consensus). In this process, China agreed to make major changes in many of its trade policies and other economic policies—in some ways the commitments go well beyond those of members who joined many years ago.

Has China gained what it hoped from its mem- bership in the WTO? Broadly, China has obtained substantial benefits from freer trade. China’s trade continues to grow rapidly, as does its economy. China has gained the general benefits of WTO membership. China now has MFN treat- ment by other members. It has gained a seat at WTO-sponsored multilateral trade negotiations, although its role in the Doha Round negotiations was low-keyed until 2008.

As a WTO member, China qualified for the end of the VERs that limited its exports of clothing and textiles. As discussed in the box earlier in the chapter, when the VERs were removed, China’s exports were limited for a few more years by safeguards imposed by the United States and the European Union. Still, its export of these products has grown rapidly during the past decade.

China’s entry into the WTO has continued its integration into the global economy, and it became more attractive as a destination for direct investments by foreign firms (a topic taken up in more depth in Chapter 15). In turn, the operations of foreign firms in China have spurred its trade and economic growth. In addi- tion, the WTO commitments have been useful in domestic politics, by strengthening the positions of reformers within the Chinese government leadership.

In pursuit of these economic benefits, what commitments did China make to join the WTO, and how has it been doing in meeting these com- mitments? Here are some major areas covered by the accession agreement.

• Tariff reductions: China had been reducing its tariff rates prior to joining the WTO, and it continued to do so. For industrial products, the average tariff rate has declined to 9 percent from 14 percent in 2001. Some reductions are dramatic. The tariff on autos declined from 80 percent to 25 percent, and tariffs on com- puters, telecommunications equipment, and other information technology products were eliminated. For agricultural products, China has dropped its average tariff to 16 percent from 23 percent in 2001. All tariff rates are bound (so that China cannot arbitrarily increase them in the future).

• Services: China agreed to a range of commitments under the General Agreement on Trade in Services to provide better market access for foreign services firms. For instance, China has removed or liberalized limits on the local activities of foreign firms engaged in banking, financial services, and insurance. Still, foreign firms have expressed some concerns that other rules and regulations have been used to limit their ability to benefit from the changes. High capital requirements have been imposed on foreign-owned banks and the process of gaining approvals for new office locations and for additional products has been costly and slow. Another concern is that China has failed to implement a process for approving the entry of foreign firms providing computer travel reservation services.

• Intellectual property: China agreed to bring its laws protecting intellectual property rights (patents, brand names and trademarks, and copyright) into conformity with WTO and other international standards and to enforce these laws. China’s laws are generally in con- formity. However, there remain major concerns that piracy and product counterfeiting are rampant and that the laws are not enforced.

Overall, China has made major changes, including amending several thousand laws and

184 Part Two Trade Policy

pug21774_ch09_160-191.indd 184pug21774_ch09_160-191.indd 184 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

regulations. China generally has met the commit- ments that it made to join the WTO, though in some areas it has been slow or has taken other actions that offset some of its liberalizations.

By joining the WTO, China also became part of the WTO’s dispute settlement system. After a slow start, China is now fully enmeshed in the sys- tem. Before 2007, China filed only one complaint and was the respondent to only four complaints from other countries (and three of these were about the same matter). Since 2007, China has lodged the third-largest number of complaints (behind the United States and the EU), and it has been the alleged violator more than any other WTO member.

From 2002 to early 2014, China filed 12 com- plaints in total, with the United States or the EU the respondent in all of them. In all but one of these cases, China alleged that the respondent had misused or misapplied antidumping duties, countervailing duties, or safeguards, types of contingent protection that we will examine in Chapter 11. Most of these cases led to decisions by panels after the countries could not reach agreements by consultation. Most panel deci- sions found that the United States or the EU had violated WTO rules, and they then implemented changes. For example, in the one case that did not involve contingent protection, in 2009 China complained that the United States had not fol- lowed WTO rules when it banned imports of Chinese poultry. After the panel ruled in favor of China’s complaint, the United States removed the ban.

From the first case in 2004 to early 2014, China was the respondent in 31 cases that involved 19 distinct matters. In all the matters except one, the complainants included the United States or the EU (sometimes both). For three matters, consultations led to mutually agreed solutions in which China changed its policies. Five matters had not (yet) progressed past consultations, and the other 11 matters went to panels. Six panel deci- sions found that China had violated WTO rules,

and China then made changes to bring itself into conformity. As of early 2014, there were only two matters in which China had lost panel decisions but had not implemented changes within a rea- sonable time, and in one of these China seemed to be moving slowly to make changes.

Here are a few of the cases with China as the respondent. In 2004, the United States filed the first WTO case against China, alleging that China was using discriminatory domestic tax rates to favor integrated circuits that were designed or made in China. Negotiations led to a resolution in which China ended the tax differential.

The first complaints against China to go to a panel were filed in 2006 by the EU, the United States, and Canada, alleging that China was imposing tariffs on automobile parts that exceeded China’s bound rate, through a form of domestic content requirement. In early 2008 the panel hearing the case ruled that the Chinese pol- icy violated WTO rules, and China then changed its policies.

In 2010, the United States, the EU, and Mexico complained that China’s limits on exports of cer- tain raw materials provided unfair advantages to Chinese producers that used these raw materials as inputs. After the panel ruled against China, China removed its restrictions. In 2012 the United States, the EU, and Japan filed similar complaints that China was restricting exports of rare earths. In 2014, the WTO panel again ruled that China had violated WTO rules and commitments with its export restrictions.

China’s role as a major player in the WTO dispute settlement system shows the value of the WTO processes. China has a legitimate way to address and attempt to resolve trade conflicts with two of its largest trade partners, the United States and the EU. In most dispute cases in which one of these countries is using procedures or enacting policies that do not conform to WTO rules and commitments, the country has eventu- ally amended its procedures and policies to bring them in line with WTO rules.

Chapter 9 Nontariff Barriers to Imports 185

pug21774_ch09_160-191.indd 185pug21774_ch09_160-191.indd 185 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

U.S. president the power to negotiate to eliminate “unfair trade practices” of foreign

governments. As part of the process, the U.S. government can threaten to enact new

barriers to imports into the United States from the allegedly offending country if that

country does not change its policies. (U.S. law also has “Special 301,” which mandates

an annual report on foreign countries that do not provide adequate protection to intel-

lectual property.)

What are the effects of unilateral actions by the U.S. government to open foreign

markets using a threat of retaliation? That depends on whether the threatened country

gives in and removes the practices that the United States deems unfair. If it does, then

the U.S. government achieves some of its objectives, and it probably is a move toward

at least somewhat freer trade. About half of the 100 or so Section 301 cases since 1974

ended in this way, though the increases in U.S. exports usually were small.

However, if the other country does not accede to the U.S. demands to change its

policies, and the U.S. government imposes trade sanctions (usually in the form of high

tariffs on an arbitrary set of products imported from the other country), then carrying

out the retaliation is likely to reduce the well-being of both sides. Unfortunately, nearly

a quarter of Section 301 cases have led to such mutually harmful U.S. sanctions.

Not surprisingly, other countries resent U.S. government use of this law. They are

irked by the self-righteous tone with which the United States has written and used

301. They rightly point out that 301 has allowed the United States to conduct its own

unilateral “trade crimes” trials, deciding by itself what is unfair.

There has been a drop-off in Section 301 cases since the early 1990s. U.S. com-

plaints are now much more likely to be sent to and resolved using the WTO dispute

settlement process.

Dispute Settlement in the WTO During the Uruguay Round of multilateral trade negotiations, governments recog-

nized both the shortcomings of the then-existing GATT dispute process and the con-

cerns about the unilateral approach embodied in U.S. Section 301. The World Trade

Organization that came into existence in 1995 has a much stronger dispute settlement

procedure than the GATT had.

If the government of a member country believes that another member country gov-

ernment is violating a commitment or WTO rule, it can file a complaint. The goal of

the WTO is then to find a resolution to the dispute, including removing any violation

that exists. The first step is consultations between the governments. If discussions can-

not resolve the dispute, a panel of experts examines the case and reaches a decision. A

country can appeal the decision by this panel, but it cannot block it just by objecting.

If the complaint is upheld, the offending country is instructed to correct its policy. In

most cases, the countries find a mutually acceptable solution to the dispute. But, if the

offending country does not correct its policy or provide other compensation, then as a

last resort the WTO can authorize retaliation by the complaining country against the

offending country.

In its first 10 years (1995–2004), the WTO received an average about 32 complaints

per year. Then, during 2005–2013, the average decreased to about 17 per year. For

the entire period, in about 40 percent of these cases, the United States or the European

Union has been the complaining country; in about 40 percent, the United States or

186 Part Two Trade Policy

pug21774_ch09_160-191.indd 186pug21774_ch09_160-191.indd 186 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

the European Union has been the alleged violator (the respondent); and often it is one

complaining about the other.

The dispute settlement procedure has also been widely used by other countries,

though not so intensively. In about 45 percent of the cases, a developing country has

brought the complaint, and in about 45 percent, a developing country is the alleged

violator. Since joining the WTO in 2001, China has brought 12 complaints (as of early

2014), and it has been the alleged violator in 31 cases. (The box “China in the WTO”

discusses disputes and other aspects of China’s membership.) It is also worth noting

that about half of the dispute cases are complaints about the types of nontariff barriers

that we have discussed in this chapter.

WTO authorization of retaliation is rare, and actual imposition of trade sanctions

against a recalcitrant violating country even rarer (about 2 percent of cases filed). The

sanctions are usually in the form of high tariffs against a set of products exported by

the violating country. The threat of retaliation appears to be useful in getting violating countries to correct their policies, but actual retaliation is problematic. It runs counter to the WTO’s goal of trade liberalization, and it is likely to reduce the well-being of

both countries involved and of the world as a whole. It is fortunate that such retalia-

tion has been rare.

Summary Nontariff barriers (NTBs) reduce imports by limiting quantities, increasing costs, or creating uncertainties. An import quota sets a maximum quantity of imports. If markets are competitive, a quota has the same effects as a tariff that results in the same

import quantity, with one possible exception. Just as for imposing a tariff, imposing

a quota raises the domestic price, reduces domestic quantity demanded, increases

domestic quantity supplied, reduces domestic consumer surplus, increases domestic

producer surplus, and, if the importing country is large, reduces the world price by

reducing demand for the foreign product. The exception is what happens to what

would be government revenue with a tariff. With a quota this amount is a markup of

the domestic price over the world price for each unit imported. If the government freely gives away licenses to import under the quota, the lucky importers get this amount as

extra profit. If the government auctions or sells the import licenses, the government can get the amount as revenue. If the government has a complicated process for obtaining

import licenses, then some of this amount is lost to resource-using application procedures. For a small country, a quota is just as bad as a tariff, and it can be worse if resources are used up in pursuit of licenses to import or if the quota creates domestic

monopoly power.

A form of protection that became important in the 1980s, especially in the United

States and the EU, is the voluntary export restraint (VER) arrangement. Here the importing country threatens foreign exporters with stiff barriers if they do not agree

to restrict exports by themselves. Under a negotiated VER arrangement, the main for-

eign exporters form a cartel among themselves, agreeing to cut export quantities. At

the same time, they are allowed to charge the full markup on their limited sales to the

importing country, where the product has become more expensive. A curious result

is that the importing country, which insisted on the VER in the first place, loses even

more than if it had collected a tariff or quota markup itself.

Chapter 9 Nontariff Barriers to Imports 187

pug21774_ch09_160-191.indd 187pug21774_ch09_160-191.indd 187 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

Other important nontariff barriers include domestic content requirements, mixing requirements, government procurement favoring domestic products, and a host of quality and safety standards that have protectionist effects.

The net costs of import barriers, both tariff and nontariff, often look small as a

share of GDP when calculated in terms of the ordinary deadweight loss triangles.

Yet this analysis overlooks foreign retaliation, enforcement costs, rent-seeking, and

other considerations that can make import barriers more expensive. In relation to the

boost provided to producer surplus in protected sectors, the net costs of import bar-

riers are larger.

Global efforts to liberalize nontariff barriers have generally met with less success

than the global efforts to reduce tariff rates. Under the GATT and the WTO, most

import quotas have been eliminated, but the use of other NTBs has increased in

recent decades. Multilateral trade negotiations in the Kennedy Round and the Tokyo

Round resulted in voluntary codes for some types of NTBs, but these codes had

modest effects. The Uruguay Round agreements have a wider set of NTB codes and

rules that apply to all WTO members, including the phasing out of VERs on textiles

and clothing.

The Uruguay Round agreements also began the process of liberalizing trade in

agricultural products and trade in services, as well as requiring members to provide

minimum levels of ownership protection for intellectual property. The current Doha

Round of trade negotiations has an ambitious agenda, but progress has been stymied

by the inability of the United States, the European Union, and developing countries

(led by Brazil and India) to agree on how and how much to liberalize government

policies toward agriculture and agricultural trade.

Beginning in the late 1970s, the United States, frustrated by the weakness of the

dispute settlement procedures of the GATT, shifted toward using its Section 301 to try to resolve its complaints about foreign countries’ trade practices and policies.

Other countries resented the unilateral U.S. approach. With the advent of the much-

improved dispute settlement process in the WTO, the United States has reduced its

use of Section 301.

The WTO’s dispute settlement procedures are generally viewed as successful. Many

complaints are resolved by negotiated agreements between the countries to the dis-

putes, and others are resolved after panels issue their formal rulings. If the WTO panel

hearing a case finds that a country’s policies are in violation of WTO rules, and the

country does not change its policies, the WTO can approve retaliatory measures, usu-

ally that the complainant country can impose high tariffs on imports from the country

in violation. The threat of retaliation can induce compliance by the violator country,

but it also has a downside. If the country in violation does not change, and the retalia-

tion is enacted, the countries involved in the dispute and the world are then worse off.

Key Terms

Nontariff barrier (NTB)

Import quota (quota)

Fixed favoritism

Import license auction

Resource-using application

procedures

Voluntary export restraint

(VER)

Domestic content

requirement

Mixing requirement

Section 301

188 Part Two Trade Policy

pug21774_ch09_160-191.indd 188pug21774_ch09_160-191.indd 188 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

Suggested Reading

Questions and Problems

1. What are import quotas? Why do some governments use them instead of just using tar-

iffs to restrict imports by the same amounts? Is it because quotas bring a bigger national

gain than tariffs?

2. What are voluntary export restraint (VER) agreements? Why do some governments

force foreign exporters into them instead of just using quotas or tariffs to restrict

imports by the same amounts? Is it because VERs bring the importing country a

bigger national gain than quotas or tariffs?

3. Under what conditions could an import quota and a tariff have exactly the same effect

on price and bring the same gains and losses (given a tariff level that restricts imports

just as much as the quota would)?

4. Define each of the following import policies and describe its likely effects on the well-

being of the importing country as a whole: (a) product standards and (b) domestic

content requirements.

5. To protect American jobs, the U.S. government may decide to cut U.S. imports of

bulldozers by 60 percent. It could do so by either (a) imposing a tariff high enough

to cut bulldozer imports by 60 percent or (b) persuading Komatsu and other foreign

bulldozer makers to set up a VER arrangement to cut their exports of bulldozers to

the United States by 60 percent. Which of these two policies would be less damag-

ing to the United States? Which would be less damaging to the world as a whole?

Explain.

✦

World Trade Organization (2012) provides a broad survey of nontariff barriers to imports.

Trionfetti (2000) examines government procurement as an NTB. Berry, Levinsohn,

and Pakes (1999) provide a technical analysis of the VER on Japanese auto exports to

the United States. Findlay and Warren (2000) present evidence on barriers to trade in

services, and Hoekman (2000) looks at gains from liberalizing services trade. Footer

and Graber (2000) examine barriers to trade in cultural goods and services (films, music

recordings, and so forth).

Feenstra (1995) provides a technical survey of work estimating the effects of

protection. Anderson and Wincoop (2004) provide a survey of the magnitudes of a broad

range of policies and other influences that seem to impede international trade. Kee et al.

(2010) and Evenett (2009) examine protectionism during the global crisis. Irwin (2011)

explores the rise of protectionism during the Great Depression.

Destler (2005) and Pearson (2004) survey the development of U.S. trade policy.

Hoekman and Kostecki (2001) examine the WTO’s rules and activities. Jones (2004)

explores the controversies surrounding the WTO and its activities. Bagwell and Staiger

(2002) provide a conceptual analysis of why the WTO and its rules make economic

sense. Bhattasali et al. (2004) analyze China’s accession to WTO membership. Elliott

(2006) and McCalla and Nash (2007) examine the issues of agricultural liberalization

in the Doha Round negotiations. Bown (2009) critiques the role of developing countries

in the WTO dispute settlement process. Using the gravity model described in the box in

Chapter 6, Rose (2004) concludes that the WTO has not increased international trade, but

a series of researchers, including Dutt et al. (2013), Liu (2009), and Subramanian and Wei

(2007) counter with evidence that it has.

Chapter 9 Nontariff Barriers to Imports 189

pug21774_ch09_160-191.indd 189pug21774_ch09_160-191.indd 189 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

6. The United States is considering adopting a regulation that foreign apples can be

imported only if they are grown and harvested using the same techniques that are used

in the United States. These techniques are used in the United States to meet various

government standards about worker safety and product quality.

a. As a representative of the U.S. government, you are asked to defend the new import regulation before the WTO. What will you say?

b. As a representative of foreign apple growers, you are asked to present the case that this regulation is an unfair restriction on trade. What will you say?

7. A small country imports sugar. With free trade at the world price of $0.10 per pound,

the country’s national market is:

Domestic production 120 million pounds per year

Domestic consumption 420 million pounds per year

Imports 300 million pounds per year

The country’s government now decides to impose a quota that limits sugar imports to

240 million pounds per year. With the import quota in effect, the domestic price rises

to $0.12 per pound, and domestic production increases to 160 million pounds per year.

The government auctions the rights to import the 240 million pounds.

a. Calculate how much domestic producers gain or lose from the quota. b. Calculate how much domestic consumers gain or lose from the quota. c. Calculate how much the government receives in payment when it auctions the

quota rights to import.

d. Calculate the net national gain or loss from the quota. Explain the economic reason(s) for this net gain or loss.

8. A small country’s protectionism can be summarized: The typical tariff rate is

50 percent, the (absolute value of the) price elasticity of demand for imports is 1,

imports would be 20 percent of the country’s GDP with free trade, and the protected

industries represent 15 percent of GDP. Using our triangle analysis, what is the ap-

proximate magnitude of the economic costs of the tariff protection, as a percentage of

the country’s GDP? As a percentage of the gain of producer surplus in the protected

sectors?

9. For a small country, consider a quota and an equivalent tariff that permit the same

initial level of imports. The market is competitive, and the government uses fixed

favoritism to allocate the quota permits, with no resources expended in the process.

There is now an increase in domestic demand (the domestic demand curve D d shifts

to the right). If the tariff rate is unchanged, and if the quota quantity is unchanged,

are the two still equivalent? Show this using a graph. Be sure to discuss the effects on

domestic price, production quantity, and consumption quantity, on import quantity,

and on producer surplus, consumer surplus, deadweight losses, and government

revenue or its equivalent for the quota.

10. A Japanese friend asks you to explain and defend American use of Section 301. What

will you say?

11. Suppose that the U.S. government is under heavy pressure from the Rollerblade and

K2 companies to put the brakes on imports of Bauer in-line skates from Canada. The

protectionists demand that the price of a $200 pair of in-line skates must be raised to

✦

190 Part Two Trade Policy

pug21774_ch09_160-191.indd 190pug21774_ch09_160-191.indd 190 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

$250 if their incomes are to be safe. The U.S. government has three choices: (1) free

trade with no protection, (2) a special tariff on in-line skates backed by vague claims

that Canada is using unfair trade practices (citing Section 301 of the Trade Act of

1974), and (3) forcing Bauer to agree to a voluntary export restraint. The three choices

would lead to these prices and annual quantities:

With Free Trade With an $80 Tariff With a VER

Domestic U.S. price per pair $200 $250 $250 World price per pair $200 $170 $170 Imports of in-line skates (millions of pairs) 10 6 6

Note that the $80 tariff reduces imports by 4 million pairs a year, the same reduction

that the VER arrangement would enforce.

a. Calculate the U.S. net national gains or losses from the tariff, and the U.S. gains or losses from the VER, relative to free trade. Which of the three choices looks best

for the United States as a whole? Which looks worst?

b. Calculate the net national gains or losses for Canada, the exporting country, from the tariff and the VER. Which of the three U.S. choices harms Canada most?

Which harms Canada least?

c. Which of the three choices is best for the world as a whole?

12. A small country initially has free trade in motorcycles, it has one local motorcycle

producer, and imports account for over half of local motorcycle sales. The govern-

ment has decided to impose a tariff of 20 percent, aimed to reduce motorcycle imports

by about a third. The local producer proposes that a quota equal to two-thirds of the

free-trade level of imports be imposed instead of the tariff because the quota will ben-

efit the country by providing certainty about the import quantity. You are employed

in the Ministry of the Economy and have been asked to provide a briefing on whether

the government should use a tariff or a quota. What will you say in your presentation?

13. “In comparison to the GATT, two advantages of the WTO are that (a) the WTO has

been more successful in completing rounds of multilateral trade negotiations and

(b) the WTO has a better dispute settlement procedure.” Do you agree or disagree?

Why?

✦

Chapter 9 Nontariff Barriers to Imports 191

pug21774_ch09_160-191.indd 191pug21774_ch09_160-191.indd 191 11/4/14 4:38 PM11/4/14 4:38 PM

Final PDF to printer

Chapter Ten

Arguments for and against Protection Why do most countries have policies that limit imports? The previous two chapters

found only bad barriers, ones that brought net harm to the world economy. Because

free trade led to a fully efficient outcome for the world in our analysis, any trade

barriers could only be bad. We did find one barrier, the nationally optimal tariff,

that could be good for the country that imposed it. But it, too, was bad for the

world as a whole, and it could end up being bad for the country that tried to impose

it if other countries retaliate by raising their own tariffs on products that the first

country exports.

A key objective of this chapter is to examine a variety of arguments proposing that

import protection is good for the country (and perhaps for the world) because it allows

the country to address some market shortcoming or to achieve some objective other

than economic efficiency. We know that a tariff or nontariff barrier (NTB) to imports

of a product can

• Increase domestic production of the product.

• Increase employment of labor and other resources in this domestic production.

• Decrease domestic consumption of the product.

• Increase government revenue.

• Alter the distribution of income or well-being in the country.

Corresponding to each of these effects, here are five generic arguments in favor of

tariffs (or NTBs) that we will examine:

• If there is something extra good about local production of a product, then a tariff

can be good for the country because the tariff leads to more domestic production

of the product.

• If there is something extra good about employing people or other resources in

producing a product, then a tariff can be good for the country because the tar-

iff leads to more employment in the sector as local production of the product

increases.

• If there is something extra bad about local consumption of a product, then a tariff

can be good for the country because the tariff leads to less domestic consumption

of the product.

192

pug21774_ch10_192-221.indd 192pug21774_ch10_192-221.indd 192 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

• If there is something extra good about the government collecting more revenue,

then a tariff can be good for the country.

• If it is desirable to enhance the incomes of factors used intensively in the import-

competing industry, then a tariff can be good for the country.

In each of these cases, the tariff could also be good for the world as well. (We defer

examination of one other generic argument for import protection, that foreign export-

ers are engaging in unfair trade, until the next chapter.)

Our analysis here will establish two main conclusions:

• There are valid “second-best” arguments for protection—situations in which pro-

tection could be better than free trade.

• Some other government policies are usually better than import barriers in these

situations.

If there are few situations in which import protection is the best policy for a

country, why do we see so many import barriers? The second part of the chapter

focuses on the politics of protection. We examine how political actions by different

self-interested groups in the country can influence political decisions about import

barriers. Our political excursion indicates that institutions are important. Import

protection is more likely in a representative democracy for products in which

import-competing domestic producers organize into effective lobbies but domestic

consumers do not.

THE IDEAL WORLD OF FIRST BEST

In the previous two chapters we assumed an ideal, or “first-best,” world in which all

private incentives aligned perfectly with benefits and costs to society as a whole. In a first-best world, any demand or supply curve can do double duty, representing both

private and social benefits or costs. The domestic demand curve represented not only

marginal benefits of an extra bicycle to its private buyer but also the extra benefits of

another bicycle to society as a whole. The domestic supply curve represented not only

the marginal cost to private producers of producing another bicycle at home but also

the marginal cost to society as a whole.

The first row of Figure 10.1 summarizes what an economist means by a first-best

world. The market price ( P ) acts as a signal to consumers and producers. Consumers buy the product up to the point where the price they are willing to pay, which equals

the extra private benefits ( MB ) they receive from another unit, just equals the price that they must pay. The extra benefit to society ( SMB ) is just the extra benefit that the consumer gets. Producers supply the product up to the point where the price they

receive just covers the extra costs ( MC ) of producing the product. The extra costs to society ( SMC ) of producing another unit of this product are just the extra costs that the individual firm incurs. That is, all five values are equal:

Price ( P ) 5 Buyers’ private marginal benefit ( MB ) 5 Social marginal benefit ( SMB )

5 Sellers’ private marginal cost ( MC ) 5 Social marginal cost ( SMC )

Chapter 10 Arguments for and against Protection 193

pug21774_ch10_192-221.indd 193pug21774_ch10_192-221.indd 193 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

Situation Incentives at the Margin Effects

First-best world P 5 MB 5 MC 5 SMB 5 SMC Exactly the right amount is supplied and demanded. Distortions

External costs SMC . P (5 MB 5 MC 5 SMB) Too much is supplied because suppliers make and sell extra units for which the social costs exceed the price (which equals MC and MB and SMB). Example: production that pollutes air or water.

External benefits SMB . P (5 MB 5 MC 5 SMC) Not enough is demanded because demanders receive only private benefits equal to the price, not the full social benefits. Example: training or education that brings extra gains in attitudes or team skills.

Monopoly power P . SMC Not enough is demanded because the monopoly sets the price too high.

Monopsony power P , SMB Not enough is supplied because the (a case not developed monopsony sets its buying price too low. in this textbook) Example: a single firm that dominates a labor market and uses its power to set a low wage.

Distorting tax P with tax . SMC Not enough is demanded because the tax makes the price to buyers exceed the revenue per unit received by suppliers.

Distorting subsidy P with subsidy , SMC Too much is demanded because the subsidy makes the price to buyers lower than the revenue per unit received by suppliers.

FIGURE 10.1 Distortions and Their Effects

P 5 Market price MB 5 Private marginal benefit of an activity (to those who demand it) MC 5 Private marginal cost of an activity (to those who supply it) SMB 5 Social marginal benefit of an activity (to everybody affected) SMC 5 Social marginal cost of an activity (to everybody affected)

In a first-best world free trade is economically efficient. Free trade allows the

“invisible hand” of market competition to reach globally. Private producers, reacting

to the signal of the market price, expand production in each country to levels that are

as good as possible for the world as a whole. Private consumers, also reacting to price

signals, expand their purchases of products to levels that make the whole world as

well off as possible.

THE REALISTIC WORLD OF SECOND BEST

Our world is not ideal. Distortions exist, and they do not automatically cancel each

other out. The distortions result from ongoing gaps between the private and social

194 Part Two Trade Policy

pug21774_ch10_192-221.indd 194pug21774_ch10_192-221.indd 194 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

benefits or costs of an activity. We live in a second-best world, one that includes distortions. As long as these gaps exist between what private individuals use to make

their decisions and the full effects of these decisions on society, private actions will not lead to the best possible outcomes for society.

There are two major sources of distortions in an economy. First, market failures are ways in which private markets fail to achieve full economic efficiency. Second,

government policies can distort an otherwise economically efficient private market. Figure 10.1 provides information on six specific types of distortions, with the first four

being types of private market failures and the last two being government policies that

can create distortions.

The first two types of distortions in the figure are externalities or spillover effects (net effects on parties other than those agreeing to buy or sell in a market- place). The first example of an externality is the classic case of pollution. Consider

the case of river pollution, an example we will explore at length in Chapter 13. If the

sellers of paper products are not forced to do so, they do not reckon the damage done

by the paper mills’ river pollution as part of the cost of their production. So the pollu-

tion costs are not incorporated into the price of paper. Similarly, buyers of petroleum

fuels do not reckon that the social cost of air pollution from using those fuels is part

of the fuel price that they have to pay. If some costs of producing or consuming a

product are ignored by the private decision-makers, then too much of the product is

produced or consumed.

Our second example of an externality supposes that jobs in a certain import-

competing sector generate greater returns for society than are perceived by the people

who decide whether or not to take the jobs. These external benefits can happen, for

instance, if working in the sector brings gains in knowledge, skills, and attitudes that

benefit firms or people other than the workers and employers in the sector. In this

example the social marginal benefits ( SMB ) of working in the sector are higher than the wage rate (or the price, P ) that workers receive. If some benefits of the activity are ignored by private decision-makers, then too little of the activity occurs (in the

example, too few people are hired into jobs in the sector).

In this chapter we focus on distortions caused by externalities. In fact, we

focus on various kinds of external benefits that are the “extra good” that can

accompany local production of a product or employment in producing the prod-

uct. We only briefly mention here the other four types of distortions shown in

Figure 10.1.

Monopoly power can create a distortion because a powerful seller restricts out-

put to raise price and increase profits. For a domestic monopoly firm, free trade

can eliminate this distortion by forcing the domestic firm to compete with foreign

firms. Monopsony power can create a distortion because a powerful buyer sets a

price that is too low.

In the absence of any other distortion, a tax creates a distortion by artificially rais-

ing the price to buyers. Our analysis of a tariff in Chapter 8 is an example of a tax

distortion and the inefficiency caused by this distortion.

In the absence of any other distortion, a government subsidy creates a distortion by

artificially lowering the price to buyers. Essentially, a subsidy is like a negative tax.

We will examine subsidies later in this chapter and in the next chapter.

Chapter 10 Arguments for and against Protection 195

pug21774_ch10_192-221.indd 195pug21774_ch10_192-221.indd 195 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

Government Policies toward Externalities External costs and external benefits pose some of the most intriguing policy problems

in economics. How should a society try to fix distortions caused by externalities?

There are two basic alternative approaches for government policy. One approach is

the tax-or-subsidy approach developed by British economist A. C. Pigou. The other approach is the property-rights approach , which builds on the ideas of Nobel Prize winner Ronald Coase. 1

In this chapter we use the tax-or-subsidy approach because the trade policy debate

is usually over taxes and subsidies (e.g., a tariff is a tax). While we explore how gov-

ernment taxes and subsidies, at their best, can cure externality distortions, remember that there is reason to debate whether such government interventions will work well in practice. 2 The idea is to explore the best possible cases for government interference

with trade. At the same time, we have to keep in mind the real possibility of govern- ment failure to correctly identify problems and enact solutions.

The tax-or-subsidy approach says that we should spot distortions in people’s and

firms’ private incentives and have a wise government policy correct the incentives with

taxes or subsidies. What if social marginal cost exceeds private cost and market price

( SMC . MC 5 P 5 MB 5 SMB ), as in the pollution case? The government should levy a tax of ( SMC – MC ) to bring everything into equality by raising the market price to match the full social marginal cost (including the external costs created by the pollution). If the

social marginal benefit exceeds the private benefit and the market price ( SMB . MB 5 P 5 MC 5 SMC ), as in the training case, let the government pay a subsidy of ( SMB – MB ) so that decision-makers in the marketplace recognize the full social returns.

Could trade barriers help to cure distortions caused by externalities? Even before we

get to the details, we can see that the tax-or-subsidy approach can relate to the debate over

trade barriers. If there is a distortion in our economy, perhaps cutting imports will help.

A quick example is the worker-training case already mentioned. If the social benefit of

having workers get training in a certain industry is greater than their current market wage,

we could reap net social gains by protecting their jobs against foreign competition. This

is the kind of issue that we return to repeatedly in this chapter.

The Specificity Rule Externalities and other incentive distortions complicate the task of judging whether a

trade barrier is good or bad for the nation as a whole. Realizing this, some scholars

1 For example, the property-rights approach says that, if there is a problem of a paper mill polluting a river, we can make private incentives include all social effects by making the river someone’s private property. Either let the downstream river users own it and charge the paper mill for any pollution, or let the paper mill own the river and demand compensation for cleaning it up. Choose between these two property-right assignments by choosing the one that costs less to implement and enforce. The property-rights approach will resurface in Chapter 13’s treatment of international environmental issues.

2 We can see this more broadly and also clear up a possible confusion. In Figure 10.1 a tax and a subsidy are listed as possible sources of distortions. That is, if the market otherwise gets to the first-best solution (because there is no other distortion), then introducing a tax or subsidy causes a distortion. If, instead, a distortion already exists, then the market will not get to the first-best outcome by itself. If a distortion already exists, then an appropriate tax or subsidy can improve the market outcome. But the wrong tax or subsidy could make things even worse.

196 Part Two Trade Policy

pug21774_ch10_192-221.indd 196pug21774_ch10_192-221.indd 196 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

have stressed that there is no cure-all prescription for trade policy in a second-best

world. Once you realize that distortions exist, things become complicated. It seems

that each situation must be judged on its own merits.

Yet we are not cast totally adrift in this world of distortions. We do not have to

shrug and just say, “Every case is different. It all depends.” There is a useful rule that

works well in most cases. The specificity rule states that it is usually more efficient to use the government policy tool that acts as directly as possible on the source of the distortion separating private and social benefits or costs. In short, identify the specific source of the problem and intervene directly at this source.

The specificity rule applies to all sorts of policy issues. Let’s illustrate it first by

using an example removed from international trade. Suppose that the problem is

crime, which creates fear among third parties and direct harm to victims. Since crime

is caused by people, we might consider combating crime by reducing the whole popu-

lation through compulsory sterilization laws or taxes on children. But such actions

are obviously inefficient ways of attacking crime because less social friction would

be generated (per crime averted) if we fought crime more directly through greater law

enforcement and programs to reduce unemployment, a major contributor to crime.

The next sections of the chapter examine various arguments that restrictions on

imports are a good way for the government to deal with distortions caused by spillover

effects. As we will see in these cases, the specificity rule tends to cut against import

barriers. Although a barrier against imports can be better than doing nothing in a second-best world, the specificity rule shows us that some other policy instrument is usually more efficient than a trade barrier in dealing with a domestic distortion.

PROMOTING DOMESTIC PRODUCTION OR EMPLOYMENT

Protectionists often come up with reasons that it is good to maintain high levels of

domestic production of a product that is imported or high levels of employment of

workers (and perhaps other resources) in this domestic production. They offer reasons

that this is good for the nation as a whole (and not just for the firms and workers that receive the protection). In fact, most popular second-best arguments for protection

can be viewed as variations on the theme of favoring a particular import-competing

industry because there are extra social benefits to domestic production or employment

in this particular import-competing industry. Here are several versions that we will

examine in this chapter:

• Local production of this product produces spillover benefits because other firms

and industries benefit from production know-how or management techniques intro-

duced by the firms in this industry.

• Employment in this industry imparts new worker skills and attitudes, and some

workers carry these when they switch jobs to work for other firms and industries.

• By producing now at high cost, firms in the industry can find ways to lower their

costs over time.

• There are extra costs to workers if they are forced to switch to jobs in other

industries.

Chapter 10 Arguments for and against Protection 197

pug21774_ch10_192-221.indd 197pug21774_ch10_192-221.indd 197 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

• The country and its citizens take pride from producing this product locally.

• The product is essential to national defense.

• Employment in the industry is a way to redistribute income to poor or disadvan-

taged members of society.

In examining these proposed reasons that protection is good for the country, we con-

sider the case of a small country (one whose trade has no impact on world prices), so that our analysis is not complicated by any effects of the trade barrier on the country’s

international terms of trade.

Let us turn first to the pros and cons of a tariff to promote domestic production

or employment because this production or employment creates positive externalities

(the first two of the reasons shown in the above list). Analysis of these two reasons is

important, and we will be able to use the insights from this analysis in examining the

other reasons in the list.

Let’s look at the case in which a nation might want to encourage domestic production

of bicycles because this production creates positive spillovers elsewhere in the country.

It could achieve the production objective by putting a $30 tariff on imported bicycles, as

shown in the diagram of the national bicycle market in Figure 10.2A . The nation loses

area b by producing at greater expense what could be bought for less from abroad, and it loses area d by discouraging purchases that would have brought more enjoyment to con- sumers than the world price of a bicycle. But now something is added: The lower part of

the diagram portrays extra social benefits (or spillover benefits) from local production,

benefits that are not captured by the domestic bicycle producers. That is, we suppose

that the marginal external benefits of making our own bicycles can be represented by the MEB curve at the bottom. By raising the domestic price of bicycles, the tariff encour- ages more production of bicycles. This increase in domestic production, from 0.6 to 0.8

million bikes, brings area g in extra gains to the nation. Compared with doing nothing, levying the tariff in Figure 10.2A could be good or

bad for the nation, all things considered. The net outcome depends on whether area g is larger or smaller than the areas b and d . To find out, we would have to develop empiri- cal estimates reflecting the realities of the bicycle industry. We would want to estimate

the dollar value of the annual spillover benefits to society and the slopes of the domestic

supply and demand curves. The net national gain ( g – b – d ) might turn out to be posi- tive or negative. Until we know the specific numbers involved, all we can say, so far, is

that the tariff might prove to be better (or worse) than doing nothing.

We should use our institutional imagination, however, and look for other policy

tools. The specificity rule prods us to do so. The locus of the problem is really

domestic production, not imports. What society wants to encourage is more domes-

tic production of this good, not less consumption or fewer imports of it. Instead

of a tariff, why not encourage the domestic production directly by rewarding firms

for producing?

Society could directly subsidize the domestic production of bicycles by having the

government pay bicycle firms a fixed amount for each bicycle produced and sold.

This would encourage them to produce more bicycles. Any increase in production

that a given tariff could coax out of domestic firms could also be yielded by a produc-

tion subsidy. Figure 10.2B shows such a subsidy, namely, a $30 subsidy per bicycle

198 Part Two Trade Policy

pug21774_ch10_192-221.indd 198pug21774_ch10_192-221.indd 198 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

produced domestically. The subsidy increases the revenue per unit sold to $330 ($300

paid by consumers and $30 paid by the government). This subsidy is just as good for

domestic bicycle firms as the extra $30 in selling price that the tariff made possible.

Either tool gets the firms to raise their annual production from 0.6 to 0.8 million, giv-

ing society the same external benefits.

The $30 production subsidy in Figure 10.2B is better than the $30 tariff in

Figure 10.2A. Both generate the same external social benefits (area g ), and both cause domestic firms to produce 0.2 million extra bicycles each year at a higher direct cost

than the price at which the nation could buy foreign bicycles. (In both cases this extra

cost is area b .) Yet the subsidy does not discourage the total consumption of bicycles by raising the price above $300. Consumers continue to pay $300 for each bicycle,

equal to the world price of obtaining an imported bicycle. They continue to consume

1.6 million bicycles. Consumers do not lose the additional area d . This is a clear advantage of the $30 production subsidy over the $30 tariff.

Compare the effects of two ways of getting the same increase in domestic output (0.2 million 5 0.8 – 0.6 million)

and in domestic jobs. Both the $30 tariff and the $30 subsidy to domestic production encourage the same change

in domestic production. But the tariff also needlessly discourages some consumption of imports (the amount

0.2 million 5 1.6 – 1.4 million) that was worth more to the buyers than the $300 each unit of imports would

have cost the nation. The production subsidy is better than the tariff because it strikes more directly at the

task of raising domestic production of this good.

FIGURE 10.2 Two Ways to Promote Import-Competing Production

Price ($ per bike)

0.6 1.60.8

0.6 0.8

Marginal external benefits from domestic production ($ per bike)

Quantity0

300

330

B. With a Subsidy to Domestic Production

Production subsidy

Quantity0

World price

MEB

With the subsidy to domestic production gain g, lose b

Quantity (millions of bikes per year)

Price ($ per bike)

300

0.6 1.61.40.8

0.6 0.8

330

A. With a Tariff

Tariff

Quantity0

Marginal external benefits from domestic production ($ per bike)

g MEB

b d

With the tariff gain g, lose b + d

Chapter 10 Arguments for and against Protection 199

pug21774_ch10_192-221.indd 199pug21774_ch10_192-221.indd 199 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

What makes the production subsidy better is its conformity to the specificity rule:

Since the locus of the externality is domestic production, it is better to attack it in a

way that does not also distort the price that consumers pay for the product.

Although this conclusion is broadly valid, a special assumption is needed to make

the net advantage of the production subsidy exactly equal area d . We are assuming that no other distortions between private and social incentives result when the government

comes up with the revenues to pay the production subsidies to the bicycle firms. That is,

we are assuming that there is no net social loss from having the government either raise

additional taxes or reduce some other spending to pay this subsidy to bicycle producers.

This assumption is strictly valid if the extra tax revenues going into the subsidy come

from a head tax, a tax on people’s existence, which should only redistribute income

and not affect production and consumption incentives. Yet head taxes are rare, and the

more realistic case of financing the production subsidy by, say, raising income taxes or

cutting other government spending programs is somewhat murkier. Raising the income

tax distorts people’s incentives to earn income through effort. Or if the government

spending reallocated to the production subsidy had previously been providing some

other public goods worth more than their marginal cost, there is again an extra loss that

can attend the production subsidy. Policymakers would have to consider these possible

source-of-subsidy distortions. Yet it seems reasonable to presume that such distortions

are less important than the distorting of consumption represented by area d . If our concern is with maintaining or expanding jobs, rather than output, in the

import-competing industry, the same results hold with a slight modification. A produc-

tion subsidy would still be preferable to the tariff because it still achieves any given

expansion in both bicycle production and bicycle jobs at lower social cost. We could

come up with an even better alternative. If the locus of the problem is really the num-

ber of jobs in the bicycle industry, it would be even more efficient to use a policy tool

that not only encourages production but also encourages firms to come up with ways

of creating more jobs per dollar of bicycle output. A subsidy tied to the number of workers employed is better than a subsidy tied to output. 3 The box “How Much Does It Cost to Protect a Job?” examines the costs of using tariffs and NTBs to prop up jobs

in import-competing industries.

So why do governments so often use import barriers instead of direct production or

employment subsidies that are less costly to the economy? Once an industry’s political

lobby is strong enough to get government help, it uses its influence to get a kind of

help that is sheltered from political counterattacks. The subsidy favored by our eco-

nomic analysis provides less shelter. The subsidy is a highly visible target for fiscal

budget cutters. Every year it has to be defended again when the government budget

is under review. A tariff or other import barrier, however, gives much better shelter to

the industry that seeks continuing government help. Once it is written into the law,

it goes on propping up domestic prices without being reviewed. In fact, it generates

government revenue (e.g., tariff revenue), giving it more political appeal. We examine

the politics of protection in more depth later in this chapter.

3 Alternatively, if the object is to create jobs and cure unemployment throughout the entire domestic economy, then it is logical to look first to economywide expansionary policies, such as fiscal policy or monetary policy, and not to policy fixes in any one industry.

200 Part Two Trade Policy

pug21774_ch10_192-221.indd 200pug21774_ch10_192-221.indd 200 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

THE INFANT INDUSTRY ARGUMENT

The analysis of using a tariff to promote domestic production helps us judge the

merits of a number of popular arguments for protection. Of all the protectionist

arguments, the one that has long enjoyed the most prestige among both economists

and policymakers is the infant industry argument, which asserts that a tem- porary tariff is justified because it cuts down on imports while the infant domestic

industry learns how to produce at low enough costs. Eventually the domestic indus-

try will be able to compete without the help of a tariff. The infant industry argument

differs from the optimal tariff argument by claiming that in the long run the tariff

protection will be good for the world as well as for the nation. It differs from most

other tariff arguments in being explicitly dynamic, arguing that the protection is

needed only for a while.

The infant industry argument has been popular with aspiring countries at least

since Alexander Hamilton used it in his Report on Manufacturers in 1791. The United States followed Hamilton’s protectionist formula, especially after the Civil

War, setting up high tariff walls to encourage production of textiles, ferrous metals,

and other goods still struggling to become competitive against Britain. Similarly,

Friedrich List reapplied Hamilton’s infant industry ideas to the cause of shielding

nascent German manufacturing industries against British competition in the early

19th century. The government of Japan has believed strongly in infant industry

protection—sometimes, but not always, in the form of import protection. In the

1950s and 1960s in particular, Japan protected its steel, automobile, shipbuilding,

and electronics industries before they became tough competitors and the import

barriers were removed.

The infant industry argument will continue to deserve attention because there will

always be infant industries. As some countries gain the lead in producing new prod-

ucts with new technologies, other countries will have to consider time and again what

to do about the development of their own production of these new products.

How It Is Supposed to Work Figure 10.3 provides a schematic for understanding the infant industry argument,

using the example of small farm tractors. Now, as shown in the left side of the figure,

no amount of production in this country is cost-competitive by world standards (the

current domestic supply curve S dn

is everywhere above the world price of $3,000 per

tractor). Apparently, no domestic production would occur now with free trade. If the

country’s government imposes a tariff of 33 percent, the domestic price rises to $4,000

per tractor and domestic firms produce 20,000 tractors. Now (and for as many years

as this situation persists) we know that the country incurs inefficiencies of area b and area d because of the tariff.

The payoff to incurring these inefficiencies is that the infant industry grows up.

As firms produce tractors, they find ways to lower their costs. Sometime in the future

the domestic industry’s supply curve will shift down to S df . The government can then

remove the tariff. As shown in the right side of the figure, the country will then have a

tractor industry that can produce 50,000 tractors per year at costs that are competitive

with world standards. This competitive domestic production creates producer surplus

Chapter 10 Arguments for and against Protection 201

pug21774_ch10_192-221.indd 201pug21774_ch10_192-221.indd 201 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

With free trade now, there would be no domestic production. A tariff can induce domestic production now of 20,000

tractors per year. After a number of years of domestic production, the domestic firms will find ways to lower their

costs, so the domestic supply curve in the future is lower. The government can remove the tariff in the future, and

the future production of 50,000 tractors per year is cost-competitive by world standards.

FIGURE 10.3 The Infant Industry Argument

Quantity (thousands of tractors)

0 20

Price ($ per tractor)

3,000

4,000

A. The Domestic Market, Now

b d

Sdn

Price with tariff

World price

60 85 Quantity (thousands of tractors)

Price ($ per tractor)

3,000

B. The Domestic Market in the Future, If There Is Domestic Production Now

Sdf

World price

8550

of area v , surplus that would not exist if the country had not protected the industry in its early years. (For simplicity, the example assumes that the world price and the

domestic demand curve do not change over time. This is not essential to the story.

Also, the domestic industry is shown as still competing with imports in the future.

This is not essential to the story, either. If the domestic cost curve falls low enough,

the industry would become an exporter. The gain for the country in the future is still

an area like v .)

How Valid Is It? Whether the infant industry argument is a valid argument for a (temporary) tariff or

other import barrier depends on whether the benefits to the country exceed the costs.

The benefits are the stream of future producer surplus amounts (area v ) that accrue to domestic producers once their production becomes cost-competitive by world

standards. The costs are the deadweight losses (areas b and d ) that the country incurs while the tariff is in place. It is not just that some domestic production in the future

becomes cost-competitive. Rather, the cost-competitive future production must cre-

ate enough surplus to exceed the deadweight losses of the tariff. Because this is an

investment problem over time, we should carefully say that it is a valid argument if

the present value of the stream of national benefits exceeds the present value of the

stream of national costs.

The infant industry argument for protection looks great in theory. Still, there are

important questions about how well it works in practice. Here are three questions to ask.

202 Part Two Trade Policy

pug21774_ch10_192-221.indd 202pug21774_ch10_192-221.indd 202 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

First, is any government policy really needed ? The infant industry argument seems to be a story about firms that would make losses when they begin operations but

eventually will become profitable. This is not an unusual business problem; in fact, it

describes almost any new business. The standard solution is for the firm to obtain pri-

vate financing, using personal wealth, borrowing from relatives and friends, obtaining

bank loans, using venture capital, and so forth. If private financing is available, there

is nothing left for the government to do.

Yet there are at least two reasons why there could be a beneficial role for govern-

ment assistance. They both follow from distortions of the type that we have been

examining in this chapter.

1. There are imperfections in the financial markets. Financial institutions like banks and stock markets may be underdeveloped or unwilling to take on certain kinds of

risk. If the government cannot act directly to improve financial markets and institu-

tions, then there could be a second-best argument for the government to provide

assistance to the infant firms.

2. The benefits from the early business investments do not accrue to the firms mak- ing these early investments. Infant firms must spend a lot of money to learn about the product and the production process, to train workers, and to master

the marketing of the product. They will not be able to earn profits on these early

investments if follower firms can enter the industry later and imitate products

and production technology, hire away experienced workers, and copy marketing

practices. Competition from follower firms then means that the early firms do not

earn much in the way of future profits. But if they probably will not earn future

profits that can be used to pay back the loans, prudent lenders will not finance

their early investments. Essentially, the early firms create positive externalities

for the follower firms rather than future profits for themselves. In the face of this

distortion, there could be a positive role for the government to provide assistance

to the infant industry.

Second, if the government is going to provide assistance, what government policy is best? If the goal is to induce early production even when the early firms are not cost-competitive by world standards, we know that a production subsidy is better than a tariff or other import barrier. In Figure 10.3A, the national cost of a production subsidy in the early phase is only area b , not areas b and d . Other government policies could be even better if we can identify the exact reason why

government intervention is needed. If the problem is imperfections in financial

markets and institutions, the government should offer loans to the infant firms.

If the problem is that the early firms train workers who then may leave and take

their new skills to other firms, the government should offer a subsidy to defray

some of the training costs. The specificity rule is very powerful in thinking about

the best government policy to use to assist an infant industry. The rule cuts against

the tariff.

Third, will the infant industry really grow up ? It is cheap to claim to be a firm in an infant industry; it is much harder to become internationally competitive. If

the tariff is truly temporary, then firms have a powerful incentive to grow up. But

Chapter 10 Arguments for and against Protection 203

pug21774_ch10_192-221.indd 203pug21774_ch10_192-221.indd 203 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

Focus on Labor How Much Does It Cost to Protect a Job?

Defenders of protection against imports claim that it is needed to protect domestic jobs. Although it sometimes sounds like any people who lose their jobs to increased imports are unemployed forever, we know that that is not true. Workers lose their jobs for many reasons, and nearly all of them then look for and find other jobs. It may take awhile and the new jobs may not pay as much (at first) as the previous jobs did, but they will be reemployed.

So the proponents of protection are really saying that restrictions on imports are needed to maintain jobs in the import-competing industry that is receiving the protection . We know that import barriers can maintain jobs in an import- competing industry by permitting domestic pro- duction at a level higher than it would be with free trade. But we also know from the discussion in the text that the specificity rule shows that an import barrier is not the best government policy to accomplish this objective.

Still, governments do use tariffs and non- tariff barriers to prop up domestic production and maintain jobs in import-competing indus- tries. How large are the costs of doing so? We can examine the costs in two ways. First, how much does it cost domestic consumers of the product per job maintained? That is, what is the consumer surplus loss per job maintained? Second, what is the net cost to the country per job maintained?

We can turn to researchers at the Institute of International Economics to provide some esti- mates. Hufbauer and Elliott (1994) examined 21 highly protected industries in the United States, and Messerlin (2001) examined 22 highly pro- tected industries in the European Union, both for 1990. Their estimates assume that the tariffs and import quotas do not affect world prices, the small-country assumption that is standard for this chapter.* Here is what they found:

Cost per Job Maintained ($ thousands)

Production Worker To Domestic Jobs Maintained Consumers To the Nation

United States (21 industries) 191,764 169 54 European Union (22 industries) 243,650 191 99

* If, instead, the importing country is a large country, then including the effects of a change in the world prices would have almost no effect on the estimates of the cost to consumers per job maintained. For each industry both the numerator and the denominator of the calculation used to obtain the estimate would change by about the same proportion. Ignoring the world price change could result in estimates of the net cost to the country per job maintained that are larger than the costs actually are. If the importing country is large enough to drive down a product’s world price when it imposes a tariff or quota, then the gains from the improved terms of trade would be set against the standard efficiency losses.

For the 21 industries in the United States, the jobs maintained by import protection rep- resented about 10 percent of workers in these industries and less than 0.2 percent of the U.S. labor force. For the European Union, the main- tained jobs were about 3 percent of workers in the 22 industries and less than 0.2 percent of the labor force.

These estimates show the high cost of main- taining industry jobs through high levels of

import protection. For the United States, con- sumers paid an average of about $169,000 per job maintained, and in Europe about $191,000 per job. Per year, this was over six times the average annual compensation for a manufac- turing worker in each country. It would have been much cheaper for domestic consumers to simply pay these workers not to work than it was to maintain their jobs using import protec- tion. For some specific industries the consumer

204 Part Two Trade Policy

pug21774_ch10_192-221.indd 204pug21774_ch10_192-221.indd 204 11/3/14 7:07 PM11/3/14 7:07 PM

Final PDF to printer

cost per job maintained in the industry is breathtaking:

• For the United States, $600,000 for a sugar job and $498,000 for a dairy products job.

• For the European Union, $512,000 for an autoworker job and $474,000 for a chemical fiber job.

The net national cost per job was also high in both countries: $54,000 in the United States and $99,000 in the European Union. The net national cost per job was higher than the compensation earned by the typical manufacturing worker. It is worth noting that the average net national costs per job were this high because some of the protection was through VERs and similar policies

that permit foreign exporters to raise their prices. Even if we remove these price markups lost to foreign exporters, the net national cost per job was still rather large—an average $18,000 in the United States and $42,000 in the European Union.

If our goal is to maintain jobs in these indus- tries, the specificity rule says we can do better. Just paying the workers to have jobs in which they do nothing would be less costly. Indeed, the cost per person of a high-quality worker adjust- ment program that offers training and assistance to these workers to find well-paying jobs in other industries would be much less than the net national cost of maintaining these jobs through high import barriers.

the pressure is much less if the firms expect that they can ask for more time with

the tariff because childhood is longer than they planned for. There is a danger that

the industry remains high-cost behind the protection of the tariff for a long time.

This is probably another reason to favor a subsidy. The subsidy is more likely to

be temporary because there is likely to be ongoing political pressure to remove

the subsidy.

There are cases of apparently successful infant industry protection, such as comput-

ers and semiconductors in Japan. The qualifier apparently is used because it is difficult to be sure that the eventual national benefits were more than the initial national costs,

and because it is also difficult to show how much of a difference the government

assistance actually made in the future success of the national industry. Another appar-

ent success is Airbus in Europe, a case in which the governments provided subsidies

and loans, not import protection. There are also many cases of failed infant industry

protection. For instance, Brazil first offered “temporary” protection to its nascent

automobile industry in 1952. More than 60 years later the tariff on imports is still

35 percent, and Brazil recently added an additional import tax that can be reduced if

the car firm has sufficient local content or local research and development. It has been

a long toddlerhood for auto production in Brazil.

In conclusion, how valid is the infant industry argument? Four conclusions

emerge:

1. There can be a case for some sort of government encouragement.

2. A tariff may or may not be good.

Chapter 10 Arguments for and against Protection 205

pug21774_ch10_192-221.indd 205pug21774_ch10_192-221.indd 205 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

3. Some form of government help other than a tariff is a better infant industry policy

than a tariff.

4. It is hard for a government to know which industries to support because it is diffi-

cult to predict which industries can reduce their costs enough in the future to create

net national benefits.

THE DYING INDUSTRY ARGUMENT AND ADJUSTMENT ASSISTANCE

The issues and results that arise in the infant industry debate also arise in the debate

about saving dying industries from import competition. Once again, protection against

imports might or might not be better than doing nothing. And, once again, doing

something else is better than blocking imports.

Should the Government Intervene? With regularity, rising imports of a product threaten the well-being and even the

survival of import-competing domestic firms and industries. Time and again society

faces a choice: Should the firms be allowed to shrink, perhaps to go out of business,

or should they be protected?

If we are in a first-best world, the answer is clear. Since the social value of any-

thing is already included in private incentives, ordinary demand and supply curves are

already leading us to the right choice without any government intervention. If rising

import competition is driving domestic producers out of business, so be it. Adjustment

out of the industry is necessary so that the country can enjoy the net gains from

increasing trade. It is true that there will be some losses to workers, managers, inves-

tors, and landowners. They must shift their resources into other uses that may not pay

quite as well as the original uses did. These losses are already measured in the loss of

producer surplus. Consumers gain more, and net national well-being increases.

There are, however, ways in which we could reject the rosy first-best view of the

world. One important assumption is that the workers, managers, capital, and land

quickly are reemployed in other uses, even if their pay is less. A protectionist would

be right to insist that this adjustment does not always work so smoothly. For instance,

firms in an import-competing industry are often concentrated in a small geographic

area within the country. (For the United States examples include steel firms in the

industrial Midwest from Pittsburgh to Chicago and clothing firms in North Carolina.)

If large numbers of workers lose their jobs in one of these industries within a short

time period, the labor market becomes “congested.” Many people are looking for new

jobs, and many do not have the skills that match the available jobs. Steelworkers do

not easily start new careers as electronics workers next Monday in the same town.

Many people will probably suffer through long spells of unemployment.

While these displaced workers and other resources are unemployed, they lose all

income, not just the loss of producer surplus that would occur if they could easily shift

into the next-best employment. In this case, the amount of their income that imports

take away is a loss to society as well as to them. Wouldn’t it be better for society to

intervene? Wouldn’t blocking the rising imports be better than standing by while the

domestic industry withers?

206 Part Two Trade Policy

pug21774_ch10_192-221.indd 206pug21774_ch10_192-221.indd 206 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

The protectionist argument about a dying industry is just as valid as the arguments

we examined in the past two sections. And the argument has the same flaws. In fact,

it is the same argument, but in a different setting. The argument that workers and

other resources will not quickly be reemployed outside the threatened industry can be

recast in terms of Figure 10.2. The marginal external benefit (area g in Figure 10.2) of continuing production of 0.8 million bikes, instead of letting production shrink to

0.6 million bikes, is avoiding the costs of unemployment if resources are forced out

of the bicycle industry. Area g ’s extra benefits from maintaining the level of domestic production exist, in this case, because workers and other resources do not have to bear

the lost income and other costs of shifting to employment in other industries. So it may

be true that protecting a dying industry against imports is better than doing nothing. It

depends, again, on whether area g is greater than areas b + d in panel A of Figure 10.2. However, there is some other policy that works better than putting up import bar-

riers. The specificity rule reminds us to look for the true source of the problem. The

problem is really about employment or production, not imports. There is, again, no

reason to make imports more expensive to consumers as long as we can help produc-

ers directly. If the problem is the cost of relocating to other geographic areas, then a

subsidy for the costs of moving is better than import protection. If the problem is a

mismatch of worker skills and available jobs, then a subsidy for the costs of retrain-

ing is better. Or, if the social losses can be avoided only by maintaining current

production and employment in the threatened industry, then a subsidy to production

(as we showed in Figure 10.2) or to employment in this industry is better.

In fact, governments do sometimes try to help import-threatened industries with

something other than import protection. One example was the U.S. government’s

bailout loans to Chrysler at the end of the 1970s. Chrysler used the loans to make

capital improvements that allowed it to survive and repay the loans on time. Of course,

not all bailouts work so well. Many just end up being a continual drain on taxpayers,

as rounds of new assistance are needed to keep the firms in business.

Trade Adjustment Assistance Governments in a number of developed countries offer trade adjustment assistance to workers and firms in import-threatened industries. For instance, in the United States workers can petition the U.S. Department of Labor for this

assistance. If the department accepts that this group of workers is being harmed

by increased imports, workers who lose their jobs receive up to 30 months of

unemployment compensation (much more than the 6 months that is usual in most

states), and they are eligible for retraining programs and subsidies for job search

and moving expenses. 4

Trade adjustment assistance sounds like it is reasonably consistent with the

specificity rule because it focuses on income losses, retraining, and job mobility.

Nonetheless, it is controversial. In the United States it has been attacked from dif-

ferent sides. First, U.S. labor groups that originally backed it have felt betrayed

4 In addition, an eligible worker who is over 50 years of age and whose annual earnings are less than $50,000 can receive a cash supplement equal to up to half of the wage difference if the earnings at a new job are less than the earnings at her previous job. Some other benefits had been available in earlier years but expired in 2011 or 2014.

Chapter 10 Arguments for and against Protection 207

pug21774_ch10_192-221.indd 207pug21774_ch10_192-221.indd 207 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

because, in practice, it has provided so little support. The standards for eligibility are

rather stringent. During 2009–2013 about two-thirds of the petitions for assistance

were accepted. On average, about 150,000 workers per year qualify for assistance.

Only about one-third of these workers use any of the assistance benefits. Labor

groups believe that the assistance mainly provides temporary compensation (the

extended unemployment benefits), and that the retraining has been rather ineffective.

The retraining often does not result in new skills and good alternative employment.

From a different side, defenders of the free market question the whole concept of

adjustment assistance for import-competing industries. They ask why society should

single out this group for special aid. Jobs and incomes are affected by many differ-

ent pressures for change in the economy, including shifts in consumer tastes, techno-

logical change, bad management decisions, government rerouting of highways, and bad

weather. The government provides general unemployment compensation and some gen-

eral support for retraining and relocation. Why should the government give more gener-

ous assistance to those whose jobs and incomes are affected by rising imports but not

to those affected by the many other reasons that supply and demand shift in a market?

Free-market opponents of trade adjustment assistance also argue that this assistance

creates perverse incentives. It encourages people to change their behavior for the

worse. First, firms and workers are encouraged to gamble on entering or staying in

import-vulnerable industries because they know that extra relief will be given if things

work out badly. Second, workers are encouraged to remain unemployed for longer

periods of time because they can receive unemployment compensation for a longer

time. These perverse incentives (called moral hazards in discussions of insurance) do not automatically mean that the assistance program is bad. However, the net benefit

of the program is reduced, and it may turn into a net cost because people change their

behavior. (This set of problems affects many other government programs offering

assistance. For instance, flood disaster relief helps victims of floods who have incurred

large losses, but it also encourages people to settle in flood-prone areas.)

Thus, the economic case for a government to offer trade adjustment assistance

is mixed. Still, there may be a good practical and political case for tying extra

assistance to import injury. Where foreign trade is involved, free-trade advocacy

is weakened because many of its beneficiaries, being foreign, have no votes in the

national politics of the importing country. With no votes for foreign workers or

firms, there is extra danger that injured workers and firms that lobby aggressively for

sweeping protectionist legislation will prevail. More generous adjustment assistance

for import-competing groups than for others may be an effective political step to

forestall more protectionist policies.

THE DEVELOPING GOVERNMENT (PUBLIC REVENUE) ARGUMENT

Import tariffs can be justified by another second-best argument relating to conditions

in developing countries. In a poor nation, the tariff as a source of revenue may be

beneficial and even better than any feasible alternative policy, both for the nation and for the world as a whole .

208 Part Two Trade Policy

pug21774_ch10_192-221.indd 208pug21774_ch10_192-221.indd 208 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

For a developing nation with low living standards, the most serious “domestic

distortions” may relate to the government’s inability to provide an adequate supply of

public goods. A low-income nation like Mali would receive large social benefits if it

expanded such basic public services as the control of infectious diseases, water control

for agriculture, and primary schooling. Yet the administrative resources of many poor

nations are not great enough to capture these social gains.

The developing government argument states that in poor developing nations the import tariff becomes a crucial source, not of industrial protection but of govern-

ment revenue. Revenue can be raised more cheaply by simply guarding key ports and

border crossings with a few customs officials who tax imports than by levying more

elaborate kinds of taxes. Production, consumption, income, and property cannot be

effectively taxed when they cannot be measured and monitored.

The developing government argument is a valid reason why very low-income

countries receive on average about 16 percent of their government revenue from

customs duties, a higher dependence on customs than is found in equally trade-

oriented high-income countries such as Canada. (On average for industrialized

countries, taxes on international trade are about 1 percent of government revenues.)

In principle, a developing-country government can use the tariff revenues to create

net social gains, gains that may even benefit the world as a whole. This is not to say

that every government that heavily taxes foreign trade is using the money to fund

socially worthy investments. Foreign trade has also been heavily taxed by corrupt

and wasteful governments. Based on available data for 2010, six of the seven coun-

tries that collected more than 20 percent of their total government revenues through

import tariffs were also among the worse half of countries for perceived levels of

government corruption.

OTHER ARGUMENTS FOR PROTECTION: NONECONOMIC OBJECTIVES

The other leading arguments for tariff protection relate to the national pursuit of

noneconomic objectives, that is, goals other than achieving economic efficiency. The

potential range of such arguments is limitless, but the view that people do not live by

imported bread alone usually focuses on three other goals: national pride, national

defense, and income distribution. Fortunately, a modified version of the specificity

rule applies to a country pursuing a noneconomic objective: To achieve the noneco- nomic objective with the least economic cost to the nation, use a policy that acts as directly as possible on the specific objective.

National Pride Nations desire symbols as much as individuals do, and knowing that some good is

produced within our own country can be as legitimate an object of national pride as

having cleaned up a previous urban blight or winning Olympic medals. As long as the

pride can be generated only by something collective and nationwide, something not

purchased by individuals in the marketplace, there is a case for policy intervention. If

the pride is generated by domestic production itself, then the appropriate policy tool

Chapter 10 Arguments for and against Protection 209

pug21774_ch10_192-221.indd 209pug21774_ch10_192-221.indd 209 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

is a domestic production subsidy, not an import barrier. Only if the pride comes from

increased self-sufficiency is restricting imports the best policy approach.

National Defense The national defense argument says that import barriers would help the nation to have or to be ready to produce products that would be important in a future military

emergency. It has a rich history and several interesting twists to its analysis. English

mercantilists in the 17th century used the national defense argument to justify restric-

tions on the use of foreign ships and shipping services: If we force ourselves to buy

English ships and shipping, we will foster the growth of a shipbuilding industry and

a merchant marine that will be vital in time of war. Even Adam Smith departed from

his otherwise scathing attacks on trade barriers to support the restrictive Navigation

Acts where shipping and other defense industries were involved. The national defense

argument remains a favorite with producers who need a social excuse for protection.

In 1984, the president of the Footwear Industry of America, with a straight face, told

the Armed Services Committee of Congress,

In the event of war or other national emergency, it is highly unlikely that the domestic

footwear industry could provide sufficient footwear for the military and civilian

population . . . We won’t be able to wait for ships to deliver shoes from Taiwan,

or Korea or Brazil or Eastern Europe . . . [I]mproper footwear can lead to

needless casualties and turn sure victory into possible defeat. 5

The importance of having products ready for defense emergencies is clear. Yet

a little reflection shows that none of the popular variants of the national defense

argument succeeds in making a good case for an import barrier. That is, the popular

national defense arguments fail to follow the specificity rule. For instance, if the

objective is to maintain domestic production capacity for a product that is crucial to

the national defense, then a production subsidy is the policy that has the lower cost

to the nation.

The possibilities of storage and depletion also argue against the use of a tariff to

create defense capability. If the crucial goods can be stored inexpensively, the cheapest

way to prepare for the emergency is to buy them from foreigners at low world prices

during peace. Thus, the United States could stockpile low-cost imported footwear

instead of producing it domestically at greater cost. And if the crucial goods are deplet-

able mineral resources, such as oil, the case for the tariff is even weaker. Restricting

imports of oil when there is no foreign embargo or blockade causes us to use up our

own resources faster, cutting the amount we can draw on when an embargo or block-

ade is imposed. It is better to stockpile imports at relatively low peacetime cost, as

the United States has done with its Strategic Petroleum Reserve since the mid-1970s.

Income Redistribution A third, less economic objective to which trade policy might be addressed is the

distribution of income within the nation. Often one of the most sensitive questions in

national politics is either “What does it do to the poor?” or “What effect does it have

5 Quoted in Far Eastern Economic Review, October 25, 1984, p. 70.

210 Part Two Trade Policy

pug21774_ch10_192-221.indd 210pug21774_ch10_192-221.indd 210 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

on different regions or ethnic groups?” A tariff could sometimes be defended on the

grounds that it restores equity by favoring some wrongly disadvantaged group, even

though it may reduce the overall size of the pie to be distributed among groups. It is

certainly important to know the effects of trade policy on the distribution of income

within a country, a subject we have already examined in a number of previous chapters.

If the issue is inequity in how income is distributed within our country, why should

trade policy be the means of redressing the inequity? Why not attack the problem

directly? If, for example, greater income equality is the objective, it is less costly to

equalize incomes directly, through tax-and-transfer programs, than to try to equalize

incomes indirectly by manipulating the tariff structure. Only if political constraints are

somehow so binding that the income distribution can be adjusted only through import

policy would import barriers be justified on this ground.

THE POLITICS OF PROTECTION

We have now made much progress in our search for good import barriers. We have

found a number of situations in which import protection could be better than free

trade, but in nearly all of these some other form of government policy is even better.

If the economic case for import protection is so weak, why do most countries have

many import barriers in place? Why are import barriers high for some products and

low for others? In each country import barriers are adopted and maintained through

a political process of decision-making. Understanding the answers to questions about

why import barriers exist requires a mixture of political and economic insights. There

is a growing literature on the “political economy of trade barriers.” It focuses on

activities by pressure groups and the self-interested behavior of political representa-

tives who seek to maximize their chances of staying in office.

The Basic Elements of the Political–Economic Analysis Let’s take a look at the political process that leads to a decision about whether or

not to impose a tariff on imports of a good, say, socks. As we have seen in previous

chapters, imposing the tariff will have different effects on the well-being of different

groups in the country, with both winners and losers. In addition, we presume that

the tariff would cause some economic inefficiency—a decrease in national well-

being because the losers lose more than the winners gain. When will such a tariff be

enacted? Why?

There are a number of key elements in our political–economic analysis:

1. The size of the gains for the winners from protection, and how many individuals are in the group of winners. Let’s call the total gains B

p , and presume that this is the

producer surplus gained from securing government protection—the same thing as

area a in diagrams like Figure 8.4. N p is the number of individuals benefiting from

the protection.

2. The size of the losses for the losers from protection, and how many individuals are in the group of losers. In the political fight, they gain by defeating the tariff. Their total gains are B

c , which we presume to be at least as large as areas a + b + d in

Chapter 10 Arguments for and against Protection 211

pug21774_ch10_192-221.indd 211pug21774_ch10_192-221.indd 211 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

Figure 8.4. (Consumers may not view the tariff revenue area c as a loss to them if the government uses the revenue to reduce other consumer taxes or spends the rev-

enue on projects valued by the consumers.) N c is the number of individuals losing

from protection (gaining from defeating protection).

3. Individuals’ reasons for taking positions for or against protection. We presume that direct gains and losses of well-being ( B

p and B

c ) are reasons for taking positions.

There may be other reasons. One is sympathy for groups who are suffering losses.

Another is ideology or other closely held core beliefs about politics and economics.

4. Types of political activities and their costs. Individuals (and groups of individuals sharing a common interest) can engage in a range of different political activities.

Assuming that the country has elections or referendums, individuals can vote.

Individuals can themselves engage in lobbying of their government officials, in

which the individuals provide information on their position, or they can hire others

to lobby for them. Individuals can provide campaign contributions to politicians

running for office. Or individuals can provide bribes or other side payments to

attempt to gain the support of government officials. The costs of these different

types of political activities include both money cost and the opportunity cost of any

time or other efforts used in the activity.

5. Political institutions and the political process. We will closely examine two types of political processes: first, direct voting on the tariff by all individuals and, second,

elected representatives voting on the tariff. These seem most relevant to a demo-

cratic system like that used in most industrialized and many developing countries.

(Other possibilities include a single decision-maker or decision-making by an

appointed committee of experts.)

When Are Tariffs Unlikely? Under some circumstances, inefficient trade barriers would be rejected, and we

would have a world closer to free trade than we observe. Let’s consider two sets of

circumstances.

Our first case is direct democracy. Consider what will happen if we have (1) a direct

vote by individuals on each tariff (or import barrier), with (2) voting (almost) cost-

less so that (almost) everyone votes, and (3) each person voting based on her direct

interest as a winner or a loser from protection. Nearly always the number of losers,

N c (the number of consumers of the product), is larger than the number of winners, N

(the number of people involved in production of the import-competing product). In

the example of socks, nearly everyone buys socks, but only a small number of people

work in (or provide substantial amounts of other resources like land or capital to) the

sock industry. The sock tariff would be defeated by a large margin. Most trade barri-

ers protect only a minority, and this is probably true even if many trade barriers are

combined into a single vote.

The trade barriers that we see in most countries depart from what simple majority-

rule democracy would give us. Indeed, countries usually do not use direct votes to set

protection. Rather, a group of elected representatives or some other government offi-

cials decide. Winning the political fight is gaining the support of a majority of these

representatives or officials.

212 Part Two Trade Policy

pug21774_ch10_192-221.indd 212pug21774_ch10_192-221.indd 212 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

Are forms of government like representative democracy inherently protectionist?

Our second case shows that representative democracy can also lead to little or no

protection. Consider what will happen if (1) each group is willing to devote all of its

total gain ( B p and B

c ) to political activity like lobbying or contributions and (2) politi-

cians decide which side to support according to the amount of lobbying or contribu-

tions they receive. The fact that the tariff causes economic inefficiency means that B c

is larger than B p . Those opposed to the tariff would be willing to spend up to B

c to

prevent the tariff, while the protectionists would not rationally spend more than the

smaller stake B p . The inefficiency of the tariff (equal to B

c – B

p ) dooms that tariff. Even

if the political process does not work exactly like this, it still would tend to reject the

more inefficient of protectionist proposals.

When Are Tariffs Likely? Lobbying and contributions can lead to political decisions enacting protection if

protectionist groups are more effective than other groups in organizing their political

activities. In this case we reach a surprising conclusion: The group with the smaller

number of individuals can be more effective. We can see two different reasons for this

surprising conclusion. Both are based on the fact that each individual in the smaller

group tends to have a larger individual gain.

First, consider what happens when there is some fixed cost per individual to being

involved in any political activity. This cost could be a minimum amount of time

that must be spent, or it could be the per person cost of organizing a group effort to

engage in lobbying. If the benefit to an individual is less than the cost to participate,

the individual will probably decide not to participate. The average gain per supporter

of protection is B p / N

p , and the average gain per opponent of protection is B

c / N

c .

The individual gain tends to be larger as the number of individuals in the group is

smaller. In our sock example, the number of sock producers is small, but the gain to

each from protection is large (perhaps hundreds or thousands of dollars per year).

The number of sock consumers is large, but the loss to each from protection is small

(probably a few tens of dollars or less per year). If consumers’ benefits from defeat-

ing the protectionist measure are small per person, many (or all) of them may decide

that it is not worth it to fight protectionism. (That is, they see that B c / N

c is less than

the minimum per person cost of participating.) The protectionist minority is the only

active interest group, and it gains the majority of representatives’ votes.

Second, consider what happens when some members of the group can decide to

“free-ride” on the contributions of others in the group. The free-rider problem arises whenever the benefits of a group effort fall on everyone in the group regardless

of how much each individual does (or does not) contribute (in time, effort, voting, or

money). Each selfishly rational individual tries to get a free ride, letting others advance

the common cause. The free-rider problem usually affects a large, dispersed group

more seriously than it affects a small, well-defined group. Conquering the free-rider

problem is what political action groups—special interests—are all about.

Import-competing producers are motivated to participate in the politics of protec-

tion. They often overcome the free-rider problem to become a well-organized group

with substantial resources to use in political activity. The group lobbies vociferously

in favor of protection. The group uses campaign contributions to enhance the chances

Chapter 10 Arguments for and against Protection 213

pug21774_ch10_192-221.indd 213pug21774_ch10_192-221.indd 213 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

of electing representatives friendly to their position, to gain access to the representa-

tives for lobbying, to influence the representatives’ positions on votes, and reward

those who vote in favor of industry protection. In contrast, each individual in the large,

diffuse consumer group has a small incentive to become active and a large incentive

to free-ride. But if all or most try to free-ride, the large group of consumers is not

organized or has few resources to use for political activity. In our sock example, a

trade association may organize and represent the interests of the sock-producing firms,

and if the industry is unionized, the labor unions represent the interest of workers. An

organization of sock consumers is unlikely.

The outcome is often that the well-organized protectionist lobby sways a majority

of representatives, even though this protection is economically inefficient and hurts a

majority of voters. Generally, the politicians in favor of protection trade a small reduc-

tion in the individual well-being of many voters, with some loss of votes possible in

the next election, for the votes and largess of those protected, including the ability to

use their campaign contributions to gain votes in the next election.

The tariffs imposed by the U.S. government on steel imports in 2002 provide a

stark example of the political economy of protection. The small number of American

steel firms are well organized as a political lobbying force. The industry employs

only about 200,000 workers, about 0.1 percent of the U.S. workforce, but the United

Steelworkers union is also politically active. Users of steel are much more dispersed.

They did achieve some organization and mount a campaign to oppose the tariffs, but

their effort was not as effective. In addition, steel firms and steelworkers are con-

centrated in a few states, including West Virginia, Pennsylvania, and Ohio, that were

considered crucial for the 2002 and 2004 elections. In March 2002 the protectionists

won—President George W. Bush announced new tariffs of up to 30 percent on imports

of many types of steel. The box “How Sweet It Is (or Isn’t)” presents another example

by examining the political–economic forces in play for sugar protection.

In addition to this recognition of the important general role of lobbying and

contributions by special interest groups, other specific features of the country’s

political institutions affect the political economy of protection. Here are two that are

documented for the United States. First, the U.S. Senate gives exactly two senators

to each state, regardless of population. States that are mainly rural and agricultural

are overrepresented, providing extra support for protection of agricultural industries.

Second, for the U.S. House of Representatives, in which there is one representative

for each district, it helps to have the production activities of an import-competing

industry spread over a substantial number of states or districts, so that a large num-

ber of representatives are likely to become a core of supporters for protection for

the industry.

Applications to Other Trade-Policy Patterns The simple model of political activity in a representative democracy can also explain

other patterns besides the overall favoring of producer interests over consumer interests.

Some of these patterns are extensions of the same producer-bias pattern; some are not.

The tariff escalation pattern is a general symptom of the importance of group size and concentration to effective lobbying. Economists have found that nominal and

effective tariff rates rise with the stage of production. That is, tariff rates are typically

214 Part Two Trade Policy

pug21774_ch10_192-221.indd 214pug21774_ch10_192-221.indd 214 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

Do you like to eat things that are sweet? If you do, and if you live in the United States, the European Union, or Japan, then you are a victim of your country’s protectionist policies toward sugar. The domestic price of your sugar is about double the world price. For the United States, on average during 2000–2013, the domestic price of raw sugar was $0.24 per pound, while the world price was $0.14 per pound. For the United States, sugar pro- tection costs consumers about $3.5 billion per year.

If you live in any of these countries, have you ever sent a letter to your legislative representa- tive asking him or her to oppose sugar protection, a policy that is clearly against your interests? Have you contributed money or time to a group that lobbies the government to end sugar protection? Do you know anyone who has ever done so? Presumably not. Why not? While $3.5 billion per year sounds like a lot of money, it is only about $11 per person per year. As discussed in the text, the average gain for any one person to oppose this protection is small. It’s not worth your effort.

The situation is a little different for sugar produc- ers. For the United States, the increase in domestic producer surplus is about $1.5 billion per year. These gains are concentrated in a small number of firms. It is worth it for them to actively seek policies that restrain sugar imports. Two companies, American Crystal in North Dakota and Minnesota, and Flo-Sun in Florida, have been particularly active, contribut- ing millions of dollars in recent years to Democratic and Republican congressional candidates and politi- cal parties. For Flo-Sun, owned by two brothers, Alfonso and Jose Fanjul, one estimate is that pro- tectionist sugar policies add $65 million per year to their profits. A few million bucks to defend this profit stream is definitely a good investment.

Another group active in lobbying is the American Sugar Alliance, representing major U.S. sugar growers. In addition, the high domestic price for sugar expands demand for corn sweet- eners, a close substitute for sugar. Corn farmers in the American Midwest like the sugar protection, and they have a major influence on the positions taken by their states’ representatives and senators.

The Coalition for Sugar Reform, which includes food manufacturers that use sugar, consumer

groups, taxpayer advocates, and environmental groups, is active in opposing sugar protection. It has some good arguments on its side. As Jeff Nedelman, a spokesperson for the coalition, said, “This is a corporate welfare program for the very rich.” * The coalition points out that jobs are being lost as sugar- using firms shift production to other countries where sugar prices are cheaper. Furthermore, by polluting and disrupting water flows, the protected sugar production in Florida is also a cause of serious environmental decline in the Everglades. These are good points, but they are no match for the money and organization of the proponents of protection.

Foreign sugar producers, many of them poor farmers in developing countries, are also hurt by protectionist policies in importing countries. Researchers estimate that the world sugar price would rise by 17 percent if the United States removed its sugar policies. But it is not easy for foreign interests to have an effect on the U.S. political process. Foreigners don’t vote, and polit- ical opponents can charge that legislators who openly side with foreigners against U.S. workers and companies are “anti-American.”

So the sugar protection policies continue. For the United States, the net cost to the country is close to $2 billion per year. It is not that sugar is so large or important a part of the economy that we have to protect it. In the United States, about 6,000 people work growing sugar, and about 12,000 people work in sugar refining. If we shifted to free trade, employment would probably decline by about 3,000. The small number of people who lose their jobs could be reemployed with little trouble in other sectors of the economy. Instead, we see the pure political economy of protection, with the producer interests in this case much better organized and effective than the consumers are.

DISCUSSION QUESTION A U.S. company (like Jelly Belly) makes its gour- met jelly beans in the United States, and sugar is about half the cost of production. Can the com- pany change U.S. sugar policy? If not, what are its other options?

*As quoted in “Sugar Rules Defy Free-Trade Logic,” New York Times, May 6, 2001.

Case Study How Sweet It Is (or Isn’t)

Chapter 10 Arguments for and against Protection 215

pug21774_ch10_192-221.indd 215pug21774_ch10_192-221.indd 215 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

higher on final consumer goods than on intermediate goods and raw materials sold to

producing firms. 6 The explanation would seem to be that household consumers are

a particularly weak lobby, being many people who are not well organized into dues-

collecting lobbying associations. Consumer groups fight only weakly against the pro-

ducers of final products, whose cause is championed by influential large firms and trade

associations. When it comes to fights over protecting producers of intermediate goods,

the story can be quite different. The buyers of intermediate goods are themselves firms

and can organize lobbying efforts as easily as their suppliers can. The outcome of a

struggle over tariffs on intermediate goods is thus less likely to favor protection.

The bias in favor of producer interests over consumer interests also shows up in multi-

lateral negotiations to liberalize trade. There are curious guidelines as to what constitutes

a fair balance of concessions by the different nations at the bargaining table. A conces-

sion is any agreement to cut one’s own import duties, thereby letting in more imports.

Each country is pressured to allow as much import expansion as the export expansion

it gets from other countries’ import liberalizations. It is odd to see import liberalization

treated as a concession by the importing nation. After all, cutting your own import tar-

iffs usually should bring net national gains, not losses. The concession-balancing rule is

further evidence of the power of producer groups over consumer groups. The negotiators

view their own import tariff cuts as sacrifices because they have to answer politically to

import-competing producer groups but not to masses of poorly organized consumers. In

addition, another producer group in the country—producers of exportable products—is

active in lobbying to influence the trade negotiations. The balancing “concessions” by

other countries to lower foreign import barriers bring benefits to export producers so that

they politically support the multilateral trade liberalization.

So far we have presumed that each individual takes a position in favor of or against

protection according to his or her own direct self-interest. But, in some cases, it seems

that sympathy (or other reasons) determines an individual’s position.

Interest groups are often victorious because they gain the sympathy of others,

that is, of people who will not directly gain if policy helps the interest group.

Political sympathy often surges when a group suffers a big income loss all at once,

especially in a general recession. Sympathy creates this sudden-damage effect. The sympathy can spring from either of two sources. One is compassion for those

suffering large income losses. Political sentiments often yield to pleas for protec-

tion when a surge of import competition wipes out incomes, just as we provide

generous relief for victims of natural disasters. The other source shows up more

when a deep recession hits the whole economy. In a recession, an increased number

of people are at risk of having their incomes cut. More of them identify with the

less fortunate, thinking, “That could be me.” One policy response is to help those

damaged by import competition, whose pleas are heard above the mild complaints

of many consumers who would suffer small individual losses from import barriers.

Thus, both a surge in import competition and a general recession raise sympathy

for protectionism.

6 The tariff escalation pattern does not apply to agricultural products in most industrialized countries, however. Farmers get at least as much effective protection as the processors and wholesalers to whom they sell.

216 Part Two Trade Policy

pug21774_ch10_192-221.indd 216pug21774_ch10_192-221.indd 216 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

Our discussion began in this section with the general question of why the overall

level of trade barriers is higher than the analysis of economic efficiency would justify.

But now that we have examined the political economy of trade barriers, we might eas-

ily ask the opposite question. Given the power of well-organized import-competing

producers favoring protection, as well as the appeal of sympathy for local producers

struggling against imports produced by foreign firms, why are our import barriers not

so very high? One reason is that there are organized producer groups that are opposed

to protection. These include firms that use imported products in their own produc-

tion, the wholesalers and retailers who distribute imports, and export producers who

generally favor free trade. A second reason is that we have used mutual “concessions”

during multilateral trade negotiations to lower trade barriers. There is probably also

a third reason. Economic ideology probably does have some impact. Politicians who

espouse the merits of free enterprise, markets, and competition probably do see that

protection is inconsistent with these concepts. This does make them somewhat less

likely to support protection.

Summary There are valid arguments for import barriers, though most are quite different from those usually given. One way or another, valid defenses of import barriers lean on the

existence of relevant distortions (resulting from gaps between private and social costs

or benefits) or noneconomic objectives.

In a second-best world where there are distortions in the domestic economy, imposing a tariff may be better than doing nothing. Whether or not it is better will

depend on the details of the specific case. Yet, even when imposing the tariff is better

than doing nothing, something else is usually better than the tariff. The specificity rule is a guideline that says: Use the policy tool that is closest to the true source of the distorting gap between private and social incentives. This rule cuts against

import barriers, which are usually only indirectly related to the source of the distor-

tion. Thus, many of the main arguments for blocking imports—such as maintaining

jobs in an industry, the infant industry argument, and the national defense argument —are really arguments for government policies other than import barriers. The case for tariffs is most secure in the developing government setting. If a country

is poor and its government limited in its administrative ability, then tariffs can be a

vital source of government revenue to finance basic public investments and services.

Where, then, are the borders that separate good trade barriers from bad ones?

Figure 10.4 maps those borders by summarizing the policy results of the main cases

surveyed in this chapter plus Chapter 8’s nationally optimal tariff plus two relevant

cases coming up in the next chapter. Note the clear contrast in the answers in the

two columns. In the middle column, the answer repeatedly is yes, an import barrier

can be better than doing nothing, depending on factors discussed in this chapter. In the right column, the answer is generally no, the import barrier is not the best

policy tool except in cases where the exact locus of the distortion is in international

trade itself.

If analysis of economic efficiency indicates that import protection is often a bad

policy and seldom the best policy, why do so many countries have so many import

barriers? The political economy of trade barriers explains them in terms of the gains

Chapter 10 Arguments for and against Protection 217

pug21774_ch10_192-221.indd 217pug21774_ch10_192-221.indd 217 11/4/14 4:42 PM11/4/14 4:42 PM

Final PDF to printer

FIGURE 10.4 Can an Import Barrier Be Better Than Doing Nothing, and Is It the Best Policy?

A Summary of Verdicts*

Can an Import Barrier Be Is an Import Barrier Goal to Be Promoted Better Than Doing Nothing? the Best Policy Tool?

Domestic production Yes, it can No Domestic jobs Yes, it can No An infant industry Yes, it can No A developing government Yes, it can No National pride Yes, it can No, unless only self-sufficiency can make the nation proud National defense Yes, it can No A fairer income distribution Yes, it can No National monopsony power Yes, it can For the nation, yes (if no (a large country) retaliation); for the world, no (Chapter 8’s nationally optimal tariff) Antidumping (Chapter 11) Usually, no Usually, no Counter a foreign export subsidy Usually, no For the nation, no; for the (Chapter 11) world, yes

Note: Remember that “Yes, it can” does not mean “Yes, it is.” To see what separates situations when the import barrier is better than

nothing from situations when it is worse, review the text of this chapter. * In all verdicts except that for national monopsony power, the conclusions refer to a small country, so that the conclusions are not

confounded by the possibility of optimal-tariff effects on the terms of trade .

for the winners from protection; the losses to those hurt by protection; the costs of

engaging in political activities like voting, lobbying, and making campaign contribu-

tions; and the way that the political process works.

We can imagine political systems in which protection would be unlikely. If every-

body voted directly, the majority would probably vote against a tariff or nontariff

barrier because more people would be hurt as consumers than would be helped as

producers of the product. Or, if everyone was willing to devote the entire amount that

they would gain or lose to political activities like lobbying or campaign contributions,

then political representatives would probably oppose protection because the loss to

consumers would be larger than the gain to producers.

In reality, some groups are more effective than others at taking political actions to

influence the votes of representatives. Producer groups are often more effective than

consumer groups because the benefits of protection are concentrated in a small group

of producers. The benefits are large enough to spur actions by individual producers,

and the free-rider problem is more easily solved in a small group. In addition, sup- port for protection often increases when the losses to the group hurt by rising imports

generate sympathy among the rest of the population.

This approach also helps to explain other patterns. The group-size effect can explain

the tariff escalation pattern. A few large firms buying intermediate goods make a stronger lobby against protection of the products they are buying than do masses of

218 Part Two Trade Policy

pug21774_ch10_192-221.indd 218pug21774_ch10_192-221.indd 218 11/4/14 4:43 PM11/4/14 4:43 PM

Final PDF to printer

final consumers, each of whom has too small an interest to go to battle over consumer-

good import policy. The ability of producer interests to lobby effectively also explains

why, in international trade negotiations, each nation treats its own tariff reductions as

if they were sacrifices. They are sacrifices for politicians who must answer to well-

organized import-competing producer groups. And the concessions offered by other

countries to reduce their trade barriers mobilize well-organized groups of export pro-

ducers to support the multilateral agreement.

Key Terms Second-best world Externalities

Spillover effects

Specificity rule

Infant industry argument

Trade adjustment assistance

Developing government

argument

National defense argument

Free-rider problem

Tariff escalation

Sudden-damage effect

Suggested Reading

The theory of trade policy in a second-best world was pioneered by Nobel laureate James

Meade (1955). Johnson (1965) and Bhagwati (1969) made major contributions, and Dixit

(1985) provides a survey of related research.

Irwin (2009) examines economic and political arguments for protection. Kletzer

(2001) discusses the experiences of U.S. workers who lost their jobs due to import

competition. Baicker and Rehavi (2004), Kletzer and Rosen (2005), and Reynolds and

Palatucci (2012) describe and analyze trade adjustment assistance in the United States.

The Organization for Economic Cooperation and Development (2007) estimates the

effects of protectionist sugar policies in a number of countries.

Two pioneering theories of political behavior and lobbying biases are Downs (1957)

and Olson (1965). Grossman and Helpman (1994) provide an influential technical

analysis of the political economy of trade barriers. Magee (2011) explores why tariffs are

actually low.

Questions and Problems

1. A single firm’s innovations in production technology often benefit the production of

other firms because these other firms learn about the new technology and can use

some of the ideas in their own production.

a. Is there an externality here? b. How would an economist rank the following two policies in this situation? Why?

i. A tariff on imports, to make sure that domestic production using the new technology occurs.

ii. A subsidy to domestic production, to make sure that domestic production using the new technology occurs.

c. What third policy (a tax or a subsidy to something) would the economist recom- mend as even better than these two?

2. What is the specificity rule?

✦

Chapter 10 Arguments for and against Protection 219

pug21774_ch10_192-221.indd 219pug21774_ch10_192-221.indd 219 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

3. A small price-taking nation imports a good that it could not possibly produce itself at

any finite price. Can you describe plausible conditions under which that nation would

benefit from an import tariff on the good?

4. What is the infant industry argument for putting up barriers to imports? What are its

merits and weaknesses?

5. Can you describe plausible conditions under which a nation would benefit from sub-

sidizing imports of a good?

6. What is the national defense argument for putting up barriers to imports? Why is

import protection probably not the best approach?

7. “The infant industry argument is not really an argument for a tariff on imports of a

product.” Do you agree or disagree? Why?

8. The minister for labor of the small nation of Pembangunan is eager to encourage

domestic production of digital clocks. A small clock industry exists, but only a few

producers can survive foreign competition without government help. The minister

argues that helping the industry would create jobs and skills that will be carried over

into other industries by workers trained in this one. He calls for a 10 percent tariff to

take advantage of these benefits. At the same cabinet meeting, the minister for indus-

try argues for a 10 percent subsidy to domestic clock production instead, stating that

the same benefits to the nation can be achieved at less social cost.

a. Show the following diagrammatically: i. The effects of the tariff on domestic clock output and consumption.

ii. The beneficial side effects of the tariff described by the minister for labor. iii. The net gains or losses for the nation as a whole.

iv. All the same effects for the case of the production subsidy. v. The differences in the effects of the two alternatives on the government’s budget.

Which policy would appeal more to a deficit-conscious minister for finance?

b. Can you describe a policy that captures the benefits of worker training better than either the 10 percent tariff or the 10 percent production subsidy?

9. Australia has only one firm that makes aircraft. Without assistance from the govern-

ment, that firm has lost most of its business to imports from the United States and

Europe. Which of the following policies would be most costly for the Australian

nation as a whole, and which would be least costly?

Policy A: Paying the lone Australian firm a production subsidy per plane, without protecting it against imports.

Policy B: Imposing a tariff equal to the production subsidy in policy A. Policy C: Imposing an import quota that cuts imports just as much as policy B would.

10. Assume that the sock-importing countries are determined to expand their domestic pro-

duction of socks. From the point of view of the sock-exporting countries, how would

you rate each of these three policies that could be used by the sock importers? Why?

Policy A: Subsidies to domestic sock production in the importing countries.

Policy B: Tariffs on sock imports.

Policy C: VERs on sock exports.

11. Do you favor or oppose the government policy of offering extra adjustment assistance

to workers displaced by increasing imports? Why?

✦

220 Part Two Trade Policy

pug21774_ch10_192-221.indd 220pug21774_ch10_192-221.indd 220 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

12. What is the free-rider problem, and how does it affect trade policy?

13. Elected legislative representatives are considering enacting a quota on imports of

baseball bats, with the rights to import the quota amount of bats to be given for free

to the three companies that currently distribute imported baseball bats. Identify the

groups that have a direct interest in whether or not the quota is enacted. How effective

do you think each will be in lobbying?

14. What is the tariff escalation pattern? Why does it exist in many countries?

15. In Chapter 2 we introduced the one-dollar, one-vote metric. If political decisions in

a small country about imposing tariffs were based on this metric, how many tariffs

would this country have?

16. A country currently has free trade in men’s t-shirts, and the country imports half of its

total domestic consumption. The government of the country has fully committed to

the goal of reducing the quantity imported of t-shirts by one-third. The government is

considering either a subsidy to domestic production or a tariff on imports to achieve

its goal.

A friend who works in the foreign ministry knows that you are studying interna-

tional economics, and she asks you to write a report comparing and contrasting the

two policy alternatives (production subsidy or tariff). To make the report more au-

thoritative, you are going to use at least one graph and one or more key concepts that

you just learned in this chapter. What will you write and show in your report?

✦

Chapter 10 Arguments for and against Protection 221

pug21774_ch10_192-221.indd 221pug21774_ch10_192-221.indd 221 10/27/14 6:30 PM10/27/14 6:30 PM

Final PDF to printer

Chapter Eleven

Pushing Exports Controversy over export behavior and export policy rivals the perennial fights over

import barriers. On the export side, however, the fight takes on a somewhat different

form. Here the fight usually centers on the artificial promotion of trade rather than on trade barriers. This chapter explores how both businesses and governments may push

for more exports than their country would sell under ordinary competition. The under-

lying policy questions are: Can a country export too much for its own good or for the

good of the world? Is that happening today? If so, what should an importing country

do about another country’s apparently excessive exports?

These questions do not arise in a vacuum. Governments, pressured by business and

labor lobbies, have long fought over what producers in importing countries consider arti-

ficial and excessive exports from other countries. The heat of debate on this issue inten-

sified during the past three decades. U.S. and European producers charged that Japan,

China, India, Taiwan, South Korea, and other rapidly growing countries were engaging

in “unfair trade” because exports from these countries were priced too low or subsidized

by their governments. These countries were repeatedly accused of violating both the

rules of ordinary competition and the rules of the World Trade Organization (WTO).

In response, India, China, and several other countries enacted their own procedures and

now bring many of their own cases charging unfair exporting by other countries.

To address the debate over unfair trade, we turn first to dumping, a way in which

private firms may export more than competitive supply and demand would lead us

to expect. Then we explore how governments push exports with outright or subtle

subsidies.

DUMPING

Dumping is selling exports at a price that is too low—less than normal value (or “fair market value,” as it is often called in the United States). There are two legal

definitions of normal value:

• The long-standing definition of normal value is the price charged to comparable domestic buyers in the home market (or to comparable buyers in other markets).

Under this traditional definition, dumping is international price discrimination

favoring buyers of exports.

• The second definition of normal value arose in the 1970s. It is cost-based—the average cost of producing the product, including overhead costs and profit. Under

222

pug21774_ch11_222-251.indd 222pug21774_ch11_222-251.indd 222 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

this second standard, dumping is selling exports at a price that is less than the full

average cost of the product.

Why would an exporting firm engage in dumping? Why would it sell exports at a

price lower than the price it charges for its product in its home market, or lower than

its average cost? There are several reasons. To judge whether dumping is good or bad,

it is important to understand the full range of reasons why dumping occurs.

Predatory dumping occurs when a firm temporarily charges a low price in the foreign export market, with the purpose of driving its foreign competitors out of busi-

ness. Once the rivals are gone, the firm will use its monopoly power to raise prices

and earn high profits.

Cyclical dumping occurs during periods of recession. During the part of the cycle when demand is low, a firm tends to lower its price to limit the decline in quantity sold.

For instance, in a competitive market initially in long-run equilibrium, price equals

full average cost (long-run average cost) for the representative firm. If an industry

recession or an economywide recession then causes demand to decline, market price

will fall below this full average cost in the short run. A firm continues to produce and

sell as long as price exceeds average variable cost. If any of these sales are exports,

the firm is dumping.

Seasonal dumping is intended to sell off excess inventories of a product. For instance, toward the end of a fashion season, U.S. clothing manufacturers may decide

to sell off any remaining stock of swimsuits at prices that are below full average cost.

That is, they have a sale. With production costs sunk, any price above the marginal

cost of making the sale is sensible. If some of these low-priced sales are to Canada,

the U.S. firm is dumping. Perishable agricultural products are also good candidates

for seasonal dumping. A big harvest tends to lower the market price and to provide a

larger quantity available for export. Similarly, dumping can be a technique for promot-

ing new products in new markets. This is the equivalent of an introductory sale that an

exporting firm could use to establish its product in a new foreign market.

Persistent dumping occurs because a firm with market power uses price discrimination between markets to increase its total profit. A firm maximizes profits by charging a lower price to foreign buyers if

• It has less monopoly power (more competition) in the foreign market than it has in

its home market and

• Buyers in the home country cannot avoid the high home prices by buying the good

abroad and importing it cheaply.

When these conditions hold, the firm can make home-country buyers pay a higher

price and thus earn a higher total profit. This is not predatory; it is not intended to

drive any other firms out of business. And it can persist for a long time—as long as

these market differences continue.

Figure 11.1 shows such a case of profitable price discrimination under the simplify-

ing assumption that the firm faces a constant marginal cost (and average cost) of pro-

duction. (In addition, the marginal production cost is the same regardless of whether the

product is sold in the home market or exported because essentially the same product is

sold in both places.) The illustration is based on a real case that surfaced in 1989. The

Chapter 11 Pushing Exports 223

pug21774_ch11_222-251.indd 223pug21774_ch11_222-251.indd 223 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

FIGURE 11.1 Persistent

Dumping

The monopolist uses price discrimination to maximize profits in two markets. The firm charges a

higher price in the market where the demand curve is steeper. In this case, that is the home market

in Japan, perhaps because in its home market the firm is protected from foreign competition. In

the more competitive U.S. market, the firm charges a lower price for its exported product. Total

profits are the sum of the two shaded rectangles. The price discrimination is viable only if there is

no way for consumers in the high-price market to buy the product from the low-price market, and if

policymakers in the importing country do not impose antidumping duties.

Quantity sold in Japan

Price ($ per phone)

100

MR Demand

This firm’s MC = AC = 18

The home market in Japan

Quantity exported to the United States

150

MC = AC = 18

The U.S. market for this firm’s exports

MR Demand

U.S. government determined that firms in Japan, Korea, and Taiwan were all guilty of

dumping telephones in the U.S. market, causing injury to AT&T (the plaintiff) and other

U.S. firms. 1 We illustrate with the case of a single Japanese firm (e.g., Matsushita).

What makes persistent dumping profitable is that, at any common price, the firm faces

a less elastic (steeper) demand curve in its home market than in the more competitive for-

eign market. That is, home-country buyers would not change the quantity they buy very

much in response to an increase in price, whereas foreign buyers would quickly abandon

this firm’s product if the firm raised its price much. Sensing this, the firm maximizes prof-

its by equating marginal cost and marginal revenue in each market. In the U.S. market the

profit-maximizing price is $25. With the $25 price U.S. consumers buy 150 telephones

a year, at which level marginal revenue just equals the marginal cost of $18. In Japan’s

home market, where consumers see fewer substitutes for the major Japanese brands, the

profit-maximizing price is $60. With the $60 price Japanese consumers buy 100 phones

a year, and marginal cost equals marginal revenue at this quantity.

Price discrimination is more profitable for the firm than charging the same price in

both markets. Charging the same price would yield lower marginal revenues in Japan

1 The actual dumping case involved phone equipment for small businesses, although here we illustrate with the case of personal phones from Japan. The U.S. Department of Commerce estimated dumping margins (home-market price above price on sales to the United States) of 120 to 180 percent for major firms in Japan and Taiwan, but only a trivial difference for Korean firms. The Asian exporters had raised their share of the U.S. phone market for small businesses to 60 percent by 1989.

224 Part Two Trade Policy

pug21774_ch11_222-251.indd 224pug21774_ch11_222-251.indd 224 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

than in the United States. As long as transport costs and import barriers in Japan make

it uneconomical for Japanese consumers to import low-priced telephones back from the

United States, the firm continues to make greater profits by charging a higher price in

the Japanese market. Often tariffs or nontariff barriers to import (back into the exporting

country) are what keep the two markets separate. These barriers also protect the dumper

against foreign competition in the higher-priced home market (Japan, in this example).

REACTING TO DUMPING: WHAT SHOULD A DUMPEE THINK?

Domestic firms competing against exports dumped into their market are likely to com-

plain loudly to their government, charging that this is unfair. How should the import-

ing country view dumping? What should be its government policy toward dumping?

In one sense the importing country’s view is easy. It should welcome dumping and

thank the exporting country. After all, we do not usually argue when someone tries

to sell us something at a low price. This instinct seems clearly correct for persistent

dumping. Compared to the high price in the exporting country, the importing country

gets the gains from additional trade at the low export price. The importing country’s

terms of trade are better. The benefits to consumers are larger than the losses to the

import-competing producers. To see this, consider what will happen to the import-

ing country if it imposes a tariff on the dumped imports, to force the tariff-inclusive

price up to about the level in the exporting country. In Figure 11.1, the duty would be

140 percent (5 [60 2 25]/25). In this example the tariff of 140 percent is prohibitive.

The Japanese firm would cease all exports to the United States. The United States thus

would lose all net gains from trade in this product. Although there would be an increase

in the surplus of domestic producers when the prohibitive duty was imposed, the loss

of domestic consumer surplus would be larger. Through similar logic, the importing

country generally should welcome seasonal and introductory-price dumping.

However, the other two types of dumping may not be so simple. There is a sound

economic reason for the importing country to view predatory dumping negatively.

Although the importing country gains from low-priced imports in the short run, it will

lose because of high-priced imports once the exporting firm succeeds in establishing

its monopoly power.

A key question is how frequently foreign firms use predatory dumping. Predatory

dumping of manufactured goods was widely alleged during the international chaos

of the 1920s and 1930s. In truth, there is no clear evidence that widespread predatory

dumping has been practiced, despite a rich folklore about it. Predatory dumping is likely to be rare in modern markets. An exporting firm considering predatory dumping must weigh the sure losses from low prices in the short run against the possible but uncertain

profits in the more distant future. Even if the firm could drive out its current competitors

in the importing country, it may expect that, once it raises prices, new firms, including

new exporters from other countries, will enter as competitors. The predatory exporter

would not be able to raise prices or to keep them high for very long. Recent research

suggests that no more than 5 percent of all cases of alleged dumping in the United States,

the European Union, Canada, Mexico, and India show even a moderate possibility for

predation (and it is possible that none of these cases involves predation).

Chapter 11 Pushing Exports 225

pug21774_ch11_222-251.indd 225pug21774_ch11_222-251.indd 225 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

Cyclical dumping is the most complicated kind of dumping for the importing

country. Most cyclical dumping is probably the normal working of well-functioning,

competitive global product markets. When demand declines, the market price falls in

the short run. A firm will continue to produce, sell, and even export some amount of

the product, as long as the revenue earned at least covers variable cost. This is exactly

what we want to happen when there is a decline in demand. Production declines

somewhat in many countries as the world price falls. There is an efficient global “shar-

ing” of the decline in demand. Once the recession ends, demand, price, and global

production will recover. (If instead too much production capacity continues to exist,

then eventually there will need to be an efficient global sharing of capacity reduction

before price can recover.)

The importing country may not be completely convinced that cyclical dumping

is fair just because it is usually globally efficient. When demand declines by, say,

10 percent, which countries absorb how much of global reduction in output? Is it

fair that the import-country firms have to reduce their output and suffer losses?

In particular, if the decline in demand is a result of a national recession in the

exporting country, why is it fair that the exporting country can “export some of its

unemployment”?

As usual, it is not easy to answer the question of what is fair. The international

sharing of recessions is one of the effects that comes with the general benefits of

international trade. We can also recall the key lesson from the previous chapter—use

the specificity rule. The real problem here is the concern about producer losses. For

instance, if the key concern is about unemployed workers, the country should provide

suitable unemployment insurance or adjustment assistance.

ACTUAL ANTIDUMPING POLICIES: WHAT IS UNFAIR?

Our discussion suggests that dumping is often good for the country importing the

dumped exports but that two types of dumping could be bad for the importing country.

Predatory dumping can be bad if it is successful, but success is probably rare. Cyclical

dumping can sometimes unfairly harm the importing country, but much of the time

it is probably the normal working of the competitive market. The implication is that

the importing-country’s government policy toward dumping (its antidumping policy)

should examine each case and consider benefits and costs before imposing antidump-

ing duties or other restrictions on dumped imports. In fact, actual government policies

are not at all like this.

The WTO rules permit countries to retaliate against dumping if the dumping

injures domestic import-competing producers. If the government in the importing

country finds both dumping and injury, then the government is permitted to impose an

antidumping duty —an extra tariff equal to the discrepancy (the dumping margin) between the actual export price and the normal value.

Antidumping cases throughout the world actually were infrequent until the late

1970s, and as of 1980 only about 34 countries had antidumping laws. Then more

countries adopted antidumping laws, especially since 1990, and by 2010 more than

100 countries had them.

226 Part Two Trade Policy

pug21774_ch11_222-251.indd 226pug21774_ch11_222-251.indd 226 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

FIGURE 11.2 Top 9 Initiators of Antidumping Cases

Number of Cases Initiated

Number of New Antidumping

Measures

Antidumping Measures in Effect

Average Antidumping

Duty Imposed*

1986–1990 2008–2012 2008–2012 June 2013

India 0 167 149 215 77% Brazil 6 133 59 91 53 Argentina 0 81 52 89 85 European Union 182 79 43 111 43 United States 184 65 66 243 89 China 0 53 42 118 54 Australia 156 52 22 35 59 Pakistan 0 52 24 45 35 Turkey 12 47 33 120 11

World 736 982 634 1,374 NA

Notes: NA: Not available .

*For India, average 1992–2002, source Ganguli (2008); for the European Union, the United States, and China, average 2002–2004,

source Bown (2010a); for other countries, average 1995–1999, source Congressional Budget Office (2001).

Other sources: Zanardi (2004); World Trade Organization, “Report (2013) of the Committee on Anti-Dumping Practices,” G/L/1035, October 29, 2013; World Trade

Organization, “Antidumping: Statistics on Antidumping,” www.wto.org/english/tratop_e/adp_e/adp_e.htm .

Up to the late 1980s, the four “traditional users” of antidumping (the United

States, the European Union, Canada, and Australia) accounted for over 90 percent of

the cases, but then the use spread. Figure 11.2 shows the countries that are the major

users of antidumping actions during 2008–2012. From 1986–1990 to 2008–2012

the number of cases worldwide increased by 33 percent, and the share of the four

traditional users (including Canada, with 24 cases during 2008–2012) dropped to

22 percent of total cases. India had no antidumping cases until 1992, but by 2008–

2012 it was the top initiator in the world. China enacted its antidumping policies

in 1997 and quickly rose to be a major initiator. Argentina and Pakistan also went

from zero to top 10.

Worldwide, the products most often involved in dumping cases are chemicals,

steel and other metals, plastics and rubber products, machinery, textiles, and apparel.

The countries whose exporters are most frequently charged with dumping are China,

South Korea, Taiwan, the United States, Thailand, and Indonesia. For China, in 2009,

about 2 percent of its exports were subject to antidumping measures in the importing

countries.

Let’s look more closely at U.S. antidumping policy. A case usually begins with a

complaint from U.S. producers. The U.S. Department of Commerce examines whether

dumping has actually occurred, and the U.S. International Trade Commission exam-

ines whether U.S. firms have been injured. In addition, negotiations may occur with

foreign exporters. If they agree to raise prices or to limit their exports, then the case

can be terminated or suspended. (This type of outcome has been common in cases

involving steel and chemicals.)

Chapter 11 Pushing Exports 227

pug21774_ch11_222-251.indd 227pug21774_ch11_222-251.indd 227 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

In about 94 percent of it determinations, the Department of Commerce finds some

amount of dumping—the law and the procedures are biased to make showing dump-

ing easy. In cases in which the comparison is between the export price and the home

market price, there are arcane rules about cost tests and ignoring export prices that

are above the home market price. The upshot is that only low-priced exports tend to

be compared to only high-priced home market sales. In cases in which export prices

instead are compared to average cost, obtaining and interpreting data on the costs

incurred by foreign exporters are often difficult, so the Commerce Department has

leeway in determining what normal value is. Lindsey and Ikenson (2002), using actual

data for 18 antidumping cases, examined them for specific biases in the methods used

by the Department of Commerce. They concluded that in 10 of the 18 cases there actu-

ally was no dumping, and in 4 of the other 8 cases the actual dumping was less than

half the amount found by the Department.

The injury standard is not strict, but injury is usually the key to the outcome of a

case. In about two-thirds of the cases, the International Trade Commission finds mate-

rial injury to U.S. import-competing industries.

If both dumping and injury are found, customs officials are instructed to levy an

antidumping duty. More than half of the cases brought in the United States result in

antidumping duties or an exporter agreement to restrain its export prices or volumes.

(By comparing the two columns in Figure 11.2 for new cases initiated and new anti-

dumping measures for 2008–2012, we can see that more than half of the cases in most

of the other countries shown and in the world overall result in antidumping duties or

exporter agreements.)

Recent research shows some clear patterns of effects from all this. Shortly after the

complaint is filed, the prices of the exporters charged with dumping increase, probably to

try to reduce the final dumping margin. Export quantities decrease because of the higher

price and because of the uncertainty about the outcome of the case. If antidumping

duties are imposed, the export quantities decrease further, by an average of 70 percent,

and often to zero (as we noted for the case shown in Figure 11.1). The exporter also has

an incentive to raise its export price. The antidumping duties are reduced or eliminated

if a subsequent review by the Department of Commerce finds less or no dumping.

A study of the overall effects of imposing antidumping duties concluded that the

United States suffers a loss of well-being of nearly $4 billion per year. About half of

that amount is deadweight loss (like areas b 1 d in Figure 8.5 or Figure 9.3). The other half is the transfer to foreign exporters that raises their prices (like area c in Figure 9.3). The net loss to the United States could be lower than this because the

study does not attempt to quantify the value of avoiding any harmful effects from

predatory dumping (probably minimal) and cyclical dumping (hard to measure).

Under current antidumping policies in the United States and a growing number of

other countries, we get the following results:

1. The procedure is biased toward finding dumping.

2. The injury test considers only harm to import-competing producers. There is no

consideration of whether predation or some other source of harm to the country

is involved. There is little or no consideration of the benefits to consumers of the

low-priced imports.

228 Part Two Trade Policy

pug21774_ch11_222-251.indd 228pug21774_ch11_222-251.indd 228 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

3. Overall, the process is biased toward imposing antidumping duties, even though

this usually lowers the well-being of the importing country. Antidumping duties

also generally lower world welfare.

See the box “Antidumping in Action” for specific examples that illustrate these conclusions.

If an exporting country’s government believes that an importing country’s gov-

ernment violated the WTO’s rules in deciding to impose an antidumping duty, it can

complain to the WTO. By early 2014 there had been 101 such complaints, includ-

ing 47 about the laws and procedures of the U.S. government. As of early 2014,

panels had been convened and reached decisions in close to half of these 101 cases.

Usually, the panels found errors by the importing countries, including using inap-

propriate procedures, determining dumping margins (or subsidy rates) in a manner

inconsistent with WTO rules, and determining injury using incomplete information

or biased analysis. In some of the cases the importing country implemented changes

(like revoking the duties) to bring their practices in line with WTO rules, but in oth-

ers they have not (yet). While the WTO dispute settlement procedure can provide

some guard against misuse of antidumping duties, the process is too slow to mini-

mize the effects of such misuse.

Antidumping policy starts out sounding like it is about unfair exports. But a closer

examination indicates that something else is going on. Antidumping policy has become a major way for import-competing producers in a growing number of countries to gain new protection against imports, with the usual deadweight costs to the world and to the importing country . As shown in Figure 11.2, the average antidumping duties imposed against foreign exporters are generally very high, much higher than most regular tariffs,

so the deadweight losses can be large. There is also the cost of arguing the cases and

gathering the data to prove or disprove dumping and injury. In addition, import-competing

firms use the threat of a dumping complaint to prod exporters to raise their prices and

restrain their competition—the harassment effect —even if no complaint is actually filed.

PROPOSALS FOR REFORM

Although there are exceptions, the current practice of retaliation against dumping

is usually bad for the world and for the importing country. 2 Yet this practice is fully

consistent with current WTO rules. Reform of the WTO rules is an important item on

2Here is an example in which retaliation against persistent dumping could bring gains to the whole world. If the “convicted” dumper ceases all price discrimination, continues to serve both markets with a single price that is not too high, and is rewarded by getting the duty removed, the world could end up better off from the temporary punitive use of the duty. The world is better off in the sense that output is redirected to the home-country buyers who value the good more highly at the margin. One example of this kind of gain is the outcome of a U.S. dumping case against Korean consumer electronics producers, which led to a lowering of the high prices Korean consumers had been paying for these products.

This is only one of a number of possible outcomes, and the others are usually bad for the world. For instance, the dumpers may move their export-market production to the importing country at some extra expense of world resources. Or they might abandon the controversial foreign market as not worth the bother if it is spoiled by an antidumping duty. The issue of dumping is complex. The text gives the welfare results that seem most likely.

Chapter 11 Pushing Exports 229

pug21774_ch11_222-251.indd 229pug21774_ch11_222-251.indd 229 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

Case Study Antidumping in Action

Dumping laws and antidumping procedures sound technical and boring. The firms that use antidumping complaints to get protection from imports like it that way. Nobody else is much interested in what’s going on. Yet the stakes are large. Maybe we should follow the money—now that’s more interesting.

Here are three examples of antidumping in real life. One sad moral of these tales is that any exporter that succeeds in building market share is at risk of being accused of dumping, and defense against this charge will be very difficult.

A GAME OF CHICKEN When it comes to chicken, Americans prefer white meat. South Africans prefer dark meat. Sounds like the basis for mutually beneficial trade. And it would be, if it weren’t for those pesky dumping laws.

U.S. chicken producers noticed the differences in demand. They began exporting dark-meat chicken to South Africa. This created extra com- petition for South African chicken producers, but South African consumers gained more than local producers lost. That’s the way trade works. In addition, U.S. chicken producers were happy. The price they received for their dark-meat exports was somewhat higher than the price they could get in the United States. This added to their profitability.

South African chicken producers scratched back. They charged U.S. producers with dump- ing by exporting dark-meat chicken at a price less than production cost. This is an ideal situation for a biased antidumping authority because there is no one way to determine this production cost. (What comes first, the dark meat or the white?) In 2000, the South African government determined that the U.S. firm Tyson was dumping by a margin of 200 per- cent (its export price was only one-third of its estimated production cost) and Gold Kiss was dumping by an incredible 357 percent margin. Something is fowl in South Africa. Good-bye gains from trade.

WHAT’S SO SUPER ABOUT SUPERCOMPUTERS? In 1996 the Japanese company NEC won the con- tract to supply a supercomputer to a university consortium funded by the U.S. National Science Foundation, to be used for weather forecasting. This was the first-ever sale of a Japanese super- computer to an agency of the U.S. government. It seemed to be a major setback for Cray Research, then the major U.S. supercomputer maker. But Cray thought it saw unfair trade.

With encouragement from the U.S. Depart- ment of Commerce, Cray filed a dumping com- plaint. NEC guessed that it was not likely to win with the Department of Commerce also acting as the judge, and it refused to participate in the case. Based on information provided by Cray, the U.S. government imposed antidumping duties on NEC supercomputers at the super rate of 454 percent (and at the almost super rate of 173 percent for supercomputers from Fujitsu, the other major Japanese producer). With these antidumping duties in place, no one in the United States would be buying NEC or Fujitsu supercomputers.

Not so super for U.S. users of supercomputers. Or for anyone in the United States who wanted accurate weather forecasts. NEC supercomputers were simply the best in the world for this purpose.

There’s one more twist in this wired tale. Hey, maybe it isn’t dumping after all. In 2001, Cray was in financial trouble, and its technology was lagging. In exchange for a $25 million invest- ment by NEC and a 10-year contract to be the exclusive distributor of NEC supercomputers in North America, Cray asked the Department of Commerce to end the antidumping duty.

AMERICAN STEEL: THE KING OF ANTIDUMPING If antidumping were like the Super Bowl, the American steel industry would be the winner. In early 2014 nearly half of all antidumping duties in effect in the United States were on steel products. As a comparison, steel accounts for about 2 percent of U.S. imports. How did one

230 Part Two Trade Policy

pug21774_ch11_222-251.indd 230pug21774_ch11_222-251.indd 230 11/3/14 7:37 PM11/3/14 7:37 PM

Final PDF to printer

industry that employs about 200,000 workers become the king of antidumping?

In the first half of the 20th century, the American steel industry was the world leader in output and productivity. In 1950 the United States produced about half of the world’s total steel output. Since then the situation has changed dramatically. Steel producers in other countries increasingly have sourced high-quality raw mate- rials globally (for instance, iron ore from Australia and Brazil). These foreign firms focused on raising productivity and lowering costs. They often had support from their national governments. At the same time, the managers of the large integrated American steel producers made poor decisions, including lagging innovation of technological improvements and payment of uncompetitive high wages and benefits to unionized workers. By 2013 American steel firms accounted for only about 5.5 percent of world production. Half of U.S. production was by minimills, another source of competitive pressure on the large integrated American firms (often called Big Steel).

American steel firms fought back. A large part of their strategy was the use of political lobbying and U.S. trade laws to attack imports. In the 1980s, to head off a large number of steel dumping com- plaints, the U.S. government forced the European Union and other countries to impose voluntary export restraints (VERs). As these VERs ended, on one day in 1992 American steel firms filed 80 dumping complaints against 20 countries. (Note that American steel producers buy about one- quarter of all steel imported into the United States, in the form of raw steel slabs that they use to make finished steel products. Amazingly, raw steel slab is apparently never dumped into the United States, but all kinds of finished steel products are.)

American steel firms are well organized. Statisticians at steel-producer organizations and at individual steel firms closely examine each month’s trade data. When they see an increase of imports in a specific steel product, the American firms are likely to file a dumping complaint. The American firms actually “lose” or withdraw at

least half of these complaints. But they don’t really lose. For instance, in 1993, American firms filed dumping complaints against exporters of carbon steel rod. In the early months of the inves- tigation, the price of this product in the United States increased by about 25 percent. Eventually, the American firms lost the cases or withdrew the complaints. An executive of a foreign-owned steel firm commented, “But who says they lost? I would say they won. Whatever they spent in legal fees, they probably recouped 50 times in extra revenue. That is the great thing about fil- ing: Even if you lose, you win.”*

Since the early 1990s there have been several other bursts of dumping cases filed by American steel firms. In the aftermath of the Asian crisis of 1997, demand collapsed in the crisis countries (especially Korea, Thailand, Indonesia, Malaysia, and the Philippines). Steel firms that had been selling to the crisis countries shifted sales to other countries. In 1998 imports of finished steel into the United States rose rapidly and prices for steel products typically fell by 20 to 25 percent. A strong case can be made that 1998 was a fairly typical down phase in the global cycle of a com- petitive industry. Still, American firms swung into action. They filed four major dumping cases in 1998 and four in 1999. The International Trade Commission found injury to U.S. steel firms in six of these cases, and the Department of Commerce found dumping margins of up to 185 percent. In the large case involving cold-rolled steel, imports declined by 20 percent in the months after the case was filed, even though the U.S. firms even- tually “lost” the case when no injury was found.

As prices remained relatively low around the world, the U.S. steel firms continued to find new dumping. They brought five major cases in 2000 and six major cases in 2001.

—Continued on next page

* Mr. Nicholas Tolerico, executive vice president of Thyssen, Inc., a U.S. subsidiary of Thyssen AG, a German steel company. Quoted in The Wall Street Journal , March 7, 1998.

Chapter 11 Pushing Exports 231

pug21774_ch11_222-251.indd 231pug21774_ch11_222-251.indd 231 11/3/14 7:37 PM11/3/14 7:37 PM

Final PDF to printer

In early 2002 President Bush imposed new general tariffs of up to 30 percent on imports of steel, and the number of new dumping cases decreased. Under pressure from U.S. steel users and an adverse WTO ruling, he removed these tariffs in late 2003. But then global steel prices rose by more than 50 percent during 2004, driven by rapidly rising demand in China and other developing countries. With strong world prices continuing into 2008, there were few new anti- dumping suits in the United States.

As the global crisis hit in 2008, the steel industry went into recession and the share of the U.S. mar- ket served by imports increased. The U.S. industry filed seven new dumping cases in 2009. After a few years’ lull, steel imports into the United States began to grow rapidly at the beginning of 2013, driven both by slowing demand for steel

and excess capacity in the rest of the world and by strong demand in the United States (especially domestic demand for steel used in oil, natural gas, and automobile production). The great American steel machine that rolls out complaints about foreign dumping restarted, and the industry filed seven new dumping cases charging firms from 16 countries with dumping various steel products, the largest being tubular goods for oil production.

Steel remains the U.S. antidumping king, and the oil industry and many other users of steel in the United States pay the (higher) price.

DISCUSSION QUESTION For the U.S. cases alleging dumping filed in 2013, why might the number of these cases that actually result in the imposition of antidumping duties turn out to be relatively low?

the agenda for the current Doha Round of multilateral trade negotiations. Three pos-

sibilities for reform are discussed in the following paragraphs.

First, antidumping actions could be limited to situations in which predatory dumping is plausible . This reform would focus on the type of dumping that is most likely to be bad for the world and for the importing country. It would also align antidumping policy

with antitrust policy (as it is called in the United States; it is called competition policy,

antimonopoly policy, or similar names in other countries). Pro-competition policies

usually forbid any predatory action to gain monopoly power. This reform would try to

limit the scope of antidumping policy. However, the procedures in a country could still

be biased toward finding both dumping and something potentially predatory about it.

Second, the injury standard could be expanded to require that weight be given to consumers and users of the product . This change would shift the discussion toward injury to net national well-being, not just injury to domestic import-competing pro-

ducers. Some countries, including the European Union, Canada, and Thailand, already

have a “public interest test” in their antidumping regulations. This reform would try

to limit the scope for antidumping actions in a general way rather than by focusing on

one type of dumping.

This reform would also change an odd feature of current antidumping policy, that

consumers will be substantially affected by dumping decisions but have no legal

standing in the process. In fact, most antidumping actions involve intermediate goods

like steel and chemicals. The buyers (like automobile firms) of these products are

often well organized politically. They can be effective in opposing import protection

232 Part Two Trade Policy

pug21774_ch11_222-251.indd 232pug21774_ch11_222-251.indd 232 11/3/14 7:38 PM11/3/14 7:38 PM

Final PDF to printer

on the intermediate products that they buy and use. Current dumping policies give

import-competing producers of intermediate products an end run around this political

battle. Reforming antidumping policy to include consumer interests would reopen the

battle and probably reduce some of the bad use of antidumping policy.

Third, antidumping policy could be replaced by more active use of safeguard policy, another kind of increased import protection allowed by WTO rules. Safeguard policy is the use of temporary import protection when a sudden increase in imports causes injury to domestic producers. The intent is to give some time for

import-competing firms and their workers to adjust to the increased import competi-

tion (recall the discussion of adjustment assistance in the previous chapter).

Defenders of antidumping policy often state that antidumping policy facilitates

trade liberalization because it allows protection for industries that are hurt more

than expected by increasing imports. This is really an argument for safeguard policy.

Safeguard policy is better because:

• There is no need to show that foreign exporters have done anything unfair.

• The interests of consumers can be considered in the process that leads to the

decision of whether or not to impose a safeguard, and what form it will take if

imposed.

• The focus is on adjustment by the import-competing producers.

• There is pressure to adjust because the import protection is temporary.

Safeguard actions have not been much used in the United States. One famous case

is Harley-Davidson in the 1980s. After a safeguard was imposed, Harley-Davidson

came back so strongly and quickly in its battle with Japanese competitors (Suzuki

and Honda) that it asked that the safeguard protection be removed earlier than

scheduled. More recently, the tariffs on steel imposed by the U.S. government in

2002 were the outcome of the government’s investigation of a request by American

steel firms for safeguard relief. The tariffs that the U.S. government imposed in 2009

on imports of tires from China are another example. Clearly, safeguard actions such

as these steel and tire tariffs can still be controversial, but at least all parties affected

have a right to be heard in the debate.

EXPORT SUBSIDIES

Governments promote or subsidize exports more often than they restrict or tax exports. 3

Some government efforts to promote exports are not controversial according to interna-

tional precepts (although there are questions about how effective they are). Government

agencies like Export.gov of the U.S. Department of Commerce provide foreign-market

research, information on export procedures and foreign government regulations, and

help with contacting buyers. Government agencies sponsor export promotion events

like trade fairs and organized trips. Governments establish export processing zones

that permit imports of materials and components with easier customs procedures and

low or no tariffs.

3 In the United States this is not surprising because the U.S. Constitution prohibits the taxing of exports.

Chapter 11 Pushing Exports 233

pug21774_ch11_222-251.indd 233pug21774_ch11_222-251.indd 233 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

Governments also provide various forms of financial assistance that benefit their

exporters. An export subsidy is controversial because it violates international norms about fair trade. Our analysis of export subsidies will conclude that export subsidies

are usually bad from a world point of view. However, the international division of

gains and losses turns out to be very different from what you would expect just by

listening to who favors export subsidies and who complains about them. Export

subsidies are bad for the countries that use them but are good for the countries that

complain about them!

Governments subsidize exports in many ways, some of them deliberately subtle

to escape detection. They use taxpayers’ money to give low-interest loans to export-

ers or their foreign customers. An example is the U.S. Export-Import Bank, or

Eximbank. Founded in the 1930s, it has compromised its name by giving easy credit to

U.S. exporters and their foreign customers but not to U.S. importers or their foreign sup-

pliers. Governments also charge low prices on inputs (such as raw materials or domestic

transport services) that go into production that will be exported. Income tax rules are

also twisted to give tax relief based on the value of goods or services each firm exports.

Export subsidies are small on average, but they loom large in certain products

and for certain companies. For instance, most Eximbank loans have been channeled

toward a few large U.S. firms and their customers. Boeing, in particular, has been

helped to extra foreign aircraft orders by cheap Eximbank credit. More broadly, the

biggest export subsidies apply to agricultural products.

What are the effects on the country whose government offers the export subsidy?

Let’s examine the effects for a competitive industry, using our standard supply-and- demand framework. We will reach the following conclusions:

1. An export subsidy expands exports and production of the subsidized product. In fact,

the export subsidy can switch the product from being imported to being exported.

2. An export subsidy lowers the price paid by foreign buyers, relative to the price that

local consumers pay for the product. In addition, for the export subsidy to work as

intended (the government subsidizes only exports, not domestic purchases), something

must prevent local buyers from importing the product at the lower foreign price.

3. The export subsidy reduces the net national well-being of the exporting country.

Let’s examine three cases to see the validity of these conclusions.

Exportable Product, Small Exporting Country Figure 11.3 shows a small country, in this case a country whose exports of steel

pipes do not affect the world price of $100 per pipe (standard length). With free trade

the firms in the country’s competitive steel-pipe industry produce 160 million pipes

per year and export 90 million (5 160 2 70). The government of this country then

decides to offer to its firms an export subsidy of $20 per pipe. The revenue per pipe

exported then is $120, equal to the $100 price paid by foreign buyers plus the $20 sub-

sidy. If a pipe firm can get $120 for each pipe exported, it will not sell to any domestic

buyer at a price lower than $120. Of course, this is only possible if domestic buyers

cannot just buy imported pipes from the world market at $100. Something must keep

the export market separate from the domestic market. (This should sound familiar—it

234 Part Two Trade Policy

pug21774_ch11_222-251.indd 234pug21774_ch11_222-251.indd 234 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

sounds like persistent dumping. In fact, receiving an export subsidy is another reason

why an exporting firm would engage in dumping.)

What are the other effects of the export subsidy in this case? If revenue per unit

rises to $120 (for both export and local sales), the quantity produced increases

to 190 million. If the domestic price increases to $120, local quantity demanded

decreases to 50 million. Quantity exported increases to 140 million (5 190 2 50).

Who are the winners and losers in the exporting country? Producers gain surplus

equal to area e 1 f 1 g . Consumers lose surplus equal to area e 1 f . The cost to the government of paying the export subsidy is area f 1 g 1 h , equal to the export sub- sidy of $20 per pipe times the 140 million pipes exported with the subsidy.

The export subsidy has increased exports and production of this product, but is it

good for the exporting country? Using our one-dollar, one-vote metric, the answer

is no. After we cancel out the matching gains and losses, the net loss in national

well-being is areas f and h . Area f is the consumption effect of the export sub- sidy, the lost consumer surplus for those consumers squeezed out of the market

when the domestic price rises above the world price. Area h is the production

FIGURE 11.3 Export Subsidy,

Small Country,

Exportable

Product

With free trade at the world price of $100, this small country exports 90 million steel pipes. If the

country instead offers an export subsidy of $20 per unit exported, revenue per unit exported rises to

$120, and the exporting firms must receive this amount as the selling price from domestic buyers

as well. Domestic production rises from 160 to 190 million, domestic consumption falls from 70

to 50 million, and the country exports 140 million pipes. Domestic producers gain surplus equal to

area e 1 f 1 g , domestic consumers lose surplus equal to area e 1 f , and the cost to the government of paying the export subsidy is area f 1 g 1 h . The net loss in national well-being because of the export subsidy is area f plus area h .

Quantity (millions of pipes)

Price ($ per pipe)

100

120

e gf h

World price

190160

Chapter 11 Pushing Exports 235

pug21774_ch11_222-251.indd 235pug21774_ch11_222-251.indd 235 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

effect of the export subsidy, the loss due to encouraging domestic production that has a resource cost greater than the world price (the world standard for efficient

production). Although these two triangles are on the opposite sides of the graph,

because this is an exportable product rather than an importable product, they are the

same kinds of effects shown for the import tariff in Figure 8.4. The loss of national

well-being for this small exporting country is also a loss for the world.

Exportable Product, Large Exporting Country We’ve just seen that a small exporting country harms itself by offering an export sub-

sidy to its competitive exporting industry. Perhaps the result is different if the export-

ing country is large enough to affect the world price. Not so—in fact, it may be worse.

Figure 11.4 shows this case. With free trade the world price is $100 per pipe. When

the exporting-country government offers the export subsidy of $20 per pipe, exporting

firms want to export more to get more of the subsidy. To get foreign consumers to buy

more of the exported product, the exporting firms must lower the export price. And,

just as in the small-country case, domestic buyers in the exporting country must end

up paying $20 more than the export price (assuming that they cannot import from the

rest of the world at the new world price).

We can see the resulting equilibrium more easily in panel B of Figure 11.4. The

export subsidy creates a wedge of $20 between the price that foreign importers pay

and the revenue per unit that exporters receive. This $20 wedge “fits” (vertically) at

the quantity traded of 110 million pipes. The new world price is $88, the price paid

by the importers. The revenue per unit to the exporting firms, and the new price in the

exporting country, is $108.

Panel A of Figure 11.4 shows what is happening in the exporting country. At

$108 per pipe, production in the exporting country increases from 160 million to

172 million, and domestic consumption decreases from 70 to 62 million. Quantity

exported increases from 90 million to 110 million.

As in the small-country case, the export subsidy has increased domestic production

and exports of pipes. What are the effects on well-being in the exporting country?

Producer surplus increases by area e 1 f 1 g . Consumer surplus falls by area e 1 f . The export subsidy costs the government $20 times the 110 million units exported.

This government cost of $2.2 billion is area f 1 g 1 h 1 i 1 j 1 k 1 l 1 m in panel A (or area f 1 g 1 h 1 n 1 r 1 t 1 u in panel B).

The net loss to the exporting country is the shaded area in panel A or B. This net

loss has three parts:

• The consumption effect (area f ). • The production effect (area h ). • The loss due to the decline in the exporting country’s international terms of trade

(area i 1 j 1 k 1 l 1 m 5 area n 1 r 1 t 1 u ).

The export subsidy gives a good bargain to foreign buyers. However, their gain is a

loss to the exporting country from selling at a lower world price.

We can also use panel B to see the effect on world well-being. Area n 1 r 1 t is increased surplus for the importing country. The net loss to the world is the triangular

area f 1 h 1 u . This is the loss from too much trading of steel pipes.

236 Part Two Trade Policy

pug21774_ch11_222-251.indd 236pug21774_ch11_222-251.indd 236 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

With free trade at the world price of $100, this large country exports 90 million steel pipes. If instead the country

offers an export subsidy of $20, its extra exports drive the world price down to $88. The revenue per unit received

by the exporting firms is $108, and domestic buyers pay a price of $108. The net loss of well-being for the

exporting country is area f 1 h 1 i 1 j 1 k 1 l 1 m . The export subsidy both distorts domestic production and consumption and worsens the exporting country’s international terms of trade. The inefficiency created for the

world is area f 1 h 1 u .

FIGURE 11.4 Export Subsidy, Large Country, Exportable Product

Quantity (millions of pipes)

0 62

Price ($ per pipe)

108

A. The Domestic Market for Pipes

100

108

100

88 j ki l m n r t

f he g

17270 160 90 110 Quantity (millions of pipes)

Price ($ per pipe)

B. The International Market for Pipes

Foreign demand for imports

Supply of exports

f + h

Switching an Importable Product into an Exportable Product “If you throw enough money at something, it will happen.” This adage applies to

export subsidies. They can turn an importable product into one that is exported. Let’s

see how.

To keep things from getting too complicated, we will examine the small-country

case shown in Figure 11.5 . With free trade at the world price of $2 per kilogram, the

country would import 80 million kilos of butter (5 120 2 40). The government now

offers an export subsidy of $2 per kilo and prevents domestic consumers from import-

ing cheap foreign butter. The revenue per kilo exported now rises to $4, and domestic

production increases to 90 million kilos. At the higher domestic price of $4 per kilo,

domestic consumers reduce their butter purchases to 60 million kilos. With the export

subsidy, the country is now an exporter of 30 million kilos. The export subsidy switches an importable product into an exportable product.

Domestic producers gain surplus of area ACFE . Domestic consumers lose surplus of area ABJE . The cost of the export subsidy to the government is area BCHG . The net loss of national well-being looks a bit peculiar because the triangles of the consump-

tion effect and the production effect overlap each other. The net national loss (and the

net loss to the world) is area BJG plus area CHF .

Chapter 11 Pushing Exports 237

pug21774_ch11_222-251.indd 237pug21774_ch11_222-251.indd 237 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

FIGURE 11.5 An Export

Subsidy Turns

an Importable

Product into

an Export

With free trade and no export subsidy, this small country imports 80 million kilos of butter. If

instead the country’s government offers an export subsidy of $2 per kilo, the revenue per unit

received by producers doubles to $4. The country becomes an exporter of 30 million kilos of butter.

The net loss of national well-being is the sum of a production deadweight loss of area FCH and a consumption deadweight loss of area BJG .

Quantity (millions of kilos)

Price ($ per kilo)

6040

E F J

G H

B C

World price

90 120

This example of using export subsidies to create exportables is not far-fetched! See

the box “Agriculture Is Amazing.”

At this point you might want to return to the conclusions stated at the beginning of

this section. You should see that these conclusions apply to all three of our cases. If the

market is competitive, an export subsidy is bad for the exporting country.

WTO RULES ON SUBSIDIES

As a result of the agreements reached in the Tokyo Round and Uruguay Round of

trade negotiations, the WTO now has a clear set of rules for subsidies that may benefit

exports. The WTO rules divide subsidies into two types:

• Subsidies linked directly to exporting are prohibited, except export subsidies used by the lowest-income developing countries. Example: A firm receives a tax break

based on the amount that it exports.

• Subsidies that are not linked directly to exporting but still have an impact on

exports are actionable . Example: Low-priced electricity is provided to assist pro- duction by local firms in an industry, and some of this production is exported.

238 Part Two Trade Policy

pug21774_ch11_222-251.indd 238pug21774_ch11_222-251.indd 238 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

If an importing country’s government believes that a foreign country is using a pro-

hibited subsidy or an actionable subsidy that is harming its industry, the importing

country can follow one of two procedures:

• File a complaint with the WTO and use its dispute settlement procedure.

• Use a national procedure similar to that used for dumping (used more often).

If the importing country can show the existence of a prohibited or actionable subsidy

and harm to its industry, it is permitted to impose a countervailing duty, a tariff used to offset the price or cost advantage created by the subsidy to foreign exports.

SHOULD THE IMPORTING COUNTRY IMPOSE COUNTERVAILING DUTIES?

How should the importing country respond to subsidized exports? Should the coun- try simply enjoy the bargain? Or should the importing-country government heed the

complaints from import-competing producers about unfair competition and impose a

countervailing duty on the subsidized exports?

If the exporting country is large enough to affect world prices, then the export

subsidy lowers the price that the importing country pays for these exports. As we saw

in Figure 11.4B , the importing country overall is better off, but the import-competing

industry is harmed. By WTO rules, the importing-country government is permitted to

impose a countervailing duty. What happens if it does so?

To keep things from getting too complicated, let’s use an extreme version of

the large-country case examined in Figure 11.4. In this version, all of the export

subsidy is passed forward to the buyers of imports in the foreign country. That

is, the price charged to importers falls by the full amount of the export subsidy.

Still, be warned: Even this simplified case can be confusing. We will focus on

two different measures of well-being, one for the importing country and one for

the world. We will make comparisons among three different situations: (1) free

trade, (2) export subsidy with no countervailing duty, and (3) export subsidy plus

countervailing duty.

Figure 11.6 shows the Canadian and international market for cold-rolled steel.

With free trade, Canada imports 50 million tons per year from Brazil at the free-trade

price of $300 per ton. Then, the Brazilian government offers a subsidy of $50 per ton

exported. If all of this is passed on to buyers, the export price declines to $250 per

ton. Canadian imports increase to 80 million tons, Canadian production declines to

130 million tons, and Canadian producer surplus declines by area v . Canadian con- sumption increases to 210 million tons, and Canadian consumer surplus increases by

area v 1 w 1 y 1 z . The net Canadian gain from the Brazilian export subsidy is area w 1 y 1 z . Still, Canadian producers are harmed, and they complain about the unfair competition.

For the world, this is too much steel trade. Steel tons that each cost $300 of

Brazilian resources to produce are valued at less than $300 per ton by Canadian buyers

(as shown ton-by-ton on the Canadian demand-for-import curve).

Chapter 11 Pushing Exports 239

pug21774_ch11_222-251.indd 239pug21774_ch11_222-251.indd 239 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

What happens if the Canadian government imposes a countervailing duty of $50

per ton of imported steel? The duty-inclusive price of imports rises back to $300. In

this subsidy-plus-countervailing-duty situation, the world returns to the same price

$300 and volume of trade (50 million tons) as with free trade. This makes good

sense for world efficiency because the deadweight loss of excessive trade (area x in Figure 11.6B) is eliminated. For the world, the countervailing duty is a successful use

of Chapter 10’s specificity rule. In this case the world’s problem is excessive exports

of steel, and the countervailing duty directly affects exactly the problem activity.

Conclusions about the effects of the countervailing duty on Canada’s well-being depend on what we compare to. In comparison to the situation with the export subsidy and no countervailing duty, Canada is worse off for imposing the countervailing duty. That’s right—a countervailing duty in this case is bad for the country imposing it but

good for the whole world. We can use Figure 11.6A to see the effect on the importing

country of imposing the countervailing duty, given that an export subsidy exists. The

duty-inclusive price rises to $300. Canadian producers gain area v , Canadian consum- ers lose area v 1 w 1 y 1 z , and the Canadian government collects area y as revenue from the countervailing duty. The net national loss to Canada of imposing the coun-

tervailing duty is area w 1 z (the standard result for imposing a tariff ). Let’s look at a second valid comparison, the comparison between free trade and the

combination of the export subsidy and countervailing duty . In both of these situations, the price in Canada is the same ($300), as are all quantities. The only difference is that

The diagram shows the effect of (1) a Brazilian export subsidy on steel to Canada and (2) a Canadian countervailing

duty on imports of subsidized steel exports from Brazil. An odd pattern results: Each policy in turn brings a net loss

to the country adopting it, yet for the world as a whole the Canadian countervailing duty undoes the harm done by the

Brazilian export subsidy.

FIGURE 11.6 A Foreign Export Subsidy and a Countervailing Duty

Quantity (millions of tons)

0 130

Price ($ per ton)

300

A. The Canadian Market for Cold-Rolled Steel

250 xyv w zy

210150 80

300

250

50200 Quantity (millions of tons)

Price ($ per ton)

B. The International Market for Cold-Rolled Steel

Canadian demand for imports

w + z

240 Part Two Trade Policy

pug21774_ch11_222-251.indd 240pug21774_ch11_222-251.indd 240 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

the Canadian government is collecting revenue (area y ) in the subsidy-and-duty situ- ation. Who is effectively paying the countervailing duty? The Brazilian government!

It pays the export subsidy to the Brazilian firms, who pass it on to import buyers in

Canada through the lower export price. The Canadian import buyers then send it to

the Canadian government when they pay the countervailing duty. The well-being of

Canada is higher than it would be with free trade because the Brazilian government is

now effectively paying Canadian taxes.

Because export subsidies are bad for the world as a whole, and retaliating against

them is good for the world as a whole, WTO rules are wise to allow importing coun-

tries to impose countervailing duties. However, it turns out that subsidy complaints

and countervailing duties are much less frequent than dumping complaints and

antidumping duties. During 2008–2012 only 101 subsidy cases were initiated in the

world, and in mid-2013 there were only 93 countervailing actions in effect.

The United States has been the largest user of countervailing duties, with 37 of

these new cases and 52 of the countervailing duties in force. The European Union

and Canada also make some use of countervailing duties. China, the United States,

and India are the countries most frequently charged with subsidizing exports. Steel

products are the most frequently involved. Countervailing duties also tend to be lower

than antidumping duties. For instance, for the United States the average countervailing

duty is about 10 percent.

While countervailing duties are often good for the world, they can also be misused

in the same way that antidumping duties are misused. Import-competing producers have

an incentive to complain about possible foreign subsidies to exports, in an effort to gain

protection against these exports. Many activities of a government could have some ele-

ment of subsidy in them. In antisubsidy cases, it is often possible for the complaining

firms to establish that some kind of foreign subsidy exists that might benefit exports,

perhaps with some help from a government process biased toward helping the import-

competing domestic firms. Then, these firms can gain the protection of countervailing

duties if they can show that they have been injured by the “subsidized” exports.

The softwood lumber dispute between the United States and Canada is an example

of a controversial antisubsidy case. In early 2001 a VER limiting Canadian exports

expired. U.S. lumber firms immediately renewed their complaint that Canadian lum-

ber firms benefit from a subsidy because the Canadian government does not charge

high enough fees for logging on government lands. The Canadian government con-

tended that its fees were appropriate, so there was no subsidy. The U.S. government

found otherwise. The U.S. Commerce Department concluded that the low fee was

a subsidy of 19 percent and that Canadian lumber exporters also were dumping by

an additional 8 percent on average. The U.S. International Trade Commission found

injury to U.S. firms from the lumber imports that grew rapidly after the VER expired.

U.S. lumber producers clearly gained surplus from the combined average duty of

27 percent against Canadian lumber. U.S. consumers lost. Most obviously, the cost

of building a typical new home rose by over $1,000. Most new-home buyers could

pay this, so they suffered a straight loss of money. The deadweight loss consumption

effect occurred for the estimated 300,000 American families that could not afford the

higher house prices. Most of them had modest incomes, and they reluctantly remained

in less desirable housing.

Chapter 11 Pushing Exports 241

pug21774_ch11_222-251.indd 241pug21774_ch11_222-251.indd 241 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

Case Study Agriculture Is Amazing

I don’t want to hear about agriculture from any- body but you . . . Come to think of it, I don’t want to hear about it from you either.

President Kennedy to his top agricultural policy adviser

Agriculture is another world. Sometimes it seems as if the laws of nature have been repealed. From the late 1980s to the late 1990s, the desert kingdom of Saudi Arabia grew more wheat than it consumed, so it was a net exporter of wheat. Wheat is exported by other countries with unfa- vorable soils and climates, including Great Britain and France. And crowded, mountainous Japan has often been a net exporter of rice.

All this happens because governments are more involved in agriculture than in any other sector of the private economy. In 2012 govern- ment policies in industrialized countries pro- vided about $259 billion of support to farmers, equal to about 19 percent of farmers’ revenues. Government policies in the European Union (EU) provided $107 billion (19 percent of farm revenues), in the United States $30 billion (7 percent), and in Japan $65 billion (an amaz- ing 56 percent of the revenues of Japanese farmers). The farmers’ political lobbies in these countries are remarkably powerful, especially relative to the small role of agriculture in the economy (only about 2 percent of gross domes- tic product). Farmers producing rice, milk, sugar, and beef are the biggest recipients of these subsidies.

Close to half of the increased farm income is provided through price supports. For the typical price support, the government sets a minimum domestic price for the agricultural product, and the government buys any amounts that farm- ers cannot sell into the market at the minimum (support) price. Domestic farmers receive at least the minimum price when they sell, and domestic consumers pay at least the minimum price when they buy. All of this sounds domestic—domestic

minimum price, domestic farmers, domestic consumers. Yet something that starts “domes- tic” transforms itself on the way to the global markets.

The support price is almost always higher than the world price for the agricultural product. If the country would import the product with free trade, the price support requires that imports be restricted . Otherwise, cheap imports would flood into the country and undermine the price support. If the support price is not too high (less than or equal to the no-trade price for the coun- try), then the price support is actually a form of import protection. The analysis of this type of price support mirrors that of import barriers pre- sented in Chapters 8 and 9. Interesting, but not amazing yet.

If the country would export the product with free trade, but the support price is above the world price, then the country’s farmers produce more than is purchased by domestic consumers. The government must buy the excess production at the high support price. The government could just destroy what it buys or let it rot, but that would be remarkably wasteful. The government could give it away to needy domestic families, but there are limits to how much can be given away before this free stuff starts to undermine regular domestic demand. The government could turn to the export market, which sounds like an excellent way to dispose of the excess national production. Perhaps it is, but the government will take a loss on each unit exported. This loss, the difference between the support price that the government pays and the lower world price that it receives, is an export subsidy from the government. Foreign buyers will not pay the high domestic support price; they buy only if the government offers a subsidized export price.

In this case, in which an exporting country sets a support price that is above the world price for the product, the price support policy is actually

242 Part Two Trade Policy

pug21774_ch11_222-251.indd 242pug21774_ch11_222-251.indd 242 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

a combination of import protection and export subsidy. The analysis mirrors that accompanying Figures 11.3 and 11.4. We are getting closer to amazing.

Price supports can also s witch agricultural products from being importable to being exported . Wheat is an example for Britain, France, and other EU members. Butter and other dairy products in the EU are other examples of products that have become exports because of generous price supports. With free trade, wheat, butter, and other dairy products would be imported into the EU because the world prices of these products are lower than the EU’s no-trade prices. (More simply, the EU has a comparative disadvantage in these products.) The EU’s support prices are so high that EU farm- ers produce much more than is sold in the EU. The EU uses export subsidies to export some of its excess production. The analysis of this case mirrors that for Figure 11.5. Now that’s pretty amazing. Domestic price supports morph into a combination of import protection and export subsidies that transform the country from an importer to an exporter of the products.

It takes a lot of government money to cre- ate amazement. The EU’s Common Agricultural Policy (CAP) covers a broad range of agricultural products (including wheat, butter, and other dairy products). CAP spending represents over 40 percent of all EU fiscal expenditures. And the amazement brings a large national cost. The inefficiency of the CAP is equal to a loss of about 1 percent of the EU’s gross domestic product.

Agriculture has also been another world for WTO rules. In contrast to the rules for industrial products, governments had been permitted to use import quotas and export subsidies. But things are changing. The agricultural provisions of the Uruguay Round trade agreement made agriculture less different, especially for devel- oped countries. Governments converted quotas

and other nontariff barriers into tariff rates, a process called tariffication . Each developed coun- try reduced its budget outlays for export subsi- dies by 36 percent and its volume of subsidized exports by 21 percent. Each developed country reduced its domestic subsidies to agriculture by 20 percent, with exceptions. The requirements for developing countries were less stringent.

The effects of these changes are not as large as one might expect. Most developed countries have maintained import protection through art- ful implementation of the agreement. Generally, highly protected products remain highly pro- tected. The reduction of export subsidies has had some impact, especially in reducing subsidization of exports by the EU. The effects of the general reduction in domestic subsidies are moderate because major subsidy programs in the United States and the EU were exempt from the cuts.

After the Uruguay Round agreement, agricul- ture is becoming less different. One way is that tariffication has placed import barriers into a form in which they can be compared across coun- tries. A second way is that there is now pressure to reduce the use of subsidies in agriculture. Countries can use the WTO dispute settlement process to examine excessive agricultural subsi- dies. Decisions in 2005 in two major cases—EU export subsidies for sugar and U.S. subsidies to cotton—found subsidies that violated WTO rules and agreements.

The Uruguay Round agreement also laid the groundwork for negotiations during the current Doha Round that are aimed to achieve more sub- stantial liberalizations. In this sector that would be amazing.

DISCUSSION QUESTION For the European Union, can a tariff or import quota turn butter into an EU export product? If not, why can a price support turn butter into an EU export product?

Chapter 11 Pushing Exports 243

pug21774_ch11_222-251.indd 243pug21774_ch11_222-251.indd 243 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

If the Canadian logging fee was a subsidy because it was too low, then world well-

being was enhanced by the U.S. countervailing duty. However, if the Canadian fee was

appropriate and not a subsidy, then the countervailing duty (and perhaps the antidump-

ing duty) was simple import protection, with a net loss for the world. It is not an easy

call for the referee of world efficiency. 4

STRATEGIC EXPORT SUBSIDIES COULD BE GOOD

In the previous section we assumed competitive supply and demand, and we reached

the conclusion that an export subsidy harmed the exporting country. For some indus-

tries this competitive assumption is wrong. Suppose instead that the real-world mar-

ket in question features the clash of two giant firms, each of which could supply the

whole market. The economics of an export subsidy looks very different if international

competition in the industry consists of an oligopolistic duel between two firms for the

global market. In this battle of giants, an export subsidy can be either good or bad,

both for the exporting country and for the world.

To see the possibility of a good subsidy, let us imagine a simplified case inspired

by the continuing real-world competition between Boeing of the United States

and Europe’s Airbus. Suppose that it becomes technologically possible for them

to build a new kind of passenger plane, perhaps a superjumbo jet. To keep a clear

focus on the key points, let us say that there is no inherent difference between

Airbus and Boeing in the cost of making the new plane. Still, aircraft manufacture

can benefit from scale economies—as a firm expands its planned output, the cost

of making another unit drops as output rises. Either firm is capable of supplying

the whole world market at a low cost. If only one firm captures the whole world

market, it will reap some monopoly profits. If both firms produce, they will vie

for sales and drive the price down to their marginal costs. In this rivalry case, they

make no operating profits.

Figure 11.7 sets the stage by considering what might happen if Airbus and Boeing

simultaneously face a decision about whether to make the new plane. For either of

them, it is a tough decision. Let’s look at it from Airbus’s viewpoint. Should it choose

to invest 8 in development costs and then produce the new planes (left column), or

should it not invest and not produce (right column)? Well, that all depends on what

Boeing does. If Airbus could be sure Boeing would stay out, it should definitely invest

the 8 and produce, making the profit of 100 shown in the lower left box. But what if

Boeing does produce? Then the two of them will have a price war and get no operating

profits to offset their initial development investment of 8 each.

So choosing to enter the market looks risky for Airbus. It looks similarly risky for

Boeing. As you can see by studying the payoffs for the two rows, Boeing would want

to produce only if it could be sure that Airbus won’t produce (upper-right box). But

in a noncooperative game like this, neither firm can choose the outcome—each can

4 This case led to several complaints to both the WTO and the North American Free Trade Agreement for dispute resolution. The duty rates declined and then were replaced in 2007 by a system in which the Canadian government will impose export taxes if the Canadian share of the U.S. market exceeds a specified percentage or if U.S. prices fall below a specified level.

244 Part Two Trade Policy

pug21774_ch11_222-251.indd 244pug21774_ch11_222-251.indd 244 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

FIGURE 11.7 A Two-Firm

Rivalry Game

with No

Government

Subsidies:

Airbus versus

Boeing

When two competing firms face each other with identical

choices and no government help, there is no clear result to the

game if both must decide simultaneously. Each would like to

be the only producer, but if both decide to produce, both lose.

Knowing this, both may decide not to produce.

Airbus does not produce

100

Airbus produces

–8

100

Boeing produces

Boeing does not produce

Airbus gains this

Boeing gains this

Payoff Matrix, with No Subsidies:

5 Another form of strategic trade policy is protection of the home market if the home market is large and scale economies are important. The domestic firm can then use production to meet demand in its protected home market as the basis for low-cost production that allows it to compete aggressively in the foreign market. Aggressive exporting in this situation is sometimes called strategic dumping .

only choose a strategy (column or row). The two firms might react to the threat of

competition by producing nothing, leaving the world in the lower right-box—with no

new planes.

Either government could break through the uncertainty by offering a subsidy

to its producer, for instance, a subsidy that more than covers the producer’s initial

development costs. Again, let’s take the European viewpoint. The governments of

Britain, France, Germany, and Spain could agree to give subsidies to Airbus. If they

give Airbus a start-up subsidy of 10, we could have the situation shown in panel A

in Figure 11.8 . Looking down the left column of possibilities, Airbus can see that it

should definitely produce. Either it gains only 2 (invest 8, get 10 back in subsidies) in

the face of competition from Boeing, or it gains a full 110 if Boeing is frightened off.

And Boeing will be frightened off. Because Boeing is sure that Airbus will produce,

Boeing’s best choice is not to produce (no loss or gain is better than losing 8).

So, Airbus gains, and the world’s consumers gain (an amount not shown here).

Even Europe as a whole gains if Airbus makes the 110 in profits because after sub-

tracting the subsidy of 10, the net gain to Europe is still 100. So here is a case of a

subsidy that is good for the world as a whole and good for the exporting country (the

European Union) as well. This subsidy is a form of strategic trade policy, in which government policy helps its own firm’s strategy to win the game and claim the prize

(here, 100 of economic profit). 5

Chapter 11 Pushing Exports 245

pug21774_ch11_222-251.indd 245pug21774_ch11_222-251.indd 245 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

Global Governance Dogfight at the WTO

In October 2004, the U.S. government filed a complaint with the World Trade Organization that the European Union had given and contin- ued to give massive subsidies to Airbus in support of Airbus’s production of civil aircraft. Later the same day the European Union filed a complaint that the U.S. government had given and con- tinued to give massive subsidies to Boeing in support of its production of civil aircraft. The dogfight over airplane subsidies had moved to the WTO, with combat in the form of the two largest WTO dispute cases ever.

The story began in the late 1960s, when sev- eral national governments in Europe decided to offer infant industry support to a new airplane producer. The development of Airbus was slow, but in the 1980s it achieved a share of global deliveries of new civil aircraft (seating more than 100 passengers, distinct from smaller “regional” aircraft) of 10–20 percent. As the leading U.S. firm, Boeing complained to the U.S. government about the subsidies that Airbus was receiving. The U.S. government began discussions with the European Union. These talks culminated in a 1992 bilateral agreement to restrain subsidies offered by both sides:

• Direct government support for new airplane development (usually called launch aid) lim- ited to no more than one-third of the total development cost, and only in the form of loans with minimum required interest rate and maximum repayment period.

• Indirect government support (for instance, research support offered through defense contracts) limited to no more than 4 percent of a firm’s civil aircraft sales.

• No production or marketing subsidies, and limits on government financing assistance to airplane buyers.

The limit on launch aid restricted the major way that European governments have helped Airbus, and the

limit on indirect support restricted the major way that the U.S. government has helped Boeing.

Airbus sales continued to grow. By the mid- 1990s, Airbus had about 30 percent of new deliveries and in 2003–2004, Airbus had more than half. Boeing and the U.S. government became increasingly unhappy with continued Airbus subsidies. They stated that assistance that might have been suitable when Airbus was an infant was no longer appropriate when Airbus is grown up and clearly successful. In 2004 the U.S. government and the EU held discussions to con- sider revisions to the 1992 agreement but made no progress. In September the U.S. government announced that it was terminating the 1992 agreement as it filed the complaint under the general WTO subsidy rules.

The U.S. government complaint focused on the billions of dollars of launch aid from European governments to Airbus since its birth. The U.S. government argued that launch-aid loans provide subsidies because they have artifi- cially low interest rates and pay-back terms that are conditional on future Airbus sales of the plane being developed. The U.S. government also complained that Airbus received billions of dollars of other government subsidies, includ- ing other low-cost loans, public investments to assist Airbus in its production, and R&D contracts that benefit its civil aircraft produc- tion. The United States specifically alleged that Airbus received $6.5 billion in subsidies in sup- port of the development and production of the new superjumbo A380.

For its complaint the EU alleged that Boeing received billions of dollars in R&D contracts from the U.S. National Aeronautics and Space Admin- istration and the U.S. Department of Defense, with the results of this research benefiting its civil aircraft production. The EU also stated that Boeing received other subsidies, including bil- lions of dollars of tax breaks from federal, state, and local governments.

246 Part Two Trade Policy

pug21774_ch11_222-251.indd 246pug21774_ch11_222-251.indd 246 11/3/14 7:11 PM11/3/14 7:11 PM

Final PDF to printer

The WTO cases moved slowly. After filing the two complaints in October 2004, the U.S. govern- ment and the EU negotiated to attempt to resolve the issues, but they made little progress. In May 2005, the U.S. government asked the WTO to cre- ate a panel to hear and judge the case about its complaint, and the next day the EU responded by asking the WTO to create a panel for its com- plaint. For the U.S. complaint, the panel issued its report five years later, in June 2010. The U.S. government and the EU both appealed certain issues of law and legal interpretations in the panel decision, and the appeal report was adopted in June 2011. For the EU complaint, the panel issued its report almost six years later, in March 2011. Again, both sides appealed, and the appeal report was adopted in March 2012.

In the final ruling for the U.S. complaint, the WTO determined that the EU had provided actionable subsidies to Airbus that had harmed Boeing. The $15 billion of launch aid included substantial subsidies, and Airbus had received about $5 billion of other subsidies. The WTO rec- ommended that the EU withdraw the subsidies or revise them to end the harm to Boeing. In the final ruling for the EU complaint, the WTO determined that the United States had provided

subsidies to Boeing totaling at least $5 billion, mostly actionable R&D subsidies (about $3 bil- lion) that had harmed Airbus and prohibited export tax subsidies ($2 billion). The WTO rec- ommended that the U.S. government withdraw the subsidies or revise them to end the harm to Airbus.

In December 2011, the EU informed the WTO that it had brought its policies into compliance. The U.S. government disagreed, claimed up to $10 billion of continuing injury, and requested approval to retaliate. The WTO established an arbitration panel to consider retaliation, but the U.S. government and the EU requested suspen- sion of the arbitration in January 2012. Much the same sequence played out for the other case. The U.S. government reported compliance in September 2012. The EU disagreed, claimed up to $12 billion in continuing injury, and requested approval to retaliate. The arbitration panel was established and then suspended in November 2012.

Thus, 10 years after the cases were filed, there is no resolution. It is not clear what this pro- tracted and expensive battle has accomplished. The dogfight seems to have ended in an uneasy draw.

It’s not so easy, though. Suppose that the U.S. government decides to subsidize

Boeing’s market entry in the same way that the EU subsidizes Airbus. Then we have

the problem shown in panel B of Figure 11.8. Each firm sees a green light and decides

to produce because each firm makes a positive profit regardless of whether or not the

other produces. This is fine for the firms, but each government is spending 10. So as nations, the EU and the United States are each losing 8 (for each, this equals the 2 of profits that the firm shows minus the 10 of subsidy cost to the government). The only

good news in panel B is hidden from view: The world’s consumers gain. But if most

of those consumers are outside the EU and the United States, these two nations are

still net losers. (In the real world both the U.S. government and European governments

provide subsidies to their aircraft manufacturers, and this has led to trade conflict, as

discussed in the box “Dogfight at the WTO.”)

Chapter 11 Pushing Exports 247

pug21774_ch11_222-251.indd 247pug21774_ch11_222-251.indd 247 11/3/14 7:11 PM11/3/14 7:11 PM

Final PDF to printer

A. If the European government gives Airbus a subsidy of 10, to ensure Airbus a profit of 2 even with full competition, Airbus will choose to produce. Knowing that Airbus will produce, Boeing will choose not to produce.

Airbus wins profits of 110. Because the airplane is built, consumers gain some surplus from the new product, and

the world as a whole gains well-being. B . In this case, with each government offering a subsidy to its firm of 10, both firms will produce the airplane. For each country the cost of the subsidy (10) is greater than the gain to the firm

(2). Each country loses by offering its subsidy, unless gains in national consumer surplus (not pictured

here) are larger than this net loss of 8.

FIGURE 11.8 A Two-Firm Rivalry Game with Government Subsidies: Airbus versus Boeing

Airbus does not produce

100

Airbus produces

–8

110

Boeing produces

Boeing does not produce

Airbus gains

thisBoeing gains this

A. Payoff Matrix, with European Government Subsidies to Airbus

Airbus does not produce

110

Airbus produces

110

Boeing produces

Boeing does not produce

Airbus gains

thisBoeing gains this

B. Payoff Matrix, with Government Subsidies to Both Firms

These simple examples bring out the two key points about an export subsidy or

similar type of subsidy in a global duel between two exporting giants:

1. The subsidy might be a good thing for the exporting country, as shown in panel A in Figure 11.8, but

2. The case for giving the subsidy is fragile, depending on too many conditions to be

a reliable policy.

In our example, we saw one condition that matters. If another national government

also offers its firm strategic policy assistance, it is quite possible that both countries

lose well-being. Another condition that matters is the possibility that there is no

prize for the game. For instance, there may not be enough consumer demand for the

new product, so economic profits will be negative instead of positive, even if there

is only one producer. How would the government separate the false pleas of some

of its firms for strategic help from the valid ones? While there is a theoretical case

for the national benefit of strategic trade policy, we may be skeptical that a national

government could actually use it effectively.

Summary Dumping is selling exports at less than normal value —a price lower than the price in the home market or lower than the full average cost of production. Export-

ers may engage in dumping to drive foreign competitors out of business ( predatory dumping ), during recessions in industry demand ( cyclical dumping ), to unload

248 Part Two Trade Policy

pug21774_ch11_222-251.indd 248pug21774_ch11_222-251.indd 248 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

excess inventory ( seasonal dumping ), or to increase profits through price discrimination ( persistent dumping ). The importing country benefits from the dumped exports because it pays a lower price for its imports. But the importing country

could be hurt by predatory dumping (higher prices in the future) or by cyclical dumping

(importing unemployment).

The WTO permits the importing country to retaliate with an antidumping duty if dumping is occurring and it is causing injury to the import-competing industry. It

appears that the process of imposing antidumping duties has become a major source

of new protection for import-competing producers because the process is biased to

find dumping and impose duties. The American steel industry is an example of a set of

firms that continually complain about dumping to gain relief from import competition.

Proposals for reform of antidumping policy include limiting its use to cases where

predatory dumping is plausible, incorporating consumer interests in the analysis of

injury from dumping, and replacing antidumping policy with more use of safeguard policy, in which a government offers temporary protection to assist an industry in adjusting to increasing import competition.

Export subsidies are condemned by the WTO, with the exception of export sub- sidies to agricultural products. If the market is competitive , an export subsidy brings a loss to the country offering the subsidy and to the world as a whole by causing exces-

sive trade. A countervailing duty against subsidized exports brings a loss to the importing country levying it but brings a gain to the world as a whole by offsetting

the export subsidy. The combination of an export subsidy and an equal countervailing

duty would leave world welfare unchanged, with taxpayers of the export-subsidizing

country implicitly making payments to the government of the importing country.

In some situations it is at least possible that export subsidies will be good for the

exporting nation and for the world as a whole. If export competition takes the form

of an oligopoly game between two giant producers, each of which could dominate the market alone (e.g., Boeing versus Airbus), then a government can offer a subsidy to its

exporter as a strategic trade policy. This firm then may capture more of the global market and bring gains both to the exporting nation and to the world as a whole. We

do not know that such a case has occurred, but it is possible.

Dumping

Normal value

Predatory dumping

Cyclical dumping

Seasonal dumping

Persistent dumping

Price discrimination

Antidumping duty

Safeguard policy

Export subsidy

Consumption effect

Production effect

Countervailing duty

Strategic trade policy

Key Terms

Suggested Reading

Bown (2011) surveys patterns of use of antidumping measures and countervailing duties.

Niels (2000), Nelson (2006), and Niels and ten Kate (2006) provide surveys of a broad

range of research on antidumping policy. Ethier (1982) presents the basic theory of

dumping. Lindsey and Ikenson (2002) and Blonigen (2006) explore biases in the ways that

the U.S. Department of Commerce determines dumping margins. Galloway, Blonigen,

Chapter 11 Pushing Exports 249

pug21774_ch11_222-251.indd 249pug21774_ch11_222-251.indd 249 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

and Flynn (1999) present estimates of the effects of U.S. antidumping and countervailing

duties. Finger and Nogues (2006) offer studies of the use of antidumping policies by Latin

American countries. Aggarwal (2011) examines the effects of antidumping actions by India.

Read (2005) examines the U.S. safeguards imposed on steel imports in 2002. Tokarick

(2005) provides estimates of the global effects of government subsidies and other support

to agriculture in industrialized countries.

Brander (1995) provides a technical survey of strategic trade policy.

Questions and Problems

1. What are the two official definitions of dumping ?

2. “U.S. antidumping policy uses its injury test to ensure that antidumping duties

imposed by the U.S. government enhance U.S. national well-being.” Do you agree or

disagree? Why?

3. Which of the following three beverage exporters is dumping in the U.S. market? Which

is not? How do you know?

Banzai Brewery Tipper Laurie, Ltd. Bigg Redd, Inc. (Japan) (UK) (Canada)

Average cost $10 $10 $10 Price charged at the brewery for domestic sales 10 12 9 Price charged at the brewery for export sales 11 11 9 Price when delivered to the U.S. port 12 13 10

4. What is persistent dumping? Does an exporter lose profit because of the low export

price? Does persistent dumping harm the importing country?

5. You have been asked to propose a specific revision of U.S. antidumping policy to make

the policy more likely to contribute to U.S. well-being. What will you propose?

6. What is a countervailing duty?

7. What would happen to world welfare if the United States paid exporters a subsidy of $5

for every pair of blue jeans they sold to Canada, but Canada charged a $5 countervail-

ing duty on every pair imported into Canada? Would the United States gain from the

combination of the export subsidy and import tariff? Would Canada? Explain. (In your

answer, assume that the blue jeans market is perfectly competitive.)

8. Consider the case of an export subsidy for an importing country that has some monop-

sony power—that is, the case in which the foreign supply-of-exports curve is upward-

sloping. Use a graph like that in Figure 11.4.

a. In comparison with free trade, what is the effect of the export subsidy on the inter- national price and the quantity traded?

b. The importing country now imposes a countervailing duty that returns the market to the initial free-trade quantity traded. In comparison with the market with just the

export subsidy, explain why the countervailing duty is good for the world. Explain why

the countervailing duty can also increase the well-being of the importing country.

✦

250 Part Two Trade Policy

pug21774_ch11_222-251.indd 250pug21774_ch11_222-251.indd 250 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

9. In the Airbus-versus-Boeing example in Figure 11.7, what strategy should the EU

governments follow if the upper-left box ( a ) gives Airbus and Boeing each a sure gain of 5 or ( b ) gives Boeing a gain of 5 and Airbus a gain of 0? In each case, should the EU offer a subsidy to Airbus? Explain.

10. Consider the export subsidy shown in Figure 11.3. Assuming that the export subsidy

remains $20, what are the effects of a decline in the world price from $100 to $90?

Show the effects using a graph, and explain them.

11. You have been hired to write a defense of the idea of having a government

plan to subsidize the expansion of an export-oriented industry, taking resources

away from the rest of the economy. Describe how you would defend such an

industrial targeting strategy as good for the nation as a whole.

12. You have been hired to discredit the argument you just presented in answering

Question 11. Present a strong case against getting the government into the export-

pushing business.

✦

Chapter 11 Pushing Exports 251

pug21774_ch11_222-251.indd 251pug21774_ch11_222-251.indd 251 10/27/14 7:10 PM10/27/14 7:10 PM

Final PDF to printer

Chapter Twelve

Trade Blocs and Trade Blocks Standard analysis of trade policy looks at equal-opportunity import barriers, ones that

tax or restrict all imports regardless of country of origin. But some import barriers are

meant to discriminate. They tax goods, services, or assets from some countries more

than those from other countries. The analysis of Chapters 8 through 10 can now be

modified to explain the effects of today’s trade discrimination.

We look at two kinds of trade barriers that are designed to discriminate:

1. Trade blocs. Each member country can import from other member countries freely, or at least cheaply, while imposing barriers against imports from outside

countries. The European Union (EU) has done that, allowing free trade between

members while restricting imports from other countries.

2. Trade embargoes, or what the chapter title calls “trade blocks.” Some countries discriminate against certain other countries, usually because of a policy dispute.

They deny the outflow of goods, services, or assets to a particular country while

allowing export to other countries, discriminate against imports from the targeted

country, or block both exports to and imports from the target.

TYPES OF ECONOMIC BLOCS

Some international groupings discriminate in trade alone, while others discriminate

between insiders and outsiders on all fronts, becoming almost like unified nations.

To grasp what is happening in Europe, North America, and elsewhere, we should

first distinguish among the main types of economic blocs. Figure 12.1 and the

following definitions show the progression of economic blocs toward increasing

integration:

1. A free-trade area, in which members remove trade barriers among themselves but keep their separate national barriers against trade with the outside world.

Most trade blocs operating today are free-trade areas. One example is the North

American Free Trade Area (NAFTA), which formally began at the start of 1994.

2. A customs union, in which members remove barriers to trade among themselves and adopt a common set of external barriers. The European Economic Community

(EEC) from 1957 to 1992 included a customs union along with some other

252

pug21774_ch12_252-274.indd 252pug21774_ch12_252-274.indd 252 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

Features of Bloc

Free Harmonization* Free Trade Common Movement of All Economic among the External of Factors of Policies (Fiscal, Type of Bloc Members Tariffs Production Monetary, etc.)

Free-trade area ✓ Customs union ✓ ✓ Common market ✓ ✓ ✓ Economic union ✓ ✓ ✓ ✓

FIGURE 12.1 Types of

Economic Blocs

*If the policies are not just harmonized by separate governments but actually decided by a unified government

with binding commitments on all members, then the bloc amounts to full economic nationhood. Some authors

call this full economic integration.

agreements. The Southern Common Market (MERCOSUR), formed by Argentina,

Brazil, Paraguay, and Uruguay in 1991, is actually a customs union.

3. A common market, in which members allow full freedom of factor flows (migration of labor and capital) among themselves in addition to having a customs

union. Despite its name, the European Common Market (EEC, which became the

European Community, EC, and is now the European Union, EU) was not a common

market up through the 1980s because it still had substantial barriers to the interna-

tional movement of labor and capital. The EU became a true common market, and

more, at the end of 1992.

4. Full economic union, in which member countries unify all their economic poli- cies, including monetary and fiscal policies as well as policies toward trade and

factor migration. Most nations are economic unions. Belgium and Luxembourg

have had such a union since 1921. The EU is on a path toward economic unity.

The first two types of economic blocs are simply trade blocs (i.e., they have

removed trade barriers within the bloc but have kept their national barriers to the flow

of labor and capital and their national fiscal and monetary autonomy). Trade blocs

have proved easier to form than common markets or full unions among sovereign

nations, and they are the subject of this chapter. Freedom of factor flows within a bloc

is touched on only briefly here—we return to it in Chapter 15. The monetary side of

union enters in Chapter 17 and beyond.

IS TRADE DISCRIMINATION GOOD OR BAD?

In 2014 about half of world trade occurred within functioning trade blocs, including:

• The 28 countries of the EU.

• The 4 remaining countries of the European Free Trade Area (EFTA).

• The preferential trade agreements that the EU has with 58 other countries ( including the

4 EFTA countries).

Chapter 12 Trade Blocs and Trade Blocks 253

pug21774_ch12_252-274.indd 253pug21774_ch12_252-274.indd 253 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

• The 3 countries of NAFTA.

• The trade agreements that Mexico has with the EU, EFTA, Chile, Costa Rica,

Colombia, El Salvador, Guatemala, Honduras, Israel, Japan, Nicaragua, Peru, and

Uruguay, in addition to its membership in NAFTA.

• The 7 countries of the Central American Free Trade Area (CAFTA-DR).

• The free-trade areas that the United States has with Australia, Bahrain, Chile,

Colombia, Israel, Jordan, Korea, Morocco, Oman, Panama, Peru, and Singapore,

in addition to its memberships in NAFTA and CAFTA-DR.

• The 5 countries of MERCOSUR (with a sixth country, Bolivia, in the process of

acceding to full membership) and its trade association agreements with Chile,

Colombia, Ecuador, Guyana, Peru, and Suriname.

• The trade agreements that Turkey has with the EU, EFTA, and 16 other countries.

As of early 2014, there were almost 250 preferential trade agreements in force in

the world, and over half of them had begun operating since 2000. Only four WTO

members (Congo, Djibouti, Mauritania, and Mongolia) were not members of some

trade bloc.

How good or how bad is all this trade discrimination? It depends, first, on what you

compare it to. Compared to a free-trade policy, putting up new barriers discriminating

against imports from some countries is generally bad, like the simple tariff of Chapters

8 through 10. But the issue of trade discrimination usually comes to us from a different

angle: Beginning with tariffs and nontariff barriers that apply equally regardless of the source country of the imports, what are the gains and losses from removing barriers only between certain countries? That is, what happens when a trade bloc like the EU

or NAFTA gets formed?

Two opposing ideas come to mind. One instinct is that forming a customs union or

free-trade area must be good because it is a move toward free trade. If you start from

an equally applied set of trade barriers in each nation, having a group of them remove

trade barriers among themselves clearly means lower trade barriers in some average

sense. Since that idea is closer to free trade, and Chapters 8 through 11 found free

trade better with only carefully limited exceptions, it seems reasonable that forming a

trade bloc allows more trade and raises world welfare. After all, forming a nation out

of smaller regions brings economic gains, doesn’t it?

On the other hand, we can think of reasons why forming a free-trading bloc can

be bad, even starting from equally applied barriers to all international trade. First,

forming the trade bloc may encourage people to buy from higher-cost partner sup-

pliers. The bloc would encourage costly production within the bloc if it kept a high

tariff on goods from the cheapest source outside the bloc and no tariff on goods from

a more costly source within the bloc. By contrast, a uniform tariff on all imports has

the virtue that customers would still do their importing from the low-cost source.

Second, the whole idea of trade discrimination smacks of the bilateralism of the

1930s, when separate deals with individual nations destroyed much of the gains

from global trade. The list at the beginning of this section indicates that we again

have quite a tangled web of discriminatory agreements. Third, forming blocs may

cause international friction simply because letting someone into the bloc will shut

others out.

254 Part Two Trade Policy

pug21774_ch12_252-274.indd 254pug21774_ch12_252-274.indd 254 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

For all these reasons, World Trade Organization (WTO) rules are opposed to trade

discrimination in principle. A basic WTO principle is that trade barriers should be

lowered equally and without discrimination for all foreign trading partners. That is, the

WTO espouses the most favored nation (MFN) principle. This principle, dating back

to the mid-19th-century wave of free trade led by Britain, stipulates that any conces-

sion given to any foreign nation must be given to all nations having MFN status. WTO

rules say that all contracting parties are entitled to that status.

However, other parts of WTO rules permit deviations from MFN under specific

conditions. One deviation is special treatment for developing countries. Developing

countries have the right to exchange preferences among themselves and receive pref-

erential access to markets in the industrialized countries.

Another deviation permits trade blocs involving industrialized countries if the trade

bloc removes tariffs and other trade restrictions on most of the trade among its mem-

bers, and if its trade barriers against nonmembers do not increase on average. In fact,

the WTO, and the GATT before it, has applied the rules loosely. No trade bloc has

ever been ruled in violation.

THE BASIC THEORY OF TRADE BLOCS: TRADE CREATION AND TRADE DIVERSION

Trade discrimination can indeed be either good or bad. We can give an example of this

and, in the process, discover what conditions separate the good from the bad cases. It

may seem paradoxical that the formation of a trade bloc can either raise or lower well-

being because removing barriers among member nations looks like a step toward free

trade. Yet the analysis of a trade bloc is another example of the not-so-simple theory

of the second best.

The welfare effects of eliminating trade barriers between partners are illustrated in

Figure 12.2 , which is patterned after Britain’s entry into the EC (now the EU). To sim-

plify the diagram greatly, all export supply curves are assumed to be perfectly flat. We

consider two cases. In one, forming the trade bloc is costly because too much trade is

diverted from lower-cost to higher-cost suppliers. In the other, forming the trade bloc

is beneficial because it creates more low-cost trade.

In Figure 12.2A , the British could buy Japanese cars at £5,000 if there were no

tariff. The next cheapest alternative is to buy German cars delivered at £5,500. If there

were free trade, at point C, Britain would import only Japanese cars and none from

Germany.

Before its entry into the trade bloc, however, Britain did not have free trade in auto-

mobiles. It had a uniform tariff, imagined here to be £1,000 per car, which marks up

the cost of imported Japanese cars from £5,000 to £6,000 in Figure 12.2. No Britons

buy the identical German cars because they would cost £6,500 (equal to the £5,500

price charged by the German producers plus the £1,000 tariff). The starting point for

our discussion is thus the tariff-ridden point A, with the British government collecting (£1,000 times 10,000 5 £10 million) in tariff revenues.

Now let Britain join the EU, as it did in 1973, removing all tariffs on goods from the

EU while leaving the same tariffs on goods from outside the EU. Under the simplifying

Chapter 12 Trade Blocs and Trade Blocks 255

pug21774_ch12_252-274.indd 255pug21774_ch12_252-274.indd 255 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

Starting from a uniform tariff on all compact cars (at point A ), Britain joins the EU trade bloc, removing tariffs on imports from EU partners like Germany but not on imports from the cheapest outside source, Japan. With the flat

supply curves assumed here, all the original imports of 10,000 cars from the cheapest outside source are replaced

with imports from new partner countries (e.g., Germany). In panel A the shift from A to B creates 5,000 extra imports, bringing national gains for the UK (area b ). But it also diverts those 10,000 cars from the cheapest foreign supplier to the partner country, imposing extra costs (area c ). In this case, the loss exceeds the gain, bringing a net loss:

Gain area b 5 (1/2)(6,000 2 5,500)(15,000 2 10,000) 5 Gain of £1.25 million Loss area c 5 (5,500 2 5,000)(10,000) 5 Loss of £5 million Net loss 5 £3.75 million

In panel B, Germany’s price is not much greater than that quoted by Japanese suppliers. Removing the tariff on German

(and other EU) cars creates 9,000 new imports of cars, yielding the trade-creation gain shown as area b . The 10,000 cars are again diverted from the cheapest supplier (Japan), but this trade diversion costs less than that in panel A. So

Gain area b 5 (1/2)(6,000 2 5,100)(19,000 2 10,000) 5 Gain of £4.05 million Loss area c 5 (5,100 2 5,000)(10,000) 5 Loss of £1.00 million Net gain 5 £3.05 million

FIGURE 12.2 Trade Diversion versus Trade Creation in Joining a Trade Bloc: UK Market for Imported Compact Cars

Quantity imported by UK

(thousands of cars per year)

Quantity imported by UK

(thousands of cars per year)

Price per car (including freight to UK)

10 2015

Initial price in home country (UK)

Price for partner country (Germany)

Outside-world price (Japan)

Initial price in home country (UK)

Price for partner country (Germany)

Outside-world price (Japan)

A. Trade Diversion Dominates, Bringing a Net Loss

B. Trade Creation Dominates, Bringing a Net Gain

£6,000

£5,500

£5,000

C F

a b

0 10 2019

£6,000

£5,100 £5,000

a b

Dm Dm

assumptions made here, German cars now cost only £5,500 in Britain (instead of that

plus the £1,000 tariff ), while the price of Japanese cars in Britain remains £6,000

because they still incur the tariff. British purchasers of imported cars switch to

buying only German cars. In addition, seeing the price of imported cars fall to £5,500

in Britain, they buy more (at point B). Clearly, British car buyers have something

256 Part Two Trade Policy

pug21774_ch12_252-274.indd 256pug21774_ch12_252-274.indd 256 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

to cheer about. They gain the areas a and b in consumer surplus, thanks to the bar- gain. But the British government loses all its previous tariff revenue, the area a 1 c (£10 million). So, after we cancel out the gain and loss of a , Britain ends up with two effects on its well-being:

1. A gain from trade creation (in this case, from the extra 5,000 cars). Trade creation is the net volume of new trade resulting from forming or joining a trade bloc. It causes the national gain shown as area b in Figure 12.2. Area b represents two kinds of gain in the British economy: gains on extra consumption of the

product and gains on replacement of higher-cost British production by lower-cost

partner production.

2. A loss from trade diversion (in this case, from the 10,000 cars). Trade diversion is the volume of trade shifted from low-cost outside exporters to higher-cost bloc-partner

exporters. It causes the national loss shown as area c .

This is the general result: The gains from a trade bloc are tied to trade creation, and

the losses are tied to trade diversion. 1

The net effect on well-being, the trade-creation gain minus the trade-diversion loss,

could be positive or negative. In the first case (Figure 12.2A), the loss on trade diver-

sion happens to dominate.

Our second case, Figure 12.2B, shows the opposite result. If the new bloc partners,

such as Germany, were almost the lowest-cost suppliers in the world, then the gain

from trade creation would dominate. If they can supply cars almost as cheaply as the

Japanese, then there won’t be much cost from diverting Britain’s customers away from

Japanese compact cars. The trade-diversion cost is only £100 on each of the diverted

10,000 cars. At the same time, there is a lot of trade creation. Removing the £1,000

tariff on German cars cuts the domestic price of imports from the old £6,000 on

Japanese cars with tariff to £5,100 on German cars without tariff, resulting in a

substantial gain. In the specific case shown in Figure 12.2B, there is a net national (and

world) gain from the effects of the bloc on trade in this kind of automobile. 2

1There is an alternative analysis assuming upward-sloping supply curves for all three countries, with similar but more widely applicable results (e.g., Harry G. Johnson, 1962). One point revealed by the upward-sloping supply analysis is that trade diversion may bring terms-of-trade gains to the bloc partners at the expense of the rest of the world. Diverting demand away from outside suppliers may force them to cut their export prices (i.e., the bloc’s import prices). On the export side, diverting bloc sales toward bloc customers and away from outside customers may raise the bloc’s export-price index. Thus, the bloc may gain from a higher terms-of-trade ratio (5 export price/import price), a possibility assumed away by the flat outside-world supply curve in Figure 12.2.

Another point revealed is that trade diversion brings gains to the partner country that is exporting the product because its producers charge a higher price on exports to the importing partner and export a larger quantity to this partner. However, the exporting-partner gains are less than the importing-partner losses, so trade diversion still creates a net loss for the trade bloc and for the world. The flat-supply-curve case is used here because its diagram (or its algebra) makes the basic points more clearly. 2To imagine a case of pure trade creation, with no trade diversion at all, just switch the words Germany and Japan in either half of Figure 12.2. With Germany now the cheapest supplier, nobody in Britain would buy Japanese cars with or without the EU customs union. Forming the union expands trade from point A to point C, bringing the net gain ACF.

Chapter 12 Trade Blocs and Trade Blocks 257

pug21774_ch12_252-274.indd 257pug21774_ch12_252-274.indd 257 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

Reflecting on the one-good cases in Figure 12.2, you can figure out what conditions

dictate whether the gains outweigh the losses. Here are two tendencies that make for

greater gains from a trade bloc:

A. The lower the partner costs relative to the outside-world costs, the greater the gains.

Any trade diversion will be less costly.

B. The more elastic the import demand, the greater the gains. The trade creation in

response to any domestic price decline will be larger.

So the best case is one with costs that are almost as low somewhere within the bloc

as in the outside world and highly elastic demands for imports. Conversely, the worst

case is one with inelastic import demands and high costs throughout the trade bloc.

OTHER POSSIBLE GAINS FROM A TRADE BLOC

Researchers have identified several other possible sources of gains from forming a trade

bloc. Several gains arise because the trade bloc creates a larger market (bloc-wide rather than only national) in which firms can sell their products with few or no trade barriers. It

is easiest to see the possibility for these gains if we think of an extreme case in which the

countries that form the bloc all had such high trade barriers before the bloc was formed

that they traded little with each other or with the rest of the world. Furthermore, scale

economies and product differentiation are important for some products. In this setting,

here are four possible sources of additional gains from forming the trade bloc:

• An increase in competition can reduce prices. Before the bloc, firms in each coun- try may have monopoly power in their separate national market, so prices are high

in each national market. When the national markets are joined in the trade bloc,

firms from the partner countries must compete with each other. The extra competi-

tion reduces monopoly power and reduces prices. The inefficiency of monopoly

pricing is reduced.

• An increase in competition can lower costs of production. If a firm has monopoly power and substantial protection from foreign competition, there is little pressure on

it to minimize costs or implement new technologies. When the national markets are

joined in the trade bloc, the extra competition forces firms to pay more attention to

reducing costs and improving technology. Studies by the consulting firm McKinsey

have repeatedly shown that a key determinant of the differences in the productivity of

firms in different countries is the intensity of competition the firms must face.

• Firms can lower costs by expanding their scale of production. Before the bloc is formed, the size of a firm is largely limited by the size of its own national market.

If scale economies are substantial, the firm may not be large enough to exploit all

of the scale economies. When the markets are joined in the trade bloc, each firm

now has a larger market to serve. Some firms expand their size to take advantage

of additional scale economies. (Other firms that cannot gain the scale economies

fast enough may be driven out of business by these larger lower-cost firms. This is

good for the trade bloc as whole, but some member countries may feel harmed if it

is their firms that disappear.)

258 Part Two Trade Policy

pug21774_ch12_252-274.indd 258pug21774_ch12_252-274.indd 258 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

• Consumers gain access to a larger number of varieties or models of a product. Before the bloc is formed, consumers in the country are mostly limited to the ver-

sions of the product produced by domestic firms. When the markets are joined

in the trade bloc, consumers can buy additional imported versions of the product

produced by firms in the partner countries.

A final possible source of gains is the possibility that forming the trade bloc increases opportunities for business investments. Multinational firms (discussed further in Chapter 15) often seek foreign production locations based on the size of the market that

can be served by their affiliates. By expanding the market that can be served inside the

external trade barriers, a trade bloc can attract more foreign direct investment into the

member countries. Global firms often bring better technologies, management practices,

and marketing capabilities. If these “intangibles” diffuse to local firms (positive exter-

nalities), then the country gains an extra benefit from the direct investment by foreign

firms. More broadly, by increasing the rate of return to business investments as the trade

bloc opens new profit opportunities, the formation of the bloc can increase real invest-

ment and can therefore expand the overall production capacity of the partner countries.

Not all of these effects occur for every product or member country when a trade bloc is

formed, but they do occur for some products and some members. They provide gains from

being a member of a trade bloc that are in addition to the basic gains from trade creation.

THE EU EXPERIENCE

Europe has been the locus of the longest and deepest regional integration. The box

“Postwar Trade Integration in Europe” provides the highlights of the chronology. In

particular, the formation of the EU’s customs union was the first major modern trade

bloc. Numerous studies have examined its economic effects. Studies in the 1960s and

1970s tended to conclude that the net gains from forming the EU (then the EEC) were

small but positive. For example, net gains on trade in manufactured goods calculated

by Balassa (1975, p. 115) were a little over one-tenth of 1 percent of members’ total

GDP. That tiny positive estimate overlooks some losses from the EU and some likely

gains. By concentrating on trade in manufactured goods, the literature generally over-

looked the significant social losses from the EU’s common agricultural policy. This

policy protects and subsidizes agriculture so heavily as to bring serious social losses

of the sort described in Chapter 11. 3 On the other hand, the studies of the 1960s and

1970s generally confined their measurements to static welfare effects like those in

Figure 12.2, omitting possible gains from increased competition, scale economies,

improved productivity incentives, and greater product variety.

3Trade diversion on agricultural products is one reason why empirical studies find that joining the EC in 1973 may have cost Britain dearly. The common agricultural policy meant that British consumers had to lose cheap access to their traditional Commonwealth food suppliers (Australia, Canada, and New Zealand). They had to buy the more expensive EU food products and had to pay taxes on their remaining imports from the Commonwealth, taxes that were turned over to French, Danish, and Irish farmers as subsidies. This cost Britain an estimated 1.8 percent of GDP in the 1970s, versus a static-analysis gain of less than 0.2 percent of GDP on manufactured goods. The Thatcher government later bargained for a fairer sharing of the burdens of farm subsidies.

Chapter 12 Trade Blocs and Trade Blocks 259

pug21774_ch12_252-274.indd 259pug21774_ch12_252-274.indd 259 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

Case Study Postwar Trade Integration in Europe

1950–1952: Following the Schuman Plan, “the six” (Belgium, France, West Germany, Italy, the Netherlands, and Luxembourg) set up the European Coal and Steel Community. Meanwhile, Benelux is formed by Belgium, the Netherlands, and Luxembourg. Both formations provide instructive early examples of integration.

1957–1958: The six sign the Treaty of Rome setting up the European Economic Community (EEC, or “Common Market”). Import duties among them are dismantled and their external barriers are unified in stages between the end of 1958 and mid-1968. Trade preferences are given to a host of developing countries, most of them former colonies of EEC members.

1960: The Stockholm Convention creates the European Free Trade Area (EFTA) among seven nations: Austria, Denmark, Norway, Portugal, Sweden, Switzerland, and the United Kingdom. Barriers among these nations are removed in stages, 1960–1966. Finland joins EFTA as an associate member in 1961. Iceland becomes a member in 1970, Finland becomes a full member in 1986, and Lichtenstein becomes a member in 1991.

1967: The European Community (EC) is formed by the merger of the EEC, the European Atomic Energy Commission, and the European Coal and Steel Community.

1972–1973: Denmark, Ireland, and the United Kingdom join the EC, converting the six into nine. Denmark and the United Kingdom leave EFTA. The United Kingdom agrees to abandon many of its Commonwealth trade preferences. Also, Ode to Joy from Beethoven’s Ninth Symphony is chosen as the EC’s anthem.

1973–1977: Trade barriers are removed in stages, both among the nine EC members and between them and the remaining EFTA nations. Meanwhile, the EC reaches trade preference agreements with most nonmember

Mediterranean countries along the lines of earlier agreements with Greece (1961), Turkey (1964), Spain (1970), and Malta (1970).

1979: European Monetary System begins to operate based on the European Currency Unit. The European Parliament is first elected by direct popular vote.

1981: Greece joins the EC as its 10th member.

1986: The admission of Portugal and Spain brings the number of members in the EC to 12.

1986–1987: Member governments approve and enact the Single European Act, calling for a fully unified market by 1992.

1989–1990: The collapse of the East German government brings a sudden expansion of Germany and therefore of the EC. East Germans are given generous entitlements to the social programs of Germany and the EC.

1991–1995: Ten countries from Central and Eastern Europe establish free-trade agreements with the EC. All become EU members in 2004 and 2007.

End of 1992: The Single European Act takes effect, integrating labor and capital markets throughout the EC.

1993: The Maastricht Treaty is approved, making the EC into the European Union (EU), which calls for unification of foreign policy, for cooperation in fighting crime, and for monetary union.

1994: The European Economic Area is formed, bringing the EFTA countries (except Switzerland) into the EU’s Single European Market.

1995: Following votes with majority approval in each country, Austria, Sweden, and Finland join the EU, bringing the number to 15. As it had done in 1972, Norway rejects membership in its 1994 vote.

1996: The EU forms a customs union with Turkey.

260 Part Two Trade Policy

pug21774_ch12_252-274.indd 260pug21774_ch12_252-274.indd 260 11/3/14 7:13 PM11/3/14 7:13 PM

Final PDF to printer

Here, unfortunately, is a research frontier still unsettled: We know that there are

probably gains in addition to those from basic trade creation, but we lack full estimates

of these other gains. For now, the empirical judgment is threefold: (1) On manufac-

tured goods, the EU has brought enough trade creation to suggest small positive net

gains. (2) The static gains on manufactures were probably smaller than the losses on

the common agricultural policy. (3) But the net judgment still depends on what we

believe about the unmeasured gains from competition, scale economies, productivity,

and product variety.

In the 1980s the EU moved beyond being a customs union and toward being a

single common market. The Single European Act, which took full effect at the end of

1992, forced many changes. First, it neutralized separate national product standards

that had often been thinly disguised devices for protecting higher-cost domestic pro-

ducers against competition from firms in other member countries. Examples included

German beer purity regulations, Italian pasta protection laws, Belgian chocolate con-

tent restrictions, and Greek ice cream specifications. Second, capital controls on the

flows of financial investments were removed. Third, restrictions on people working in

other member countries were generally removed, although there are still some limits

on licensed professionals such as lawyers.

How much benefit might such a miscellany of measures bring to the EU? It is hard

to say, given the difficulty of measuring such key determinants as increased scale

economies and increasing competition. Recent studies conclude that gains are prob-

ably 2 percent or less of GDP.

As indicated in the box “Postwar Trade Integration in Europe,” in 2004 ten additional

countries, including eight formerly communist countries in Central and Eastern Europe,

1999: Eleven EU countries establish the euro as a common currency, initially existing along with each country’s own currency. Greece becomes the 12th member of the euro area in 2001.

2002: The euro replaces the national currencies of the 12 countries.

2004: Ten countries (Estonia, Lithuania, Latvia, Poland, Czech Republic, Slovakia, Hungary, Slovenia, Malta, and Cyprus) join the EU, bringing the total number to 25.

2007: Romania and Bulgaria join the EU, bringing the total number to 27. Slovenia joins the euro area.

2008: Cyprus and Malta join the euro area.

2009: Slovakia joins the euro area.

2011: Estonia joins the euro area.

2013: Croatia joins the EU, bringing the total number to 28.

2014: Latvia joins the euro area, bringing the total number of EU countries using the euro as their currency to 18.

DISCUSSION QUESTION Which country do you think will be the next country to join the EU?

Chapter 12 Trade Blocs and Trade Blocks 261

pug21774_ch12_252-274.indd 261pug21774_ch12_252-274.indd 261 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

joined the EU, in 2007 two more formerly communist countries joined, and in 2013 one

more joined. These new members added about 27 percent to the EU’s total population.

But they are relatively poor, so they added less than 6 percent to its total GDP.

The basic requirements to join the EU are that the country have a functioning

democracy, a commitment to respecting human rights, a market economy, and the

capacity and willingness to adopt and to implement EU rules and standards. These

13 countries had to work intensely to meet the latter requirements. EU standards cover

31 major areas, and the documents listing them are 80,000 pages long.

Integration of the members that joined in 2004 and 2007 has been generally smooth.

Still, some features of EU policies were phased in slowly for them. First, to control the

costs to the EU budget, the subsidies that their farmers receive started at only one-fourth

of the standard levels for the common agricultural policy. Second, the new members

were not full members of the common market for labor. Citizens of the new members

were not generally free to work in most other EU countries until seven years after the

country joined the EU.

The new member countries experienced a mix of trade creation and trade diver-

sion. One example of the basis for trade creation is the shift away from idiosyn-

cratic national food safety laws and to the EU standards. Packaged food companies

like Coca-Cola gain the benefits of easier product and packaging design and more

flexibility in locating production facilities. One example of trade diversion is the

new members’ adoption of the EU’s sugar policy, which leads to higher prices and

purchases from other EU producers rather than from low-cost outside suppliers.

The new members also gained from access to greater product variety. Overall, we

think the gains are larger than the losses. Estimates of the economic effects of this

enlargement indicate that the new members have seen a net gain in well-being of

2 to 8 percent of their GDP, with a small gain for the other EU countries.

The EU successfully grew over time from 6 members to 28 in 2013. The out-

look for further expansion is less clear. The other countries of the Balkans (Serbia,

Montenegro, Bosnia, Macedonia, and Albania) want to join, but it probably will be

years before they qualify. Possible entry of such countries as Ukraine, Moldova, and

Georgia, Eastern European countries that were part of the Soviet Union, is more dis-

tant. Turkey is eager to join, but the EU continues to be skeptical of Turkey’s willing-

ness to make the necessary political and economic policy changes, and it is concerned

about its own ability to gainfully integrate such a large and poor country.

NORTH AMERICA BECOMES A BLOC

The North American Free Trade Area went from impossibility to reality in a few years

during the late 1980s and early 1990s. The first step was the Canada–U.S. Free Trade

Area (CUSFTA), an idea that had been debated since the 19th century. As late as 1986,

when the two countries had a minor trade war over lumber and corn plus another tiff

over Arctic navigational rights, there seemed to be little chance of forming a trade

bloc. Yet the mood swung quickly, and negotiations that began in 1986 led to a free-

trade area that came into force on January 1, 1989.

The second step was bringing Mexico into the picture. Starting in 1985, the Mexican

government became increasingly determined to break down its own barriers to a freer,

262 Part Two Trade Policy

pug21774_ch12_252-274.indd 262pug21774_ch12_252-274.indd 262 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

more privatized, more efficient Mexican economy. A series of reforms deregulated

business and reduced barriers to imports of goods. Mexico’s tariffs had been high and

were raised even higher after the 1982 debt crisis forced Mexico to tighten its belt.

By 1992, Mexico had slashed its tariffs to an average of only 10 percent. In 1990 the

U.S. government and the Mexican government began negotiations on a trade agree-

ment, and Canada joined the talks in 1991. The agreement was completed in 1992, and

NAFTA, which replaced CUSFTA, came into existence on January 1, 1994.

NAFTA: Provisions and Controversies NAFTA has eliminated nearly all tariffs and some nontariff barriers to trade within

the area (some liberalizations occurred slowly and were not completed until 2008).

It removed barriers to cross-border business investments within the area, and Mexico

phased out performance requirements, including domestic content requirements and

export requirements, that the Mexican government had previously imposed on foreign

businesses operating in Mexico. NAFTA specifies open trade and investment in many

service industries, including banking and financial services. NAFTA has its own set

of dispute settlement procedures. Supplemental agreements call for better enforce-

ment of labor and environmental standards, but these have had little effect. NAFTA

does not, however, call for free human migration between these countries, nor does it

denationalize Pemex, Mexico’s huge government oil monopoly.

NAFTA was controversial, especially in Mexico and the United States, from the

moment it became a strong political possibility in 1990. Critics in Mexico sounded

the alarm that Mexican jobs would be wiped out, widening the already enormous gaps

between rich and poor in Mexico. They also warned that the United States would use

NAFTA to force Mexico to make many changes in its policies, weakening Mexican

sovereignty. On the other side of the border, American labor groups were convinced

that they would lose their jobs to Mexicans, whose wage rates were only a tiny frac-

tion of those paid in the United States. This concern was dramatized by H. Ross

Perot’s famous claim in 1992 that NAFTA would cause a “great sucking sound” as

many American jobs were instantly shifted to Mexico. Critics in the United States also

decried that NAFTA rewarded and strengthened a corrupt political system in Mexico.

In addition, environmentalists in both countries feared that NAFTA would lead to an

expansion of the already serious pollution in Mexico, especially in the maquiladora industrial towns along the U.S.–Mexican border.

Proponents in Mexico hoped to use NAFTA to have some influence on U.S. trade

policies like antidumping, a goal that the Canadians also had for the Canada–U.S. Free

Trade Area. They also expected NAFTA to attract more investments into Mexico from

foreign businesses using Mexico as a base for North American production. Proponents

in the United States hoped to solidify the market-oriented reforms in Mexico, making

Mexico a more dependable economic and political ally. But proponents of NAFTA

were also extravagant in some of their claims, particularly when asserting that defeat-

ing NAFTA would send the Mexican economy into a giant depression, forcing an

unemployed army to march over the U.S. border in search of jobs.

Concerns over jobs and the environment were so severe within the United States

and Canada that they nearly defeated NAFTA. Yet in the end, the proponents prevailed

and NAFTA became official at the beginning of 1994.

Chapter 12 Trade Blocs and Trade Blocks 263

pug21774_ch12_252-274.indd 263pug21774_ch12_252-274.indd 263 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

NAFTA: Effects What have been the effects of NAFTA? There is broad agreement that NAFTA led

to a substantial increase in total trade among the three countries, especially in the

years up to the early 2000s. The standard view is that trade creation was larger than

trade diversion. In this standard view, all three NAFTA countries have gained from

NAFTA’s trade expansion, with a gain in well-being to Mexico estimated at close to

2 percent of its GDP, a gain to Canada of close to 1 percent of its GDP, and a gain to

the United States of perhaps 0.1 percent of its (very large) GDP.

There is a challenge to this standard view. Romalis (2007) presents a careful

and detailed study of the effects of NAFTA in its first seven years (and of CUSFTA

before it). He confirms the substantial effects on total trade, with the combination

of CUSFTA and NAFTA increasing U.S.–Canadian trade by about 4 percent, and

NAFTA increasing U.S.–Mexican trade by about 23 percent and Canadian–Mexican

trade by about 28 percent. However, he finds that the large increases in total trade

reflect both substantial trade creation and substantial trade diversion. Trade diversion

is especially large for products that have relatively high tariffs against imports from

outside countries because North American firms are often not low-cost producers of

these products. For instance, imports of textiles and clothing were diverted away from

low-cost suppliers in Asia. Romalis concludes that the gains from trade creation were

about equal to the losses from trade diversion, so the net effect of expanding NAFTA

trade on the well-being of each member country was very small.

NAFTA may also bring gains from increased competition in the larger area-wide

market and from the increased ability for firms to achieve scale economies in this

larger market. Studies of the effects on Canadian manufacturing industries during the

first 10 years of free trade with the United States do show some large positive effects.

• Increased competition led to the demise of high-cost Canadian factories and the

opening of low-cost ones.

• Average factory sizes did not become much bigger, which seems to question the

role of increased scale economies. But there is evidence that fewer different prod-

ucts are being produced in these plants, so the scale economies are probably occur-

ring through longer production runs of the smaller number of products.

• Increased competitive pressures and expanded export opportunities drove Canadian

firms to innovate better products and improved production methods.

As a result of all of this, productivity in Canadian manufacturing increased about

14 percent more than it would have without the free-trade area.

NAFTA has created benefits for Mexico because it has made Mexico a more

attractive place for business investments by foreign firms. With NAFTA firms

look more favorably on locating production in Mexico to serve the entire NAFTA

market (especially to serve the large U.S. market). The total amount invested by

foreign businesses in their Mexican operations grew from $41 billion in 1993 to

$403 billion in 2012. It is estimated that the investments would have been 40 percent

lower without NAFTA.

As trade within NAFTA has grown, there has not been the massive shift of jobs

toward Mexico that opponents in the United States predicted would result from

264 Part Two Trade Policy

pug21774_ch12_252-274.indd 264pug21774_ch12_252-274.indd 264 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

NAFTA. While U.S. imports from Mexico grew faster than U.S. exports to Mexico

during 1993–2013, U.S. exports to Mexico still grew faster than U.S. exports to other

countries. Any effects on the number of jobs in the United States are very small com-

pared to the typical rates of overall job loss and job creation in the U.S. economy.

The large increases in NAFTA trade do have effects on workers in the United

States, but they are the more subtle effects caused by shifting demands for different

types of workers (the kind of effects that we highlighted in Chapter 5). Freer trade (in

this case, NAFTA’s discriminatory freeing of trade) absolutely hurts import-competing

groups. NAFTA allows Mexico to better exploit its comparative advantage based on

less-skilled labor in such products as apparel, field crops (e.g., tomatoes), and furni-

ture and in such activities as product assembly. On the other hand, Mexico buys more

U.S. financial services, chemicals, plastics, and high-tech equipment. The expansion

of U.S. trade with Mexico spurred by NAFTA is pushing in the same direction as U.S.

trade expansion with other developing countries, putting some downward pressure

on the wages of less-skilled workers in the United States and increasing the incomes

of more-skilled U.S. workers. In Mexico, too, there have been income losses, for

instance, to small farmers growing corn (maize) who cannot readily shift to more

lucrative crops. And there are income gains to others. For instance, in agriculture,

NAFTA has facilitated large increases in Mexican exports of fruits and vegetables to

the United States.

Rules of Origin One other seemingly technical feature of NAFTA has received a surprising amount of

attention. Because each member of a free-trade area maintains its own barriers against

imports from outside the area, a member country must still police its borders, to tax

or prohibit imports that might otherwise avoid its higher external barriers by entering

through a lower-barrier partner country. Its customs officials must enforce rules of origin that determine which products have been produced within the free-trade area, so that they are traded freely within the area, and which products have not been produced

within the area. These rules guard against a firm’s ruse of doing minimal processing

within the area and then claiming that the outside product is locally produced.

The NAFTA rules of origin are incredibly complex, covering over 200 pages with

thousands of different rules for different products. Analysis of these rules has con-

cluded that many of them are so strict that they are protectionist in two ways. First, the

rules can limit the ability of firms in one member country to export freely to buyers in

other member countries. They can create a nontariff barrier that hinders cross-member

trade within the free-trade area. (The cost of documenting adherence to the rules can

also be substantial, adding to the height of the NTB between the members.)

Second, the rules can create local content requirements that provide protection

for the area producers of materials and components against rival suppliers of these

materials and components from outside the area. Here is another, more subtle reason

for producers from the rest of the world to lose. For instance, the rules of origin for

clothing indicate that the clothing must be made with fabric produced within the area

to qualify for duty-free shipping between NAFTA member countries. This rule ben-

efits U.S. fabric producers and hurts the NAFTA sales of lower-cost fabric producers

in Asia. It also reduces world well-being and North American well-being.

Chapter 12 Trade Blocs and Trade Blocks 265

pug21774_ch12_252-274.indd 265pug21774_ch12_252-274.indd 265 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

TRADE BLOCS AMONG DEVELOPING COUNTRIES

In several less-developed settings in the 1960s and 1970s, a different idea of gains from

a trade bloc took shape. The infant industry argument held sway. It was easy to imagine

that forming a customs union or free-trade area among developing countries would

give the bloc a market large enough to support a large-scale producer in each modern

manufacturing sector without letting in manufacturers from the industrialized countries.

The new firms could eventually cut their costs through scale economies and learning by

doing until they could compete internationally, perhaps even without protection.

For all the appeal of the idea, its practice “has been littered with failures,” as Pomfret

(1997) put it, and the life expectancy of this type of trade bloc was short. The Latin

American Free Trade Area (Mexico and all the South American republics) lacked bind-

ing commitment to free internal trade even at its creation in 1960, and by 1969 it had

effectively split into small groups with minimal bilateral agreements. Other short-lived

unions with only minimal concessions by their members included a chain of Caribbean

unions; the East African Community (Kenya, Tanzania, and Uganda), which disbanded

in 1977; and several other African attempts. One centrifugal force was the inherent

inequality of benefits from the new import-substituting industries. If scale economies

were to be reaped, the new industrial gains would inevitably be concentrated into one or

a few industrial centers. Every member wanted to be the group’s new industrial leader,

and none wanted to remain more agricultural. No formula for gains-sharing could

be worked out. Even the Association of Southeast Asian Nations (ASEAN), with its

broader industrial base, was unable to reach stable agreements about freer trade when

this was tried in the late 1970s and early 1980s. Mindful of this experience, most experts

became skeptical about the chances for great gains from developing-country trade blocs.

Yet the same institution can succeed later, even after earlier setbacks, especially if

economic and political conditions have changed. As we have seen, the idea of a free-

trade area between Canada and the United States failed to get launched for about a

century before its time arrived.

The key change in many developing countries’ trade policies since the 1970s, as we

will examine in more depth in Chapter 14, has been a shift in philosophy, toward an

outward, pro-trade (or at least pro-export) orientation. As in the case of Mexico, many

developing countries have pursued economic reforms to liberalize government poli-

cies toward trade and business activity more generally. Forming a trade bloc can be

a part of this thrust to liberalize (although, as we have seen, it is actually liberalizing

internal trade while discriminating against external trade).

MERCOSUR (the Southern Common Market) is the most prominent of the current

developing-country trade blocs. In 1991, Argentina, Brazil, Paraguay, and Uruguay

formed MERCOSUR, which by 1995 had established internal free trade and com-

mon external tariffs (averaging 12 percent) for most products (although progress

then stalled, so the customs union was not completed as of early 2014). One highly

protected sector is automobiles, with an external tariff of about 34 percent (and an

effective rate of protection of over 100 percent). In 1996, Chile and Bolivia became

associate members and established free-trade areas with the MERCOSUR countries.

Peru became an associate member in 2003, and Colombia, Ecuador, and Venezuela

became associate members in 2004. In 2012 Venezuela became a full member.

266 Part Two Trade Policy

pug21774_ch12_252-274.indd 266pug21774_ch12_252-274.indd 266 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

Trade among MERCOSUR countries increased rapidly, rising from 9 percent of

the countries’ total international trade in 1990 to 23 percent in 1998. However, the

Brazilian monetary crisis of 1999 and the Argentinean crisis in the early 2000s reversed

this trend, partly because demand for imports declined generally as the economies of

the countries weakened, and partly because Argentina and Brazil imposed some new

barriers to trade between the bloc members. Intrabloc trade fell to 14 percent of the

countries’ total international trade in 2012.

One study of the effects of MERCOSUR concluded that it can increase real national

incomes by 1 to 2 percent, with much of the gain coming from scale economies and the

benefits of increasing competition among firms from different MERCOSUR countries.

However, other observers are more cautious because trade within MERCOSUR increased

most rapidly in protected capital-intensive products like automobiles, machinery, and

electronic goods—products that are not consistent with the member countries’ global

comparative advantage. It is likely that substantial trade diversion is occurring in these

products, and the losses from trade diversion must be set against other gains. MERCOSUR

is a success in terms of survival, but its net effects on the well-being of its member coun-

tries are not clear.

TRADE EMBARGOES

Trade discrimination can be more belligerent—a trade block instead of a trade bloc.

A nation or group of nations can keep ordinary barriers on its trade with most countries

but insist on making trade with a particular country or countries difficult or impos-

sible. To wage economic warfare, nations have often imposed economic sanctions or embargoes, which are discriminatory restrictions or bans on economic exchange. What is being restricted or banned can be ordinary trade, or it can be trade in services

or financial assets, as in the case of a ban on loans to a particular country.

Waging economic warfare with trade embargoes and other economic sanctions

dates back at least to the fifth century bc. In the 1760s the American colonists boy-

cotted English goods as a protest against the infamous Stamp Act and Townshend

Acts. In this case, the boycott succeeded—Parliament responded by repealing

those acts.

The practice of economic sanctions was more frequent in the latter half of the

20th century than in any earlier peacetime era, and the use of sanctions increased

during the 1990s. The United States practices economic warfare more readily than

any other country. One estimate indicated that up to $20 billion of U.S. exports per

year were blocked by sanctions in the mid-1990s, at a net cost to the country of about

$1 billion per year. As of early 2014, the U.S. government had in place broad sanctions

against Cuba, Iran, North Korea, Sudan, and Syria.

The effects of banning economic exchanges are easy to imagine. A country’s

refusal to trade with a “target” country hurts both of them economically, and it

creates opportunities for third countries. But who gets hurt the most? The least?

Magnitudes matter because they determine whether the damage to the target

rewards the initiating country enough to compensate for its own losses on the

prohibited trade.

Chapter 12 Trade Blocs and Trade Blocks 267

pug21774_ch12_252-274.indd 267pug21774_ch12_252-274.indd 267 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

Moving from free trade ( F ) to an embargo ( E ) means Embargoing countries lose a Iran loses b 1 c Other countries gain b World as a whole loses a 1 c

FIGURE 12.3 Effects of an Embargo on Exports to Iran

A. In the Embargoing Countries

Sn � Export supply to Iran from nonembargoing countries

Fa c

B. International Trade

Sn � Se � World export supply to Iran from embargoing and nonembargoing countries

Dm � Iran’s import demand

Domestic supply

Domestic demand

Quantity Quantity

Price of embargoed goods

To discover basic determinants of the success or failure of economic sanctions, let

us consider a particular kind: a total embargo (prohibition) on exports to the target

country. 4 Figure 12.3 imagines a total embargo on exports to Iran. The example por-

trays one side of the restrictions that the United States, the European Union, Canada,

and other countries have imposed on Iran for its nuclear program and pursuit of

nuclear weapons capabilities. In addition to these restrictions on exports to Iran, the

countries applying sanctions have also imposed severe restrictions on Iran’s ability

to make and receive payments through the global banking and financial system, so

Iran’s exports of oil and other products have also decreased. Still, Iran has been able

to continue some trade with countries that have not joined the embargo.

In picturing international trade we will be careful to show export supply to Iran from

both embargoing and nonembargoing countries, even before the embargo. The export

supply to Iran from the nonembargoing countries is shown in Figure 12.3B as S n , a lim-

ited and rather inelastic supply. The export supply from the embargoing countries (before

they impose the embargo) is the difference between their domestic supply and domestic

demand, which are shown in Figure 12.3A. If we add the two sources of export supply

together, we get the total export supply, S n 1 S

e , available to Iran before the embargo.

Before the embargo, Iran’s import demand ( D m ) equals the total export supply at

point F on the right side of Figure 12.3. The price is P 0 , and Iran imports Q

0 .

4The case of an embargo on imports from the target country is symmetrical to the export case studied here. As an exercise at the end of this chapter, you are invited to diagram the import embargo case and to identify the gains and losses and what makes them large or small.

268 Part Two Trade Policy

pug21774_ch12_252-274.indd 268pug21774_ch12_252-274.indd 268 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

When countries decide to put an embargo on exports to Iran, part of the world export

supply to Iran vanishes. In Figure 12.3B the export supply S e is removed by the embargo.

The remaining export supply to Iran is only S n . With their imports thus restricted, Iranians

find importable goods scarcer. The price in Iran rises from P 0 to P

1 , as the free-trade equi-

librium, F , shifts to the embargo equilibrium, E . The new scarcity costs Iran as a nation the area b 1 c for reasons already described in Chapter 2 and Chapters 8 through 10.

The embargo also has a cost for the countries enforcing it because they lose exports

to Iran and the world price (outside of Iran) declines somewhat. They lose area a , which is shown in Figure 12.3 in two equivalent ways:

• On the left as the difference between producer losses and consumer gains in the

exporting countries.

• On the right as the loss of surplus on the exports that they no longer make to Iran.

Meanwhile, countries not participating in the embargo gain area b on extra sales to Iran at a higher price. What the world as a whole loses is therefore area a 1 c , the loss from restricting world trade.

Within countries on the two sides of the embargo, different groups will be affected

differently. In the embargoing countries (e.g., Canada, the United Kingdom, the

United States), the embargo lowers the price below P 0 , slightly helping some con-

sumers while hurting producers. Within Iran, there might be a similar division (not

graphed in Figure 12.3), with some import-competing producers benefiting from the

removal of foreign competition, while other groups are damaged to a greater extent.

If the embargo brings economic costs to both sides, why do it? Clearly, the countries

imposing the embargo have decided to sacrifice area a , the net gains on trade with Iran, to try to achieve some other goal, such as forcing Iran to abandon or greatly limit its nuclear

program. By their actions the embargoing governments imply that putting pressure on

Iran is worth more than area a . The lost area a is presumably not a measure of economic irrationality, but rather a willing sacrifice for a noneconomic goal. As Figure 12.3 is

drawn, the hypothetical export embargo is imagined to cause Iran more economic dam-

age, measured by area b 1 c , than the embargoers’ loss represented by area a . 5 Embargoes can fail, of course. In a study of sanctions imposed between 1945 and

2000, Gary Hufbauer et al. (2007) conclude that sanctions failed to have a substantial

impact on the policies of the target country in about two-thirds of the cases. There are

two ways in which trade embargoes fail: political failure and economic failure.

Political failure of an embargo occurs when the target country’s national decision-makers have so much stake in the policy that provoked the embargo that they

5In the real-world debate over sanctions, critics argue that the sanctions would harm large numbers of innocent civilians, whose right to a better government is a political outcome that sanctions are supposed to bring about. Thus, in the case of worldwide sanctions against South Africa (1986–1993), critics argued that the sanctions would lower incomes of “nonwhite” South Africans, the very groups the sanctions were supposed to help liberate. This may be correct in the short run, as all sides of the debate have long known.

To judge whether the sanctions are in the best interests of the oppressed within the target country, the best guide would be their own majority opinion. That opinion is not easily weighed in a context of disenfranchisement, press censorship, and tight police controls. The foreign governments imposing sanctions imply that the policy gains are worth more than their own loss of area a plus the short-run losses that they believe that oppressed groups in the target country are willing to sustain for the cause.

Chapter 12 Trade Blocs and Trade Blocks 269

pug21774_ch12_252-274.indd 269pug21774_ch12_252-274.indd 269 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

In panel A the cost to the embargoers, a , is much larger than the damage, b 1 c , to the target country. In panel B the costs to both sides are negligible because elasticities are so high.

FIGURE 12.4 Two Kinds of Economically Unsuccessful Embargoes

A. An Embargo That Backfires

B. A Virtually Irrelevant Embargo

0 Imports into target country Imports into target country

Price of embargoed goods

Sn � Se

a F

c b

a F

Dm Dm

P1 P0 P0

will stick with that policy even if the economic cost to their nation becomes extreme.

Such political stubbornness is very likely if the target country is a dictatorship and

the dictatorship would be jeopardized by retreating from the policy that provoked the

embargo. In such a case, the dictatorship will refuse to budge even as the economic

costs mount.

An example of political failure of economically “successful” sanctions was Saddam

Hussein’s refusal to retreat from Kuwait or, after Iraq was driven from Kuwait, to step

down from power. Defenders of the idea of pressuring Saddam Hussein with sanctions

were right in asserting that sanctions would bring greater damage to the economy of

Iraq than to the embargoing countries. One estimate is that the sanctions imposed a net

cost to Iraq of $15 billion per year, equal to about half of Iraq’s national income. Yet

Saddam Hussein’s grip on power was so firm that he was neither forced by internal

pressure to step down nor forced to make a major change in certain policies, even if a

majority of Iraqi citizens suffered great hardship. A counterexample is the UN-based

sanctions imposed on South Africa, which succeeded in hastening the end of apartheid

and the minority-rule police state.

The second kind of failure is economic failure of an embargo, in which the embargo inflicts little damage on the target country but possibly even great damage

on the imposing country. Figure 12.4 shows two kinds of (export) embargoes that fail

economically. In both cases, elasticities of supply and demand are the key.

In Figure 12.4A, the countries imposing the embargo have a very inelastic export

supply curve, implying that their producers really depend on their export business

in the target country. Banning such exports and erasing the supply curve S e from the

marketplace costs the embargoing nation(s) a large area a . The target country, by contrast, has a very elastic import demand curve D

m . It cuts its demand greatly when

the price goes up even slightly, from P 0 to P

1 . Apparently, it can do fairly well with

supplies from nonembargoing countries (the S n curve alone). Accordingly, it loses

270 Part Two Trade Policy

pug21774_ch12_252-274.indd 270pug21774_ch12_252-274.indd 270 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

only the small areas b 1 c . Any nation considering an embargo in such a case must contemplate sustaining the large loss a , in pursuit of only a small damage ( b 1 c ) to the target country. What works against the embargo in Figure 12.4A is the low elastic-

ity of the embargoing country itself and the high elasticity of either the target country’s

import demand or its access to competing nonembargo supplies.

Figure 12.4B shows a case in which the embargo “fails” in the milder sense of hav-

ing little economic effect on either side. Here the embargoing country is fortunate to

have an elastic curve of its own ( S e ) so that doing without the extra trade costs it only

a slight area a. On the other hand, the target country also has the elastic demand curve D

m and access to the elastic competing supplies S

n . Therefore it sustains only the slight

damage b 1 c and presumably can defy the embargo for a long time. So embargoes and other economic sanctions apply stronger pressure when the

embargoing country or countries have high elasticities and the target countries have

low ones. When is this likely to be true? Our analysis offers suggestions that seem to

show up in the real world:

1. Big countries pick on small ones. A country (or group of countries) with a large

share of world trade can impose sanctions on a small one without feeling much

effect. In economic terms, the big country is likely to have highly elastic trade curves

(like S e in the examples here) because it can deal with much larger markets outside

the target country. A small target country, on the other hand, may depend heavily on

its trade with the large country or countries. Its economic vulnerability is summa-

rized by low elasticities for trade curves like D m and S

n . Little wonder that the typical

embargo is one imposed by the United States on a small country like Nicaragua.

2. Sanctions have more chance of success if they are sudden and comprehensive

when first imposed. Recall that the damage b 1 c is larger, the lower are the target country’s trade elasticities. Elasticities are lower in the short run than in the long

run, and they are lower when a massive share of national product is involved. The

more time the target country has to adjust, the more it can learn to conserve on the

embargoed products and develop alternative supplies. Of course, quick and sudden

action also raises the damage to the initiating country itself (area a ), so success may be premised on the embargoing country’s having alternatives set up in advance,

alternatives that raise its elasticities and shrink area a . 3. As suggested by the definition and example of political failure, embargoes have

more chance of changing a target government’s policies when the citizens hurt by

the embargo can apply political pressure on the stubborn head(s) of state, as in a

democracy. In a strict dictatorship, the dictator can survive the economic damage

to citizens and can hold out longer.

The first of these three points provides insight into why the effectiveness of unilateral

sanctions imposed only by the United States has changed over time. In the 1950s, when

the United States was predominant, its own sanctions could have some effect on coun-

tries like Iran and even Britain and France (in the Suez Canal dispute). With the growth

of other countries and their economies, unilateral U.S. sanctions have become much less

effective because S n (from the rest of the world) has expanded and become more elastic.

In the 1990s, the United States shifted away from the use of unilateral sanctions

(though it still uses some, as indicated by the list presented at the beginning of this

Chapter 12 Trade Blocs and Trade Blocks 271

pug21774_ch12_252-274.indd 271pug21774_ch12_252-274.indd 271 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

section) and toward the use of sanctions imposed collectively by a coalition of

countries. For instance, the United States pushed for UN mandates for sanctions

that direct all countries to participate. Before 1990, the only UN-mandated sanc-

tions were against South Africa and Rhodesia (now Zimbabwe). During the 1990s

the UN established sanctions against Iraq, Serbia, Somalia, Libya, Liberia, Haiti,

Angola, Rwanda, and Sierra Leone. However, these UN sanctions had limited suc-

cess, while imposing often substantial costs on some of the embargoing countries. In

the 2000s the UN has backed away from mandated sanctions. As of early 2014, the

UN had only a small number of limited mandates in place, mostly arms embargoes

of African countries that were involved in civil wars or other armed conflicts, as well

as somewhat broader sanctions against Iran and North Korea.

Summary The trade bloc revolution amassing since the 1990s has raised the importance of trade discrimination. The basic three-country model of a trade bloc shows that

• Its economic benefits for the partner countries and the world depend on its trade cre- ation, the amount by which it raises the total volume of world trade.

• Its economic costs depend on its trade diversion, the volume of trade it diverts from lower-cost outside suppliers to higher-cost partner-country suppliers.

Other possible sources of gains to members of a trade bloc include increased competi-

tion that lowers prices or costs, enhanced ability to achieve scale economies, greater

product variety, and the ability to attract more direct investment by foreign compa-

nies. Whether a trade bloc is good or bad overall depends on the difference between

its gains from trade creation (and any other positive effects) and its losses from trade

diversion.

The most common kind of trade bloc is the free-trade area, in which member countries remove tariffs and other barriers to trade among themselves but keep their

separate barriers on trade with nonmember countries. In this case, member coun-

tries must use rules of origin and maintain customs administration on the borders between themselves to keep outside products from entering the high-barrier coun-

tries cheaply by way of their low-barrier partners. Examples of free-trade areas are

the European Free Trade Area created in 1960 and the North American Free Trade

Agreement (NAFTA), which came into existence in 1994.

The European Union from 1957 to 1992 was a customs union, in which member countries remove tariffs and other barriers to trade among themselves and adopt a

common set of external tariffs. In 1992 the Single European Act promoted free move-

ment of workers and capital, so the EU became a common market. (The act also required removal of many remaining nontariff barriers to trade among the member

countries.) As the EU further integrates, including the adoption of the euro as a com-

mon currency by 18 of its members, the EU is moving toward economic union, in which all economic policies would be unified.

Efforts by developing countries to form trade blocs failed in the 1960s and 1970s, but

they have become more successful since 1990. Trade among the MERCOSUR countries

in South America expanded since the bloc was formed in 1991, but some of this expanded

intrabloc trade is trade diversion.

272 Part Two Trade Policy

pug21774_ch12_252-274.indd 272pug21774_ch12_252-274.indd 272 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

Another form of trade discrimination is economic sanctions, or trade embar- goes. Our basic analysis of an export embargo (which has effects symmetrical with those of an import embargo) reveals how the success or failure of such economic

warfare depends on trade elasticities. Success is more likely when the target country

has low trade elasticities, meaning that it cannot easily do without trading with the

embargoing countries. Success is also more likely when the embargoing countries

have high trade elasticities, meaning that they easily do without the extra trade.

As the theory implies, embargoes are typically imposed by large trading countries

on smaller ones, and success is more likely the quicker and more comprehensive

the sanctions.

Trade bloc

Trade embargo

Free-trade area

Customs union

Common market

Economic union

Trade creation

Trade diversion

Rules of origin

Political failure of an

embargo

Economic failure of an

embargo

Key Terms

Suggested Reading

The trade bloc literature is usefully surveyed by Freund and Ornelas (2010) and Pomfret

(1997). Baldwin and Venables (1995) present a technical survey. Schiff and Winters

(2003, Chapter 8) examine the effects of trade blocs on nonmember countries and

on multilateral trade negotiations. Bhagwati (2008) examines the negative economic

and political effects of preferential trade agreements. Magee (2008) uses the gravity

model of trade to develop estimates of trade creation and trade diversion for a number

of trade blocs.

On the economics of the European Union, see Neal and Barbezat (1998) and the

Organization for Economic Cooperation and Development (2000). Baldwin and Wyplosz

(2012, Chapter 9) provide overview and analysis of the EU’s common agricultural policy.

Mohler and Seitz (2012) develop estimates of gains from greater product variety for the

EU’s new members.

The effects of the North American Free Trade Area are plumbed by Hufbauer

and Schott (2005). Jaramillo et al. (2006) explore the expected effects of the Central

American Free Trade Agreement.

The economics and the foreign policy effects of trade embargoes are well analyzed

by Hufbauer et al. (2007). Morgan et al. (2009) introduce a new dataset on sanctions

imposed or threatened since 1970.

Questions and Problems

1. What is the difference between a free-trade area and a customs union?

2. Are trade blocs consistent with the most favored nation principle?

3. How are trade creation and trade diversion defined, and what roles do they play in the

world gains and losses from a trade bloc?

4. Why are rules of origin needed for a free-trade area? How might they be protectionist?

✦

Chapter 12 Trade Blocs and Trade Blocks 273

pug21774_ch12_252-274.indd 273pug21774_ch12_252-274.indd 273 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

5. Homeland is about to join Furrinerland in a free-trade area. Before the union,

Homeland imports 10 million DVD recorders from the outside-world market at $100

and adds a tariff of $30 on each recorder. It takes $110 to produce each DVD recorder

in Furrinerland.

a. Once the free-trade area is formed, what will be the cost to Homeland of the DVD recorder trade diverted to Furrinerland?

b. How much extra imports would have to be demanded by Homeland to offset this trade-diversion cost?

6. Which countries are likely to gain, and which are likely to lose, from the North

American Free Trade Area? How are the gains and losses likely to be distributed

across occupations and sectors of the Mexican economy? The U.S. economy?

7. Suppose that the United States currently imports 1.0 million pairs of shoes from China

at $20 each. With a 50 percent tariff, the consumer price in the United States is $30.

The price of shoes in Mexico is $25. Suppose that, as a result of NAFTA, the United

States imports 1.2 million pairs of shoes from Mexico and none from China. What are

the gains and losses to U.S. consumers, U.S. producers, the U.S. government, and the

world as a whole?

8. In a presentation about Serbia’s future entry into the European Union, the speaker

indicates that the effects of trade creation will be equal to about 2 percent of Serbia’s

GDP, the effects of trade diversion will be equal to about 1 percent of Serbia’s GDP,

and the overall effects on Serbia will be a gain in national well-being equal to about 3

percent of its GDP. What do you think is the best explanation of how these numbers fit

together? Is anything missing that you can fill in to make better sense of the numbers?

9. What kinds of countries tend to use economic embargoes? Do embargoes have a

greater chance of succeeding if they are applied gradually rather than suddenly?

10. Draw a graph like Figure 12.3B. Initially the embargo is the one shown in this graph.

Then, half of the nonembargoing countries switch and become part of the embargo.

Use your graph to show how this changes the effects of the embargo. Specifically,

what are the effects on the initial embargoing countries and on the target country?

Does this shift make the embargo more or less likely to succeed? Why?

11. Which of the following trade policy moves is most certain to bring gains to the world

as a whole: ( a ) imposing a countervailing duty against an existing foreign export sub- sidy, ( b ) forming a customs union in place of a set of tariffs equally applied to imports from all countries, or ( c ) levying an antidumping import tariff? (This question draws on material from Chapter 11 as well as from this chapter.)

12. Draw the diagram corresponding to Figure 12.3 for an embargo on imports from the

target country. Identify the losses and gains to the embargoing countries, the target

country, and other countries. Describe what values of elasticities are more likely to

give power to the embargo effort and what values of elasticities are more likely to

weaken it.

✦

274 Part Two Trade Policy

pug21774_ch12_252-274.indd 274pug21774_ch12_252-274.indd 274 10/27/14 6:53 PM10/27/14 6:53 PM

Final PDF to printer

Chapter Thirteen

Trade and the Environment Protection. For free traders, this word represents the consummate evil.

For environmentalists, it is the ultimate good. Of course, for the trade

community, “protection” conjures up images of Smoot and Hawley,

while the environmental camp sees clear mountain streams, lush

green forests, and piercing blue skies.

Daniel C. Esty, 2001

As nations interact more and more with each other, they have more and more effect

on each other’s natural environments. Often the international environmental effects

are negative, as when activity in one nation pollutes other nations’ air and water, or

when it uses up natural resources on which other nations depend. These environmental

concerns have become irreversibly global and are a growing source of international

friction.

Inevitably, international trade has been drawn into the environmental spotlight, both

as an alleged culprit in environmental damage and as a hostage to be taken in interna-

tional environmental disputes. This chapter addresses the rising debate over the proper

role of government policies in attacking environmental problems when the problems

and policies have international effects.

IS FREE TRADE ANTI-ENVIRONMENT?

One attack on international trade is that it makes environmental problems worse. For

instance, perhaps free trade simply promotes production or consumption of products

that tend to cause large amounts of pollution. It is difficult to evaluate such a broad

claim as this. But it is easy to find cases of the opposite, where government poli-

cies that limit or distort trade result in environmental damage. In the early 1980s,

the United States forced Japan to limit its exports of autos to the United States. As

a result, U.S. consumers tended to buy U.S. cars that were less fuel-efficient than

the Japanese cars they could no longer buy, probably resulting in more pollution.

Another well-researched case is the environmental effects of government policies

275

pug21774_ch13_275-308.indd 275pug21774_ch13_275-308.indd 275 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

that protect domestic agriculture. The web of import limits and export and produc-

tion subsidies leads to excessive use of pesticides and fertilizers as protected farmers

strive to expand production. Free trade would lead to farming that is more friendly

to the environment.

Some kinds of trade can help efforts to protect the environment. Freer trade in

capital equipment that incorporates environmentally friendly technologies and freer

trade in environmental services can be conduits for improved environmental practices,

especially in developing countries.

One fear of environmentalists is that free trade permits production to be shifted

to countries that have lax environmental standards. Exports from these “pollution

havens” then would serve demand in countries with tighter standards, with the result

that total world pollution would be higher. However, research on relocation of pro-

duction in response to differences in environmental standards finds that the effects

are small. The costs to firms of meeting environmental protection regulations are

usually small (less than 1 or 2 percent of sales revenues), even in the most strin-

gent countries, so the incentive to relocate is usually small. Other determinants of

production location, like standard comparative cost advantage, transport costs, and

external scale economies, are usually more important. In addition, many multina-

tional companies refrain from setting up high-pollution operations in lax countries

because of fears of unexpected liabilities in cases of accidents, general risks to cor-

porate reputations from appearing to cause excessive harm to the environment, and

the costs of meeting more stringent regulations that are likely to be adopted in the

future in these countries.

Let’s turn to look at a concrete example of a recent global shift to freer international

trade: the agreements reached during the Uruguay Round of trade negotiations. Does

the expansion of trade resulting from these agreements harm or help the environment?

• Freer trade will alter the composition of what is produced and consumed in each country. As the composition of what is produced and consumed changes, the total

amounts of pollution will change.

• There will be additional gains from trade. These gains could set up two different

effects.

a. The size of the economy is larger. The increase in production and consumption probably leads to more pollution, other things being equal.

b. The higher income can lead to more pressure on governments to enact tougher environmental protection policies. For instance, stricter government policies

may lead firms to clean up wastes before they are released into the environment

or to switch to production methods that create less pollution per unit produced.

Demand for a clean environment is a normal good.

Before examining the effects of the Uruguay Round, it’s useful to look at how the

size and income effects play against each other. How do rising production, consump-

tion, and income in a country actually affect environmental quality? When income per

person (our overall indicator of size and income) rises, does the environment deterio-

rate or improve? That is, which tends to be larger, the harm from the size effect or the

environmental protection from the income effect?

276 Part Two Trade Policy

pug21774_ch13_275-308.indd 276pug21774_ch13_275-308.indd 276 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

There are likely to be different general patterns for this combined size–income

effect, depending on what kind of environmental problem we are examining. Here are

the three basic patterns:

1. Environmental harm declines with rising income per person . For some issues, the benefits of better environmental quality are so large that the income effect is

dominant over (almost) the entire range of income per person. That is, the demand

for better environmental quality as income rises is simply larger than any adverse

effects from rising production scale.

2. Environmental harm rises with rising income per person. For some other issues, the benefits of preventing environmental harm are not considered to be large. The

adverse effects from rising size dominate any modest increases in demand for better

environmental quality.

3. The relationship is an inverted U. For yet other issues, the demand for better envi- ronmental quality is weak at first, perhaps because the focus when people are poor

is on developing production to reduce the grip of material poverty. When income

is low, people are willing to accept some environmental harm to increase produc-

tion and income. This damage rises as economic activity rises. But, at some point

at which the dire effects of poverty have been reduced enough, the demand for

better environmental quality becomes more forceful. As incomes rise further, more

stringent government regulation takes over. The environmental harm declines even

though production and consumption are increasing.

Figure 13.1 provides some examples of these patterns for different environmental

issues. Some very basic environmental dangers, including airborne heavy particles and

lead in water, tend to fall as income rises, as shown in panel A. Some environmental

problems rise with greater income, as shown in panel B. These include emissions of

carbon dioxide, which we will discuss later in this chapter. The demand to reduce this

pollutant is not particularly strong even when incomes are high. The harm from global

warming is rather abstract, the costs of reducing these emissions are substantial, and

the problem is global, so actions by any one country would have little effect on the

problem.

Panel C of Figure 13.1 shows the inverted-U relationship. 1 The pollutants that fit

this pattern tend to be those that cause harm within the region or country, so regional

or national efforts to abate the pollution provide benefits to the people in that locale.

This pattern has been found for such air pollutants as sulfur dioxide (which causes

acid rain), airborne particulates, and lead and such water pollutants as fecal coliform

(resulting from inadequate containment or treatment of human and animal wastes) and

1The inverted-U shape is sometimes called the environmental Kuznets curve, named after Nobel Prize winner Simon Kuznets. His research on the effects of economic development found an inverted-U relationship between per capita income and income inequality.

We should be careful interpreting and using this inverted-U shape. It is a statistical relationship and does not guarantee that any single country is on the curve or follows it as the country develops. There are also other influences, including the type of government (democracy generally is more responsive to popular demand for pollution control than is dictatorship) and the source of growth in national production and income (growth could be biased toward or against pollution-intensive sectors of the national economy).

Chapter 13 Trade and the Environment 277

pug21774_ch13_275-308.indd 277pug21774_ch13_275-308.indd 277 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

Examples: Examples: Examples (estimates of turning points): Concentration of heavy particles Carbon dioxide emissions per person Air pollution:

in urban air Urban waste per person Sulfur dioxide ($3,000−$10,700)

Concentration of lead in water Suspended particulate matter

Lack of dissolved oxygen in rivers ($3,300−$9,600)

Percentage of population without Nitrogen oxides ($5,500−$21,800)

safe water Carbon monoxide ($9,900−$19,100)

Percentage of urban population Lead from gasoline ($7,000)

without sanitation Water pollution: Fecal coliform ($8,000)

Arsenic ($4,900)

Biological oxygen demand ($7,600)

Chemical oxygen demand ($7,900)

Source of examples: Edward B. Barbier, “Introduction to the Environmental Kuznets Curve Special Issue,” Environment and Development Economics 2, no. 4 (December 1997), pp. 369281.

FIGURE 13.1 Environmental Problems by Income Level

National income

per person

Environmental harm

National income

per person

Environmental harm

A. Declining Environmental Problem

B. Rising Environmental Problem

C. Inverted-U Relationship

National income

per person

Turning point

Environmental harm

arsenic. Estimates of turning points (beyond which the pollution declines) often are at levels of income per person that are higher than those of most developing countries

but lower than those of industrialized countries.

Now we have the tools that we need to examine the environmental effect of the

Uruguay Round. Figure 13.2 shows the environmental effects that the trade changes

resulting from the Uruguay Round have had on four air pollutants.

The composition effects tend to increase levels of all pollutants in the United States, the European Union, and Japan. With the exception of Latin America, the composi-

tion effects tend to reduce pollution in the developing countries. The reason for this

pattern is Heckscher–Ohlin with a twist. As the world moves toward freer trade, pro-

duction of capital- and skill-intensive products expands in the industrialized countries

and shrinks in the developing countries. These products include most of the prod-

ucts that are environmentally “dirty,” including iron and steel, the refining of other

278 Part Two Trade Policy

pug21774_ch13_275-308.indd 278pug21774_ch13_275-308.indd 278 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

FIGURE 13.2 Environmental Effects of the Uruguay Round (Percent Changes in Emissions for Each Type of Pollutant, in Each Place)

Sulfur Suspended Nitrogen Carbon Dioxide Particulates Dioxide Monoxide

Comp1 S & I2 Total3 Comp S & I Total Comp S & I Total Comp S & I Total

United States 0.4 20.7 20.3 0.2 20.8 20.6 0.1 0.0 0.1 0.1 20.6 20.5 European Union 0.3 20.4 20.1 0.2 20.3 20.1 0.1 0.2 0.3 0.2 20.3 20.1 Japan 2.0 20.6 1.4 0.3 20.5 20.2 0.3 0.1 0.4 0.3 21.0 20.7 Latin America 0.5 0.7 1.2 0.4 0.6 1.0 0.6 0.9 1.5 0.2 0.8 1.0 China 21.8 2.1 0.3 20.9 2.0 1.1 20.3 1.6 1.3 20.1 1.8 1.7 East Asia 23.1 1.8 22.2 23.0 1.7 21.3 20.1 2.0 1.9 21.9 1.9 0.0 South Asia 20.6 1.3 0.7 20.4 1.4 1.0 20.5 1.0 0.5 20.5 1.3 0.8 Africa 20.1 2.8 2.7 0.0 2.7 2.7 0.2 2.0 2.2 0.0 2.4 2.4 World 20.3 0.2 20.1 20.1 0.1 0.0 0.1 0.5 0.6 0.0 0.1 0.1

1 Composition effect. 2 Combined size effect and income effect. 3 Total change 5 Composition effect + Combined size effect and income effect.

Source: M. A. Cole, A. J. Rayner, and J. M. Bates, “Trade Liberalization and the Environment: The Case of the Uruguay Round,” World Economy 21, no. 3 (May 1997), pp. 337247.

metals, chemicals, petroleum refining, and pulp and paper. Production of unskilled-

labor-intensive products, like textiles and apparel, shrinks in the industrialized

countries and expands in the developing countries. Most less-skilled-labor-intensive

products are environmentally “clean.” Thus, as the composition of what is produced

changes, pollution-intensive production tends to expand in the high-income industrial-

ized countries and pollution-intensive production tends to decline in the low-income

developing countries.

The gains from the Uruguay Round increase size and income. As shown in

Figure 13.2, the combined size and income effects tend to lower pollution in the indus- trialized countries for sulfur dioxide, suspended particulates, and carbon monoxide

because these countries are beyond the turning points in the inverted-U curves for these

three pollutants. The combined size–income effects tend to increase nitrogen dioxide

pollution in the European Union and Japan because the turning point for this pollutant

is estimated to be at about the U.S. level of income per person. The combined size–

income effects tend to increase pollution in the developing countries because their

incomes are lower than the four turning points.

What actually happens to the environment in each place as a result of the Uruguay

Round is the sum of the effects. The actual effects (the sums of the composition effects

and the combined size and income effects) vary by country and by pollutant. The

overall effects for the world are generally small, as are the effects for most countries

and pollutants. Even for countries whose pollution increases, the monetary value of

the usual gains from freer trade is a large multiple of the monetary cost of any extra

pollution. For instance, for the world, the costs of the extra nitrogen dioxide pollution

are less than 0.3 percent of the global gains from the freer trade. If we take a slightly

different perspective, the world and the individual countries could prevent the extra

Chapter 13 Trade and the Environment 279

pug21774_ch13_275-308.indd 279pug21774_ch13_275-308.indd 279 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

pollution using only a small part of the gains that they get from the Uruguay Round

agreements. In a more limited analysis, the same study that is the source of estimates

shown in Figure 13.2 concludes that the Uruguay Round is likely to increase global

emissions of carbon dioxide by 3.3 percent. This increase is somewhat larger than that

for the other pollutants, but it is still only a small part of the global increase in carbon

dioxide that has been occurring.

In summary, free trade is not inherently anti-environment. Relocation of production

to avoid stringent environmental standards is small. Shifts toward freer trade cause a

variety of changes, but the net effects on overall pollution usually seem to be small.

IS THE WTO ANTI-ENVIRONMENT?

Even if free trade is not itself anti-environment, environmentalists often complain

that the global rules of the trading system, the rules of the World Trade Organization

(WTO), prevent governments from pursuing strong environmental protection policies.

There are some things that are not in doubt. Most important, a government that takes

actions to control environmental damage caused by its own firms’ production is not violating WTO rules. Beyond this, there are questions.

The main preoccupation of the WTO (and the GATT before it) is with liberalizing

trade, but the rules also make special mention of environmental concerns. Article

XX lists general exceptions to its free-trade approach. While Article XX begins by

repeating the signing governments’ fear that any exceptions are subject to abuse by

protectionists, it does admit exceptional arguments for trade barriers. Two of those

arguments are environmental exceptions to the case for free trade:

Subject to the requirement that such measures are not applied in a manner which would

constitute a means of arbitrary or unjustifiable discrimination between countries where the

same conditions prevail, or a disguised restriction on international trade, nothing in this

Agreement shall be construed to prevent the adoption or enforcement by any contracting

party of measures:

. . . (b) necessary to protect human, animal, or plant life or health;

. . . (g) relating to the conservation of exhaustible natural resources if such measures

are made effective in conjunction with restrictions on domestic production

or consumption.

There is an obvious tension here. The signing parties conceded that environmental

concerns might conceivably justify trade barriers, but they were suspicious that such

concerns would be a mere facade, an excuse for protectionists to shut out foreign

goods.

There are three important types of policies that may qualify for environmental

exceptions. First, consumption of products can cause damage. WTO rulings make it clear that a country generally can impose product standards or other limits on con-

sumption to protect the country’s health, its safety, or the environment, even though

such a policy will limit imports. A key is that the policy applies to all consumption, not

just to imports. For instance, the WTO ruled that France can prohibit consumption and

production of asbestos or asbestos-containing products within its borders, including

prohibiting imports of these products. Similarly, the WTO ruled that the United States

280 Part Two Trade Policy

pug21774_ch13_275-308.indd 280pug21774_ch13_275-308.indd 280 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

can impose a gas-guzzler tax on autos that get few miles per gallon, as long as the tax

applies to all cars, both domestically produced and foreign.

At the same time, the WTO is vigilant against using environmental standards as

disguised protectionism. The WTO ruled that U.S. regulations on average fuel economy

of cars sold by each manufacturer violated WTO rules because they treated imports pro-

duced by foreign automakers differently from domestic autos. The WTO also ruled that

U.S. policies on fuel additives violated the rules because they treated foreign-produced

gasoline differently from domestically produced gasoline. The WTO ruled that a ban by

Thailand on cigarette imports to promote health violated WTO rules because domesti-

cally produced cigarettes continued to be sold. In these three cases the issue was not the

environmental health objective itself. Rather, it was the fact that imports were treated

differently from domestically produced products without any overarching need to do so.

The WTO does also examine the basis for standards. As a result of the Uruguay

Round, product standards to protect health or safety must have a scientific basis. This

requirement tries to prevent a government from inventing standards that are written to

limit imports. More controversially, it also may prevent a government from responding

to public perceptions of risks, such as concern about genetically altered foods, if there

is little scientific evidence supporting the public fears.

Second, production in foreign countries can cause environmental damage. Can a government limit imports of a foreign product produced using methods that violate the

country’s own environmental standards? As discussed in the box “Dolphins, Turtles,

and the WTO,” the position of the WTO has evolved to one that permits an environ-

mental exception for national rules that limit imports of products produced using

processes that harm the environment, but with strict standards:

• The rules must demonstrably assist in pursuing a legitimate environmental goal,

and they must limit trade as little as possible.

• The rules must be applied equally to domestic producers and to all foreign exporting

firms.

• The country imposing the rules should be engaged in negotiations with other

involved countries to establish a multilateral agreement to address the environmen-

tal issue (if such agreement does not yet exist).

Again, the objective of the WTO is to allow countries to pursue environmental protec-

tion using policies that may affect international trade but to prevent countries from

using environmental claims to create disguised protectionism.

Third, there are some environmental problems that are global in scope and that may

require global solutions negotiated among many governments. Can a multilateral envi- ronmental agreement use controls on international trade to implement the agreement or sanctions on a country’s trade to enforce the agreement? Two important multilateral

agreements discussed later in this chapter—the Convention on International Trade in

Endangered Species and the Montreal Protocol—use trade bans, even for trade with

countries that have not signed the agreements. The WTO has not been asked to rule on

these agreements. The WTO seems to be comfortable with this multilateral approach

to well-defined environmental problems, but it has not actually issued any rulings

endorsing them.

Chapter 13 Trade and the Environment 281

pug21774_ch13_275-308.indd 281pug21774_ch13_275-308.indd 281 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

Global Governance Dolphins, Turtles, and the WTO

Dolphins have long had a special appeal to humans because of their intelligence and seem- ing playfulness. The sympathy for dolphins, like the sympathy for all large animals, grows with income. It was inevitable that any threat to dol- phins, even though they are not an endangered species, would mobilize a strong defense in the industrialized countries.

Most tuna are caught by methods that do not harm dolphins. But, for unknown reasons, large schools of tuna choose to swim beneath herds of dolphins in the Eastern Tropical Pacific Ocean. Before 1960, this posed no threat to dolphins. Fishing crews used hooks to catch tuna, and dol- phins’ sonar allowed them to avoid the hooks. However, the 1960s brought a new method for catching tuna, purse-seine fishing, in which speed- boats and helicopters effectively herd the dolphins and tuna into limited areas, where vast nets encir- cle large schools of tuna. As the nets draw tight underwater, the dolphins, being mammals, drown. Six million dolphins have died this way since 1960.

The United States tried to stop this purse-seine netting with the Marine Mammals Protection Act of 1972, but with limited effect. The law can prohibit use of this method in U.S. waters, out to the 200-mile limit, and use of this method by U.S. ships anywhere in the world. Fishing fleets responded to the 1972 law by reflagging as ships registered outside the United States. Between 1978 and 1990, the share of U.S. boats in the Eastern Pacific tuna fleet dropped from 62 percent to less than 10 percent.

The United States still had some economic weapons at its disposal. The government pressured the three main tuna-packing and tuna-retailing firms (StarKist, Bumble Bee, and Chicken of the Sea) to refuse to buy tuna taken with dolphin- unsafe methods. While there were charges that at least one of the firms packed dolphin-unsafe tuna under its dolphin-safe label, the dolphin-safe

scheme had some success. Through this and other forms of pressure, the estimated dolphin mortality in tuna fishing dropped from 130,000 in 1986 to 25,000 in 1991.

The United States did not let the matter rest there. In 1991, the U.S. government banned tuna imports from Mexico and four other countries. Mexico immediately protested to the GATT, where a dispute resolution panel handed down a prelimi- nary ruling that the U.S. import ban was an unfair trade practice, a protectionist act against Mexico. The GATT panel ruled that the United States can- not restrict imports based on production methods used by firms in other countries. The EU also chal- lenged the U.S. legislation as a violation of the GATT because it included a “secondary boycott” against tuna imports from any country importing dolphin-unsafe tuna from countries like Mexico that use this fishing method. In 1994, a GATT panel again ruled against the United States.

These rulings suggested that international trade rules would not endorse efforts by one country to use trade policy to impose its environ- mental policies outside of its borders, or to force other countries to change their environmental policies. Environmentalists were furious because they believed that principles of trade policy were placed ahead of environmental safeguards.

Within these constraints, what can the United States do if it wishes to save more dolphins? One possibility is to negotiate with other countries to get them to alter the methods they use to catch tuna, perhaps by offering other benefits in exchange. In 1995, six countries (including Mexico) agreed to adopt dolphin-friendly fishing. However, some fishing fleets could just reflag to yet other countries, so the best solution probably would be a global multilateral agreement on tuna fishing.

Sea turtles, a species threatened with extinc- tion, present a similar case. Some shrimp are

282 Part Two Trade Policy

pug21774_ch13_275-308.indd 282pug21774_ch13_275-308.indd 282 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

caught with nets that also trap and kill sea turtles. A U.S. law passed in 1989 requires shrimp- ers in U.S. waters to alter their nets with turtle- excluder devices, and it prohibits shrimp imports from countries whose rules do not require such devices to protect sea turtles.

The U.S. government initially applied the U.S. law to 14 Caribbean and Latin American coun- tries, negotiated with them, and allowed them three years to implement changes in their fishing methods. Following a U.S. court ruling, the U.S. government extended the application of the law to other countries unilaterally and with only a four-month phase-in.

Four Asian countries filed a complaint with the WTO in 1997. In the ruling on the case, the WTO decided that

• Protection of sea turtles was a legitimate envi- ronmental purpose.

• The actual U.S. policies violated WTO rules because they did not apply equally to all foreign exporting countries.

• The actual U.S. policies were unacceptable because they required specific actions by the foreign countries (enacting laws and using turtle-excluder devices) and did not recognize alternative ways to protect sea turtles.

• The actual U.S. approach was also unaccept- able because the U.S. did not undertake negotiations with the exporting countries affected by the extension of application of the law.

In response to the ruling, the U.S. government removed the discriminatory terms, recognized other turtle-protection methods, and began negotiations with the countries affected by the extension of the law. In 2001 the WTO ruled that, with these changes in place, the United States was in compliance with WTO rules, so it

could restrict imports of shrimp caught in ways that harm sea turtles. The WTO also ruled that good-faith negotiations toward a multilateral agreement were adequate—reaching an actual agreement was not a prerequisite for the United States to apply its law. At about the same time as the WTO rulings, the United States did reach agreements with a number of foreign countries to adopt rules to protect sea turtles.

Many environmentalists seem to believe incorrectly that WTO rules always favor free trade and so prevent a country from using trade- related measures as part of its efforts to protect the environment. The truth is more nuanced. The WTO is certainly vigilant against environ- mental policies and rules that unnecessarily limit trade or discriminate between foreign suppliers. Still, the WTO cannot force a member country to change its policies if the country does not want to. More important, the WTO generally accepts the legitimacy of protecting the environment and setting minimum environmental standards through negotiations between countries. The appellate body in the sea turtle case said in its report:

We have not decided that protection and preservation of the environment is of no significance to the members of the WTO. Clearly it is. We have not decided that the sovereign states that are members of the WTO cannot adopt effective measures to protect endangered species, such as sea turtles. Clearly, they can and they should. And we have not decided that sovereign states should not act together bilaterally, pluri- laterally,or multilaterally, either within the WTO or in other international fora, to protect endangered species or to otherwise protect the environment. Clearly, they should and do.

Chapter 13 Trade and the Environment 283

pug21774_ch13_275-308.indd 283pug21774_ch13_275-308.indd 283 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

THE SPECIFICITY RULE AGAIN

To get a better grip on the links between trade and the environment, we must first

revisit some key points of microeconomics. Environmental effects such as pollution

call for special policies or institutional changes if, and only if, they are what econo-

mists call externalities. An externality exists when somebody’s activity brings direct costs or benefits to anybody who is not part of the marketplace decisions to

undertake the activity. 2 If your activity imposes a direct cost on somebody who has

no impact on your buying or selling, he bears an external cost. If your activity brings

him a direct benefit without his participation, he receives an external benefit.

Also recall that whenever an externality exists, there is a distortion, caused by a gap

between private and social costs or benefits. Where there are distortions, a competitive

market, in the absence of government policy, results in either too much or too little of

the activity because the decision-makers consider only the private costs and benefits

of their actions, not the full social costs and benefits.

Pollution is an externality that imposes an external cost on people who do not have

any say over the pollution. That is, the social costs of production or consumption of

the product are larger than the private costs that are recognized by the people in the

market who make the decisions about producing and consuming. Social marginal cost

( SMC, which includes the marginal external cost of the pollution) exceeds private marginal cost ( MC, which does not include the marginal external cost). In the com- petitive market, price ( P ) equals private marginal cost and private marginal benefit ( MB ). If there are no external benefits, then private marginal benefit is the same as social marginal benefit ( SMB ). The distortion is that SMC > MC 5 P 5 MB 5 SMB . Because some social costs are ignored by market decision-makers, too much of the

activity (production and/or consumption) occurs. For the last unit, the social cost of

this unit exceeds the social benefit ( SMC > SMB ). This last unit is inefficient, and any other units for which SMC exceeds SMB are also inefficient. By adding more to social cost than they add to social benefit, these last units lower well-being for the society.

Because an externality leads to sub-par performance of a market, there is a role for

government policies to enhance the efficiency of the market. The specificity rule is a

useful policy guide. The specificity rule says to intervene at the source of the prob- lem. It is usually more efficient to use the policy tool that is specific to the distortion

that makes private costs and benefits differ from social costs and benefits.

If, for example, an industry is causing acid rain by discharging sulfurous com-

pounds into the air, the best approach is a policy that restrains the discharge of the

sulfur compounds themselves. That is usually better than, say, taxing electrical power

because this latter approach would not send the electric companies the signal that

2The definition refers only to “direct” effects on others so as to exclude effects transmitted through prices. If people decide to smoke fewer cigarettes, their not polluting the public air reduces an externality—the external cost to those whose pleasure and health might be hurt by the smoke. But if the switch to nonsmoking drops the price of cigarettes, we will not call the implications of that price drop externalities. So externalities do not include the income losses to tobacco companies, the possibly lower wages for tobacco workers, the lower land values in tobacco-raising areas, and so on. Those are just market-price effects, not (direct) externalities. (We stick to this definition even though Alfred Marshall tried to confuse us by calling such market-price effects pecuniary externalities.)

284 Part Two Trade Policy

pug21774_ch13_275-308.indd 284pug21774_ch13_275-308.indd 284 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

the problem is their emissions of sulfurous compounds. Even worse would be more

indirect measures like cutting down on all economic growth or all population growth

to reduce the emissions.

There are several ways for a government to attack the externality directly. Two

leading strategies represent different beliefs about the proper role of government in

our lives:

• Use of government taxes and subsidies . The government could tax private parties to make them recognize the external costs that their actions (e.g., pollution) impose

on others. (Correspondingly, it could pay them subsidies to get them to recognize

the external benefits their actions give to others.)

• Changing property rights so that all relevant resources are somebody’s private property. If somebody owns a resource, including even the right to pollute it, then

what she decides to do with it depends on what others offer to pay for that resource.

If she chooses to pollute (or to deplete the resource), it is because she was not offered

enough by others to avoid pollution (or depletion). There is a new market for the

private property, a market whose absence caused the externality in the first place.

Different as these two approaches are, they are both valid ways to attack an external-

ity. Sometimes one is more practical, sometimes the other. In our discussions, we will

often use the tax-and-subsidy approach, but we should keep in mind that the same

efficiency-enhancing outcome could sometimes be achieved using the property-rights

approach.

A PREVIEW OF POLICY PRESCRIPTIONS

Following the specificity rule, we can develop general guidelines for solutions to inter-

national externalities. If we could choose any kind of policy measure whatsoever, the

specificity rule would take us on the most direct route: If the externality is pollution in

some place, make the pollution itself more expensive; if resource depletion is exces-

sive, make the depletor pay more. Often, though, we cannot hit the exact target, the

externality itself. Often the only workable choices are policies toward some economic

flow near the target, such as production, consumption, or trade in products related to

the externality. What then?

When we have to choose between doing nothing and intervening in product mar-

kets related to externalities, as a substitute for controlling the externalities directly, we should follow guidelines like those summarized in Figure 13.3 .

Figure 13.3 contains two sets of best-feasible prescriptions: one for the whole

world acting as one government and one for a single nation unable to get cooperation

from other governments. These represent the two extremes in international negotia-

tions over issues like pollution or natural-resource depletion: The greater the scope for

international cooperation, the more relevant is the column of prescriptions for a world

with a single government. The more hopeless it is to gain cooperation, the more we

must settle on the single-nation prescriptions in the right column.

If nations cooperate, as if they formed a single world government, there would be

essentially no role for international trade policy. In the best of worlds, government would

Chapter 13 Trade and the Environment 285

pug21774_ch13_275-308.indd 285pug21774_ch13_275-308.indd 285 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

If the Whole World Had Only One Best Product- Source of External Costs Government, Its Market Policy (e.g., Pollution) Harming Best Product-Market for Our Nation Our Nation Examples Policy Would Be Acting Alone

Just our own production Chemicals Tax our production Tax our production (as in Figure 13.4) Just foreign production Acid rain across borders; Tax foreign production Tax our imports tuna and dolphins; ivory World production CO

2 buildup from fossil Tax world production Tax our production

fuels (or consumption) and imports Just our own consumption Tobacco, narcotics Tax our consumption Tax our consumption Just foreign consumption Mercury (used in small-scale gold mining) Tax foreign consumption Tax our exports World consumption CFCs Tax world consumption Tax our consumption (or production) and exports

FIGURE 13.3 Types of Externalities and Product-Market Prescriptions

Note: Tax here means “impose government restrictions.” These could be taxes, quantitative limits, or outright prohibitions. Remember that only “best product-market policy” interventions are considered here. In many cases, a more direct approach would tax an input

or specific technology (e.g., use of high-sulfur coal or fuel-inefficient automobiles) rather than the final product (e.g., electricity from

power plants or road transportation). And in other cases, an optimal policy might manipulate more than one product market at once.

devise a way to tax the activity of pollution itself, to translate its concern about pollution

into direct incentives. In the one-world-government column of Figure 13.3, the recom-

mended policies are one step away from taxing pollution itself, taking the form of taxes

on production or consumption. They are not taxes on exports or imports. This is because

pollution and other externalities seldom arise from trade as such. The specificity rule

accordingly calls for taxes near the source of the pollution, and taxes on production or

consumption are closer to that target than taxes on international trade are. 3

If one nation must act alone, trade barriers can be an appropriate second-best solu-

tion. That would happen if our nation suffered from transborder pollution, either from

foreign production (e.g., foreign producers of our imported steel causing acid rain in

our country) or from foreign consumption (e.g., foreign cars burning our exported

gasoline upwind from our nation). In this situation, the only way that our nation can

discourage the foreign pollution is by taxing imports of the products made by a pollut-

ing process (e.g., foreign steel) or by taxing exports of products that generate pollution

when consumed (e.g., gasoline).

The rest of the chapter takes up discussion of each of three types of sources of

external costs noted in Figure 13.3. First we look at issues when the external costs are

ones we impose on ourselves—domestic pollution and similar national externalities.

3It may seem suspicious that Figure 13.3 mentions raising taxes but not lowering them or giving out subsidies. The reason is simply that the cases listed here are all cases of negative externalities, the kind that do harm and must be reduced by taxing the polluting activities. If Figure 13.3 had dealt with the mirror-image cases, in which there were external benefits rather than costs, it would have recommended lower taxes or subsidies.

286 Part Two Trade Policy

pug21774_ch13_275-308.indd 286pug21774_ch13_275-308.indd 286 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

Then we analyze cases in which the activity of another country imposes an external

cost on our country—transborder pollution and similar cross-country externalities.

Finally, we examine the challenges of global external costs—global pollution and

similar worldwide externalities.

TRADE AND DOMESTIC POLLUTION

Economic activities sometimes produce significant amounts of domestic pollution (or similar environmental degradation). That is, the costs of the pollution fall only (or

almost completely) on people within the country. If there are no policies that force market decision-makers to internalize these external costs, then we reach two surpris- ing conclusions about trade with domestic pollution. First, free trade can reduce the well-being of the country. Second, the country can end up exporting the wrong prod- ucts; it exports products that it should import, for instance.

To see this, consider the case of an industry whose production activity creates sub-

stantial pollution in the local rivers, lakes, and groundwater. For instance, consider the

paper-making industry in a country like Canada. It is very convenient for paper com-

panies to dump their chemical wastes into the local lakes, and the firms view this as a

free activity (if the Canadian government has no policy limiting this kind of pollution).

The Canadian companies are happy that the lakes are there, and the firms’ operations

thrive, producing profits, good incomes for their workers, and good products for their

customers at reasonable prices.

Other Canadians have a different view, of course. Having the lakes turn brown with

chemical waste spoils the scenery, the swimming, the fishing, and other services that

they get from their lakes. The dumping of wastes into the lakes imposes an external

cost on other users of the lakes.

The top half of Figure 13.4 shows the Canadian market for paper, with the domestic

supply curve reflecting the private marginal cost of production and the domestic

demand curve reflecting the private marginal benefits of paper consumption (which

are also the social marginal benefits if there are no external benefits). The bottom half

of Figure 13.4 shows the additional costs imposed on the country by the pollution

that results from production of paper in the country. We keep track of this negative

externality using the marginal external costs (MEC) of the pollution. (This figure

is the analog of Figure 10.2, which showed the case of external benefits.) To keep

the analysis simple, we assume that the external cost of the pollution is constant at

$0.30 per ream of paper.

With no international trade (and no government policies limiting pollution), the

paper market clears at a price of $1 per ream, with 2 billion reams produced and

consumed per year. Because there is no recognition in the market of the cost of the

pollution, this is overproduction of paper.

Consider the shift to free trade, with an international price of $1.10 per ream (and

still no government policies limiting pollution). Domestic production expands to

2.3 billion reams, domestic consumption declines to 1.8 billion, and 0.5 billion reams

are exported. For the case shown in Figure 13.4, free trade unfortunately makes the

country worse off. The usual gain from trade is shown by the shaded triangle a in the

Chapter 13 Trade and the Environment 287

pug21774_ch13_275-308.indd 287pug21774_ch13_275-308.indd 287 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

When domestic production causes pollution that imposes an external cost on the country, we find

several surprising results about trade. If the government has no policy limiting this pollution, then

domestic firms ignore the marginal external costs (MEC) of their pollution and operate along the

supply curve S d . If the world price is $1.10, then the country exports 0.5 billion reams of paper. In

comparison with no trade, the country may be worse off, as it is here (gain of the shaded triangle

a in the top of the figure, but loss of the shaded rectangle b in the bottom). The country may also export the wrong products. Here it would be best if the country actually

imported 0.4 billion reams. That would happen if a $0.30 tax, equal to the MEC, made domestic

producers operate along the supply curve S d + $0.30, which reflects all social costs.

Quantity (billion reams per year)

Price ($ per ream)

0 2 2.31.4 1.8

2 2.3

MEC

1.00 1.10

Marginal external costs from domestic production ($ per ream)

0 0

0.30

e a

Sd � $0.30

FIGURE 13.4 When Domestic Production Causes Domestic Pollution

288 Part Two Trade Policy

pug21774_ch13_275-308.indd 288pug21774_ch13_275-308.indd 288 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

upper graph, a gain of $25 million. But the extra production brings pollution that has

an extra cost of the shaded area b in the lower graph, an external cost of $90 million ($0.30 per ream on the additional 300 million reams produced). Free trade reduces the

well-being of the country by $65 million.

The country’s government could avoid this loss by prohibiting exports of paper.

But we know from the specificity rule that this is not the best government policy. The

best policy attacks pollution directly, for instance, by placing a tax on pollution from

paper production. If there is no way to reduce pollution per ream produced, then the

tax should add $0.30 per ream to the firms’ cost of production. The tax forces the firms

to recognize the cost of pollution, and it alters their behavior. The domestic supply

shifts up by the amount of the tax, to S d + $0.30. This new supply curve now reflects

all social costs, both the private production costs and the external pollution costs.

If this government policy is in place, what happens with free trade? Domestic

consumers still buy 1.8 billion reams of paper, but now domestic producers supply

only 1.4 billion reams. As shown, it is actually best for the country to import paper,

not export it. Because the new supply curve (with the $0.30 tax) includes the external

cost of pollution, we can read the effects of trade on the country from the top half of

Figure 13.4, without referring to the bottom half. We find the usual triangle of gains

from importing, the shaded triangle e . From this example we see that pollution that imposes costs only on the local

economy can still have a major impact on how we think about international trade.

With no government policy limiting pollution, the country can end up worse off with free trade, and the trade pattern can be wrong. In the case of pollution caused by

production that we examined, the country exported a product that it should instead

import. (If, instead, the pollution cost is not so high, then the problem is that the

country exports too much.) 4

The country can correct this type of distortion by using a policy that forces polluters

to recognize the external cost of their pollution. In our paper example, the government

used a pollution tax, but instead it could establish property rights. For instance, people

could be given the right to the water. Polluting firms then must pay the owners for

the right to pollute. Or a limited number of rights to pollute could be created by the

government, so that firms need to buy these rights if they want to pollute.

If domestic firms must pay the pollution tax (or pay for the right to pollute), they

probably will not be happy. The pollution tax raises their production costs, and they

produce and sell less. In addition, they face competition from imports at the world price

of $1.10. Even if they accept the reason for the pollution tax, they may still complain

about the imports. If other countries do not impose a similar pollution tax on their

producers, then the domestic firms often complain that the imports are unfair. They

claim that the lack of foreign pollution controls is a form of implicit subsidy, or that the

foreign firms are engaged in “eco-dumping” based on lax foreign government policies.

What are we to make of these complaints? Should the country impose countervailing

duties on imports from a country with different pollution policies? From the national

4What can happen if pollution is caused by consumption, not production? In this case the country tends to consume too much of the product, so the country could import a product that it should instead export (or, at least, it imports too much of the product).

Chapter 13 Trade and the Environment 289

pug21774_ch13_275-308.indd 289pug21774_ch13_275-308.indd 289 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

perspective of the importing country, the answer is generally no. Foreign production may

create pollution in the foreign country, but this has no impact on the importing country if

the costs of this foreign pollution affect only foreigners. As with many other complaints

about unfair exports, the best policy for the importing country is simply to enjoy the

low-price imports. Indeed, under the rules of the World Trade Organization, lax foreign

pollution policies are not a legitimate reason for imposing countervailing duties.

From the perspective of the whole world, it depends on why the foreign pollution

policies are different from those of the importing country. It may be efficient for the

foreign country to have different, and perhaps more lax, pollution policies. The pol-

lution caused by foreign production may not be so costly because the foreign produc-

tion itself creates less pollution, the foreign environment is not so badly affected, or

foreigners place less value on the environment. In our paper example, the production

process or the raw materials used in foreign production may create less pollution. Or

the foreign country may have larger water resources or rainfall, in which case the pol-

lution is not so damaging because the foreign environment has a larger “assimilative

capacity.” Or the foreign country may assign a high value to producing income to

purchase basic goods because its people are poor and are therefore willing to accept

some extra pollution more readily.

On the other hand, the foreign country may simply have policies that are too lax.

From the point of view of the foreign country and the world, it would be better if it had

tougher pollution policies. As a type of second-best approach, import limits by other

countries can improve things. But these limits will not make the importing country

better off, even though the limits might raise world well-being.

TRANSBORDER POLLUTION

In the previous section we considered pollution that had costs only to the country

doing the pollution. While we reached some surprising conclusions about free trade

in the absence of government policies limiting pollution, we also had a ready solution.

The government should implement some form of policy addressing pollution that is

occurring in its country. If each country’s government addresses its own local pol-

lution problems, then each can enhance its own national well-being. In the process,

world well-being is also raised.

However, many types of pollution have transborder effects—effects not just on the

country doing the pollution but also on neighboring countries. Examples include air

pollution like particulates and sulfur dioxide that drifts across national borders and

water pollution when the body of water (river or lake) is in two or more countries.

Transborder pollution raises major issues for government policies toward pollution. Suppose that a German paper company builds a large new paper mill on the Danube

River, just to the west of where the river flows into Austria. It is very convenient for

the paper company to dump its chemical wastes into the river, and it views this as a

free activity (if the German government has no policy limiting this kind of pollution).

Austrians have a different view. The dumping of wastes into the German Danube

imposes an external cost on the Austrians and others (Slovaks, Hungarians, Serbs,

Romanians, and Bulgarians) downstream.

290 Part Two Trade Policy

pug21774_ch13_275-308.indd 290pug21774_ch13_275-308.indd 290 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

The Right Solution Figure 13.5 shows how we can determine the “right” amount of pollution, the

amount that brings the greatest net gain to the world as a whole. 5 The figure focuses

directly on pollution, without also showing the supply and demand for paper. It por-

trays Germany’s benefits and Austria’s costs from different rates of dumping waste

into the Danube by the German paper mill. If left to itself, the German mill dumps as

much as it wants into the Danube, ignoring the costs to Austria (and other nations).

It will pollute until there is no more that it wants to dump at zero cost. That will

be at point A , with the paper company dumping 180 million tons of waste per year. Point A is a disaster in Austria, where the river damage rises along the marginal cost curve in Figure 13.5.

Point A is also inefficient from a world perspective. Any pollution beyond 80 million tons is inefficient—it does more damage than it benefits the paper company. In the

figure any waste dumping above 80 million tons has marginal costs that are above the

marginal benefits. For instance, while the last few tons dumped bring the German firm

almost no extra benefits (perhaps because these would be easy to avoid or clean up),

these last few tons cost the Austrians about 700 euros per ton.

But, looking at it from the other side, we see that a total ban on dumping into the

Danube would also be a mistake in this situation. The total ban, if effectively enforced,

would force the paper mill to point F . Downstream users would be delighted, of course,

5Here, as in other chapters, the interest of the “world as a whole” is the sum of net gains to all parties, with each dollar (or euro) of gain or loss worth the same regardless of whose gain or loss it is. That is, we continue to follow the one-dollar, one-vote metric introduced in Chapter 2. To reject it, we would have to have another set of welfare weights, considering a dollar or euro of gain to the German firm to have a different value from the same value of gain or loss to Austrians.

If there are no limits on pollution, then the German firm dumps 180 million tons. If the

countries could negotiate the best solution, the pollution would be limited to 80 million tons.

Millions of tons of chemical waste dumped by the German

paper mill each year

Euros (per ton)

720 F

Germany’s marginal benefits from dumping waste in the Danube

400

180

Marginal costs of waste dumping (loss of river services in Austria, etc.)

FIGURE 13.5 A Classic Case

of International

Pollution with

an Ideal Policy

Solution

Chapter 13 Trade and the Environment 291

pug21774_ch13_275-308.indd 291pug21774_ch13_275-308.indd 291 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

to have the river clean. But the complete cleanup costs more than it is worth. That

is, allowing the first ton of pollution each year is worth 720 euros to the paper com-

pany (perhaps because it is very costly to capture the last small amounts of waste for

alternative disposal). Yet downstream users lose only 60 euros of extra enjoyment and

income (at point C ). The downstream cost of the first ton of pollution is not that high, probably because the river can assimilate this small amount of pollution without much

damage. From a world viewpoint, the first ton of pollution should be allowed.

If Figure 13.5 correctly portrays the marginal benefits and costs, pollution up to

80 million tons adds to world well-being because the benefit to Germany from using

the Danube for its waste is greater than the costs imposed on Austria. The paper com-

pany should be allowed to dump waste up to 80 tons per year, but no more than that.

At point B , the benefits of using the river as a drain for wastes stop exceeding the costs of doing that. However offensive the idea may be to those who love clean water

and don’t buy much paper, the economist insists that 80 million tons, not zero tons (or

180 million tons), is the “optimal amount of pollution” in this situation. 6

To get the right solution, something must be done to make the German paper com-

pany recognize the costs of its pollution, and this something cannot be too drastic. The

specificity rule indicates that the best government policy is one that acts directly on

the problem. A government can use the tax/subsidy approach to guide the use of the

Danube to the optimal point B , if the government has good estimates of the marginal costs and benefits of the pollution. For instance, the government can tax the paper

company 400 euros for every ton it dumps into the river. The company will respond

by dumping 80 million tons a year (at point B ) because up to that 80 millionth ton the company’s gain from putting each extra ton of waste in the river exceeds the 400-euro

tax. An efficient balance would be struck between the competing uses of the river.

A pollution tax like the one just described could well happen if “the government”

were the Austrian government. But here the problem becomes international. Austria

has no direct tax power over a paper mill in Germany, except to the extent that the

mill happens to do business in Austria. More likely, the tax/subsidy option is in the

hands of the German government because the paper mill is on the German side of

the border. Germany might not tax the paper mill at all. Dumping 180 tons a year

(at point A again) brings greater national gains to Germany than the world-efficient pollution tax at point B .

The likelihood that one country would decide to go on imposing an excessive exter-

nal cost on other countries is a setback for the economist seeking global efficiency.

To the efficiency-minded economist, it would not matter how we got to point B as long as we got there. But the German government has no incentive to tax the German

company for its pollution.

We can imagine another way, assigning property rights, to try to get the efficient

solution. A World Court could rule that the Danube is the property of the German

paper company (or the German government) and that Austria must pay the German

company to reduce its pollution. Or the World Court could rule that the Danube

belongs to Austria and that the German company must buy the right to pollute for

6At point B, allowing 80 million tons of pollution (instead of none) brings the world a net gain of area BCF, or (1/2) 3 (720 2 60) 3 80 5 26.4 billion euros per year.

292 Part Two Trade Policy

pug21774_ch13_275-308.indd 292pug21774_ch13_275-308.indd 292 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

each ton it dumps. The Nobel Prize–winning economist Ronald Coase pointed out

that either court ruling could result in the same amount of pollution, as long as the property rights could be enforced. If the German company owned the river, the

Austrian users would be willing to pay 400 euros per ton to reduce pollution to

80 million tons, and the German firm would agree to reduce its pollution to this

level. If Austria owned the river, the German firm would be willing to pay 400 euros

per ton for the right to dump 80 million tons, and the Austrians would accept this

offer. Who gets the money depends on who owns the river, but in either case the

same amount of pollution results.

This private-property approach has a major problem, however, when it comes to

international disputes. There is no supreme world court that can enforce a property

claim of one country’s residents in another country. Austrians have no real legal

recourse if the German paper mill insists on discharging all its wastes into the Danube.

The Austrian government could threaten to take retaliatory actions against Germany.

But it is unlikely that Austria would hold the right kind of power to force Germany to

cooperate on the specific issue of the paper mill and the Danube if the Germans did

not want to cooperate. The result is likely to be inefficient. 7

We therefore get the same striking results for either the tax/subsidy approach or the

property-rights approach. The good news is that any of several arrangements could give us the efficient compromise solution to the transborder pollution problem (at

point B ). The bad news is that the two countries often would not reach that efficient solution. Instead, negotiations would break down and each country would do as it

pleased in its own territory. The result could be costly rampant pollution, as at point A , if the polluting firms can do as they please.

A Next-Best Solution If international negotiations fail, the Austrian government must still consider what it

can do on its own. If an international agreement is not possible, what can the govern-

ment of the country that is being harmed by the other country’s pollution do? It cannot

tax or restrict the pollution-creating activity in the other country directly. But it may be

able to have some influence by adopting policies toward international trade.

In our example, let’s say that Austria imports paper from Germany and that Austrian

paper production does not create much pollution (or this pollution is controlled by

appropriate Austrian government policies). The Austrian government could attempt to

reduce the dumping of waste into the Danube by limiting its imports from Germany

(or, if possible, from the specific firm whose factory is responsible for the pollution).

7As it happens, the German–Austrian case is relatively benign in real life because Germany does care greatly about good relations with Austria, and both are members of the European Union. Yet the question “Whose river is it, anyway?” is destined to arise more and more often. Here are some examples: (1) Turkey has upstream control of the Euphrates, a vital resource for Syria and Iraq. (2) The potential for rising conflicts among China, Pakistan, and India over the waters of the Indus River system. (3) If the eight upstream nations use the Nile more intensively, there will be consequences for Egypt. (4) The Zambezi River will be the focus of disputes as Zambia, Angola, Botswana, Zimbabwe, and Mozambique construct dams to support irrigation projects. (5) Several drought-prone nations, most notably Mali and Niger, compete for the waters of the Niger River upstream from Nigeria. (6) The dams that have been built and the dams that are proposed could dramatically alter the flow of the Mekong River, affecting China, Myanmar, Thailand, Laos, Cambodia, and Vietnam.

Chapter 13 Trade and the Environment 293

pug21774_ch13_275-308.indd 293pug21774_ch13_275-308.indd 293 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

If the decline in German paper exports reduces German paper production, then this also

reduces the amount of waste that is dumped into the Danube. Austria gives up some

of the gains from importing paper—that is, Austria suffers the usual deadweight losses

from restricting imports. But Austria can still be better off if the gain from reducing

the costs of the river pollution exceeds these usual deadweight costs. If instead Austria

exports paper to Germany, then the Austrian government should consider subsidizing

paper exports to Germany. The increase in Austrian exports can reduce German import-

competing paper production, again leading to less dumping of waste.

There is a major problem with this indirect approach to addressing transborder

pollution. The rules of the WTO generally prohibit the Austrian government from

increasing its import tariffs or subsidizing its exports. Although, as we have seen, the

rules also offer exceptions for measures intended to protect the environment, the WTO

interprets this exception narrowly. So the WTO probably would not permit Austrian

use of trade policy in response to lax German environmental policies.

NAFTA and the Environment Environmental problems along the Mexico–U.S. border provide a real case of the

challenges of transborder pollution. This issue was prominent in the fight over approv-

ing the North American Free Trade Agreement (NAFTA), adding to the concerns

already discussed in the previous chapter, and it remains contentious in evaluations of

the effects of NAFTA.

Mexico has a strong set of environmental protection laws and regulations on the

books, comparable to those of the United States. But Mexican enforcement of these

is weak. Weak enforcement is not surprising, and it is not only the result of limited

administrative resources. Popular demand for clean air and water is a normal good.

Nations feel they can afford to control many pollutants only when GDP per capita has

reached high enough levels. Mexico has sacrificed air and water quality for economic

development. Mexico City’s smog is as bad as any in the world.

For the United States, a major concern is the pollution emanating from the Mexican

side of the Mexico–U.S. border. The environmental problems in the border region

arose well before NAFTA. In the 1960s, the governments of Mexico and the United

States encouraged growth of industry just south of the border, where businesses could

assemble goods for reentry into the United States without the usual tariffs and quotas.

The arid border is not a forgiving place for a large industrial population. The absence

of infrastructure for the several thousand maquiladora firms producing on the Mexican side, and the millions of people attracted by the jobs available, became (and remains)

all too obvious. U.S. critics can point to unmanaged hazardous wastes, soil erosion, air

pollution, raw sewage and other water pollution, lack of organized rubbish disposal,

and lack of clean drinking water. While the pollution is most severe on the Mexican

side of the border, major damage also affects the American side. Coal-fired power

plants in northern Mexico cause serious air pollution in Texas, and Mexican water pol-

lution is fouling the Rio Grande, a prime source of water for many U.S. towns.

Critics of NAFTA argued that freer trade would yield more environmental damage

in the trade-oriented maquiladora zone, and they recommended rejecting NAFTA. In response to these criticisms, a side agreement on environmental issues was attached to

NAFTA. It established a commission to investigate complaints about failure to enforce

294 Part Two Trade Policy

pug21774_ch13_275-308.indd 294pug21774_ch13_275-308.indd 294 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

national environmental laws. It set up the North American Development Bank, owned

by the U.S. and Mexican governments, to fund cleanup projects. Mexico also prom-

ised to enforce its environmental standards more effectively. With these additional

provisions, environmental lobbying groups were actually divided about approving the

final version of NAFTA.

What have been the effects since NAFTA began in 1994? NAFTA has not led to a

decline in environmental standards in the United States, and it has not made Mexico

a “pollution haven” for dirty industries, as some opponents had feared. But the insti-

tutions set up by the side agreement have had limited effects. The commission can

investigate, but it has no power to mandate enforcement. It appears to have had little

impact on Mexican enforcement of its environmental laws, which remains weak. The

bank got off to a slow start, with few projects during its first five years. Since 1999 it

has become more active, so that by December 2013 it had approved total funding (both

loans and grants) of about $2.25 billion, although only half is to projects in Mexico,

where the major problems exist. The projects supported have prevented conditions

from deteriorating further, especially as population and business activities in the

border area continue to grow. But, as Hufbauer and Schott (2005, p. 62) observe, the

bank’s project funding “still remains far below levels that would perceptibly improve

border environmental conditions.”

NAFTA has engendered a spirit of cooperation between the U.S. and Mexican

governments, but the two countries still do not share the same views about the impor-

tance of ameliorating environmental damage. The environmental problems along the

Mexico–U.S. border show how difficult it can be to address transborder pollution.

GLOBAL ENVIRONMENTAL CHALLENGES

Our discussion of transborder pollution focused on cases in which one country’s

activities impose external costs on neighboring countries. Things become even more

controversial when the whole world’s economic activities impose external costs on

the whole world. Two important global environmental challenges are depletion of

the ozone layer and global warming resulting from the buildup of greenhouse gases.

Other challenges also have a global dimension, especially those that involve extinction

of species or depletion of common resources such as fish stocks. We begin with an

overview of important concepts and then examine specific applications.

Global Problems Need Global Solutions Consider a global environmental problem like the depletion of the ozone layer caused

by human release of chemicals. As we will see when we look at this in more detail,

many types of activities release these chemicals, and the total of the global release

causes the depletion. The harm of ozone depletion has global effects, with some coun-

tries more affected than others.

What would each country do if it sets its own policy toward this problem? From

the purely national viewpoint, each country would recognize that chemical releases

have some negative effect on its people, and it might use a policy to limit releases if it

thought the national harm was large enough. But, for the whole world, total releases

Chapter 13 Trade and the Environment 295

pug21774_ch13_275-308.indd 295pug21774_ch13_275-308.indd 295 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

would be much too large. Each country would ignore the harm that its own releases

did to other countries, so it would not be sufficiently stringent with its own environ-

mental policy.

To get closer to the best global policy, the countries would need to find some way

to cooperate. Each would need to tighten its standards compared to what it would do

on its own. If each country does this, the whole world is better off. Many, but perhaps

not all, of the countries will also each be better off. Each country incurs some costs

in tightening its standards, but each also derives benefits from the reduction of the

environmental damage.

Still, it may be very difficult to reach this global agreement. One problem is that

there may be disagreement about the costs of the environmental damage or the costs

of tightening standards. Science is unlikely to provide a definitive accounting, and

countries differ in their willingness to take environmental risks. Even if this problem

is not so large, others are likely to arise. Countries that suffer net losses from tighten-

ing may be unwilling to take part, unless they receive some other kind of compensa-

tion. Even countries that gain from the global agreement have a perverse incentive.

A country can gain even more by free-riding. That is, it can gain most of the benefits

if other countries abide by the agreement to tighten standards, even if this country does

not, and it avoids the costs of tightening its own standards.

Because of the free-rider problem, a global agreement needs some method of

enforcement, to get “reluctant” countries to agree in the first place and to assure that

they abide by the agreement after it is established. There is no global organization that

can provide these enforcement services. Countries can establish an enforcement mech-

anism as part of the global agreement, but it is not clear what it should be. It is gener-

ally not possible to impose fines directly. One possible penalty is some kind of trade

sanctions to reduce the offending country’s gains from trade. Such sanctions also have

costs for the countries imposing the sanctions, and in any case they often do not work.

This is a sobering analysis. When an environmental problem causes only domestic

costs, it is up to the government of the country to address it. When the problem is trans-

border but regional among a small number of countries, it is more difficult but still may

be solvable by negotiations. When the problem is global, a global (or nearly global) mul-

tilateral agreement is needed, but negotiating and enforcing this agreement may prove to

be very difficult or impossible. To gain more insight, let’s turn to four global problems.

We begin with a fairly effective global agreement to use trade policy to prevent the

extinction of endangered species. Next we depict depletion of ocean fishing stocks and

the lack of effective solutions to this global inefficiency. Then we portray a successful,

nearly global agreement to reverse ozone depletion. We conclude with the most daunting

of global environmental issues: greenhouse gases and global warming.

Extinction of Species Extinction of species can be a natural process outside of human influence. Still,

within the past half century the specific role of human activity in causing extinction

has become recognized and controversial. There is a general belief that there is a loss

when a species becomes extinct, perhaps because there may be future uses for the spe-

cies (for instance, as a source of medicinal products). Thus, a global effort to prevent

extinction of species can be economically sensible.

296 Part Two Trade Policy

pug21774_ch13_275-308.indd 296pug21774_ch13_275-308.indd 296 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

Human activities contributing to extinction include destruction of habitat, intro-

duction of predators, and pollution. In addition, excessive hunting and harvesting

can also cause extinction. The specificity rule indicates that the best global policy

to preserve species would be a policy that promotes the species through such direct

means as protected parks and wild areas; ranching, cultivation, and similar manage-

ment intended to earn profits from the ongoing existence of the species; and zoos

and gardens to maintain species in captivity. While there is no global agreement

specifically to promote these best solutions, there is a global agreement that attempts

to control the pressure of international demand as a source of incentives for exces-

sive hunting and harvesting.

In 1973, over 100 nations signed the Convention on International Trade in

Endangered Species of Wild Fauna and Flora ( CITES ). With 180 member countries by 2014, CITES establishes international cooperation to prevent international trade

from endangering the survival of species. An international scientific authority rec-

ommends which species are endangered. Commercial trade is usually banned for

species threatened with extinction—about 900 species, including elephants, gray

whales, and sea turtles. To export these products for noncommercial purposes, a

nation must obtain an export permit from the central authority, and it must have

a copy of an import permit from a suitable buyer in a country that signed CITES.

Commercial trade is limited for an additional 34,000 species because free trade

could lead to the threat of extinction.

No CITES-listed species has become extinct as a result of international trade.

Some, including the rhino and the tiger, continue to decline, but CITES has probably

slowed the declines. Generally, CITES seems to be fairly effective. This is impressive

in that most member countries have incomplete national legislation, poor enforce-

ment, and weak penalties for violating the trade bans or controls.

Much of the conflict over endangered species centers on Africa, with its unique

biodiversity and its fragile ecosystems. The biggest fight so far has been over the fate

of the African elephant, which is hunted for its ivory tusks.

The human slaughter of elephants accelerated at an alarming rate in the 1970s

and 1980s. The African elephant population was cut in half within a span of only

eight years in the 1980s. The problem was most severe in eastern Africa, north of

the Zambezi River. The governments of Kenya, Tanzania, the Sudan, Zaire (now the

Congo), and Zambia, while ostensibly committed to protecting elephants, were not

preventing killing by poachers. The threat to elephants was weaker in southern Africa,

south of the Zambezi, for three reasons: The governments of Zimbabwe, Botswana,

South Africa, and Namibia enforced conservation more aggressively; agriculture was

less of a threat to the wild animal population; and some elephants of Botswana and

Zimbabwe had tusks of poor commercial quality.

In 1977, the African elephant was placed on the list of species with controlled

trade. Public pressure from affluent countries to save the elephants became intense

by the late 1980s. Although the African elephant did not fully meet the official

definition, in 1989 it was moved to the list of endangered species. Also in 1989,

most of the CITES countries signed a complete ban on exporting or importing ivory.

Education and information on the plight of the elephant reduced demand for ivory,

especially demand in affluent countries, and ivory prices plummeted from $100 per

Chapter 13 Trade and the Environment 297

pug21774_ch13_275-308.indd 297pug21774_ch13_275-308.indd 297 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

kilogram to $3 or $4 per kilogram in the 1990s. Poaching decreased (mostly a move-

ment down the poachers’ supply curve) and the elephant populations stabilized or

increased. However, demand for ivory rose in the 2000s, especially increased Asian

buying as incomes expanded there, and ivory prices rose to over $2,000 per kilo-

gram by 2012. Poaching has increased in some parts of Africa, and illegal trade has

increased.

Elephant numbers rose in the 1990s in the countries of southern Africa to such an

extent that these countries argued that they had too many elephants. In 1997 these

countries asked CITES to end bans for their elephants. They argued that they needed

some economic use of elephants to justify the costs of managing the herds. In 1992

CITES had adopted the principle of “sustainable use,” but CITES has moved very

cautiously. For the countries of southern Africa, CITES has permitted limited hunting

and a few sales of ivory.

CITES has generally been reasonably effective, but the situation of the elephant since

2000 shows the challenges facing CITES. First, a ban on exporting by itself restricts

legal supply, so it raises the world price and encourages poaching and illegal trade. The

ban works well only if it is coupled with a demand shift away from the animal. For a

while demand for elephants’ ivory did decrease, but demand has returned. Second, a ban

adversely affects the people and the governments where the animal lives. To preserve the

animal, it helps to make the animal valuable to the people who have other uses for the

land. Africa’s human population growth will bring more crop cultivation, and cultiva-

tion is simply incompatible with a roaming elephant population. Economic incentives

to keep the animals in the wild can arise from tourism and from hunting and harvesting.

If tourism is not enough, then the long-run solution probably is based on commercial

hunting and trade that are consistent with sustainable use. For many species the ultimate

success of CITES depends less on its precautionary bans and, paradoxically, more on its

ability to encourage economic management for commercial uses.

Overfishing The oceans, along with fish and other marine life, are one of the great global resources.

However, major problems can develop because no one actually owns these resources.

The world’s fish catch has been roughly flat since 1990. About a quarter of the earth’s

200 main fish stocks are overfished; sustainable catches could be larger if the stocks

were better managed. For most fish species, overfishing does not pose a threat of

extinction, but it does mean that populations are becoming smaller than they should

be. Why are we squandering this resource? What can we do?

We have here an example of the “tragedy of the commons.” With open access to

fishing and no ownership, the incentive of each fishing firm is to catch as many fish

as possible. There is no incentive to conserve. Even if one fishing firm did restrain its

catch to maintain the fish stock, others would simply increase their catch. So all fish

too much, and the fish stock declines. Rather than limiting their fishing industries,

governments often make matters worse by subsidizing them. The result is severe over-

capacity of fishing boats, perhaps twice as much ship tonnage as would be needed for

a sustainable fish catch.

With good management of fishing stocks, the world catch of fish could be 10 to

20 percent larger than it is now. But even single nations have trouble managing their

298 Part Two Trade Policy

pug21774_ch13_275-308.indd 298pug21774_ch13_275-308.indd 298 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

fishing activities. The fishing industry, with its overcapacity, pushes for lesser limits,

even if this is helpful only in the short run. Global or multilateral agreements could

enhance global fishing. But given the difficulty of negotiating and enforcing such

agreements, effective ones are rare. The World Bank and the Food and Agriculture

Organization (2009) estimate that the inefficiencies result in an annual global loss

of $50 billion.

CFCs and Ozone The 1940s brought new technologies for using chlorofluorocarbon compounds (CFCs)

in several industries. About 30 percent of CFCs came to be used in refrigeration, air-

conditioning, and heat pumps; about 28 percent in foam blowing; about 27 percent in

aerosol propellants; and about 15 percent in dry cleaning and other industrial cleaning

and degreasing. By the early 1970s, evidence had accumulated showing that CFCs and

the halons used in fire extinguishers, while not directly toxic, were depleting ozone

in the upper atmosphere. The chemical process is slow and complex. It takes 7 to

10 years for released CFCs to drift to the stratosphere, where their chlorine compounds

interact with different climatic conditions to remove ozone. By 1985, the now-famous

ozone holes were clearly detected in the stratosphere near the North and South Poles.

Stratospheric ozone is an important absorber of ultraviolet rays from the sun, and its

removal raises dangers of skin cancer, reduced farm yields, and climatic change.

In 1987, over 50 nations signed the Montreal Protocol on Substances that Deplete the Ozone Layer, and by 2014 the number of signatories had risen to 197 countries.

The signing parties agreed to ban exports and imports of CFCs and halons. After more

scientific evidence accumulated, most signatory nations agreed in 1990 to phase out

their own production of these chemicals by 2000, with later deadlines and interim

production limits for developing countries.

Note that the protocol called for outright bans and other quantitative limits, not a

pollution tax or polluting-product tax like those discussed in Figures 13.3 through 13.5.

The reason is that the scientific evidence suggested a steeply rising social-cost curve

for CFC emissions into the atmosphere. With the cost curve so vertical, it did not make

sense to use tax rates on a trial-and-error basis in the hope of achieving the large cut in

pollution. It was better to legislate the bans and limits from the start, without waiting

several years to see if some tax schedule had the right effects.

The Montreal Protocol is achieving much of the intended economic and environ-

mental effects. Concentrations of chlorine-containing compounds in the stratosphere

peaked and began to decline in 2000. Yet, because of the slow chemical process of

recovery, the ozone holes will remain for a long time; ozone concentrations in the

stratosphere will not return to normal levels until about 2070.

Why the success in this case? Why didn’t nations try to free-ride by refusing to

comply while demanding that others do so, as so often happens? Experts point to sev-

eral factors that eased the signing and enforcement of the Montreal Protocol:

• The scientific evidence was clearer about CFCs and ozone than it is about other

possible human threats to the atmospheric balance.

• A small group of products was involved, for which substitutes appeared to be tech-

nologically feasible with limited cost increases.

Chapter 13 Trade and the Environment 299

pug21774_ch13_275-308.indd 299pug21774_ch13_275-308.indd 299 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

• Production of CFCs was concentrated in the United States and the EU, and in a few

large publicity-conscious firms (mainly DuPont), so that agreement could be easily

reached and enforced.

• The same higher-income countries that dominated production and use of these

chemicals are also closer to the North and South Poles, so they expected to suffer

most of the environmental damage themselves.

Greenhouse Gases and Global Warming Finally, we turn to the most challenging environmental problem of all. Human activity

is raising the concentration of carbon dioxide (CO 2 ) and other greenhouse gases in the

earth’s atmosphere. Most climate scientists believe that the rise of these gases is causing a

pronounced warming of the earth’s climate through a “greenhouse effect.” The warming

could bring desertification of vast areas and could flood major coastal cities and farm areas

as it melts glacier ice and warms ocean water. It is hard to imagine a solution as clean

and workable as the Montreal Protocol’s phase-out of chlorofluorocarbons. The activities

that release carbon dioxide, methane, and other greenhouse gases into the atmosphere are

harder to do without than were CFC refrigerants and sprays. In addition, the damage from

adverse climatic change would be spread around the globe unpredictably and unevenly.

To see the available options, we should first clear the air, so to speak, by noting

some limits on the choices available. Three main points must be made at the outset:

(1) The scientific facts are not fully established, (2) three palatable solutions will fall short

of arresting the CO 2 buildup, and (3) international trade is not the cause or the cure.

First, the scientific facts about the greenhouse effect are less certain than the facts

about CFCs and stratospheric ozone. We do know that atmospheric concentrations of

CO 2 have risen by about 40 percent since 1750. The atmospheric concentrations con-

tinue to rise, and a reasonable estimate is that they will double during the 21st century

if we do nothing to limit emissions. Human activity, especially the burning of fossil

fuels, is the main source of the buildup.

The effects of the CO 2 buildup cannot be predicted precisely. We do know that there

is a greenhouse effect—in fact, it is crucial to keeping the earth’s surface and lower

atmosphere warm. From 1900 the earth’s average surface temperature has increased

about 0.9°C (1.6°F), mostly since 1980. Most forecasts are that temperatures will rise

by anywhere from 0.3°C to 4.8°C during the 21st century.

Even if the earth is getting warmer and CO 2 buildup is the main reason, the climatic

changes and economic effects cannot be predicted with certainty. Nonetheless, the

best available climate forecasts indicate that countries closer to the equator are likely

to experience more adverse climate change, with potentially large economic losses for

developing countries in Africa, South and Southeast Asia, and Latin America. Smaller

relative economic losses, or even possible gains, are expected for most industrialized

countries, China, Central and Eastern Europe, and Russia. Two areas that face a risk

of catastrophic losses are India (if there is major change in monsoon patterns) and

Europe (if the warming Atlantic current changes direction).

Scientific uncertainties do not justify doing nothing. The risks are real and indicate that

a path of taking out “insurance” makes sense. We do not need radical actions that risk

wrecking the world economy. We should move in the direction of cutting greenhouse-gas

emissions, with adjustments in the future as scientific knowledge improves.

300 Part Two Trade Policy

pug21774_ch13_275-308.indd 300pug21774_ch13_275-308.indd 300 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

Second, it must be understood that three relatively palatable policy changes will fall

far short of stopping the CO 2 buildup:

1. One desirable option is known as the “no-regrets” option. Let’s just remove all

those unwarranted subsidies to fossil fuel use, about $500 billion per year world- wide, subsidies that should have been removed anyway. Removing bad energy

subsidies would reduce, at most, no more than 10 percent of the emissions, and the

net global buildup of CO 2 would continue.

2. A second option would be to take CO 2 out of the atmosphere with afforestation, that

is, by stopping deforestation and reforesting previously cleared land. Unfortunately, a

mature forest does not absorb CO 2 from the atmosphere. It has achieved an equilib-

rium in which the absorption of atmospheric CO 2 by plant growth is approximately

canceled by the release of CO 2 from decaying plant matter. Only growth of new forests

absorbs CO 2 in significant degree. It would take perpetual growth of new forests equal

in area to all current U.S. forests to cut the CO 2 buildup by 20 to 25 percent. Forests

play much less role in the greenhouse-gas balance than does the burning of fossil fuels.

3. A third option that doesn’t work is to wait for depletion of the earth’s fossil fuels to

push up the price of energy to a point where we stop raising the global CO 2 levels.

Finite as planet Earth may be, there is no prospect of exhaustion, or even severe

scarcity, of fossil fuels in the next few decades. Earth contains so much oil, coal,

and other fossil fuels that our current fuel habits may exhaust our good air long

before they exhaust our cheap fuel supplies. To clean up the air, we must artificially

raise the price of fuel long before geology will do the job for us.

A third initial point is that international trade policy cannot be the best tool. If we

are to attack greenhouse-gas emissions near their source, we must attack either total

consumption or total production of fossil fuels, the main human source of greenhouse-

gas emissions. International trade in fuels is large, but well below half the total fuel

consumption. If we were to tax international trade as such, there would still be too

much substitution of one source for another to achieve a large global reduction in

emissions. If we relied on taxing international trade in fuels, fuel-importing countries

like the United States would substitute home supplies for imports, and fuel-exporting

countries like Mexico would divert their fuel from exports to home use.

Thus far, we have limited the search for solutions in three ways. First, scientific

uncertainty urges an “insurance” approach, somewhere in between doing nothing and

taking radical steps. Second, some hopes—the “no-regrets” reforms, afforestation, and

naturally rising fuel scarcity—fall short as cures for the CO 2 buildup. Finally, trying to

cut emissions by cutting international trade leaves too many options for substituting

home fuel use for traded fuel.

Kyoto Protocol What progress have we made in finding a more comprehensive way to address global

warming? Actual world agreements so far have not been effective. Industrial countries

committed in Rio de Janeiro in 1992 to keep their CO 2 emissions at 1990 levels, but

they failed to do so.

With the Kyoto Protocol, reached in late 1997, industrialized countries, which at that time accounted for about 42 percent of global greenhouse-gas emissions, agreed to cut

Chapter 13 Trade and the Environment 301

pug21774_ch13_275-308.indd 301pug21774_ch13_275-308.indd 301 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

their emissions. In the first phase, industrialized countries agreed to reduce annual emis-

sions to an average of about 5 percent below their 1990 levels by the years 2008–2012.

Developing countries refused to make any commitments, however. They argued that they

are poor and should not have to slow their economic growth. The Protocol came into

effect in 2005, but the United States and Australia decided against ratifying it. (Australia

subsequently signed on in late 2007, after an election changed the party in power.)

Each country with a required 2008–2012 emission level had to decide how to meet

its target. The European Union has taken the lead in using tradable rights to emit carbon

dioxide. This approach is a variation on the idea mentioned earlier in the chapter that

property rights can be used to address pollution problems, in this case using property

rights to pollute (rather than property rights to clean air). Each country allocates a lim-

ited number of rights to its individual firms that are the major sources of emissions. Then

the firms can trade among themselves, as some firms lower emissions and have rights to

sell, while other firms find that their emissions exceed their initial allocations and they

must buy additional rights. The market for the rights sets the price of emitting the pol-

lutant, in this case CO 2 . Trading in carbon emission permits, mostly through the EU’s

Emission Trading Scheme, reached $106 billion in 2010 before falling off as it became

clear that the EU would more than meet its target for an 8 percent emission reduction.

Even with the EU and some other industrialized countries meeting their targets

for reducing emissions during the first phase, the Kyoto Protocol did not accomplish

much. Worldwide, annual greenhouse-gas emissions increased by 39 percent during

1990–2010. Here are three major reasons that the Kyoto Protocol has had so little effect.

First, some other industrialized countries missed their targets. Canada committed

to reducing its emissions by 6 percent, but its emissions actually increased by about

20 percent. To avoid possible penalties, Canada withdrew from the protocol in 2011.

Australia committed to limiting its emissions increase to 8 percent, but its emissions

actually increased by about 30 percent. Japan committed to reducing its emissions

by 6 percent, but its own emissions were approximately unchanged. (Japan may still

meet its commitment by buying credits for, and thus effectively funding, projects that

reduced emissions in developing countries.)

Second, the United States, which accounted for about 20 percent of global greenhouse-gas

emissions in 1997, decided not to take part. In March 2001 President George W. Bush

indicated that the science was too uncertain for taking on such a costly process to reduce

U.S. emissions. He also stated that it was unacceptable that developing countries, espe-

cially China, had made no commitments. He indicated that the U.S. government instead

was urging voluntary actions by U.S. firms. Voluntary actions were not enough. Instead

of its Kyoto target reduction of 7 percent, U.S. emissions actually increased by about

10 percent.

Third, and most important, annual greenhouse-gas emissions by developing countries

increased dramatically, by 64 percent during 1990–2010. China’s annual greenhouse-gas

emissions tripled from 1990 to 2010, and China is now the largest emitter of greenhouse

gases, accounting for 23 percent of worldwide emissions in 2010.

A Global Approach At the 2012 United Nations climate conference, there were two developments. First, the

countries agreed to the second and final phase of the Kyoto Protocol, but the participat-

ing industrialized countries (without the United States and Canada) committed to modest

302 Part Two Trade Policy

pug21774_ch13_275-308.indd 302pug21774_ch13_275-308.indd 302 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

targets for their emissions in 2020, and Japan and Russia made no commitments. Second,

the countries set a goal to negotiate a new, broader treaty to replace the Kyoto Protocol.

Can we imagine a policy approach that would be much more effective? What would

it do, and how expensive would it be? Global problems require global solutions, and

long-term problems usually require long-term solutions. The solution to excessive

global warming should include the following elements:

• Economic incentives are used to encourage emission reductions.

• All countries are involved.

• The policy extends over decades.

Economic incentives are created by establishing a price for greenhouse-gas emissions,

to reflect their external costs. Pricing emissions encourages reductions in two ways.

First, with a cost now attached to emissions, the price of emission-intensive products

increases, and consumers react by buying less. Second, producers have the incentive to

look for technologies that generate fewer emissions per unit of product. Through both

of these effects, the policy spurs emission reductions at low cost. Pricing of emissions

can be achieved by a tax on emissions or by tradable rights to pollute such as those

used by the European Union to meet its obligations in the Kyoto Protocol.

All countries should be involved, for both effectiveness and efficiency. With no

policies restricting emissions (often called “business as usual”), emissions would con-

tinue to grow quickly in developing countries. There is no way to stabilize greenhouse

gases in the atmosphere at reasonable levels without the participation of developing

countries. Furthermore, the marginal costs of reducing emissions are generally lower in

developing countries because they often do not make use of the most energy-efficient

technologies and because they often rely heavily on coal to generate electricity. To

achieve reductions in global emissions at low cost, much of the reduction should occur

in developing countries.

The policies should be in place for a long time span because they should affect deci-

sions about investments in long-lived capital equipment and decisions about research

and development of new technologies that can lower future emissions. The price of

emissions in the future is a key input into these investment and research decisions.

A number of researchers have examined global, long-term policies toward

greenhouse-gas emissions. Let’s consider the results of one study, reported by the

International Monetary Fund in its April 2008 World Economic Outlook . The study examines several alternative policies, and we will look at the imposition of a tax on

carbon dioxide emissions at the same rate in all countries. 8

The global CO 2 tax would begin in 2013, at a rate of $3 per ton of CO

2 emissions,

and rises by about $3 per year, to a level of $86 per ton in 2040, and then rises some-

what more slowly to a level of $168 per ton in 2100. (To get a feel for what this means

for consumer prices, a tax of $86 per ton would result in an increase of about $0.80 in

the price of a gallon of gasoline.) The rising CO 2 tax is chosen for two reasons. First,

8The study also examines different types of global schemes that use tradable rights to emit. For the same path of reduction of global emissions, the global costs in terms of income loss are similar under a carbon tax and the different emission-rights schemes. The choice of scheme does matter for the effects on different countries’ national incomes.

Chapter 13 Trade and the Environment 303

pug21774_ch13_275-308.indd 303pug21774_ch13_275-308.indd 303 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

it avoids large, unnecessary disruptions in the early years. Second, it is calibrated to

achieve eventual stabilization of greenhouse-gas concentrations in the atmosphere at

about 550 parts per million, a level that is expected to result in a manageable rise in

average global temperatures. The policy results in annual emissions in 2100 that are

only 40 percent of current levels.

How expensive is this policy approach? That is, how much does it reduce conven-

tional measures of national income? The IMF study focuses on the effects in 2040, a year

that is within our lifetimes. Figure 13.6 summarizes what the IMF study sees for both

emissions and national incomes, contrasting starting values in the year 2010 ( just before

the CO 2 tax is enacted), the baseline values for the year 2040 (if no emissions policies are

adopted—“business as usual”), and the values for 2040 with the global CO 2 tax policy.

Here are some key points that we can take from the information in Figure 13.6.

First, in the absence of an emissions policy (the baseline), CO 2 emissions in 2040

are about 2.5 times the 2010 emissions, and much of the increase occurs in develop-

ing countries. Second, the CO 2 tax succeeds in restraining emissions, so that global

emissions levels would be somewhat lower in 2040 than they are in 2010. Much of

the effect of the tax is achieved by eliminating the growth of emissions in develop-

ing countries (other than Russia and Eastern Europe), with reductions in China being

especially large. There is also a substantial reduction of emissions by the United

States. Third, the emissions reduction is achieved at what seems to be a reasonable

cost. With no policies (the baseline), world income would be 2.45 times as large in

2040 as it was in 2010. With the emission tax, world income is 2.37 times as large.

Each country or region suffers some loss in national income, but, with the exception

of the larger loss in the OPEC countries, it is equivalent to a reduction of only about

0.1 percentage point per year in the average annual economic growth rate.

The IMF study and others like it show that we can address the problem of global

warming without imposing heavy damages on the global economy or on most if not

all individual countries, if we can harness long-term economic incentives to achieve

emissions reductions at low cost and if we can achieve participation by all countries

FIGURE 13.6 Carbon Tax to Stabilize Atmospheric Carbon Dioxide

*From burning of fossil fuels.

Source: International Monetary Fund, World Economic Outlook , April 2008, Chapter 4. The author is grateful for data provided by Natalia Tamirisa.

Annual CO 2 Emissions* Real Annual National Income

(gigatons) (U.S. $ trillions)

2040 2040

Country or Region 2010 Baseline With CO 2 Tax 2010 Baseline With CO

2 Tax

United States 6.2 11.0 3.5 12.0 25.7 25.1 Western Europe 3.7 5.4 4.4 10.5 20.9 20.4 Other industrialized countries 2.3 3.8 2.6 6.1 11.2 10.9 Russia and Eastern Europe 3.0 4.8 3.8 3.9 8.6 8.3 OPEC countries 1.4 3.6 0.8 1.0 2.9 2.3 Other developing countries 8.7 35.4 8.7 8.0 32.4 31.3 World 25.3 64.0 23.9 41.5 101.6 98.2

304 Part Two Trade Policy

pug21774_ch13_275-308.indd 304pug21774_ch13_275-308.indd 304 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

(or, at least, all of the large emitter countries). The economics are promising. Still, it

will be challenging to gain agreement from enough countries to negotiate and imple-

ment such a global approach to global warming.

Summary International trade is not inherently anti-environment, and the best solution to environ- mental problems is seldom one that involves trade policy. The rules of the WTO are

generally consistent with this application of the specificity rule. They permit countries to impose environmental standards on domestic production activities and on domestic

consumption activities (including environment-based product standards). The WTO also

offers limited environmental exceptions to its free-trade thrust. The WTO places strict

requirements on a single country that attempts to use trade policy to punish what the country

views as environmentally damaging production activities in other countries. The WTO

seems willing to accept trade limits that are part of multilateral environmental agreements.

Because environmental problems like pollution involve an externality, govern- ment policies are usually needed to get markets to be efficient. In fact, if a country’s

government fails to implement a policy to limit pollution, free trade may make a coun-

try worse off and the country may end up exporting the wrong products.

Transborder pollution is an example of an international externality, in which pro- duction (or consumption) activities in one country impose external costs on neighboring

countries. As with all external costs, the best solution is one that addresses the pollution

directly, by imposing a tax on the pollution or by establishing property rights (to water or

whatever is being polluted, or as limited rights to pollute). However, it is often challeng-

ing for the government of the country hurt by the pollution to gain the cooperation of

the government of the country doing the pollution. For instance, little progress has been

made in reducing environmental problems along the Mexico–U.S. border, even though a

side agreement to NAFTA established a commission and a bank for this purpose.

In some cases the environmental problem is global: Global production or consump-

tion is imposing a worldwide external cost. The best approach to a global environmen-

tal problem is a global cooperative agreement, but achieving one is usually difficult.

Often, there are differences of opinion about the size of the external costs or the

appropriate policies to adopt. Countries that suffer little or no harm have little incentive

to cooperate and impose costs on themselves. More generally, countries have an incen-

tive to free-ride on the efforts of others. Often an agreement has no real enforcement

mechanism. Trade sanctions provide a possible threat against countries that do not

abide by an agreement, but sanctions often do not work.

The chapter concluded with four examples of global environmental problems. Two

have been addressed by successful global agreements. An agreement ( CITES ) on using trade limits and trade bans to prevent the extinction of species has been fairly effective.

But the ultimate solution may well involve creating economic incentives for “sustainable

use’’ (the propagation and economic management of the previously endangered species),

as the discussion of elephants and ivory suggested. The global agreement on CFCs (the

Montreal Protocol ) has also been effective and should reverse the ozone damage over time. Success here seems to be based on clear scientific evidence, the rather small num-

ber of CFC producers, the availability of substitutes at reasonable cost, and the fact that

the major producing countries were also those likely to suffer the most damage.

Chapter 13 Trade and the Environment 305

pug21774_ch13_275-308.indd 305pug21774_ch13_275-308.indd 305 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

Two problems have not been addressed successfully. Because no one owns the

oceans and their resources, overfishing has led to declines in fish stocks. The large number of fishing firms and their political activity to resist limits have prevented

effective global agreements. Global warming as a result of the atmospheric buildup of CO

2 and other greenhouse gases is the most daunting global environmental problem.

Science does not provide full guidance on the magnitude of the problem and its likely

effects on different countries. All countries contribute to global emissions of green-

house gases. The Kyoto Protocol is an attempt to address the problem, but it has had little effect. A better economic approach to managing global warming would include

the pricing of emissions to provide economic incentives for achieving emission reduc-

tions at low cost, the involvement of all countries in the effort to reduce emissions, and

the extension of the policy over decades to encourage and guide long-term investments

and research.

Key Terms

Externality

Specificity rule

Transborder pollution

CITES

Montreal Protocol

Kyoto Protocol

Suggested Reading

Copeland and Taylor (2004) provide an excellent survey of trade and environment

issues. Esty (2001), Neumayer (2000), and Irwin (2009) present critical analyses of the

controversies. Brunnermeier and Levinson (2004) survey research on the pollution-haven

hypothesis. Kelly (2003) examines WTO dispute settlement rulings on environmental and

health issues. For appraisals of global environmental problems, see the series of studies,

World Resources Report, from the World Resources Institute. On NAFTA and the environment, see Hufbauer and Schott (2005, Chapter 3). On

greenhouse gases, see Chapter 4 of the International Monetary Fund’s April 2008 World Economic Report, Tamiotti et al. (2009), Organization for Economic Cooperation and Development (2009), Aldy et al. (2010), and Nordhaus (2013).

Questions and Problems

1. Does a rise in national production and income per capita tend to worsen or improve air

pollution, water pollution, and sanitation? Explain.

2. “One of the benefits of free trade is that it corrects the distortion caused by pollution.”

Do you agree or disagree? Why?

3. Which of the following probably violate the rules of the WTO?

a. A country’s government places a tax on domestic production to reduce pollution caused by this production.

b. A country’s government prohibits imports of foreign goods produced using production methods that would violate this importing country’s environmental protection laws.

c. A country’s government places a tax on domestic consumption of goods (both imported and domestically produced) to reduce pollution caused by this consumption.

d. A country’s government restricts imports of a good to reduce pollution caused by consumption of this good.

✦

306 Part Two Trade Policy

pug21774_ch13_275-308.indd 306pug21774_ch13_275-308.indd 306 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

4. Mining of metallic ores often causes harm to the environment in the area around the

mines. Some countries impose strict policies to limit the environmental damage caused

by this mining, but others do not. The mining companies in the strict countries complain

that this is unfair and ask for limits on imports of ores and metals from the lax countries.

As a government official interested in advancing the national interest in a strict country,

how would you evaluate the request of your mining companies?

5. Oil spills from oceangoing tankers are rare but bring huge damages to coastlines when

they occur within 200 miles of shore. Unfortunately, most tanker spills do occur on

or near coasts. Rank the following alternatives according to how efficient they are in

responding to the threat of oil spills. Explain your ranking.

a. Each nation with an endangered coastline should impose a tax on all imported oil, a tax that raises enough revenue to compensate for any oil-spill damages.

b. Each coastal nation should impose a tax on all domestically purchased oil, a tax that raises enough revenue to compensate for any oil-spill damages.

c. Oil-carrying companies should be legally liable for all damages, in the courts of the countries whose national waters are polluted by the spills.

d. Each coastal nation should intercept all oil tankers in national waters and charge them a fee that will cover the estimated costs of future oil spills.

e. We might as well save ourselves the expense of trying to prevent spills. They are just

accidents beyond the control of the shipping companies; they are part of the cost of

having coasts.

6. Consider the example of domestic pollution shown in Figure 13.4. Suppose that the

marginal external cost of the pollution is $0.05 per ream produced (instead of $0.30).

a. With this different MEC, does free trade make the country better off or worse off? b. To gain the most from trade, should the country export or import paper? How much?

7. Which of the following would do most to cut the global buildup of carbon dioxide over

the next 30 years?

a. Elimination of all subsidies to energy use. b. Restoration of the original tropical rain forest. c. A tax that rises to $86 per ton of emitted carbon dioxide, as described in this chapter. d. The trend toward rising fuel scarcity, caused by exhausting the world’s reserves of

fossil fuels.

8. Assume that the production of cement also produces a substantial amount of air

pollution and that a technology is available that can lower the pollution but with

somewhat higher production costs for the cement. Because of the availability of raw

materials in Lindertania, it produces large amounts of cement, and its exports supply

most demand in Pugelovia. But the air pollution from Lindertania’s production blows

into Pugelovia, causing a noticeable deterioration in Pugelovia’s air quality. Although

Lindertania suffers some harm itself from this air pollution, it does not now have any

policy to reduce the pollution. The Pugelovian government wants to address this air

pollution problem.

a. If the two countries’ governments cooperate, what is the best solution to address the problem? Explain.

b. If Pugelovia must come up with a solution on its own, what should the Pugelovian government do? Explain.

✦

Chapter 13 Trade and the Environment 307

pug21774_ch13_275-308.indd 307pug21774_ch13_275-308.indd 307 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

9. Use your no. 2 pencil to write down your views on this trade-and-environment

debate:

According to the Rainforest Action Network (RAN), a rain-forest wood called

jelutong is being logged at a dangerous rate in Indonesia. The reason is that pencil

makers recently shifted about 15 percent of their production from the more expensive

cedar wood to jelutong, saving $1 on every dozen pencils. The Incense Cedar Institute,

which represents three major companies growing cedar in the United States, echoes

the concerns of RAN about the threat to tropical rain forests. Speaking for the pencil

makers, executives of Dixon Ticonderoga explain that the jelutong wood in Indonesia

is not gathered from rain forests, but is planted and harvested on plantations.

What should be done about the use of jelutong wood in making pencils? Should

the government of Indonesia block the export of jelutong wood? Should the govern-

ment of the United States tax or prohibit jelutong imports? Defend your view. If you

feel you need more information than is given here, what extra information would be

decisive?

10. Draw a graph like the one in Figure 13.5, which shows the effects of transborder pol-

lution. There is no governmental agreement on how to control the pollution, so the

German firm is dumping 180 tons of waste into the river. There is free trade in paper,

and Austria imports paper.

Now Austria imposes a 30 percent tariff on paper imports, which reduces Austrian

imports of paper from Germany by 20 percent. As a result of imposing the tariff,

Austria suffers standard deadweight losses from the tariff equal to €5 billion. Also as

a result of the tariff, Germany produces less paper, and the German firm shown in the

graph reduces its dumping of waste by 10 percent.

a. Using your graph, show the effect on Austria of this change in the waste dumping. Calculate the euro value of the effect of the change in waste dumping on Austria’s

well-being.

b. Overall, including both the standard effect of the tariff (not shown in the graph) and the effect of the change in waste dumping, is Austria better off or worse off (than

it was before it imposed the tariff)?

11. Rhinoceroses are an endangered species. Worldwide, the number of rhinos has

decreased 90 percent in the past 50 years, to about 28,000. Since 1977, CITES has had

a ban on international trade in rhino parts. The most valuable part of a rhino is its horn,

which can be sold for prices that have risen to close to $14,000 per kilogram. Given

the very high price, illegal poaching, in which rhinos are killed for their horns, has

increased rapidly. Interestingly, if done properly, the horn of a rhino can be harvested

without killing the rhino, and the horn will grow back.

What challenges does CITES face in attempting to prevent international trade from

contributing to the extinction of the rhino?

12. Why did the Montreal Protocol succeed in limiting global emissions of chlorofluo-

rocarbons (CFCs), whereas the world has found it difficult to limit the emissions of

CO 2 ? What differences between the two cases explain the difference in outcome?

✦

308 Part Two Trade Policy

pug21774_ch13_275-308.indd 308pug21774_ch13_275-308.indd 308 10/29/14 7:16 PM10/29/14 7:16 PM

Final PDF to printer

Chapter Fourteen

Trade Policies for Developing Countries Much of the world’s attention focuses on the industrialized economies—especially the

United States, Japan, and the countries of Western Europe. The attention is not surpris-

ing, given that these areas produce over half of world output and an even greater share

of the supply of media services. Yet about 6 billion people (six-sevenths of the world’s

population) live in countries that are considered developing countries. One surprise is

how widely the fortunes of these developing countries vary. Some have succeeded in

developing and have experienced high growth rates. Others have experienced serious

economic declines.

Figure 14.1 summarizes the best available measures of growth rates in real gross

domestic product (GDP) per person for broad regions and for selected individual

countries. The first point shown by Figure 14.1 is that the average product per person

has grown faster in the developing countries than it has grown in the industrialized

countries since 1990. 1 Yet, even with such a growth advantage, it would still take more

1Following the global convention, we use the term developing countries to refer to countries with low to moderate levels of income per capita.

The choice of terms to describe countries with low income levels has changed constantly over the past century. The general pattern of evolution has been toward increasingly optimistic, or even euphemistic, terminology in official international discourse. In the mid-20th century commentators could still speak of rich and poor countries. Soon, however, neither the high-income nor the low-income countries would abide such a stark contrast. From the mid-1950s to the mid-1960s, it was generally acceptable to speak of underdeveloped countries or less developed countries. With time, however, even terms like these were viewed as condescending.

From the 1960s through the 1980s, another attractive alternative presented itself. The Third World was a handy and relatively judgment-free way to contrast the low- and middle-income countries of the noncommunist world with the high-income market economies (First World) and the communist bloc (Second World). But in 1989–1991 the Second World vanished with the breakup of the communist bloc and the Soviet Union. Without a Second World, what does Third World mean? These formerly communist countries became the transition economies, and they are now part of the set of developing countries.

Diplomatic practice has retreated to the relatively benign term developing country. Few are bothered by two curious implications of this term: (1) that the high-income “developed” countries are no longer developing and (2) that countries whose incomes are dropping are “developing” if and only if their incomes are already low. Another name for developing countries is emerging economies, used especially for their emerging financial markets.

309

pug21774_ch14_309-333.indd 309pug21774_ch14_309-333.indd 309 11/5/14 7:51 PM11/5/14 7:51 PM

Final PDF to printer

Annual Growth Rate Per Capita GDP, 2012 Region or Nation in per Capita GDP, 1990–2012 (at international U.S. dollar prices)

Industrialized Countries 1.4 40,571

United States 1.5 51,749 Australia 1.8 43,818 Germany 1.4 42,700 Canada 1.3 41,298 United Kingdom 1.7 35,722 Japan 0.8 35,618

Developing Countries 3.0 7,303

European and Central Asian countries 1.8 12,282 Latin American and Caribbean countries 1.7 12,673 Arab countries 2.1 10,005 East Asian and Pacific countries 7.5 7,836 South Asian countries 4.3 3,506 Sub-Saharan African countries 0.9 2,356

Saudi Arabia 1.7 31,214 Russia 0.8 23,589 Poland 3.7 22,783 Chile 3.8 21,468 Turkey 2.4 18,551 Romania 1.9 18,063 Mexico 1.2 16,426 Mauritius 3.5 14,902 Venezuela 0.9 13,267 Brazil 1.6 11,716 South Africa 0.9 11,021 Thailand 3.5 9,660 China 9.4 9,083 Ukraine 21.0 7,298 Indonesia 3.3 4,876 Philippines 1.9 4,339 India 4.8 3,870 Vietnam 5.5 3,787 Pakistan 1.8 2,741 Nigeria 2.1 2,620 Tajikistan 22.0 2,192 Ghana 3.0 2,014 Bangladesh 3.7 1,851 Uganda 3.3 1,330 Congo, Democratic Republic of 22.7 415

FIGURE 14.1 Real Growth Rates, 1990–2012, and Levels of Income per Capita, 2012

Note: Measures of gross domestic product per capita adjusted for purchasing power parity (at international dollar prices) are better

than the often-cited estimates of average dollar incomes based on exchange-rate conversions. The purchasing power parity estimates

reflect the ability to buy a broad range of goods and services at the prices prevailing in each country, whereas using exchange rates

to convert other-currency values into U.S. dollars misleads by reflecting only the international prices of goods that are heavily traded

between countries. As a rule, comparisons based on exchange-rate conversions overstate the relative poverty of low-income countries

by failing to reflect the cheapness of their nontraded services. For more on purchasing power parity, see Chapter 19.

Sources: World Bank, World Development Indicators.

310 Part Two Trade Policy

pug21774_ch14_309-333.indd 310pug21774_ch14_309-333.indd 310 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

than a century for the developing countries to catch up with the average per capita

income in the industrialized countries.

The most striking pattern shown in Figure 14.1 , however, is the wide disparity

in growth rates among the developing countries. Some are achieving supergrowth,

while some have suffered declining income levels since 1990. Incomes have tended

to grow fastest in East Asia. The “Four Tigers” (South Korea, Taiwan, Singapore, and

Hong Kong) have grown so quickly over the past two decades that they now have

relatively high incomes. South Korea’s per capita GDP is about $30,000 and those

of the other three Tigers are even higher. Several other countries in East Asia also

achieved high growth rates, including China and Vietnam. At the rate achieved in

1990–2012, China’s per capita income doubles in less than eight years.

However, in one-seventh of the developing countries for which we have data,

income per person declined between 1990 and 2012. Most are countries in Africa and

countries in Central and Eastern Europe and Central Asia that are making a transition

from central planning to a market-based economy. The gaps in growth rates are much

wider among developing countries than among high-income countries.

Why are the fortunes of developing countries so different, with some growing

rapidly while others stay poor? Do differences in their trade policies play a role? Are

there lessons about trade policy to be learned by studying what the supergrowing

newly industrializing countries (NICs) did that countries with stagnating or declining incomes did not? This chapter reveals some clear answers and some still-unresolved

questions about the trade-policy options for developing countries.

WHICH TRADE POLICY FOR DEVELOPING COUNTRIES?

Trade is important for developing countries. Exports of goods and services on aver-

age are about 37 percent of GDP in developing countries. (For developed countries

exports are about 28 percent of GDP on average.) Developing countries are the source

of about 46 percent of all world exports. About 42 percent of exports by developing

countries go to industrialized countries, and these are about 38 percent of industrial-

country imports.

What role can trade and trade policy play in development? How can trade and

trade policy be used to boost incomes and economic growth in poor countries? Many

developing countries have comparative advantages based on land (usually with a

tropical climate) and in various natural resources “in the ground.” Exploiting these

comparative advantages would lead to exports of foods, fuels, and other primary

products. Developing countries also generally have a comparative advantage based

on less-skilled labor. This abundant labor could be used in combination with the land

and natural resources in producing primary commodities, or it could be used in the

production of less-skilled-labor-intensive manufactures. Developing countries could

also seek to develop more advanced manufacturing industries using infant industry

policies.

What should the government of, say, Ghana do about imports and exports if it is

determined to reverse the economic stagnation that has held down the living standards

Chapter 14 Trade Policies for Developing Countries 311

pug21774_ch14_309-333.indd 311pug21774_ch14_309-333.indd 311 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

of its people? To supplement the greater task of reforming its whole economy, Ghana

has these basic trade-policy choices:

1. A trade policy that accepts and exploits the country’s comparative advantages in

land and natural resources. For Ghana this means encouraging greater exports of cocoa, coffee, gold, and other primary products, but offering no encouragement to industrial development by restricting imports or encouraging exports of manufac-

tured products.

2. A trade policy that attempts to enhance the gains from exporting primary products by raising the world prices of these products. If the country’s exports of a product are large enough, the country could use an export tax in a way that is similar to the nationally optimal import tariff of Chapter 8. If the country cannot accomplish

much by itself, it could organize or join an international cartel. For Ghana, this means taxing exports of cocoa or organizing a cartel of cocoa producers or coffee

producers.

3. A policy that taxes and restricts imports to protect and subsidize new industries serving the domestic market. For Ghana, this might mean forcing Ghanaians to buy more expensive domestic steel, televisions, and airline services. If the strategy nur-

tures infant industries successfully, firms in these industries eventually can compete

at world prices.

4. A trade policy that encourages the development of new industries whose products can be readily exported . Most of these new industries would make manufactured products that exploit the country’s comparative advantage in less-skilled labor. For Ghana, the new export production would probably be textiles, clothing, or the

assembly of electrical products.

A developing country today does indeed face this choice alone, for the most part,

without much international help other than negotiated trade liberalizations like the

Uruguay Round.

In choosing a trade policy, should a developing country just follow the trade-policy

guidelines laid out in Chapters 8 through 11? Or are developing countries so differ-

ent that they need a separate trade-policy analysis? The basic answer is that the trade

policy conclusions of Chapters 8 through 11 do apply to all countries, whether indus-

trialized or developing. The pros and cons of restricting or subsidizing trade are the

same, and the specificity rule still compels us to consider alternatives to trade policy

when trade is not the source of the development problem. All that is different in this

chapter is the degree of emphasis put on certain points.

Developing countries are different in that they face certain challenges that are less

formidable, though still present, in a developed economy. These challenges fall into

two categories:

1. Capital markets work less efficiently in developing countries. A defining char- acteristic of a lower-income country is that there are more barriers to the lending of

money to the most productive uses. As a result, good projects must overcome a higher

cost of capital (interest rate) than the rate at which capital is available to less promising

sectors. One underlying reason is that property rights are less clearly defined, holding

back the willingness to invest in new assets.

312 Part Two Trade Policy

pug21774_ch14_309-333.indd 312pug21774_ch14_309-333.indd 312 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

2. Similarly, labor markets work less efficiently in developing countries. The wage gaps between expanding and declining sectors are greater than those in higher-income

countries. The wider wage gaps are an indirect clue that some labor is being kept from

moving to its most productive use.

These differences imply some special tasks for the government of a developing

country. There is a case for considering which sectors to protect or subsidize or give

cheap loans to, if the government cannot quickly eliminate the barriers to efficient

capital and labor markets. The government must also decide whether it is realistic to

try to change the nation’s comparative advantage, for instance, by increasing its invest-

ment in education and health care to expand the country’s endowment of human skills.

The shift from central planning to a market economy has required yet other policy

decisions, as discussed in the box “Special Challenges of Transition.”

We now explore the alternatives for trade policy for a developing country in the

order that we presented them for Ghana: focus on exporting primary products, use

export taxes or international cartels to influence the world prices of these primary

products, use import protection to develop new manufacturing industries, or encour-

age the development of export-oriented new manufacturing industries.

ARE THE LONG-RUN PRICE TRENDS AGAINST PRIMARY PRODUCERS?

It seems natural that developing countries export primary products (agriculture, for-

estry, fuels, and minerals), and these are often called traditional exports. The major- ity of developing countries get half or more of their export revenues from primary

products. Many developing countries have exports concentrated in one or a few

products like petroleum, coffee, cotton, gold, sugar, timber, diamonds, and bauxite/

aluminum.

A recurring idea is that developing countries’ growth is held back by relying on

exports of primary products. In the 1950s, Raul Prebisch and others argued that devel-

oping countries are hurt by a downward trend (and instability) in primary-product

prices. International markets, ran the argument, distribute income unfairly. Since

developing countries are net exporters of primary products, they are trapped into

declining incomes relative to incomes in the industrialized world. 2

Does the fear of falling prices sound reasonable? Economic analysis shows that

there are at least two major forces depressing, and at least two forces raising, the trend

in the prices of primaries relative to manufactures.

The relative price of primary products is depressed by Engel’s law and synthetic

substitutes.

2Be careful not to assume, as many discussions imply, that there is a tight link between being a developing country and being an exporter of primary products. Overall, the developing countries are only moderate net exporters of primary products and import significant amounts of them from North America, Australia, and New Zealand. And their comparative advantage in primary products varies greatly. Some developing countries (e.g., Nigeria) export mostly primary products, while others (e.g., South Korea) export almost no primary products and are heavily dependent on importing them.

Chapter 14 Trade Policies for Developing Countries 313

pug21774_ch14_309-333.indd 313pug21774_ch14_309-333.indd 313 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

Case Study Special Challenges of Transition

In 1989, a massive transition from central plan- ning to market economies began in the formerly socialist countries of Central and Southeastern Europe. With the breakup of the Soviet Union in 1991, the former Soviet Union countries joined this transition. This is the most dramatic epi- sode of economic liberalization in history. What role have changing policies toward international trade played in the transition?

Prior to 1989–1991, central planning by each government directed the economies in these countries. National self-sufficiency was a policy goal. Imports were used to close gaps in the plan, and a state bureaucracy controlled exports and imports. When trade was necessary, the countries favored trade among themselves and strongly discouraged trade with outside countries. They tended to use bilateral barter trade, with lists of exports and imports for each pair of countries. The trade pattern had the Soviet Union specializ- ing in exporting oil and natural gas (at prices well below world prices) and other countries export- ing industrial and farm products.

As the transition began, these countries had a legacy of poor decision-making under central planning, including overdevelopment of heavy industries (like steel and defense), outdated tech- nology, environmental problems, and little estab- lished trade with market economies. They needed to remove state control of transactions and under- take a major reorganization of production.

Transition involves accomplishing three chal- lenging tasks: (1) shifting to competitive mar- kets and market-determined prices, with a new process of resource allocation; (2) establishing private ownership, with privatization of state businesses; and (3) establishing a legal system, with contract laws and property rights. For suc- cess, the transition process must

• Impose discipline on firms inherited from the era of central planning.

• Provide encouragement for new firms that are not dependent on the government.

Opening the economy to international trade and direct investments by foreign firms can be part of both the discipline (through the competition provided by imports) and the encouragement (through access to new export markets and to foreign technology and know-how).

Domestic and international reforms usually advanced together in a transition country, and success requires a consistent combination of reforms. We can identify several different groups of countries that pursued reforms in different ways and at different speeds.

The Central European countries (Czech Republic, Hungary, Poland, Slovakia, and Slovenia), the Baltic countries (Estonia, Latvia, and Lithuania), and the Southeastern European countries (Albania, Bosnia, Bulgaria, Croatia, Macedonia, Montenegro, Romania, and Serbia) pursued strong, rapid lib- eralizations (except for Bosnia, Serbia, and Montenegro, which were involved in fighting). As we discussed in Chapter 12, the Central European and Baltic countries joined the European Union in 2004, Bulgaria Romania joined in 2007, and Croatia joined in 2013.

The members of the Commonwealth of Independent States (CIS, the countries that were formerly part of the Soviet Union, excluding the Baltic countries) have instead followed paths of less liberalization. Three countries, Belarus, Turkmenistan, and Uzbekistan, continue to resist enacting reforms. The other CIS countries (Armenia, Azerbaijan, Georgia, Kazakhstan, Kyrgyz Republic, Moldova, Russia, Tajikistan, and Ukraine) enacted partial reforms that were adopted slowly over time and that sometimes were reversed.

How do trade patterns evolve during transi- tion? One pressure is clear, toward rapid growth of imports, especially consumer goods, based on pent-up demand. Transition countries must

314 Part Two Trade Policy

pug21774_ch14_309-333.indd 314pug21774_ch14_309-333.indd 314 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

export to pay for their rising imports, and Western Europe and other industrialized countries are cru- cial as major markets for expanding their exports. However, exporting to demanding customers in the competitive markets of the industrialized countries was not going to be easy. Under central planning these countries had major deficiencies in their products and businesses, including poor product quality, lack of marketing capabilities, and lack of trade financing.

How successful have the transition countries been in reorienting their trade patterns? By 1998 the Central European, Baltic, and Southeastern European countries on average were selling over 60 percent of their exports to buyers in industri- alized countries. Rapid and deep liberalizations, along with favorable geographic location close to the markets of Western Europe, have facili- tated the shift by these countries to a desirable export pattern. They increased their exports of light manufactured goods like textiles, cloth- ing, and footwear. They also used their low-cost skilled labor to expand export of such products as vehicles and machinery.

In contrast, most CIS countries did not reorient their exports much, and on average only about a quarter of their exports went to industrialized countries in the late 1990s. Many CIS countries resisted trade liberalizations and continued to pro- duce low-quality manufactured products that could not be exported outside the region. As of early 2014, only 7 of the 12 CIS countries had become members of the World Trade Organization.

How does all of this combine to determine the success of economic transition? One broad indicator is the growth or decline of domestic production (real GDP). In the beginning transi- tion is likely to cause a recession, as business prac- tices and economic relationships are disrupted. Only after reforms begin to take hold can the economy begin to grow. This process is like that of the shift from no trade to free international

trade. As we saw beginning in Chapter 2, the gains from opening to trade are based largely on disrupting previous patterns of production and consumption activities.

The evidence indicates that the depth and speed of reforms matter for the success of transi- tion. In addition, as with developing countries generally, we see greater success for those coun- tries adopting more open and outward-oriented trade policies.

The fast and deep reformers in Central and Southeastern Europe suffered through early- transition recessions that were not that deep and not that long. The recessions in the Baltic countries were somewhat longer and somewhat deeper. Then, starting between 1992 and 1996, each of these countries has generally had sub- stantial and sustained growth.

The nine partial-reform and less open CIS countries have broadly performed the worst, even compared with the three nonreform CIS countries. Most partial-reform CIS countries experienced deep early-transition recessions, and three (including Russia) did not return to sustained growth until 1998 or later. They seemed to be caught in a trap in which special interests, oligarchs, and insiders who benefit from the partial reforms gain the political power to block or slow further reform. One advan- tage of speed in reform is that the reforms are enacted and the increased international trade and greater market competition impose disci- pline and offer encouragement, before such special interest groups have time to coalesce and exert their power.

DISCUSSION QUESTION Based on the international economics of the situ- ation, should a country like Ukraine strengthen its orientation toward the customs union that includes Russia and several other CIS countries or reorient itself more toward the European Union?

Chapter 14 Trade Policies for Developing Countries 315

pug21774_ch14_309-333.indd 315pug21774_ch14_309-333.indd 315 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

1. Engel’s law. In the long run, per capita incomes rise. As they rise, demand shifts toward luxuries—goods for which the income elasticity of demand (percent

rise in quantity demanded/percent rise in income causing the change in demand) is

greater than 1. At the same time, the world’s demand shifts away from staples—goods

for which the income elasticity of demand is less than 1. The 19th-century German

economist Ernst Engel (not Friedrich Engels) discovered what has become known as

Engel’s law: The income elasticity of demand for food is less than 1 (i.e., food is a

staple). Engel’s law is the most durable law in economics that does not follow from

definitions or axioms. It means trouble for food producers in a prospering world. If

the world’s supply expanded at the exact same rate for all products, the relative price

of foods would go on dropping because Engel’s law says that demand would keep

shifting (relatively) away from food toward luxuries.

2. Synthetic substitutes. Another force depressing the relative prices of primary products is the development of new human-made substitutes for these natural materi-

als. The more technology advances, the more we are likely to discover ways to replace

minerals and other raw materials. The most dramatic case is the development of

synthetic rubber around the time of World War I, which ruined the incomes of rubber

producers in Brazil, Malaysia, and other countries. Another case is the development

of synthetic fibers, which has lowered demand for cotton and wool.

On the other hand, two other basic forces tend to raise the relative prices of primary

products:

1. Nature’s limits. Primary products use land, water, mineral deposits, and other limited natural resources. As population and incomes expand, the natural inputs

become increasingly scarce, other things being equal. Nature’s scarcity eventually

raises the relative price of primary products, which use natural resources more inten-

sively than do manufactures.

2. Relatively slow productivity growth in the primary sector. For several cen- turies productivity has advanced more slowly in agriculture, mining, and other

primary sectors than in manufacturing. A reason is the tendency for cost-cutting

breakthroughs in knowledge to be more important in manufacturing than in prima-

ries. Slow productivity advance translates into a slower relative advance of supply

curves in primary-product markets than in manufacturing markets, and therefore a

rising relative price of primaries (or a falling relative price of manufactures), other

things being equal.

So we have two tendencies that depress the relative price of primary products,

and we have two that raise it. How does the tug-of-war work out in the long run?

Figure 14.2 summarizes the experience since 1900.

It depends on when you look at the data and how far back into history you look.

Studying Figure 14.2A , we can understand why the fear of falling relative primary

prices was greatest in the 1950s (when Prebisch’s argument achieved popularity) and

the 1980s. Those were periods of falling primary prices. On the other hand, little was

written about falling primary prices just before World War I, the historical heyday of

high prices for farm products and other raw materials. Nor was there much discussion

316 Part Two Trade Policy

pug21774_ch14_309-333.indd 316pug21774_ch14_309-333.indd 316 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

For each commodity group, the relative price index is the ratio of the dollar-price index

for the indicated primary products to the dollar-price index for exports of manufactures

by industrialized countries.

Relative price index (set at 1900 � 100)

A. Overall Indexes

B. Three Subgroups of Primary Commodities

100

120

140

160

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

All primaries/manufactures

All nonfuel primaries/manufactures

100

120

140

160

180

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

Nonfood agricultural/manufactures

Food/manufactures

Metals/manufactures

FIGURE 14.2 The Relative

Price of Primary

Products,

1900–2013

Sources: Grilli and Yang (1988), updated

using information

on prices of primary

products from

International Monetary

Fund, International Financial Statistics, and information on

the unit values of

manufactured-good

exports from

Pfaffenzeller et al.

(2007), and United

Nations Commodity

Trade Statistics,

International Trade Statistics Yearbook, 2012 .

Chapter 14 Trade Policies for Developing Countries 317

pug21774_ch14_309-333.indd 317pug21774_ch14_309-333.indd 317 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

of depressed prices during World War II, the Korean War of 1950–1953, the boom in

primary-product prices in the early 1970s, or the run-up in commodity prices during

the 2000s. During such times, many writers revived the Malthusian arguments about

the limits to planet Earth.

To stand back from the volatile swings in commodity prices, let’s look over as long

a period as possible. For Figure 14.2, we can scan the period 1900–2013, though fol-

lowing some price series back to 1870 would tell a similar story. For the top panel,

we also have to allow for the very large increase in energy prices since 1999, which

causes a divergence between the relative price of all primary products and the relative

price of nonfuel primary products at the end of the time period.

Figure 14.2 shows a fairly clear long-term trend. For the top panel, we can see

that the general trend for relative nonfuel primary-product prices is downward.

Statistically, if we fit the best trend line to the data over this entire time period, we

find that these prices are declining at about 0.8 percent per year. (For all primary

products, including energy fuels, the general trend is also downward, but the spike

since the late 1990s pulls the trend line up somewhat. Statistically, the best trend line

shows a price decline of about 0.4 percent per year.) Somehow, Engel’s law and the

technological biases toward replacing primary products have outrun nature’s limits

and the relative slowness of productivity growth in primary sectors. (Or, in shorthand,

Prebisch outran Malthus.)

Some commodities have declined in price more seriously than others. The price of

rubber snapped downward between 1910 and 1920 and has never really bounced back

since. The relative prices of wool, cocoa, aluminum, rice, cotton, and sugar declined

by more than half during the 20th century. In contrast, the relative prices of lamb,

timber, and beef more than doubled.

While the net downward trend in primary prices stands as a tentative conclusion,

there are two biases in the available measures, like those presented in Figure 14.2.

1. The fall in transport costs. The available data tend to be gathered at markets in the industrial countries. Yet technological improvements in transportation have been

great enough to reduce the share of transport costs in those final prices in London,

New York, or Tokyo. That has left more and more of the final price back in the hands

of the primary-product exporters. Quantifying this known change would tilt the trend

in the prices received by producers toward a flatter, less downward trend.

2. Faster unmeasured quality change in manufactures. We are using long runs of price data on products that have been getting better over time. Quality improvements

(including those in the form of new products) are thought to have been more impres-

sive in manufactures (and services) than in primary products. So what might look like

a rise in the relative price of manufactures might be just a rise in their relative quality,

with no trend in the relative price for given quality. This data problem is potentially

serious, given that many 20th-century data have, for example, followed the prices of

machinery exports per ton of exports, as if a ton of today’s computers were the same

thing as a ton of old electric motors.

When all is said and done, the relative price of primary products may have declined

as much as 0.8 percent a year since 1900 (as in Figure 14.2), or there could have been

318 Part Two Trade Policy

pug21774_ch14_309-333.indd 318pug21774_ch14_309-333.indd 318 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

almost no trend. There is a weak case for worrying about being an exporter of agricul-

tural or extractive products on price-trend grounds.

INTERNATIONAL CARTELS TO RAISE PRIMARY-PRODUCT PRICES

Perhaps the developing-country producers of primary products can take actions to turn

the price trends in their favor. Perhaps the primary-product exporters can become more

powerful if they cooperate with each other, using international cartels or other types of concerted action.

The OPEC Victories History records many attempts at international cartels (international agreements

to restrict competition among sellers). The greatest seizure of monopoly power in

world history was the price-raising triumph of the Organization of Petroleum Exporting Countries (OPEC) 3 in 1973–1974 and again in 1979–1980.

A chain of events in late 1973 revolutionized the world oil economy. In a few

months’ time, the 12 members of OPEC effectively quadrupled the dollar price of

crude oil, from $2.59 to $11.65 a barrel. Oil-exporting countries became rich almost

overnight. The industrial oil-consuming countries sank into their deepest recession

since the 1930s. The relative price of oil (what the price of a barrel of oil could buy in

terms of manufactured exports from industrial nations) tripled.

The sequel was a plateau of OPEC prosperity, a further jump, and then growing

signs of weakness. From 1974 to 1978, the relative price of oil dipped by about a

sixth, but stayed much higher than it had been at any time before 1973. Next came the

second wave of OPEC price hikes, the second “oil shock,” in 1979–1980. Led by the

Iranian Revolution and growing panic among oil buyers, the relative oil price more

than doubled. In the mid-1980s, however, OPEC weakened. The relative price of oil

dropped suddenly in late 1985, from four to five times the old (pre-1973) real price in

1980–1984 to less than two times the old price for 1986–1989.

The tale of oil and OPEC in the 1970s and 1980s is one of two dramatic cartel

victories and a subsequent retreat. The victories and the retreat both need explanation.

First the victories. The oil shocks of 1973–1974 and 1979–1980 were not the result

of a failure of supply or exhaustion of earth’s available resources. The world’s “proved

reserves” of known and usable oil were growing faster than world oil consumption.

Nor were the costs of oil extraction rising much.

The 1973–1974 and 1979–1980 oil price jumps were human-made. The key was

that world demand was growing far faster than non-OPEC supplies. Oil discoveries had been very unevenly distributed among countries. The share of OPEC coun-

tries in world crude oil production rose to over 50 percent by 1972. Furthermore,

3OPEC was created by a treaty among five countries—Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela— in 1960. Since that time, the following countries have joined: Qatar (1961), Libya (1962), United Arab Emirates (1967), Algeria (1969), Nigeria (1971), and Angola (2007). Ecuador joined in 1973, withdrew in 1992, and rejoined in 2007. Indonesia joined in 1962 and withdrew in 2009. Gabon joined in 1975 and withdrew in 1995.

Chapter 14 Trade Policies for Developing Countries 319

pug21774_ch14_309-333.indd 319pug21774_ch14_309-333.indd 319 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

OPEC’s share of proved reserves—roughly, its share of future production—was over

two-thirds.

By the early 1970s, the United States was for the first time becoming vulnerable

to pressure from oil-exporting countries. Largely immune to oil threats in earlier

Middle East crises, the United States found itself importing a third of its oil con-

sumption, part of it from Arab countries, by 1973. With their growing importance in

world production, and with growing U.S. reliance on oil imports, OPEC countries

were able to create a scramble among buyers to pay higher prices for oil in 1973

and again in 1979.

Classic Monopoly as an Extreme Model for Cartels How big could the cartel opportunity be? That is, if a group of nations or firms were

to form a cartel, as OPEC did, what is the greatest amount of gain they could reap at

the expense of their buyers and world efficiency? If all of the cartel members could

agree on simply maximizing their collective gain, they would behave as though they

were a perfectly unified profit-maximizing monopolist. Because a commodity like

oil is fungible, they would probably not be able to discriminate by setting different

prices to different foreign buyers (except for standard distinctions by quality that we

can safely ignore here). The cartel members acting as a monopoly would try to find

the price level that would maximize the gap between their total export sales revenues

and their total costs of producing exports. When cutting output back to the level of

demand yielded by their optimal price, they would take care to shut down their most

costly production units (e.g., oil wells) and keep in operation only those with the low-

est operating costs.

Figure 14.3 portrays a monopoly or cartel that has managed to extract maximum

profits from its buyers. To understand what price and output yield that highest level of

profits, and what limits those profits, we must first understand that the optimal price

lies above the price that perfect competition would yield, yet below the price that

would discourage all sales.

If perfect competition reigned in the world oil market, the marginal-cost curve in

Figure 14.3 would also be the supply curve for oil exports. Competitive equilibrium

would be at point C , where the marginal cost of extra oil exports has risen to meet $40, the amount that the extra oil is worth to buyers (as shown by the demand curve).

The cartel members want to set a price higher than the competitive price, but their

pricing power is limited by the negative slope of the demand curve for the cartel’s

product. This point is clear if we just consider the extreme case of a prohibitive price

markup. If the cartel were foolish enough to push the price to $195 a barrel in Figure

14.3, it would lose all of its export business, as shown at point A . The handsome markup to $195 would be worthless because nobody would be paying it to the cartel.

Thus, the cartel’s best price must be well below the prohibitive price.

The cartel members could find their most profitable price by using the model of

monopoly: The highest possible profits are those corresponding to the level of sales

at which the marginal-revenue curve intersects the marginal-cost curve, at point F in Figure 14.3. These maximum profits would be reaped by selling 30 million bar-

rels of export sales a day, at a price of $100 per barrel. The monopoly profits will

be ($100 2 $5) 3 30 million barrels 5 $2.85 billion a day. If the cartel had not

320 Part Two Trade Policy

pug21774_ch14_309-333.indd 320pug21774_ch14_309-333.indd 320 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

*Before subtracting any fixed costs.

If a cartel were so tightly disciplined as to be a pure monopoly, it would maximize profits according

to the familiar monopoly model. It would not keep prices so low and output so high as to behave

like a competitive industry, at point C . Why not? Because the slightest price increase, starting at point C , would give it net gains. Instead, the cartel would set price as high, with quantity demanded and output as low, as shown at point B . At this level of output (30 million barrels a day), profit is maximized because the marginal revenue gained from a bit more output raising and price cutting

just balances the marginal cost of the extra output.

FIGURE 14.3 A Cartel

as a Profit-

Maximizing

Monopoly

Oil exports (millions of barrels per day)

Price ($ per barrel)

195

4930

Marginal-revenue curve

100

Marginal-cost curve ( � supply curve if there is competition)

Demand curve

Maximum monopoly profits∗

been formed, competition would have limited the profits of its members to the area

below the $40 price line and above the marginal-cost curve. Given the demand curve

and the marginal-cost curve, the profit gained by pushing price and quantity to point B is the best the cartel can do.

The cartel price that is optimal for its members is not optimal for the world, of

course. For the 30 million barrels per day, the extra cartel profits above the $40 price

line are just a redistribution of income from buying countries to the cartel, with no

net gain or loss for the world. However, the cartel causes net world losses by cur-

tailing oil exports that would be worth more to buyers around the world than those

exports cost the cartel members themselves to produce. The world net loss from the

cartel is represented in Figure 14.3 by the area BCF (which equals a little more than $900 million a day, as drawn in Figure 14.3). This area shows that what the cartel is

costing the world as a whole is the gap between what buyers would have willingly

paid for the extra 19 million barrels a day, as shown by the height of the demand

curve, and the height of the marginal-cost curve between 30 million barrels and

49 million barrels.

Chapter 14 Trade Policies for Developing Countries 321

pug21774_ch14_309-333.indd 321pug21774_ch14_309-333.indd 321 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

The Limits to and Erosion of Cartel Power How high is the cartel’s profit-maximizing price if the cartel is functioning at full

effectiveness? The theory of cartels provides some rules. 4 The first two rules follow

from the monopoly model:

• The higher the marginal cost of production, the higher the price. In Figure 14.3,

consider the effect on the monopoly price if the entire marginal-cost curve is higher

than that shown.

• The higher the elasticity of demand, the lower the price. If demand is elastic, buyers

easily find other ways of spending their money if the product price rises much. In

Figure 14.3, consider the effect on the monopoly price of a different demand curve,

one through point C and flatter (more elastic) than the curve shown.

However, even a well-functioning cartel usually does not control all of the world’s

production. If it doesn’t, then we have two more rules:

• The larger the share of world production controlled by the cartel, the higher

the price. Controlling more of the world production effectively increases the

demand for the cartel’s production (rather than having this demand lost to outside

producers).

• The larger the elasticity of supply of noncartel producers, the lower the price. The

elasticity of noncartel supply acts in the same way that the elasticity of demand

does. The cartel refrains from raising the price too much because doing so results

in too large a loss of its own sales.

These rules also suggest forces that work increasingly against cartels over time. When the cartel is first set up, it may well enjoy low elasticities and a high market

share. Yet its very success in raising price is likely to set four anticartel trends in

motion: sagging demand, new competing supply, declining market share, and cheating.

Sagging Demand First, the higher price will make buying countries look for new ways to avoid import-

ing the cartel’s product. If the search for substitutes has any success at all, imports of

the buying countries will drop over time for any given cartel price. These countries’

long-run demand curve for imports of the product is more elastic than their short-run

demand curve. This happened to OPEC. As theory predicts, and as some OPEC oil

ministers had feared, the oil-importing countries slowly came up with ways to con-

serve on oil use, such as more fuel-efficient cars.

New Competing Supply Second, the initial cartel success will accelerate the search for additional supplies

in noncartel countries. If the cartel product is an agricultural crop, such as sugar or

coffee, the cartel’s price hike will cause farmers in other countries to shift increasing

amounts of land, labor, and funds from other crops into sugar or coffee. If the cartel

product is a depletable mineral resource, such as oil or copper, noncartel countries will

4Appendix D presents the mathematical formula for the optimal cartel price.

322 Part Two Trade Policy

pug21774_ch14_309-333.indd 322pug21774_ch14_309-333.indd 322 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

respond to the higher price by redoubling their explorations in search of new reserves.

If the noncartel countries have any luck at all, their competing supply will become

increasingly elastic with time. Again, that happened to OPEC—other countries dis-

covered new oil at a faster rate.

Declining Market Share Third, the cartel’s world market share will fall over time. To raise the product’s price

without piling up ever-rising unsold inventories, the cartel must cut its output and sales.

Since nonmembers will be straining to raise their output and sales, the cartel’s share

of the market will drop even if all of its members cooperate solidly. OPEC’s share of

world oil production fell from over half in the early 1970s to less than a third in 1985.

Cheating Theory and experience add a fourth reason for a decline in cartel power—the incentive

for members to cheat on the cartel agreement.

To see why, suppose that you are a member of the successful oil export cartel shown

back in Figure 14.3. As a typical cartel member, you have enough oil reserves to pump

and sell more than your agreed output (OPEC calls this your production quota) for

as long in the future as you need to plan. Raising your output above your production

quota might cost you only, say, $6 a barrel at the margin. Buyers are willing to pay

close to $100 for each barrel you sell if the other cartel members are faithfully holding

down their output. Why not attract some extra buyers to you by shaving your price

just a little bit below $100, say, to $98? You can do so in the hope that your individual

actions will not cause the cartel price to drop much, if at all. Theory says that this

incentive to cheat tends to undermine the whole cartel. Perhaps some large members

can keep the cartel effective for a while by drastically cutting their own outputs to

offset the extra sales from the cheaters. Their aggregate size determines how long they

can hold out.

OPEC members cheated on the cartel, even openly, just as theory would predict. Up

to the mid-1980s, the largest producer, Saudi Arabia, had to hold the cartel together

by cutting its production while others cheated. Then the Saudis themselves shifted to

a more competitive stance, and the relative price of oil fell dramatically in late 1985.

The usual theory of cartels thus correctly explains why cartel profit margins and

profits will erode with time. 5 Yet the theory does not say that cartels are unprofitable

or harmless. On the contrary, it underscores the profitability of cartel formation to

cartel members. Even a cartel that eventually erodes can bring fortunes to its members.

The Oil Price Increase since 1999 Following the price collapse of 1986, crude oil prices remained rather low (with the

exception of a few months in 1990 during the time of Operation Desert Storm action

against Iraq). By late 1998 the relative price of oil had fallen back to about its level in

1973. But then oil prices began to rise, from $11 per barrel in late 1998 to $34 per barrel

5These same reasons also imply that a cartel probably would be wise to charge a lower markup, even at the start, than the markup implied by short-run elasticities of demand and noncartel supply. The higher the initial markup, the faster the erosion of the cartel’s market share and the lower the optimal markup that the cartel can charge later on.

Chapter 14 Trade Policies for Developing Countries 323

pug21774_ch14_309-333.indd 323pug21774_ch14_309-333.indd 323 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

in late 2000, and then remained rather flat to the beginning of 2004. Oil prices then

climbed, with a price spike in 2007–2008 that had a peak price of over $140 per barrel

in June 2008. With the recession that accompanied the global financial and economic

crisis, oil prices collapsed to less than $40 per barrel in 2009. As global demand began

to increase again, oil prices rose rapidly, moving above $100 per barrel in early 2011.

So, is this the reemergence of OPEC’s monopoly power? Only partly. In the late

1990s and early 2000s OPEC did attempt with some success to reduce its production

to raise the price. However, much of the price rise seems to reflect the broader dynam-

ics of the industry, dynamics that are based on the competitive aspects of the market.

Demand from China and India grew rapidly. Furthermore, the years of rather low oil

prices discouraged investment in new crude oil production capabilities, leading to tight

supply and a lack of spare production capacity. As a result of the demand increases and

capacity limits, oil prices rose well above OPEC price targets in 2008. The big price rise

in the mid- and late 2000s looks more like a boom period in a highly cyclical industry

than it looks like the planned exercise of market power by the cartel.

Other Primary Products Do theory and OPEC experience hold out hope for developing countries wanting to make

large national gains by joining cartels in other primary products besides oil? Not much.

There are good reasons for believing that international cartels would collapse faster, with

less interim profit, for the non-oil primary products. For agricultural crops in particular,

there is the problem of competing supply. Other countries usually can easily expand the

acreage they devote to a given crop.

History agrees with this verdict. Of the 72 commodity cartels set up between the

two world wars, only 2 survived past 1945. Of the few dozen set up in the 1970s, only

5 lived as late as 1985: cocoa, coffee, rubber, sugar, and tin. These 5 cartels have been

so weak that they have had little effect on commodity markets since 1985.

Given the limits of international cartel power, a developing nation could still tax

its own primary-product exports for the sake of economic development. In principle,

the strategy could work well. A tax on exports of Nigerian oil, Ghanaian cocoa, or

Philippine coconuts could generate revenues for building schools, hospitals, and roads.

Unfortunately, the political economy of some developing countries seems to

divert the export-tax revenues away from the most productive uses (as we noted

in Chapter 10 when discussing the developing government argument for import

tariffs). So it has been with the three examples just imagined. Nigeria’s oil revenues

are lost in a swollen government bureaucracy and ravenous corruption. For two

decades Ghana’s cocoa marketing board used its heavy taxation of cocoa farm-

ers to support luxury imports by officials. The Marcos government distributed the

Philippine coconut-tax revenues among a handful of Marcos’s friends and relatives.

IMPORT-SUBSTITUTING INDUSTRIALIZATION (ISI)

Exporting primary products is a way for many developing countries to use their

comparative advantages based on land and natural resources. But reliance on such

traditional exports brings risks, including what appear to be slowly declining relative

324 Part Two Trade Policy

pug21774_ch14_309-333.indd 324pug21774_ch14_309-333.indd 324 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

prices of these products and exposure to the wide swings in world prices. Perhaps

shifting the emphasis toward developing new industries, especially in manufacturing,

is better for countries that want to grow more rapidly. After all, most high-income

countries have industrialized.

To develop, officials from many countries have argued, they must cut their reliance

on exporting primary products and must adopt government policies allowing industry

to grow at the expense of the agricultural and mining sectors. Can this emphasis on

industrialization be justified? If so, should it be carried out by restricting imports of

manufactures?

The Great Depression caused many countries to turn toward import-substituting industrialization (ISI). In the early 1920s and again in the early 1930s, world prices of most primary products plummeted. Although these price declines did not prove

that primary exporters were suffering more than industrial countries, it was common

to suspect that this was so. Several primary-product-exporting countries, among them

Brazil and Australia, launched industrialization at the expense of industrial imports in

the 1930s.

The ISI strategy gained additional prestige among newly independent nations in the

1950s and 1960s. This approach soon prevailed in most developing countries whose

barriers against manufactured imports came to match those of the most protectionist

prewar industrializers. Though many countries have switched toward more pro-trade

and export-oriented policies since the mid-1960s, ISI remains an important policy for

developing countries.

ISI at Its Best To see the merits and drawbacks of ISI, let us begin by noting the four main arguments

in its favor. If ISI could be fine-tuned to make the most of these arguments, it would

be a fine policy indeed.

1. The infant industry argument from Chapter 10 returns, with its legitimate emphasis on the economic and social side benefits from industrialization. These

side benefits may include gains in technological knowledge and worker skills tran-

scending the individual firm, new attitudes more conducive to growth, and national

pride. As we saw in Chapter 10, the economist can imagine other tools more suitable

to each of these tasks than import barriers. But in an imperfect world these better

options may not be at hand, and protection for an infant modern-manufacturing sec-

tor could bring gains.

2. The developing government argument from Chapter 10 lends further support to ISI. Suppose that the only way that a government can raise revenues for any kind of

economic development is to tax imports and exports. Such taxation can bring gains to

a nation whose government cannot mobilize resources for health, education, and so on

without taxing trade. ISI is a by-product of such taxation of foreign trade.

3. For a large country, replacing imports can bring better terms-of-trade effects than expansion of export industries. Here we return to a theme sounded first in the discus-

sion of “immiserizing growth” in Chapter 7 and again during Chapter 8’s discussion

of the nationally optimal tariff. Replacing imports with domestic production will, if

it has any effect at all on the foreign price of the continuing imports, tend to lower

Chapter 14 Trade Policies for Developing Countries 325

pug21774_ch14_309-333.indd 325pug21774_ch14_309-333.indd 325 11/5/14 7:09 PM11/5/14 7:09 PM

Final PDF to printer

these prices (excluding the tariff or other import charge) and offer the nation a better

bargain. If you can affect the prices at which you trade, wouldn’t it be better to expand

your supply of import-competing industries, forcing foreigners to sell you the remain-

ing imports at a lower price?

4. Replacing imports of manufactures is a way of using cheap and convenient market information. A developing country may lack the expertise to judge just which of the thousands of heterogeneous industrial goods it could best market abroad. But

government officials (and private industrialists) have an easy way to find which mod-

ern manufactures would sell in their own markets. They need only look at the import

figures. Here is a handy menu of goods with proven markets.

Experience with ISI History and recent economic studies offer four kinds of evidence on the merits of ISI.

Casual historical evidence suggests a slightly charitable view, while three kinds of

detailed tests support a negative verdict.

In support of ISI, it can be said that today’s leading industrial countries protected

their industry against import competition earlier, when their growth was first acceler-

ating. The United States, for example, practiced ISI from the Civil War until the end of

World War II, when most American firms no longer needed protection against imports.

Japan, in the 1950s, launched its drive for leadership in steel, automobiles, and elec-

tronics with heavy government protection against imports. When these industries were

able to compete securely in world markets, Japan removed its redundant protection

against imports into Japan.

Such a casual reading of history is at least correct in its premise: The industrialized

countries did at times give import protection to industries that became their export

strengths. But it is wrong to infer that most cases of industrial protection nurtured sec-

tors that responded with strong productivity gains. On the contrary, even Japan, like

the United States and most other industrialized countries, gave its strongest protection

to sectors whose decline was long-lasting. ISI in the earlier history of these countries

may well have slowed down their economic growth. Most of the infant industries, in

other words, never grew up.

In contrast to the weaknesses of the evidence for ISI, the evidence against it takes

three forms that in combination add up to a strong case. The first kind of test casting

serious doubt on the merits of ISI is the estimation of its static effects on national well-being, using the methods introduced in Chapter 8. A series of detailed country studies quantified the welfare effects of a host of developing-country trade barriers in

the 1960s and early 1970s, many of which were designed to promote industrialization.

The barriers imposed significant costs on Argentina, Chile, Colombia, Egypt, Ghana,

India, Israel, Mexico, Pakistan, the Philippines, South Korea, Taiwan, and Turkey.

Only in Malaysia did the import barriers bring a slight gain, here because of a favor-

able terms-of-trade effect. 6

By themselves, these standard calculations of welfare costs of trade barriers are

vulnerable to the charge of assuming, not proving, that ISI is bad. Such calcula-

tions assume that all the relevant effects are captured by measures of consumer and

6See Balassa (1971), Bhagwati and Krueger (1973–1976), and Choksi et al. (1991).

326 Part Two Trade Policy

pug21774_ch14_309-333.indd 326pug21774_ch14_309-333.indd 326 11/5/14 7:09 PM11/5/14 7:09 PM

Final PDF to printer

producer surplus, without allowing protection any chance to lower cost curves as it is

imagined to do in the infant industry case. It would be fair to demand firmer proof.

A second kind of test looks at what happens when a country changes its trade- policy orientation toward manufactures, away from restricting imports (ISI), and toward championing exports. Here there were two dramatic early cases. Until the late

1950s, Taiwan used ISI but then switched to a policy that encouraged exports. It subse-

quently achieved growth rates of about 10 percent per year. South Korea used ISI until

policy reforms in the early 1960s increased its incentives for exports and lowered its

import barriers. Its growth rate increased to about 10 percent per year. Hong Kong and

Singapore also used policies that encouraged exports and achieved high growth rates.

Other countries have achieved substantial effects. In the case of Ghana, the ISI strat-

egy was part of a larger heavy hand of government that turned early growth into a 42

percent decline of Ghana’s living standards over the decade 1974–1984. The country

was saddled with costly industrial white elephants that never became efficient. Only

after partial reforms that included a partial liberalization of trade policy did Ghana

regain positive economic growth.

A third kind of test compares growth rates of countries practicing ISI with growth rates of countries using policies that emphasize exporting. The 1987 World Development Report presented the results of the World Bank’s study of growth rates in 41 countries, which were placed into four categories according to their trade policy:

strongly outward-oriented, moderately outward-oriented, moderately inward-oriented,

and strongly inward-oriented. Hong Kong, South Korea, and Singapore followed

strongly outward-oriented policies, with low trade barriers and some use of export

subsidies. The strongly inward-oriented countries used high trade barriers. These

included Argentina, Bangladesh, Chile (up to 1973), India, and Turkey (to 1973).

In the two time periods that the World Bank examined, 1963–1973 and 1973–1985,

the average growth rate of real GDP per person was highest for the three countries

with strongly outward-oriented trade policies (6.9 percent and 5.9 percent per

year, respectively). The average growth rate in the countries with strongly inward-

oriented trade policies was lowest in both periods (1.6 percent and 20.1 percent per

year, respectively). An update in the 1994 World Development Report found that this pattern also held for the time period 1980–1992 (a 6.2 percent annual growth rate

for strongly outward-oriented countries and a 20.4 percent annual growth rate for

strongly inward-oriented countries).

In a 2002 study, the World Bank contrasted the experience of developing countries

that have increased their integration into world markets since 1980 with the experience

of other countries. The newly globalizing developing countries, as the World Bank calls them, are countries that

• had relatively low involvement in international trade and high tariffs in 1980 but then

• greatly increased their international trade (measured by the increase in the ratio of

exports and imports to national GDP) and

• substantially lowered their tariff rates.

The 24 newly globalizing developing countries had a total population of 3 billion

and included Argentina, Bangladesh, Brazil, China, Colombia, India, Nicaragua,

Chapter 14 Trade Policies for Developing Countries 327

pug21774_ch14_309-333.indd 327pug21774_ch14_309-333.indd 327 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

Thailand, and Uruguay. The other developing countries had a total population of

about 2 billion and included many African countries and countries of the former

Soviet Union. Most of these other developing countries concentrate on exporting

primary products.

The World Bank found that the newly globalizing developing countries achieved

average growth rates of GDP per person of 3.5 percent during the 1980s and 5.0 per-

cent during the 1990s. These average growth rates were above their average annual

growth rates in the 1960s (1.4 percent) and 1970s (2.9 percent). Their average growth

rates in the 1980s and 1990s were also higher than the average growth rates of other

developing countries (0.8 percent and 1.4 percent, respectively) and of the industrial-

ized countries (2.3 percent and 2.2 percent, respectively). The differences between the

newly globalizing and other developing countries do not seem to reflect favorable ini-

tial economic conditions for the new globalizers. In 1980 the people in the two groups

had comparable average levels of education, and the newly globalizing countries on

average had somewhat lower incomes per capita.

Such direct comparisons (as in these several World Bank studies) between countries practicing or adopting freer-trade regimes and countries practicing a variant of ISI or resisting further liberalization of their trade policies have the virtue of simplicity: They look directly at the two variables of interest (trade policies and economic

growth). Yet here, as always, correlation cannot prove causation. By itself, this kind

of evidence against ISI and restricting trade is subject to the suspicion that maybe

some other force caused economic growth to be correlated with freer-trade policies.

Or perhaps the causation ran the opposite way—perhaps successful growth itself

brings freer-trade policies, even though policies departing from free trade helped

promote growth. While it is not possible to answer these concerns fully, economists

have conducted more complicated tests of the statistical significance of trade policy.

After allowing for the effects of other variables such as investment, initial income,

and education, the research tends to confirm that ISI-type trade barriers are a negative

influence on economic growth.

If theory suggests that ISI can work well, why does experience make it look like a

bad idea? There is no direct contradiction because theory only asserted that ISI can be better than free trade under certain conditions. It just so happens that those conditions

have not held since the early 1960s. The theory failed, above all, in the assumption that

an informed government tries to maximize national income. Real-world governments

are ill-informed, and they lack the power to stop protecting industries that turn out to

be inefficient. Worse, many governments have their own self-interest, which conflicts

with the goal of maximizing national well-being. Embarking on a policy of ISI has

so far not turned any economy into a supergrower like South Korea. More often, the

ISI route is the road that turns a South Korea into a North Korea. ISI often results in

industries in which domestic firms have high costs and domestic monopoly power and

produce products of low quality.

Outward-oriented policies encourage domestic firms to make use of the country’s

abundant resources, and the firms can use sales into international markets to achieve

scale economies. The efforts to succeed in foreign markets also mean that domestic

firms face international competitive pressure, so that they are driven to raise product

quality and resource productivity. The country can use its rising exports to pay for its

328 Part Two Trade Policy

pug21774_ch14_309-333.indd 328pug21774_ch14_309-333.indd 328 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

rising imports. At the same time, an outward-oriented policy is not enough by itself to

produce high growth rates. It must be part of a set of policies that minimize distortions

in the economy, that nurture high rates of investment by establishing clear property

rights and an impartial system of business law, and that provide such infrastructure as

ports, airports, electricity, and communications.

EXPORTS OF MANUFACTURES TO INDUSTRIAL COUNTRIES

Since 1980, developing countries have turned increasingly toward our fourth trade-

policy choice, emphasizing new exports of less-skilled-labor-intensive manufac-

tured goods to the industrialized countries. As Figure 14.4 shows, the switch from

primary-product exports to manufactured exports gained momentum in the 1980s and

continued thereafter. Disillusionment with both primary-product cartels and ISI was

probably a factor in the new push.

Is it wise for a developing nation to plan on being able to raise its exports of manu-

factures to the already industrialized countries? Should Mexico, Ghana, and India

follow the example of South Korea, making strategic plans to become major exporters

of manufactures? Would the same thing happen without planning, as in the market-

directed development of Hong Kong and Taiwan?

For their part, the industrialized countries have not made the task easy. They have,

in fact, discriminated against exports of manufactures from developing countries.

Nontariff import barriers apply to a greater percentage of goods from developing

countries than to goods from other industrial countries. As for tariffs, the rates are in

principle nondiscriminatory. Tariff rates differ, however, by type of product. In gen-

eral, the highest tariff rates among manufactures are those on textiles, apparel, and

footwear—the kind of manufactures in which developing countries have their broadest

comparative advantage.

Developing countries are thus justified in charging the industrial nations with

hypocrisy. The industrial nations have not practiced the policies of free trade and

comparative advantage that they have urged on developing countries. Furthermore, the

departures of practice from preaching have been greatest on manufactures exported

from developing countries. The Doha Round of multilateral trade negotiations is billed

by the World Trade Organization as a “development round” in which a major focus

will be improving access for the exports of developing countries into markets in both

the industrialized countries and other developing countries. As of late 2014, the Doha

1970 1980 1990 2000 2012

Nonfuel primary products 49.9% 18.7% 18.7% 11.5% 14.6% Fuels 32.4 61.3 27.5 21.4 28.0 Manufactures 17.4 18.5 52.9 65.5 56.1

FIGURE 14.4 The Changing Mix of Exports from Developing Countries, 1970–2012

Note: Columns do not add to 100% because of a small amount of unclassified exports in each year.

Source: United Nations Conference on Trade and Development, Handbook of International Trade and Development Statistics, 1987 and 1995, and United Nations Conference on Trade and Development, UNCTADStat.

Chapter 14 Trade Policies for Developing Countries 329

pug21774_ch14_309-333.indd 329pug21774_ch14_309-333.indd 329 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

Round negotiations were at a standstill. You can watch to see if the round will achieve

its vision of expanding trade for development.

Despite some discrimination against their exports, developing countries have been

able to break into world markets for their exports of manufactures. One reason is that

developing countries have been able to become exporters in standardized manufac-

turing lines where technological progress has cooled down, such as textiles, tires,

and simple electrical appliances. A second reason is that developing countries have

become locations for low-cost assembly of more technologically advanced products

like computers, with multinational firms from the industrialized countries providing

the advanced technology, the components, and the marketing and distribution of the

finished products.

A third reason is that barriers against imports of manufactures from developing

countries are not all that solid. Consider barriers based on voluntary export restraints,

antidumping duties, or countervailing duties. These barriers can limit increases in

exports from countries that have already succeeded in establishing their exports

to the industrialized countries. But newcomers can gain market access for new

manufactured-product exports because they are not hindered by such country-specific

barriers. In this way a developing country can gain valuable new export markets,

despite the protectionism of the industrialized countries, although there may eventu-

ally be limits on how large these export sales can grow.

All in all, betting on exports of manufactures is part of the most promising strategy

for most developing countries. And as Figure 14.4 has made clear, the developing

countries are relying more and more on this strategy.

Summary The gaps in living standards are widening among developing countries. Developing countries in East Asia have grown quickly. For a number of poor countries in Africa,

average incomes have been declining for several decades. And countries in transition

from central planning to market economies experienced large declines in output and

income during the early years of transition, with most countries of the former Soviet

Union experiencing especially large declines.

Developing countries must decide what trade policies to adopt toward primary-

product exports, industrial imports, and industrial exports.

A traditional fear about relying on exports of primary products is that the world

market price trends are unfavorable to producers, especially those in developing

countries. The evidence shows a downward trend in the relative prices of most

primary products, as commonly feared. Two factors lowering the relative price

of primary products are Engel’s law and the development of modern synthetic

substitutes for primary materials. Two opposing forces, which would tend to raise

primary-product prices, are natural resource limits and the fact that productivity

growth is often slower in the primary sectors than in the rest of the economy.

Joining an international cartel could bring gains to a developing country that exports the cartelized product. The greatest cartel success by far is OPEC’ s pair of price victories in 1973–1974 and 1979–1980. With all international cartels, even

OPEC, success breeds decline. Four forces dictate the speed at which a cartel erodes:

the rise in product demand elasticity, the rise in the elasticity of competing supplies,

330 Part Two Trade Policy

pug21774_ch14_309-333.indd 330pug21774_ch14_309-333.indd 330 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

Key Terms International cartel

Suggested Reading

Studies of the ISI and outward-oriented strategies are Choksi et al. (1991), Sachs

and Warner (1995), Bruton (1998), World Bank (2002a), Panagariya (2004), and

Estevadeordal and Taylor (2013). Waugh (2010) explores how extra trade costs for

exports from developing countries limit their trade and lower their national incomes.

Grilli and Yang (1988) and Harvey et al. (2010) provide careful examinations of long-

run trends in the relative prices of primary products. Gilbert (1996) discusses the failures

of international commodity cartels.

The European Bank for Reconstruction and Development issues an annual Transition Report. Broadman (2005) examines trade policies in transition countries. World Bank (2002b) summarizes what we learned from the first decade of transition.

1. List the main pros and cons of taking the import-replacing road to industrialization

versus concentrating government aid and private energies on developing new manufac-

turing exports.

2. Under what conditions would ISI have the greatest chance of being better than any

alternative development strategy? What other policies should accompany it?

3. “The terms of trade move against primary producers in the long run.” What is the evi-

dence in support of this proposition? How solid is the evidence?

✦

Questions and Problems

Organization of Petroleum

Exporting Countries (OPEC)

Import-substituting

industrialization (ISI)

the decline in the share of the cartel in the world market, and the rise in cheating by

members of the cartel. Because of supply conditions, it is unlikely that cartels in other

primary products could achieve anything close to OPEC’s success.

One strategy open to developing countries is that of import-substituting industrialization (ISI). It could raise national skill levels, bring terms-of-trade gains, and allow planners to economize on market information (because they can just take

industrial imports themselves as a measure of demand that could be captured with the

help of protection). Studies of ISI and related policies, however, show that income

growth is negatively correlated with antitrade policies like ISI and positively corre-

lated with outward-oriented policies that are closer to free trade.

Another strategy is to concentrate on developing exports of manufactured goods,

especially those that are intensive in less-skilled labor. This has been a slowly prevail-

ing trend since the 1960s, though ISI also remains practiced in developing countries.

Relying on exports of manufactures has its risks, however. Developing nations have

rightly complained about import barriers against their new manufactures erected by

the industrialized countries. Such barriers have indeed been higher than the barriers

on manufactures traded between industrialized countries. Still, evidence shows that

an outward-oriented trade policy encouraging exports of manufactures is part of the

most promising strategy for most developing countries.

Chapter 14 Trade Policies for Developing Countries 331

pug21774_ch14_309-333.indd 331pug21774_ch14_309-333.indd 331 11/5/14 7:20 PM11/5/14 7:20 PM

Final PDF to printer

4. You are an adviser to the government of a country whose exports are mainly a few pri-

mary products and whose imports are mainly manufactured products. You are asked to

prepare a short report on the forces that are likely to drive the country’s terms of trade

during the next two decades. What will the main points of your report be?

5. The United States, China, India, Brazil, and Turkey are forming an international associa-

tion known as Tobacco’s Altruistic Raisers (TAR) to increase the world price of tobacco.

TAR’s members control 60 percent of world tobacco production. The price elasticity

of world demand for tobacco is rather low in the short run but somewhat higher in the

long run. The ability of other countries who are not TAR members to increase their

production of tobacco is very small for a period of several years; but, with a few years

to prepare, other countries could easily expand their tobacco production. You are asked

to write a report on the outlook for TAR’s success. What will you say in the report?

6. Drawing on material from this chapter and earlier chapters, weigh the pros and cons of

restricting and taxing a country’s exports of primary products. How could it raise the coun-

try’s national income? What are the drawbacks of such a policy for a developing country?

7. Consider Figure 14.3, which shows what a cartel can do if it can act as a monopolist.

In Figure 14.3, the cartel supplies the entire world market.

a. What is the effect on the cartel’s profit-maximizing price if a new outside source of supply now develops that can provide 10 million barrels of oil per day at any price

above $5 per barrel? Show the effect using the graph. (Hint: With this new outside

supply, what is the demand that remains for the cartel’s oil?)

b. Instead of the new outside source described in question a , consider instead a new outside source of supply that will provide amounts of oil that vary with the world

price, according to the following schedule:

Outside supply (millions of barrels per day) 5 (World price 2 5)/2

(For instance, if the world price is $15, the outside supply is 5 million barrels per

day.) Show graphically and explain the effect on the cartel’s profit-maximizing

price of this new outside supply source.

8. In the 1987 World Bank study, India was categorized as having a strongly inward

trade policy. During 1970–1990, India’s average annual growth rate of real income per

capita was about 2 percent. Around 1990, India shifted to an outward-oriented policy.

What is your prediction for India’s growth rate of income per capita since 1990? Do

the data reported in Figure 14.1 support your prediction?

9. “As long as increasing exports of less-skilled-labor-intensive manufactured products

are leading to rising employment and rising real wages for its workers, a developing

country has no interest in improving its educational system.” Do you agree or dis-

agree? Why?

10. Ukraine has to decide on a trade-policy strategy to go with other reforms for promoting

development. Comment on the merits and drawbacks of the following available choices:

a. Unilaterally taxing its wheat exports. b. Forming a wheat-exporting cartel with Argentina, Australia, and Canada, which are

also major wheat exporters.

c. Choosing manufactures it could export (e.g., batteries), giving them a profitable home-market base protected by tariffs, and encouraging exports to other countries

at competitive world prices.

✦

332 Part Two Trade Policy

pug21774_ch14_309-333.indd 332pug21774_ch14_309-333.indd 332 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

11. Some developing countries (including Ghana) are encouraging development of local

production of basic business services like call centers and data entry, to become an im-

portant destination for offshore outsourcing. Which of the four trade policies is most

closely related to a national policy to grow this kind of services production? Why?

12. In 2008 India and Vietnam restricted their rice exports to prevent increases in their do-

mestic rice prices, and world rice prices temporarily tripled. In 2011 the government of

Thailand, at that time the leading rice-exporting country, implemented a policy to buy

locally grown rice and withhold it from the market. The Thai government planned to

export the rice at a profit after world rice prices had increased substantially. The actual

outcome, as of early 2014, was that world rice prices were essentially unchanged and

that Thailand had fallen to being the third-largest rice exporter. What factors probably

contributed to the failure of the Thai government’s plan?

✦

Chapter 14 Trade Policies for Developing Countries 333

pug21774_ch14_309-333.indd 333pug21774_ch14_309-333.indd 333 10/29/14 5:48 PM10/29/14 5:48 PM

Final PDF to printer

Chapter Fifteen

Multinationals and Migration: International Factor Movements In previous chapters we looked at the economic and political battles over international

trade in goods and services. International movements of factors of production are often

even more controversial, with the debates even more emotional as well. In this chapter

we examine two major forms of international factor movements: those that occur through

the foreign activities of multinational enterprises and those that occur through the interna-

tional movement of people. In shifting our attention to international factor flows, we are

relaxing the assumption that factors do not move internationally, an assumption that we

have used through much of the discussion up to this point. That is, we now recognize that

factors of production can and do move between countries in amounts that are often large

enough to have economic effects and to grab political attention.

The global activities of multinational enterprises raise sensitive issues of whether

their objectives conflict with the well-being of individual countries and whether

they have the power to circumvent or overwhelm national-government sovereignty.

Developing countries worry both that foreign firms will invest in them and that they

won’t. They fear exploitation on the one hand and inadequate access to foreign capital,

technology, marketing, and management skills on the other. Industrialized countries

worry about being both the sources and the recipients of direct investments. As direct

investments flow out, don’t these reduce product exports and employment opportuni-

ties at home? As direct investments flow in, won’t foreigners establish undue influence

and control over the local economy?

The first part of this chapter provides a broad survey of what we know about mul-

tinationals and foreign direct investment. We explore why direct investments occur.

We also examine whether a home country or a host country has good reasons to try to

restrict (or encourage) multinational direct investment.

These national issues are important because the policies of national governments

remain powerful. All governments prohibit or restrict direct investments into certain

lines of activity. Which lines are prohibited vary from one country to another, but

the prohibitions are directed toward those activities that are regarded as particularly

vulnerable to foreign influence—including natural resources, banking, newspapers,

334

pug21774_ch15_334-369.indd 334pug21774_ch15_334-369.indd 334 11/5/14 7:52 PM11/5/14 7:52 PM

Final PDF to printer

broadcasting, telecommunications, airlines, and defense industries. Governments

also can regulate the local operations of foreign firms in a number of ways. They can

require local participation in the ownership or management of the local operations,

or they can require training, locally purchased components and parts, local research,

or exports. Governments can also use tax policy to influence both the flows of direct

investments and the division of the investment returns between the firms and the gov-

ernments. On the other hand, many governments actively court multinational enter-

prises by offering various forms of subsidies to attract them to locate in their countries.

Of all the flows that take place between nations, none is more sensitive than the

flow of humans. For those who migrate, the dangers are great but the average gain is

high. A migrant risks disease or victimization by others and may fail to find a better

income in the country of destination. Many migrants return home unsuccessful and

disillusioned. Still, they experience great gains on average, as we might expect from

so risky an activity. In some cases political and physical freedom itself is a large gain,

as in the case of refugees from repressive regimes. In other cases, the economic gains

stand out. Doctors, engineers, and other highly trained personnel from low-income

countries such as India and Jamaica have multiplied their incomes several times over

by migrating to North America, Australia, Britain, and the Persian Gulf. Mexican

craftspeople and campesinos earn enough in Texas or California to retire early (if they

wish) in comfortable Mexican homes. Turkish “guest workers” in Germany have also

gained a comfortable living and a jump up the income ranks.

In the countries that receive migrants, ethnic prejudice, general xenophobia, and the

direct economic stake of groups that fear competition from immigrants keep the issue espe-

cially sensitive. Anti-immigration groups have become more vocal since the early 1990s.

In response to rising legal and illegal immigration from Mexico and Central America,

the U.S. government enacted a federal law to deny even legal immigrants access to many

social programs, though subsequent laws restored some of the benefits. Rising immigra-

tion into the European Union, including illegal immigration that may be larger than that

into the United States, has alarmed some Europeans. In Austria, Denmark, France, Italy,

and Switzerland, political parties opposed to immigration have sometimes used virulent

rhetoric to try to gain votes. In Germany the government has put up new immigration bar-

riers in response to the growing numbers of refugees from Eastern Europe.

The second part of this chapter examines the economics of international migration.

We focus on people who migrate for economic reasons, to understand the effects on

labor markets in the sending and receiving countries. As we did for the multinational

enterprise, we then examine whether the sending or receiving country has reasons to

restrict migration to prevent adverse effects on national well-being.

FOREIGN DIRECT INVESTMENT

The U.S. company Apple pays cash to acquire all of the equity shares of a German

company that makes computer software. A U.S. investor named Pugel pays cash to

buy 10,000 shares (0.1 percent of all outstanding equity shares) of a similar German

company that also makes software. Both of these share purchases are international

flows of financial capital from the United States to Germany. But only one is foreign

Chapter 15 Multinationals and Migration: International Factor Movements 335

pug21774_ch15_334-369.indd 335pug21774_ch15_334-369.indd 335 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

direct investment. The key difference between the two investments is the degree to which each investor can control or influence the management of the company. In

foreign direct investment the investor has, or could have, an effective voice in the management of the foreign company. Foreign direct investment (FDI) is the flow of funding provided by an investor or a lender (usually a firm) to establish or acquire a

foreign company or to expand or finance an existing foreign company that the investor

owns and controls. Apple’s acquisition of the first German company is FDI.

In contrast, Pugel does not expect to have any influence on the day-to-day manage-

ment of the second German company. Rather, Pugel is seeking financial returns by

adding the 10,000 shares to his investment portfolio. Generally, the term international portfolio investment is used for all foreign securities investments that do not involve management control (that is, all that are not direct investments).

Both foreign direct investment and international portfolio investment are important

ways in which financial capital moves between countries. During 2010–2012, the

global flows of foreign direct investment and the global flows of international portfo-

lio investment each averaged close to $1.7 trillion per year. In this chapter we examine

the economics of foreign direct investment. We defer our analysis of international

portfolio investment to Chapters 18 and 19 of the book because we need the discussion

of foreign exchange rates contained there to analyze the financial returns and risks of

international investing.

In many cases, including the acquisition of the German company by Apple, we

can easily tell whether an investment is (or is not) FDI. In other cases, the investor

acquires or owns part of the equity of the foreign company but not all of it. How much

ownership is enough to the give the investor the ability to affect the management of the

foreign firm? There is no clear-cut answer to this, but it is certainly at most half, and

probably less than this. Someone who owns even, say, 20 percent of a firm can have

some ability to influence the management of the firm.

The agreed international standard is 10 percent ownership. 1 That is, foreign direct investment is any flow of lending to, or purchases of ownership in, a foreign firm in which the investor (usually a firm) has (or gains) ownership of 10 percent or more of the foreign firm. Here are some examples of investments that do and do not fit the official definition of foreign direct investment:

U.S. Foreign Direct Investments U.S. Portfolio Investments Abroad

Alcoa’s purchase of 50 percent of the Alcoa’s purchase of 5 percent of the stock stock in a new Jamaican bauxite firm in a new Jamaican bauxite firm (this 5 percent is the full amount of ownership that Alcoa then has) A loan from Ford U.S.A. to a Canadian A loan from Ford U.S.A. to a Canadian parts-making subsidiary in which Ford parts-making firm in which Ford U.S.A. holds 55 percent of the equity holds 8 percent of the equity

1 This 10 percent standard is used by the United States and many other countries, but not by all countries that report FDI data. In addition, another form of FDI recognized by the international standards involves a group of investors in a home country that establish control of a foreign affiliate, even if each investor individually owns less than 10 percent of the foreign firm.

336 Part Two Trade Policy

pug21774_ch15_334-369.indd 336pug21774_ch15_334-369.indd 336 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

Note that direct investment consists of any investment, whether new ownership or

simple lending, as long as the investing firm owns (or acquires) over 10 percent of the

foreign firm.

MULTINATIONAL ENTERPRISES

A firm that owns and controls operations in more than one country is a multinational enterprise (MNE). The parent firm in the MNE is the headquarters or base firm, located in the home country of the MNE. The parent firm has one or more foreign affiliates (subsidiaries or branches) located in one or more host countries.

The multinational enterprise uses flows of foreign direct investment to establish or

finance its foreign affiliates. However, in two different ways a multinational firm is

more than just the flow of foreign direct investment. First, foreign affiliates usually receive only part, and often a rather small part, of their total financing from the direct

investment flows. Second, the multinational enterprise transfers many other things to

its foreign affiliates in addition to the direct investment financing. The multinational

enterprise typically provides its affiliates with a variety of intangible assets for the

affiliates to use. These intangible assets can include proprietary technology, brand

names, marketing capabilities, trade secrets, and managerial practices. In this section

we focus on the first issue, the financing of the affiliates.

A foreign affiliate can obtain financing either from its parent (or other parts of the

MNE) or from outside lenders and investors (for instance, banks or the buyers of bonds

that the affiliate issues). Only the former is foreign direct investment, and it is often a

small part of the total financing of the affiliate. For all MNEs in the world in 2012, for-

eign affiliates had about $87 trillion of financing in place, but only $23 trillion of that

financing was provided by foreign direct investment by the multinational enterprises.

Evidence for U.S.-based multinationals indicates that borrowing in the host countries

provides more than half of the outside financing.

Why does FDI provide so little of the affiliates’ total funding? An important rea-

son is that a parent firm wants to reduce the risks to which its foreign activities are

exposed. One risk is unexpected changes in exchange rates, which can alter the value

of its direct investments. A good risk-reducing strategy for a parent company that has

foreign-currency assets in its affiliates is to take on foreign-currency liabilities as well,

by borrowing in foreign currencies that are used to finance the affiliate.

Another risk is political risk, the possibility that the government of a host country

will alter its policies in ways that harm the multinational enterprise. For instance,

the possibility of expropriation or nationalization of an affiliate by the host-country

government is a political risk. Since World War I and the Russian revolution, host

countries have shown willingness to seize the assets of multinationals, sometimes

without compensating the investors. For example, in recent years the Venezuelan

government has seized the local investments of Exxon Mobil (oil), Owens-Illinois

(glass), Helmerich & Payne (drilling rigs), and many other companies in the elec-

tricity, cement, coffee, and oil industries. The Bolivian government took control of

foreign-owned oil and natural gas operations in 2006, a foreign-owned electricity

generation firm in 2010, and a foreign-owned electricity distribution firm in 2012.

Realizing the danger of expropriation, many multinationals reduce their exposure

Chapter 15 Multinationals and Migration: International Factor Movements 337

pug21774_ch15_334-369.indd 337pug21774_ch15_334-369.indd 337 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

to this kind of risk by matching much of the value of their physical assets in a host

country with borrowings in that country. If political change brings expropriation, the

parents also can tell the host-country lenders to try to collect their repayments from

their own (expropriating) government. The shedding of liabilities offsets part or all of

their asset losses in the country.

FDI: HISTORY AND CURRENT PATTERNS

Although data on foreign direct investment tell us only about one aspect of the global

operations of MNEs, these data have the advantage that they are available for most

countries and for long periods of time. We use data on FDI as general indicators of

the importance of MNEs across countries and over time. Data on FDI are available for

two related but different measures:

• Flows of FDI measure new equity investments and loans within MNEs during a period of time. This is the measure of FDI we used in the section in which we

defined FDI .

• Stocks of FDI measure the total amount of direct investments that exist at a point in time. These stocks are the sums of past flows of FDI.

Let’s look first at information on flows of FDI.

Foreign direct investment has been rising and falling, mainly rising, throughout the

20th century and into the 21st. It had its fastest growth, and took its largest share of all

international investment, in the period dating roughly from the end of the Korean War

(1953) to the first oil shock (1973–1974). During that period, direct investments were

dominated by investment outflows from the United States. U.S. firms have histori-

cally shown a greater preference for FDI and direct control than have firms from other

investing countries. Britain, France, and the oil-rich nations have channeled a greater

proportion of their foreign investments into portfolio lending. Thus, the early postwar

rise of U.S. FDI propelled U.S.-based multinationals into international prominence. In

the 1970s and early 1980s, global FDI grew more slowly, being eclipsed by two waves

of portfolio lending: the ill-fated surge of lending to developing countries in 1974–1982

and the surge of lending to the United States in the 1980s.

Global FDI was driven by increasing FDI by Japanese firms in the second half of

the 1980s and by increasing FDI by U.S. firms, European firms, and firms based in

South and East Asia since 1990. The global flows of foreign direct investment rose

rapidly in the second half of the 1990s, as the value of cross-border mergers and acqui-

sitions, mostly between firms in the industrialized countries, exploded. After reaching

$1.4 trillion in 2000, FDI flows fell with the recession of the early 2000s. Then FDI

flows grew rapidly again, to $2.2 trillion in 2007, again driven by a large increase in

international mergers and acquisitions. With the sharp contraction in economic activ-

ity during the global financial and economic crisis, FDI flows fell to $1.2 trillion in

2009 and then recovered somewhat in the next years.

Foreign direct investment has also changed direction. First, in the 1970s and

1980s, it moved away from the developing countries, where it had met with resistance

and expropriations climaxing in the 1970s. This trend reversed itself beginning in

338 Part Two Trade Policy

pug21774_ch15_334-369.indd 338pug21774_ch15_334-369.indd 338 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

Host Region

Home Total European Other Latin Developing Other Country Outward FDI NAFTAa Unionb Industrialized America Asia Developingc

United States 4,085 422 2,037 418 681 373 153 Britain 1,700 377 823 104 76 182 138 France 1,505 261 923 108 50 81 82 Germany 1,208 241 720 67 26 99 54 Switzerland 1,113 263 490 42 160 88 70 Netherlands 982 144 555 122 51 75 36 Japan 963 289 215 56 119 263 21 Canada 661 273 164 37 126 20 40 Spain 657 102 336 33 139 12 34

FIGURE 15.1 Major Home Countries’ Direct Investments, End of 2011 (Billions of U.S. Dollars)

FDI shows noticeable regional patterns, with substantial direct investments between the United States and Canada, from Japan into the

developing countries of Asia, and between European countries.

a North American Free Trade Area: Canada, Mexico, and the United States. b For the 27 member countries as of 2010. c Includes FDI not allocated to specific host countries.

Source: Organization for Economic Cooperation and Development, OECD International Direct Investment Statistics: Foreign Direct Investment, Positions by Partner Country, 2014; and United Nations Conference on Trade and Development, Bilateral FDI Statistics 2014.

about 1990, as FDI flows into developing countries increased dramatically. Growing

domestic markets, low production costs, and reforms of economic policies attracted

direct investment, especially into a small number of developing countries in South

and East Asia and Latin America. Included in these is China, following its opening

to foreign trade and investment that began in the late 1970s. Second, the United

States attracted more FDI inflows than any other nation in the 1980s. The share of

the United States then declined somewhat, but it continued to receive about one-

seventh of new FDI flows during 2010–2012. Third, the deepening of integration in

the European Union has encouraged FDI into and within the EU, and the formation

of the North American Free Trade Area (along with Mexico’s own policy reforms)

has encouraged FDI into Mexico.

Let’s turn now to information on the stocks of FDI. Recall that FDI stocks are the

cumulation of the FDI flows that we have just been talking about. FDI stocks measure

total amounts in existence as of the stated time. Figure 15.1 shows the geographic

pattern of direct investment stocks by nine large home (or source) countries at the end

of 2011. These nine countries are the source of about 62 percent of all existing direct

investments. In fact, industrialized countries as a group are overwhelmingly the home

countries of direct investments, accounting for about 79 percent of the world total.

The six columns toward the right in Figure 15.1 indicate different regions that host

the direct investments. Reading across a row shows where the nine source countries

invest. Half of U.S. direct investment is in Europe. The United States is also a major

investor in Canada. (Most of the $422 billion of U.S. direct investment in the two

other countries of NAFTA is in Canada.) Canada has placed about 40 percent of its

direct investment in the United States. Japan has substantial direct investments in the

Chapter 15 Multinationals and Migration: International Factor Movements 339

pug21774_ch15_334-369.indd 339pug21774_ch15_334-369.indd 339 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

developing countries of Asia, and it built a large position in the United States in the

1980s. Britain, France, Germany, the Netherlands, and Switzerland have close to half

of their direct investments in other European countries, as well as substantial direct

investments in the United States. Spain has about half of its direct investments in other

European countries, and about a fifth in Latin American countries.

About 63 percent of the stock of direct investment is in industrialized countries.

To a large extent, FDI involves firms from industrialized countries investing in other

industrialized countries. With one exception, the major home countries are also major

host countries. The exception is Japan. One way in which Japan is truly different from

other major industrialized countries is that it is host to relatively little direct invest-

ment. In 2012, the stock of direct investment in Japan was only $205 billion, less than

one-third of the FDI that Spain, a much smaller country, had received.

In which industries does FDI occur? That has changed over time. In 1970, about

one-quarter of the world’s direct investment was in the primary sector, mainly min-

ing and extraction activities. About half was in the manufacturing sector, and about

a quarter was in the services sector. The share of mining and extraction has since

declined, especially in the 1970s as developing countries nationalized many firms

and exerted greater control over the extraction of their natural resources. The share of

manufacturing has declined to less than 30 percent, and the share of services has risen

to over 60 percent. In manufacturing, firms that produce pharmaceuticals and other

chemicals, electrical and electronic equipment, automobiles, machinery, and food

tend to be active in direct investment, while firms in industries like textiles, cloth-

ing, and paper products tend to do rather little direct investment. Within the services

sector substantial direct investment occurs in banking and other financial services; in

business services such as consulting, accounting, and advertising; and in wholesaling

and retailing.

WHY DO MULTINATIONAL ENTERPRISES EXIST?

This seems to be a silly question! The answer seems simple—because they are profit-

able. But the issue is more complicated than it sounds.

We should first dispose of one possible explanation, that multinationals are simply

a way of shifting financial capital between countries based on national differences in

returns and risks. Although return and risk must play a role in the decisions by firms

about whether to make direct investments, this financial theory of direct investment is

not adequate. It does not explain why these international investments would be large

enough to establish managerial control over the foreign companies. If the challenge is

to transfer capital from one country to another, international portfolio investment can

accomplish this task better than direct investment by firms whose major preoccupation

lies in production and marketing.

There is some agreement that five different pieces together provide a good explana-

tion of why multinational firms exist (and why they are as large as they are). The five

pieces are

1. Inherent disadvantages of being foreign.

2. Firm-specific advantages (to overcome the inherent disadvantages).

340 Part Two Trade Policy

pug21774_ch15_334-369.indd 340pug21774_ch15_334-369.indd 340 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

3. Location factors (that favor foreign production over exporting).

4. Internalization advantages (that favor direct investment over contracting with inde-

pendent firms).

5. Oligopolistic rivalry (among multinational enterprises).

The combination of these pieces into a framework for understanding the multinational

enterprise is often called the eclectic approach, with credit for the synthesis going to

John Dunning.

Inherent Disadvantages Our first step is to recognize that there are good reasons why multinational enterprises

should not exist. An MNE has inherent disadvantages in trying to compete against foreign rivals by operating on their own turf. The multinational is at a disadvantage

in this foreign production environment because it does not initially have the native

understanding of local laws, customs, procedures, practices, and relationships. In

addition, the firm has the extra costs of maintaining management control. It is expen-

sive to operate at a distance, expensive in travel and communications, and especially

expensive in misunderstanding. Furthermore, the MNE may lack useful connections

with political leaders in the foreign country, or it could face actual or potential hostility

from the foreign country’s government.

Firm-Specific Advantages What makes it possible for a multinational to overcome the inherent disadvantages

of being foreign? To be successful, the multinational must have one or more firm- specific advantages —that is, one or more assets of the multinational enterprise that are not assets held by its local competitors in the host country (or, perhaps, by

any other firm in the world). A firm’s secret technology or its patents are a firm-

specific advantage (examples: Siemens in electrical and electronic products, Pfizer

in pharmaceuticals). Or, as in the case of petroleum refining (Royal Dutch Shell) or

metal processing (Alcoa), the firm may gain advantage by coordinating operations and

capital investments at various stages in a vertical production process. Because of heavy

inventory costs and its knowledge of the requirements at each stage, the firm may be

able to economize through synchronizing operations. Or the firm may have marketing

advantages based on skilled use of advertising and other promotional methods that

establish product differentiation—for instance, through highly regarded brand names

(examples: Nestlé, Procter & Gamble). Or an advantage may inhere in superior man-

agement techniques (example: General Electric). Or, as for many of these large MNEs,

it has access to very large amounts of financial capital, amounts far larger than the

ordinary national firm can command. Some special advantage is necessary for the firm

to overcome the disadvantages of operating at a distance in a foreign environment. It is

costly for the firm to develop these assets (for instance, the cost of research and devel-

opment to develop new technology, the marketing expenses to establish and maintain a

strong brand name). The challenge to the firm is to maximize its returns on these assets.

We now have an enterprise that has firm-specific advantages such that it could oper-

ate profitably as a multinational. But should it? Even for the firm that has firm-specific

Chapter 15 Multinationals and Migration: International Factor Movements 341

pug21774_ch15_334-369.indd 341pug21774_ch15_334-369.indd 341 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

advantages, it must also consider alternatives to foreign direct investment for earning

profits from activities in a foreign market. It must be more profitable for a multinational

enterprise to own and manage a foreign operation, rather than adopting some other way

of earning profits. Let’s focus on the situation in which a firm wants to earn profits

by selling to local buyers in the foreign country. Here are two questions for the firm’s

managers:

1. Should the firm sell to foreign buyers by exporting from its home country, or should

the firm set up local production in the foreign country to produce the products that

are sold to the foreign buyers?

2. Should the firm license local firms in the foreign country to use its advantages in

their own operations that serve the foreign buyers, or should the firm set up foreign

operations that it owns and controls?

The answers to these questions bring location factors and internalization advantages

into the explanation.

Location Factors Location factors are all of the advantages and disadvantages of producing in one country (the home country) or in another country (the foreign country). We have

already developed, in the previous chapters of the book, many of the location factors

that we need to answer the question “Export or FDI?” Here are four key location fac-

tors from our previous explorations:

• Comparative advantage: the effects of resource availability (labor, land, and so forth) on the costs of producing in different countries.

• Scale economies : size advantages that favor concentrating production in a few loca- tions and serving other national markets by exporting.

• Governmental barriers to importing into the foreign country: tariffs and nontariff barriers that make it difficult to export from the home country.

• Trade bloc: setup that favors FDI if the foreign country is a member of a free-trade area (or similar arrangement) but the home country is not a member because production in

the foreign country can also be used to serve buyers in the other member countries.

There are other location factors that are important in some industries. High costs

of transporting a product favor FDI to locate production units close to foreign buyers,

rather than serving faraway buyers by exporting. Government taxes, subsidies, and

regulations affect the profitability of producing in different countries. The need to

adapt products to the specific tastes of foreign buyers can favor FDI because it is more

effective to have close links among the local marketing group, the product redesign

group, and the operations group that must produce the redesigned products at accept-

able costs.

Location factors are key to answering the question “Export or FDI?” Note that the

answer could go either way for a specific firm and product. In some cases it is more

profitable to export from the home country, for instance, because the home country

has a comparative advantage in the availability and low cost of the most important

resource needed in producing the product. In other cases foreign production in an

342 Part Two Trade Policy

pug21774_ch15_334-369.indd 342pug21774_ch15_334-369.indd 342 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

affiliate established by direct investment is more profitable, for instance, because the

foreign country has high tariffs on imports of the product.

Internalization Advantages Even if the firm rules out exporting as a way of serving the foreign market, it still has

alternatives for earning profits from that foreign market. Instead of using foreign direct

investment to set up an affiliate, the firm could sell or rent its firm-specific advantages

to foreign firms for them to use in their own production. For instance, if the advantages

are based on superior technology, a strong brand name, or better management prac-

tices, the firm could license one or more foreign firms to use these assets. A license is an agreement for one firm to use another firm’s asset, with restrictions on how the

asset can be used, and with payments for the right to use the asset.

In making the decision between FDI and licensing of foreign firms, the firm with

the asset must weigh the advantages and disadvantages of each alternative. An impor-

tant advantage of licensing foreign firms is that the firm avoids (most of) the inherent

disadvantages of establishing and managing its own foreign operations. On the other

side there are advantages to keeping the use of the firm-specific advantages within

(internal to) the enterprise. Internalization advantages are the advantages of using an asset within the firm rather than finding other firms that will buy, rent, or license

the asset. Internalization advantages exist because there are drawbacks to using the

market for many firm-specific advantages, particularly intangible assets like technol-

ogy, brand names, marketing techniques, and management practices.

Internalization advantages arise from avoiding the transaction costs and risks of licens- ing an independent firm. Negotiating the license is often costly and difficult. The licensor wants a high payment, and the licensee wants a low payment. The licensee is likely to be

skeptical of claims by the licensor that the intangible asset is valuable and should com-

mand a high price. The licensor also wants to put various restrictions on how the licensee

can use the asset, but the licensee wants to have as few restrictions as possible. Then, even

if the license agreement can be negotiated, the licensor still faces some important risks.

The licensee may not be as careful with the asset as the licensor would be. For instance,

the licensee may let secret technology leak out to other competitors, or the licensee may

itself apply the technology to other activities not covered by the license. Or the licensee

may fail to maintain product quality, leading to news reports (“brand-name cola causes

widespread illness in Austria”) that harm the global reputation and value of the brand.

Foreign direct investment keeps the use of the assets under the control of the enter-

prise itself. It avoids many of the drawbacks of using the market for these kinds of

assets. The advantages of internalization are based on the ability of the MNE’s man-

agement to set the terms for the use of the assets in its foreign affiliates. The returns

to the use of the assets are part of the profits earned by the affiliate, and the enterprise

2 Buckley and Casson (1976) stressed the importance of internalization advantages for our understanding of MNEs. Magee (1977) developed a similar approach that stresses the importance of approbriability— the ability of an MNE to earn the best returns on its investment in intangible assets. The analysis by Nobel Prize winner Ronald Coase is also relevant. The economics of whether to engage in FDI is an international extension of the decision about the boundaries of the firm (whether to make or buy, whether to own or rent, and so forth).

Chapter 15 Multinationals and Migration: International Factor Movements 343

pug21774_ch15_334-369.indd 343pug21774_ch15_334-369.indd 343 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

can enforce policies to safeguard the ongoing value of its intangible assets. The mul-

tinational enterprise uses FDI to better appropriate the returns to its intangible assets. 2

The importance of internalized use of firm-specific intangible assets explains why

foreign direct investment occurs to a greater extent in high-technology industries

(electronic products or pharmaceuticals, for example) and marketing-intensive indus-

tries (food products or automobiles, for example) than it does in standard-technology

industries (clothing, for example) or less-marketing-intensive industries (paper prod-

ucts, for example).

Oligopolistic Rivalry Many multinational enterprises are not the tiny firms that populate perfectly competi-

tive markets. Instead, they are large firms that often compete among themselves for

market shares and profits. They have used their intangible assets (like new technolo-

gies and strong brand names) to obtain large market shares. The same intangible assets

drive their FDI. These multinationals are involved in global oligopolistic rivalry of the

sort that we discussed in Chapters 6 and 11.

Multinationals can use their decisions about foreign direct investment as part of

their strategies for competing. For instance, multinationals compete for location. A

multinational sometimes seems to set up an affiliate that looks only marginally profit-

able, yet it does so with the stated purpose of beating its main competitors to the same

national market. General Motors may set up a foreign affiliate in a developing country

mainly because it fears that if it doesn’t, Toyota will. With some regularity other mul-

tinational rivals then quickly respond by setting up their own affiliates in this country,

to prevent the first mover from gaining any lasting advantage. Such follow-the-leader

behavior results in a bunching of the timing of entries by rival multinationals into a

host country. Most of the affiliates may have a tough time earning profits.

Multinationals can also use FDI to try to mute competition and enhance their

market power. First, a multinational may acquire foreign firms that are beginning to

challenge their international market position. Second, a multinational may set up an

affiliate in the home country of one of its rivals, to establish a competitive threat to this

rival. The message is “Don’t compete too vigorously against me in other countries, or

I will make life tough for you in your own home market.”

TAXATION OF MULTINATIONAL ENTERPRISES’ PROFITS

The profits of multinational enterprises come from the operations of the parent

firms and their foreign affiliates. National governments impose taxes on business

profits, and the taxation of the profits of multinational enterprises can become com-

plicated and contentious. Let’s look first at how the profits of these global firms are

taxed and then at two important issues that arise from this taxation.

Part of how a multinational enterprise’s profits are taxed is conceptually straight-

forward (although the details can be vexing). The host-country governments tax the

profits of the local affiliates of the multinational, and the home-country government

taxes the parent company’s “local” profits earned on its own activities. A key question

344 Part Two Trade Policy

pug21774_ch15_334-369.indd 344pug21774_ch15_334-369.indd 344 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

Our discussion in the text stresses that multination- als succeed by using their firm-specific advantages throughout their global operations. We have also noted that most foreign direct investments are made by firms based in the industrialized coun- tries. This is the story of CEMEX, a firm that rapidly has become multinational since 1990. The reasons for its multinational success fit very well with the advantages stressed in the eclectic approach. What makes the firm unusual is that it is based in Mexico. CEMEX is an example of a growing group of multinationals based in developing countries.

CEMEX began business in 1906. For most of its life this cement company focused on selling in the Mexican market. Cement is a product that is expensive to ship, especially overland, so cement plants ship mostly to customers within 300 miles of a plant. Shipment by water is moderately (but not prohibitively) expensive. Most cement produc- ers in the 1980s were local producers with tradi- tional business practices. New managers at CEMEX broke with tradition by introducing extensive use of automation, information technology, and a satellite-based communication network into CEMEX operations. They used the technology to improve quality control and to provide detailed information on production, sales, and distribution to top man- agers in real time. Delivery of ready-mix concrete is particularly challenging in cities. Traditionally, cement firms could ensure delivery only within a time period of about three hours. CEMEX pio- neered the use of computers and a global position- ing system to guarantee delivery to construction sites within a 20-minute window. These innovations became the company’s firm-specific advantages.

Also in the 1980s CEMEX began to export more aggressively to the United States using sea trans- port, and it was increasingly successful. However, competing U.S. cement producers complained to the U.S. government, and in 1990 CEMEX exports to the United States were hit by a 58 percent antidumping duty. With exporting to the United States limited by the antidumping order, CEMEX looked for other foreign opportunities.

In 1991, it began exporting to Spain, and in 1992 it made its first foreign direct investment

by acquiring two Spanish cement producers. CEMEX minimized its inherent disadvantages by investing first in a foreign country with the same language as the firm’s home country and a simi- lar culture. In addition, CEMEX used its expansion into Europe as a competitive response to the pre- vious move by the Swiss-based firm Holcim into the Mexican cement industry.

The management team sent by CEMEX to reorganize the acquired companies was amazed to find companies that kept handwritten records and used almost no personal computers. They upgraded the Spanish affiliates to CEMEX technology and management practices. The improvement in affiliate operations from this internal transfer of CEMEX’s intangible assets was remarkable—profit margins improved from 7 percent to 24 percent in two years.

Since then, CEMEX has made a series of foreign direct investments by acquiring cement producers in Latin America (including Venezuela, Panama, the Dominican Republic, Colombia, and Costa Rica), the United States, Britain, the Philippines, Indonesia, and Egypt. CEMEX used the same type of process that it used in Spain to bring its tech- nology and management practices into its new foreign affiliates, and generally achieved similarly impressive improvements in performance.

By 2000, CEMEX was the third largest cement producer in the world, behind Lafarge of France and Holcim. More than 60 percent of its physical assets were in its foreign affiliates. It was also the largest exporter of cement in the world (a fact consistent with the proposition discussed in the text that FDI and trade are often complemen- tary). CEMEX is considered one of the best net- worked companies globally by computer industry experts, well ahead of its rivals. Its investments in developing and enhancing its firm-specific advantages have been paying off globally.

DISCUSSION QUESTION In countries like Spain, Colombia, and the Philippines, why did CEMEX not just license inde- pendent local producers to use its operations technologies?

Case Study CEMEX: A Model Multinational from an Unusual Place

Chapter 15 Multinationals and Migration: International Factor Movements 345

pug21774_ch15_334-369.indd 345pug21774_ch15_334-369.indd 345 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

is, then, whether the home-country government also imposes any taxes on the profits

earned by the foreign affiliates of the parent company.

Because the profits of these foreign affiliates have been taxed already by the host

government, the home government usually tries to avoid double taxation of the for-

eign affiliate profits. While the exact rules vary by country, the outcome is that the

home-country government collects few or no extra taxes on the profits of foreign

affiliates. 3 Thus, the tax rate on the profits of a foreign affiliate is largely that

imposed by the host government. Because tax rates vary across host countries, and

because global multinational enterprises try to minimize the total taxes that they

pay (as long as lower tax payments increase global after-tax profits), two important

issues arise.

First, a multinational enterprise can shop around among countries and locate

its affiliates in the jurisdictions of governments offering low tax rates. FDI allows

a multinational enterprise to settle in countries with lower taxes. Whether this is

good or bad from a world point of view depends on the uses to which tax revenues

are put and whether the productivity of the investing firm is lower in the lower-tax

country.

Second, multinational enterprises can use transfer pricing and other devices to

report more of their profits in low-tax countries, even though the profits were actu-

ally earned in high-tax countries. Transfer pricing is the setting by the company of prices (or monetary values) for things that move between units of the company. Many

things move between the parent and an affiliate or between affiliates of a multinational

enterprise. These include materials and components, finished products, the rights to

use technology and brand names, and financial capital. For accounting for each unit

(the parent or an affiliate), each of these things must be assigned a price or value.

Therefore, all multinationals must engage in setting these transfer prices.

The multinational can set transfer prices to achieve any of a number of enterprise

objectives, and one of these is reducing the global taxes that the multinational pays.

For instance, to lower its corporate income taxes, the MNE can have its unit in a

high-tax country be overcharged (or underpaid) for goods and services that the unit

buys from (sells to) an affiliate in a low-tax country. That way, the unit in the high-tax

country doesn’t show its tax officials much profit, while the unit in the low-tax country

shows high profits. Profits are shifted from the unit in the high-tax country to the unit

in the low-tax country. The result: net tax reduction for the multinational enterprise

in question.

Here is a numerical example to show how this could work. An MNE produces a

component in Germany where the tax rate on corporate income is, say, 50 percent.

The component costs $8 per unit to produce in Germany, and the MNE sells all units

that it produces there to its affiliate in Singapore, where the tax rate on corporate

income is, say, 20 percent. The affiliate in Singapore uses this component and $7

3 The United States imposes taxes on the portion of foreign affiliate profits sent home to the U.S. parents, but it also allows tax credits for taxes already paid to the host-country governments on these profits. Most other industrialized countries basically impose no taxes on the profits of the foreign affiliates of firms based in their countries.

346 Part Two Trade Policy

pug21774_ch15_334-369.indd 346pug21774_ch15_334-369.indd 346 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

of labor to produce a finished product that it sells to outside buyers for $20 per

unit. Thus, for each unit sold to a final buyer the multinational has $5 of before-tax global profit ($20 – $8 – $7). But the multinational is most interested in the profit

that it gets to keep after it pays its corporate income taxes. Its after-tax global profit depends on what transfer price it sets for the sale of the component by its German

affiliate to its Singapore affiliate. Here are three possibilities and the resulting after-

tax global profit per unit:

German Affiliate Singapore Affiliate Global MNE

Transfer Price of Before-Tax After-Tax Before-Tax After-Tax Before-Tax After-Tax the Component Profit Profit Profit Profit Profit Profit

$13.00 $5.00 $2.50 $0.00 $0.00 $5.00 $2.50 10.00 2.00 1.00 3.00 2.40 5.00 3.40 8.00 0.00 0.00 5.00 4.00 5.00 4.00

Of the three possible transfer prices shown, the multinational achieves the highest

global after-tax profit by using the lowest transfer price.

Governments know that multinational enterprises can use transfer prices to shift

their profits and lower their taxes. Many governments attempt to police transfer pric-

ing to ensure that the transfer prices used between units within a multinational enter-

prise are similar to the market prices that independent firms would pay to each other

for similar transactions. However, determining whether transfer prices differ from

market prices is complex and costly, so multinational enterprises usually have some

scope to use transfer pricing to alter the taxes the multinationals pay (and to which

countries they pay those taxes).

MNES AND INTERNATIONAL TRADE

It is natural to think of foreign direct investment in a host country as a substitute for

exports by the parent firm (or other home-country firms) to the host country, just as

we concluded in Chapter 5 that trade and international movements of production fac-

tors are substitutes. Yet it turns out that multinational enterprises are actually heavily

involved in international trade. About one-third of the world’s international trade

in goods occurs as intrafirm trade between units of the multinational enterprises located in different countries. Another third of the world’s international trade involves

a multinational enterprise as the seller (exporter) or buyer (importer), trading with

some other firm.

Why are multinational enterprises so involved in world trade? Especially, why is

intrafirm trade so important? When are trade and FDI substitutes? Can FDI comple-

ment trade? We will answer these questions, first for the easier case in which a parent

and its affiliates are engaged in different stages of overall production, then for the

harder case in which the affiliate is largely doing the same types of production activi-

ties as the parent (or other affiliates).

As long as transport costs and trade barriers are low enough, FDI can be used to

reduce total costs by locating different stages of overall production in different countries.

Chapter 15 Multinationals and Migration: International Factor Movements 347

pug21774_ch15_334-369.indd 347pug21774_ch15_334-369.indd 347 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

Compared with the situation in which the firm would perform most of these activities

in a single country, FDI leads to more trade as the firm’s overall production is spread

across units in different countries.

For instance, for electronics products like televisions, communications equipment,

and computer hard drives, each stage of production can be located according to the

country’s comparative costs advantage (or, in the case of marketing and distribution,

according to the need to locate close to the customers for the final products). Design

and development of new products are located in countries (often the home country)

abundant in engineers and other skilled labor; production of components in

countries with capabilities to make high-quality, complex products; and assembly

in countries abundant in less-skilled labor. In this case, FDI is pro-trade, with large

amounts of intrafirm trade as components produced by units in one set of countries

are shipped to units in other countries for assembly, and the assembled final products

are shipped to units around the world for sale to final customers.

Trade among parents and affiliates engaged in different stages of production shows

that FDI and trade can sometimes be complements . Yet most FDI is not used primarily to locate different stages of production in different countries. Rather, most affiliates

largely duplicate the production activities of the parent firm or affiliates located in

other countries.

In the case in which foreign affiliates undertake the same kind of production as that

of the parent firm or other affiliates, FDI and trade could be substitutes or comple-

ments. To some extent they are substitutes . In many industries a firm must find a reasonable trade-off between (1) centralizing production in one or a few locations and

exporting to many other countries, to achieve scale economies (recall the discussion of

scale economies from Chapter 6), and (2) spreading production to many host countries

where the buyers are, to reduce transport costs, to avoid actual or threatened barriers

to importing into these countries, or to gain local marketing advantages. When scale

economies are less important, or when transport costs and trade barriers are higher,

for example, the trade-off would tilt toward FDI. Foreign production through direct

investment then substitutes for international trade.

However, the effects of this kind of FDI on trade are actually more complex. To

some extent this FDI is also likely to promote or complement trade, for two reasons. First, the affiliates’ production of the final product requires components and materials

as inputs into production. Often it is most economic to acquire these components and

materials from the parent firm, affiliates in other countries, or independent suppliers

in other countries. Although trade in final products may decrease, trade in materials

and components increases.

Second, this FDI can increase trade in final products because the affiliate improves

the marketing of all of the firm’s products in the host country. In many cases the

affiliate produces only some of the firm’s entire product line locally. Other items in

the product line must be imported from the parent or other affiliates. The affiliate

displaces some trade for the specific products that it produces, but it expands trade through better local marketing of other products produced by the multinational in

other countries.

We have just seen that there are good reasons to think that FDI and trade could be

substitutes, and good reasons to think that they could be complements. While each

instance of FDI has its own outcome, can we say anything about the overall relationship?

348 Part Two Trade Policy

pug21774_ch15_334-369.indd 348pug21774_ch15_334-369.indd 348 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

Most studies conclude that FDI, on average, is somewhat complementary to international

trade. For instance, studies of U.S., German, Japanese, French, and Swedish multinationals

find that, controlling for other influences, FDI is associated with higher home exports

of products in the same broad industry. The overall complementarity seems to reflect

both higher home exports of components used in affiliate production and higher home

exports of final goods (the latter applies to many but not all industries).

SHOULD THE HOME COUNTRY RESTRICT FDI OUTFLOWS?

To decide whether FDI should be restricted by the home (or source) country is a dif-

ficult task. Let’s approach it using a framework similar to the approach we used to

examine restrictions on international trade. We can then identify several key effects:

• The effect on workers and others who provide inputs into production in the home

country.

• The effects on the owners of the multinational enterprises based in this home country.

• The effects on the government budget, especially the effects on government tax

revenues.

• Any external benefits or costs associated with direct investments out of the country.

Notice that we are now dividing the producer side of the market into (1) workers and

other providers of inputs and (2) the owners of the multinational enterprises. Our pre-

sumption is that the multinational enterprises are more mobile internationally than are

the workers and some of the providers of other inputs.

A good starting point for policy judgments about FDI and multinationals is a static

economic analysis of the effects of shifting some of the country’s capital stock out of

the country. If FDI shifts some of the home country’s capital to other countries, then

less is available to use in production at home. With less capital to use in production,

workers may be harmed. Some workers will experience temporary unemployment as

they adjust to the reduction in home production by the multinationals. If the demand for

labor decreases in the home country, then the real wages of workers will decline broadly.

Representatives of organized (unionized) labor in the United States and Canada

have fought hard for restrictions on the freedom of companies to set up affiliates pro-

ducing overseas and in Mexico, arguing that their jobs are being exported. Basically,

their protest is correct, even though there are indirect ways in which outbound FDI

creates some jobs in the United States and Canada. Organized labor may be especially

affected because firms faced with strong labor organizations in the home country often

replace or threaten to replace home-country production and jobs with production and

jobs in other countries.

Workers are not the only ones in the home country who lose from FDI. The home-

country government in general loses. It receives few or no taxes from the part of the

multinationals’ profits that becomes the profits of their foreign affiliates, and spending

on government services provided to the multinationals probably does not decline by as

much as the tax revenues decline. Other home-country taxpayers then have the choice

of paying more taxes or cutting back on government-funded public programs.

The owners of the multinationals are the key group that gains from the FDI. They

receive increased returns to their equity investments as the returns to the multinational

Chapter 15 Multinationals and Migration: International Factor Movements 349

pug21774_ch15_334-369.indd 349pug21774_ch15_334-369.indd 349 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

enterprises’ assets increase. In fact, in the standard economic analysis, the gains to

the owners can be greater than the losses to workers and the government. If the home

country is made up of the workers, the owners, and the government, there can be a net

gain for the country as a whole. But it also is possible that the gains to the owners are

less than the losses to workers and to the home-country government. In addition, some

of the owners of the multinationals can be foreign investors, so some of the owners’

gains do not accrue to the home country.

There is one more effect of FDI outflows that can be important. FDI may carry exter-

nal technological benefits out with it. For all the multinationals’ attempts to appropriate

all the fruits of their technology, many gains may accrue to others in the location of the

firms’ production, through training of workers and imitation by other local producers.

If so, outward FDI takes those external benefits away from the home country.

When we put all the possible losses and gains from FDI outflows together, the eco-

nomics of the situation do not provide clear guidance on whether the home country

would gain or lose well-being by restricting FDI outflows. Both are possible.

What are the actual policies of home-country governments toward outward FDI?

Industrialized countries, the source of most of the world’s FDI, actually impose few

restrictions on outbound FDI. If anything, their policies are somewhat supportive of

outbound FDI because they impose little or no extra tax on affiliates’ profits.

A key reason for the neutral-to-supportive home policies is that the multinationals

have used their resources and common interests to enhance their political influence

through lobbying. In particular, multinationals have been successful in emphasizing

the competition among firms from different countries for global market shares and

profits. In this competition, using foreign affiliates is often the best way for the multi-

nationals to compete (for instance, through the affiliates’ better marketing in the host

countries, as we discussed in the previous section). Home-country governments gener-

ally refrain from restricting outbound FDI so that firms from the country can compete

better globally. Indeed, multinationals sometimes gain enough political power to bend

the foreign policy of a home-country government to their own ends. Historically,

the governments of the United States, Britain, and other investing nations have been

involved in costly foreign conflicts in defense of MNE interests that do not align with

the interests of other voters in the home country.

SHOULD THE HOST COUNTRY RESTRICT FDI INFLOWS?

The effects of FDI on the host country, and the pros and cons of host-country restric-

tions on it, are symmetrical in form to those facing the home country.

First, the standard static analysis of foreign direct investment finds that workers in

the host country gain from increased demand for their services, as do other suppli-

ers of inputs to the affiliates of foreign multinationals. The host-country government

gains from the taxes collected on affiliate profits, as long as these exceed the extra

costs of any additional government services provided to the affiliates. Domestic firms

that must compete with the affiliates lose. Overall there is a presumption that the host

country gains well-being in this standard analysis. Workers and suppliers to the affili-

ates, along with the national taxing government, gain more than owners of competing

350 Part Two Trade Policy

pug21774_ch15_334-369.indd 350pug21774_ch15_334-369.indd 350 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

domestic firms lose. One residual concern mirrors that of predatory dumping, that the

foreign multinationals will exercise substantial market power to raise prices once they

have thinned the ranks of the local competitors.

Second, as with the home country’s perspective, the host country must weigh indi-

rect economic effects when deciding what its policy toward incoming FDI should be.

And again the main kind of effects to consider are positive externalities. Multinational

enterprises bring technology, marketing capabilities, and managerial skills to the host

country. While the multinational attempts to keep these intangible assets to itself,

some of them do leak out to local firms. Workers in the affiliates receive training and

insights into the practices of the multinational. Local firms can use the proximity to

affiliates to learn about their technologies and practices.

The actual thrust of the policies of host-country governments toward MNEs has

shifted dramatically in the past 40 years. From the 1950s to the 1970s, host-country

policies, especially those of developing countries, were based more on ideology and

politics than on economics. The ideology ascendant in many developing countries at

that time stressed government intervention in the economy. National goals empha-

sized political and economic independence, national identity and autonomy, and

self-reliance. There was skepticism about the workings of markets and the benefits of

international trade. One result of this way of thinking was the focus of development

policies on industrialization by import protection and import substitution, which we

discussed in the previous chapter.

Skepticism and suspicion led to the characterization of MNEs as the instruments of

injustice. Although there was recognition of the economic benefits that MNEs could

bring to host countries, much of the discussion focused on complaints about MNEs.

Here are some of the allegations: Economic gains were tilted toward MNEs because

of their economic size and monopolistic power, leaving little for the host countries.

MNEs used capital-intensive production methods that were not suitable to developing

countries, and they “denationalized” the host country’s industries by displacing local

firms. MNEs acted as an extension of the power of their home-country governments,

and they enlisted the support of home-country governments to pressure the host

country in a confrontation. They also bought host-country politicians and bankrolled

plots against the government, as International Telephone and Telegraph did against the

Allende government in Chile in 1972–1973.

In short, at that time multinationals were seen by many as threats to the sovereignty

(power) of host-country governments and to the well-being of the host countries. To

reassert sovereignty and to minimize the alleged adverse effects of the local activities

of foreign MNEs, many host-country governments adopted controls and restrictions

on the entry and operations of MNEs. For instance, the governments of countries like

India and Mexico adopted policies that required that a majority of ownership of any

foreign affiliate be in local hands.

The economic effects of these inward-oriented government policies (antitrade and

anti-FDI) came to be seen as quite negative. Instead, the countries that began to grow

fastest were those that adopted outward-oriented policies. Heavy-handed government

intervention sank in perceived value, and the strengths of using markets increasingly

were accepted. Even developing countries that might have resisted this policy shift

had to confront the problems of the high levels of international debt they had built up

Chapter 15 Multinationals and Migration: International Factor Movements 351

pug21774_ch15_334-369.indd 351pug21774_ch15_334-369.indd 351 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

Focus on China China as a Host Country

In 1978 the Chinese government began a process of slowly opening China to direct investments by foreign multinationals. The cumulation of lib- eralizations paid off in the 1990s, when annual inflows of FDI increased 10-fold from 1991 to 1997. Inflows since then have remained strong, and during 2010–2012 China was the second- largest recipient of direct investment flows in the world (behind only the United States).* About half of FDI into China is in manufacturing, and foreign- affiliated firms account for about one-third of production value added in Chinese manufacturing.

Where is all of this FDI coming from? China has been unusual in that much of the FDI has come from developing countries located close to it, not from the industrialized countries whose firms are the source of most FDI worldwide. Firms from Hong Kong and Taiwan have been attracted to China because they were seeking low-cost labor and land ( location factors ) to produce products like cloth- ing, toys, and shoes, and to assemble products like consumer electronics, for export to third countries. They faced rather low inherent disadvantages , based on their cultural and geographic proximity, and their moderate firm-specific advantages , based on their knowledge of their businesses, were suf- ficient to allow them to be generally successful in China. Firms from Hong Kong and Taiwan were also comfortable with forming joint ventures with Chinese firms—such joint ventures were previously mandated by the Chinese government and still are required for some industries.

The surge of FDI into China in the 1990s cor- responded to the growth of FDI by the more typi- cal MNEs based in industrialized countries. These firms, in such industries as autos, machinery, and chemicals, faced larger inherent disadvantages, but they also had more substantial firm-specific advantages. Increasingly they have used wholly owned Chinese subsidiaries rather than joint ven- tures, as they have gained experience in operat- ing in China and as the Chinese government has become more tolerant of full foreign ownership. While some of their operations were geared to exporting, a key location factor for many of them has been using local production as the base for gaining sales in the rapidly growing Chinese market (incomes have grown rapidly, and a substantial urban middle class has developed). Oligopolistic rivalry among firms from industri- alized countries reinforced the rush to China in some industries (for instance, autos). One con- straint on firms from industrialized countries is that it has been very difficult to enter or expand by acquisition of local Chinese firms.

A key issue for a foreign firm in China is protection of its intellectual property (patents, trade secrets, brand names, trademarks, and copyrights). Like many other developing coun- tries, China has good intellectual property laws but weak enforcement. A foreign firm contract- ing with an independent Chinese firm, say, for the production of its brand-name products, risks losing some control of its brand. This happened to the sneaker company New Balance when one of its contract manufacturers in China produced hundreds of thousands of pairs beyond what New Balance ordered and then sold the sneakers both locally and internationally. A foreign firm sees the internalization advantages of managing its intellectual property in China by owning and controlling its Chinese operations. For instance, the Japanese firm Matsushita Electric makes sure that each of its Chinese employees knows only a small part of the overall production process for its most advanced products, so no employee can leave with its advanced technologies.

*One should interpret economic data on China with some caution, though there is no doubt that China’s inflows of FDI are large. In addition to the usual concerns about the accuracy of the data, there is one interesting feature of FDI into China that skews the data. Some substantial amount of the recorded FDI is actually not FDI at all, but what is called round-tripping . That is, firms and individuals in China find ways to shift funds out of China, usually to Hong Kong, and then use these funds to make “foreign” direct investments back into China. They do this to gain the incentives and favorable treatment given by the Chinese government to “foreign-owned” firms. A typical guess is that perhaps 20 to 25 percent of Chinese FDI inflows have actually been round-tripping.

352 Part Two Trade Policy

pug21774_ch15_334-369.indd 352pug21774_ch15_334-369.indd 352 11/5/14 7:31 PM11/5/14 7:31 PM

Final PDF to printer

Another use of location factors is to under- stand where within China the foreign-affiliated firms are located. Most FDI into China is located in the coastal areas of eastern China. These areas were opened to FDI earlier than the rest of the country; they have better transportation and com- munication infrastructure, including port facilities for exporting; and they have stronger consumer markets because they have higher per capita incomes. Guangdong Province alone is host to about one-sixth of all China’s FDI. Its early advan- tages were that it borders on Hong Kong and that it had three of the first four Special Economic Zones, established by the central government in 1979 to offer foreign firms preferential treatment and fewer restrictions on their local operations.

Inflows of FDI are generally viewed as benefit- ing China’s economic development. A study by the Organization for Economic Cooperation and Development concluded that FDI has assisted the development of new industries in China, offered new and better products to Chinese consumers, brought new technologies to China, offered employment to Chinese workers, provided them with training and experience that has allowed them to build their technological and managerial skills, and increased China’s exports. For exports, China is a good example of how FDI and trade are complements—foreign-affiliated firms make over half of China’s exports. In addition, other research suggests that the presence of foreign- affiliated firms has led to increases in the produc- tivity of local firms. Part of this productivity effect may be spillovers of technologies and worker skills. Another part of the effect may be the pres- sure of increased competition, as local firms are forced to “dance with wolves.”

Policies of China’s government continue to influence FDI into China. China has a complex system of screening and approvals for the entry of foreign firms into China, including both pub- lic (published) rules and internal (unpublished) rules. Some screening and approval are done at

the central (national) level, and some are done at the local level. There are four categories by industry or type of operation:

• Some types of FDI, including investments that bring in advanced and environmentally friendly technologies, are encouraged , so they receive incentives and privileges, like low taxes for extended time periods.

• Some types of FDI, including investments that use old technologies and investments in many mining and service industries, are restricted , so they get additional scrutiny before approval.

• Some types of FDI, including investments that would be highly polluting, investments in defense industries, and investments in tradi- tional Chinese crafts, are prohibited .

• All other types of FDI not named in the first three categories are permitted .

The complexity and time needed to gain approvals act as a disincentive for foreign firms to invest in China. In addition, the Chinese government imposes some forms of operating requirements on foreign-owned affiliates. The ones related to exports and local content gen- erally have declined as China has implemented the liberalizations that it committed to when it joined the WTO. The major remaining perfor- mance requirement is pressure from the Chinese government to transfer foreign technologies to Chinese firms (often, to the local partners in joint ventures), as General Electric is doing in its joint venture that produces and sells advanced electricity-generating turbines.

China’s government also offers a variety of incentives to FDI, including tax breaks, low rents on land, and provision of infrastructure improve- ments. Overall, though, the Chinese government does not usually engage in “bidding wars” with other countries to attract FDI.

Beginning in 2006, the Chinese government began to shift its policy on inbound FDI, stating

—Continued on next page

Chapter 15 Multinationals and Migration: International Factor Movements 353

pug21774_ch15_334-369.indd 353pug21774_ch15_334-369.indd 353 11/5/14 7:31 PM11/5/14 7:31 PM

Final PDF to printer

that it would focus more on the quality of the investments and deemphasizing the quantity of investments. It tightened some restrictions on for- eign acquisitions of Chinese publicly traded compa- nies. In 2008 it implemented a change in its tax law, eliminating or starting the phase-out of many of the tax incentives that it had offered to foreign-owned firms. In 2011 it added to the list of encouraged investments: components for alternative-energy vehicles, next-generation Internet products, bio- technology, intellectual property consulting firms, venture capital firms, and waste-recycling firms. It moved from restricted to permitted medical facili- ties and services, financial leasing firms, distribution and import of newspapers and books, and carbon- ated soft drinks. It moved automobile design and manufacturing from encouraged to permitted. It moved domestic mail courier services and the con- struction of luxury villas to prohibited.

One way that China has looked different from much of the rest of the world is that most FDI into China has been in manufacturing. The changes in China’s policy since 2006 are likely to shift manu- facturing FDI away from unskilled-labor-intensive production (e.g., toys) and assembly (e.g., elec- tronics products). It remains to be seen if there will also be a shift toward FDI in service indus- tries. As part of the obligations that the Chinese government accepted to join the WTO, it agreed to liberalize entry and ownership limits in a range of services, including banking and finance, distri- bution, retail and wholesale, advertising, archi- tecture, engineering, and law. In some of these industries the government has used regulations to slow the process. It now appears that with the recent policy shift the government will allow or encourage FDI in some service industries while becoming more restrictive in others.

by borrowing from banks. With the debt crisis of the early 1980s, lending by foreign

banks and financing from other foreign portfolio investors dried up.

Although concerns about the MNEs’ political and economic power did not disap-

pear, policy discussions began to stress the static economic gains from direct investment

into the country plus the possibility of technological and other beneficial spillovers. As

an example of spillovers, a number of Irish workers in the local affiliates of foreign

software firms have left their multinational employers to found their own software

companies. MNEs were viewed more favorably as a source of inflows of foreign capital

and as a set of investors that did not rush to the exits at the first whiff of trouble.

These advantages increasingly impressed developing-country governments that had

previously restricted inward FDI. Since the mid-1970s, many governments have liber-

alized their previous restrictions on direct investments into their countries (including

the shift by China, as discussed in the box “China as a Host Country”). Many gov-

ernments instead now compete aggressively by offering special tax breaks and other

subsidies as each government attempts to woo direct investors to locate affiliates in its

country rather than some other country.

MIGRATION

We have now completed our look at the role of multinational enterprises as conduits

for the international movement of such resources as technology, capabilities, and

354 Part Two Trade Policy

pug21774_ch15_334-369.indd 354pug21774_ch15_334-369.indd 354 11/5/14 7:31 PM11/5/14 7:31 PM

Final PDF to printer

*The temporary jump in U.S. immigration, 1989–1991, reflected the amnesty granted to previously unrecorded immi- grants and their families under the Immigration Reform and Control Act of 1986.

Source: U.S. annual rates, 1820–1970, from U.S. Bureau of the Census, Historical Statistics of the United States, Colonial Times to 1970 (1976); 1971–1999, from U.S. Bureau of Census, Statistical Abstract of the United States, various years; and 2000–2012, from U.S. Department of Homeland Security, Office of Homeland Security, 2012 Yearbook of Immigration Statistics. Canadian annual rates, 1852–1977, from Statistics Canada, Historical Statistics of Canada, second edition; and 1978–2012, from Citizenship and Immigration Canada, Facts and Figures: Immigration Overview, Permanent and Temporary Residents, 2012 .

FIGURE 15.2 Gross Immigration Rates into the United States, 1820–2012, and Canada, 1852–2012 A

n n

u a l im

m ig

ra n

ts p

e r

1 ,0

0 0 o

f p

o p

u la

ti o

1 8 2 0

1 8 3 0

1 8 4 0

1 8 5 0

1 8 6 0

1 8 7 0

1 8 8 0

1 8 9 0

1 9 0 0

1 9 1 0

1 9 2 0

1 9 3 0

1 9 4 0

1 9 5 0

1 9 6 0

1 9 7 0

1 9 8 0

1 9 9 0

2 0 0 0

2 0 1 0

United States

Canada

financial capital. For the rest of the chapter we will shift to examining the international

movement of labor that accompanies emigration and immigration.

International migration is the movement of people from one country (the sending country ) to another country (the receiving country ) in which they plan to reside for some noticeable period of time. International migration has played

an enormous role in the past expansion of receiving countries. Indeed, most of the

populations of the Western Hemisphere and of Australia and New Zealand consist of

descendants of those who immigrated in the past several centuries. In addition, since

1960 the fastest-growing migration has been from developing countries to industrial-

ized countries.

The basic modern history of immigration flows into North America and Europe is

sketched in Figures 15.2 and 15.3 . Figure 15.2 shows that the rising tide of immigra-

tion into North America since World War II has still not reached its levels before World

War I, when both Canada and the United States opened their doors to immigrants and

even advertised in Europe to attract them. After World War I, the door swung toward

shut. The United States severely restricted immigration in 1924, using a system of

quotas by national origin, in response to unprecedented public fear of strange cultures,

revolutionary radicalism, and job competition. Canada also switched from actively

recruiting immigrants to limiting them, especially when hard times hit in the 1930s.

Chapter 15 Multinationals and Migration: International Factor Movements 355

pug21774_ch15_334-369.indd 355pug21774_ch15_334-369.indd 355 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

Net immigration = (Gross) immigration minus emigration. “The 10” EU countries = the original six (Belgium, France, Germany, Italy, Luxembourg, and the Netherlands) plus the

UK, Ireland, Denmark, and Greece.

“The 25” EU countries = the 25 member countries as of the end of 2004.

“The 28” EU countries = the 28 member countries as of the end of 2013.

Sources: European Communities, Statistical Offices (Eurostat), Bevolkerungsstatistik (Demographic Statistics), Brussels, 1986; Eurostat, Population Statistics, 2006 edition; and Eurostat, Statistics Database, Population.

FIGURE 15.3 Net Immigration Rates into the European Union, 1960–2012

N e

t im

m ig

ra ti

o n

p e

r 1

,0 0

0 o

f p

o p

u la

ti o

–2

–1

4 1

9 6

1 9

6 5

1 9

7 0

1 9

7 5

1 9

8 0

1 9

8 5

1 9

9 0

1 9

9 5

2 0

0 0

2 0

1 0

2 0

0 5

"The 10" EU countries "The 25"

EU countries

"The 28" EU countries

After World War II, both countries relied on partial controls that favored immi-

grants arriving with training and experience. In 1965, the United States replaced the

national-origin quotas with a system that gave preference to applicants with fam-

ily relatives already in the United States, and subsequent changes opened the door

to more refugees. In 1974, Canada also shifted to a liberal policy toward relatives.

Family members and refugees began to arrive at a quickening rate in the 1980s. In

the Immigration Reform and Control Act (IRCA) of 1986, the United States tried to

solve two immigration policy problems at once: cutting the further inflow of “illegal”

(undocumented) immigrants and giving amnesty (permanent residence rights) to those

who came earlier. One result of IRCA was the temporary jump in legal immigration

for 1989–1991, a jump that helped reawaken natives’ concern about being burdened

with a new wave of immigrants.

The doors in the European Union (EU) have also swung open, then shut, and then

more open again, in this case within the shorter period since the EU was formed

in 1957. In the 1950s and 1960s, the EU countries welcomed and even recruited

workers from Turkey and other nonmember countries to help with the postwar

reconstruction boom. In the early 1970s, however, the mood changed, as suggested

356 Part Two Trade Policy

pug21774_ch15_334-369.indd 356pug21774_ch15_334-369.indd 356 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

by Figure 15.3 . One EU country after another tightened up its immigration policy,

partly out of rising cultural frictions and partly to protect jobs after the first oil

crisis began to raise unemployment in 1974. Fewer immigrants were granted entry

into the EU from 1974 to 1988. Then, the inflow began to rise again. The reason

is not that EU immigration policy liberalized after 1988, but rather that a change

in conditions outside the EU forced more immigrants through the same half-open

doors. In particular, the rise of asylum seekers from the Balkan and other formerly

communist countries made greater demands on those countries whose laws allowed

for compassion toward refugees. The strain was particularly great on Germany

because of its prosperity, the reunification of West and East Germany, Germany’s

proximity to the transition countries, and the German constitution’s provision that

refugees must be given safe haven. In 1993, Germany repealed the constitutional

safe-haven guarantees and began clamping down on immigration.

HOW MIGRATION AFFECTS LABOR MARKETS

To see some important economic effects of migration, let’s squeeze as much as

we can out of a thrice-squeezed orange, the familiar demand–supply framework

already used extensively in earlier chapters. To simplify the analysis, we aggregate

the whole world into two stylized countries: a low-income “South” and a high-

income “North.” Let’s start with a situation in which no migration is allowed, as

at the points A in the two sides of Figure 15.4 . In this initial situation northern workers earn $6.00 an hour and southern workers of comparable skill earn $2.00

an hour. (Realistically, we presume that factor-price equalization, as discussed in

Chapter 5, does not hold, perhaps because of governmental barriers to free trade or

differences in technologies.)

If all official barriers to migration are removed, southern workers can go north and

compete for northern jobs. If moving were costless and painless, they would do so in

large numbers until they had bid the northern wage rate down and the southern wage

rate up enough to equate the two.

Yet moving also brings costs to the migrants. Monetary costs include the trans-

portation and other expenses of migration, as well as lost wages while relocating. In

addition, migrants usually feel uprooted from friends and relatives. They feel uncer-

tain about many dimensions of life in a strange country. They may have to learn new

customs and a new language. They may have to endure hostility in their new country.

All these things matter, so much so that we should imagine that wide wage gaps would

persist even with complete legal freedom to move. Thus only a lesser number of per-

sons, 20 million of them in Figure 15.4, find the wage gains from moving high enough

to compensate them for the migration costs ( c ), here valued at $1.80 per hour of work in the North. The inflow of migrant labor thus bids the northern wage rate down only

to $5.00, and the outflow of the same workers only raises southern wages up to $3.20.

The new equilibrium, at points B, finds the number who have chosen to migrate just equal to the demand for extra labor in the North at $5.00 an hour.

Those who decide to migrate earn $5.00 an hour in the North, but it is worth only

as much as $3.20 in the South because of the costs and drawbacks of working in the

Chapter 15 Multinationals and Migration: International Factor Movements 357

pug21774_ch15_334-369.indd 357pug21774_ch15_334-369.indd 357 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

Group Their Economic Gains or Losses

Migrants Gain area (e 1 f ) Workers remaining in the South Gain area d Southern employers Lose area (d 1 e) Native northern workers Lose area a Northern employers Gain area (a 1 b) The world Gains area (b 1 f )

m 5 number of migrants 5 20 million . c 5 annuitized cost of migrating, both economic and psychic (being uprooted, etc.), which offsets $1.80 per hour of extra pay .

(By holding the labor demand curves fixed, we gloss over the small shifts in them that would result from the migrants’

own spending.)

FIGURE 15.4 Labor-Market Effects of Migration

6.00

North South

5.00

3.20

2.00

Wages ($ per hour)

Workers (millions)

90 100 110

70 82 90

Sr Sr � Smig

d A

0 0

} Lose area e } Gain area b

North. To measure their net gain, we take the area above the migrants’ labor supply

curve between the old and the new wage rates ($2.00 and $3.20), or areas e and f . 4 It is not hard to identify the other groups of net gainers and losers in the two

regions. Workers remaining in the South, whose labor supply curve is S r , gain because

the reduction in competition for jobs raises their wage rates from $2.00 to $3.20. We

can quantify their gains as sellers of their labor with a standard surplus measure, area

d , in the same way used to quantify the gains to producers as sellers of their products in previous chapters. Their employers lose profits by having to offer higher wage rates.

The southern employers’ loss of surplus is area d 1 e . (They lose surplus because they are buyers of now higher-priced labor, just as consumers as buyers of products lose

4 The migrants’ labor supply curve S mig

can be derived by subtracting the curve S r from the combined curve

S r 1 S

mig . Note that their welfare gain does not equal the full product of ($3.20 – $2.00) times

the 20 million unless their labor supply curve ( S mig

) is perfectly vertical, in which case the amount of time they devote to work is independent of the wage rate. (Note that their supply curve can be interpreted as a curve showing the marginal opportunity cost of their time.)

358 Part Two Trade Policy

pug21774_ch15_334-369.indd 358pug21774_ch15_334-369.indd 358 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

surplus when the product price increases.) Employers in the North gain, of course,

from the extra supply of labor. Having the northern wage rate bid down from $6.00 to

$5.00 brings them area a 1 b in extra surplus. Workers already in the North lose area a by having their wage rate bid down. So here, as in the analysis of product trade in earlier chapters, some groups absolutely gain and others absolutely lose from the new

international freedom.

The analysis in Figure 15.4 shows some clear and perhaps unexpected effects on

the well-being of entire nations (excluding those who migrate because it is debatable

which country they belong to). Let’s turn first to the effects on the North, here defined

so as to exclude the migrants even after they have arrived. As a nation the North gains

in standard economic terms—the gain to employers (and the general public buying

their products) clearly outweighs the loss to “native” workers. Area b is the net gain. The case of restricting immigration cannot lie in any net national economic loss unless

we can introduce substantial negative effects not shown in Figure 15.4.

The sending country, defined as those who remain in the South after the migrants’

departure, clearly loses. Employers’ losses of d 1 e exceed workers’ gain of d alone. So far it looks as though receiving countries and the migrants gain, while sending

countries lose. The world as a whole gains, of course, because freedom to migrate

sends people toward countries where they will make a greater net contribution to

world production.

Does migration really work that way? Does it make wage rates more equal in dif-

ferent countries? Are competing workers harmed in receiving countries? Do immi-

grants eventually catch up with them in pay? Does the world as a whole gain? Several

studies have shown that the predictions of Figure 15.4 are borne out by the history

of migration, both in the great integration of the world economy before 1914 and

again in experience since the mid-1970s. Here are some of the main findings of the

empirical studies: 5

• Freer migration makes wage rates in the migrant-related occupations more equal

between countries.

• Directly competing workers in the receiving countries have their pay lowered,

relative to less immigrant-threatened occupations and relative to such nonlabor

incomes as land rents. For the United States, the proportion of immigrants who

have not completed high school is relatively large, and the major group of workers

hurt by rising immigration since 1980 consists of the least-skilled American work-

ers (e.g., high school dropouts).

• Immigrants’ earnings catch up partly, but not completely, within their own life-

times. Numerous studies have traced their convergence toward the better pay

enjoyed by native-born workers, but the deficit is not erased in the first generation

after migration. The pay deficit has grown more pronounced in Canada and the

United States since the 1970s.

• World output is raised by allowing more migration.

5 For a sampling from this literature, see Borjas, Freeman, and Katz (1997, on the United States); Dustman, Frattini, and Preston (2013, on Britain); Pope and Withers (1993, on Australia); Bloom, Grenier, and Gunderson (1994, on Canada); and Friedberg and Hunt (1995).

Chapter 15 Multinationals and Migration: International Factor Movements 359

pug21774_ch15_334-369.indd 359pug21774_ch15_334-369.indd 359 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

SHOULD THE SENDING COUNTRY RESTRICT EMIGRATION?

Our analysis of the labor market shows that the sending country loses economic well-

being because of emigration. Employers (and consumers of the products produced

by these firms) lose more than the remaining workers gain. Before deciding that this

means that the sending countries should try to restrict out-migration, it is important to

look at several other important costs and benefits of emigration for the sending country.

First, let’s look at the effects on the government budget. The sending-country

government loses the future tax payments that the emigrants would have made (and

perhaps also their military service). At the same time, those who emigrate no longer

require government goods, services, and public assistance, so government spending

also goes down. However, some public-expenditure items are true “public goods” in

the economic sense that one person’s enjoyment does not increase if there are fewer

other users. That is, to provide the same level of benefits to the people who do not emi-

grate, the government has to continue spending the same amount of money. Examples

of true public goods include national defense and flood-control levees.

Because some government spending is for true public goods, the loss of future tax contributions is likely to be larger than the reduction in future government spending as people migrate from the sending country. The likelihood of a net fiscal drain from emigration is raised by the life-cycle pattern of migration. People tend to migrate in

early adulthood. This means that emigrants are concentrated in the age group that has

just received some public schooling funded by the government, yet the migrants will

not be around to pay taxes on their adult earnings. For this age group, the net loss

to the sending country is likely to be largest for highly skilled emigrants—the brain drain . They have received substantial education at public expense, and they would pay substantial taxes on their above-average earnings if they stayed. For example, in some

small developing countries, including Guyana, Haiti, Jamaica, Senegal, Mozambique,

and Trinidad and Tobago, over half of the college-educated people have emigrated.

There is also a monetary benefit to the sending country that is not captured in the

examination of the labor market effects of migration. Those who emigrate often send vol-

untary remittances back to relatives and friends in their home country. Globally, emigrants

send home at least $400 billion in remittances per year. Remittances add over 20 percent

to the national incomes of such countries as Haiti, Lesotho, Moldova, Nepal, and

Tajikistan. Sending countries that do not receive much in the way of remittances probably lose well-being, but those that receive substantial remittances probably gain well-being.

What could the sending country do to try to restrict emigration or its negative

effects? It could simply block departures. However, this would probably require

severe restrictions on any foreign travel, with all of the losses that such travel restric-

tions would impose on the businesses and people of the country. A more defensible

policy would be a tax on emigrants that is roughly equal to the net contributions

the country has made to them through public schooling and the like. An alternative

policy approach is to encourage return after the emigrant has been gone for a while,

by appealing to national pride, offering good employment, and so forth. Taiwan and

South Korea have encouraged the return of their scientists and engineers to work in

their rapidly developing high-tech industries.

360 Part Two Trade Policy

pug21774_ch15_334-369.indd 360pug21774_ch15_334-369.indd 360 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

SHOULD THE RECEIVING COUNTRY RESTRICT IMMIGRATION?

Our analysis of the labor market shows that the receiving country gains economic

well-being because of immigration, even if we ignore the gains to the migrants them-

selves. Employers (and consumers of the products produced by these firms) gain

more than the native workers lose. Before deciding that this means that the receiving

countries should not restrict in-migration, we should look at several other important

costs and benefits of immigration for the receiving country.

Effects on the Government Budget The effects here are symmetrical to those noted for the sending country. Immigrants

pay taxes in their new country, and they use government goods and services. Some

of the government goods and services are pure public goods, so we begin with a pre-

sumption that the tax payments are larger than the extra government spending required

to serve the immigrants. However, there is a concern in many receiving countries that

immigrants use government social services disproportionately. This suspicion was the

basis for a 1996 U.S. law that made even legal immigrants ineligible for some forms

of public assistance.

The true fiscal effects of immigrants are hard to measure, as discussed in the box

“Are Immigrants a Fiscal Burden?” For immigration into the United States before

1980 or so, there is consensus that immigrants generally were major net taxpayers, not

a fiscal drain. There is also consensus that the fiscal effects of an immigrant depend

on the skill level of the immigrant. More-educated, more-skilled immigrants have

higher earnings, pay larger taxes, and are less likely to use public assistance. For the

United States since 1970, the fiscal balance is shifting toward immigrants being a fis-

cal burden because the average skill level of immigrants is declining relative to that

of natives. Still, any net positive or net negative effect on the government budget from

current immigration into the United States is probably small.

External Costs and Benefits Other possible effects of migration elude both labor-market analysis and fiscal

accounting. Migration may generate external costs and benefits outside private and

public-fiscal marketplaces. Three kinds of possible externalities merit mention:

1. Knowledge benefits. People carry knowledge with them, and much of that knowl- edge has economic value, be it tricks of the trade, food recipes, artistic talent,

farming practices, or advanced technology. American examples include migrants

Andrew Carnegie, Albert Einstein, and many virtuosi of classical music. Often only

part of the economic benefits of this knowledge accrues to the migrants and those

to whom the migrants sell their services. Part often spills over to others, especially

others in the same country. Migration may thus transfer external benefits of knowl-

edge from the sending to the receiving country.

2. Congestion costs. Immigration, like any other source of population growth, may bring external costs associated with crowding: extra noise, conflict, and crime. If

so, then this is a partial offset to the gains of the receiving country.

Chapter 15 Multinationals and Migration: International Factor Movements 361

pug21774_ch15_334-369.indd 361pug21774_ch15_334-369.indd 361 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

Case Study Are Immigrants a Fiscal Burden?

It is widely suspected that immigrants are a fiscal burden, swelling the rolls of those receiv- ing public assistance, using public schools, and raising police costs more than they pay back in taxes. This suspicion was the basis for a U.S. law that made immigrants (both legal and illegal) ineligible for some forms of public assistance. This suspicion, applied to illegal immigrants, was the basis for citizens first in California, and later in Arizona, to vote to deny public services to immigrants whose papers are not in order.

Are immigrants a burden to native taxpayers? The answer to this question is more complicated than it sounds, for two reasons:

• While some effects are easy to quantify using government data, other effects must be es- timated without much guidance from avail- able data.

• The full fiscal effects of a new immigrant occur over a long time—the immigrant’s remaining lifetime and the lives of her descendants.

Let’s look first at the effects of the set of immigrants that are in a country at a particular time. This kind of analysis provides a snapshot of the fiscal effects of immigrants during a year. We can see clearly what we can and cannot quantify well, but we do not see effects over lifetimes.

The Organization for Economic Cooperation and Development (2013, Chapter 3) examined the fiscal effects of immigrants in each of a number of countries during 2006–2008. Part of the analy- sis was relatively easy. The OECD researchers had good information on direct financial payments to and from the government. The immigrants’ pay- ments to the government include income taxes and social security contributions. Government payments to the immigrants include public pen- sions and transfers for public assistance, unem- ployment and disability benefits, family and child benefits, and housing support. If these were all the fiscal effects of immigrants, then, in most countries examined, immigrants made a positive net fiscal contribution. The first column of the

table shows the sizes of the net direct payments as a percent of GDP, for a few countries from the study. For Germany, the net effect of immi- grants was negative because many immigrants in Germany are pensioners (Turks who arrived as guest workers in the 1960s and refugees from the former Soviet Union who arrived in the 1990s).

The remaining part is hard. Immigrants pay other kinds of taxes, including value added or sales taxes and, indirectly, corporate income taxes. And immigrants share in using all kinds of public services, including schools, medical care, training and labor market assistance, infrastruc- ture, police, public administration, and defense. How much does immigrants’ use of each of these items expand government spending on it? The answer varies by the type of service and immi- grants’ use. Immigrants probably have almost no effect on national defense expenditures. (Indeed, they might add effective soldiers.) Immigrants’ use of education and health services probably does require additional government expendi- tures to maintain the same level of services to everyone else. Immigrants’ use of transport infrastructure, police services, and similar items may require some expansion of government expenditure on these items. The hard part is that there is no good way to know how much immigrants expand government expenditures on most of these items. To go further, we must make assumptions.

The OECD researchers made assumptions to allocate these items (excluding defense spending and interest on government debt), generally by using per person estimates of the items. The sec- ond column of the table shows the estimates for the net fiscal effects of both the direct payments and the allocated items. Based on the assump- tions used by the researchers, the allocated items are net negative for most countries, including the five shown here. For the United States, the estimated net fiscal effect of its immigrants shifts from a positive contribution to a negative “burden.” However, perhaps the most defensible conclusions are that, for most countries including

362 Part Two Trade Policy

pug21774_ch15_334-369.indd 362pug21774_ch15_334-369.indd 362 07/11/14 10:48 pm07/11/14 10:48 pm

Final PDF to printer

the United States, the current fiscal effects of immigrants are challenging to measure and prob- ably are relatively small.

Another way to look at the fiscal effects of immigrants is over their entire remaining life- times, and even to examine the fiscal effects of their descendants. For government programs that have costs for recipients of some ages but generate tax revenues from these same recipients at other ages, the lifetime approach is the more sensible way to calculate the fiscal effects of a small increase in immigration. One example is public schooling. Immigrants’ children increase the cost of providing public schooling. But the schooling increases the children’s future earn- ings, so the government eventually collects more taxes. Another example is social security. While working, immigrants pay social security taxes, but in the future they will collect social security payments.

Analysis of the fiscal effects of immigrants over lifetimes is complicated and requires many assumptions, including assumptions about how much immigrants add to costs as they consume various public services. Smith and Edmonston (1997, Chapter 7) examine the lifetime fiscal effects of typical immigrants in the United States as of 1996. Over the lifetime of the average immi- grant (not including descendants), the net fiscal effect is slightly negative, about $3,000 net cost to native taxpayers. However, the effect depends strongly on how educated the immigrant is. (Education is used as an indicator of earnings potential based on labor skill or human capital.)

• The average immigrant who did not complete high school imposes a lifetime net cost of $89,000.

• The average immigrant who is a high school graduate imposes a net fiscal cost of $31,000.

• The average immigrant who has at least one year of college provides a lifetime net fiscal benefit of $105,000.

These findings indicate that the fiscal effects of immigrants depend very much on the levels of labor skills of the immigrants. More-educated, more-skilled immigrants have higher earnings, resulting in larger payments of taxes. Immigrants with greater skills and higher earnings are also less likely to use public assistance.

In addition, Smith and Edmonston conclude that the descendants of the typical immigrant provide a net fiscal benefit of $83,000. Thus, the typical immigrant and her descendants provide a net fiscal benefit of $80,000 (5 2$3,000 1 $83,000). Interestingly, this net fiscal benefit is not spread evenly over government units. State and local governments bear a net fiscal cost of $25,000, while the U.S. federal government receives a net benefit of $105,000. * We can see a clear basis for tension between states and the federal government over immigration policies. Especially, we can see the basis for California’s efforts to limit its outlays for immigrants because California has by far the largest proportion of immigrants of any state.

DISCUSSION QUESTION Immigrants, compared to natives in a country, tend to be young, to have lower wage rates, to be healthier, and to have more children. For fis- cal effects for this country, how do these charac- teristics of immigrants matter?

* This differential is not unique to immigrants. The typical native-born child also imposes a net cost on state and local governments. They largely bear the costs of education, health care, and other transfers early in the child’s life, while the federal government collects most of taxes paid after the child grows up.

Direct Direct Payments Payments, and Allocated Net Items, Net

United States 0.03 20.64 Britain 0.46 20.01 Germany 21.13 21.93 Switzerland 1.95 1.42 Spain 0.54 0.07

Chapter 15 Multinationals and Migration: International Factor Movements 363

pug21774_ch15_334-369.indd 363pug21774_ch15_334-369.indd 363 07/11/14 10:48 pm07/11/14 10:48 pm

Final PDF to printer

3. Social friction. Immigrants are often greeted with bigotry and harassment—even from native groups that would benefit from the immigration. Long-lasting restric-

tions on the freedom to migrate, such as American discrimination against Asian

immigrants beginning in the late 19th century, the sweeping restrictions during

the “red scare” of the early 1920s in the United States, and Britain’s revocation

of many Commonwealth passport privileges since the 1960s, have been moti-

vated largely by simple dislike for the immigrating nationalities. Although the

most appropriate form of social response to this kind of prejudice is to work on

changing the prevailing attitudes themselves, policymakers must also weigh the

frictions in the balance when judging how much immigration and what kind of

immigration to allow.

There is at least indirect support for the idea that admitting immigrants gradually

would go far to removing social frictions and congestion costs. The United States

experienced its worst surge of anti-immigrant feeling in the early 1920s, when the

immigration rate was increasing toward the peak rate it had reached just before World

War I. The immigration rate was higher then, just before and after World War I, than

it is today, even if we add reasonable estimates of the number of unrecorded illegal

immigrants. Even though some of the historic reasons for the anti-immigrant senti-

ment of that time (e.g., the Bolshevik Revolution) transcend economics, the high rate

of immigration itself must have contributed to the fears and resentments of those

Americans whose families had migrated earlier.

What Policies to Select Immigrants? The major industrialized countries have policies to limit the rate of immigration. If a

country is going to limit immigration, on what basis should it select the immigrants

that it accepts? Our economic analysis offers some insights. Two features of the

analysis are prominent. First, the types of immigrant workers admitted will affect

which groups within the native population win and which groups lose as a result of

the immigration. For instance, if relatively less-educated and less-skilled immigrants

are admitted, these immigrant workers will compete for jobs against less-skilled

native workers, further reducing their already low earnings. Second, the types of

immigrants admitted will affect the net fiscal benefit or burden of immigration. To

gain greater fiscal benefits, the country should admit young adults who have some

college education. In addition, admitting highly educated and skilled immigrants is

likely to enhance the external knowledge benefits we just mentioned.

Australian policies toward immigration seem to draw from these economic les-

sons. Australia has used a point system to screen applicants, focusing on those

whose age and skills are likely to be beneficial to the Australian economy. New

Zealand uses a similar point system, and Britain began one in 2008. Canada also

uses a point system to screen some of its applicants, but about three-fourths of

immigrants into Canada enter based on family links or refugee status. 6 Immigration

into the United States is even more heavily skewed toward family and refugees, with

about one-tenth entering based on their worker skills. For both the United States and

6 To see how you score on the Canadian point system, go to www.cic.gc.ca/english/immigrate/skilled/

364 Part Two Trade Policy

pug21774_ch15_334-369.indd 364pug21774_ch15_334-369.indd 364 07/11/14 10:48 pm07/11/14 10:48 pm

Final PDF to printer

Canada, the results of these policies are that the average skill levels of their immi-

grants have been declining.

Economic analysis can make a strong case for a country like the United States

or Canada to tilt its immigration policies toward encouraging and selecting more-

skilled immigrants while reducing the number of less-skilled immigrants that it

admits. Of course, economic objectives are not the only national goals. A shift

toward pursuing national economic gain would come at a cost of achieving less

toward other worthy goals, including promoting family reunification and providing

humanitarian assistance to refugees. And the shift toward pursuing economic objec-

tives would make the brain drain worse and leave more people in the rest of the

world with lower income levels.

Summary A multinational enterprise (MNE) is a firm that owns and controls operations in more than one country. Multinationals usually send a bundle of financial capital and

intangible assets like technology, managerial capabilities, and marketing skills to their

foreign affiliates. Foreign direct investment (FDI) is any flow of lending to, or purchase of ownership in, a foreign firm that is largely owned by residents of the invest-

ing, or home, country.

FDI grew rapidly for several decades after World War II, with the United States

being the largest source country. FDI grew more slowly from the mid-1970s to the

mid-1980s, but since the mid-1980s, FDI has grown rapidly. From the mid-1970s to

the early 1990s, direct investment flows into developing countries slowed, but these

flows then increased substantially. Nonetheless, most direct investment is from one

industrialized country into another industrialized country. In the 1980s, the United

States became an important host country, leaving Japan as the only major home coun-

try that is not also a major host to direct investment.

Explaining why multinational enterprises exist requires us to go beyond a simple

competitive model. Multinationals can overcome the inherent disadvantages of being foreign by using their firm-specific advantages . Still, there are at least two alternatives to direct investment. The firm could export from its home country, but

location factors often favor foreign production. The firms could rent or sell their advantages to foreign firms using licenses. Multinationals see internalization advantages to full control of the foreign use of their firm-specific advantages, especially their intangible assets like proprietary technology, marketing capabili-

ties, brand names, and management practices. Negotiating licenses with indepen- dent foreign firms for them to use these assets would be costly and risky. Large

multinationals are often involved in oligopolistic competition among themselves. For instance, one multinational attempts to gain an advantage by entering a foreign

country first, and the others follow quickly to try to neutralize any advantage to

the first firm.

The profits of foreign affiliates are taxed by the host-country government, but gen-

erally not taxed or taxed little by the home-country government. When multinationals

shop around the globe for the lowest-cost sites, they favor low tax rates. Part of decid-

ing which country to invest in involves the desire to keep taxes down. In addition,

firms can use transfer pricing to shift some reported profits to low-tax countries.

Chapter 15 Multinationals and Migration: International Factor Movements 365

pug21774_ch15_334-369.indd 365pug21774_ch15_334-369.indd 365 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

FDI could lead to less international trade in products (substitute for trade) or to

more (complement to trade). FDI used to locate different stages of production in

different countries increases trade. FDI used to establish affiliate production of final

goods for local sales substitutes for imports. But better marketing by the affiliate can

also expand imports of other final goods produced by the multinational enterprise in

other countries. And affiliate production of final goods often requires use of imported

components and materials. Studies of FDI and trade conclude that they are somewhat

complementary, on average.

The home (or investing) country gains from the basic market effects of FDI, as

long as the government loss from collecting less corporate income tax revenue is not

too large. The home country may have other reasons to restrict outward-bound FDI:

the possibility that it loses external benefits that accompany FDI and the possibility

of foreign-policy distortion from lobbying by multinationals. The actual policies of

the industrialized countries (the major home countries) toward outbound FDI are

approximately neutral.

The host country has less reason to restrict FDI than does the home country. It gains

from the basic market effects of FDI, and it gains from positive external technologi-

cal and training benefits. In the past three decades many developing countries have

shifted from restricting FDI inflows to encouraging them. Political dangers remain,

however, in the relationship between host-country governments and major multina-

tional enterprises.

Free international migration of people, like free trade in products, is the policy most likely to maximize world income. Yet perfect freedom to migrate is politically

unlikely. The main beneficiaries of such a liberal policy, the migrants themselves, have

little political voice in any country. More vocal are groups that resent the departure of

emigrants or, more often, the arrival of immigrants.

The labor-market analysis of migration flows shows who wins and who loses from

extra migration, and by how much. The main winners and losers from migration are

the ones intuition would suggest: the migrants, their new employers, and workers

who stay in the sending country all gain; competing workers in the new country and

employers in the old country lose. Yet the net effects on nations, defined as excluding

the migrants themselves, may clash with intuition.

The sending country as a whole loses, both in the labor markets and in the nega- tive effect on the government budget. However, if the emigrants make large enough

remittances back to the country, the sending country can gain from emigration. A case

can be made for a brain-drain tax that compensates the sending country for its public

investments in the emigrants.

The receiving country is a net gainer according to the labor-market analysis. In addition, it has often been true that immigrants pay more to their new country in taxes

than they receive in public services. However, the declining relative skill levels of

immigrants to the United States suggests that the government-budget effect is not as

positive as it once was, and may now be negative. Immigrants also cause externalities,

both positive (new knowledge) and negative (congestion, social friction).

The reason for the U.S. drift toward immigrants being a net fiscal burden is that the

relative education of immigrants has declined, as U.S. admission policy has given pref-

erence to family relatives and refugees since the mid-1960s. A country can improve the

366 Part Two Trade Policy

pug21774_ch15_334-369.indd 366pug21774_ch15_334-369.indd 366 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

Key Terms Foreign direct investment (FDI)

Multinational enterprise

(MNE)

Parent firm

Home country

Foreign affiliate

Host country

Inherent

disadvantages

Firm-specific

advantages

Location factors

License

Internalization

advantages

Transfer pricing

Intrafirm trade

International

migration

Sending country

Receiving country

Suggested Reading

Caves (2007) and Barba Navaretti and Venables (2004) provide good surveys of the

economics of multinationals. Mutti (2003) and Organization for Economic Cooperation

and Development (2008) examine the effects of tax differences on the location of

MNE production activities. Brainard (1997) presents a careful analysis of the trade-

off between FDI and trade. Moran (2011) examines FDI in developing countries. The annual World Investment Report, published by the United Nations Conference on Trade and Development, presents a broad discussion of trends and issues involving FDI and

multinational enterprises.

Collier (2013) and Hanson (2009) provide surveys of migration and its economics. Jean

et al. (2007) survey research on the experiences of immigrants in industrialized countries.

Smith and Edmonston (1997); Borjas, Freeman, and Katz (1997); Borjas (1994 and 1995);

and Card (2009) analyze U.S. immigration and immigration policy. Hanson (2006) surveys

economic research on illegal immigration into the United States. Docquier and Rapoport

(2012) and Gibson and McKenzie (2011) survey economic analysis of the brain drain.

Questions and Problems

1. “Most FDI is made to gain access to low-wage labor.” Do you agree or disagree? Why?

2. “Industrialized countries are the source of most FDI because they have large amounts

of financial capital that they must invest somewhere.” Do you agree or disagree? Why?

3. “Multinational enterprises often establish affiliates using little of their own financial capital

because they want to reduce their exposure to risks.” Do you agree or disagree? Why?

4. What might be the reasons that Japan is host to little direct investment?

5. Why does much FDI occur in such industries as pharmaceuticals and electronic prod-

ucts, while little FDI occurs in such industries as clothing and paper products?

6. Which of the following is foreign direct investment?

a. A U.S. investor buys 1,000 shares of stock of BMW AG, the German automobile company.

b. Procter & Gamble lends $2 million to a firm in Japan that is half-owned by Procter & Gamble and half-owned by a Japanese chemical company.

✦

net economic effects of immigration by skewing its admissions toward selecting young,

educated, and skilled adults and away from less-skilled persons. While this policy would

improve the economic side of the immigration accounts, it may clash with other objec-

tives such as reuniting families and providing humanitarian aid to refugees.

Chapter 15 Multinationals and Migration: International Factor Movements 367

pug21774_ch15_334-369.indd 367pug21774_ch15_334-369.indd 367 11/5/14 7:33 PM11/5/14 7:33 PM

Final PDF to printer

c. Mattel, a U.S.-based toy company, buys the 51 percent of its Mexican affiliate that it did not already own.

d. Intel sets up an affiliate in Brazil using only two sources of financing for the affili- ate: $100,000 of equity capital from Intel and a $1 million loan from a Brazilian

bank to the new affiliate.

7. A firm has affiliates in both Japan, whose corporate income tax rate is 40 percent,

and Ireland, whose corporate income tax rate is 15 percent. The major activity of the

Irish affiliate is to produce a special component that it sells to the Japanese affiliate,

initially at a price of $18 per unit. The cost of producing the component in Ireland has

just risen from $12 per unit to $14 per unit. The controller of the MNE is considering

three possible changes in the price of the component (for the sales between the Irish

and the Japanese affiliate):

Ignore the cost increase, and leave the price at $18 (no price change).

Increase the price to $20, to reflect exactly the increase in cost.

Increase the price to $22, and, if necessary, explain the price increase by making

general reference to unavoidable cost increases at the Irish affiliate.

a. If the goal of the MNE is to maximize its global after-tax profit, which of these three should the controller choose? Why?

b. What does each national government think of this use of transfer pricing?

8. Labor groups in the United States seek restrictions on the flow of direct investment out

of the country. Why? Is their opposition to FDI defending only their special interest,

or might it also be in the national interest? Explain.

9. A country currently prohibits any FDI into the country. Its government is considering

liberalizing this policy. You have been hired as a consultant to a group of foreign firms

that want to see the policy loosened. They ask you to prepare a report on the major

arguments for why the country should liberalize this policy. What will your report say?

10. “As Chinese companies expand their FDI into the United States by establishing new

affiliates and expanding existing affiliates, U.S. imports from China will tend to

decrease.” Do you agree or disagree? Why?

11. What are two reasons that immigration into the United States was so low in the 1930s?

12. “The size of remittances can affect the conclusion about whether or not a sending

country gains from international migration.” Do you agree or disagree? Why?

13. For each of the following observed changes in wage rates and migration flows from

the low-wage South to the high-wage North, describe one shift in conditions that, by

itself, could have caused the set of changes:

a. A rise in wage rates in both South and North, and additional migration from South to North.

b. A drop in wage rates in both South and North, and additional migration from South to North.

c. A drop in the northern wage rate, a rise in the southern wage rate, and additional migration from South to North.

14. Consider the labor-market effects of migration shown in Figure 15.4. What is the

effect of a decrease in the annualized cost of migration (a decrease in c ) on each group?

✦

368 Part Two Trade Policy

pug21774_ch15_334-369.indd 368pug21774_ch15_334-369.indd 368 10/29/14 5:53 PM10/29/14 5:53 PM

Final PDF to printer

15. Review the areas of gain and loss to different groups in Figure 15.4. Why do the

migrants gain only areas e and f ? Why don’t they each gain the full southern wage markup ($3.20 − $2.00)? Why don’t they each gain ($5.00 − $2.00)?

16. “Sending countries should cheer for emigration because the migrants improve their

economic well-being.” Do you think this statement is true or false? Why?

17. Japan currently has a very low rate of immigration because of very restrictive Japanese

government policy. You are trying to convince your Japanese friend that Japan should

change its laws to permit and encourage substantially more immigration. What are

your three strongest arguments?

18. Your Japanese friend, from Question 17, is skeptical. What are her three strongest

arguments that Japan should continue its policy of permitting little immigration?

19. Which of the following kinds of immigrants probably contributed the greatest net

taxes, after deducting public-assistance and similar payments, to the U.S. govern-

ment? Which probably contributed the least?

a. Political refugees arriving around 2000. b. Electrical engineers arriving around 1990. c. Earlier immigrants’ grandparents, arriving around 2010.

✦

Chapter 15 Multinationals and Migration: International Factor Movements 369

pug21774_ch15_334-369.indd 369pug21774_ch15_334-369.indd 369 11/5/14 7:33 PM11/5/14 7:33 PM

Final PDF to printer

Chapter Sixteen

Payments among Nations In previous chapters we focused on international trade in products. This focus is justi-

fied by the need to understand the basis for international trade and the effects of vari-

ous government policies toward trade. In that discussion countries seemed to exchange

exports of goods and services for imports of goods and services. Little attention was

given to the monetary and financial aspects of international transactions.

It is now time to add money and international finance to our discussion. We will

recognize (1) that many international transactions are trades in financial assets like

bonds, loans, deposits, stocks, and other ownership rights and (2) that nearly all inter-

national transactions involve the exchange of money (or some other financial asset) for

something else—for a good, service, or a different financial asset.

This chapter examines the framework used to summarize a country’s interna-

tional transactions. The scorecard is the balance of payments, the set of accounts recording all flows of value between a nation’s residents and the residents of the rest

of the world during a period of time. The balance of payments shows us an abun-

dance of information about a country’s international activities. As we shall see in

subsequent chapters, it is also key to understanding how people trade one country’s

money for that of another country. In addition, the exchanges documented in the bal-

ance of payments have major implications for macroeconomic concerns like growth,

inflation, and unemployment.

ACCOUNTING PRINCIPLES

In balance of payments accounting, we need to keep track of flows of value both in

and out of the country and (arbitrarily) assign a positive sign to one direction and a

negative sign to the other direction:

• A credit item (measured with a positive sign) is an item for which the country must be paid. It sets up the basis for a payment by a foreigner into the country—that

is, it creates a monetary claim on a foreigner.

• A debit item (measured with a negative sign) is an item for which the country must pay. It sets up the basis for a payment by the country to a foreigner—that is,

it creates a monetary claim owed to a foreigner.

Examples of credit items include the country’s exports of goods, purchases by

foreign tourists traveling in this country, and foreigners’ investing in a new issue of the

370

pug21774_ch16_370-388.indd 370pug21774_ch16_370-388.indd 370 11/5/14 9:12 PM11/5/14 9:12 PM

Final PDF to printer

country’s government bonds. In each of these cases someone in the country is entitled

to receive payment from a foreigner. Examples of debit items include the country’s

imports of goods, purchases by firms in this country of consulting services from provid-

ers located in foreign countries, and purchases by investors in this country of the equity

shares of a foreign company from the foreigner that previously owned the shares. In each

of these cases someone in the country is obligated to make a payment to a foreigner.

Each transaction between a country and the rest of world involves an exchange of

value for value (if we ignore, for the moment, pure gifts). Each transaction has two

items, one positive and one negative, of equal value. Balance of payments accounting

is just an international application of the fundamental accounting principle of double- entry bookkeeping . (Appendix E provides examples of international transactions and how to identify and name the two items. Here in the text we simply take for granted

that we are using double-entry bookkeeping.)

Double-entry bookkeeping has a key implication. If we add up all the positive items

(credits) and all the negative items (debits) in a country’s balance of payments, we know

exactly what the total will be— zero ! That is, with everything in, the country’s balance of payments always “balances.” So why is the balance of payments interesting? The inter-

est comes in how we get to that all-in zero value. We look at smaller collections of posi-

tive and negative items by grouping them into categories. For each of these categories,

we can examine the total of all of the credit and debit items in that category. While this

total might best be called a “sub-balance,” it is usually just referred to as a “balance.”

For any single category or any combination of categories that is not the entire balance

of payments, the balance could be positive, zero, or negative, and this can be interesting.

A balance that is positive is called a surplus, and negative balance is called a deficit .

A COUNTRY’S BALANCE OF PAYMENTS

There are three major broad categories of items that define the three major parts of a

country’s balance of payments: the current account, the financial account, and changes

in official international reserves. Let’s look at each of these categories and what goes

into them using the example of the balance of payments of the United States for 2013,

as shown in Figure 16.1 .

Current Account The current account includes all debit and credit items that are exports and imports

of goods and services, income receipts and income payments, and gifts. Let’s take a

look at each of these.

Exports and imports of goods (also called merchandise) are easy to understand. But

what are the major services that are exported and imported? Tourism or travel services

include the expenditures of foreign visitors on such items as hotel rooms, meals, and

transportation. In addition, nations trade transportation, insurance, education, finan-

cial, technical, telecommunications, and other business and professional services.

Nations also pay each other royalties for use of technologies or brand names.

If we add up all the items for exports and imports of goods and services, we get

the goods and services balance, an important balance within the current account.

Chapter 16 Payments among Nations 371

pug21774_ch16_370-388.indd 371pug21774_ch16_370-388.indd 371 10/29/14 6:05 PM10/29/14 6:05 PM

Final PDF to printer

FIGURE 16.1 U.S. Balance of

Payments, 2013

($ billions)

Source: Bureau of Economic Analysis,

U.S. Department

of Commerce,

“U.S. International

Transactions: Fourth

Quarter and Year

2013,” Survey of Current Business, April 2014.

Current Account

Exports of goods and services 2,271 Imports of goods and services 22,746 Income received from foreigners 789 Income paid to foreigners 2560 Unilateral transfers, net 2133 Current account balance 2379

Financial Account (excluding official international reserves)

Changes in U.S. direct investments abroad 2360 Changes in foreign direct investments in the United States 193 Changes in U.S. holdings of foreign stocks and bonds 2389 Changes in foreign holdings of U.S. stocks and bonds 247 Changes in U.S. loans to foreigners and other investments 191 Changes in foreign loans to the U.S. and other investments 182 Financial account balance 64

Official International Reserves

Changes in U.S. official holdings of foreign assets 3 Changes in foreign official holdings of U.S. assets 284 Changes in official international reserves, net 287

Statistical Discrepancya 28

Other important balances: Goods and services balance 2475 Overall balanceb 2287

a The statistical discrepancy is the net value of all errors and omissions in measuring the items. It equals the

negative of the sum of the current account balance, the financial account balance, and the net changes in

official international reserves. Here it equals 2(2379 1 64 1 287). b The overall balance is also called the official settlements balance. It equals the current account balance plus

the financial account balance plus the statistical discrepancy because it is the total of all items except for the

changes in official international reserves. (It is also equal to the negative of the net changes in official reserves.)

The balance on goods and services measures the country’s net exports. It is often

called the trade balance, although this somewhat imprecise term also sometimes refers to the goods (merchandise) trade balance. 1

Income flows are mainly payments to holders of foreign financial assets. In addi-

tion to interest, these payments include dividends and other claims on profits by the

owners of foreign businesses. Income flows also include payments to foreign workers

who are only in the country for a short time, such as the honorarium paid to a U.S.

professor for giving a talk at a Canadian university.

Unilateral (or unrequited) transfers are the items that keep track of gifts that the

country makes and gifts that it receives. These credit and debit items are needed so that

1The United States reports the goods and services balance monthly. This provides monthly information that is meaningful for many economic analyses. Nonetheless, there is considerable noise or variation in these data, so be careful when interpreting month-to-month changes. The United States reports its complete balance-of-payments accounts quarterly.

372 Part Three Understanding Foreign Exchange

pug21774_ch16_370-388.indd 372pug21774_ch16_370-388.indd 372 10/29/14 6:05 PM10/29/14 6:05 PM

Final PDF to printer

there is a double entry for each gift. For instance, consider the situation in which the

U.S. government gives Mali foreign aid in the form of wheat (that has been grown in

the United States), perhaps in response to famine in Mali because of a severe drought

there. The U.S. export of wheat would be measured as a credit and recorded. But there

is no item of value moving in the other direction because Mali does not pay for the

wheat. The accountants create a debit item that matches the value of the wheat export

and call the debit item a unilateral transfer.

There are several types of unilateral transfers. In addition to government grants in

aid to foreigners, private individuals also make unilateral transfers. One large kind

of private transfer is international migrants’ remittances of money and goods back to

their families in the home country. Another kind of private aid is charitable giving,

such as international disaster relief.

The net value of flows of goods, services, income, and unilateral transfers is the

current account balance. As shown in Figure 16.1, the current account balance for the United States for 2013 is a deficit of $379 billion. Most of this current account

deficit was the deficit in the goods and services balance.

Financial Account The net value of flows of financial assets and similar claims (excluding official

international reserve asset flows) is the private financial account balance. 2 The values reported in the financial account are for the principal amounts only of assets traded—any flows of earnings on foreign assets are reported in the current account. What counts as a credit and what counts as a debit in the financial account (and also

for official reserves) can be a bit confusing. Here are four possible items:

1. A U.S. resident increasing his holding of a foreign financial asset (a stock, a bond,

or an IOU from a loan) is a debit. The U.S. individual is making a payment now

(or extending a loan now) to the foreigner, so funds are flowing out of the United

States now (negative item).

2. A foreign resident increasing her holding of a U.S. financial asset (a stock, a bond,

or an IOU from a loan) is a credit. The U.S. seller (or borrower) is receiving pay-

ment now (or getting a loan now) from the foreigner, so funds are flowing into the

United States now (a positive item).

3. A U.S. resident decreasing her holding of a foreign financial asset (a stock, a bond,

or an IOU from a loan) is a credit. The U.S. individual is receiving a payment now

(or receiving repayment of a previous loan) from the foreigner, so funds are flowing

into the United States now (positive item).

4. A foreign resident decreasing his holding of a U.S. financial asset (a stock, a bond,

or an IOU from a loan) is a debit. The U.S. buyer (or borrower) is making a pay-

ment now (or repaying a previous loan) to the foreigner, so funds are flowing out

of the United States now (a negative item).

2Financial account is the term that the International Monetary Fund (IMF) and most countries now use for what traditionally was called the capital account. Confusingly, the IMF also now has a separate, very small category that it calls the “capital account,” made up mostly of capital transfers that traditionally were included in unilateral transfers. Our presentation of the financial account actually includes the combination of the IMF’s financial account and capital account.

Chapter 16 Payments among Nations 373

pug21774_ch16_370-388.indd 373pug21774_ch16_370-388.indd 373 10/29/14 6:05 PM10/29/14 6:05 PM

Final PDF to printer

If we focus on the direction of movement of the financial asset itself, then the debits

and credits are just like exports and imports of goods and services. In examples 2 and 3

above, the United States is exporting financial assets, and each is measured as a posi- tive value. In examples 1 and 4 above, the United States is importing financial assets, and each is measured as a negative value. However, we often focus on which way the

funds are flowing, so examples 2 and 3 are often called capital imports and examples 1 and 4 are often called capital exports .

Some varieties of private financial flows call for special comment here. Direct investments, discussed in depth in the previous chapter, are defined as any flow of lending to, or purchases of ownership in, a foreign enterprise that is largely owned

and controlled by the entity (usually a multinational enterprise) doing this lending or

investing. Foreign investments that are not direct include international flows of securi-

ties, loans, and bank deposits. The securities are bonds and stocks. A foreign invest-

ment in a bond or a stock that is not a foreign direct investment is sometimes called

an international portfolio investment, indicating that the investor does not own a large share of the enterprise being invested in, but is just investing as part of a diversified

portfolio.

As shown in Figure 16.1, the United States had a reported financial account surplus

of $64 billion in 2013. Given the way that the debits and credits work, this means that

foreign residents on net were increasing their holdings of U.S. financial assets relative

to the increase in U.S. holdings of foreign financial assets.

Official International Reserves The third major part of the balance of payments keeps track of changes in official

holdings of international reserves. Official international reserve assets are money-like assets that are held by governments and that are recognized by govern-

ments as fully acceptable for payments between them. The distinction between private

(or nonofficial) international financial assets and official international reserve assets

is not quite the same as the distinction between private and government. The term

official refers to assets held by monetary -type officials, not all government. Other (“non official”) government assets are included in the private category. The purpose of

this distinction is to focus on the monetary task of regulating currency values, to which

we return in discussing the overall surplus or deficit.

In the late 19th and early 20th centuries gold was the major official reserve asset. While gold is still held as a reserve asset, it is now little used in official reserve trans-

actions. The majority of countries’ official reserve assets are now foreign exchange assets, financial assets denominated in a foreign currency that is readily acceptable in international transactions. For the United States, these foreign exchange assets

are euro (formerly German mark) and Japanese yen assets. For other countries these

foreign exchange assets are often U.S. dollar assets. Two other small categories of

official reserve assets are claims that a country has on the International Monetary

Fund (IMF)—the country’s reserve position in the fund and the country’s holdings of

special drawing rights (SDRs), a reserve asset created by the IMF.

As shown in Figure 16.1, the United States received substantial financing from

changes in the holdings of official international reserves. (The signs of the values

374 Part Three Understanding Foreign Exchange

pug21774_ch16_370-388.indd 374pug21774_ch16_370-388.indd 374 10/29/14 6:05 PM10/29/14 6:05 PM

Final PDF to printer

here are interpreted in the same way as those for the financial account.) The U.S.

government had almost no change in its holdings of international reserves. The big

change was that foreign monetary authorities increased their holdings of U.S. dollar-

denominated official reserve assets (mostly U.S. Treasury bonds) by a huge amount —

$284 billion. The surplus in net changes in official reserve assets ($287 billion) pro-

vided the majority of the funds that the United States needed to finance its current

account deficit.

Statistical Discrepancy At the bottom of the accounts comes the suspicious item statistical discrepancy. If the flows on the two sides of every transaction were correctly recorded, there would not be

any statistical discrepancy. In fact, as shown in Figure 16.1, the statistical discrepancy

for the U.S. balance of payments for 2013 was a credit of $28 billion, meaning that

the credit items for the United States were less fully measured than its debit items. The

accountants add the statistical discrepancy to make the accounts balance and to warn

us that something was missed. In fact, the statistical discrepancy understates what was

missed. It is the net result of errors and omissions on both the credit and debit sides. In truth, more than $28 billion of credits were missed, but some were offset by failure

to measure all the debits.

How do the measurement errors arise? Which items appear to be most seriously

undermeasured? For the United States, we suspect that much of the discrepancy is

undermeasurement of private capital flows, so the true financial account balance for

2013 is probably a larger surplus. For some developing countries, capital flight, in

which people send wealth to foreign countries, away from the rules and supervision

of one’s home government, is another source of mismeasurement. We can imagine that

people and firms also sometimes have an incentive to hide or underreport imports of

products and income from their offshore investments.

THE MACRO MEANING OF THE CURRENT ACCOUNT BALANCE

The current account balance (CA) has several meanings. The first meaning comes

from the fact that all of the items in a country’s balance of payments must add to

zero (because it is double-entry bookkeeping). All of the items other than the current

account items are flows of international financial investments, both private or nonof-

ficial (in the financial account) and official (changes in official international reserve

assets). Therefore, the country’s current account balance must equal net foreign investment ( I

f ), the increase in the country’s foreign financial assets minus the

increase in the country’s foreign financial liabilities.

• If the country has a current account surplus, then its foreign assets are growing faster than its foreign liabilities. Its net foreign investment is positive —it is acting as a net lender to the rest of the world.

• If the country has a current account deficit, then its foreign liabilities are growing faster than its foreign assets. Its net foreign investment is negative —it is acting as a net borrower from the rest of the world.

Chapter 16 Payments among Nations 375

pug21774_ch16_370-388.indd 375pug21774_ch16_370-388.indd 375 10/29/14 6:05 PM10/29/14 6:05 PM

Final PDF to printer

As we saw in Figure 16.1, the United States was financing its current account

deficit in 2013 partly by building its liabilities to foreign private or nonofficial inves-

tors and lenders (the private financial account was in surplus) and partly by building

its liabilities to foreign monetary authorities (which were increasing their holdings of

official reserve assets denominated in dollars).

A country’s current account balance is also linked to its national saving and domes-

tic real investment. A country can do two things with its national saving ( S ):

• Invest at home in domestic capital formation, which is domestic real investment ( I d ).

• Invest abroad in net foreign investment ( I f ).

That is, national saving S 5 I d 1 I

f . Looked at another way, the country’s net foreign

investment equals the difference between national saving and domestic investment ( I f 5

S – I d ) or, equivalently, the country’s current account balance equals national saving

that is not invested at home ( CA 5 S – I d ).

For the United States in 2013, another way to look at its current account deficit

is that U.S. national saving was low, relative to domestic real investment. To finance

part of the U.S. real domestic investment, it had to rely on foreign funding. (We take

up this interpretation again in Chapter 24, when we examine how the U.S. current

account deficit is related to the U.S. government budget deficit, the latter being a form

of national dissaving.)

A country’s current account balance also is linked to domestic production, income,

and expenditure. A country’s current account balance is the difference between its domestic production of goods and services and its total expenditures on goods and services. Recall from basic macroeconomics that domestic production of goods and services ( Y ) equals the demand for the country’s production,

Y 5 C 1 I d 1 G 1 X 2 M

where

C 5 domestic household consumption of goods and services

I d 5 domestic real investment in buildings, equipment, software, and inventories

G 5 government spending on goods and services

X 5 foreign purchases of the country’s exports of goods and services

M 5 the country’s purchases of imports of goods and services from other countries

C , I d , and G all include purchases of both domestically produced and imported goods

and services. Imports must be subtracted separately because imports are not demand

for this country’s products.

The country’s total expenditures on goods and services ( E , sometimes called absorption) simply equals consumption, domestic investment, and government

spending:

E 5 C 1 I d 1 G

Therefore, domestic product equals the country’s total expenditures plus net exports,

or Y 5 E 1 ( X – M ). The country’s current account balance is (approximately) equal

376 Part Three Understanding Foreign Exchange

pug21774_ch16_370-388.indd 376pug21774_ch16_370-388.indd 376 10/29/14 6:05 PM10/29/14 6:05 PM

Final PDF to printer

to its net exports, so a country’s current account balance is (approximately) equal

to the difference between domestic product and national spending on goods and

services: 3

CA 5 X 2 M 5 Y 2 E

Yet another way to interpret the U.S. current account deficit in 2013 is that U.S.

households, businesses, and government were buying more goods and services than

they were producing.

To summarize, the current account balance turns out to be equal to three other things:

Current Account Balance CA

5 Net foreign investment 5 I f

5 The difference between national saving and domestic investment 5 S 2 I d

5 The difference between domestic product and national expenditure 5 Y 2 E

We have illustrated these meanings using the U.S. current account deficit. What

would they mean for a country with a current account surplus ?

• The country has positive net foreign investment (that is, the country is acting as a

net lender to or investor in the rest of the world).

• The country is saving more than it is investing domestically.

• The country is producing more (and has more income from this production) than it

is spending on goods and services.

Note that we are not saying that any of these is good or bad (at least not yet). Right

now we just want to know that they are all ways of looking at the same situation.

These identities help us see what must be changed if the current account balance

is to be changed. Consider a country that seeks to reduce its current account deficit

(that is, increase the value of its current account balance, making it less negative). One

implication of our analysis is that an improvement in the country’s current account

balance must be accompanied by an increase in the value of domestic product ( Y ) relative to the value of national expenditure ( E ). If domestic production cannot expand much, then national spending on goods and services must fall in order to decrease

imports or to permit more local production to be exported.

The identities also help us to understand what forces might be causing changes in

the current account balance. To see some uses for the current account, let’s look at

how it has behaved since the early 1960s for the four countries in Figure 16.2 . Figure

16.2 shows both the country’s current account balance and its net exports of goods

and services—its goods and services balance—each as a share of the country’s gross

domestic product. The two measures differ by the country’s net income flows and

transfers. (It is good to look at these latter two items here, especially income flows,

although we usually ignore them in broad macroeconomic analysis.)

3In equating X 2 M, exports minus imports of goods and services, with the current account balance, we are ignoring income flows and unilateral transfers. This is one of several simplifications generally used in macroeconomic analysis. (Another is equating domestic product with national income.)

Chapter 16 Payments among Nations 377

pug21774_ch16_370-388.indd 377pug21774_ch16_370-388.indd 377 10/29/14 6:05 PM10/29/14 6:05 PM

Final PDF to printer

FIGURE 16.2 Current Account

Balances

and Goods

and Services

Balances for the

United States,

Canada, Japan,

and Mexico,

1963–2013

Source: International Monetary Fund,

International Financial Statistics.

P e rc

e n

ta g

e o

f G

D P

A. United States

–7

–6

–5

–4

–3

–2

–1

1 9 6 5

1 9 7 0

1 9 7 5

1 9 8 0

1 9 8 5

1 9 9 0

1 9 9 5

2 0 0 0

2 0 0 5

2 0 1 0

Current account balance

Goods and services balance

P e rc

e n

ta g

e o

f G

D P

B. Canada

–6

–4

–2

1 9 6 5

1 9 7 0

1 9 7 5

1 9 8 0

1 9 8 5

1 9 9 0

1 9 9 5

2 0 0 0

2 0 0 5

2 0 1 0

Current account balance

Goods and services balance

Panel a in Figure 16.2 shows that the United States has evolved from a net exporter

and lender after World War II to a net importer and borrower. Up through the 1960s,

the United States had a positive current account balance and a positive trade balance.

The United States was a net exporter and lender largely because Europe and Japan, still

recovering from World War II, badly needed American goods and loans. During the

1970s and up through 1981, a new pattern began to emerge. The United States became

a net importer of goods and services but still kept its current account approximately in

balance, thanks largely to interest and profit earnings on previous foreign investments.

During the 1980s, the United States shifted into dramatic trade and current account

—Continued on next page

378 Part Three Understanding Foreign Exchange

pug21774_ch16_370-388.indd 378pug21774_ch16_370-388.indd 378 11/5/14 9:12 PM11/5/14 9:12 PM

Final PDF to printer

C. Japan

P e rc

e n

ta g

e o

f G

D P

–2

–1

–3

1 9 6 5

1 9 7 0

1 9 7 5

1 9 8 0

1 9 8 5

1 9 9 0

1 9 9 5

2 0 0 0

2 0 0 5

2 0 1 0

Current account balance

Goods and services balance

D. Mexico

P e rc

e n

ta g

e o

f G

D P

–8

–6

–4

–2

1 9 6 5

1 9 7 0

1 9 7 5

1 9 8 0

1 9 8 5

1 9 9 0

1 9 9 5

2 0 0 0

2 0 0 5

2 0 1 0

Current account balance

Goods and services balance

deficits, becoming the world’s largest borrower. The underlying reason: Led by new

federal government deficits, the United States cut its rate of national saving ( S ) much faster than its domestic investment ( I

d ) and therefore borrowed heavily from Japan and

other countries (negative I f 5 negative CA). The deficits declined in the late 1980s, but

then began to increase again after 1991. By 2005–2006, the value of the U.S. current

account deficit had grown to be about 6 percent of U.S. GDP, though it then decreased

to about 3 percent of GDP in 2009.

Canadian experience up to the late 1990s fits a classic pattern of a borrowing

country with good growth potential. Most of that time Canada borrowed from other

countries (especially from the United States), as indicated by Canada’s current account

Chapter 16 Payments among Nations 379

pug21774_ch16_370-388.indd 379pug21774_ch16_370-388.indd 379 12/11/14 1:27 PM12/11/14 1:27 PM

Final PDF to printer

deficits. Canada used its typical goods and services surplus to pay foreign investors

some of the earnings on their earlier investments. The payment of interest and profits

on past borrowings is much of the gap between the goods and services balance and the

current account balance in Figure 16.2 panel b.

Japan’s goods and services balance and current account balance were nearly the

same until the mid-1980s. These typically have been in surplus since the early 1960s.

The surpluses became large and controversial in the 1980s, as Japanese goods gained

major shares of foreign markets. Of course, the other way to look at this is that Japan’s

net foreign investment ( I f 5 CA > 0) became large in the mid-1980s. In those years

Japanese foreign investment, including heavy lending to the United States, became

the dominant force in international finance (although its role then diminished in the

1990s). Behind this shift to net foreign lending in the early and mid-1980s lay a wid-

ening gap between Japan’s high national savings and its domestic capital formation

(CA 5 S 2 I d > 0). In addition, the rising net income from Japan’s holdings of foreign

assets has created a growing positive gap between the current account balance and the

goods and services balance since the mid-1980s.

Until the debt crisis of 1982, Mexico was a consistent borrower. Its current account

was in deficit (negative I f ), and net payments of interest and dividends to foreign

creditors showed up as a widening gap between the goods and services balance and

the current account balance. Figure 16.2 shows part of the tremendous shock Mexico

felt when its debt crisis hit in 1982. Its trade balance jumped to a surplus of more than

9 percent of GDP in 1983, not because exports grew (they did not) but because Mexico

had to cut out two-thirds of its imports in the belt tightening necessary to pay most of

its swollen interest and repay principal to foreign creditors. Between 1983 and 1987,

Mexico was actually a net “investor,” in that it reduced its net foreign liabilities by

running current account surpluses. From 1988 to 1994, Mexico returned to being a net

foreign borrower (CA < 0). The peso crisis of late 1994 again forced Mexico into a

radical readjustment of its current account, with a shift to a goods and services surplus

in 1995 and 1996 and little net foreign borrowing (CA almost equal to zero) during

those years. Moderate deficits reappeared in 1998.

THE MACRO MEANING OF THE OVERALL BALANCE

The overall balance should indicate whether a country’s balance of payments has achieved an overall pattern that is sustainable over time. Unfortunately, there is no one

indicator that represents overall balance perfectly. The indicator often used is based on

the division of net foreign investment (or borrowing), I f , into its two components: the

net private (or nonofficial) capital flows, as shown by the financial account balance

(FA), and the net flows of official reserve assets (OR). The official settlements balance (B) measures the sum of the current account balance plus the (nonofficial) financial account balance ,4

B 5 CA 1 FA

4The official settlements balance also includes the statistical discrepancy because we assume that the discrepancy results from mismeasurement of private transactions.

380 Part Three Understanding Foreign Exchange

pug21774_ch16_370-388.indd 380pug21774_ch16_370-388.indd 380 10/29/14 6:05 PM10/29/14 6:05 PM

Final PDF to printer

Because all items in the balance of payments must sum to zero, any imbalance

in the official settlements balance must be financed (or paid for) through official

reserves flows:

B 1 OR 5 0

If the overall balance B is in surplus, it equals an accumulation of official reserve assets by the country or a decrease in foreign official reserve holdings of the coun-

try’s assets (that is, a debit in the official reserves account). If the overall balance

is in deficit, it equals a decrease in the country’s holdings of official reserve assets

or an accumulation of foreign official reserve holdings of the country’s assets (that

is, a credit in the official reserves account). In some situations such changes in

official reserve holdings can be specifically desired by the monetary authorities (for

instance, gradually to increase the country’s holdings of official reserve assets). In

other situations these changes are not specifically desired and indicate an overall

imbalance.

The official settlements balance measures the net flows of all private trans-

actions in goods, services, income, transfers, and (nonofficial) financial assets.

However, it is the counterbalancing items—the changes in official reserve

holdings—that show the macroeconomic meaning of the official settlements bal-

ance. Most of the transactions by countries’ monetary authorities that result in

changes in official reserve holdings are official intervention by these authorities in

the foreign exchange markets. The monetary authorities enter the foreign exchange

markets to buy and sell currencies, usually exchanging domestic currency and

some foreign currency. For instance, the monetary authority of a country can buy

domestic currency and sell foreign currency. The selling reduces the authority’s

holdings of foreign exchange assets that count as official international reserves. Or

the authority can sell domestic currency and buy foreign currency. The buying adds

to its official international reserves.

As reported in Figure 16.1, the United States had an official settlements deficit of

$287 billion in 2013. Foreign central banks added about this amount to their official

reserve holdings of dollars, mostly by intervening in foreign exchange markets to

buy dollars.

As we will see in the chapters that follow, foreign exchange intervention changes

not only official international reserve holdings, it can also have impacts on many

other economic variables. The intervention can affect exchange rates, money sup-

plies, interest rates, private international flows of financial capital, domestic capital

formation, domestic product, and exports and imports of goods and services.

THE INTERNATIONAL INVESTMENT POSITION

Complementing the balance of payments accounts (which record flows of transac-

tions) is a balance sheet called the international investment position, a state- ment of the stocks of a nation’s international assets and foreign liabilities at a point

in time, usually the end of a year. Flows change stocks, and so it is with the balance

of payments and the international investment position. For instance, if the country

Chapter 16 Payments among Nations 381

pug21774_ch16_370-388.indd 381pug21774_ch16_370-388.indd 381 10/29/14 6:05 PM10/29/14 6:05 PM

Final PDF to printer

1897 1914 1930 1946 1960 1983 2013

U.S. investments abroad $1.3 $5.0 $21.5 $39.4 $85.6 1,129.7 22,947.2 Private 0.7 3.5 17.2 13.5 49.3 924.9 22,407.3 Direct investments* 0.6 2.6 8.0 7.2 31.9 274.3 6,349.5 Other 0.1 0.9 9.2 6.3 17.4 650.6 16,057.8 U.S. government (nonofficial) 0.0 — — 5.2 16.9 81.7 91.6 U.S. official reserve assets† 0.6 1.5 4.3 20.7 19.4 123.1 448.3 Foreign investments in the United States 3.4 7.2 8.4 15.9 40.9 868.2 28,297.7 Direct investments* — 1.3 1.4 2.5 6.9 153.3 4,935.2 Other 3.4 5.9 7.0 13.4 34.0 714.9 23,362.5 U.S. net international investment position 22.1 22.2 13.1 23.5 44.7 261.5 25,350.5

FIGURE 16.3 U.S. International Investment Position at the End of Selected Years, 1897–2013 ($ billions)

*Direct investment refers to any international investment in a foreign enterprise owned in large part by the investor. For 1982 and subsequent years, direct investments are reported at estimated market values. For previous years, they are reported at historic cost. †U.S. official reserve assets consist of gold and foreign exchange assets plus the reserve position at the IMF and Special Drawing

Rights. For 1982 and subsequent years, reserve gold is reported at market values.

Sources: U.S. Bureau of the Census, Historical Statistics of the United States: Colonial Times to 1970 (Washington, DC: U.S. Government Printing Office, 1976); and U.S. Bureau of Economic Analysis, Survey of Current Business, July 2013 and April 2014.

has a current account surplus for the year, its net foreign investment (as a flow) is

positive. The country is adding to its holding of foreign financial assets (or decreas-

ing its foreign liabilities). The value of its international investment position at the

end of that year will be more positive (or less negative) than it was at the beginning

of the year. 5

The link between the two kinds of accounts relates to a subtle but common seman-

tic distinction. We say that a nation is a lender or a borrower depending on whether its current account is in surplus or deficit during a time period. We say that a nation is

a creditor or debtor depending on whether its net stock of foreign assets is positive or negative. The first set of terms refers to flows during a period of time, and the second

set to stocks (or holdings) at a point in time. The box “International Indicators Lead

the Crisis” discusses how the current account balances and international investment

positions of Greece, Ireland, Portugal, and Spain foreshadowed the euro crisis.

Within the 20th century and into the 21st, the United States has come full circle in

its international investment position. As shown in Figure 16.3 , the nation was a net

debtor before World War I. World War I abruptly transformed the United States into

the world’s leading creditor, and it reached a peak nominal creditor position by the end

of 1983. However, the large current account deficits that the United States experienced

during the 1980s required financing through increased international borrowing. The

creditor position built up over 60 years was erased and reversed in the next 6 years.

By early 1989, the United States again had become a net debtor, and the indebtedness

keeps rising. Figure 16.3 dramatizes the change with the stark contrast in the net posi-

tions at the end of 1983 and the end of 2013.

5Changes in the market values of assets previously acquired can also change the international investment position.

382 Part Three Understanding Foreign Exchange

pug21774_ch16_370-388.indd 382pug21774_ch16_370-388.indd 382 10/29/14 6:05 PM10/29/14 6:05 PM

Final PDF to printer

Euro Crisis International Indicators Lead the Crisis

–15

–5

1 9 9 0

1 9 9 5

2 0 0 0

2 0 0 5

2 0 1 0

–10

Ireland

Portugal

Greece

Spain

Current Account Balance as a Percent of GDP

Source: Economist Intelligence Unit, CountryData.

The beginning of the euro crisis is usually consid- ered to be the announcement in October 2009 by the new Greek government that the country’s fiscal deficit for the year would be much larger than the previous government had stated. If you had been watching two international indicators presented in this chapter, you would have been expecting that something was likely to go wrong in some of the countries in the euro area, with Greece as a leading candidate for trouble.

Consider the current account balances of sev- eral of the euro-area countries. The figure below shows the current account balances of four coun- tries that all required bailout assistance during the crisis. The current account balances were close to zero up to about 1995. Beginning in 1995, the CA balances for both Portugal and Greece began to deteriorate. In 2008, as a percent of national GDP,

Greece’s CA deficit reached about 15 percent and Portugal’s CA deficit reached almost 13 percent. Spain’s CA deficit began to deteriorate in 1997 and reached 10 percent of GDP in 2007. Ireland’s CA deficit was not as problematic, but it did reach over 5 percent of the country’s GDP in 2008.

Consider next the net international invest- ment position for each country, again as a percent of the country’s GDP, as shown in the figure on the next page. In 1999, when the euro was created, Greece, Spain, and Portugal were moderate net debtors, with negative net inter- national investment positions equal to about 30 percent of GDP. (Ireland’s data do not start until 2001, but its net debtor position was presum- ably less than 30 percent of GDP in 1999.) For Greece, Spain, and Portugal, the position steadily deteriorated. For Ireland, its net foreign debt

—Continued on next page

Chapter 16 Payments among Nations 383

pug21774_ch16_370-388.indd 383pug21774_ch16_370-388.indd 383 11/5/14 9:13 PM11/5/14 9:13 PM

Final PDF to printer

384 Part Three Understanding Foreign Exchange

exploded starting in 2007, as it entered into a massive banking crisis. By 2009, all had negative net international investment positions of between 90 and 110 percent. (In comparison, the net foreign debt shown in Figure 16.3 for the United States in 2013 was only 31.9 percent of U.S. GDP.)

For these countries, entry into the euro area (in 1999 for Ireland, Portugal, and Spain and in 2001 for Greece) lowered interest rates and encour- aged borrowing, including foreign borrowing. Each country had its own borrowing pattern, as we discussed briefly in Chapter 1 and will discuss further in a “Euro Crisis” box in Chapter 21. The macroeconomic outcome was the same. Rising net foreign borrowing (I

f negative) financed a

growing current account deficit by financing national spending on goods and services (E) that exceeded national income from production of goods and services (Y). The flows of foreign bor- rowing led to the buildup of foreign debt.

Someone watching these indicators would have seen that, by 2008–2009, these countries’ negative net international investment positions had become very large relative to the sizes of their national economies. With heightened sensitivity to risk from the global crisis that began in 2007 and intensified in 2008, foreign financial investors and lenders were unlikely to go on lending so freely to coun- tries that had become so indebted. These develop- ments were part of the lead-in to the euro crisis.

–120

–100

–80

–60

–40

–20

Ireland

Portugal

Greece

Spain

Net International Investment Position as a Percent of GDP

2 0 0 0

2 0 0 5

2 0 1 0

Source: International Monetary Fund, International Financial Statistics.

pug21774_ch16_370-388.indd 384pug21774_ch16_370-388.indd 384 11/5/14 9:13 PM11/5/14 9:13 PM

Final PDF to printer

Summary Basic definitions abound in this chapter. Terms introduced here appear constantly in the news media, and they will reappear throughout this book. Defi nitely review any of

them that are not familiar at fi rst sight.

A country’s balance of payments is a systematic account of all the exchanges of value between residents of that country and the rest of the world during a given time

period. Two flows occur in any exchange, or transaction, according to double-entry

bookkeeping:

• A credit item (1) is a flow for which the country is paid. • A debit item (2) is a flow for which the country must pay.

We can group the items into three major categories: those items that go into the cur-

rent account, those items that go into the (private or nonofficial) financial account, and

those items that are changes in official international reserve assets (countries’ official holdings of gold, foreign exchange assets, and certain assets related to the

IMF). Using these categories, we can create four important (net) balances:

1. The goods and services balance equals the net exports of both goods and ser- vices. It is often called the trade balance.

2. The current account balance equals the net credits minus debits on the flows of goods, services, income, and unilateral transfers.

3. The net private financial account balance equals net credits minus debits involving changes in nonofficial foreign financial assets and liabilities.

4. The overall balance (or official settlements balance ) equals the sum of the current account balance and the private financial account balance (plus the statis-

tical discrepancy from mismeasuring items in the current account and financial

account). If the overall balance is in surplus, it is counterbalanced by an increase in

the country’s official reserve holdings or a decrease in its official liabilities to other

countries’ monetary authorities (debit items at the bottom of the accounts). If it is

in deficit, it is counterbalanced by a decrease in the country’s official reserve assets

or an increase in its official liabilities (credit items at the bottom of the accounts).

The current account balance (CA) has special macroeconomic meaning. Because

the current account balance equals net foreign investment ( I f ), it also equals the

difference between national saving ( S ) and domestic capital formation ( I d ). A nation

that is running a current account deficit, like the United States since 1982, is a nation

that is saving less than its domestic capital formation. The current account deficit

represents net foreign borrowing used to finance part of its relatively high level of

domestic investment. The current account balance also equals the difference between

domestic production of goods and services ( Y ) and national expenditures ( E , expendi- ture on consumption, domestic capital formation, and government goods and services).

Thus, yet another way of looking at the U.S. current account deficit is that the United

States is buying more goods and services than it is producing (or spending more than

its national income).

The overall balance is intended to indicate whether the overall pattern of the

country’s balance of payments has achieved a sustainable equilibrium. The offi-

cial settlements balance does not quite match this concept, but it is still useful in

Chapter 16 Payments among Nations 385

pug21774_ch16_370-388.indd 385pug21774_ch16_370-388.indd 385 10/29/14 6:05 PM10/29/14 6:05 PM

Final PDF to printer

macroeconomic analysis. It indicates the extent of official intervention in the foreign

exchange markets—the buying and selling of currencies by the monetary authorities.

As we will see in subsequent chapters, such intervention can have effects on exchange

rates, money supplies, and many other macroeconomic variables.

A nation’s international investment position shows its stocks of international assets and liabilities at a moment in time. These stocks are changed each year by the

flows of private and official assets measured in the balance of payments. As a result of

large current account deficits since the early 1980s, the United States switched from

being the world’s largest net creditor to being its largest net debtor.

Key Terms Balance of payments Credit item

Debit item

Goods and services

balance

Current account balance

Financial account balance

Official international

reserve assets

Net foreign investment

Overall balance

Official settlements

balance

International investment

position

Suggested Reading

Lane and Milesi-Ferretti (2007) develop and analyze estimates of the international

investment positions of a large number of industrialized and developing countries.

Higgins and Klitgaard (2014) discuss balance of payments aspects of the euro crisis. The

balance-of-payments accounts of most nations are summarized in the IMF’s International Financial Statistics and in its Balance of Payments Statistics. More detailed accounts for the United States appear regularly in the Survey of Current Business, and those for Canada are in the Canada Yearbook.

Questions and Problems

1. What is the current account balance of a nation with a government budget deficit

of $128 billion, private saving of $806 billion, and domestic capital formation of

$777 billion?

2. “A country is better off running a current account surplus rather than a current account

deficit.” Do you agree or disagree? Explain.

3. “National saving can be used domestically or internationally.” Explain the basis for

this statement, including the benefits to the nation of each use of its saving.

4. “Consider a country whose assets are not held by other countries as official interna-

tional reserves. If this country has a surplus in its official settlements balance, then the

monetary authority of the country is decreasing its holdings of official reserve assets.”

Do you agree or disagree? Explain.

5. Which of the following transactions would contribute to a U.S. current account

surplus?

a. Boeing barters a $100 million plane to Mexico in exchange for $100 million worth of hotel services on the Mexican coast.

b. The United States borrows $100 million long-term from Saudi Arabia to buy $100 million of Saudi oil this year.

✦

386 Part Three Understanding Foreign Exchange

pug21774_ch16_370-388.indd 386pug21774_ch16_370-388.indd 386 10/29/14 6:05 PM10/29/14 6:05 PM

Final PDF to printer

c. The United States sells a $100 million jet to Turkey, and Turkey pays by transferring the $100 million from its bank account to the U.S. seller.

d. A British investor buys $100 million of IBM bonds from the previous U.S. owner of these bonds, and the British buyer pays by transferring the $100 million from his

bank account to the previous U.S. owner.

6. For each of the following changes (other things equal), has the value of the country’s

current account balance increased (become more positive or less negative), decreased

(become less positive or more negative), or stayed the same?

a. Net foreign investment out of the country increases. b. Exports of goods and services increase by $10 billion, and imports of goods and

services increase by $10 billion.

c. National expenditures on goods and services ( E ) increase by $150 billion, and pro- duction of goods and services ( Y ) increases by $100 billion .

d. To assist recovery from a foreign disaster, the country gives a foreign transport authority a collection of transport equipment that has been produced in this (donor)

country and that is valued at $500 million.

7. “For a country that has a surplus in its current account and wants to reduce this surplus,

one way to do so would be to encourage its people to save more and spend less.” Do

you agree or disagree that such a shift would reduce the surplus? Explain.

8. You are given the following information about a country’s international transactions

during a year:

Merchandise exports $330 Merchandise imports 198 Service exports 196 Service imports 204 Income flows, net 3 Unilateral transfers, net –8 Increase in the country’s holding of foreign assets, net (excluding official reserve assets) 202 Increase in foreign holdings of the country’s assets, net (excluding official reserve assets) 102 Statistical discrepancy, net 4

a. Calculate the values of the country’s goods and services balance, current account balance, and official settlements balance.

b. What is the value of the change in official reserve assets (net)? Is the country increasing or decreasing its net holdings of official reserve assets?

9. Which of the following can effectively provide financing for a country’s current

account deficit?

a. Residents of the country sell foreign government bonds (that they had previously purchased) to residents of the foreign country.

b. Residents of the country receive dividends and interest on their portfolio investments in foreign stocks and bonds.

c. Foreign residents purchase newly issued equity in a number of the country’s start-up companies.

✦

Chapter 16 Payments among Nations 387

pug21774_ch16_370-388.indd 387pug21774_ch16_370-388.indd 387 10/29/14 6:05 PM10/29/14 6:05 PM

Final PDF to printer

10. For the past year, a country has $200 million of exports of goods and services, $160

million of imports of goods and services, $60 million of income received from for-

eigners, and −$40 million of net unilateral transfers. What is the range of values for

income paid to foreigners, so that each of the following would be true?

a. The country has a current account surplus.

b. The country has a deficit for its goods and services balance.

c. The country is a net borrower from the rest of the world.

11. What are the effects of each of the following on the U.S. international investment

position?

a. Foreign central banks increase their official holdings of U.S. government securities.

b. U.S. residents increase their holdings of stocks issued by Japanese companies.

c. A British pension fund sells some of its holdings of the stocks of U.S. companies in order to buy U.S. corporate bonds.

12. On December 31, a country has the following stocks of international assets and

liabilities to foreigners.

• The country’s residents own $30 billion of bonds issued by foreign governments.

• The country’s central bank holds $20 billion of gold and $15 billion of foreign-

currency assets as official reserve assets.

• Foreign firms have invested in production facilities in the country, with the value of

their investments currently $40 billion.

• Residents of foreign countries own $25 billion of bonds issued by the country’s

companies.

a. What is the value of the country’s international investment position? Is the coun- try an international creditor or debtor?

b. If the country during the next year runs a surplus in its current account, what will the impact be on the value of the country’s international investment position?

✦

388 Part Three Understanding Foreign Exchange

pug21774_ch16_370-388.indd 388pug21774_ch16_370-388.indd 388 10/29/14 6:05 PM10/29/14 6:05 PM

Final PDF to printer

Chapter Seventeen

The Foreign Exchange Market In foreign commerce, as in international dialogue, somebody has to translate. People

in different countries use different currencies as well as different languages. The

translator between different currencies is the exchange rate, the price of one country’s

money in units of another country’s money. You can go only so far using just one

currency. If an American wants to buy something from a foreign resident, the foreign

resident will typically want to have the payment translated into her home currency.

This chapter introduces the real-world institutions of currency trading. It also

begins to build a theory of exchange rates, starting with the role of forces that show

up in the balance-of-payments entries of Chapter 16.

Much of the study of exchange rates is like a trip to another planet. It is a strange

land, far removed from the economics of an ordinary household. It is populated by

strange creatures—hedgers, arbitrageurs, the Gnomes of Zurich, the Snake in the

Tunnel, the crawling peg, and the dirty float. Yet the student of exchange rates is

helped by the presence of two familiar forces: profit maximization and competition.

The familiar assumption that individuals act as though they are out to maximize the

real value of their net incomes (profits) appears to be at least as valid in international

financial behavior as in other realms of economics. To be sure, people act as though

they are maximizing a subtle concept of profit, one that takes account of a wide vari-

ety of economic and political risks. Yet the parties engaged in international finance do

seem to react to changing conditions in the way that a profit-maximizer would.

It also happens that competition prevails in most international financial markets

despite a folklore full of tales about how wealthy speculators manage to corner those

markets. There is competition in the markets for foreign exchange and in the inter-

national lending markets. Thus, for these markets, we can use the familiar demand–

supply analysis of competitive markets. It is important also to make one disclaimer:

It is definitely not the case that all markets in the international arena are competi-

tive. Monopoly and oligopoly are evident in much of the direct investment activity

discussed in Chapter 15 as well as in the cartels discussed in Chapter 14. Ordinary

demand and supply curves would not do justice to the facts in those areas. Yet in the

financial markets that play a large role in this chapter and the ones that follow, com-

petitive conditions do hold, even more so than in most markets usually thought of as

competitive.

389

pug21774_ch17_389-404.indd 389pug21774_ch17_389-404.indd 389 11/5/14 7:50 PM11/5/14 7:50 PM

Final PDF to printer

THE BASICS OF CURRENCY TRADING

Foreign exchange is the act of trading different nations’ moneys. 1 The moneys take the same forms as money within a country. The greater part of the money assets traded

in foreign exchange markets are demand deposits in banks. A very small part consists

of coins and currency of the ordinary pocket variety.

An exchange rate is the price of one nation’s money in terms of another nation’s money. 2 There are two basic types of exchange rates, depending on the timing of the

actual exchange of moneys. The spot exchange rate is the price for “immediate” exchange. (For standard large trades in the market, immediate exchange for most cur-

rencies means exchange or delivery in two working days after the exchange is agreed,

while it means one working day after the exchange is agreed for exchanges between

U.S. dollars, Canadian dollars, and Mexican pesos.) The forward exchange rate is the price set now for an exchange that will take place sometime in the future. Forward

exchange rates are prices that are agreed today for exchanges of moneys that will

occur at a specified time in the future, such as 30, 90, or 180 days from now. This

chapter focuses on foreign exchange in general and spot exchange rates specifically.

Chapter 18 examines forward foreign exchange and its uses.

In today’s increasingly international world, many online websites and newspapers keep

track of exchange rates with quotations like those shown in Figure 17.1 . Notice that each

price is stated in two ways: first as a U.S. dollar price of the other currency and next as the

price of the U.S. dollar in units of the other currency. The pairs of prices are just recipro-

cals of each other. Saying that the British pound sterling equals 1.6756 U.S. dollars is the same as saying that the U.S. dollar is worth 0.5968 British pound (0.5968 5 1/1.6756),

and so forth. Each exchange rate can be stated in two ways. Each of the two ways sounds

reasonable because both sides of the price are moneys. In contrast, for regular prices of

goods and services, only one of the things being traded is money. So there is one natural

way to quote the price (for instance, $9.00 per movie ticket). It is good practice to be

careful to specify how an exchange-rate value is quoted, by stating the units in both the

numerator and the denominator. As with other prices, the item that is being priced or

valued is in the denominator. For instance, $1.6756/£ is the price or value of the pound. 3

1The term foreign exchange also refers to holdings of foreign currencies. 2Exchange rates are one kind of price that a national money has. Another is its ability to buy goods and services immediately. This second kind of a price is the purchasing power of a unit of money—the reciprocal of the money cost of buying a bundle of goods and services. A third kind of price of money is the cost of renting it, and having access to it, for a given period of time. This is (roughly) the rate of interest that borrowers pay for the use of money, and it is analogous to other rental prices such as the price of renting an apartment or a car. 3Traders in the market also have conventions for stating exchange rates. In the market, most rates referring to the U.S. dollar are quoted as units of other currency per U.S. dollar, but some (the euro, British pound, Australian dollar, and New Zealand dollar) are quoted as U.S. dollars per unit of this currency. In addition, traders who are willing to buy or sell foreign exchange quote two exchange rates: one for buying and the other for selling. The resulting bid-ask spread is a source of profits to the traders. Furthermore, the difference between buying and selling rates (or the bid-ask spread) varies by size (or type) of trade. It is larger for smaller trades and largest for small transactions in actual currency and coins. The difference between buying and selling rates typically is very small for large trades in major currencies. We will ignore differences in buy and sell rates in most subsequent discussions, talking instead about the exchange rate as a single number.

390 Part Three Understanding Foreign Exchange

pug21774_ch17_389-404.indd 390pug21774_ch17_389-404.indd 390 10/29/14 6:06 PM10/29/14 6:06 PM

Final PDF to printer

Country/currency in US$ per US$

Americas

Argentina peso .1238 8.0784 Brazil real .4462 2.2410 Canada dollar .9220 1.0846 Chile peso .001821 549.10 Colombia peso .0005271 1897.00 Ecuador US dollar 1 1 Mexico peso .0778 12.8576 Peru new sol .3617 2.764 Uruguay peso .04338 23.0525 Venezuela b. fuerte .157480 6.3500

Asia-Pacific

Australian dollar .9311 1.0740 1-mo forward .9292 1.0762 3-mos forward .9252 1.0808 6-mos forward .9194 1.0876 China yuan .1600 6.2486 Hong Kong dollar .1290 7.7529 India rupee .01686 59.309 Indonesia rupiah .0000857 11675 Japan yen .009825 101.78 1-mo forward .009827 101.77 3-mos forward .009830 101.72 6-mos forward .009837 101.66 Malaysia ringgit .3112 3.2135 New Zealand dollar .8498 1.1768 Pakistan rupee .01013 98.695 Philippines peso .0228 43.845 Singapore dollar .7973 1.2542 South Korea won .0009794 1021.00 Taiwan dollar .03328 30.047 Thailand baht .03044 32.848 Vietnam dong .00004731 21135

Country/currency in US$ per US$

Europe

Czech Rep. koruna .04960 20.163 Denmark krone .1826 5.4750 Euro area euro 1.3632 .7336 Hungary forint .004505 222.00 Norway krone .1674 5.9748 Poland zloty .3290 3.0398 Russia ruble .02866 34.895 Sweden krona .1495 6.6886 Switzerland franc 1.1167 .8955 1-mo forward 1.1171 .8952 3-mos forward 1.1178 .8946 6-mos forward 1.1192 .8935 Turkey lira .4768 2.0972 UK pound 1.6756 .5968 1-mo forward 1.6753 .5969 3-mos forward 1.6745 .5972 6-mos forward 1.6731 .5977

Middle East/Africa

Bahrain dinar 2.6528 .3770 Egypt pound .1398 7.1511 Israel shekel .2878 3.4742 Jordan dinar 1.4115 .7085 Kuwait dinar 3.5474 .2819 Lebanon pound .0006616 1511.45 Saudi Arabia riyal .2666 3.7506 South Africa rand .0946 10.5729 UAE dirham .2723 3.6730

FIGURE 17.1 Exchange Rate Quotations, May 30, 2014 The foreign exchange rates below apply to trading among banks in amounts of $1 million and more in late afternoon

New York trading.

Source: The Wall Street Journal, May 31–June 1, 2014.

The foreign exchange market is not a single gathering place where traders shout

buy and sell orders at each other. Rather, banks that act as dealers and the traders who

work at these banks are at the center of the foreign exchange market. These banks and

their traders use computers and telephones to conduct foreign exchange trades with

their customers and with each other. The trading done with customers is called the

retail part of the market. Some of this is trading with individuals in small amounts.

Chapter 17 The Foreign Exchange Market 391

pug21774_ch17_389-404.indd 391pug21774_ch17_389-404.indd 391 10/29/14 6:06 PM10/29/14 6:06 PM

Final PDF to printer

One of the currencies shown in Figure 17.1 was not there in the mid-1990s. On January 1, 1999, a major new currency, the euro (€ ), was born. The European Union (EU) created the euro, and 11 of the 15 EU countries began using it immediately, with Greece joining the club on January 1, 2001. For several years after the euro’s birth in 1999, both the euro and the national currencies of these countries coex- isted. Then, during the first two months of 2002, the national currencies of these 12 countries were completely replaced by the euro. The conversion rates were that 1 euro replaced each of

13.7603 Austrian schillings 40.3399 Belgium francs 5.94573 Finnish markka 6.55957 French francs 1.95583 German marks 0.787564 Irish punt 1,936.27 Italian lira 40.3399 Luxembourg francs 2.20371 Netherlands guilder 200.482 Portuguese escudos 166.386 Spanish pesetas 340.750 Greek drachma

Subsequently, Slovenia joined the euro area in 2007, Cyprus and Malta in 2008, Slovakia in 2009, Estonia in 2011, and Latvia in 2014, so that 1 euro has also replaced each of

239.640 Slovenian tolar 0.585274 Cyprus pound 0.429300 Maltese lira 30.1260 Slovakian koruna 15.6466 Estonian kroon 0.702804 Latvian lats

As recently as the late 1980s, the idea of merging the EU national currencies seemed like science fiction. But, in 1991, the EU countries drafted the

Maastricht Treaty, and it became effective in 1993 after all EU countries approved it, some by close national votes. The Maastricht Treaty set a process for establishing a monetary union and a single unionwide currency, including a timetable and criteria for a country to join. But the system that preceded the euro, the Exchange Rate Mechanism of the European Monetary System, came under severe pressure in 1992–1993 and nearly collapsed. Monetary union still looked far away.

The national governments persisted, and peo- ple began to believe. In early 1998, 11 EU countries were deemed to meet the five criteria, covering each country’s inflation rate, long-term interest rate, exchange-rate value of its currency, govern- ment budget deficit, and government debt. Three countries—the United Kingdom, Denmark, and Sweden—could have met the criteria but chose not to join the euro. Each had serious political concerns about the loss of national power and the loss of the national money as a symbol. The other EU country at that time, Greece, did not meet the criteria at first but joined two years later.

The euro is now one of the three major world currencies, along with the U.S. dollar and the Japanese yen. It is part of the growing integra- tion within the EU, a process that also includes the “Europe 1992” drive for a single European market. The euro came under stress in 2010 and 2011 when rescue loans had to be granted to the governments of, first, Greece and then several other euro countries. In later chapters we will examine the implications of the euro for the macroeconomic performance of the EU countries.

DISCUSSION QUESTION You are a Japanese citizen about to travel to France, Italy, and Slovenia for a vacation. Are you happy or unhappy that the euro exists?

Case Study Brussels Sprouts a New Currency: €

We see this part of the market, for instance, when we travel to a foreign country, but

individuals’ exchanges are a very small part of overall foreign exchange trading. Most

of the retail part of the market involves nonfinancial companies, financial institutions,

and other organizations that undertake large trades as the customers of the banks that

392 Part Three Understanding Foreign Exchange

pug21774_ch17_389-404.indd 392pug21774_ch17_389-404.indd 392 10/29/14 6:06 PM10/29/14 6:06 PM

Final PDF to printer

actively deal in the market. The trading done between the banks active in the market

is called the interbank part of the market . The banks active in foreign exchange trading are located in countries around the

world, so this is a 24-hour market. On working days, foreign exchange trading is

always occurring somewhere in the world. Although banks throughout the world par-

ticipate, over half of foreign exchange trading involves banks in two locations: London

and New York.

The total volumes traded in the foreign exchange market are enormous. Foreign

exchange trading in 2013 has been estimated at about $5 trillion per day, which can be compared to a daily turnover of only about $500 billion for U.S. govern-

ment securities and only about $300 billion for all stock trading around the world.

Yet the number of people employed as foreign exchange traders in banks in this

industry is several thousand for the world as a whole. (See the box “Foreign

Exchange Trading.”)

Most foreign exchange trading involves the exchange of U.S. dollars for another

currency. Indeed, although some trades are made directly between currencies other

than the U.S. dollar, many such trades are actually done in two steps. One foreign

currency is exchanged for dollars, and these dollars are then exchanged for the other

foreign currency. Because the dollar is often used in this way to accomplish trading

between two other currencies, the dollar is called a vehicle currency .

Using the Foreign Exchange Market In the customer or retail part of the spot foreign exchange market, individuals, busi-

nesses, and other organizations can acquire foreign moneys to make payments, or

they can sell foreign moneys that they have received in payments. The spot foreign

exchange market thus provides clearing services that permit payments to flow between

individuals, businesses, and other organizations that prefer to use different moneys.

These payments are for all of the types of items included in the balance-of-payments

accounts, including payments for exports and imports of goods and services and pay-

ments for purchases and sales of foreign financial assets.

An example can show how this works. The example also demonstrates the role

of demand deposits as the major form of money traded in the foreign exchange

market. Consider a British firm that has purchased a small airplane (a corporate

jet) from the U.S. producer of the plane and now is making the payment for it. If

the British firm pays by writing a check in pounds sterling, the U.S. firm receiv-

ing the sterling check must be content to hold on to sterling bank deposits or sell

the sterling for dollars. Alternatively, if the U.S. firm will accept payment only in

dollars, then it is the British buyer who must sell sterling to get the dollars to pay

the U.S. exporter.

Let’s assume that the latter is the case. The British firm contacts its bank and

requests a quotation of the exchange rate for selling pounds and acquiring dollars.

If the rate is acceptable, the British firm instructs its bank to take the pounds from

its demand deposit (checking) account, to convert these pounds into dollars, and

to transfer the dollars to the U.S. producer. The British bank holds dollar demand

deposits in the United States, at its correspondent bank in New York. The British

bank instructs its correspondent bank in New York to take dollars from its demand

Chapter 17 The Foreign Exchange Market 393

pug21774_ch17_389-404.indd 393pug21774_ch17_389-404.indd 393 10/29/14 6:06 PM10/29/14 6:06 PM

Final PDF to printer

In 2013, foreign exchange trading was an astound- ing $5 trillion per day. It is difficult to comprehend how large this number is. One comparison offers some guidance. In less than four days the amount of money traded in the foreign exchange market is a little larger than the value of U.S. production of goods and services for an entire year. In just the nine years from 2004 to 2013, global foreign exchange trading more than tripled. This rapid growth seems to be driven by large increases in trading by hedge funds, pension funds, and other financial institu- tions. These institutions have expanded their for- eign exchange trading as they pursue international diversification of their financial investment portfo- lios. They also are increasingly using algorithms for computer-driven foreign exchange trading, includ- ing automated highfrequency trading.

What exactly is being traded in the huge global foreign exchange market? Where is the trading done? And who are the traders?

First, the what. In addition to spot and forward foreign exchange, there is one other traditional for- eign exchange contract, the foreign exchange swap. A foreign exchange swap is a package trade that includes both a spot exchange of two currencies and an agreement to the reverse forward exchange of the two currencies (the future exchange back again). This type of package contract is useful when the parties to the trade have only a temporary need for the currency each is buying spot. In the 2013 global market, spot exchange was 41 percent of trading, forward exchange 14 percent, and foreign exchange swaps 45 percent. For all of this foreign exchange trading in 2013, the U.S. dollar was involved in 87 percent of all trades, the euro in 33 percent, the Japanese yen in 23 percent, the British pound in 12 percent, the Australian dollar in 9 percent, and the Swiss franc in 5 percent.

Second, the where. The global business was distributed in 2013 as follows:

United Kingdom 41% United States 19 Japan 6 Singapore 6 Hong Kong 4

Switzerland 3 Other countries 21

About 60 percent of global trading is done in the United Kingdom (mostly London) and the United States (mostly New York). Even though the British pound itself is not that important in foreign exchange contracts, London is clearly the center of global foreign exchange trading.

Now, the who. Most foreign exchange trad- ing is done by and through a network of dealer banks worldwide, banks that actively “make a market” in foreign exchange by quoting rates and being willing to buy or sell currencies for their own account. According to Euromoney magazine, in 2014 four banks conducted over half of the global trading in foreign exchange: Citigroup and Deutsche Bank, each about 16 percent, and Barclays Capital and UBS, each about 11 percent.

Most trading is done by several thousand trad- ers who are employed at these several hundred banks. This is a surprisingly small number of traders, relative to the huge volume of trading conducted. There are good reasons why there are so few foreign exchange traders. One is the capital intensity of this business. It takes a lot of money and substantial investments in computer and telecommunications hardware and software, but only a few decision-makers. Another is the nature of the work itself.

Trading millions of dollars of foreign exchange per minute is a harrowing job; it’s almost in the same category with being an air traffic controller or a bomb defuser. A trader should be somebody who loves pressures, makes quick decisions, and can take losses. Many who try it soon develop a taste for other work. Once an economics student visiting a foreign exchange trading room in a major bank asked a trader, “How long do people last in this job?” The enthusiastic answer: “Yes, it is an excellent job for young people.”

DISCUSSION QUESTION For foreign exchange trading, what is different about Asia, compared to Europe and the America? Do you think that this difference is surprising?

Case Study Foreign Exchange Trading

394 Part Three Understanding Foreign Exchange

pug21774_ch17_389-404.indd 394pug21774_ch17_389-404.indd 394 10/29/14 6:06 PM10/29/14 6:06 PM

Final PDF to printer

deposit account and transfer the dollars to the U.S. producer, by transferring them

to the U.S. producer’s bank for deposit into the producer’s demand deposit account. 4

As with most payments that are purely domestic, demand deposits are used in this

foreign exchange trade and in completing the international payment for the airplane.

The British firm uses the pounds in its demand deposit account to acquire the dollars

needed. The U.S. producer uses its demand deposit account to receive the dollar pay-

ment. The British bank uses its dollar demand deposits in its correspondent bank in

New York for two purposes: (1) as the dollars that it sells to its customer in the foreign

transaction and (2) as the (same) dollars that are then transferred to the U.S. producer

as payment.

Interbank Foreign Exchange Trading A little less than 40 percent of foreign exchange trading is trading among the dealer

banks themselves in the interbank (or interdealer) part of the foreign exchange mar-

ket. What’s being traded is still the same—demand deposits denominated in different

currencies. But each deal is between one foreign exchange trader and another trader,

not an “outside” customer.

The interbank part of the market serves several functions. Participation in the

interbank (or interdealer) part of the market provides a bank with a continuous

stream of information on conditions in the foreign exchange market through com-

munications with traders at other banks and through observing the prices (exchange

rates) being quoted. Interbank trading allows a bank to readjust its own position

quickly and at low cost when it separately conducts a large trade with a customer.

For instance, if Citigroup buys a large amount of yen from Toyota (and sells dollars

to Toyota), Citigroup may be unwilling to continue holding the yen. Citigroup then

can sell the yen to another bank (and buy dollars) quickly and at low cost. Interbank

trading also permits a bank to take on a position in a foreign currency quickly if

the bank and its traders want to speculate on exchange-rate movements in the near

future. Such speculative positions are usually held only for a short time, typically

being closed out by the end of the day.

About half of interbank trading occurs through brokers, and most brokered trading

uses electronic brokering systems. The use of brokers provides anonymity to the trad-

ers until an exchange rate is agreed on for a trade. The other half of interbank trading

involves traders at different banks in direct contact, mostly through electronic trading

platforms. In addition, in the past decade the line between the customer part of the

market and the interbank part of the market has blurred. A number of other financial

institutions now have access to and trade on electronic platforms that previously had

been a dealer-only part of the foreign exchange market.

Foreign exchange trading in this interbank part of the market is not for the

little guy. Notice that the quoted interbank rates in Figure 17.1 are for amounts of

$1 million or more. In fact, traders often save time by referring to each million dollars

as a “dollar.” With millions being exchanged each minute, extremely fine margins of

profit or loss can loom large. For example, a trader who spends a minute shopping

4The British bank can also use dollars available at its own U.S. branch to carry out this payment in the United States if it has a branch there.

Chapter 17 The Foreign Exchange Market 395

pug21774_ch17_389-404.indd 395pug21774_ch17_389-404.indd 395 10/29/14 6:06 PM10/29/14 6:06 PM

Final PDF to printer

and secures 10 million pounds at $1.6756 per pound, instead of accepting a ready

offer at $1.6757, has brought her bank an extra $1,000 within that minute. That’s

equivalent to a wage rate of $60,000 an hour. Correspondingly, anyone who reacts a

bit too slowly or too excitedly to a given news release (e.g., announcement of rapid

growth in the Canadian money supply, rumors of a coup in Libya, or a wildcat steel

strike in Italy) can lose money at an even faster rate. On the average, these profes-

sionals make more than they lose, enough to justify their rates of pay. But foreign

exchange trading is a lively and tense job. That department of a large bank is usually

run as a tight ship with no room for “passengers” who do not make a good rate of

return from quick dealings at fine margins.

DEMAND AND SUPPLY FOR FOREIGN EXCHANGE

To understand what makes the exchange-rate value of a country’s currency rise and

fall, you should proceed through the same steps used to analyze any competitive

market. First, portray the interaction of demand and supply as determinants of the

equilibrium price and quantity, and then explore what forces lie behind the demand

and supply curves.

Within the foreign exchange market, people want to trade moneys for various

reasons. Some are engaged in trading goods and services and are making or receiv-

ing payments for these products. Some are engaged in international flows of finan-

cial assets. They are investing or borrowing internationally and need to convert one

nation’s money to another money in the process of buying and selling financial assets,

incurring and paying back debts, and so forth.

A nation’s export of goods and services typically causes foreign moneys to be

sold in order to buy that nation’s money. For instance, the importer in a foreign

country desires to pay using her currency, while the U.S. exporter desires to be

paid in dollars. Somewhere in the payments process, foreign money is exchanged

for dollars. We saw a specific example of this in the previous section on using the

foreign exchange market. Thus, U.S. exports of goods and services create a supply of foreign currency and a demand for U.S. dollars to the extent that foreign buyers have their own currencies to offer and U.S. exporters prefer to end up holding U.S.

dollars and not some other currency. Only if U.S. exporters are happy to hold on

to pounds (or the UK importers somehow have large holdings of dollars to spend)

can U.S. exports to Britain keep from generating a supply of pounds and a demand

for dollars.

Importing goods and services correspondingly tends to cause the home currency

to be sold in order to buy foreign currency. For instance, if a U.S. importer desires

to pay in dollars, and the British exporter desires to be paid in pounds because

she wants to end up holding her home currency, then somewhere in the payments

process dollars must be exchanged for pounds. Thus, U.S. imports of goods and services create a demand for foreign currency and a supply of U.S. dollars to the extent that U.S. importers have dollars to offer and foreign exporters prefer to end

up holding their own currencies. Only if foreign exporters are happy to hold on to

dollars (or the U.S. importers somehow have large holdings of foreign currencies

396 Part Three Understanding Foreign Exchange

pug21774_ch17_389-404.indd 396pug21774_ch17_389-404.indd 396 10/29/14 6:06 PM10/29/14 6:06 PM

Final PDF to printer

to spend) can U.S. imports keep from generating a supply of dollars and a demand

for foreign currency. 5

Similar reasoning applies to transactions in financial assets. Consider a U.S. insurance

company that wants to replace some of its current holdings of U.S.-dollar-denominated

bonds with British-pound-denominated bonds, perhaps because it expects a higher rate

of return on the sterling investment. The company will need to sell dollars and buy

pounds in the foreign exchange market, then use these pounds to make payment in

the process of buying the pound-denominated bonds. U.S. capital outflows create a demand for foreign currency and a supply of U.S. dollars to the extent that the inves- tors begin with dollars and a desire to invest in foreign financial assets that must be

paid for in foreign currencies.

In another case, a British resident currently holding sterling demand deposits

wishes to buy shares in Facebook. The person will need to sell pounds and buy dollars

in the foreign exchange market, then use these dollars to make payment in the process

of buying the stock. U.S. capital inflows create a supply of foreign currency and a demand for dollars to the extent that investors begin with foreign currency and desire

to invest in U.S. financial assets that must be paid for in dollars.

All of these transactions create supply and demand for foreign exchange. The sup-

ply and demand determine the exchange rate, within certain constraints imposed by

the nature of the foreign exchange system or regime under which the country operates.

Floating Exchange Rates The simplest system is the floating exchange-rate system without intervention by governments or central bankers. The spot price of foreign currency is market-

driven, determined by the interaction of private demand and supply for that currency.

The market clears itself through the price mechanism. The two parts of Figure 17.2

show how such a system could yield equilibrium exchange rates for the pound sterling

($1.60/£) and the Swiss franc ($1.20/SFr) at the E points. Let’s digress for a little while, to examine the logic behind the slopes of the curves

in Figure 17.2. We’ll focus on the demand curve for foreign currency. What makes

the demand curve slope downward? That is, why should a lower (higher) price of a

currency generally mean that more (less) of it is demanded?

To see the likelihood of the downward slope, imagine that the exchange rate in

Figure 17.2A has just shifted from $1.98 to $1.60. As the pound declines below $1.98,

Americans will discover more uses for it. One use would be to buy wool sweaters

in Britain. Before the pound sinks, a sweater selling for £50 in London would cost

American tourists $99 (5 50 3 $1.98). If the pound suddenly sank to $1.60, the same

£50 wool sweater would cost American tourists only $80. They would start buying

more. To pay for the extra sweaters, they would want more pounds sterling, to be paid

to British merchants. As long as the level of business remains higher, there is more

demand for pounds to conduct that business.

5International payments of income and unilateral transfers can also result in demand or supply of foreign currency. For instance, if a foreign company pays a dividend in its own currency, U.S. holders of its stock supply foreign currency if they want to take payment in dollars. As another example, some people in the United States and Canada demand foreign currency to send remittances and cash gifts to relatives in Italy, Mexico, or some other country from which they emigrated.

Chapter 17 The Foreign Exchange Market 397

pug21774_ch17_389-404.indd 397pug21774_ch17_389-404.indd 397 10/29/14 6:06 PM10/29/14 6:06 PM

Final PDF to printer

The demand and supply curves represent all demand and supply for that currency in the foreign exchange market,

except for any official intervention by the official government monetary authorities (like central banks). With a floating exchange rate, the market reaches an equilibrium at points E in panels A and B. If the government wishes to fix the exchange rate at a different level, then it must intervene to buy or sell the currency to meet any difference between private (or nonofficial) quantity demanded and quantity supplied. In panel A, if the British government is committed not

to let the pound fall below $1.98/£, the government must buy 50 billion pounds, equal to the gap AB . In panel B, if the Swiss government is committed not to let the franc rise above $1.01/SFr, the government must sell 100 billion Swiss

francs, equal to the gap AB .

£ (billions)

Exchange rate ($ per £)

1.60

D£

S£

320

1.98

270 SFr (billions)

Exchange rate ($ per SFr)

1.01 A

DSFr

SSFr

575

1.20

500 475

A. The Market for Pounds B. The Market for Swiss Francs (SFr)

300

FIGURE 17.2 The Spot Exchange Market: Floating and Fixed Exchange Rates

The case of British wool sweaters is just one illustration of the forces that would

make the demand curve for a currency slope downward. There are usually many such

responses of trade to a change in the exchange rate. A sinking pound means that

Americans buy more cheese from British producers and buy less from cheesemakers

in Wisconsin. There is more reason for Americans to buy British products and there-

fore more demand for pounds as a currency to facilitate such transactions. As long

as a lower exchange rate raises the quantity demanded, the demand curve will slope

downward. 6

Now let’s return to our market-driven floating exchange rate. What makes the

floating exchange rate rise or fall over time? To answer we need to know the forces

that shift the supply and demand curves. Again, let’s focus on the demand curve.

The demand curve is shifted by a variety of changes in the economy. Many of the

demand-side forces relate to the balance-of-payments categories of the previous

chapter. Shifts in demand away from U.S. products and toward UK products (caused

6Similar logic can be applied to examine the slope of the supply curve for foreign exchange, but the actual slope of the supply curve is not so clear-cut. We presume for now that the supply curve has the usual upward slope.

398 Part Three Understanding Foreign Exchange

pug21774_ch17_389-404.indd 398pug21774_ch17_389-404.indd 398 10/29/14 6:06 PM10/29/14 6:06 PM

Final PDF to printer

The demand curve for foreign exchange can be shifted to the right (or raised) by either of

the following changes related to the balance of payments:

A shift of U.S. demand toward the goods and services of other countries.

A rise in U.S. willingness to lend money to or invest in other countries.

If the demand curve shifts to the right, then the market equilibrium exchange-rate value

of the pound rises. (Chapter 19 discusses in more depth the forces that shift the demand

and supply curves and change the exchange rate.)

£ (billions)

Exchange rate ($ per £)

1.60 E

D£

S£

310

1.80

300

FIGURE 17.3 A Shift in

Demand for

Pounds in the

Spot Exchange

Market

by forces other than changes in the exchange rate) would result in extra attempts

to sell dollars and buy pounds. This can be graphed as a shift to the right (or up) in

the demand curve for pounds. Similarly, a rise in U.S. residents’ willingness to lend

money to UK borrowers or to invest in pound-denominated financial assets usually

requires that extra dollars be converted into pounds, thus shifting the demand curve

for pounds to the right.

In a floating-rate system, if for any reason the demand curve for foreign currency

shifts to the right (representing increased demand for foreign money), and the supply

curve remains unchanged, then the exchange-rate value of the foreign currency rises.

Such a shift is shown in Figure 17.3 . The rightward shift in demand for pounds to D 2

increases the price of pounds from $1.60 to $1.80 per pound, as the market equilib-

rium shifts from E to E 2 .

Fixed Exchange Rates The other main foreign exchange regime is the fixed exchange-rate system. Here, officials strive to keep the exchange rate virtually fixed (or pegged) even if the rate

they choose differs from the current equilibrium rate. Their usual procedure under

such a system is to declare a narrow “band” of exchange rates within which the rate

is allowed to vary. If the exchange rate hits the top or bottom of the band, the officials

must intervene. Let’s return to Figure 17.2 to see how this could work.

Chapter 17 The Foreign Exchange Market 399

pug21774_ch17_389-404.indd 399pug21774_ch17_389-404.indd 399 10/29/14 6:06 PM10/29/14 6:06 PM

Final PDF to printer

In Figure 17.2A, consider an officially declared “par value” of $2.00, at which

the pound is substantially overvalued relative to its market-clearing rate of $1.60 per

pound. British officials have announced that they will support the pound at 1 percent

below par (about $1.98) and the dollar at 1 percent above par (about $2.02). In

Figure 17.2A, they are forced to make good on this pledge by officially intervening

in the foreign exchange market, buying £50 billion (and selling $99 billion, equal to

£50 billion times $1.98 per pound). This intervention fills the gap AB between nonof- ficial supply and demand at the $1.98 exchange rate. 7 Only in this way can they bring

the total demand for pounds, private plus official, up to the 320 billion of sterling

money supplied. If their purchases of pounds with dollars fall short, total demand can-

not meet the supply and the price will fall below the official support price of $1.98.

However, British officials wanting to defend the fixed exchange rate may not have

sufficient reserves of dollars to keep the price fixed indefinitely, a point to which we

will return several times in the rest of the book.

Another case of official intervention in defense of a fixed exchange rate is shown

in Figure 17.2B. Swiss government officials have declared that the par value of the

Swiss franc (SFr) shall be U.S. $1.00 and that the support points are $1.01 and $0.99.

As the demand and supply curves are drawn, the franc is substantially undervalued at

this fixed rate, relative to the market-clearing rate of $1.20 per franc. To defend the

fixed rate, government officials must intervene in the foreign exchange market and sell

100 billion francs to meet the strong demand at $1.01. If the Swiss government offi-

cials cannot tolerate buying enough dollars to plug the gap AB and keep the exchange rate down at $1.01, they may give up and let the price rise.

Changes in exchange rates are given various names depending on the kind of

exchange-rate regime prevailing. Under the floating-rate system a fall in the market

price (the exchange-rate value) of a currency is called a depreciation of that currency; a rise is an appreciation. We refer to a discrete official reduction in the otherwise fixed par value of a currency as a devaluation; revaluation is the antonym describing a discrete raising of the official par. Devaluations and revaluations

are the main ways of changing exchange rates in a nearly fixed-rate system, a system

where the rate is usually, but not always, fixed.

Current Arrangements Which countries have floating exchange rates for their currencies and which have

fixed exchange rates? Here is an overview, without getting into everything now.

First, most major currencies, including the U.S. dollar, the euro, the Japanese yen,

the British pound, the Canadian dollar, the Australian dollar, and the Swedish krona,

have floating exchange rates relative to each other. Second, the governments of a large

number of other countries say they have floating exchange rates, though many use

some amount of official exchange market intervention to “manage” the float. Third,

some countries have fixed exchange rates between their currencies and the U.S. dol-

lar. These countries include Hong Kong and Saudi Arabia. Fourth, some countries,

7Such official intervention could also be pictured as shifting the demand or supply curves. However, it seems more descriptive, when examining the defense of a fixed rate, to consider official exchange market intervention as filling the gap between quantity demanded and quantity supplied in the absence of the intervention.

400 Part Three Understanding Foreign Exchange

pug21774_ch17_389-404.indd 400pug21774_ch17_389-404.indd 400 10/29/14 6:06 PM10/29/14 6:06 PM

Final PDF to printer

including Denmark, Bulgaria, and former French colonies in Africa, fix the exchange-

rate value of their currencies to the euro. We will examine these and other exchange-

rate policies in more depth in Chapter 20.

ARBITRAGE WITHIN THE SPOT EXCHANGE MARKET

We have pictured foreign exchange as a single market for trading between two curren-

cies. Yet we have also noted that trading occurs in different locations around the world.

For instance, for a period of time each day, trading is occurring in both New York and

London as well as in other money centers in Europe. Will the rates in the different

locations be essentially the same at a point in time, or can they diverge as local supply

and demand conditions differ? Furthermore, exchange rates exist for many different

currencies, both rates representing the dollar price of various foreign currencies and

the cross-rates between foreign currencies. Are these exchange rates and cross-rates related in some way, or can they have independent levels?

Arbitrage, the process of buying and selling to make a (nearly) riskless pure profit, ensures that rates in different locations are essentially the same, and that rates

and cross-rates are related and consistent among themselves. What would happen if

pounds were being exchanged at $1.70 per pound in London and $1.60 per pound

at the same time in New York? If foreign exchange trading and money transfers can

be done freely, then there is an opportunity to make a riskless profit by arbitraging

between the two locations. Buy pounds where they are cheap (in New York) and

simultaneously sell them where they are expensive (in London). For each pound

bought and sold at the initial exchange rates, the arbitrage profit is 10 cents. Such

arbitrage would occur on a large scale, increasing the demand for pounds in New York

and increasing the supply of pounds in London. The dollar–pound exchange rate then

would increase in New York and/or decrease in London. The two rates would be driven

to be essentially the same (that is, within the small range reflecting transactions costs

that prevent any further profitable arbitrage).

What happens if the exchange rate for the pound in terms of dollars is $1.60, the

exchange rate for the Swiss franc in terms of dollars is $0.50, and the cross-rate

between the franc and the pound is 3 francs per pound? Although it is more subtle,

there is also an opportunity to make a riskless profit by arbitraging through the three

rates—a process called triangular arbitrage. To see this, start with some number of dollars, say $150. Your $150 buys 300 francs (150/0.50). Use these francs to buy

pounds at the cross-rate, and you have 100 pounds (300/3). Convert these pounds back

into dollars and you end up with $160 (100 3 1.60). Your triangular arbitrage has

made $10 profit for each $150 you started with. This profit occurs almost instantly and

with essentially no risk if you establish all three spot trades at the same time.

As a large amount of this triangular arbitrage occurs, pressures are placed on the

exchange rates to bring them into line with each other. The extra demand for francs

tends to increase the dollar–franc exchange rate. The extra demand for pounds (paid

for by francs) tends to increase the franc–pound cross-rate. The extra supply of

pounds (to acquire dollars) tends to reduce the dollar–pound exchange rate. One or

more of the exchange rates will change (due to demand and supply pressures) so that

Chapter 17 The Foreign Exchange Market 401

pug21774_ch17_389-404.indd 401pug21774_ch17_389-404.indd 401 10/29/14 6:06 PM10/29/14 6:06 PM

Final PDF to printer

the cross-rate of francs per pound essentially equals the ratio of the dollar–pound

exchange rate to the dollar–franc exchange rate. For instance, if only the cross-rate

changes, then its value must shift to 3.2 francs per pound (1.60/0.50). At this cross-rate

there is no further opportunity for profits from triangular arbitrage.

Just the threat of arbitrage of these types usually keeps the exchange rate between

two currencies essentially the same in different locations and keeps cross-rates in cor-

rect alignment with other exchange rates. Opportunities for actual arbitrage of these

types are rare.

Summary A foreign exchange transaction is a trade of one national money for another. The exchange rate is the price at which the moneys are traded. The spot exchange rate is the price for immediate exchange of the two currencies. The forward exchange rate is the price agreed now for a currency exchange that will occur sometime in the future. Dealer banks and their traders are at the center of the foreign exchange market.

They use computers and telephones to conduct foreign exchange trades with customers

(the retail part of the market) and with each other (the interbank part of the market).

Spot foreign exchange serves a clearing function, permitting payments to be made

between entities who want to hold or use different currencies. The exchange rate

is determined by supply and demand, within any constraints imposed by the gov-

ernmental choice of an exchange-rate system or regime. Under a freely flexible or

floating exchange-rate system, market supply and demand set the equilibrium price (exchange rate) that clears the market. A floating exchange rate changes over

time as supply and demand shift over time. Under a fixed exchange-rate system (also called a pegged exchange-rate system), monetary officials buy and sell a cur-

rency so as to keep its exchange rate within an officially stipulated band. When the

currency’s value threatens to fall below the bottom of its official band, officials must

buy it by selling other currencies. When the currency’s value presses against the top of

its official price range, officials must sell it in exchange for other currencies.

Key Terms Foreign exchange Exchange rate

Spot exchange rate

Forward exchange rate

Foreign exchange swap

Floating exchange-rate

system

Fixed exchange-rate system

Depreciation

Appreciation

Devaluation

Revaluation

Arbitrage

Triangular arbitrage

Suggested Reading

King et al. (2012) and Sager and Taylor (2006) describe the structure of and practices

in the foreign exchange market. Two good textbook views are Eun and Resnick (2012,

Chapter 5) and Eiteman, Stonehill, and Moffet (2013, Chapter 6). Cheung and Wong

(2000) and Cheung and Chinn (2001) report information obtained from their surveys of

foreign exchange traders. Fenn et al. (2009) examine opportunities for triangular arbitrage

using detailed real-time data.

402 Part Three Understanding Foreign Exchange

pug21774_ch17_389-404.indd 402pug21774_ch17_389-404.indd 402 10/29/14 6:06 PM10/29/14 6:06 PM

Final PDF to printer

Questions and Problems

1. What are the major types of transactions or activities that result in demand for foreign

currency in the spot foreign exchange market?

2. What are the major types of transactions or activities that result in supply of foreign

currency in the spot foreign exchange market?

3. What has happened to the exchange-rate value of the dollar in each case?

a. The spot rate goes from $1.25/SFr to $1.30/SFr. b. The spot rate goes from SFr 0.80/$ to SFr 0.77/$. c. The spot rate goes from $0.010/yen to $0.009/yen. d. The spot rate goes from 100 yen/$ to 111 yen/$.

4. A U.S. firm must make a payment of 1 million yen to a Japanese firm that has sold the

U.S. firm sets of Japanese baseball-player trading cards. The U.S. firm begins with a

dollar checking account. Explain in detail how this payment would be made, including

the use of the spot foreign exchange market and banks in both countries.

5. A British bank has acquired a large number of dollars in its dealings with its clients.

How could this bank use the interbank foreign exchange market if it was unwilling to

continue holding these dollars?

6. A trader at a U.S. bank believes that the euro will strengthen substantially in exchange-

rate value during the next hour. How would the trader use the interbank market to

attempt to profit from her belief ?

7. For each of the following, is it part of demand for yen or supply of yen in the foreign

exchange market?

a. A Japanese firm sells its U.S. government securities to obtain funds to buy real estate in Japan.

b. A U.S. import company pays for glassware purchased from a small Japanese producer.

c. A U.S. farm cooperative receives payment from a Japanese importer of U.S. oranges.

d. A U.S. pension fund uses some incoming contributions to buy equity shares of several Japanese companies through the Tokyo stock exchange.

8. You have access to the following three spot exchange rates:

$0.01/yen

$0.20/krone

25 yen/krone

You start with dollars and want to end up with dollars.

a. How would you engage in arbitrage to profit from these three rates? What is the profit for each dollar used initially?

b. As a result of this arbitrage, what is the pressure on the cross-rate between yen and krone? What must the value of the cross-rate be to eliminate the opportunity for

triangular arbitrage?

9. The spot exchange rate between the dollar and the Swiss franc is a floating, or flexible,

rate. What are the effects of each of the following on this exchange rate?

a. There is a large increase in Swiss demand for U.S. exports as U.S. culture becomes more popular in Switzerland.

✦

Chapter 17 The Foreign Exchange Market 403

pug21774_ch17_389-404.indd 403pug21774_ch17_389-404.indd 403 10/29/14 6:06 PM10/29/14 6:06 PM

Final PDF to printer

b. There is a large increase in Swiss demand for investments in U.S. dollar- denominated financial assets because of a Swiss belief that the U.S. economy and

political situation are improving markedly.

c. Political uncertainties in Europe lead U.S. investors to shift their financial invest- ments out of Switzerland, back to the United States.

d. U.S. demand for products imported from Switzerland falls significantly as bad press reports lead Americans to question the quality of Swiss products.

10. Assume instead that the spot exchange rate between the dollar and Swiss franc is

a fixed or pegged rate within a narrow band around a central rate. For each change

shown in Problem 9, assume that just before the change private (or nonofficial)

supply and demand intersected at an equilibrium exchange rate within this narrow

band. For each change shown in Problem 9, what intervention is necessary by the

monetary authorities to defend the fixed rate if the change shifts the intersection of

private supply and demand outside the band?

11. You are a foreign exchange trader and you receive the following two quotes for spot

trading:

• Bank A is willing to trade at $1.50 per Swiss franc.

• Bank B is willing to trade at 0.50 Swiss franc per dollar.

Is there an opportunity to make an arbitrage profit? If there is, explain what you will

do. If there is not, why not?

12. You are an analyst following a medium-sized country that has a fixed exchange rate of

5 dinars per U.S. dollar (with a band of 2 percent above and below this par value).

During March of last year you know that the country’s monetary authority intervened in

the foreign exchange market by buying U.S. $2 billion. During the next month (April)

you know that the country’s monetary authority intervened to sell U.S. $3 billion.

What are two different changes in the foreign exchange market that could explain the different interventions during these two months? For each of the two changes, use

a graph of the foreign exchange market to illustrate why the change resulted in the

different interventions.

✦

404 Part Three Understanding Foreign Exchange

pug21774_ch17_389-404.indd 404pug21774_ch17_389-404.indd 404 11/5/14 7:49 PM11/5/14 7:49 PM

Final PDF to printer

Chapter Eighteen

Forward Exchange and International Financial Investment Many international activities lead to money exchanges in the future. This is true of

many international trade activities, whose payments are not due until sometime in

the (usually near) future. It is also true of international financial activities, which are

specifically designed to create future flows of moneys as returns are received, debts

are repaid, or financial assets are sold to others. A major challenge in conducting all of

these activities is that we do not know for sure the exchange rates that will be available

in the future to translate one country’s money into another country’s money.

This chapter examines future exchanges of moneys and the exposure to the risks of

uncertain future exchange rates. It discusses how forward foreign exchange contracts can

be used to reduce the risk exposure or to speculate on future exchange rates. Much of

the chapter focuses on the returns to and risks of investments in foreign financial assets.

EXCHANGE-RATE RISK

Exchange rates change over time. In a floating-rate system, spot exchange rates change

from minute to minute because supply and demand are constantly in flux. Indeed, as

we have seen since the early 1970s, floating rates sometimes change quickly by large

amounts as a result of large shifts in supply and demand. In a fixed-rate system, spot

exchange rates also can change from minute to minute, but the range of the rate is typi-

cally limited to a small band around the par value as long as the fixed rate is defended

successfully by the government authorities. Nonetheless, even in a fixed-rate system

large changes can and do sometimes occur when the currency is devalued or revalued

by the authorities. While some portion of the change in spot exchange rates in either

system can be predicted by participants in the foreign exchange market, another part—

often a large part—of exchange-rate change cannot be predicted.

A person (or an organization like a firm) is exposed to exchange-rate risk if the value of the person’s income, wealth, or net worth changes when exchange rates

change unpredictably in the future. This is a broad concept, but it has specific mean-

ings in particular situations. If you are an American, take a vacation in Japan, and take

405

pug21774_ch18_405-432.indd 405pug21774_ch18_405-432.indd 405 11/6/14 4:07 PM11/6/14 4:07 PM

Final PDF to printer

U.S. dollars along with you to convert into yen as needed to pay for your expenses and

purchases, you are exposed to exchange-rate risk. The dollar value of the things that you

buy and the number of things that you can afford to do will be affected by the dollar–yen

exchange rates during your vacation. While you have some expectation of what those

exchange rates will be, the actual rates will probably be different. From your point of

view, the risk is that the yen could appreciate substantially so that it would take more

dollars to obtain the same number of yen. The dollar prices of the things that you want to

do and to buy will be higher; you will enjoy your vacation less. Of course, the yen might

instead depreciate. In this case you will be pleasantly surprised by the increased buying

power of your dollars. Still, as you begin your vacation you are exposed to exchange-

rate risk because you do not know what will happen to the yen during your vacation.

Another example of exposure to exchange-rate risk is your first purchase of a finan-

cial asset denominated in a foreign currency—for instance, an investment in Mexican

stocks. You may have heard that an investment in emerging markets is “where the

action is.” This may turn out to be too true. The dollar value of your investment depends

not only on changes in the market prices of your Mexican stocks (valued in pesos) but

also on changes in the dollar value of the peso. If the peso depreciates, the dollar value

of your stock investment falls. Even if you expect some amount of peso depreciation,

and incorporate that into the overall dollar return that you expect on your investment,

the risk to you is that the peso could depreciate more than you are expecting.

The fact that exchange rates can change over time leads people to two types of

responses. These appear contradictory, but actually just represent the responses of dif-

ferent people to different situations.

Some people do not want to gamble on what exchange rates will be in the

future. They have acquired exposures to exchange-rate risk in the course of their

regular activities, but they seek to reduce or eliminate their risk exposure by hedging.

Hedging a position exposed to rate risk, here exchange-rate risk, is the act of reduc- ing or eliminating a net asset or net liability position in the foreign currency.

Other people, thinking they have a good idea of what will happen to exchange

rates, are quite willing to gamble on what exchange rates will be in the future. They

are willing to take on or to hold positions that are exposed to exchange-rate risk. They

are willing to bet that the rates are going to move in their favor so that they make a

profit. Speculating is the act of taking a net asset position (“long”) or a net liability position (“short”) in some asset class, here a foreign currency.

These two attitudes have been personified into the concepts of hedgers and

speculators, as though individuals were always either one or the other. Actually, the

same person can choose to behave as a hedger in some situations and as a specula-

tor in others.

THE MARKET BASICS OF FORWARD FOREIGN EXCHANGE

There are a number of ways to hedge an exposure to exchange-rate risk, or to take on

additional exposure in order to speculate. For your vacation in Japan, you could hedge

by buying yen (or yen-denominated traveler’s checks) before you depart, thus having

yen money to pay for your yen expenses and purchases.

406 Part Three Understanding Foreign Exchange

pug21774_ch18_405-432.indd 406pug21774_ch18_405-432.indd 406 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

For larger transactions involving international trade in goods and services, interna-

tional financial investment, or pure speculation on future exchange-rate movements,

forward foreign exchange and forward exchange rates are often useful. As we men-

tioned in the previous chapter, a forward foreign exchange contract is an agree- ment to exchange one currency for another on some date in the future at a price set

now (the forward exchange rate ). Banks acting as foreign exchange dealers generally are willing to meet the needs of

their customers for the specific size of the forward exchange contract (the amount of

foreign exchange) and the specific date in the future for the exchange. Common dates

for future exchange are 30, 90, and 180 days forward (one, three, and six months). 1

For instance, to buy £100,000 of 90-day forward sterling at $1.6745/£, you sign an

agreement today with your bank that 90 days from now you will deliver $167,450 in

dollar bank deposits and receive £100,000 in pound bank deposits. The exchange of

these amounts will take place to carry out the forward contract, regardless of what the

actual spot exchange rate turns out to be in 90 days. In the opposite trade, somebody

agreeing now to sell 90-day forward sterling must deliver pounds at the agreed price of

$1.6745/£ in 90 days. That person need not own any sterling at all until then, but the

rate at which he gives it up in 90 days is already set now. Do not confuse the forward rate with the future spot rate, the spot rate that ends up prevailing 90 days from now. The actual spot price of sterling that exists in 90 days could be above, below, or equal

to the forward rate. In this respect, a forward exchange rate is like a commodity futures

price or a binding advance hotel reservation.

The forward exchange market is particularly convenient for large customers, typi-

cally corporations, that are viewed by their banks as acceptable credit risks. These

customers typically do not need to commit anything other than the written agreement

until the exchange actually occurs in the future. Some customers must pledge a margin

that the bank can seize if the customer fails to fulfill the contract in the future, but this

margin is only a fraction of the total size of the contract (because the bank only needs

to recover any net loss on the other party’s position).

Hedging Using Forward Foreign Exchange Hedging involves acquiring an asset in a foreign currency to offset a net liability

position already held in the foreign currency, or acquiring a liability in a foreign cur-

rency to offset a net asset position already held. Hedgers in international dealings are

persons who have a home currency and seek a balance between their liabilities and

assets in foreign currencies. In financial jargon, hedging means reducing both kinds

of “open” positions in a foreign currency—both long positions (holding net assets in the foreign currency) and short positions (owing more of the foreign currency than one holds). An American who has completely hedged a position in euros has ensured

that the future of the exchange rate between dollars and euros will not affect his net

worth. Hedging is a perfectly normal kind of behavior, especially for people whose

main business is not international finance. Simply avoiding any net commitments in

1 In the usual forward exchange contract, the actual exchange of currencies will occur two (or one) days after the stated time period, to match the two-day (or one-day) delay in settling standard spot contracts. The discussion in this chapter ignores the two- or one-day delay in actually exchanging the currencies.

Chapter 18 Forward Exchange and International Financial Investment 407

pug21774_ch18_405-432.indd 407pug21774_ch18_405-432.indd 407 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

a foreign currency saves on the time and trouble of keeping abreast of fast-changing

international currency conditions.

There are usually a number of ways to hedge a position that is exposed to exchange-

rate risk. For many types of exposure, a forward exchange contract is a direct way to

hedge. Consider a U.S. company that has bought some merchandise and will have to

pay £100,000 three months from now. Assuming that this represents an overall net lia-

bility position in pounds (perhaps because the company has no other assets or liabilities

in pounds), the company is exposed to exchange-rate risk. It does not know the dollar

value of its liability because it does not know the spot exchange rate that will exist 90

days from now. One way to hedge its risk exposure is to enter into a forward contract to

acquire (or buy) £100,000 in 90 days. If the current forward rate is $1.6745/£, then the

company must deliver (or sell) $167,450 in 90 days. The company has an asset position

in pounds through the forward contract (the company is owed pounds in the contract).

This exactly matches its pound liability to pay for the merchandise, creating a “perfect

hedge.” The company now is assured that the merchandise will cost $167,450 regard-

less of what happens to the spot exchange rate in the next 90 days. 2

Forward exchange contracts can be used to hedge exposures to exchange-rate risk

in many other situations. A U.S. company that will receive a payment of £1 million

in 60 days is unsure of the dollar value of this receivable because the spot exchange

rate in 60 days is uncertain. It can hedge by selling pounds (and buying dollars) in

a 60-day forward exchange contract, using the forward exchange rate to lock in the

number of dollars it will receive. A British firm needing to pay $200,000 in 30 days

on its dollar-denominated debt can hedge its exchange-rate risk exposure by buying

dollars (and selling pounds) in a 30-day forward contract. A British individual inherit-

ing $2 million that will be disbursed (in dollars) in 180 days can hedge by selling the

dollars (and buying pounds) in a 180-day forward contract.

Speculating Using Forward Foreign Exchange Speculating means committing oneself to an uncertain future value of one’s net worth in

terms of home currency. A rich imagery surrounds the term speculator . Speculators are usually portrayed as a class apart from the rest of humanity. These speculators are viewed

as being excessively greedy—unlike us, of course. They are also viewed as exception-

ally jittery and as adding an element of subversive chaos to the economic system. They

come out in the middle of storms—we hear about them when the markets are veering

2 There are several other ways in which the U.S. company can acquire an asset in pounds that hedges its pound liability. It could sell merchandise to someone else and bill the buyer in pounds payable in 90 days. Or it could use dollars that it has now to buy pounds now at the current spot rate and invest those pounds to earn interest for 90 days. The pound proceeds from the investment can then be used to pay the pound debt. Or it could enter into a long position (buying pounds) in a pound futures contract traded on an organized exchange. Or it could buy a currency option call contract that gives the company the right to buy pounds at a price set in the option contract (the exercise or strike price). Each of these establishes an asset in pounds that hedges its pound liability. The company’s decision to hedge using a forward contract or one of the other methods depends on the cost of each method and how closely each method offsets its exposed position. In many cases the forward contract is a low-cost way of establishing the exact hedge desired by the company. Futures and options contracts are discussed further in the box “Futures, Options, and Swaps.”

408 Part Three Understanding Foreign Exchange

pug21774_ch18_405-432.indd 408pug21774_ch18_405-432.indd 408 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

out of control, and then it is their fault. Although speculation sometimes has played such

a sinister role, it is an open empirical question whether it does so frequently.

More to the present point, we must recognize that the only concrete way of defining

speculation is the broad way just offered. A speculator is anybody who is willing to

take a net position in a foreign currency, whatever his motives or expectations about

the future of the exchange rate. There is nothing necessarily sinister about this. Still,

banks and other international financial players often claim that they invest while oth-

ers speculate, implying that the latter action is more risky and foolhardy. Yet there is

no clear difference here. Any investment that is exposed to exchange-rate risk has a

speculative element to it.

There are a number of ways deliberately to establish speculative foreign-currency

positions. One direct way to speculate on the value of the future spot exchange rate

is a forward foreign exchange contract. Forward foreign exchange provides the same

bridge to future currency exchanges for speculators as for hedgers, and there are no

credentials checks that can sort out the two groups in the marketplace. If a speculator

thinks he has a fairly good idea of what will happen to the spot exchange rate in the

future, it is easy to bet on the basis of that idea using the forward market. It is so easy,

in fact, that the speculator can even bet with money he does not have in hand.

To illustrate this point, suppose that in May you are convinced that the pound

sterling will take a dive from its current spot exchange-rate value of about $1.68 and

be worth only $1.50 in August. Perhaps you see a coming political and economic

crisis in Britain that others do not see. You can make an enormous gain by using the

forward market. Contact a foreign exchange trader at your bank and agree to sell

£10 million at the current 90-day forward rate of $1.6745. If the bank believes in your

ability to honor your forward commitment in August, you do not even need to put

up any money now in May. Just sign the forward contract. How will you be able to

come up with £10 million in August? Given your knowledge of a coming crisis, there

is nothing to worry about. Relax. Take a three-month vacation in Hawaii. From time

to time, stroll off the beach long enough to glance at the newspaper and note that the

pound is sinking, just as you knew it would. On the contract date in August, instruct

your bank to settle the forward contract against the actual spot rate, which has sunk as

you expected to $1.50. Effectively, in August you are buying £10 million in the spot

market at $1.50 (total cost of $15 million) and selling the pounds at $1.6745 into the

forward contract (total receipt of $16.745). You net a profit of $1.745 million for a few

minutes’ effort, a lot of foresight, and an understanding of “buy low, sell high.” If you

are smarter than the others in the marketplace, you can get rich using the convenient

forward exchange market.

Your speculation may turn out differently, however. Suppose you are wrong.

Suppose that Britain’s prospects brighten greatly between May and August. Suppose

that, when August comes around, the spot value of the pound has risen to $1.90. Now

in August you must come up with $19 million to get the £10 million you commit-

ted to sell in the forward contract for only $16.745 million. It does not take much

arithmetic to see what this means for your personal wealth. It is time to reevaluate

your lifestyle.

What happens if in May many people expect the spot exchange-rate value of the pound to depreciate to $1.50 by August, and they are willing to speculate using the

Chapter 18 Forward Exchange and International Financial Investment 409

pug21774_ch18_405-432.indd 409pug21774_ch18_405-432.indd 409 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

Extension Futures, Options, and Swaps

A forward foreign exchange contract is one type of agreement that can be reached now about an exchange of currencies that will occur in the future. This traditional form of future-oriented currency agreement has some relatives that have been introduced since the early 1970s. Someone wishing to hedge or speculate can now choose from among currency futures, currency options, and currency swaps in addition to traditional forward exchange.

Currency futures are contracts that are traded on organized exchanges, such as the Chicago Mercantile Exchange. By entering into a currency futures contract, you can effectively lock in the price at which you buy or sell a foreign currency at a set date in the future. This sounds very much like a forward foreign exchange contract, and it is. There are some differences, though. First, a futures contract is a standard contract (mak- ing it tradable on the organized exchange)—for instance,12.5 million yen to be exchanged for dol- lars in March of next year. A forward contract can be customized by the bank to meet the needs of the customer. Second, if you enter into a futures contract, the exchange requires that you provide money as a margin to ensure that you will honor the contract. A margin might be required in a forward contract, but usually it is not. Third, the profits and losses on your futures contract accrue to you daily, as the contract is “marked to market” daily. Too many losses and you will receive a call to add to your margin account. The profit or loss on a forward contract usually is not taken until the maturity date. Fourth, and perhaps most important from your perspective, almost anyone able to put up a margin can enter into a futures contract, whereas banks usually are willing to enter into forward contracts only for large amounts (millions of dollars) with highly creditworthy customers. Futures contracts give ordinary people and small businesses access to a low-cost direct method for currency hedging or speculation.

For some purposes a major drawback to forward and futures contracts is that losses on your open positions can become very large. You

must honor your agreements. If the spot rate has moved in a way that is against your position, you will have to buy high and sell low, resulting in what can be a large loss. Some hedgers and spec- ulators may dislike this feature. There is another alternative—an option contract.

A currency option gives the buyer (or holder) of the option the right, but not the obligation, to buy foreign currency (a call option) or to sell foreign currency (a put option) at some time in the future at a price set today. The price set into the contract now for the foreign exchange trans- action that the holder may make in the future is called the exercise price or strike price. The option is a valuable right, and the buyer pays a premium (a fee) to the seller (or writer) of the option to acquire the option.

Let’s say that you believe that the Swiss franc is going to appreciate substantially during the next month. The current spot price is $1.20 per franc and the current 30-day forward rate (or, for that matter, the current futures price for franc contracts maturing next month) is $1.21 per franc. You expect the spot value of the franc to be $1.26 in 30 days. If you speculate using a for- ward (or futures) contract, going long in francs, you will make a profit if the actual spot rate in 30 days is above $1.21 per franc. But if the actual spot rate in 30 days is below $1.21 per franc, you will make a loss, and the loss is larger the lower the spot rate is in 30 days. If the actual spot rate in 30 days is $1.14, you must buy francs at the forward price of $1.21 when the francs are worth only $1.14. You have a large actual loss.

You can instead speculate on the franc exchange rate using a currency option contract. The disadvantage of the option is that you must pay a premium to obtain it. (There is no compa- rable charge to obtain a forward contract.) The advantage of the option is that the size of any loss on the contract is limited to this premium— you cannot lose more. For instance, you can buy a 30-day currency call option that gives you the right to buy Swiss francs at an exercise price of $1.21 per franc. If the actual spot rate in 30 days is above $1.21 per franc, you exercise the option.

410 Part Three Understanding Foreign Exchange

pug21774_ch18_405-432.indd 410pug21774_ch18_405-432.indd 410 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

Your overall profit here is somewhat lower than the comparable forward contract because you had to pay the premium to buy the option. Still, your profit can be large if the actual spot rate in 30 days has moved well above the $1.21 exercise price. (You buy francs low by exercising the option and sell the francs high at the higher spot rate.) If the actual spot rate in 30 days is below $1.21, you let the option expire unexer- cised. You have lost the premium, but you are not required to lose any more, even if the actual spot rate is substantially below the exercise price.

Another important future-oriented currency agreement is the currency swap. In a currency swap two parties agree to exchange flows of different currencies during a specified period of time. For instance, Microsoft might enter into a swap with its bank in which Microsoft agrees (1) to deliver a large number of euros in exchange for a comparable number of dollars now, (2) every three months to make dollar inter- est payments and to receive euro interest pay- ments, and (3) at the end of the swap to return the large number of dollars and receive back the comparable number of euros. Because Microsoft has committed to exchanging dollars for euros, at various times now and in the future, you might think that this sounds something like spot and forward foreign exchange contracts, and you would be right. A swap is basically a set of spot and forward foreign exchanges packaged into one contract. The advantages of the swap over a package of separate foreign exchange contracts are two: lower transactions costs by using one contract and a subtle but important decrease in risk exposure. In a swap any failure by the other side to honor the contract cancels all future obli- gations, while in the package of separates the other side might try to default on some contracts but force you to honor others.

Why would Microsoft want to enter into such a swap? One reason could be that Microsoft dis- covers that it has an unusual opportunity to issue euro-denominated bonds at a low interest rate, perhaps because EU investors strongly desire to add some Microsoft bonds to their portfolios.

But Microsoft actually needs dollars to finance the expansion of its business and wants to pay dollar interest on its debt. Microsoft can take advantage of the EU opportunity by issuing euro- denominated debt and then swapping the euros into dollars. Microsoft must pay euro interest to its EU investors, but it is receiving euro interest in the swap. These euro flows approximately equal each other, so Microsoft mostly is left with the obligation to pay dollar interest into the swap. Microsoft accomplishes two things with the structured combination of euro bonds and swap. First, Microsoft can lower its overall cost of financing by taking advantage of the unusu- ally low interest cost in the EU, even though it really does not want euro-denominated debt. Second, Microsoft effectively does not have euro- denominated debt—the cash flows (on net) are converted through the swap into the dollar cash flows that Microsoft prefers to have.

Currency futures, options, and swaps are rela- tively recent additions to the set of foreign exchange products. The first foreign-currency futures contract was offered in 1972. The first exchange-traded foreign-currency option was offered in 1982. Foreign-currency options are also offered directly by banks and other financial institutions in customized contracts with their customers. The first major currency swap was contracted in 1981 between the World Bank and IBM (dollars for German marks and Swiss francs).

Exchange-traded currency futures and options are of some importance, with the equivalent of $244 billion and $143 billion in existence in December 2013. Still, most foreign exchange is transacted directly among banks, other financial institutions, and their customers. The size of the “over-the-counter” products (spot exchange, for- ward exchange, directly written currency options, and currency swaps) is much larger than the size of the exchange-traded foreign-currency futures and options. Currency swaps have become a big product, with $25.4 trillion of swap contracts in force in December 2013. And $11.9 trillion of directly written currency options existed in December 2013.

Chapter 18 Forward Exchange and International Financial Investment 411

pug21774_ch18_405-432.indd 411pug21774_ch18_405-432.indd 411 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

forward exchange market? They will sell pounds forward in large amounts. The

increased supply of pounds forward will put downward pressure on the forward

exchange-rate value of the pound, driving it toward $1.50. Generally, all specula-

tors will not have the exact same view as to the expected future spot exchange rate.

Nonetheless, we hypothesize that speculators’ pressures on supply and demand should drive the forward exchange rate to equal the average expected value of the future spot exchange rate . For instance, the 90-day forward rate may indicate what informed opinion thinks the pound should be worth spot in 90 days’ time. It would be an aver-

age expectation of the future spot value, much as the point spread in football betting

is the number of points by which the average bettor expects the stronger team to win.

INTERNATIONAL FINANCIAL INVESTMENT

International financial investment has grown rapidly in recent decades. Decisions

about international investments are based on the returns and risks of the available

investment alternatives. How do we calculate the overall returns on financial assets

denominated in foreign currencies? What are the sources of risk that apply specifi-

cally or especially to foreign financial investments? Can the investor hedge exposure

to exchange-rate risk? The remainder of this chapter explores these questions about

international financial investment. Although our discussion focuses on investing, most

of the principles also apply to a borrower deciding whether to take out loans or issue

securities denominated in foreign currencies.

Consider an investor who holds dollars now and plans to end up a year from now

also holding dollars (or, at least, who calculates her wealth and returns in dollars). If

she invests in a dollar-denominated financial asset like a U.S. government security or

a dollar time deposit, then she will earn dollar returns and have dollar wealth a year

from now. No currency translation is necessary. If she invests in a foreign-currency-

denominated financial asset, like a British government security or a pound time

deposit, her situation is not so simple. First, she must convert her dollars into

pounds at the initial spot exchange rate. Then, she uses the pounds to buy the pound-

denominated financial asset. She holds this asset, earning pound returns and having

wealth in pounds a year from now. This can be converted back into dollars (either actu-

ally or simply to determine the dollar value of wealth) at some dollar–pound exchange

rate that applies to foreign exchange transactions a year from now.

What exchange rate can be used to convert pounds back into dollars a year from

now? There are two major alternatives, and these correspond to our concepts of hedg-

ing and speculation. First, she can contract now for the exchange of pounds back into

dollars at the one-year forward exchange rate using a forward exchange contract. Her pound liability in the forward contract matches her pound asset position, so

she has hedged her exposure to exchange-rate risk. She has a hedged or covered international investment . Second, she can wait and convert back into dollars at the future spot exchange rate, the one that will exist a year from now. She does not know for sure what this future spot exchange rate will be, so her investment is exposed

to exchange-rate risk. This unhedged investment has a speculative element to it, and it

is called an uncovered international investment.

412 Part Three Understanding Foreign Exchange

pug21774_ch18_405-432.indd 412pug21774_ch18_405-432.indd 412 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

i US

5 Current 90-day interest rate in the United States (not annualized)

i UK

5 Current 90-day interest rate in Britain (not annualized)

e 5 Current spot price of the pound ($/£) f 5 Current forward price of the pound, for exchange 90 days from now ($/£) In moving from one currency to another at a point in time, or between the present and the future in

a single currency, the arrows show what action you are taking. The mathematical expressions show

what to multiply by, to convert from one to another. There are two ways to get from any one corner

to any other corner, and at least one of these two ways requires multiple conversions.

Future $ (e.g., 90 days from now)

Future £ (e.g., 90 days from now)

Invest in United States

Ti m

Current £Current $

Invest in Britain

(1 � iUK)(1 � iUS) 1_______

1 � iUK

Sell £ spot (e)

Buy £ spot (1/e)

Buy £ forward (1/f)

Sell £ forward (f)

Currencies

Borrow in Britain

( )1_______1 � iUS( ) Borrow in

United States

FIGURE 18.1 Current and

Future Asset

Positions in

Two Currencies:

The “Lake”

Diagram

INTERNATIONAL INVESTMENT WITH COVER

We can compare domestic investment and covered international investment using

Figure 18.1 , which shows ways of investing (or borrowing) as paths around a “lake.”

People moving their assets from left to right are buying pounds and selling dollars,

whereas those transferring from right to left are buying dollars with pounds. People

moving upward in either country are investing or lending, whereas those moving

downward from future to current positions are either selling off interest-earning assets

or borrowing at interest. The corresponding expressions in terms of exchange rates

(the current spot rate, e , and the current forward rate, f ) and current interest rates ( i

US and i

UK ) show how the value of one’s assets gets multiplied by each move. The

exchange rates are quoted as dollars per pound. The interest rates are measured for the

actual time period examined and are in decimal, not percent, form. 3

Studying how one gets from any corner to any other for any purpose, you will find

that the choice of the more profitable of the two possible routes always depends on

the comparison of two expressions. Suppose we want to convert present dollars into

future dollars. We could route our money through Britain, buying pounds in the spot

market, obtaining 1/ e pound for each dollar. We would then invest these pounds at interest and have (1 1 i

UK )/ e pound at maturity for each initial dollar. At the time of

3 That is, the interest rates are not annual rates unless the time period is one year. If interest rates are quoted as annualized rates, they must be converted. For instance, the 90-day interest rate is approximately one-quarter the annualized interest rate.

Chapter 18 Forward Exchange and International Financial Investment 413

pug21774_ch18_405-432.indd 413pug21774_ch18_405-432.indd 413 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

the investment we also sell the upcoming pounds in the forward market (at the rate

of f ) to get an ensured number of dollars in the future. Overall, this yields (1 1 i UK

) •

f/e future dollars for every dollar invested now. Or we could simply invest our money at interest in America, getting (1 1 i

US ) future dollars for every present dollar. Which

road we should take depends on the sign of the difference between the two returns.

This difference is sometimes called the covered interest differential (CD):

CD 5 (1 1 i UK

) • f/e 2 (1 1 i US

)

If the covered interest differential is positive, one is better off investing in Britain.

If it is negative, one should avoid investments in Britain, investing in America instead.

Why is it called covered? Because the investor is fully hedged or covered against exchange-rate risk if he uses a foreign-currency investment to get from his own cur-

rency today to the same currency in the future.

There is an approximation that provides insight into what the covered differential

is actually comparing. Before we see this handy formula, we first need to define the

forward premium ( F ) as the proportionate difference between the current forward exchange-rate value of the pound and its current spot value: 4

F 5 ( f 2 e )/ e

The forward premium (converted into a percentage) shows the rate at which the

pound gains value between a current spot transaction to buy pounds and future selling

of pounds at the forward rate that we can lock in today. (If F is negative, the pound is at a forward discount because it loses value between buying it at the current spot rate and selling it at the current forward rate.)

The handy approximation is that the covered interest differential is approximately

equal to the forward premium on the pound plus the interest rate differential: 5

CD 5 F 1 ( i UK

2 i US

)

The formula shows that the net incentive to go in one particular direction around the

lake depends on how the forward premium on the pound compares with the difference

between interest rates.

There is another way to interpret the approximation. The overall covered return (in

dollars) to a U.S. investor from investing in Britain is approximately equal to the sum

of two components: the gain (or loss) from the spot and forward currency exchanges

4 This is often stated on an annualized percent basis:

F 5 (f 2 e)

______ e • 360 ____ n • 100

where n is the number of days forward and a year is taken to be 360 days for convenience. 5 To see the approximation involved, first complete the multiplication of terms in the first equation for CD:

CD 5 f/e 1 i UK

• f/e 2 1 2 i US

Next, add and subtract i UK

: CD 5 f/e 1 i

UK • f/e 2 i

UK 2 1 1 i

UK 2 i

Now group terms, using the fact that the forward premium F 5 f / e 2 1:

CD 5 F 1 i UK

2 i US

1 i UK

• F

If the British interest rate ( i UK

) and forward premium on the pound ( F ) are small (in decimal form), then the last term (the product of two small numbers) is very small, and it is ignored in the approximation.

414 Part Three Understanding Foreign Exchange

pug21774_ch18_405-432.indd 414pug21774_ch18_405-432.indd 414 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

(the forward premium, F , on the pound) plus the interest return on the pound invest- ment itself ( i

UK ). The covered interest differential is then approximately equal to the

difference between the overall covered return to investing in pound-denominated

assets ( F 1 i UK

) and the return to investing in dollar-denominated assets ( i US

). 6

Covered Interest Arbitrage The covered differential is such a handy guide to the profitable exchange between cur-

rencies that traders can use it to make arbitrage profits on any differential. Covered interest arbitrage is buying a country’s currency spot and selling that country’s cur- rency forward, to make a net profit from the combination of the difference in interest rates between countries and the forward premium on that country’s currency. Covered

interest arbitrage is essentially riskless, although it does tie up some assets for a while.

One way of engaging in this arbitrage is in fact the ultimate in hedging: We can start

with dollars today and end up with a guaranteed greater amount of dollars today by

going all the way around the lake.

To see how this arbitrage works, let’s suppose that British and U.S. interest rates

are i UK

5 .04 (4 percent) and i US

5 .03 (3 percent), respectively, for 90 days and that

both the spot and forward exchange rates are $2.00/£, so that there is neither a pre-

mium nor a discount on forward sterling ( F 5 0). Seeing that this means CD 5 .01 (1 percent), a New York arbitrageur uses his computer and sets up a counterclockwise

journey around the lake. He contracts to sell, say, $20 million in the spot market, buy-

ing £10 million. He informs his London correspondent bank or branch bank of the

purchase and instructs that bank to place the proceeds in British Treasury bills that

will mature in 90 days. This means that after 90 days he will have £10 million • 1.04

to dispose of. He covers himself against exchange-rate risk by contracting to sell the

£10.4 million in the forward market, receiving $20.8 million deliverable after 90 days.

He could leave the matter there, knowing that his computer trip in and out of Britain

will give $20.8 million in 90 days’ time, instead of the $20.6 million he would have

received by investing his original $20 million within the United States. Or if he has

excellent credit standing, he can celebrate his winnings by borrowing against the $20.8

million in the United States at 3 percent, giving himself $20,194,175 5 $20.8 million/

(1.03) right now, or about 1 percent more than he had before he used the computer.

So that’s $194,175 in arbitrage gains minus any transactions fees, the use of part of a

credit line in the United States, and a few minutes’ time, not a bad wage. The operation

is also riskless as long as nobody defaults on a contract. (The reader can confirm that if

forward sterling instead were at a 2 percent discount [ F 5 2.02 because f 5 $1.96] the New York arbitrageur would invest in the United States, buy forward sterling, borrow

or sell bills in Britain, and sell pounds spot, making a net profit of about 1 percent.)

What happens if many people take advantage of an opportunity for interest arbi-

trage? Their activities will put pressures on the various rates. In the example in which,

initially, the British interest rate is 4 percent, the U.S. interest rate is 3 percent, and

both the spot and forward exchange rates are $2.00/£, here are the pressures:

6The approximation is also useful because all rates can be stated on an annualized basis and in percent terms—the way we usually say them. In this case, F is the annualized percent forward premium (as defined in footnote 4) and the interest rates are annualized percent rates, regardless of the number of days forward being considered.

Chapter 18 Forward Exchange and International Financial Investment 415

pug21774_ch18_405-432.indd 415pug21774_ch18_405-432.indd 415 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

• As many arbitrageurs sell dollars and buy pounds for immediate delivery, the spot

exchange rate tends to rise above $2.00/£.

• As the arbitrageurs also buy dollars and sell pounds forward, the forward exchange

rate tends to fall below $2.00/£.

• As the arbitrageurs shift their funds from dollar-denominated investments to

pound-denominated investments (or borrow dollars to fund the pound investments),

U.S. interest rates tend to rise and British interest rates tend to fall.

If one or more of the rates change in these ways, the size of the covered interest

differential shrinks. Where is all this heading?

Covered Interest Parity John Maynard Keynes, himself an interest arbitrageur, argued that the opportunities to

make arbitrage profits would be self-eliminating because rates would adjust so that the

covered interest differential would be driven to zero. Since Keynes we have referred

to the condition CD 5 0 as covered interest parity . Here are two equivalent ways to think of covered interest parity:

• A currency is at a forward premium (discount) by as much as its interest rate is

lower (higher) than the interest rate in the other country (that is, F 5 i US

2 i UK

our example).

• The overall covered return on a foreign-currency investment equals the return on a

comparable domestic-currency investment ( F 1 i UK

5 i US

In the numerical example on page 415, covered interest parity would exist if the for-

ward rate were $1.98/£ (rather than $2.00/£). Then the forward discount on the pound of

1 percent (equal to the proportionate difference between the $1.98 forward rate and the

$2.00 spot rate) would offset the amount by which the British interest rate (4 percent) was

higher than the U.S. interest rate (3 percent). U.S. investors would earn only 3 percent on

their covered investments in pound-denominated assets—the 4 percent interest minus the

1 percent lost in the currency exchanges. This 3 percent is equal to the rate that they receive

on investments in dollar-denominated assets, so there would be no incentive for arbitrage.

Covered interest parity provides an explanation for differences between current spot

and current forward exchange rates. A country with an interest rate that is lower than

the corresponding rate in the United States will have a forward premium on its currency,

with the percentage point difference in the interest rates equal to the percent forward pre-

mium. According to the exchange-rate quotations in Figure 17.1, the currencies of Japan

and Switzerland have 90-day forward rates (in dollars per this currency) above their cur-

rent spot rates. These currencies are at a forward premium, and we could confirm that

Japanese and Swiss 90-day interest rates were less at that time than the interest rates on

comparable assets denominated in U.S. dollars. The currencies of Australia and Britain

have 90-day forward rates below their current spot rates, showing forward discounts that

are connected to relatively high Australian and British interest rates.

Covered interest parity links together four rates: the current forward exchange rate,

the current spot exchange rate, and the current interest rates in the two countries. If one

of these rates changes, then at least one of the other rates also must change to maintain

(reestablish) covered interest parity. For instance, if the spot exchange rate increases

416 Part Three Understanding Foreign Exchange

pug21774_ch18_405-432.indd 416pug21774_ch18_405-432.indd 416 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

and the interest differential is unchanged, then the forward exchange rate also must

rise to keep the forward premium steady. In this case, whatever moves the spot rate up

(or down) will do the same to the forward rate. In fact, short-term interest differentials

have not varied much over the past several decades for the major world currencies, so

spot and forward rates between any two of these currencies have tended to go up or

down together over time. That is, the current spot and current forward rates are highly

positively correlated over time. 7

INTERNATIONAL INVESTMENT WITHOUT COVER

Uncovered international financial investment involves investing in a financial asset

denominated in a foreign currency without hedging or covering the future proceeds of

the investment back into one’s own currency. In the simplest case, the foreign currency

proceeds will be translated back into domestic currency using whatever spot exchange

rate exists at the future date (either actually or to calculate wealth and overall returns

in one’s own currency). The future spot rate is not known for sure at the time of the

initial investment, so the investment is exposed to exchange-rate risk (assuming that

the investor has no other offsetting liability in this currency).

At the time of the initial investment, the investor presumably has some idea of what

the future spot rate is likely to be. The investor’s expected future spot rate ( e ex ) can be used to determine an expected overall return on the uncovered international invest-

ment. (This expected future spot rate is the same type of rate used in deciding whether

to speculate using a forward contract.)

A kind of “lake” diagram similar to that used in Figure 18.1 applies here, but

the top side of the lake refers to currency exchanges in the future at the future spot

exchange rate. At the time of initiating the foreign investment (“ex ante”), we only

have a notion or an expectation of what the future spot rate will be. Of course, once we

get to the future date (the end or maturity of the foreign investment—“ex post”), we

will know what the future spot rate actually is, and then we can determine the actual

overall return on the uncovered foreign investment.

To see how this works, again consider that we want to convert present dollars into

future dollars. We again could route our money through Britain, but in this case we decide

not to cover against exchange-rate risk. We first buy pounds in the spot market, obtain-

ing l/ e pound for each dollar. We then invest these pounds, and we will have (1 1 i UK

)/ e pound at maturity for each initial dollar. We have an expectation that we can convert these

pounds back into dollars at the rate of e ex to obtain (1 1 i UK

) • e ex / e future dollars expected for each dollar invested now. This can be compared to the future dollars (1 1 i

US ) that we

could obtain simply by investing each present dollar in a dollar-denominated asset. The

comparison is the expected uncovered interest differential (EUD):

EUD 5 (1 1 i UK

) • e ex / e 2 (1 1 i US

)

7 Covered interest parity also has implications for our earlier discussion of hedging a future pound liability. The goal is to get from current dollars to future pounds (needed to pay for the merchandise). If covered interest parity holds, then the cost of hedging using a forward contract (going up the lake and then across at the top toward the right) will essentially equal the cost of hedging by buying pounds spot now and investing these pounds for 90 days (going across the lake to the right at the bottom and then going up).

Chapter 18 Forward Exchange and International Financial Investment 417

pug21774_ch18_405-432.indd 417pug21774_ch18_405-432.indd 417 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

If this is positive, then the expected overall return favors uncovered investing in a pound-

denominated asset. If it’s negative, then the expected overall return favors staying at home. 8

The expression for the expected uncovered interest differential is almost the same

as the expression for the covered interest differential. The only difference is that the

expected future spot rate, e ex , replaces the forward rate, f . This is not surprising—the difference between the two is specifically the decision not to cover or hedge the expo-

sure to exchange-rate risk by using a forward contract.

We can also show that the expected uncovered interest differential has a handy

approximation. It approximately equals the expected rate of appreciation (depreciation

if negative) of the foreign currency plus the regular interest rate differential: 9

EUD 5 Expected appreciation 1 ( i UK

2 i US

)

For a different view of this, note that the expected overall uncovered return (in dollars)

to a U.S. investor from investing in Britain is approximately equal to the sum of the

expected gain (or loss) from the currency exchanges (current spot and future spot) as

the pound appreciates (or depreciates) during the time of the investment, plus the inter-

est return on the pound investment itself. This expected overall return on the pound

investment (expected appreciation 1 i UK

) is compared to the return on investing in dollar-

denominated assets ( i US

) to approximate the expected uncovered interest differential.

Let’s consider a numerical example similar to the one used in the section on covered

investment. The current spot exchange rate ( e ) is $2.00/£ and the current interest rates on 90-day investments are i

UK 5 0.04 (4 percent) and i

US 5 0.03 (3 percent). If a U.S.-based

investor expects the spot rate ( e ex ) to remain at $2.00/£ in 90 days, what is the expected uncovered interest differential? Because he expects no change in the pound’s exchange-

rate value, the expected differential is 1 percent (equal to the interest rate differential,

4 2 3) in favor of the pound investment. The investor expects a higher return to invest-

ing uncovered in pound assets, but he is not certain of the extra return. The actual spot

exchange rate in 90 days could be quite different from what he is expecting.

If an uncovered foreign financial investment is exposed to exchange-rate risk, why

would anyone want to invest uncovered? The answer has two components: one related

to return and one to risk. First, the expected overall return on the uncovered investment

may be higher than the return that can be obtained at home (EUD is positive), as in the

numerical example just completed. Presumably, the investor would undertake such an

uncovered investment if he expected to be adequately compensated for the risks that

he is taking on, especially the exchange-rate risk that the actual future spot rate could

be much lower than he is expecting.

However, the issue of risk exposure is really more subtle. It is not the risk of this

individual investment that matters, but rather the contribution of this uncovered invest-

ment to the riskiness of the investor’s full investment portfolio. While we will not

develop this fully, analysis of portfolios indicates that the addition of an uncovered

8 From the perspective of a UK investor considering an uncovered dollar investment, the expected uncovered interest differential is (1 1 i

US ) • e ex/ e 2 (1 1 i

UK ), where the exchange rates are now measured

as pounds per dollar. 9 For the actual time period involved, the expected rate of appreciation equals ( e ex 2 e )/ e . This is often stated on a percent annualized basis,

e ex 2 e _______ e •

360 ____ n • 100

where n is the number of days in the future for the expected future spot rate.

418 Part Three Understanding Foreign Exchange

pug21774_ch18_405-432.indd 418pug21774_ch18_405-432.indd 418 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

foreign investment can sometimes increase overall riskiness, but in other cases it can

instead lower it because of the benefits of diversification of investments. If it lowers

overall riskiness, then the investor would look favorably on an uncovered foreign

investment even if the expected uncovered interest differential is somewhat negative.

To see the importance of uncovered foreign investments and the expected uncov-

ered interest differential, let’s examine what is likely to be true if risk considerations

are small. Risk considerations can be small if investors do not care much about risk

exposures (they are risk neutral ) or if the benefits of diversification indicate that additional uncovered investments add little or nothing to the overall riskiness of the

investor’s portfolio. In this case each investor is willing to undertake uncovered for-

eign investments if the uncovered interest differential is positive. As investors make

shifts in their portfolios, they place supply and demand pressures on the current spot

exchange rate, by buying or selling pounds for dollars to shift into or out of pound-

denominated investments. (They may also place pressures on the interest rates as they

buy and sell the financial assets themselves.)

Generally, the pressures on the rates will subside only when there is no further incen-

tive for large shifts in investments. When the expected uncovered differential equals zero

(EUD 5 0), at least for the average investor, we have a condition called uncovered interest parity. (This parity is also called the “international Fisher effect,” named for Irving Fisher, the economist who first proposed it.) Here are two ways to say it:

• A currency is expected to appreciate (depreciate) by as much as its interest rate

is lower (higher) than the interest rate in the other country (for instance, expected

appreciation of the pound 5 i US

2 i UK

• The expected overall uncovered return on the foreign-currency investment equals

the return on the domestic-currency investment (expected appreciation 1 i UK

5 i US

Consider the rates used in our previous numerical example: British and U.S. inter-

est rates of 4 and 3 percent and an expected future spot exchange rate of $2.00/£. For

these rates uncovered interest parity holds if the current spot rate is $2.02/£. Then the

expected depreciation of the pound of about 1 percent (from the current spot rate of

$2.02 to a future spot rate of $2.00) matches the 1 percent by which British interest

rates exceed U.S. interest rates (4 2 3).

If uncovered interest parity holds, then it links together four rates: the current spot

exchange rate, the spot exchange rate that is currently expected to exist (on average)

in the future, and the current interest rates in the two countries. As with covered inter-

est parity, if one of these four rates changes, then at least one of the other rates must

change to maintain or reestablish uncovered interest parity. Consider several possible

changes that can lead to quick appreciation of the pound. If the interest rate in the

United Kingdom increases, this can increase the current spot exchange-rate value of

the pound, thus reducing the expected rate of further pound appreciation (or increasing

the expected rate of pound depreciation) into the future (assuming that the value of the

expected future spot rate is unchanged). If, instead, the value of the expected future spot

rate increases and there is no change in interest rates, then the value of the current spot

exchange rate must increase to maintain the same rate of further pound appreciation (or

depreciation) expected into the future. We will look at these relationships more deeply in

the next chapter, when we search for the determinants of spot exchange rates.

Chapter 18 Forward Exchange and International Financial Investment 419

pug21774_ch18_405-432.indd 419pug21774_ch18_405-432.indd 419 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

Case Study The World’s Greatest Investor

George Soros was born Dzjchdzhe Shorask (pro- nounced “Shorosh”) in Budapest in 1930. The son of a lawyer, he became a global investment super- star, with a net worth in 2014 estimated at about $23 billion. In the years since its founding in 1969, his investment fund has earned an incredible aver- age return of about 30 percent per year.

As a Jewish boy, he and his family struggled to evade the Nazis, and they managed to survive. In 1947 he went to England, expecting to continue his engineering studies. Instead, he enrolled in the London School of Economics and graduated in 1952. He began working at a small London brokerage, but he was frustrated by the lack of responsibilities.

In 1956, Soros moved to New York City, where he worked at two securities firms before joining the firm Arnold & Bleichroeder in 1963. In 1967, he became head of investment research, and he was successful at finding good investment opportunities in undervalued European stocks. In 1969, he founded an offshore hedge fund, using $250,000 of his own money and about $6 million from non-American investors whom he knew. (A hedge fund is an investment partnership that is not restricted by regulations of government agencies like the U.S. Securities and Exchange Commission. Each hedge fund can establish its own investment style and strategy, and these vary. While some hedge funds do use investment strategies that involve different kinds of hedg- ing, others do not. The manager of a fund usually gets fees and a percentage of the profits, as well as having a substantial amount of his own money invested in the fund.)

Soon Soros left Arnold & Bleichroeder, taking his Soros Fund with him. While the 1970s were poor years for the U.S. stock market generally, the Soros Fund prospered. As the manager, Soros focused on finding undervalued sectors in the United States and other countries. He bought unpopular low-priced stocks and sold short popu- lar high-priced stocks. He expected oil demand to outstrip oil supply, so he bought stocks of com- panies in oil-field services and oil drilling before the first oil shock in 1973. In the mid-1970s, he

invested heavily in Japanese stocks. In 1979, he changed the name of the fund to Quantum Fund, in honor of Heisenberg’s uncertainty principle in quantum mechanics. In 1980, the fund return was 103 percent. It had grown to $380 million.

In 1981, Institutional Investor magazine named him “the world’s greatest investor.” But 1981 was a difficult year. The fund lost 23 percent, and one- third of his investors withdrew their investments. This was their mistake. Spectacular returns were still to come.

In August 1985, Soros became convinced that the U.S. dollar was overvalued relative to the Japanese yen and the German mark, and that a correction was coming soon. He decided to establish speculative investment positions to try to profit from the changes he expected. For instance, he borrowed dollars, used the dollars to buy yen and marks, and bought Japanese and German government bonds. In total, he established an $800 million position, a position larger than the entire capital of the fund. In late September the major governments announced the Plaza Agreement, in which they vowed to take coordinated actions (like intervention in the foreign exchange markets) to raise the values of other major currencies relative to the dollar. Within a month, as the dollar depreciated, Soros had profits of $150 million. The fund’s total return for 1985 was 122 percent, as he had also invested in foreign stocks and long-term U.S. Treasury bonds. Of course, not all of his positions turned out so well. For instance, in 1987, the Quantum Fund lost up to $840 million when the U.S. and other stock markets crashed in October. But the fund still earned a return of 14 percent for the entire year.

In September 1992, Soros placed his most famous bet. Following German reunification in 1989, German interest rates increased, and the mark tended to appreciate. But most EU curren- cies were pegged to each other in the Exchange Rate Mechanism (ERM) of the European Monetary System. So the other countries had to raise their interest rates to maintain the pegged exchange rates. Soros predicted that the British government

420 Part Three Understanding Foreign Exchange

pug21774_ch18_405-432.indd 420pug21774_ch18_405-432.indd 420 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

could not sustain this policy because the British economy was already weak and unemployment was high. He expected that Britain would either devalue the pound within the ERM or pull out of the ERM. In either case, the exchange-rate value of the pound would decline. He established his speculative investment positions short in pounds and long in marks, using pound borrowings and mark investments, as well as futures and options. And the positions were big—$10 billion. As Soros and other speculative investors established their positions, they sold pounds, putting downward pressure on the exchange-rate value of the pound. The central banks tried to defend the pegged rate, but soon the British government gave up and pulled out of the ERM. The pound depreciated against the mark. Within a month the Quantum Fund made a profit of about $1 billion on its pound positions, and a profit of up to $1 billion on other European currency positions. The Economist magazine called Soros “the man who broke the Bank of England.”

After 1992, Soros turned over most trading decisions in the Quantum Fund to his chosen successor, Stanley Druckenmiller. The Quantum Fund continued to have some large successes and some large losses. In early 1997, Soros and Druckenmiller foresaw weakness in the Thai baht, and Quantum established short baht posi- tions in January and February. The crisis hit in July, the Thai baht depreciated, and Quantum made money. But when the Thai baht and other Asian currencies continued to depreciate, they thought that the market had taken the rates too far. For instance, when the Indonesian rupiah fell from 2,400 per dollar to 4,000 per dollar, they established long positions in rupiah, and then lost money as the rupiah continued to fall beyond 10,000 per dollar.

In 1998, the Quantum Fund lost $2 billion on investments in Russia when Russian financial markets and the ruble collapsed. But the fund still earned more than 12 percent for the entire year. In 1999 the fund shifted to investing in tech stocks and was up 35 percent for the year. The tech investments and long positions in the euro

took revenge in early 2000. For the first four months the fund was down 22 percent.

Weary of the battles, Druckenmiller resigned in April. Soros announced that the fund was shift- ing to investing with less risk and lower returns. Still, as the global financial and economic crisis began in summer 2007, Soros temporarily came out of retirement to trade with great success. During the crisis years 2007–2009, the Quantum Fund earned a phenomenal annual average return of 22 percent, and Soros himself earned over $7 billion. In 2011 Soros converted his fund to a family office, to manage only his investments and those of his family and foundations.

As he reduced his role in fund management, Soros turned to writing articles and books, phi- lanthropy, and political activities. His writing is curious. He is deeply critical of excessive capital- ism and individualism—what he calls “market fundamentalism.” He believes that unregulated global financial markets are inherently unstable, and he calls for greater national regulation and the establishment of new global institutions like an international credit-insurance organization to guarantee loans to developing countries.

Soros is the quintessential international specu- lative investor. His name is synonymous with hedge funds, especially those that take large speculative positions. He has been denounced by government officials, like Prime Minister Mahathir Mohamad of Malaysia in 1997, as the source of immense and unjustified speculative pressures on their countries’ currencies and financial markets. Soros continues to defend his own investment activities, stating that he merely perceived changes that were going to happen in any case. But, as his writings indicate, at a broader level he has mixed feelings about the current global financial system.

DISCUSSION QUESTION In late 2012 Scott Bessent, chief investment offi- cer of Soros’ family office, concluded that coming political changes in Japan probably would lead to yen depreciation. His actions resulted in a gain of $1 billion during the next three months. What are some actions he probably took?

Chapter 18 Forward Exchange and International Financial Investment 421

pug21774_ch18_405-432.indd 421pug21774_ch18_405-432.indd 421 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

DOES INTEREST PARITY REALLY HOLD? EMPIRICAL EVIDENCE

The relationships among exchange rates and interest rates that we have discussed

in this chapter are powerful concepts. Do these rate relationships hold for actual

exchange rates and interest rates? Let’s look at the evidence.

Evidence on Covered Interest Parity Covered interest parity states that the forward premium should be (approximately) equal

to the difference in interest rates. All of these rates can be seen in the foreign exchange

markets and the short-term financial markets, so a test of covered interest parity is straight-

forward. The only further requirement is to identify comparable financial assets denomi-

nated in different currencies. Generally, we want to use financial assets with little or no

risk of default so that any subtle differences in default risk do not muddy the empirical test.

Let’s start by looking at broad evidence for major currencies for the time period that

begins shortly after the world shifted to managed floating exchange rates in the early

1970s. Figure 18.2 shows the results from one careful study that examined the covered

interest differentials between short-term financial assets in the United States and those in

Germany, Japan, and France, starting in 1978. For Germany and Japan, the covered inter-

est differential is consistently very close to zero (and thus within the small range created

by modest transactions costs) beginning in about 1985. For France this is true beginning

in about 1987. Since about the mid-1980s, covered interest parity has held for comparable

short-term assets for these four currencies (and for a number of others not shown as well).

The divergences in the earlier period appear to reflect actual or threatened govern-

ment capital controls, which are restrictions on the ability of financial investors to transfer moneys in or out of the country. Germany and Japan largely eliminated these

capital controls in the early 1980s. With freer flows of moneys, covered interest arbi-

trage became possible, and covered interest parity has held between the United States

and these two countries since the mid-1980s.

With the election of Mitterrand, a socialist, as president of France in 1981, foreign

investors began to fear the imposition of more severe capital controls. This added a risk

to covered investments into France, the political risk that investors would not be able to remove their moneys from France when they wanted to. Because of this additional

risk, major deviations from covered interest parity arose in 1981, at times reaching

an annualized covered interest differential of 10 percentage points. Foreign investors’

fears were correct. France tightened its restrictions in 1981 and did not substantially

liberalize these controls until 1986. Once the restrictions were removed and the risk

that they might be reimposed subsided, covered interest parity began to hold in 1987.

Let’s continue with a more granular look. How often do even small deviations from

covered interest parity occur, and how quickly are they eliminated? Akram, Rime, and

Sarno (2008) provide some answers using detailed second-by-second data for seven

and a half months in 2004, for the euro, British pound, and Japanese yen, each relative

to the U.S. dollar. For interest rates they use the rates on Eurocurrency deposits offered

by large banks to their international customers. A bank active in the Eurocurrency

market is willing to accept interest-paying deposits denominated in any of a number of

currencies, not just the currency of the country in which the bank is located. (The box

“Eurocurrencies: Not (Just) Euros and Not Regulated” says more about this market.)

422 Part Three Understanding Foreign Exchange

pug21774_ch18_405-432.indd 422pug21774_ch18_405-432.indd 422 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

The (annualized) covered interest differential is measured in favor of the United States, CD 5 F 1 i US

2 i F , where F

is the forward premium on the dollar and i F is the interest rate for the other country (Germany, Japan, or France). The

forward rate and the interest rates are 90-day rates. The interest rates are for commercial paper in the United States and

for interbank borrowing in the other three countries.

Source: Pigott (1993–1994).

�5 1978 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93

Percent

France Germany Japan

FIGURE 18.2 Covered Interest Differentials: The United States against Germany, Japan, and France, 1978–1993

Previous studies found that, broadly, covered interest parity applies extremely well

to Eurocurrency deposits. Akram, Rime, and Sarno use their detailed data to look

very closely, and they find potentially profitable deviations from covered interest par-

ity about 1 percent of the time for the euro, about 2 percent for the pound, and about

0.6 percent for the yen. These deviations, though profitable, are generally small and

last briefly, usually less than a minute. While rapid-fire trading can find some oppor-

tunities for covered interest arbitrage, the opportunities also disappear quickly.

Overall, covered interest parity is an important and empirically useful concept.

During normal times, it applies very well—forward and spot exchange rates are tightly

linked to interest rates for major-currency countries and for a growing number of other

countries that have liberalized or eliminated their restrictions on international movements

of financial capital. However, even for major currencies, parity does not always apply

during times of turmoil in financial markets, as discussed for the global financial and

economic crisis and the euro crisis in the box “Covered Interest Parity Breaks Down.”

Evidence on Uncovered Interest Parity Uncovered interest parity states that the expected rate of appreciation of the spot

exchange-rate value of a currency should (approximately) equal the difference in

interest rates. Testing uncovered interest parity is much more difficult than testing

covered interest parity. We have no direct information on people’s actual expectations

of exchange-rate changes.

One approach is to survey knowledgeable market participants about their exchange-

rate expectations (and hope that they answer truthfully). The average expected future

spot rate can then be used to calculate the expected appreciation and the expected

Chapter 18 Forward Exchange and International Financial Investment 423

pug21774_ch18_405-432.indd 423pug21774_ch18_405-432.indd 423 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

Case Study Eurocurrencies: Not ( Just) Euros and Not Regulated

The Eurocurrency market is a worldwide wholesale money market of enormous scope, one beyond the easy control of any government. The tradi- tional definition of a Eurocurrency deposit is a bank deposit denominated in a currency differ- ent from the currency of the country where the bank is located. However, since 1981, the equiva- lent of Eurodollar deposits can be booked in the International Banking Facility of a U.S. bank. The better definition of a Eurocurrency deposit is a bank deposit that is not subject to the usual government regulations imposed by the country of the currency in which the deposit is denominated. Eurodollar deposits are dollar deposits that are not subject to the same regulations imposed by the U.S. banking authorities on regular dollar deposits. In fact, the prefix Euro has now come to be used in interna- tional finance to refer not to geographic location but rather to financial instruments or activities that are subject to little or no government regulation. Eurobonds are bonds that are issued outside of the usual regulations imposed by the country in whose currency the bond is denominated.

Eurocurrency deposits are large time depos- its. In 2013, banks in various areas of the world, including Europe, North America, Asia, and the Caribbean, had Eurocurrency deposits totaling about $19 trillion. About three-fifths of these deposits are Eurodollar deposits. About one- fifth are euro Eurodeposits! (Yes, we have some confusing terminology—the euro as a currency is different from Euro as a prefix.) Eurosterling and Euroyen deposits are sizable too.

Eurocurrency deposits seem to have begun in Europe in the late 1950s. Several reasons explain the development and rapid growth of Eurocurrencies. European firms active in interna- tional trade began to hold dollars temporarily in their local banks that were willing to accept dol- lar deposits. The Soviet Union began to deposit U.S. dollars in European banks to keep the dollars out of the direct reach of the U.S. government during the Cold War. In the 1970s, Arab countries earning dollars on oil exports also feared possible restrictions if they placed their dollars on deposit in the United States, and turned to Eurodollar deposits. Most important to the long-run devel- opment of the market, banks involved in taking

these deposits (and making loans with the funds) found that they could avoid various regulations.

One type of regulation that can be avoided is any restriction of international flows of moneys. Thus, in the late 1950s, the British government restricted the ability of British banks to lend pounds to foreigners but permitted them to lend dollars to foreigners. In the 1960s, the U.S. gov- ernment attempted to restrict capital outflows. Borrowers turned to the Eurodollar market to obtain dollars that they could no longer borrow from the United States.

Other regulations that can be avoided in the Eurocurrency market are the standard regu- lations imposed on domestic banking activi- ties. Countries that wish to attract Eurocurrency deposit activity generally do not impose reserve requirements on these deposits, or deposit insur- ance premiums, and they lighten or eliminate other regulations. Freedom from the burdens and extra costs of various regulations permits banks to offer somewhat higher interest rates on Eurocurrency deposits than are available on regular domestic bank deposits and perhaps also to charge somewhat lower interest rates on loans funded by these deposits. The lack of regu- lation implies that Eurocurrency deposit claims are somewhat riskier for depositors. They face somewhat more uncertainty about whether their claims will be honored if the bank should fail.

Eurocurrency deposits and loans are generally credited with enhancing the efficiency of inter- national financial markets. Eurocurrencies offer large corporations, financial institutions, and governments another alternative as to where they can invest their funds to earn interest or where they can borrow to obtain low-cost financ- ing. Some of the efficiencies here come from the lack of burdens and costs imposed by govern- ment regulations, while others come from addi- tional and fierce competition among banks from many countries for the same business.

DISCUSSION QUESTION If the Soviet Union and Arab oil-exporting coun- tries had not been fearful of possible U.S govern- ment actions, would the Eurocurrency market still have developed into a large market?

424 Part Three Understanding Foreign Exchange

pug21774_ch18_405-432.indd 424pug21774_ch18_405-432.indd 424 11/6/14 4:08 PM11/6/14 4:08 PM

Final PDF to printer

uncovered interest differential. Figure 18.3 shows the results of one study that reports

this differential. The two panels show the uncovered interest differential for the

United States relative to Germany and to Japan. In both panels it appears that market

participants often expected large uncovered interest differentials. This suggests that

uncovered interest parity does not hold nearly as closely as does covered interest parity.

A second approach is to examine actual returns on uncovered international invest-

ments to draw out inferences about expected returns and exchange-rate expectations.

Looking at the actual overall return (including both the foreign interest return and the actual gain or loss on the currency exchanges) on any one uncovered foreign invest- ment does not tell us much. The actual uncovered return may not equal the return on

*The exchange rate is the German mark–U.S. dollar exchange rate through 1998 and the euro–U.S. dollar exchange rate thereafter.

The (annualized) expected uncovered interest differential is measured in favor of the United States.

EUD 5 expected appreciation of the dollar 1 i US

2 i F . The expected 90-day appreciation of the

dollar is based on forecasts of currency movements from Consensus Forecasts . Interest rates are those on 90-day Eurocurrency deposits.

Source: Balakrishnan and Tulin (2006). The author is grateful for data provided by Ravi Balakrishnan and Volodymyr Tulin.

United States against Germany*

United States against Japan

–30

–20

–10

50 Percent

–25

–20

–15

–10

–5

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Percent

FIGURE 18.3 Uncovered Interest Differentials: The United States against Germany and Japan, 1991–2005

Chapter 18 Forward Exchange and International Financial Investment 425

pug21774_ch18_405-432.indd 425pug21774_ch18_405-432.indd 425 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

Global Crisis and Euro Crisis Covered Interest Parity Breaks Down

The global financial and economic crisis that began in summer 2007 saw the disruption of many finan- cial markets. While the foreign exchange market was less affected than many others, it still took its hits. One indication of the effect of the crisis on the foreign exchange market was the develop- ment of substantial deviations from covered inter- est parity for rates that would be at parity during normal times. With the euro crisis that began in 2010 and intensified in 2011, substantial devia- tions from covered interest parity reappeared.

The graph indicates how the crises affected covered interest parity, focusing on London inter- bank offered rates (LIBOR), interest rates that large banks in London use for borrowing from and lending to each other in various currencies. Similar to Figure 18.2, the graph here shows the annual- ized covered interest differential measured in favor of the United States, for the 90-day forward

exchange rates and 90-day LIBOR interest rates, relative to each of the euro and the British pound.

Up to August 2007, covered interest parity held well for these financial assets, a continuation of what we showed in Figure 18.2. The first part of the global crisis began in August when BNP Paribas announced that it could not value mortgage assets held by several of its mutual funds. By late August the covered interest differential had generally widened and fluctuated more. Rates returned to covered interest parity during January to mid- March 2008, when Bear Stearns nearly failed, and larger parity deviations reappeared. The second and much worse phase of the global crisis began on September 15, 2008, with the failure of Lehman Brothers. Deviations from covered interest parity widened, reaching over 2 percentage points for the euro relative to the dollar in late September and early October and over 3 percentage points for the

426 Part Three Understanding Foreign Exchange

Ja n

0 6

Ja n

0 7

Ja n

0 8

Ja n

0 9

Ja n

1 0

Ja n

1 1

Ja n

1 2

Ja n

1 3

Ja n

1 4

Percentage points

Euro

British pound

Covered Interest Differentials, the U.S. Dollar Relative to the Euro and the British Pound, 2006–2014

Source: Levich (2013). The author is grateful for data with updates provided by Richard Levich.

pug21774_ch18_405-432.indd 426pug21774_ch18_405-432.indd 426 11/6/14 4:15 PM11/6/14 4:15 PM

Final PDF to printer

pound relative to the dollar in late September. After some large fluctuations, the differentials became smaller and less variable by early 2009. Still, covered interest differentials remained larger than they had been before August 2007. (Other major currencies, including the Swiss franc, Canadian dol- lar, Japanese yen, and Australian dollar, had similar parity deviations during the global crisis.)

At first, during 2010 and the first half of 2011, the euro crisis was focused on Greece, Ireland, and Portugal. There was no additional effect on deviations from covered interest parity. In mid- 2011 new concerns arose that Spain and Italy, much larger countries, could require large bailout assistance; that Greece might be forced somehow to exit the euro area; and that the monetary union itself could enter a period of turmoil and possible collapse. With new concerns about bank obligations in euros, the deviations from covered interest parity for the euro relative to the dollar (but not for the pound relative to the dollar) widened to about 1.5 percentage points in late 2011. As the euro crisis abated, and as the finan- cial system moved further away from the global financial crisis, the differentials became smaller.

Indeed, since early 2013, the rates have returned to a close fit for covered interest parity.

Why did we see such large deviations from covered interest parity? There were no gov- ernment controls preventing international capi- tal flows or preventing banks from lending to each other. Rather, the banks themselves were not exploiting the covered interest differentials that existed. While forward cover eliminates exchange-rate risk, it does not remove the risks of relying on the other parties to the arbitrage transactions to fulfill their sides of the contracts, both the future delivery of currency to settle for- ward foreign exchange contracts and the future repayment of loans. In normal times the risk of dealing with other large banks is considered min- imal. But during the global crisis perceptions of such counterparty risks rose to high levels, based on the chance that other banks had large, unre- vealed losses that could bring them down. Similar concerns arose during the euro crisis, though to a lesser extent and focused on the euro. Without a highly elastic supply of funds willing to under- take covered interest arbitrage, covered interest parity broke down.

a comparable domestic investment simply because the actual future spot exchange

turned out to be somewhat different from the future spot exchange rate that was

expected at the time of the investment. Nonetheless, if expected uncovered returns

are typically at parity, then over a large number of investments the actual uncovered differentials should be random and on average approximately equal to zero. Various

studies have shown that the actual uncovered differentials are not completely random

and for some time periods are not on average equal to zero. Uncovered interest parity

applies roughly, but there also appear to be deviations of some importance.

Why does uncovered interest parity not hold perfectly? One possible explanation

is simple—exchange-rate risk matters. Investors will not enter into risky uncovered

foreign investments unless they expect to be compensated adequately for the risk that

this adds to their portfolios. Divergences from uncovered interest parity then reflect

the risk premium necessary to compensate for exchange-rate risk. However, a number

of studies conclude that the uncovered interest differential is often larger than the risk

premium necessary to compensate for this risk.

To the extent that the differential is larger than that necessary to compensate for

risk, it appears that the expectations of market participants about future spot exchange

Chapter 18 Forward Exchange and International Financial Investment 427

pug21774_ch18_405-432.indd 427pug21774_ch18_405-432.indd 427 11/6/14 4:15 PM11/6/14 4:15 PM

Final PDF to printer

rates are biased. For some periods of time the market participants are consistently

expecting an exchange-rate change that is different from what will actually occur.

Research has attempted to determine the nature of the biases that may exist in market

expectations of future spot exchange rates. One possible explanation is troubling. If

the biases are simply consistent errors, the foreign exchange market is an inefficient

market. Other possible explanations are more subtle and probably less troubling. One

is that market participants learn slowly about exchange-rate behavior, but their fore-

casts are biased while they are learning. Another is that market participants (correctly)

expect a large, rather sudden shift in an exchange rate at some point in the future.

During the time before the large shift occurs, forecasts appear to be biased because

they give some probability to the much different exchange rate that has not yet arrived.

For instance, if the market expects a large devaluation of a now fixed-rate currency, the

expected value of the spot exchange rate 90 days from now is an average of the current

spot rate (if the devaluation does not occur within the next 90 days) and a much lower

rate (if the devaluation does occur within the next 90 days). During the time before

the devaluation actually occurs, the expected exchange rate appears to be biased—it is

consistently lower than the actual (fixed) rate that continues to hold.

The conclusions that we reach are cautious. Uncovered interest parity is useful

at least as a rough approximation empirically, but it appears to apply imperfectly to

actual rates.

Evidence on Forward Exchange Rates and Expected Future Spot Exchange Rates If there is substantial speculation using the forward exchange market, then the forward

rate should equal the average market expectation of the future spot exchange rate.

Although this seems quite different from the interest parity relationships, it is actually

closely related to them. If covered interest parity applies to actual rates, then testing

whether the forward rate is a predictor of the future spot exchange rate is the same as

testing uncovered interest parity. The only difference between covered and uncovered

interest parity is the replacement of the current forward exchange rate with the cur-

rently expected future spot exchange rate.

For currencies for which covered interest parity holds, conclusions about the for-

ward rate are then the same as those about uncovered interest parity. The forward

exchange rate is roughly useful as an indicator of the market’s expected future spot

rate or as a predictor of this future spot rate, but there are also indications of biases in

the predictions. Some part of the biases probably reflects risk premiums, but another

part appears to reflect biases in the forecasts themselves. In addition, the forward rate

is not a particularly accurate predictor of the future spot exchange rate. The errors in

forecasting are often large. Indeed, as we will see in the next chapter, no method of

forecasting exchange rates into the near future is particularly accurate!

Summary A person holding a net asset position (a long position) or a net liability position (a short position) in a foreign currency is exposed to exchange-rate risk. The value of the person’s income or net worth will change if the exchange rate changes in a way that the

person does not expect. Hedging is the act of balancing your assets and liabilities in a

428 Part Three Understanding Foreign Exchange

pug21774_ch18_405-432.indd 428pug21774_ch18_405-432.indd 428 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

foreign currency to become immune to risk resulting from future changes in the value

of foreign currency. Speculating means taking a long or a short position in a foreign currency, thereby gambling on its future exchange value. There are a number of ways

to hedge or speculate in foreign currency.

A forward exchange contract is an agreement to buy or sell a foreign currency for future delivery at a price (the forward exchange rate ) set now. Forward foreign exchange contracts are useful because they provide a straightforward way to hedge

an exposure to exchange-rate risk or to speculate in an attempt to profit from future

spot-exchange-rate values. An interesting hypothesis that emerges from the use of the

forward market for speculation is that the forward exchange rate should equal the aver-

age expected value of the future spot rate.

International financial investment has grown rapidly in recent years. Investment

in foreign-currency assets is more complicated than domestic investment because

of the need for currency exchanges, both to acquire foreign currency now and to

convert back the foreign currency in the future. If the rate at which the future sale of

foreign currency will occur is locked in now through a forward exchange contract,

we have a hedged or covered international investment. If the future sale of foreign currency will occur at the future spot rate, we have an uncovered inter- national investment, one that is exposed to exchange-rate risk and therefore speculative.

As a result of covered interest arbitrage , to exploit any covered interest differential between the returns on domestic and covered foreign investments, we expect that covered interest parity will exist (as long as there are no actual or threatened government restrictions on international money flows). Covered interest

parity states that the percentage by which the forward exchange value of a currency

exceeds its spot value equals the percentage point amount by which its interest rate is

lower than the other country’s interest rate. For countries with no capital controls and for comparable short-term financial assets, covered interest parity normally holds

almost perfectly when actual rates are examined empirically.

At the time of the investment, the expected overall return on an uncovered interna- tional investment can be calculated using the investor’s expected future spot exchange

rate. The overall expected return on the uncovered international investment can be

compared to the return available at home. The expected uncovered interest differential is one factor in deciding whether to make the uncovered international investment. Exposure to exchange-rate risk must also be considered in the decision. If

this risk is of little or no importance, then we hypothesize that uncovered interest parity will exist. The expected rate of appreciation of a currency should equal the percentage point amount by which its interest rate is lower than the other country’s

interest rate. Uncovered interest parity is not easy to test or examine empirically

using actual rates because we do not directly know the expected future spot rate or

the expected rate of appreciation. It appears that uncovered interest parity is useful

as a rough approximation, but it does not apply almost perfectly. Rather, exchange-

rate risk appears to be of some importance, and investors’ expectations or forecasts

of future spot exchange rates appear to be somewhat biased. (A similar conclusion is

that, empirically, the forward exchange rate is a rough but somewhat biased predictor

of the future spot exchange rate.)

Chapter 18 Forward Exchange and International Financial Investment 429

pug21774_ch18_405-432.indd 429pug21774_ch18_405-432.indd 429 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

Key Terms Exchange-rate risk Hedging

Speculating

Forward foreign exchange

contract

Forward exchange rate

Currency futures

Currency option

Currency swap

Covered international

investment

Uncovered international

investment

Covered interest

differential

Forward premium

Covered interest

arbitrage

Covered interest parity

Expected uncovered

interest differential

Uncovered interest parity

Capital controls

Eurocurrency deposit

Suggested Reading

Good presentations of theory and evidence on the parity relationships among forward

exchange rates, spot exchange rates, and interest rates include Pigott (1993–94) and

Marston (1995). Akram et al. (2008) examine the opportunities for covered interest

arbitrage using detailed real-time data on exchange rates and interest rates. Levich

(2013) and Baba and Packer (2009) analyze deviations from covered interest parity

during the global crisis. Froot and Thaler (1990) and Levich (1989) discuss evidence

about the efficiency or inefficiency of the foreign exchange market. A good textbook

view of foreign exchange futures, options, and swaps is found in Eun and Resnick (2012,

Chapters 7 and 14). Pojarliev and Levich (2012) explore the strategies of active currency

investment managers. Bartram and Dufey (2001) provide an overview of portfolio aspects

of international investment.

Questions and Problems

1. “For an investment in a foreign-currency-denominated financial asset, part of the return

comes from the asset itself and part from the foreign currency.” Do you agree or dis-

agree? Explain.

2. You have been asked to determine whether covered interest parity holds for one-year

government bonds issued by the U.S. and British governments. What data will you

need? How will you test?

3. Explain the nature of the exchange-rate risk for each of the following, from the perspec-

tive of the U.S. firm or person. In your answer, include whether each is a long or short

position in foreign currency.

a. A small U.S. firm sold experimental computer components to a Japanese firm, and it will receive payment of 1 million yen in 60 days.

b. An American college student receives a birthday gift of Japanese government bonds worth 10 million yen, and the bonds mature in 60 days.

c. A U.S. firm must repay a yen loan, principal plus interest totaling 100 million yen, coming due in 60 days.

4. The current spot exchange rate is $0.010/yen. The current 60-day forward exchange

rate is $0.009/yen. How would the U.S. firms and people described in question 3 each

use a forward foreign exchange contract to hedge their risk exposure? What are the

amounts in each forward contract?

✦

430 Part Three Understanding Foreign Exchange

pug21774_ch18_405-432.indd 430pug21774_ch18_405-432.indd 430 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

5. The current spot exchange rate is $0.50/SFr. The current 180-day forward exchange

rate is $0.52/SFr. You expect the spot rate to be $0.51/SFr in 180 days. How would you

speculate using a forward contract?

6. The current spot exchange rate is $1.20/euro. The current 90-day forward exchange rate

is $1.18/euro. You expect the spot rate to be $1.22/euro in 90 days. How would you

speculate using a forward contract? If many people speculate in this way, what pressure

is placed on the value of the current forward exchange rate?

7. You have access to the following rates:

Current spot exchange rate: $0.0100/yen

Current 180-day forward exchange rate: $0.0105/yen

180-day U.S. interest rate (on dollar-denominated assets): 6.05%

180-day Japanese interest rate (on yen-denominated assets): 1.00%

The interest rates are true 180-day rates (not annualized). You can borrow or invest at

these rates. Calculate the actual amounts involved for the two ways around the lake

(Figure 18.1) to get between each of the following.

a. Start with $1 now and end with dollars in 180 days. b. Start with $1 now and end with yen in 180 days. c. Start with 100 yen now and end with yen in 180 days.

8. The following rates are available in the markets:

Current spot exchange rate: $1.000/SFr

Current 30-day forward exchange rate: $1.010/SFr

Annualized interest rate on 30-day dollar-denominated bonds: 12% (1.0% for 30 days)

Annualized interest rate on 30-day Swiss franc–denominated bonds: 6% (0.5% for

30 days)

a. Is the Swiss franc at a forward premium or discount? b. Should a U.S.-based investor make a covered investment in Swiss franc–denominated

30-day bonds, rather than investing in 30-day dollar-denominated bonds? Explain.

c. Because of covered interest arbitrage, what pressures are placed on the various rates? If the only rate that actually changes is the forward exchange rate, to what value will

it be driven?

9. The following rates exist:

Current spot exchange rate: $1.80/£

Annualized interest rate on 90-day dollar-denominated bonds: 8% (2% for 90 days)

Annualized interest rate on 90-day pound-denominated bonds: 12% (3% for 90 days)

Financial investors expect the spot exchange rate to be $1.77/£ in 90 days.

a. If he bases his decisions solely on the difference in the expected rate of return, should a U.S.-based investor make an uncovered investment in pound-denominated

bonds rather than investing in dollar-denominated bonds?

b. If she bases her decision solely on the difference in the expected rate of return, should a UK-based investor make an uncovered investment in dollar-denominated

bonds rather than investing in pound-denominated bonds?

c. If there is substantial uncovered investment seeking higher expected returns, what pressure is placed on the current spot exchange rate?

✦

Chapter 18 Forward Exchange and International Financial Investment 431

pug21774_ch18_405-432.indd 431pug21774_ch18_405-432.indd 431 10/30/14 6:20 PM10/30/14 6:20 PM

Final PDF to printer

10. Here are today’s rates:

Spot exchange rate: 3.20 Polish zloty per U.S. dollar

6-month forward exchange rate: 3.24 Polish zloty per U.S. dollar.

You expect the spot exchange rate in 6 months to be 3.26 Polish zloty per U.S. dollar.

Evaluate the validity of the following statement: “Given this information, you will

profit from a forward exchange speculative position based on your expected future

spot exchange rate, if the actual future spot exchange rate in 6 months is 3.25 zloty

per U.S. dollar.”

11. The following exchange rates exist on a particular day.

Spot exchange rate: U.S. $1.400/euro

Forward exchange rate (90 days): U.S. $1.427/euro

The following (annualized) interest rates on 90-day government bonds also exist on

this day:

Euro-denominated bonds: 8%

U.S. dollar–denominated bonds: 16%

a. Financial investors in all countries have the expectation that the spot exchange rate in 90 days will be 0.7100 euro/U.S. dollar. Are investors expecting the euro will

appreciate or depreciate during the next 90 days?

b. Consider the comparison between investments in U.S. dollar–denominated bonds and euro-denominated bonds, with any foreign investment done as uncovered for-

eign investment. In which direction (between the United States and the euro area)

will there be an incentive for uncovered investment to flow, based on a comparison

of returns? Calculate the relevant returns and explain your answer.

12. Why is testing whether uncovered interest parity holds for actual rates more difficult

than testing whether covered interest parity holds?

✦

432 Part Three Understanding Foreign Exchange

pug21774_ch18_405-432.indd 432pug21774_ch18_405-432.indd 432 11/6/14 4:16 PM11/6/14 4:16 PM

Final PDF to printer

Chapter Nineteen

What Determines Exchange Rates? Thinking in terms of supply and demand is a necessary first step toward understanding

exchange rates. The next step is the one that has to be taken in any market analysis:

finding out what underlying forces cause supply and demand to change.

We need to know what forces have caused the changes in exchange rates observed

since the start of widespread “floating” back in the early 1970s. Figure 19.1 reminds us

just how variable exchange rates have been. Between 1971 and the end of 1973, most

currencies of other industrialized countries rose in value relative to the dollar, the aver-

age rise being about 20 percent. After 1973, when the modern era of floating exchange

rates clearly took hold, we can see three types of variability for these exchange rates.

First, there are long-term trends. As shown in Figure 19.1A, over the entire period the Japanese yen, Swiss franc, and German mark (DM) tended to appreciate, with

the Swiss franc almost quintupling in value, the yen more than tripling and the DM

(fixed to the euro in 1999 and then retired in 2002) more than doubling. As shown in

Figure 19.1B, over the period, and especially up to early 2000s, the Italian lira, British

pound, Australian dollar, and Canadian dollar tended to depreciate. From 1970 to

2002, the lira (also fixed to and then replaced by the euro) lost about seven-tenths of

its exchange-rate value against the dollar, the Australian dollar lost about a half, the

pound lost about four-tenths, and the Canadian dollar lost about a third. Still other

currencies, such as the Israeli shekel and Argentine peso, dropped so far in value that

they would almost hit zero if we added them to Figure 19.1B.

Second, there are medium-term trends (over periods of several years), and these medium-term trends are sometimes counter to the longer trends. For instance,

the Swiss franc, DM, and to a lesser extent the yen depreciated during the period

1980–1985. Another trend is the appreciation of the pound and the lira from 1985 to

1988. The decline in the dollar value of the euro from its introduction at the beginning

of 1999 to late 2000, and then the euro’s rise back up in value from late 2000 to early

2008, can be seen in either of two currencies shown (DM, lira) that it has replaced.

Third, there is substantial short-term variability in these exchange rates from month to month (and, indeed, from day to day, hour to hour, and even minute to minute).

We can look at the movements in the exchange-rate value of the dollar as the reverse of

those for each foreign currency, or we can calculate the average movement against a set of

other currencies. After the dollar’s average value against the currencies of other industrialized

countries fluctuated modestly from 1973 to 1980, nearly all observers were stunned as the

433

pug21774_ch19_433-463.indd 433pug21774_ch19_433-463.indd 433 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

*At the beginning of 1999, the German mark and Italian lira were fixed to the euro, and in 2002 the euro replaced

these currencies. Each of these rates is tracking the U.S.$/euro exchange-rate movement from January 1999.

For each currency, the dollar price of that currency (e.g., $/£) is shown, with units adjusted so that its January 1970 value

is 100. For any currency, an increase in the value shown from one time to another indicates that the currency increased in

exchange-rate value (appreciated) relative to the U.S. dollar during that time period; a decrease in the value shown indicates

that the currency depreciated relative to the U.S. dollar. For the currencies shown, the Japanese yen, Swiss franc, and German

mark appreciated over the entire 44-year period, while the Italian lira, Australian dollar, and British pound sterling depreci-

ated. The Canadian dollar tended to depreciate gradually to 2002 and then appreciated back to move above its 1970 value.

Source: International Monetary Fund, International Financial Statistics.

FIGURE 19.1 Selected Exchange Rates, 1970–2014 (Monthly)

A. Swiss Franc, German Mark (DM), and Japanese Yen Exchange Rate (January 1970 5 100)

100

150

200

250

300

350

400

500

550

450

Ja n

1 9 7 0

Ja n

1 9 7 5

Ja n

1 9 8 0

Ja n

1 9 8 5

Ja n

1 9 9 0

Ja n

1 9 9 5

Ja n

2 0 0 0

Ja n

2 0 1 0

Ja n

2 0 0 5

Swiss franc

DM*

Yen

Exchange Rate (January 1970 5 100)

100

120

140

Ja n

1 9 7 0

Ja n

1 9 7 5

Ja n

1 9 8 0

Ja n

1 9 8 5

Ja n

1 9 9 0

Ja n

1 9 9 5

Ja n

2 0 0 0

Ja n

2 0 1 0

Ja n

2 0 0 5

Canadian $

Australian $

Lira*Pound

B. Australian Dollar, Canadian Dollar, British Pound Sterling, and Italian Lira

434 Part Three Understanding Foreign Exchange

pug21774_ch19_433-463.indd 434pug21774_ch19_433-463.indd 434 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

dollar rallied. By the time the dollar peaked in early 1985, it had gained over 50 percent in

value since 1980 and was about 20 percent above its value in 1970. From early 1985 to early

1988, the dollar then fell (even more quickly) by a little more than it had risen in the previ-

ous five years. From early 1988 to 1995, the dollar fluctuated somewhat but did not show

any pronounced overall trend. From 1995 to early 2002, the dollar’s average value rose by

about 40 percent. It then fell to about 12 percent below its 1995 value by early 2008, and in

the following years to mid-2014 it fluctuated somewhat with no trend.

Why do we see large changes in the values of floating exchange rates? How does

short-run variability turn into long-run trends? Why are medium-run trends sometimes

opposite to these longer trends? This chapter presents what economists believe, what they

think they know, and what they admit they do not know about this challenging puzzle.

A ROAD MAP

This chapter focuses on the determinants of exchange rates.1 The first part of the

chapter focuses on short-run movements in exchange rates. To understand exchange

rates in the short run, we must focus on the perceptions and actions of international

financial investors. We believe that rather little of the $5 trillion of foreign exchange

trading that occurs each day is related to international trade in goods and services.

Instead, most of it is related to the positioning or repositioning of the currency

composition of the portfolios of international financial investors.

The asset market approach to exchange rates emphasizes the role of portfolio repositioning by international financial investors. As demand for and supply of financial

assets denominated in different currencies shift around, these shifts place pressures

on the exchange rates among the currencies. Fortunately, we have a head start on this

analysis because we can use the concept of uncovered interest parity from Chapter 18

the previous chapter. Major conclusions of our analysis are that the exchange-rate value

of a foreign currency (e) is raised in the short run by the following changes:

• A rise in the foreign interest rate relative to our interest rate (i f – i).

• A rise in the expected future spot exchange rate (eex).

The second part of the chapter turns to long-term trends. Why do some currencies

tend to appreciate over the long run, while others tend to depreciate? A key economic

“fundamental” that appears to explain these long trends is the difference in national

rates of inflation of the prices of goods and services. The concept of purchasing power parity (PPP) contains our core understanding of the relationship between product prices and exchange rates in the long run.

The third part of the chapter examines the role of money as a determinant of

national product price levels and inflation rates. Through the link of money to

price levels and inflation rates, the monetary approach to exchange rates

1The forces examined here are central not only to understanding what causes floating rates to change but also to understanding the pressures on a system of fixed rates. Whatever would make a floating currency sink or rise would also make a fixed exchange rate harder to defend. The material has more uses than simply the search for determinants of floating exchange rates. It also applies to the analysis of the balance of payments under a fixed-rate system or a managed floating rate.

Chapter 19 What Determines Exchange Rates? 435

pug21774_ch19_433-463.indd 435pug21774_ch19_433-463.indd 435 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

emphasizes the importance of money supplies and demands as key to understanding the

determinants of exchange rates. A major conclusion of the monetary approach is that

the spot exchange rate e, the price of foreign currency in units of our currency, is raised in the long run by the following changes:

• A rise in our money supply relative to the foreign money supply (M s/M s

• A rise in foreign real domestic product relative to our real domestic product (Y f /Y ).

The fourth part of the chapter shows one way in which the short term flows into

the medium term and then into the long term. We examine the tendency for exchange

rates to “overshoot,” to change more than seems necessary in reaction to changes

in government policies or to other important economic or political news. After the

overshooting in the short run, the exchange rate moves in the medium run toward its

long-run fundamental value.

The final part of the chapter examines two questions. First, how useful are these

concepts and relationships—how well can we forecast future exchange rates? Second,

how many different ways can we use to measure the exchange-rate value of a coun-

try’s currency?

EXCHANGE RATES IN THE SHORT RUN

Economists believe that pressures on exchange rates in the short run can best be

understood in terms of the demands and supplies of assets denominated in different

currencies. In principle the asset market approach to exchange rates incorporates all

financial assets. Fortunately, we can grasp its key elements by focusing on investments

in debt securities, such as government bonds, denominated in different currencies.

In the analysis here we build on the discussion of uncovered international financial

investment and uncovered interest parity from the previous chapter. Recall that

investors determine the expected overall return on an uncovered investment in a bond

denominated in a foreign currency by using

• The basic return on the bond itself (the interest rate or yield).

• The expected gain or loss on currency exchanges (the expected appreciation or

depreciation of the foreign currency).

While we may not believe that uncovered interest parity holds exactly, we still expect

that there will be a noticeable relationship between the return on home-currency bonds

and the expected overall return on foreign-currency bonds. These two returns will tend

to be equal (or at least not too different). Emerging differences in these two returns will

cause international financial investors to reposition their portfolios, and this reposition-

ing creates the pressures that move the two returns toward equality.2

2This broad asset market approach built on uncovered interest parity is a kind of portfolio balance approach because it emphasizes the role of portfolio repositioning in the determination of exchange rates. However, the portfolio balance approach can go further than this. One further conclusion of the portfolio balance approach is that a change in the supplies of assets denominated in different currencies affects the deviation from uncovered interest parity (in the form of a risk premium) that is necessary to induce investors to hold (demand) all of these assets. This conclusion results because assets denominated in different currencies actually are not perfect substitutes for each other in investors’ portfolios.

436 Part Three Understanding Foreign Exchange

pug21774_ch19_433-463.indd 436pug21774_ch19_433-463.indd 436 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

FIGURE 19.2 Determinants of the Exchange Rate in the Short Run

Implications for the Current Direction of International Spot Exchange Rate Change in Variable Financial Repositioning (e 5 Domestic currency/Foreign currency)

Domestic Interest Rate (i)

Increases Toward domestic-currency assets e decreases (domestic currency appreciates) Decreases Toward foreign-currency assets e increases (domestic currency depreciates)

Foreign Interest Rate (i f )

Increases Toward foreign-currency assets e increases (domestic currency depreciates) Decreases Toward domestic-currency assets e decreases (domestic currency appreciates)

Expected Future Spot Exchange Rate (eex)

Increases Toward foreign-currency assets e increases (domestic currency depreciates) Decreases Toward domestic-currency assets e decreases (domestic currency appreciates)

The analysis for each change in one of the variables assumes that the other two variables are unchanged.

Uncovered interest parity (whether exact or approximate) links together four vari-

ables: the domestic interest rate, the foreign interest rate, the current spot exchange

rate, and the expected future spot exchange rate. (The two exchange rates together

imply the expected appreciation or depreciation.) Change in any one of these four

variables implies that adjustments will occur in one or more of the other three. We

will focus on implications for the current spot exchange rate of changes in each of the

other three variables. Figure 19.2 provides a summary of the effects.

The Role of Interest Rates Foreign exchange markets do seem sensitive to movements in interest rates. Jumps

of exchange rates often follow changes in interest rates. The response often looks

prompt, so much so that press coverage of day-to-day rises or drops in an exchange

rate often point first to interest rates as a cause.

If our interest rate (i) increases, while the foreign interest rate (i f ) and the spot

exchange rate expected at some appropriate time in the future (eex) remain constant, the return comparison shifts in favor of investments in bonds denominated in our

currency. If international financial investors want to shift toward domestic-currency

assets, they first need to buy domestic currency before they can buy the domestic-

currency bonds. This increase in demand for domestic currency increases the current

spot-exchange-rate value of domestic currency (so e decreases). Given the speed with which financial investors can initiate shifts in their portfolios, the effect on the spot

exchange rate can happen very quickly (instantaneously or within a few minutes).

Let’s consider an example involving the United States, Switzerland, and 90-day

bonds. Initially, the U.S. interest rate is 9 percent per year, and the Swiss interest

rate is 5 percent per year. The current spot rate is $1.200 per Swiss franc (SFr), and

the spot rate expected in 90 days is about $1.212 per SFr. The franc is expected to

appreciate about 1 percent during the next 90 days, so the annual rate of expected

Chapter 19 What Determines Exchange Rates? 437

pug21774_ch19_433-463.indd 437pug21774_ch19_433-463.indd 437 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

appreciation is about 4 percent. (Uncovered interest parity holds at these rates, as the

expected annualized overall return on the SFr-denominated bonds is about 9 percent,

equal to 5 percent interest plus about 4 percent expected currency appreciation.) What

happens if the U.S. interest rate increases to 11 percent? Given the other initial rates,

the return differential shifts in favor of U.S.-dollar-denominated bonds. International

financial investors have an incentive to shift toward dollar-denominated bonds, and

this increases the demand for dollars in the foreign exchange market. The dollar tends

to appreciate immediately. Furthermore, we can determine that the dollar should

appreciate to about $1.194 per SFr, assuming that the interest rates and the expected

future exchange rate do not change. Once this new current spot exchange rate is posted

in the market, the SFr then is expected to appreciate during the next 90 days at a faster

rate, equal to about 6 percent at an annual rate. This reestablishes uncovered inter-

est parity (5 percent interest plus about 6 percent expected appreciation matches the

11 percent U.S. interest) and eliminates any further desire by international investors

to reposition their portfolios.

If our interest rate instead decreases, with foreign interest rates and the expected

future spot rate unchanged, the spot-exchange-rate value of our currency is predicted

to decrease (e increases). If the foreign interest rate (i

f ) increases, the story is similar. Assuming that the

domestic interest rate and the expected future spot exchange rate are constant, the

return comparison shifts in favor of investments in bonds denominated in foreign

currency. A shift by international financial investors toward foreign-currency bonds

would require them first to buy foreign currency in the foreign exchange market. This

increase in demand for the foreign currency increases the current spot exchange rate,

e (the domestic currency depreciates). Consider a variation on our previous example, still using 90 days and annualized

rates. If the U.S. interest rate is 9 percent, the spot exchange rate is $1.200 per SFr, and

the expected future spot rate is about $1.212 per SFr, what is the effect of an increase

in the Swiss interest rate from 5 to 7 percent? The return differential shifts in favor of

Swiss bonds. The increased demand for francs in the foreign exchange market results

in a quick appreciation of the franc (and depreciation of the dollar). The current spot

exchange rate must jump immediately to about $1.206 per SFr to reestablish uncov-

ered interest parity.

If instead the foreign interest rate decreases, the spot rate, e, decreases. (The domes- tic currency appreciates.)

What happens if both interest rates change at the same time? The answer is straight-

forward. What matters is the interest rate differential i – i f . If the interest rate differ-

ential increases, the return differential shifts in favor of domestic-currency bonds, and

e tends to decrease. (The domestic currency appreciates.) If it decreases, e tends to increase.

The Role of the Expected Future Spot Exchange Rate Expectations of future exchange rates can also have a powerful impact on international

financial positioning, and through this on the value of the current exchange rate.

Consider what happens when financial investors decide that they now expect the

future spot exchange rate to be higher than they previously expected. Relative to the

438 Part Three Understanding Foreign Exchange

pug21774_ch19_433-463.indd 438pug21774_ch19_433-463.indd 438 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

current spot rate, this means that they expect the foreign currency to appreciate more,

or to depreciate less, or to appreciate rather than depreciate. Assuming that the interest

rate differential is unchanged, the increase in the expected future spot rate alters the

return differential in favor of foreign-currency-denominated bonds. The story from

here is familiar. If international financial investors want to shift toward foreign-

currency assets, they first need to buy foreign currency in the foreign exchange market

before they can buy the foreign-currency bonds. This increase in demand for foreign

currency increases the current spot exchange rate e. (The foreign currency appreciates; the domestic currency depreciates.) If instead the expected future spot exchange rate

decreases, with the interest rate differential unchanged, the return differential changes

in favor of domestic-currency investments, and the current spot-exchange-rate value

of our currency increases (e decreases). Consider another variation on our previous example. With the U.S. annualized

interest rate at 9 percent, the Swiss annualized interest rate at 5 percent, and the cur-

rent spot exchange rate at $1.200 per SFr, what happens if the spot exchange rate

expected in 90 days increases from about $1.212 to about $1.236 per SFr (perhaps

because international investors believe that the political situation in Switzerland will

improve rapidly)? Relative to the initial current spot rate, investors now expect the

franc to appreciate more in the next 90 days, at about a 12 percent annual rate (rather

than the previously expected 4 percent). This shifts the return differential in favor of

Swiss-currency bonds. Because investors desire to reposition their portfolios toward

Swiss assets, demand for the franc increases in the foreign exchange market. The cur-

rent spot exchange rate increases (the franc appreciates and the dollar depreciates).

In fact, the spot exchange rate moves to about $1.224 per SFr. At this new spot rate,

the franc then is expected to appreciate further by only about 4 percent (annual rate).

Uncovered interest parity is reestablished, and there is no further incentive for inter-

national investors to reposition their portfolios.

As with a change in interest rates, the effect of a change in the expected future spot

rate on the current spot exchange rate can happen very quickly (instantaneously or

within a few minutes). This can be like a rapid-fire self-confirming expectation. In the Swiss franc example, the expectation that the franc would appreciate more than was

previously expected resulted in a rapid and large appreciation of the franc. For another

example, consider what happens if international financial investors shift from expect-

ing no change in spot exchange rates (eex equals the initial e) to expecting a deprecia- tion of the foreign currency (eex decreases so that it is then below the initial current spot rate e). The willingness of international investors to reposition their international portfolios away from foreign-currency bonds results in a depreciation of the foreign

currency (e decreases)—exactly what they were expecting. Given the powerful effects that exchange-rate expectations can have on actual

exchange rates, we would like to know what determines these expectations. Many dif-

ferent things can influence the value of the expected future exchange rate.

Some investors, especially for expectations regarding the near-term future (the

next minutes, hours, days, or weeks), may expect that the recent trend in the exchange

rate will continue. They extrapolate the recent trend into the future. This is a

bandwagon. For instance, currencies that have been appreciating are expected to continue to do so. The recent actual increase in the exchange-rate value of a country’s

Chapter 19 What Determines Exchange Rates? 439

pug21774_ch19_433-463.indd 439pug21774_ch19_433-463.indd 439 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

currency leads some investors to expect further increases in the near future. If they act

on this belief, the currency will tend to appreciate further. This bandwagon effect is

the basis for fears that speculation can sometimes be destabilizing in that the actions of international investors can move the exchange rate away from a long-run equilibrium

value consistent with fundamental economic influences. Expectations can be desta-

bilizing if they are formed without regard to these economic fundamentals, which is

quite possible if recent exchange-rate trends are simply extrapolated into the future.

For example, the depreciation of the euro against the U.S. dollar after the euro was

introduced in 1999 appears to have led to a bandwagon that drove continued deprecia-

tion of the euro into late 2000. (The euro fell in value from $1.18 in January 1999 to

less than $0.83 in October 2000.)

Expectations can also be based on the belief that exchange rates eventually return to

values consistent with basic economic conditions (for instance, purchasing power par-

ity, which we will discuss in the next section). Expectations of this sort are considered

stabilizing in the sense that they lead to stabilizing speculation, which tends to move the exchange rate toward a value consistent with some economic fundamentals such

as relative national product price levels.

Changes in expectations can be based on various kinds of new information. The

important part of the “news” is any unexpected information about government poli- cies, about national and international economic data or performance, and about politi-

cal leaders and situations (both domestic politics and international political issues and

tensions). An example is that foreign exchange markets often react to news of official

figures about a country’s trade or current account balances, measures that largely

reflect the balance or imbalance between a country’s exports and imports of goods

and services. There is logic to the market’s reactions to such news. For instance, an

unexpected increase in a country’s trade deficit or (especially) its current account

deficit indicates that the country requires an increasing amount of foreign financing

of the deficit. If the increased foreign financing is not assured to be forthcoming, then

the country’s currency will tend to fall in the foreign exchange market. The increasing

demand for foreign currency as part of the process of paying for the excess of imports

over exports tends to appreciate the foreign currency and depreciate the domestic

currency. If this logic is built into the changed expectations of international investors,

then the exchange-rate change can occur quickly, rather than gradually as the trade

imbalance would slowly add to market pressures.

THE LONG RUN: PURCHASING POWER PARITY (PPP)

In the short run, floating exchange rates are often highly variable, and there are times

when it is not easy to understand why the rates are changing as they are. In the long

run, economic fundamentals become dominant, providing an “anchor” for the long-term

trends. Our understanding of exchange rates in the long run is based on the proposition

that there is a predictable relationship between product price levels and exchange rates.

The relationship relies on the fact that people choose to buy goods and services from one

country or another according to the prices they must pay. We can present three versions

of this relationship, depending on whether we are examining one product or a set of

440 Part Three Understanding Foreign Exchange

pug21774_ch19_433-463.indd 440pug21774_ch19_433-463.indd 440 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

products, and whether we are looking at a snapshot of the product price–exchange rate

relationship or how product prices and exchange rates are changing over time.

The Law of One Price The law of one price posits that a product that is easily and freely traded in a perfectly competitive global market should have the same price everywhere, once

the prices at different places are expressed in the same currency. In Chapters 2–4

we called this the equilibrium international, or world, price, although we did not

specifically bring exchange rates into the picture. Now we can. The law of one price

proposes that the price (P) of the product measured in domestic currency will be equated to the price (P

f ) of the product measured in the foreign currency through the

current spot exchange rate (e, Domestic currency/Foreign currency):

P 5 e • P f

The law of one price works well for heavily traded commodities, either at a point in time or for changes over time, as long as governments permit free trade in the com-

modity. Such heavily traded commodities include gold, other metals, crude oil, and

various agricultural commodities.

Consider, for example, No. 2 soft red Chicago wheat, and suppose that it costs $4.80

a bushel in Chicago. Its dollar price in London should not be much greater, given the

cheapness of transporting wheat from Chicago to London. To simplify the example, let

us say that it costs nothing to transport the wheat. It seems reasonable, then, that the

pound price of wheat will be £3.00 if the exchange rate is $1.60 per pound. The dollar

price of the wheat in London then is $4.80 per bushel (5 3.00 • 1.60). If it is not, it would pay someone to trade wheat between Chicago and London to profit from the price gap.

For example, if an unexpected increase in British demand for wheat temporarily forces

the price of wheat in London up to £3.75 per bushel, and the exchange rate is still $1.60

per pound, the dollar price in London is $6.00. As long as free trade is possible, we

expect that the two prices would soon be bid back into equality, presumably somewhere

between $4.80 and $6.00 per bushel for both countries. In the case of wheat (a standard-

ized commodity with a well-established world market), we expect that arbitrage will

bring the two prices into line within a week.

However, the law of one price does not hold closely for most products that are traded

internationally, including nearly all manufactured products. It is not hard to find the

culprits that explain the discrepancy. International transport costs are not negligible.

Governments do not practice free trade. And many markets are imperfectly competitive.

Firms with market power sometimes use price discrimination to increase profits by charg-

ing different prices in different national markets. One study concluded that the effect of

the national border between the United States and Canada on product price differences is

like adding thousands of miles of distance between Canadian and U.S. cities. For many products the law of one price does not hold closely.

Absolute Purchasing Power Parity Absolute purchasing power parity posits that a basket or bundle of tradable products will have the same cost in different countries if the cost is stated in the

same currency. Essentially, the average price of these products, often called the

Chapter 19 What Determines Exchange Rates? 441

pug21774_ch19_433-463.indd 441pug21774_ch19_433-463.indd 441 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

product-price level, or just price level, stated in different currencies is the same when

converted to a common currency:

P 5 e • P f

Here P and P f refer to the average product price or price level in the domestic and the

foreign countries. The equation can be rearranged to provide an estimate of the spot

exchange rate that is consistent with absolute PPP:

e 5 P/P f

Absolute PPP is clearly closely related to the law of one price. The equations are

the same, except that the price variables refer either to only one product (law of one

price) or to a bundle of products (absolute PPP). If the law of one price holds for all

the products, then absolute PPP will also hold (as long as the product bundle is the

same in both countries). Even if the law of one price does not hold exactly, absolute

PPP can still be a useful guide if the discrepancies tend to average out over the differ-

ent products in the bundle.

Based on the evidence, however, absolute PPP does not fare much better than the

law of one price in the real world. Divergences from absolute PPP can be large at any

given time. (The divergences are even larger if nontraded products are included in the

bundles. See the box “Price Gaps and International Income Comparisons.”) In addi-

tion, we can get into technical difficulties of comparing index numbers if the infor-

mation sources, like national governments, do not use the same bundles of products

for the different countries. Nonetheless, there is evidence that large divergences from

absolute PPP do tend to shrink over time for traded products.

Relative Purchasing Power Parity Both the law of one price and absolute purchasing power parity are posited to

hold at a point in time. Another version of PPP looks specifically at how things

are changing over time. Relative purchasing power parity posits that the difference between changes over time in product-price levels in two countries will

be offset by the change in the exchange rate over this time. The exact formula for

relative PPP is

( e

t __ e 0

) 5 (P

t /P

0 ) _______

(P f,t

/ Pf,0

)

where the subscripts indicate the values for the initial year, 0, and some later year, t, for each variable. Each ratio in parentheses shows the increase from the initial year

to the later year for each variable. If you compare this equation to the second one for

absolute PPP, you will see that relative PPP holds if absolute PPP holds for both the

initial year and the later year. In addition, relative PPP may be useful as a guide to

why exchange rates change over time, even if absolute PPP does not hold closely at

specific times.

Relative PPP is often defined using an approximation:

Rate of appreciation of the foreign currency 5 π 2 π f

442 Part Three Understanding Foreign Exchange

pug21774_ch19_433-463.indd 442pug21774_ch19_433-463.indd 442 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

where π and π f are the (product-price) inflation rates for the domestic and the

foreign countries.3 Relative PPP posits that the exchange rate changes over time at

a rate equal to the difference in the two countries’ inflation rates during that time

period.

Something like the purchasing power parity the- ory has existed throughout the modern history of international economics. The theory keeps resurfacing whenever exchange rates have become more variable as a result of wars or other events. Sometimes the hypothesis is used as a way of describing how a nation’s general price level must change to reestablish some desired exchange rate, given the level and trend in foreign prices. At other times it is used to guess at what the equi- librium exchange rate will be, given recent trends in prices within and outside the country. Both of these interpretations crept into the British “bullionist–antibullionist” debate during and after the Napoleonic Wars, when the issue was why Britain had been driven by the wars to dislodge the pound sterling from its fixed exchange rates and gold backing, and what could be done about it.

The PPP hypothesis came into its own in the 1920s, when Gustav Cassel and others directed it at the issue of how much European countries would have to change their official exchange rates or their domestic price levels, given that World War I had driven the exchange rates off

their prewar par values and had brought vary- ing percentages of price inflation to different countries. For instance, PPP was a rough guide to the mistake made by Britain in returning to the prewar gold parity for the pound sterling in 1925 despite greater price inflation in Britain than in Britain’s trading partners.

With the restoration of fixed exchange rates fol- lowing World War II, the PPP hypothesis again faded from prominence, ostensibly because its defects had been demonstrated, but mainly because the issue it raised seemed less compelling as long as exchange rates were expected to stay fixed.

After the resumption of widespread floating of exchange rates in the early 1970s, the hypoth- esis has been revived once again. It is now used as a standard for examining whether countries’ currencies are undervalued or overvalued at their market exchange rates.

DISCUSSION QUESTION Why was the PPP hypothesis less interesting when the major countries had fixed exchange rates and similar product-price inflation rates?

Case Study PPP from Time to Time

3To see the approximation, restate each variable at time t as being equal to its initial value at time 0 plus its change from time 0 to time t:

e 0 1De e

5 [(P

0 1 DP)/P

0 ]

[(P f,0

1 DP f )/P

f,0 ]

which equals

[1 1 (De/e 0 )] 5

[11 (DP/P 0 )]

[11 (DP f /P

f,0 )]

Multiplying the denominator to the left-hand side, multiplying out the expressions, and simplifying, we obtain,

(De/e 0 ) 5 (DP/P

0 ) 2 (DP

f /P

f,0 ) 2 [(De/e

0 ) • (DP

f /P

f,0 )]

If the rate of appreciation of the foreign currency (De/e 0 ) and the foreign inflation rate (DP

f /P

f,0 ) are small

(in decimal form), then the last term (the product of two small numbers) is very small, and it is ignored in the approximation.

Chapter 19 What Determines Exchange Rates? 443

pug21774_ch19_433-463.indd 443pug21774_ch19_433-463.indd 443 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

Case Study Price Gaps and International Income Comparisons

There is tremendous social importance to inter- national comparisons of income or production levels. To judge which countries are most in need of United Nations aid, World Bank loans, and other help, officials compare their incomes per capita. To judge whether South Korea has overtaken Japan in supply prowess, we compare Korean and Japanese gross domestic product per capita. All such comparisons are dangerous as well as unavoidable. The comparisons are likely to contain a host of errors.

One of the worst pitfalls comes in converting from one national currency to another. It turns out that the market exchange rate is a poor way to convert because the purchasing power parity hypothesis is not reliable when applied to all the goods and services that make up national expenditure or domestic production. Many of the products in such a broad bundle are not traded internationally. There is no direct reason (like arbitrage) to think that the prices of non- traded products should equalize internationally when stated in a common currency using market exchange rates, and they usually do not.

If the market exchange rate is unreliable, what should we use for comparing values of income per capita between countries? The principle is clear: We want to take the national income per capita measured using whatever prices exist in each country and convert these into values of national incomes per capita using a set of common international prices like those that would exist if PPP applied. That way, we are comparing how many units of a consistently priced bundle of goods and services the aver- age resident of each nation could buy. But it is difficult to get data on the prices of a wide- ranging bundle of goods and services for every country.

That is where the United Nations International Comparisons Project (ICP) came in. Teams of researchers have done the hard work of measur- ing the prices of items in separate countries. What they have found, in effect, are the true levels of P and P

f for deflating the current-price national

income figures. They confirm what was widely feared: On average for all goods and services, the

market exchange rate e is often far from the ratio P/P

f that absolute PPP says it would equal.

The accompanying table shows the typical pattern in departures from absolute PPP and the importance of replacing exchange-rate conver- sions of income per capita with the better com- parisons based on common price levels.

If purchasing power parity really held, then every number in the right-hand column would be 100. The departures from that PPP norm are great enough to reshuffle some of the international rankings, making the better (PPP-based) mea- surements of the center column differ from the exchange-rate-based measures on the left. Two patterns are apparent in the figures. One is that the price-difference ratio in the right-hand col- umn is above unity for most industrialized coun- tries. Their PPP-measured real average income is not as high relative to that of the United States as the exchange-rate figures imply.

Another pattern is that the usual comparisons— the ones using exchange rates—overstate the real income gaps between rich and poor nations because the price-difference ratio is below unity for the lower-income countries in the bottom half of the list. For some of the poorest countries, the price disparity can be as large as 1:4, a sub- stantial deviation from absolute PPP.

Why do lower-income countries have prices so much lower than U.S. prices? Most of the depar- tures come from the wide international gaps in the prices of nontraded products like housing, haircuts, and other local services. The prices of nontraded products differ radically between lower-income and higher-income countries. The gaps in the prices of these products seem to be widened by two forces. One is the tendency for the price of land in towns and cities to be highly sensitive to the income of the country’s residents. So a country with twice as high an income would have more than twice as high a cost for business and residential space, making space-intensive nontraded products cost much more. A second explanation is that, as a country develops, its productivity in making traded goods rises much faster than its productivity in making nontraded goods and services. The higher productivity in making traded goods tends to

444 Part Three Understanding Foreign Exchange

pug21774_ch19_433-463.indd 444pug21774_ch19_433-463.indd 444 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

increase wage rates in more developed countries. Firms making nontraded goods and services must also pay these higher wage rates. With less pro- ductivity advantage, this results in costs and prices of nontraded products that are higher in more- developed countries.

DISCUSSION QUESTION The table reports that Singapore’s national income per capita was a little less than that of the United States, when compared using the market exchange rate for the Singapore dollar. Why is Singapore at the top of the list?

National Income per Capita, 2012, Relative to the United States 5 100

Domestic Price Level (This Country/U.S.) Using the Using as a Percentage of the Country Exchange Rate Common Prices Level Predicted by PPP

Singapore 95 137 69 Norway 189 128 147 Switzerland 155 105 148 United States 100 100 100 Sweden 107 84 128 Germany 86 83 104 Australia 113 81 140 Canada 99 80 123 France 80 71 112 Japan 91 70 131 Britain 74 68 109 Italy 66 66 101 Israel 61 58 106 South Korea 43 57 76 Czech Republic 35 48 72 Russia 24 43 56 Poland 24 41 58 Chile 27 39 70 Turkey 21 35 59 Mexico 18 31 60 Brazil 22 27 82 Thailand 10 25 39 South Africa 14 23 63 China 11 21 53 Egypt 6 20 28 Indonesia 7 17 39 Nigeria 5 10 47 India 3 10 31 Pakistan 2 9 27 Ghana 3 7 44 Tanzania 1 3 34

Source: World Bank, World Development Indicators.

Chapter 19 What Determines Exchange Rates? 445

pug21774_ch19_433-463.indd 445pug21774_ch19_433-463.indd 445 14/11/14 4:39 pm14/11/14 4:39 pm

Final PDF to printer

Relative PPP provides some strong predictions about exchange-rate trends, espe-

cially in the long term:

• Countries with relatively low inflation rates have currencies whose values tend to

appreciate in the foreign exchange market.

• Countries with relatively high inflation rates have currencies whose values tend to

depreciate in the foreign exchange market.

In fact, a strict application of relative PPP implies that each percentage point more of

a country’s inflation per year tends to be related to a 1 percent faster rate of deprecia-

tion of the country’s currency (or slower rate of currency appreciation) per year, given

the inflation rate in the other country. Relative PPP thus has an important message to

offer countries, such as Switzerland, that seek to keep domestic prices stable when the

rest of the world is inflating. If prices elsewhere are rising 10 percent a year, in the

long run a country can keep its domestic prices stable only by accepting a rise of about

10 percent a year in the exchange value of its currency in terms of inflating-country

currencies.

Relative PPP: Evidence We just suggested that PPP holds reasonably well in the long run but poorly in the

short run. We can examine specific evidence about PPP for recent decades. Figure 19.3

provides evidence on the long run during the current period of floating exchange rates.

For each country included in samples of industrialized and developing countries, the

average annual rate of change of its currency’s exchange rate against the U.S. dollar is

compared to the difference between the average U.S. inflation rate and the country’s

inflation rate.4 Relative PPP predicts that, when the inflation differential is positive

(the United States has a higher inflation rate, or the country has a lower one), the

country’s currency should appreciate. When the inflation differential is negative, the

country’s currency should depreciate. Looking across the countries in each sample,

we can see that this relationship is clear. In fact, the relationships are very close to the

one-to-one relationship implied by a strict version of relative PPP.5

We can also examine recent performance of PPP for both short and long periods

using data on the exchange rates of individual countries over time. Figure 19.4 shows

the actual exchange rates against the U.S. dollar and the exchange rates that would be

consistent with PPP (relative to the base year 1975), month-by-month, for the German

mark (DM) and Japanese yen. The exchange rate consistent with PPP is the rate that

equals the ratio of the national price levels P/P f (relative to the value of this ratio in

4The period is 1975–2012. The beginning year 1975 is somewhat arbitrary; it was chosen to be close to the beginning of the current floating-rate period and to allow several years of adjustment following the end of the previous fixed-rate period. Inflation rates are measured using the wholesale price index or a similar price index that includes only (or mostly) traded products. 5A standard statistical test of the relationship is to fit the best straight line to the data points using a simple regression. For the industrialized countries, the slope of the line (0.902) is not significantly different from 1 (and the intercept is not significantly different from zero). For the developing countries, the slope coefficient (0.965) also is not significantly different from 1 (and the intercept also is not significantly different from zero). The results show strong support for the one-to-one relationship. Furthermore, both straight lines fit the data very well. For industrialized countries about 92 percent of the variation in the rates of exchange-rate change across the countries is “explained” by the inflation rate differences and for developing countries about 99 percent is “explained.”

446 Part Three Understanding Foreign Exchange

pug21774_ch19_433-463.indd 446pug21774_ch19_433-463.indd 446 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

FIGURE 19.3 Relative Purchasing Power Parity: Inflation Rate Differences and Exchange-Rate Changes, 1975–2012

On average from 1975 to 2012, strong support is found for PPP. If the U.S. inflation rate is higher than

the other country’s inflation rate, the country’s currency tends to appreciate; if the U.S. inflation rate is

lower, the currency tends to depreciate.

Inflation rates are measured using wholesale (or similar producer-oriented) price indexes. Annual

rates of change are calculated using the differences in natural logarithms.

–2

–4

–6

–8 –8 –6 –4 –2 0 2 4

–30

–25

–20

–15

–10

–5

Difference in Average Annual Inflation Rate (U.S. Rate minus the Country’s Rate)

A. 16 Industrialized Countries

Average Annual Rate of Change of the Exchange Rate (U.S. Dollars per Unit of the Country’s Currency)

–30 –25 –20 –15 –10 –5 0 5

B. 25 Developing Countries

1 2 3 4 5 6 7 8 9

10 11 12 13 14 15 16

Australia Austria Canada Denmark Finland France Germany Greece Ireland Japan Netherlands New Zealand Spain Sweden Switzerland United Kingdom

1 2 3 4 5 6 7 8 9

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Brazil Chile Colombia Costa Rica Cyprus Egypt El Salvador Hungary India Indonesia Israel Jordan Korea Kuwait Mexico Morocco Pakistan Poland Singapore South Africa Sri Lanka Thailand Tunisia Uruguay Venezuela

12 13 5

22 16

14 19

23 9

8 17

20 6

21 10

25 15

11 24

1 ( −75.8, −73.1 )

16 1

14 9

4 6

Chapter 19 What Determines Exchange Rates? 447

pug21774_ch19_433-463.indd 447pug21774_ch19_433-463.indd 447 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

*Beginning January 1999, the German mark is fixed to the euro, so its rate is tracking the U.S.$/euro exchange-

rate movement from that date.

The exchange rate implied by PPP equals the ratio of national price levels P/P f . The actual exchange rate can

differ substantially from this PPP rate, and the divergences can persist for several years. Nonetheless, there is a

tendency for the actual exchange rate to follow the PPP rate in the long run.

National price levels are measured by wholesale (or producer) price indexes.

Source: International Monetary Fund, International Financial Statistics.

FIGURE 19.4 Actual Exchange Rates and Exchange Rates Consistent with Relative PPP, Monthly, 1975–2014

100

120

140

160

180

200

Ja n

1 9

7 5

Ja n

1 9

8 0

Ja n

1 9

8 5

Ja n

1 9

9 0

Ja n

1 9

9 5

Ja n

2 0

0 0

Ja n

2 0

0 5

Ja n

2 0

1 0

PPP

Actual*

A. U.S. Dollars per DM

Exchange Rate (January 1975 5 100)

B. U.S. Dollars per Yen

Exchange Rate (January 1975 5 100)

100

150

200

250

300

350

400

Ja n

1 9 7 5

Ja n

1 9 8 0

Ja n

1 9 8 5

Ja n

1 9 9 0

Ja n

1 9 9 5

Ja n

2 0 0 0

Ja n

2 0 0 5

Ja n

2 0 1 0

Actual

PPP

448 Part Three Understanding Foreign Exchange

pug21774_ch19_433-463.indd 448pug21774_ch19_433-463.indd 448 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

the base year). If relative PPP always held, the actual exchange rate would equal the

exchange rate implied by PPP. As we can see easily in the figure, the deviations of the

actual exchange rate from its PPP value can be large and can persist for a number of

years. The DM was substantially undervalued relative to the implied PPP value from

1981 through 1986, and then was somewhat overvalued for much of the first half

of the 1990s. After the euro replaced the DM as Germany’s currency beginning in

1999, the euro fell below its PPP value and then returned to and fluctuated around its

PPP value. The yen tracked its PPP value reasonably well from 1976 through 1986

but then became overvalued. During 2005–2008 the yen returned to its PPP value,

then again rose above its PPP value before again returning to its PPP value in 2013.

In the long run there is a tendency for the actual exchange rates to move in a manner

consistent with PPP.

If we examined evidence for other countries, we would generally reach similar

conclusions: noticeable deviations from PPP in the short run but a tendency for PPP to

hold in the long run. Based on a survey of rigorous studies, Froot and Rogoff (1995)

conclude that it takes about four years on average for a deviation from PPP to be

reduced by half for the exchange rates of major industrialized countries.

THE LONG RUN: THE MONETARY APPROACH

Purchasing power parity indicates that, at least in the long run, exchange rates are

closely related to the levels of prices for products in different countries. But this also

suggests the next question: What determines the average national price level or the

rate at which it changes, the inflation rate? Economists believe that the money supply

(or its growth rate) determines the price level (or the inflation rate) in the long run.

This suggests that money supplies in different countries, through their links to national

price levels and inflation rates, are closely linked to exchange rates in the long run.

Indeed, this is not surprising. An exchange rate is the price of one money in terms of

another. Trying to analyze exchange rates or international payments without looking

at national money supplies and demands is like presenting Hamlet without the prince of Denmark.

Relative money supplies affect exchange rates. On the international front as on the

domestic front, a currency is less valuable the more of it there is to circulate. Extreme

cases of hyperinflation dramatize this fundamental point. The trillionfold increase in

the German money supply in 1922–1923 was the key proximate cause of the trillion-

fold increase in the price of foreign exchange and of everything else in Germany at

that time. Hyperinflation of the money supplies is also the key to understanding why

the currencies of Israel and several Latin American countries lost almost all their value

during the 1970s and 1980s.

Money, Price Levels, and Inflation The relationship between money and the national price level (or inflation rate)

follows from the relationship between money supply and money demand. Why do

we “demand,” or hold, money? The key reason is that money is used as a medium of

exchange. People and businesses want to hold a certain amount of money to be able

Chapter 19 What Determines Exchange Rates? 449

pug21774_ch19_433-463.indd 449pug21774_ch19_433-463.indd 449 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

to carry out transactions that require the exchange of money for other items. This

transaction demand varies with the annual turnover of transactions requiring money,

a turnover that is fairly well proxied by the money value of gross domestic product.

The link between domestic product and the demand for a nation’s money is central

to the quantity theory of demand for money. The quantity theory equation says that in a country the money supply is equated with the demand for money, which is

directly proportional to the money value of gross domestic product. In separate equa-

tions for the home country and the rest of the world, the quantity theory equation

becomes a pair:

M s = k • P • Y

and

M s f

= k

f • P

f • Y

where M s and M s

f are the home and foreign money supplies (measured in dollars and

foreign currency, respectively), P and P f are the home and foreign price levels, and

Y and Y f are the real (constant-price) domestic products. For each country, the nominal

or money value of GDP equals the price level times the real GDP (P • Y and P f • Y

f ).

The k and k f indicate the proportional relationships between money holdings and the

nominal value of GDP. They represent people’s behavior. If the value of GDP and thus

the value of transactions increase, k indicates the amount of extra money that people want to hold to facilitate this higher level of economic activity. Sometimes quantity

theorists assume that the ks are constant numbers, sometimes not. (The facts say that any k varies.) For the present long-run analysis, we follow the common presumption that each money supply (M

s and M s

) is controlled by each government’s monetary

policy alone and that each country’s real production (Y and Y f ) is governed by such

supply-side forces as factor supplies, technology, and productivity.

By taking the ratio of these two equations and rearranging the terms, we can use the

quantity theory equations to determine the ratio of prices between countries:

(P/P f ) 5 (M

s / M s

) • (k

f / k) • (Y

f / Y )

Money and PPP Combined Combining the absolute purchasing power parity equation with the quantity theory

equations for the home country and the rest of the world yields a prediction of

exchange rates based on money supplies and national products:

e 5 P/P f 5 (M

s /M s

) • (k

f /k) • (Y

f / Y)

The exchange rate (e) between one foreign currency (say, the British pound) and other currencies (here represented by the dollar, the home currency in our example) can now

be related to just the M s s, the ks, and the Ys. The price ratio (P/P

f ) can be set aside as

an intermediate variable determined, in the long run, by the M s s, ks, and Ys.

The equation predicts that a foreign nation will have an appreciating currency (e up) if it has some combination of slower money supply growth (M

s /M s

up), faster growth

in real output (Y f / Y up), or a rise in the ratio k

f /k. Conversely, a nation with fast money

growth and a stagnant real economy is likely to have a depreciating currency.

450 Part Three Understanding Foreign Exchange

pug21774_ch19_433-463.indd 450pug21774_ch19_433-463.indd 450 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

Going one step further, we can use the same equation to quantify the percent effects

of changes in money supplies or domestic products on the exchange rate. The equation

implies that some key elasticities are equal to 1. That is, if the ratio (k f /k) stays the

same, then e rises by 1 percent for

• each 1 percent rise in the domestic money supply (M s ),

• each 1 percent drop in the foreign money supply ( M s

• each 1 percent drop in domestic real GDP (Y ), or • each 1 percent rise in foreign GDP (Y

f ).

The exchange rate elasticities imply something else that seems reasonable too: An

exchange rate will be unaffected by balanced growth. If money supplies grow at the

same rate in all countries, leaving M s /M s

unchanged, and if domestic products grow at

the same rate, leaving Y f /Y unchanged, there should be no change in the exchange rate.

Changes in the ks would have comparable effects on the exchange rate in the long run, but we choose not to examine these here. Instead, let’s look a little more closely

at the effects of money supply and real income.

The Effect of Money Supplies on an Exchange Rate Let’s look at an example in which Britain is the foreign country and the United States is the

domestic country. If, for instance, the supply of pounds were cut by 10 percent, each pound

would become more scarce and more valuable. The cut would be achieved by a tighter

British monetary policy. This contractionary policy would restrict the reserves of the

British banking system, forcing British banks to tighten credit and the outstanding stock

of sterling bank deposits, which represent most of the British money supply. The tighter

credit would make it harder to borrow and spend, cutting back on aggregate demand,

output, jobs, and product prices in Britain. With the passage of time, the fall in output and

jobs should reverse, and the reduction in prices should reach 10 percent. Over time, relative

PPP predicts that the pound should rise in value. The 10 percent cut in Britain’s money

supply should eventually lead to a 10 percent higher exchange-rate value of the pound.

The same shift should result from a 10 percent rise in the dollar money supply. If

the U.S. central bank lets the dollar money supply rise 10 percent, the extra dollar

money available should end up inflating dollar prices by 10 percent. For a time, the

higher dollar prices might cause international demands for goods and services to

shift in favor of buying the sterling-priced goods, which are temporarily cheaper.

Eventually, relative purchasing power parity should be restored by a 10 percent rise in

the exchange rate (e). One other result predicted above follows as a corollary: If the preceding equations are correct, a balanced 10 percent rise in all money supplies, both

pounds and dollars, should have no effect on the exchange rate.

The Effect of Real Incomes on an Exchange Rate The same kind of reasoning can be used to explore how long-run changes in real

income and production should affect an exchange rate. Let us first follow this

reasoning on its own terms and then add a word of caution.

Suppose that Britain’s real income shifts up to a growth path 10 percent above

the path Britain would otherwise have followed. This might happen, for instance, as

Chapter 19 What Determines Exchange Rates? 451

pug21774_ch19_433-463.indd 451pug21774_ch19_433-463.indd 451 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

a result of a spurt in British productivity. The extra transactions associated with the

higher British production and income would call forth a new demand for holding

pounds. If the extra productivity results in a 10 percent rise in real British national

income, the quantity theory predicts a 10 percent higher transactions demand for the

pound. But this extra demand cannot be met, assuming that Britain’s money stock has

not increased. Instead, the price level must decline in Britain by 10 percent so that the

overall money value of British national income is unchanged. Essentially, in this case

the increase in productivity is passed forward to buyers in the form of lower product

prices. Then, according to relative PPP, the decline in British prices leads to a rise in

the value of the pound. The rise again equals 10 percent. Again, we have two corol-

laries that can be seen from the equations: A 10 percent decline in U.S. real income

should also raise e by 10 percent, and a balanced 10 percent rise in incomes in both Britain and the United States should leave the exchange rate the same.

A caution must be added to this tidy result, however. You can be misled by memo-

rizing a single “effect of income” on the exchange rate. Income is not an independent

force that can simply move by itself. What causes it to change has a great effect on an

exchange rate. In the British productivity example, real income was being raised for

a supply-side reason—Britain’s ability to produce more with its limited resources. It is easy to believe that this would strengthen the pound by using the quantity theory

equation (or by thinking about the extra British exports, made possible by its rising

productivity, as something other countries would need pounds to pay for). But sup-

pose that Britain’s real income is raised by the Keynesian effects of extra government

spending or some other aggregate-demand shift in Britain. This real-income increase might or might not strengthen the pound. If its main effect were to add inflation in

Britain (or to make Britons buy more imports), then there would be reason to believe

that the extra aggregate demand would actually lower the value of the pound.

Since the effects of aggregate demand shifts tend to dominate in the short run, while

supply shifts dominate in the long run, the quantity theory yields the long-run result, the

case in which higher production or income means a higher value of the country’s currency.

To conclude this section, let’s briefly return to the major-currency experience

shown in Figure 19.1. Can we use the monetary approach to understand the long-term

trends in some of the exchange rates shown in this figure? Over the long sweep of the

flexible-exchange-rate era since the early 1970s, we know part of the reason why the

Japanese yen rose: during the years to the early 1990s, Japan’s stronger real economic

growth (growth in Y ), combined with the fact that its money supply did not grow much faster than the average, kept inflation down in Japan and raised the international value

of the yen. The Swiss franc rose because Switzerland kept tight control over its money

supply. The lira sank because Italy’s money supply rose faster than average.

EXCHANGE-RATE OVERSHOOTING

Our view of exchange rates as being determined in the long run by purchasing power

parity, with its emphasis on average rates of inflation over many years, seems quite

removed from the view that exchange rates in the short run are buffeted by rapid shifts

in investors’ portfolio decisions, as we discussed earlier in the chapter. Yet the two

must be related. The short run eventually flows into the long run. We have already

452 Part Three Understanding Foreign Exchange

pug21774_ch19_433-463.indd 452pug21774_ch19_433-463.indd 452 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

mentioned one basis for this flow. International investors form their expectations of

future exchange rates partly on the belief that exchange rates will move toward their

PPP values because eventually the economic fundamentals of money supply, GDP,

and inflation rates become the key determinants of exchange rates.

It is useful to consider this relationship in more depth, to explore the phenomenon

of overshooting. We will see that international investors can react rationally to news by driving the exchange rate past what they know to be its ultimate long-run equilibrium value. The actual exchange rate then moves slowly back to that long-run

rate later on. That is, in the short run the actual exchange rate overshoots its

long-run value and then reverts back toward it.

Figure 19.5 provides an overview of our story about how an exchange rate can over-

shoot its eventual long-run equilibrium value, even if all investors correctly judge the

future equilibrium rate. Suppose that the domestic money supply unexpectedly jumps

10 percent at time t 0 and then resumes the rate of growth investors had already been

expecting. Investors understand that this permanent increase of 10 percent more money

stock should eventually raise the price of foreign exchange by 10 percent if they believe

that purchasing power parity and the monetary approach hold eventually. In the long run,

both the domestic price level (P) and the price of foreign exchange (the exchange rate e) should be 10 percent higher. So, the expected future spot exchange rate increases, with

investors expecting that eventually the future spot exchange rate will be 10 percent higher.

Two realistic side effects of the increase in the domestic money supply intervene

and make the exchange rate take a strange path to its ultimate 10 percent increase:

• Product prices are somewhat sticky in the short run, so considerable time must pass

for domestic inflation to raise domestic prices (P) by 10 percent (relative to foreign prices, P

f ).

• Because prices are sticky at first, the increase in the money supply drives down the

domestic interest rate, both real and nominal.

FIGURE 19.5 Overview of

Key Elements,

Exchange-Rate

Overshooting

Adjustment in the Medium Run

Outcome in the Long RunImmediate Effects

The country’s money supply increases by 10 percent

The country’s interest rate decreases

Expected exchange- rate value of the foreign currency increases

The country’s product prices do not change

Outflow of financial capital from the country

Exchange- rate value of the foreign currency increases by more than the increase expected in the long run

The country’s product prices rise slowly

Exchange- rate value of the foreign currency decreases slowly

The country’s product prices rise by 10 percent

Exchange- rate value of the foreign currency is 10 percent higher than it was before the money supply increase

Chapter 19 What Determines Exchange Rates? 453

pug21774_ch19_433-463.indd 453pug21774_ch19_433-463.indd 453 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

With the domestic interest rate (i) lower, the return differential shifts to favor foreign- currency assets (assuming that the foreign interest rate (i

f ) remains unchanged).

Therefore, at the initial spot exchange rate, the overall return differential actually favors foreign-currency assets for two reasons:

• The foreign currency is expected to appreciate.

• The domestic interest rate has decreased.

The desire by investors to reposition their portfolios toward foreign-currency assets

increases the demand for foreign currency and results in a quick appreciation of the

foreign currency.

By how much will the foreign currency appreciate immediately? On the basis of

only the expected appreciation of the foreign currency by 10 percent, the foreign

currency would appreciate immediately by 10 percent. The decrease in the domestic

interest rate creates additional supply–demand pressure, so the current spot exchange

rate must rise immediately by more than 10 percent. Figure 19.6 shows the time path of the exchange rate, including this immediate

large change and then the adjustment in the medium run toward its new long-run

equilibrium. After the initial jump in the exchange-rate value, the suddenly much

higher spot rate will then slowly decline back toward its expected future value. That

is, the new current spot rate e immediately rises above the new eex so that the foreign currency is then expected to depreciate slowly back toward the new expected rate.

This is necessary to reestablish uncovered interest parity once the current spot rate

adjusts. The domestic return is lower because of the lower domestic interest rate i. After the current spot rate overshoots, the overall return on foreign investments then

also becomes lower. Even though the foreign interest rate (i f ) is unchanged, the overall

expected foreign return is lower because the foreign currency is expected to depreci-

ate from its now high value. Investors must have the prospect of seeing the foreign

currency depreciate later in order to stem their outflow encouraged by relatively high

foreign interest rates.

So, once the news of the extra 10 percent money supply is out, investors will quickly

bid up the spot price of foreign exchange by more than 10 percent (Dornbusch, 1976).

One test by Jeffrey Frankel (1979) suggested that perhaps the announcement of a sur-

prise 10 percent increase in the domestic money supply would trigger a jump of the

spot rate by 12.3 percent, before it begins retreating back to just a 10 percent increase.

Viewed another way, the overshooting is even larger. The exchange rate overshoots

by even more in the short run if we compare the actual exchange rate to the path

implied by PPP for each time period. Because the domestic price level rises only

slowly toward its ultimate 10 percent increase, PPP alone implies that the exchange

rate should rise only gradually toward its 10 percent increase. Thus, in the year or so

after the money supply increase, little of the large increase in the actual spot exchange

rate appears to be consistent with the limited amount of additional domestic inflation

that occurs during that first year.

This case shows how exchange rates can be highly variable in the short run (driven

by the reactions of international financial investors to policy surprises and other news),

while at the same time exchange rates eventually change in the long run in ways con-

sistent with PPP. The case also shows that it can be difficult to identify clearly cases of

454 Part Three Understanding Foreign Exchange

pug21774_ch19_433-463.indd 454pug21774_ch19_433-463.indd 454 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

An unexpected 10 percent increase in the domestic money supply causes

the spot-exchange-rate value of the country’s currency to decline quickly

by more than 10 percent, “overshooting” its eventual long-run value.

Then the country’s currency appreciates slowly until its exchange-rate

value is 10 percent lower than what it was before the unexpected

money-supply increase.

Time

e, the exchange-rate value of foreign currency

e 10% higher

t0: Domestic money supply unexpectedly rises 10%

Original e

FIGURE 19.6 Exchange-

Rate Path,

Exchange-Rate

Overshooting

“destabilizing speculation.” Exchange-rate movements that appear to be extreme and

inconsistent with the economic fundamentals in the short run can be part of a process

that is understandable, reasonable, and stabilizing in the long run.

HOW WELL CAN WE PREDICT EXCHANGE RATES?

We would like to be able to forecast exchange rates. One purpose of having theories

is to predict tendencies in the real world. International experience since the switch to

floating exchange rates in the early 1970s provides a rich data set against which to test

the value of our theories.

How accurate would we want our theories to be in predicting changes in exchange

rates? Clearly we should not expect perfect forecasts. But presumably we would

expect a useful economic model at least to be able to outpredict a naive model that

says the future spot exchange rate is predicted simply to be the same as the current

spot exchange rate. This is a minimal standard. The naive model is equivalent to say-

ing that the spot exchange rate follows a random walk, so we have no ability to pre- dict whether it will go up or down. The predictions of any useful economic structural

model presumably ought to be able to do better than this naive model.

Somewhat to our consternation, there is now general agreement that economic

structural models are generally of no use in predicting exchange rates in the short

Chapter 19 What Determines Exchange Rates? 455

pug21774_ch19_433-463.indd 455pug21774_ch19_433-463.indd 455 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

run (for future periods up to about one year). Frankel and Rose (1995) and Rossi

(2013) survey many studies that use various models based on many different eco-

nomic fundamentals, including money supplies and real incomes, interest rates,

expected inflation rates, and trade and current account balances. They conclude

that structural economic models cannot reliably outpredict the naive alternative of

a random walk for short forecast horizons.

The economic fundamentals stressed by purchasing power parity and the monetary

approach are of some use in forecasting exchange rates farther into the future. There is

value in predicting that some portion of any current deviation of an exchange rate from

its estimated PPP value will be eliminated during the next years. Still, economists

should be humble. Their forecast errors at these longer horizons are still large in an

absolute sense, even though they are smaller than the (even larger) errors from simply

predicting that the future exchange rate will be the same as the current exchange rate.

Why is it so difficult to predict exchange rates using economic models? There

appear to be two parts to the answer.

First, and probably more important, the exchange rate reacts strongly and immedi-

ately to new information. Exactly because news is unexpected, it cannot be incorporated

into any predictions. The reaction to such news often involves large movements in the

exchange rate. Actual exchange-rate movements appear to overshoot movements in

smoothly adjusting long-run equilibrium rates like those from PPP or the monetary

approach. Studies have documented the immediate effects of a variety of different types

of news on exchange rates, although some of these types seem to have power during

some time periods but not others. For instance, the U.S. dollar tends to appreciate when

there are unexpected contractions in the U.S. money supply, unexpected increases in

U.S. interest rates (relative to foreign interest rates), unexpected growth in U.S. real GDP,

unexpected increases in U.S. payroll employment, unexpected improvements in the U.S.

trade or current account balance, and unexpected increases in the U.S. government bud-

get deficit. In addition, casual observation indicates that the exchange rate reacts to new

information concerning both actual events and changes in probabilities about what will

happen, not only for economic variables such as those just mentioned but also for political

variables such as elections, appointments, international tensions, and wars.

The second reason is that exchange-rate expectations can be formed without much

reference to economic fundamentals. Surveys indicate that many foreign exchange

market participants just extrapolate the latest trends up to one month ahead, the

bandwagon effect that we discussed in an earlier section of this chapter. Because the

actions taken by investors can make their expectations self-confirming, recent trends

in exchange rates can be reinforced and persist for a while. If the resulting movement

in the exchange rate appears to be simply inconsistent with any form of economic fun-

damentals, it is called a bubble (or speculative bubble). While it is difficult to identify such bubbles with complete certainty, the final stage of the appreciation of the dollar

against many other currencies in 1984 and early 1985 appears to have been such a

bubble. The strong possibility that bubbles occur in the foreign exchange market from

time to time suggests that there is some economic inefficiency in foreign exchange

markets. You may recall that we reached a similar conclusion at the end of Chapter 18,

when we discussed why estimated deviations from uncovered interest parity appear to

be too large to be explained completely by risk premiums.

456 Part Three Understanding Foreign Exchange

pug21774_ch19_433-463.indd 456pug21774_ch19_433-463.indd 456 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

FOUR WAYS TO MEASURE THE EXCHANGE RATE

In this chapter we have been examining the determinants of spot exchange rates. These

“regular” exchange rates are the ones quoted in the foreign exchange markets and are

technically termed nominal bilateral exchange rates. For a single focus currency like the U.S. dollar, there are actually more than a hundred different spot exchange

rates with (more than a hundred) other currencies. For many purposes we are inter-

ested in only one or a few of these spot exchange rates with specific currencies, so we

can ignore the other spot rates.

For other purposes, including those related to macroeconomic analysis, we are

interested in knowing how the spot exchange-rate value of a country’s currency is

doing overall or on average. Furthermore, we probably do not want a simple aver-

age because some foreign countries are more important than others. Rather, we

want a weighted average of the bilateral spot exchange rates. The weights show the

importance of the other countries. For instance, an analysis of the effect of exchange

rates on the country’s exports and imports suggests using weights based on the coun-

try’s amounts of international trade with the other countries. The weighted-average

spot-exchange-rate value of a country’s currency is called the nominal effective exchange rate. We have already used this idea in the introduction to this chapter, when we discussed the average value of the U.S. dollar against the currencies of other

industrialized countries. In principle, the units used to measure the nominal effective

exchange rate are “average foreign currency units per unit of this country’s currency.”

Because we don’t really have a measure of “average foreign currency units,” the

nominal effective exchange rate is usually measured as an index with some base time

period equal to 100.

Another issue in exchange-rate analysis is the extent to which the actual exchange

rate deviates from PPP. We showed this in Figure 19.4 by comparing the actual

nominal bilateral exchange rates (for the DM and yen) to the values that the nominal

exchange rates would be if they followed relative PPP (as P/P f changed over time).

The deviation from PPP can also be measured using the real exchange rate (RER). By convention, we usually measure the real-exchange-rate value of the domestic currency:

RER t 5

(P t /P

0 ) • (e′

t /e′

0 ) ______________

(P f,t

/P f,0

) • 100

In this formula the use of e′ to indicate the nominal exchange rate reminds us that we are now measuring the spot exchange rate as foreign currency units per unit of domestic currency. (More generally, the formula shows the real-exchange-rate value of the currency that is being priced in the nominal exchange rate (e′), and the product prices (P

t /P

0 ) in the numerator must be those of the country whose currency is being priced.)

We can calculate a real bilateral exchange rate (relative to another specific country) and a real effective exchange rate (as a weighted average relative to a number of other countries).

The real exchange rate has no units, so we measure its value at a time t as an index number relative to a value of 100 in the base time period 0. If relative PPP holds continu-

ously, then the value of the real exchange rate will always be 100. If relative PPP holds in

Chapter 19 What Determines Exchange Rates? 457

pug21774_ch19_433-463.indd 457pug21774_ch19_433-463.indd 457 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

458 Part Three Understanding Foreign Exchange

the long run, then RER will tend to return to (or fluctuate around) the 100 value (assum-

ing that the base year is chosen judiciously). If the actual nominal exchange-rate value

of the currency being priced is above its implied PPP value, then the RER is above 100.

In this case we say the currency is overvalued relative to the PPP standard. If the actual nominal exchange-rate value is below its implied PPP value, then the RER is below 100,

and we say the currency is undervalued relative to PPP. In addition, increases in the RER values over time are called real appreciations; decreases are called real depreciations.

Figure 19.7 shows the nominal effective exchange-rate value of the U.S. dollar and

its real effective exchange-rate value, during 1975–2014, for a broad sample including

37 other countries (18 industrialized and 19 developing countries). We can see that

up to 2002 the dollar tended to appreciate on average on a nominal basis (especially

because the dollar tended to appreciate nominally against the currencies of many

developing countries like Mexico).

The real effective exchange-rate value of the U.S. dollar also fluctuates over time,

but it stays closer to the 100 value. The tendency to return to the 100 value indicates

that relative PPP tends to hold in the long run. Still, the divergences can be rather

large at times, although the scale used in the graph does not show this so clearly.

Effective Exchange Rate (January 1975 � 100)

100

150

200

250

300

350

400

Ja n

1 9 7 5

Ja n

1 9 8 0

Ja n

1 9 8 5

Ja n

1 9 9 0

Ja n

1 9 9 5

Ja n

2 0 0 0

Ja n

2 0 0 5

Ja n

2 0 1 0

Nominal

Real

FIGURE 19.7 Nominal and Real Effective Exchange-Rate Values of the U.S. Dollar, 1975–2014

The nominal effective exchange rate shows the average spot exchange-rate of the U.S. dollar. The dollar

tended to appreciate on average during 1975 to 2002. The real effective exchange-rate value is the average

of real bilateral exchange rates. The real effective exchange rate of the U.S. dollar has fluctuated around a

“neutral” value of about 100, consistent with relative purchasing power parity in the long run.

Source: Federal Reserve Board of Governors.

pug21774_ch19_433-463.indd 458pug21774_ch19_433-463.indd 458 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

Chapter 19 What Determines Exchange Rates? 459

In particular, the dollar went through a large real appreciation (of nearly 50 percent)

during 1980–1985. It then experienced a large real depreciation during the next three

years that left the real exchange value of the dollar back close to its 100 value. During

1995–2002 the dollar again experienced a pronounced real appreciation, this time

about 34 percent. It then fell back to about its 1995 level by early 2008.

Measuring the exchange-rate value of a country’s currency is not as simple as it

sounds. We have four ways to measure and to track the exchange-rate value: nominal

bilateral, nominal effective, real bilateral, and real effective. Each has its uses. For

instance, in a later chapter we will link the real effective exchange rate to the interna-

tional price competitiveness of a country’s products.

Summary This chapter has surveyed what we know (and don’t know) about the determinants of exchange rates. The asset market approach explains exchange rates as being part of the equilibrium for the markets for financial assets denominated in differ-

ent currencies. We gain insights into short-run movements in exchange rates by

using a variant of the asset market approach that focuses on portfolio reposition-

ing by international investors, especially decisions regarding investments in bonds

denominated in different currencies. If uncovered interest parity tends to hold (at

least approximately), then any changes in domestic or foreign interest rates (i and i

f ) or the expected future spot exchange rate (eex) create an uncovered interest dif-

ferential and create pressures for a return toward uncovered interest parity. Focusing

on the pressures on the current spot exchange rate e, the price of foreign currency, it tends to be raised by

• An increase in the interest rate differential (i f –i).

• An increase in the expected future spot exchange rate (eex).

Changes in the expected future spot exchange rate tend to be self-confirming expec-

tations in that the current spot rate tends to change quickly in the direction expected.

Furthermore, there appear to be several types of influences on the expected future spot

exchange rate, including recent trends in the actual spot rate, beliefs that the exchange

rate eventually moves toward its PPP value, and unexpected new information (“news”)

about economic performance or about political situations. The rapid, large reaction

of the current exchange rate to such news as a change in monetary policy is called

overshooting. The current exchange rate changes by much more than would be consistent with long-run equilibrium.

Our understanding of the long-run trends in exchange rates begins with purchasing power parity (PPP). Absolute PPP posits that international competition tends to equalize the home and foreign prices of traded goods and services so that P 5 e • P

overall, where the Ps are price levels in the countries and e is the exchange-rate price of foreign currency. Relative PPP focuses on the product-price inflation rates in two countries and the change in the exchange rate that offsets the inflation-rate differ-

ence. Relative PPP works tolerably well for longer periods of time, say, a decade or

more. Over the long run, a country with a relatively high inflation rate tends to have a

depreciating currency, and a country with a relatively low inflation rate tends to have

an appreciating currency.

pug21774_ch19_433-463.indd 459pug21774_ch19_433-463.indd 459 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

Key Terms Asset market approach to exchange rates

Purchasing power parity

(PPP)

Monetary approach to

exchange rates

Bandwagon

Law of one price

Absolute purchasing power

parity

Relative purchasing power

parity

Quantity theory

equation

Overshooting

Bubble

Nominal bilateral

exchange rate

Nominal effective

exchange rate

Real bilateral exchange

rate

Real effective exchange

rate

The monetary approach seeks to explain exchange rates by focusing on demands and supplies for national moneys because the foreign exchange market is where one

money is traded for another. The transactions demand for a national money can be

expressed as k • P • Y, a behavioral coefficient (k) times the price level (P) times the level of real domestic product (Y ). The equilibrium M

s 5 k • P • Y matches this demand against the national money supply (M

s ), which is controlled by the central bank’s

monetary policy. A similar equilibrium holds in any foreign country: M s f

5 k

f • P

f • Y

f .

Combining the basic monetary equilibriums with PPP yields an equation for pre-

dicting the exchange-rate value of the currency of a foreign country; e 5 (M s/M s

) •

(Y f / Y ) • (k

f /k). Ignoring any changes in the ks, we can use this equation to predict that

the price of foreign currency (e) is raised by

• An increase in the relative size of the money supply (M s/M s

• An increase in the relative size of foreign production (Y f /Y ).

Furthermore, the elasticities of the impact of (M s/M s

) and (Y f /Y ) on e should approxi-

mately equal 1.

We would like to be able to use economic models to predict exchange rates in the

future, but our ability to do so is limited. Economic models provide almost no ability

to predict exchange rates for short periods into the future, say, about a year or less.

This inability is based largely on the importance of unpredictable news as an influence

on short-term exchange rate movements, but it may also reflect the role of expecta-

tions that extrapolate recent trends in the exchange rate, leading to bandwagon effects and (speculative) bubbles. We have some success in predicting exchange-rate movements in the long run. Over long periods, exchange rates tend to move toward

values consistent with such economic fundamentals as relative money supplies and

real incomes (the monetary approach) or, similarly, relative price levels (PPP).

We also presented four ways of measuring the exchange-rate value of a currency. The

nominal bilateral exchange rate is the regular market rate between two currencies. The nominal effective exchange rate is a weighted average of the market rates across a number of foreign currencies. The real bilateral exchange rate incorpo- rates both the market exchange rate and the product price levels for two countries. The

real effective exchange rate is a weighted average of real bilateral exchange rates across a number of foreign countries. A real exchange rate can be used as an indicator of deviations from PPP or as an indicator of a country’s international price competitiveness.

460 Part Three Understanding Foreign Exchange

pug21774_ch19_433-463.indd 460pug21774_ch19_433-463.indd 460 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

Suggested Reading

Frankel and Rose (1995) and Rossi (2013) survey research on the determinants of

exchange rates, including work based on the asset market approach and the monetary

approach. Zettelmeyer (2004), using data on Australia, Canada, and New Zealand, shows

that an unexpected tightening (loosening) of the country’s monetary policy raises (lowers)

domestic interest rates and appreciates (depreciates) the country’s currency. Bjørnland

(2009) offers a similar analysis, which also includes Sweden. Lyons (2001) provides

an overview of a different approach to understanding exchange rates, one that focuses

on actual trading activity. Menkhoff and Taylor (2007) examine the use of technical or

chartist analysis by foreign exchange traders.

Froot and Rogoff (1995) survey a range of tests of purchasing power parity. The

survey by Sarno and Taylor (2002) is more technical.

Questions and Problems

1. “Short-run pressures on market exchange rates result mainly from gradual changes in

flows of international trade in goods and services.” Do you agree or disagree? Why?

2. The following rates currently exist:

Spot exchange rate: $1.000/euro.

Annual interest rate on 180-day euro-denominated bonds: 3%.

Annual interest rate on 180-day U.S. dollar–denominated bonds: 4%.

Investors currently expect the spot exchange rate to be about $1.005/euro in 180 days.

a. Show that uncovered interest parity holds (approximately) at these rates. b. What is likely to be the effect on the spot exchange rate if the interest rate on 180-day

dollar-denominated bonds declines to 3 percent? If the euro interest rate and the expected

future spot rate are unchanged, and if uncovered interest parity is reestablished, what will

the new current spot exchange rate be? Has the dollar appreciated or depreciated?

3. The current rates are:

Spot exchange rate: $2.00/£.

Annual interest rate on 60-day U.S. dollar–denominated bonds: 5%.

Annual interest rate on 60-day pound-denominated bonds: 11%.

Investors currently expect the spot exchange rate to be $1.98/pound in 60 days.

a. Show that uncovered interest parity holds (approximately) at these rates. b. What is likely to be the effect on the spot exchange rate if the interest rate on 60-day

pound-denominated bonds declines to 8 percent? If the dollar interest rate and the

expected future spot rate are unchanged, and if uncovered interest parity is reestab-

lished, what will the new current spot exchange rate be? Has the pound appreciated

or depreciated?

4. You observe the following current rates:

Spot exchange rate: $0.01/yen.

Annual interest rate on 90-day U.S. dollar–denominated bonds: 4%.

Annual interest rate on 90-day yen-denominated bonds: 4%.

a. If uncovered interest parity holds, what spot exchange rate do investors expect to exist in 90 days?

✦

Chapter 19 What Determines Exchange Rates? 461

pug21774_ch19_433-463.indd 461pug21774_ch19_433-463.indd 461 14/11/14 4:39 pm14/11/14 4:39 pm

Final PDF to printer

b. A close U.S. presidential election has just been decided. The candidate whom inter- national investors view as the stronger and more probusiness person won. Because

of this, investors expect the exchange rate to be $0.0095/yen in 90 days. What will

happen in the foreign exchange market?

5. As a foreign exchange trader, how would you react to each of the following news

items as it flashes on your computer screen?

a. Mexico’s oil reserves prove to be much smaller than touted earlier. b. The Social Credit Party wins the national elections in Canada and promises gener-

ous expansion of the supply of money and credit.

c. In a surprise vote the Swiss government passes a law that will result in a large increase in the taxation of interest payments from Switzerland to foreigners.

6. Will the law of one price apply better to gold or to Big Macs? Why?

7. For your next foreign vacation, would it be better to go to a country whose currency

is overvalued relative to PPP or one whose currency is undervalued relative to PPP

(other attractions being equal)?

8. According to PPP and the monetary approach, why did the nominal exchange-rate

value of the DM (relative to the dollar) rise between the early 1970s and the late

1990s? Why did the nominal exchange-rate value of the pound decline?

9. Mexico currently has an annual domestic inflation rate of about 20 percent. Suppose

that Mexico wants to stabilize the floating market exchange-rate value of its currency

(dollars/peso) in a world in which dollar prices are generally rising at 3 percent per year.

What must the rate of inflation of domestic peso prices come down to? If the quantity

theory of money holds with a constant k, and if Mexican real output is growing 6 percent per year, what rate of money growth should the Mexican government try to achieve?

10. To aid in its efforts to get reelected, the current government of a country decides to increase

the growth rate of the domestic money supply by two percentage points. The increased

growth rate becomes “permanent” because once started it is difficult to reverse.

a. According to the monetary approach, how will this affect the long-run trend for the exchange-rate value of the country’s currency?

b. Explain why the nominal exchange-rate trend is affected, referring to PPP.

11. In 1990, the price level for the United States was 100, the price level for Pugelovia

was also 100, and in the foreign exchange market one Pugelovian pnut (pronounced

“p’noot”) was equal to $1. In 2013, the U.S. price level had risen to 260, and the

Pugelovian price level had risen to 390.

a. According to PPP, what should the dollar–pnut exchange rate be in 2013? b. If the actual dollar–pnut exchange rate is $1/pnut in 2013, is the pnut overvalued

or undervalued relative to PPP?

12. Here is further information on the U.S. and Pugelovian economies.

1990 2013

Ms Y P Ms Y P

United States 20,000 800 100 65,000 1,000 260 Pugelovia 10,000 200 100 58,500 300 390

✦

462 Part Three Understanding Foreign Exchange

pug21774_ch19_433-463.indd 462pug21774_ch19_433-463.indd 462 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

a. What is the value of k for the United States in 1990? For Pugelovia? b. Show that the change in price level from 1990 to 2013 for each country is consis-

tent with the quantity theory of money with a constant k.

13. Consider our example of overshooting shown in Figure 19.6, in which the domestic

money supply increased by 10 percent. Assume that the path of slow adjustment of

prices is that the price level rises by about 2 percent per year for five years. What

would the path of the nominal exchange rate be if PPP held for each year? Given the

actual path for the exchange rate shown in Figure 19.6, does PPP hold in the short

run? Does it hold in the long run?

14. A country has had a steady value for its floating exchange rate (stated inversely as the

domestic currency price of foreign currency) for a number of years. The country now

tightens up on (reduces) its money supply dramatically. The country’s product price

level is not immediately affected, but the price level gradually becomes lower (relative

to what it otherwise would have been) during the next several years.

a. Why might the market exchange rate change a lot as this monetary tightening is announced and implemented?

b. What is the path of the market exchange rate likely to be over the next several years? Why?

15. The price levels in Canada and Switzerland were each 110 in 1995, and the nominal spot

rate was 1.5 Swiss francs per Canadian dollar in 1995. The Canadian price level rose to

be 160 in 2005, the Swiss price level rose to be 130 in 2005, and the spot exchange rate

was 1.3 Swiss francs per Canadian dollar in 2005.

Did the Canadian dollar experience a real appreciation or a real depreciation

(relative to the Swiss franc) between 1995 and 2005? (As part of your answer, use a

calculation of the real exchange rate.)

16. Consider an effective exchange rate value of the euro in which the Canadian dollar

gets a weight of 60 percent and the Japanese yen gets a weight of 40 percent. The

nominal bilateral rates change from 2.0 euros per Canadian dollar to 1.9 euros per

Canadian dollar and from 48 yen per euro to 50 yen per euro. Has the nominal effec-

tive exchange-rate value of the euro decreased? (That is, has the euro had a nominal

effective depreciation?)

✦

Chapter 19 What Determines Exchange Rates? 463

pug21774_ch19_433-463.indd 463pug21774_ch19_433-463.indd 463 11/5/14 6:41 PM11/5/14 6:41 PM

Final PDF to printer

Chapter Twenty

Government Policies toward the Foreign Exchange Market Chapters 16 through 19 presented the basic analysis of how currencies are exchanged

and what seems to determine the exchange rate if the determination is left mainly

to market forces. For better or worse, many governments do not usually just let the

private market set the exchange rate. Rather, governments have policies toward the

foreign exchange market in the form of policies toward exchange rates themselves,

policies toward who is allowed to use the market, or both.

Our previous discussion suggests one reason why governments adopt such poli-

cies. Exchange rates, if left to private market forces, sometimes fluctuate a lot. They

are prone to overshoot and may occasionally be influenced by bandwagons among

investors or speculators. Exchange rates are very important prices—they can affect the

entire range of a country’s international transactions. One objective for government

policy, then, can be to reduce variability in exchange rates.

Governments often have other reasons for adopting policies toward the foreign

exchange market. A government may want to keep the exchange-rate value of its cur-

rency low, preventing appreciation or promoting depreciation. This benefits certain

activities or groups in the country, including the country’s exporters and import-

competing businesses. Or, in a different setting, a government may want to do the

opposite: keep the exchange-rate value of its currency high, preventing depreciation or

promoting appreciation. This can benefit other activities or groups—for instance, buy-

ers of imports. It can also be used as part of an effort to reduce domestic inflation by

using the competitive pressure of low import prices. In addition, the government policy

may reflect other, relatively noneconomic goals. The government may believe that it

is defending national honor or encouraging national pride by maintaining a steady

exchange rate or a strong currency internationally. Devaluation or depreciation may

be feared as a confirmation of the ineptitude of the government in selecting policies.

This chapter has three objectives. First, it provides a framework for understand-

ing the range of possible government policies toward the foreign exchange market.

Second, it begins the analysis of these policies, focusing on the economics of official

buying and selling of currencies in the market and the economics of restrictions on

464

pug21774_ch20_464-501.indd 464pug21774_ch20_464-501.indd 464 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

who can use the market. Third, it explores some lessons of history by surveying

exchange-rate systems that have existed during the past 140 years, concluding with a

description of the current system.

TWO ASPECTS: RATE FLEXIBILITY AND RESTRICTIONS ON USE

Government policies toward the foreign exchange market are of two types:

• Those policies that are directly applied to the exchange rate itself.

• Those policies that directly state who may use the foreign exchange market and for

what purposes.

The first type of policy acts directly on price (the exchange rate), while the second

type acts directly on quantity (by limiting some people’s ability to use the foreign

exchange market). We saw this distinction before when we examined tariffs and quo-

tas as two forms of government policies toward imports. As in the case of imports, we

expect that any one policy has impacts on both price and quantity in the market, even

though the policy directly acts on only one of these. A policy toward the exchange

rate affects the quantity of foreign exchange traded in the market (the turnover) and a

policy restricting use has an impact on the exchange rate.

Government policies toward the exchange rate itself are usually categorized

according to the flexibility of the exchange rate—the amount of movement in the

exchange rate that the policy permits. In the simplest terms, governments choose

between floating and fixed exchange rates, although, as we will see, the reality is

often richer than this.

Government policies can also restrict access to the foreign exchange market.

One policy choice is no restriction—everyone is free to use the foreign exchange

market. The country’s currency is fully convertible into foreign currency for all uses, for both trade in goods and services (current account transactions) and

international investment activities (financial account transactions). The other

policy choice is some form of exchange control —the country’s government places some restrictions on use of the foreign exchange market. In the most

extreme form of exchange control, all foreign exchange proceeds (for instance,

proceeds resulting from foreign payments for the country’s exports) must be

turned over to the country’s monetary authority. Anyone wanting to obtain foreign

exchange must request it from the authority, which then determines whether to

approve the request. Less extreme forms of control limit access for some types

of transactions, while permitting free access for other types of transactions.

For instance, in a common form of partial exchange control, the government:

• permits use of the foreign exchange market for all payments for exports and

imports of goods and services (that is, the currency is convertible for current account transactions ) and

• imposes some form of capital controls, by placing limits or requiring approvals for payments related to some (or all) international financial activities.

Chapter 20 Government Policies toward the Foreign Exchange Market 465

pug21774_ch20_464-501.indd 465pug21774_ch20_464-501.indd 465 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

Another example of a less extreme form of restriction is limits on the use of the

foreign exchange market for transactions related to broad types of imports, such as

consumer luxury goods.

FLOATING EXCHANGE RATE

If government policy lets the market determine the exchange rate, the rate is free to

go wherever the market equilibrium is at that time. This policy choice results in a

clean float. Market supply and demand are solely private (nonofficial) activities. As private market supply and demand shift around, the value of the floating exchange rate

changes. A clean float is the polar case of complete flexibility.

Even when the country’s exchange-rate policy is to permit flexibility by floating

the rate, the government often is not willing to simply let the rate go wherever private

supply and demand drive it. Rather, the government often tries to have a direct impact

on the rate through official intervention. That is, the monetary authority enters the foreign exchange market to buy or sell foreign currency (in exchange for domestic

currency). Through this intervention, the government hopes to alter the configuration

of supply and demand, and thus influence the equilibrium value of the exchange

rate—the rate that clears the market. This policy approach—an exchange rate that is

generally floating (or flexible) but with the government willing to intervene to attempt

to influence the market rate—is called a managed float (if you are an optimist about the capabilities of the government) or a dirty float (if you are a pessimist). Often the government is attempting to lean against the wind to moderate movements

in the floating rate. For instance, if the exchange-rate value of the country’s currency

is rising (and that of foreign currency falling), then the authorities intervene to buy

foreign currency (and sell domestic currency). They hope that the intervention and the

extra supply of domestic currency can slow or stop their own currency’s rise in value

(or, correspondingly, that the extra demand for foreign currency can slow or stop its

decline). The actual effectiveness of intervention is controversial, and we will examine

this issue further in Chapter 24. Nonetheless, most governments that choose a floating

exchange-rate policy also do manage, or “dirty,” the float to some extent.

FIXED EXCHANGE RATE

If the government chooses the policy of a fixed exchange rate, then the government

sets the exchange rate that it wants. Often, some flexibility is permitted within a

range, called a band, around this chosen fixed rate, called the par value or central value . Nonetheless, the flexibility is generally more limited than would occur if the government instead permitted a floating rate.

In implementing its choice of a fixed exchange rate, the government actually faces

three specific major questions: To what does the government fix the value of its cur-

rency? When or how often does the country change the value of its fixed rate? How

does the government defend the fixed value against any market pressures pushing

toward some other exchange-rate value?

466 Part Three Understanding Foreign Exchange

pug21774_ch20_464-501.indd 466pug21774_ch20_464-501.indd 466 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

What to Fix To? A fixed rate means that the value of the country’s currency is fixed to something else,

but what is this something else? As we will see later in this chapter, the answer about a

century ago was to fix to gold. If several countries all fix the values of their currencies

to specific amounts of gold, then arbitrage ensures that the exchange rates among the

currencies will also be fixed at the rates implied by their gold values. That is, curren-

cies tied to the same thing (such as gold) are all tied to each other. In principle, any

other commodity or group of commodities could serve the same purpose—the gold

standard is one example of the broader idea of a commodity standard.

The country could choose to fix the value of its currency to some other currency,

rather than to a commodity. Since the end of World War II many countries have often

fixed the value of their currency to the U.S. dollar. Any other single currency can serve

the same purpose.

Or the country could choose to fix the value of its currency not to one other currency

but to the average value of a number of other currencies. Why would a country choose

to fix to such a basket of other currencies? The logic is the same as that of diversifying a portfolio (or not putting all your eggs in one basket). If the country fixes to one single

other currency, then it will ride along with this other currency if the other currency’s

value experiences extreme changes against any third-country currencies. Fixing to a

basket of currencies moderates this effect, in that the average value is kept steady.

What basket of currencies might the country fix to? There is one ready-made

basket—the special drawing right (SDR), a basket of the four major currencies in the world. 1 Or a country can create its own basket. For instance, the country might

be interested in maintaining a steady exchange-rate value to facilitate its international

trade activities. In this case the basket would include the currencies of its major trading

partners, and the importance of these other countries in the basket would be based on

their importance in the country’s trade. In designing its basket in this way, the country

is using the same logic as that used to calculate an effective exchange rate.

No country today fixes its currency to gold or any other commodity. Although we exam-

ine the gold standard later in this chapter, the rest of our fixed-rate discussion presumes

that a country fixes the exchange-rate value of its currency to one or more other currencies.

When to Change the Fixed Rate? Once the country has chosen what to fix to, it establishes a specific value for its cur-

rency in terms of the item chosen. As the government attempts to maintain this fixed

value over time, it faces the question of when to change the fixed rate.

The government may insist that it will never change the fixed rate. A permanently

fixed exchange rate is useful as a polar case—the opposite of a clean float. However,

it is not clear that the government’s commitment is credible. The commitment is not

truly binding—the government has the capability to alter its policy. Most probably,

nothing is fixed forever. On this basis, we often use the term pegged exchange rate

1 As we mentioned in Chapter 16, the SDR is a reserve asset created by the International Monetary Fund (IMF). The IMF periodically adjusts the specific composition of the SDR. As of 2011, one SDR equals the collection of U.S.$0.66 plus 0.423 euro plus 12.1 Japanese yen plus British £0.111. Market exchange rates can then be used to compute the SDR’s value in terms of any specific single currency.

Chapter 20 Government Policies toward the Foreign Exchange Market 467

pug21774_ch20_464-501.indd 467pug21774_ch20_464-501.indd 467 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

in place of fixed exchange rate, in recognition that the government has some ability to move the peg value.

Although the fixed rate may not be fixed forever, the government may try to keep

the value fixed for long periods of time. Nonetheless, in the face of a substantial or

“fundamental” disequilibrium in the country’s international position, the government

may change the pegged-rate value. This approach is called an adjustable peg. In other situations, the government may recognize that a specific pegged-rate

value cannot be maintained for long. For instance, if the country has a relatively high

inflation rate, then an attempt to maintain a pegged rate against the currency of a low-

inflation country will quickly lead to large violations of purchasing power parity and

declining international price competitiveness. Nonetheless, the country may prefer to

maintain some form of pegged exchange rate, perhaps because it believes that a float-

ing exchange rate would be too volatile. The solution chosen by some countries in this

position is a crawling peg. With a crawling peg the peg value is changed often (for instance, monthly) according to a set of indicators or according to the judgment of the

government monetary authority. If indicators are used, the discussion of Chapter 19

suggests one reasonable choice—the difference between the country’s inflation rate

and the inflation rate of the country whose currency it pegs to. If the inflation differ-

ence is used, the nominal pegged rate will track purchasing power parity over time,

and this bilateral real exchange rate will be stabilized. Other indicators that might be

used include the country’s holdings of official international reserve assets (indicat-

ing pressure from the country’s balance of payments), the growth of the country’s

money supply (indicating underlying inflation pressure), or the current actual market

exchange rate relative to the central par value of the pegged rate (indicating, within

the allowable band, the foreign exchange market pressure away from the par value).

In fact, the choice of the width of the allowable band is closely related to the issue of when to change the pegged rate. If the band is larger, then the actual exchange rate

has more room to move around the par value. Market pressures can result in wider

variations in the actual exchange rate, without necessarily forcing the government to

face the decision of whether to change the pegged-rate value.

At this point, it is useful to summarize the main points of our survey. For govern-

ment policies toward the exchange rate itself, we often frame the government deci-

sion as choosing between a floating or a fixed exchange rate. A floating exchange

rate seems to permit substantial flexibility or variability in the actual rate, while a

fixed rate seems to impose strict limits on this variability or flexibility. Although this

proposition is true to a large extent, the reality is also more nuanced.

In a clean float, the rate is purely market-driven, but in a managed float the govern-

ment takes actions such as exchange market intervention to influence the floating rate.

In a heavily managed float, the exchange rate may show little flexibility—it is almost

pegged, even though this is not the way that the government describes its choice.

Even with a fixed rate, much variability or flexibility may still exist for several

reasons. The band around the central pegged rate can be wide, permitting substantial

variability within the band. The exchange-rate value of the country’s currency can also

vary substantially with respect to other currencies that are not involved in the same

type of peg. Furthermore, the government can change the pegged rate, sometimes

frequently, as in a crawling peg.

468 Part Three Understanding Foreign Exchange

pug21774_ch20_464-501.indd 468pug21774_ch20_464-501.indd 468 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

The polar cases of a clean float and a permanently fixed exchange rate are useful in order to contrast the implications of a country’s choice of exchange-rate policy. At the

same time we must remember that in reality there is more of a continuum in which the country permits more or less flexibility in the movements of the exchange-rate value of the country’s currency. A full analysis of a specific country requires examination of

the true nature of government policy toward the exchange rate.

Defending a Fixed Exchange Rate The third major question confronting a country that has chosen a fixed exchange rate

is how to defend its fixed rate. The pressures of private (or nonofficial) supply and

demand in the foreign exchange market may sometimes drive the exchange rate toward

values that are not within the permissible band around the par value. The government

then must use some means to defend the pegged rate—to keep the actual exchange rate

within the band.

How does the government defend the fixed rate that it has announced? There are

four basic ways:

1. The government can intervene in the foreign exchange market, buying or selling

foreign currency in exchange for domestic currency, to maintain or influence the

actual exchange rate in the market.

2. The government can impose some form of exchange control to maintain or influ-

ence the exchange rate by constricting demand or supply in the market. (A closely

related approach would use trade controls such as tariffs or quotas to attempt to

accomplish this result.)

3. The government can alter domestic interest rates to influence short-term capital

flows, thus maintaining or influencing the exchange rate by shifting the supply–

demand position in the market.

4. The government can adjust the country’s whole macroeconomic position to make it

“fit” the chosen fixed exchange-rate value. Macroeconomic adjustments driven by

changes in fiscal or monetary policy can alter the supply–demand position in the

foreign exchange market, for instance, by adjusting export capabilities, the demand

for imports, or international capital flows.

We should also remember that there is a fifth option for the country—to surrender

rather than defend:

5. The country can alter its fixed rate (devaluing or revaluing its currency) or switch

to a floating exchange rate (in which case the currency usually will immediately

depreciate or appreciate).

The four ways of defending a fixed rate are not mutually exclusive—a country

can use several methods at the same time. Indeed, they are often closely interrelated.

For instance, changing interest rates to influence short-term capital flows relates to

overall macroeconomic management. In the next two sections of this chapter, we turn

to a closer examination of the first two options: intervention and exchange control.

Chapters 22–25 explore the broader implications of the country’s foreign exchange

policies for the whole national economy.

Chapter 20 Government Policies toward the Foreign Exchange Market 469

pug21774_ch20_464-501.indd 469pug21774_ch20_464-501.indd 469 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

DEFENSE THROUGH OFFICIAL INTERVENTION

In defending a fixed exchange rate, the country’s first line of defense is usually official

intervention in the foreign exchange market. This is the defense that we introduced

in Chapter 17, and we can now examine it in more depth. For much of our discussion

in the first parts of this section, we will examine a country that has chosen to peg its

currency to the U.S. dollar. We state the spot exchange rate value ( e ) as units of this country’s currency per dollar. (The exchange rate stated this way is directly pricing the

U.S. dollar, which is now considered the “foreign” currency.)

Defending against Depreciation Consider first the case in which the pressure from private (or nonofficial) supply and

demand in the foreign exchange market is attempting to drive the exchange rate above

the top of its allowable band—the country’s currency is tending toward depreciation.

For instance, say that this is a Latin American country that is attempting to maintain

a fixed rate of 25 pesos per dollar, with a band of plus or minus 4 percent (plus or

minus 1 peso). As shown in Figure 20.1 , nonofficial supply and demand are attempt-

ing to push the exchange rate to 28 pesos per dollar, the intersection where the market

would clear on its own. If the country’s monetary authority is committed to defending

the fixed rate within its band using intervention, then the authority must enter into

the foreign exchange market in its official role. It must sell dollars and buy domestic

currency. To keep the currency in the allowable band, it must sell 3 billion dollars into

the foreign exchange market at the rate of 26 pesos per dollar (the top of the band), so

it is buying 78 billion pesos from the foreign exchange market.

We can also see how this intervention is reflected in the country’s balance of pay-

ments. The relatively strong demand for dollars is generally related to strong demand

by the country for purchases of foreign goods, services, and (nonofficial) financial

FIGURE 20.1 Intervention

to Defend a

Fixed Rate:

Preventing

Depreciation of

the Country’s

Currency

To prevent the market exchange rate from piercing through the

top of the allowable band, the country’s central bank must sell

3 billion dollars at the exchange rate of 26 pesos per dollar.

$ (billions)

Exchange rate (pesos per $)

28 26 25 24

2320

Allowable band

Official par value � 25

470 Part Three Understanding Foreign Exchange

pug21774_ch20_464-501.indd 470pug21774_ch20_464-501.indd 470 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

FIGURE 20.2 Official

Holdings of

Reserve Assets,

End of Year,

1970–2012

(Billions of U.S.

Dollars)

Source: International Monetary Fund,

Annual Report, various years.

1970 1980 1990 2000 2012

Foreign exchange assets 45 381 806 1,935 10,950 Special drawing rights 3 15 28 24 294 Reserve position in the IMF 8 22 32 62 159 Gold 40 573 345 261 1,517 (millions of ounces) (1,057) (953) (940) (952) (912) Total reserve assets 96 991 1,211 2,282 12,920

Most official reserves are held as foreign exchange assets. The two reserve assets provided by the

IMF are relatively minor. For official holdings of gold, the amount (ounces) decreased somewhat in

the 1970s and again in the 2000s, but most of the variation in the value of official gold holdings is

driven by changes in the dollar price of gold (here measured as the London market price).

assets (relative to the demand by foreigners for this country’s goods, services, and

nonofficial financial assets). This results in an official settlements balance deficit if

the country’s monetary authority intervenes to defend the fixed rate. The intervention

provides the foreign exchange for the country to buy more (in total value) from for-

eigners than it is selling to them (for goods, services, and nonofficial financial assets).

Through intervention the monetary authority is financing the country’s deficit in its official settlement balance .

Where does the country’s monetary authority get the dollars to sell into the foreign

exchange market? This Latin American country cannot just create U.S. dollars. Rather,

the authority either uses its own official international reserve assets (or some other similar government assets) to obtain dollars from some foreign source, most likely

the U.S. monetary authority (the Federal Reserve), or it borrows the dollars . Let’s examine each of these.

There are four major components to a country’s official reserve assets: the coun-

try’s holdings of foreign exchange assets denominated in the major currencies of

the world, the country’s reserve position with the International Monetary Fund, the

country’s holdings of special drawing rights, and the country’s holdings of gold. To

indicate the magnitudes, Figure 20.2 provides information on world holdings of offi-

cial reserve assets.

As Figure 20.2 shows, total world holdings of official reserve assets have grown

rapidly, and their composition has changed. In 1980 gold (measured at its market

price) was over half of world official reserves, but then official holdings of foreign

exchange assets grew rapidly. By 2012 foreign exchange assets were about 85 percent

of world official reserves. These foreign exchange assets are mostly safe, highly liquid,

interest-earning debt securities such as government bonds. Of these foreign exchange

assets, close to two-thirds are U.S. dollar–denominated assets and almost one-fourth

are euro-denominated assets. (There are also small amounts of assets denominated in

British pounds, Japanese yen, and a few other currencies.)

If our Latin American country has official reserves in the form of dollar-

denominated foreign-currency assets, it can sell these assets to obtain dollars that can

then be used in its intervention. If the asset is denominated in some other major cur-

rency (such as euros or yen), the currency must be exchanged for dollars, and this can

easily be accomplished because the other currency is readily traded.

Chapter 20 Government Policies toward the Foreign Exchange Market 471

pug21774_ch20_464-501.indd 471pug21774_ch20_464-501.indd 471 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

If our country has a reserve position in the IMF, then it can obtain dollars from the

IMF on request. If the country is holding SDRs, then it can use these SDRs to obtain

dollars from the U.S. monetary authority or from the IMF. The SDRs actually act as

a line of credit permitting the country to borrow dollars, and SDRs are counted as

reserves because the country can automatically draw on this line. If the country has

gold, then it can sell gold to obtain dollars, but officials today almost never use gold

sales to obtain foreign currency.

In addition to using its reserve assets to obtain dollars, the country’s monetary

authority can borrow dollars. It may be able to borrow dollars (or other major cur-

rencies) from the monetary authorities of other countries. Some countries maintain

arrangements called swap lines with each other to facilitate this type of official bor- rowing. The monetary authority also may be able to borrow dollars from private—that

is, nonofficial—sources. Sometimes these borrowings are disguised to keep them

secret from other participants in the foreign exchange market.

These borrowings usually are considered to be different from normal transactions

in official international reserves because the country may not have “automatic” access

to dollars through borrowings—the lender must be willing to make the loan. There

is, however, a special case, the case of a country (like the United States) whose cur-

rency is readily held by the monetary authorities of other countries. If the country’s

currency is a reserve currency, then the country can effectively borrow through official channels by issuing assets that will be held as reserves by the central banks

of other countries. Specifically, this has allowed the United States to run what French

economist Jacques Rueff called deficits without tears . The United States, especially in the 1950s and 1960s, was given extraordinary leeway to finance its deficits. Needless

to say, this option is probably not available to the Latin American country that was the

focus of our previous example.

What is the implication of the other part of the intervention, that the country’s

monetary authority is buying domestic currency from the foreign exchange market?

In buying domestic currency, the country’s monetary authority is removing domestic

currency from the economy. This will tend to reduce the domestic money supply

unless the authority separately takes another action (called sterilization ) to restore the domestic money back into the economy. If the authority does take action to pre-

vent the domestic money supply from changing, then the authority is relying only on

intervention to defend the fixed rate. This is called sterilized intervention. If the monetary authority instead allows the intervention to reduce the money sup-

ply, then we have a clear interrelationship with two of the other defense methods. The

change in the domestic money supply is likely to alter domestic interest rates, and these

changes are likely to influence the entire macroeconomy of the country (including the

country’s price level). 2 We will examine these broader issues in depth in Chapters 23–25.

Defending against Appreciation Consider now the case in which the pressure from private (or nonofficial) supply and

demand in the foreign exchange market is attempting to drive the exchange rate, the

2 The intervention may also change the foreign country’s money supply as the monetary authority sells foreign currency, but we usually do not focus much on this effect.

472 Part Three Understanding Foreign Exchange

pug21774_ch20_464-501.indd 472pug21774_ch20_464-501.indd 472 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

FIGURE 20.3 Intervention to

Defend a Fixed

Rate: Preventing

Appreciation of

the Country’s

Currency

$ (billions)

Exchange rate (locals per $)

105 100 95

1816

Official par value 5 100

Allowable band

To prevent the market exchange rate from falling through the

bottom of the allowable band, the country’s central bank must

buy 2 billion dollars at the exchange rate of 95 locals per dollar.

price of foreign currency, below the bottom of its allowable band—the country’s cur-

rency is tending toward appreciation. For instance, say that this is an Asian country

attempting to maintain a fixed rate of 100 “locals” per dollar, with a band of plus or

minus 5 percent (plus or minus 5 locals). As shown in Figure 20.3 , nonofficial sup-

ply and demand are attempting to push the exchange rate to 85 locals per dollar, the

intersection where the market would clear on its own. If the country’s monetary author-

ity is committed to defending the fixed rate within its band using intervention, then

the authority must enter into the foreign exchange market in its official role. It must

buy dollars and sell domestic currency. To keep the currency in the band, it must buy

2 billion dollars from the foreign exchange market at the rate of 95 locals per dollar (the

bottom of the band), so it is selling 190 billion locals into the foreign exchange market.

The relatively strong demand for locals is generally related to relatively strong

demand by foreigners for the country’s goods, services, and (nonofficial) financial

assets. This results in an official settlements balance surplus if the country’s mon- etary authority intervenes to defend the fixed rate. The intervention provides the local

currency for the foreigners to buy more from the country than they are selling to the

country (for goods, services, and nonofficial financial assets).

What does the country’s monetary authority do with the dollars that it obtains from

the foreign exchange market? It adds these dollars to its official international reserve

holdings (or, if appropriate, repays prior official borrowings of dollars). Most likely,

the authority will use the dollars to obtain U.S.-dollar-denominated foreign exchange

assets, probably U.S. government bonds. The country’s holdings of official reserve assets increase . Note that this case is closely related to the idea of a U.S. “deficit with- out tears.” A U.S. deficit is a surplus for some other countries. If the other countries

want to prevent an appreciation of their currencies, they may intervene to buy dollars.

In the process, the United States finances its own official settlements deficit by issuing

financial assets that other countries hold as their reserves.

Chapter 20 Government Policies toward the Foreign Exchange Market 473

pug21774_ch20_464-501.indd 473pug21774_ch20_464-501.indd 473 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

What is the implication of the other part of the intervention, that the country’s

monetary authority is selling domestic currency into the foreign exchange market?

This will expand the domestic money supply unless the authority separately sterilizes by taking another action to remove the additional domestic money from the economy.

If the monetary authority does not (fully) sterilize, so that the domestic money supply

does increase, then domestic interest rates and the entire macroeconomy of the coun-

try are likely to be affected.

Temporary Disequilibrium A major issue for the use of intervention to defend a fixed exchange rate is the length

of time for which the intervention must continue. How long will the gap between non-

official supply and demand at the edge of the band persist? That is, how long will the

imbalance in the official settlements balance persist at this exchange rate?

If imbalances are clearly temporary, then defending the fixed exchange rate purely

through intervention can work and makes sense. In this case the monetary authorities

can finance a succession of deficits and surpluses indefinitely. In fact, we can make a

case that financing temporary deficits and surpluses is better than letting the exchange

rate float around.

Consider, for example, a situation in which Canada maintains a fixed exchange rate

with its major trading partner, Britain. The exchange rate ( e ) is in Canadian dollars per pound, the price of foreign currency if our home country is Canada. Figure 20.4

gives an example of a successful and socially desirable financing of temporary sur-

pluses and deficits with a fixed exchange rate. We have imagined that the temporary

FIGURE 20.4 A Successful

Financing of

Temporary

Deficits and

Surpluses at a

Fixed Exchange

Rate

£ (billions)

Exchange rate ($ per £)

1.80

1.60

1.40

S£

Spring– summer

D£

5040 60

C D E

S£

Autumn– winter

Autumn and winter: The monetary authority buys

DE 5 £10 billion in foreign exchange. Spring and summer: The monetary authority sells CD 5 £10 billion in foreign exchange. Such official

intervention increases well-being over the

full cycle by area ACD plus area BDE .

474 Part Three Understanding Foreign Exchange

pug21774_ch20_464-501.indd 474pug21774_ch20_464-501.indd 474 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

fluctuations in the balance of payments and the foreign exchange market arise from

something predictable, such as a seasonal pattern in foreign exchange receipts, with

Canada exporting more and earning more foreign exchange (£) during the autumn–

winter harvest season than during the nonharvest spring–summer season. To help

the example along, let us assume that it is costly for producers of the export crop

to refrain from selling it during the harvest season and that something also prevents

private investors or speculators from stepping in and performing the equilibrating

function being assigned to government officials here. If the officials did not finance

the temporary imbalances, the exchange rate would drop to $1.40 at point B in the harvest season, when the nation had a lot of exports to sell, and it would rise to $1.80

in the off-season. In this instance there is some economic loss because it would be

better if the people who wanted foreign exchange to keep up imports during the

off-season did not have to pay $1.80 for foreign exchange that is readily available

for only $1.40 during the harvest season. The officials can avoid this economic loss

by stabilizing the price at $1.60. Their stabilization is made possible because they

have somehow picked the correct price, $1.60, the one at which they can sell exactly

as much foreign exchange during one season as they buy during the other, exactly

breaking even while stabilizing the price.

The official financing of spring–summer deficits with autumn–winter foreign

exchange reserves brings a net social gain to the world. This gain arises from the fact

that the monetary authority gave a net supply of foreign exchange at $1.60 to people

who would have been willing to pay up to $1.80 a pound during the spring–summer

season, while also buying at $1.60 the same amount of foreign exchange from people

who would have been willing to sell it for as little as $1.40. The net social gain is

measured as the sum of areas ACD and BDE (or about $1 billion a year). In this case, official intervention was successful and superior to letting the exchange rate find its

own equilibrium in each season.

For intervention to finance temporary disequilibriums to be the correct policy

option, some stringent conditions must be met. First, it must be the case that private

speculators do not see, or cannot take advantage of, the opportunity to buy foreign

exchange in the fall and winter, invest it for a few months, and then sell it in the

spring and summer. If private parties could do this, their own actions would bring

the exchange rate close to $1.60 throughout the year, and there would be no need for

official intervention.

It is also crucial that the officials correctly predict the future demand and supply

for foreign exchange and that they predict what would be an equilibrium path for the

exchange rate in the absence of their intervention. If they do not forecast correctly,

their attempt to finance a deficit or a surplus at a fixed exchange rate can be costly

because their accumulation of official reserves at some times will not balance against

their loss of reserves at other times.

Disequilibrium That Is Not Temporary What happens if the disequilibrium that results in an imbalance in the country’s

official settlements balance is not temporary? Rather, what if the disequilibrium is

ongoing or fundamental ? For a country that defends its fixed rate using intervention, the country’s monetary authority is continually losing reserves (or borrowing foreign

Chapter 20 Government Policies toward the Foreign Exchange Market 475

pug21774_ch20_464-501.indd 475pug21774_ch20_464-501.indd 475 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

exchange) if the imbalance is a deficit, or it is continually accumulating reserves if the

imbalance is a surplus.

If the domestic currency is facing pressure toward depreciation because of an ongoing deficit, the authority must continually intervene to sell foreign currency . Eventually its official reserves will run low, as will its ability to borrow foreign curren-

cies. Furthermore, its problems can worsen if private investors and speculators observe

its reserve losses and begin to bet heavily that the currency must be devalued. A one- way speculative gamble exists. As investors and speculators sell domestic currency and buy foreign currency, the gap that must be filled by official intervention widens,

hastening the loss of reserves. As the country loses reserves, it also loses the ability

to defend the fixed rate by intervention alone. It must shift to one of the other three

defenses or surrender (devalue).

To see some of the economic costs of intervening to finance a “temporary” dis-

equilibrium that turns out to be a fundamental disequilibrium, consider a stunning

example of a failed defense of a currency—the depreciation of the Mexican peso in

late 1994. The Mexican monetary authority was using a heavily managed “float” to

effectively peg the Mexican currency at about 3.5 pesos per dollar. They were inter-

vening to defend this value, and their holdings of official reserves declined from nearly

$30 billion to about $6 billion during 1994. With their reserves so low, on December 20,

1994, they were forced to surrender, and the peso declined by about one-third, to

about 5 pesos per dollar by year-end. They lost billions of dollars of taxpayers’ money.

Having bought pesos at about $0.29 per peso, they subsequently had to sell pesos at

a much lower dollar value to buy dollars in order to rebuild their official reserves.

Buying high and selling low is a formula for large losses.

If, in the opposite case, the domestic currency is facing pressure toward appreciation because of an ongoing surplus, the authority must continually intervene to buy foreign currency . The country eventually accumulates large international reserves. These even- tually may be viewed as too large by the country itself for several reasons. First, the

basic rate of return on this form of national wealth tends to be low, given the types of

low-interest investments that are usually chosen for international reserve assets. Second,

the value of foreign exchange assets will decline if the country eventually must “retreat”

by revaluing its own currency (which devalues foreign currency). Furthermore, these

reserves may be viewed as too large by other countries because some other countries

are running deficits if this country is running a surplus and building its reserve holdings.

A recent example of a large buildup of official reserve assets is China, as we

discussed in Chapter 1. With the yuan fixed to the U.S. dollar since the mid-1990s,

China had official settlements surpluses, and these surpluses became large beginning

in 2001. To defend the fixed exchange rate, China’s monetary authorities intervened

continually in the foreign exchange market to buy dollars and sell yuan. China’s hold-

ings of foreign exchange reserve assets more than quadrupled from the end of 2000

to mid-2005. The overall payments surpluses did not appear to be temporary and

soon to be reversed. The Chinese government came under strong political pressure,

especially from the United States and the European Union, to revalue its currency. In

July 2005 the Chinese government instituted a small revaluation of the yuan, and then

allowed the yuan to appreciate gradually for three years. After keeping the exchange

value of the yuan steady from July 2008 to June 2010, the Chinese government then

476 Part Three Understanding Foreign Exchange

pug21774_ch20_464-501.indd 476pug21774_ch20_464-501.indd 476 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

again gradually appreciated the yuan relative to the dollar. Throughout, the overall

payments surpluses continued, and China’s monetary authorities continued to inter-

vene (buying dollars and selling yuan). By early 2014, the Chinese government had

amassed $4 trillion of official reserves.

The intervention and the accumulation of official reserves expose the Chinese gov-

ernment to the risk of the same kind of currency losses as the Mexican government

sustained in 1994. The difference is that the Chinese government officials will be

stuck holding foreign currency that is worth less than they paid for it (the depreciating dollars), whereas the Mexican officials ended up holding less-valuable domestic cur-

rency. With the gradual appreciation of the yuan since 2005, the Chinese government

has already experienced some losses on its official reserve holdings of U.S. dollar–

denominated assets. The market and political pressures continue for more appreciation

of the yuan. To the extent that the yuan’s value eventually rises by a large amount

against the dollar, the Chinese government will incur much larger losses.

These experiences do not prove that it is futile to try to keep exchange rates fixed.

They do prove that, when the existing official exchange rate is becoming a disequi-

librium exchange rate for the long run, trying to ride out the storm with interven-

tion alone is costly. Something must be added. Fundamental disequilibrium calls for adjustment, not merely financing . However, it is not easy for officials to judge what constitutes fundamental disequilibrium. We are left with the knowledge that a

fundamental disequilibrium is one that is too great and/or too enduring to be financed,

but we have no clear way of identifying one until after it has happened.

EXCHANGE CONTROL

Among the options for defending a fixed exchange rate, one (exchange control) can

be indicated as socially inferior to the others. Oddly enough, exchange controls are

widely used. According to compilations of official policies done by the International

Monetary Fund, in 2012, 56 countries, all developing countries, had fairly compre-

hensive exchange control policies in place, controls that included requirements to sur-

render export proceeds and restrictions on international portfolio investments. A large

number of other countries had more limited forms of exchange control in place. For

instance, about 35 other countries had substantial controls on financial transactions. A

number of these countries are responding to persistent deficits in their external pay-

ments by defending a fixed exchange rate with elaborate government controls restrict-

ing the ability of their residents to buy foreign goods or services, to travel abroad, or

to invest abroad.

Exchange controls are closely analogous to quantitative restrictions (quotas) on

imports, already analyzed in Chapter 9. In fact, the analogy with import quotas fits

very well, so well that the basic economics of exchange controls is simply the econom-

ics of import quotas expanded to cover imports of IOUs (investing abroad) and tourist

services as well as imports of ordinary products. In Chapter 9, we demonstrated that an

import quota is at least as bad as an import tariff using a one-dollar, one-vote analysis

of changes in well-being. So it is with exchange controls as well: They are at least as

damaging as a uniform tax on all foreign transactions, and probably they are worse.

Chapter 20 Government Policies toward the Foreign Exchange Market 477

pug21774_ch20_464-501.indd 477pug21774_ch20_464-501.indd 477 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

FIGURE 20.5 The Best of the

Worst: Welfare

Losses from

Well-Managed

Exchange

Controls

£ (billions)

Exchange rate ($ per £)

1.20

1.00

D£

30 63.350

S£ 1.50

F B

The exchange control limits the foreign currency

available to 30 billion pounds, the amount that is

earned by the country’s exporters at the exchange

rate of $1.00 per pound. Even if only those who

value the foreign currency most highly (at $1.50 or

more per pound) get it, the country suffers a loss of

well-being of area CEA .

To show the economic case against exchange controls, it is useful to start with an

oversimplified view of exchange controls that is almost certain to underestimate the

social losses coming from real-world controls. Figure 20.5 sketches the effects of a

system of binding comprehensive exchange control that is about as well managed and

benign as we can imagine. Figure 20.5 imagines that the U.S. government has become

committed to maintaining a fixed exchange rate that officially values foreign curren-

cies less, and the dollar more, than would a free-market equilibrium rate. This official

rate is $1.00 for the pound sterling, with similar subequilibrium rates for other foreign

currencies. The exchange control laws require exporters to turn over all their revenues

from foreign buyers to the U.S. government. The U.S. government, in turn, gives them

$1.00 in domestic bank deposits for each pound sterling they have earned by selling

abroad. At this exchange rate, exporters are earning, and releasing to authorities, only

£30 billion per month. This figure is well below the £63.3 billion per month that

residents of the United States want to buy at this exchange rate to purchase foreign

goods, services, and assets. If the U.S. government is committed to the $1.00 rate, yet

is not willing to intervene or to contract the whole U.S. economy enough to make the

demand and supply for foreign exchange match at $1.00, then it must ration the right

to buy foreign exchange.

Let us imagine that the U.S. officials ration foreign exchange in a sound but

seldom-tried way. Every month they announce that it is time for another public

auction-by-Internet. On January 21, they announce that anyone wanting sterling (or

any other foreign currency) for March must send in bids by February 15. A family

that plans to be in England in March could submit a form pledging its willingness to

478 Part Three Understanding Foreign Exchange

pug21774_ch20_464-501.indd 478pug21774_ch20_464-501.indd 478 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

pay up to $3 per pound for 700 pounds to spend in England and its willingness to pay

$2.50 per pound for 1,000 pounds. An importer of automobiles would also submit a

schedule of amounts of foreign currencies she wishes to buy at each exchange rate in

order to buy cars abroad. Receiving all these bids, the government’s computers would

rank them by the prices willingly pledged, and the totals pledged would be added up at

each price, thus revealing the demand curve D £ in Figure 20.5. The government would

announce on February 20 that the price of $1.50 per pound was the price that made

demand match the available £30 billion. The family who wants to be in England for

March would thus get £1,000 by paying $1,500 5 £1,000 3 $1.50 to the government. All who were willing to pay $1.50 or more for each pound would receive the pounds

they applied for, at the price of only $1.50 a pound, even if they had agreed to pay

more. Anyone who did not submit bids with prices as high as $1.50 would be denied

the right to buy pounds during March.

This system would give the government a large amount of revenues earned from

the exchange control auctions. Collecting $1.50/£ 3 £30 billion 5 $45 billion while paying exporters only $1.00/£ 3 £30 billion 5 $30 billion, the government would make a net profit of $15 billion, minus its administrative costs. This government profit

could be returned to the general public either as a cut in other kinds of taxes or as

extra government spending. Area GCAF in Figure 20.5 represents these auction profits taken from importers but returned to the rest of society, and it does not constitute a net

gain or loss for society as a whole.

The exchange control just described does impose a loss of well-being on society as a whole, however. This loss is measured by the area CEA . To see why, remember the interpretation of demand and supply curves as marginal benefit and marginal cost

curves. When the exchange controls are in effect and only £30 billion is available,

some mutually profitable trades are being prohibited. At point C , the demand curve is telling us that some American is willing to pay $1.50 for an extra pound. At point A , the supply curve is telling us that somebody else, either a U.S. exporter or her custom-

ers, would be willing to provide an extra pound per year for $1.00. Yet the exchange

controls prevent these two groups from getting together to split the $0.50 of net gain

in a marketplace for pounds. Thus, the vertical distance AC 5 $0.50 shows the social loss from not being able to trade freely another pound. Similarly, each extra vertical

gap between the demand curve and the supply curve out to point E also adds to the measure of something lost because the exchange controls hamper private transactions.

All these net losses add up to area CEA (£5 billion). Actual exchange control regimes are likely to have several other effects and costs.

First, in practice, governments usually do not hold public foreign-currency auctions.

Instead, they allocate the right to buy foreign currency at the low official rate accord-

ing to more complicated rules. To get the right to buy foreign currency, we must

go through involved application procedures to show that the purpose of the foreign

purchase qualifies it for a favored-treatment category. Importing inputs for factories

that would otherwise have to remain idle and underutilized is one purpose that often

qualifies for priority access to foreign exchange, over less crucial inputs, imports of

luxury consumer goods, or acquisition of private foreign bank deposits. One differ-

ence between actual exchange controls and our hypothetical one is that the actual

controls often incur greater administrative costs to enforce the controls, as well as

Chapter 20 Government Policies toward the Foreign Exchange Market 479

pug21774_ch20_464-501.indd 479pug21774_ch20_464-501.indd 479 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

greater private resource costs in dealing with them. Another difference is that some lower-valued uses may be approved in place of higher-valued uses . The government is not necessarily serving the demanders toward the top of the demand curve. For both

of these reasons the net loss is larger than area CEA. Second, another effect of exchange controls—efforts to evade them—is predictable.

People are frustrated when they are not allowed to buy foreign exchange, even though

they are willing to pay more than the recipients of foreign exchange will get from the

government when these holders sell their foreign currency. The frustrated demanders

will then look for other ways to obtain foreign exchange. One way is to bribe the gov- ernment functionaries in charge of determining the official approvals. Another is to offer more to the recipients of foreign exchange than the government is offering, thus

making it worthwhile for the recipients to “sell direct,” in violation of the exchange

controls. In this way a second foreign exchange market—a parallel market, or black market—develops as a way for private demanders and sellers of foreign exchange

to evade the exchange controls. Parallel markets exist in most countries that have

exchange controls. The degree to which users of these illegal markets are punished

varies widely. Some countries ignore violations of the exchange control, while others

impose death penalties. If you visit a country that has exchange controls, be sure

that you know the penalties before you use the parallel market. Your effort to take

advantage of free-market economics might make you decidedly unfree. 3

The costs of actual exchange controls are generally great enough to raise the ques-

tion of what good purpose they are intended to serve. Because controls can be used

to defend a fixed rate, we might imagine that they reduce economic uncertainty by

holding fixed the external value of the national currency. Yet they are unlikely to help

reduce uncertainty if they leave individual firms and households in doubt as to whether

they will be allowed to obtain foreign exchange at the official price. Controls are likely

to appeal mainly to government officials as a device for increasing their discretionary

power over the allocation of resources. Controls undeniably have this effect. A chari-

table interpretation is that the extra power makes it easier for government officials to

achieve social goals through comprehensive planning. A less charitable interpretation,

consistent with the facts, is that officials see in exchange controls an opportunity for

personal power and its lucrative exercise. In addition, the emergence of parallel markets

or other methods to evade the controls calls into question their true effectiveness.

INTERNATIONAL CURRENCY EXPERIENCE

The first part of this chapter has laid out a framework for describing government

policies toward the foreign exchange market and has examined some of the econom-

ics of official intervention and exchange control. The rest of the chapter surveys the

3 In a number of countries the government itself creates two or more foreign exchange markets and rates—a dual- or multiple-exchange-rate system. Each rate applies to transactions of a specific type. For instance, a dual-rate system might have one rate for current transactions and another rate for financial transactions. In 2012, 24 developing countries had some form of dual- or multiple-exchange-rate system. As part of this type of policy, some form of exchange control is needed to direct each transaction to its appropriate rate. Again, the system creates incentives for evasion. For instance, transactions may be disguised to qualify for a more favorable rate.

480 Part Three Understanding Foreign Exchange

pug21774_ch20_464-501.indd 480pug21774_ch20_464-501.indd 480 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

historical experience of actual government policies since the establishment of a nearly

worldwide gold standard over a century ago. It reports some lessons learned from

that experience. The history leads into a description of the current system (or perhaps

“nonsystem”) in the final section of the chapter.

The Gold Standard Era, 1870–1914 (One Version of Fixed Rates) Ever since 1914, the prewar gold standard has been the object of considerable nostal-

gia. In the decades after World War I, government officials in many countries believed

that the experience of the gold standard proved the desirability of a fixed-exchange-

rate system. Among scholars too, the “success” of the gold standard has been widely

accepted and research has focused on why, not whether, it worked so well. The international gold standard emerged by 1870 with the help of historical

accidents centering on Britain. Britain tied the pound sterling ever more closely to

gold than to silver from the late 17th century on, in part because Britain’s official

gold–silver value ratio was more favorable to gold than were the ratios of other

countries, causing arbitrageurs to ship gold to Britain and silver from Britain. The link between the pound sterling and gold proved crucial. Britain’s rise to primacy

in industrialization and world trade in the 19th century enhanced the prestige of the

metal tied to the currency of this leading country. Also, Britain had the advantage

of not being invaded in wars, which further strengthened its image as the model of

financial security and prudence. The prestige of gold was raised further by another

lucky accident. The waves of gold discoveries both in the middle of the 19th century

(California, Australia) and at the end of the century (South Africa, the Klondike)

were small enough not to make gold suddenly too abundant to be a standard for

international value. The silver-mining expansion of the 1870s and 1880s, by contrast,

yielded too much silver, causing its value to plummet. Through such accidents, the

gold standard, in which each national currency was fixed in gold content, remained

intact from about 1870 until World War I.

Under the gold standard each country’s government fixed its currency to a speci-

fied quantity of gold. The government also freely permitted individuals to exchange

domestic currency for gold and to export and import gold. Through gold arbitrage

the exchange rates between currencies then remained within a band (whose width

reflected the transactions costs of gold movements between countries). Furthermore,

changes in the government’s gold holdings were linked to changes in the country’s

money supply—and thus to the country’s average price level, its inflation rate, and

other aspects of its macroeconomic performance.

The actual functioning of the gold standard was not this simple. Indeed, the

process of actual payments adjustment under the prevailing fixed exchange rates

puzzled Frank Taussig and his Harvard students after World War I. They found that

international gold flows seemed to eliminate themselves very quickly, too quickly for

their possible effects on national money supplies to change incomes, prices, and the

balance of payments. The puzzle was heightened by the postwar finding of Arthur I.

Bloomfield that central banks had done little to adjust their national economies to

their exchange rates before 1914. Far from speeding up the economy’s adjustment

to payment surpluses or deficits, prewar central banks, similar to their successors in

Chapter 20 Government Policies toward the Foreign Exchange Market 481

pug21774_ch20_464-501.indd 481pug21774_ch20_464-501.indd 481 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

the interwar period, offset (sterilized) external reserve flows in the majority of cases,

so that their national money supplies did not change much. What, then, actually kept

the prewar balance of payments in line?

First, it must be noted that most countries were able to run payments surpluses

before 1914, raising their holdings of gold and foreign exchange. This removed the

cost of adjustment to fixed exchange rates because surplus countries were under little

pressure to adjust. Widespread surpluses were made possible by, aside from the slow

accumulation of newly mined gold in official vaults, the willingness and ability of

Britain—and Germany to a lesser extent—to let the rest of the world hold growing

amounts of its monetary liabilities. Between 1900 and 1913, for example, Britain ran

payments deficits that were at least as large in relation to official (Bank of England)

gold reserves as the deficits that caused so much hand-wringing in the United States

in the 1960s. In fact, it would have been impossible for Britain to honor even one-third

of its liquid liabilities to foreigners in 1913 by paying out official gold reserves. The

gold standard was thus helped along considerably by the ability of the key-currency

country to give the rest of the world liquid IOUs whose buildup nobody minded—or

even measured.

There were times, of course, when Britain was called on to halt outflows of gold

reserves that were more conspicuous than the unknown rise in its financial liabilities.

The Bank of England showed an impressive ability to halt gold outflows within a

few months, faster than it could have if it had needed to contract the whole British

economy to improve the balance of payments. It appears that higher British interest

rates, resulting from monetary tightening by the Bank of England, were capable of

calling in large volumes of short-term capital from abroad, even when central banks in

other countries raised their interest rates by the same percentage. This command over

short-term capital seems to have been linked to London’s being the financial center

for the world’s money markets. As the main short-term international lender (as well as

borrower), London could contract the whole world’s money supply in the short run if

and when the Bank of England ordered private banks in London to do so. In this way,

the prewar gold standard combined overall surplus for most countries with short-run

defensive strength on the part of the main deficit country.

In retrospect, it is clear that the success of the gold standard is explained partly by

the tranquility of the prewar era. The world economy was not subjected to shocks as

severe as World Wars I and II, the Great Depression of the 1930s, and the OPEC oil

price shocks of 1973–1974 and 1979–1980. The gold standard looked successful, in part, because it was not put to a severe worldwide test .

The prewar gold standard seemed to succeed for one other reason: “Success” was leniently defined in those days. Central banks were responsible only for fixing the gold exchange-rate value of the currency. Before World War I public opinion did not hold

central bankers (or government officials) responsible for fighting unemployment or

stabilizing prices. This easy assignment shielded officials from the policy dilemmas

between defending a fixed exchange rate and stabilizing the domestic economy, which

will be discussed in Chapter 23.

The pre-1914 tranquility also allowed some countries to have favorable experi- ences with flexible exchange rates. Several countries abandoned fixed exchange rates and gold convertibility in short-run crises. Britain itself did so during the Napoleonic

482 Part Three Understanding Foreign Exchange

pug21774_ch20_464-501.indd 482pug21774_ch20_464-501.indd 482 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

FIGURE 20.6 Selected

Exchange Rates,

1860–1913 $5.00

64 68 72 76 80 84 88 92 961860 1903–131900

4.00 3.00

2.00

1.00

.50

.238

.193

Value of this currency in gold $ (U.S. or Canadian) (ratio scale)

Italian lira Lira

FrancFrench and Belgian franc German mark

U.S. greenback dollar

Japanese yen

Yen Peso

Argentine paper peso

British pound sterling ($4.86656)

Sources: The data are annual averages of market exchange rates, except for the rates on the greenback dollar from 1862 through 1872, which are monthly averages for every third month. The Argentine paper peso rates are the John H. Williams gold premiums cited in

Alec G. Ford, The Gold Standard, 1880–1914: Great Britain and Argentina (Oxford: Clarendon, 1962), p. 139. The Italian series is from Istituto Centrale di Statistica, Sommario di Statistiche Storiche Italiane, 1861–1955 (Rome, 1958), p. 166. The gold value of the paper Japanese yen was calculated using the midrange New York dollar value of the metal-backed yen (Bank of Japan, Statistics

Department, Hundred Year Statistics of the Japanese Economy [Tokyo, 1966], p. 318) and the average price of silver in paper yen for the period 1877–1886 (Henry Rosovsky, “Japan’s Transition to Modern Economic Growth, 1868–1885,” in Industrialization in Two Systems, ed. Henry Rosovsky [New York: Wiley, 1966], pp. 129 and 136). The U.S. greenback dollar series is the W. C. Mitchell series cited in Don C. Barrett, The Greenback and Resumption of Specie Payments, 1862–1879 (Cambridge, Mass.: Harvard University Press, 1931, pp. 96–98). The virtually fixed rates are available in the Economist for prewar years.

Wars. Faced with heavy wartime financial needs, Britain suspended convertibility of

the pound sterling into gold and let the pound drop by as much as 30 percent in value

by 1813, restoring official gold convertibility after the wars. Other countries repeated

the experience, as shown for selected countries in Figure 20.6 . During the American

Civil War, the North found itself unable to maintain the gold value of the paper dollar,

given the tremendous need to print dollars to finance the war effort. The newly issued

greenback dollars had dropped in value by more than 60 percent as of 1864, before

beginning a long, slow climb back to gold parity in 1879 (accompanied by a substan-

tial deflation of U.S. product prices). Heavy short-run financial needs also drove other

countries off gold parity. War was the proximate culprit in the cases of Italy, Russia,

and Austria-Hungary.

This experience with fixed and flexible exchange rates reveals some patterns. Most

countries that abandoned fixed exchange rates did so in a context of growing payments

deficits and reserve outflows. Note that in Figure 20.6 the end of fixed exchange rates

was accompanied by a drop in the value of the national currency. This drop shows

indirectly that the fixed-rate gold standard imposed strain mostly on countries that were in payments deficit situations, not on countries in surplus. Indeed, countries in surplus found it easy to continue accumulating reserves with a fixed exchange rate.

Chapter 20 Government Policies toward the Foreign Exchange Market 483

pug21774_ch20_464-501.indd 483pug21774_ch20_464-501.indd 483 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

In general, the pre-1914 experiences with flexible exchange rates did not reveal

any tendency toward destabilizing speculation. For the most part, the exchange-rate

fluctuations did not represent wide departures from the exchange rate we would

have predicted, given the movements in price indexes. Two possible exceptions

relate to the U.S. greenback dollar and the Russian ruble. In 1864, the greenback

dollar fell in value 49 percent between April and July, even though the wholesale

price index rose less than 15 percent, suggesting that speculation greatly acceler-

ated the drop in the greenback, which then promptly rebounded. Similarly, in 1888,

political rumors caused a dive in the thinly marketed Russian ruble. With the excep-

tion of these two possible cases of destabilizing speculation, it appears that flexible

rates were quite stable in the prewar setting, given the political events that forced

governments to try them out.

Interwar Instability If the gold standard era before 1914 has been viewed as the classic example of inter-

national monetary soundness, the interwar period has played the part of a nightmare

that officials were determined to avoid repeating. Payments balances and exchange

rates gyrated chaotically in response to two great shocks: World War I and the Great

Depression. Figure 20.7 plots the exchange-rate history of the interwar period. The chaos

was concentrated into two periods: the first few years after World War I (1919–1923)

and the currency crisis in the depths of the Great Depression (1931–1934).

After World War I the European countries had to struggle with a legacy of inflation

and political instability. Their currencies had become inconvertible during the war and

their rates of inflation were much higher than that experienced in the United States, the

new financial leader. In this setting, Britain made the fateful decision to return to its

prewar gold parity, achieving this rate by April 1925. Although the decision has been

defended as a moral obligation and as a sound attempt to restore international confi-

dence as well as Britain’s role at the center of a reviving world economy, the hindsight

consensus is that bringing the pound back up to $4.86656 was a serious mistake. It

appears to have caused considerable unemployment and stagnation in traded-goods

industries, as theory would predict, because the high real exchange-rate value of the

pound corresponded to a loss of international price competitiveness.

France, Italy, and some other European countries chose a more inflationary route for

complicated political reasons. A succession of French revolving-door governments was

unable to cut government spending or raise taxes to shut off large budgetary deficits

that had to be financed largely by printing new money. Something similar happened in

Italy, both before and immediately after the 1922 coup d’état that brought Mussolini

to power. The ultimate in inflation, however, was experienced by Germany, where the

money supply, prices, and cost of foreign exchange all rose more than a trillionfold in

1922–1923. Money became totally worthless, and by late 1923 not even a wheelbar-

rowful of paper money could buy a week’s groceries. The mark had to be reissued in

a new series equal to the prewar dollar value, with old marks forever unredeemable.

The early 1930s brought another breakdown of international currency relations.

The financial community, already stunned by the early postwar chaos and the Wall

Street collapse, became justifiably jittery about bank deposits and currencies as the

Depression spread. The failure of the reputable Creditanstalt bank in Austria caused

484 Part Three Understanding Foreign Exchange

pug21774_ch20_464-501.indd 484pug21774_ch20_464-501.indd 484 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

*March 1933–February 1934: The United States raises the price of gold from $20.67 per ounce to $35

per ounce.

$5.00

20 22 24 26 28 30 32 34 361913 1938

2.00

1.00

.50

.20

.10

.05

.01

Value of this currency in U.S.$ (ratio scale)

Italian lira

German mark

Japanese yen

Canadian dollar

British pound sterling

French franc

German mark

FIGURE 20.7 Selected

Exchange

Rates, 1913,

1919–1938

(Monthly)

Source: U.S. Federal Reserve Board,

Board of Governors,

Banking and Monetary Statistics (Washington, D.C., 1943).

a run on German banks and on the mark because Germany had lent heavily to Austria.

The panic soon led to an attack on the pound sterling, which had been perennially

weak and was now compromised by Britain’s making heavy loans to the collapsing

Germans. On September 19, 1931, Britain abandoned the gold standard it had cham-

pioned, letting the pound sink to its equilibrium market value. Between early 1933

and early 1934, the United States followed suit and let the dollar drop in gold value

as President Franklin D. Roosevelt and his advisers manipulated the price of gold in

an attempt to create jobs. Other countries also used devaluations, tariffs, and other

trade restrictions to boost domestic employment. Such beggar-thy-neighbor policies (intended to benefit a country’s economy at the expense of other countries) were

widespread and probably added to worldwide depression (beggared almost everyone)

as international trade shrank rapidly in the early 1930s.

What lessons does the interwar experience hold for policymakers? During

World War II, expert opinion seemed to be that the interwar experience called for a

Chapter 20 Government Policies toward the Foreign Exchange Market 485

pug21774_ch20_464-501.indd 485pug21774_ch20_464-501.indd 485 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

compromise between fixed and flexible exchange rates, with emphasis on the former.

Ragnar Nurkse, in his book International Currency Experience, written for the League of Nations in 1944, argued, with some qualifying disclaimers, that the interwar experi-

ence showed the instability of flexible exchange rates. Figure 20.7 adds some evidence

to his premise: Exchange rates did indeed move more sharply during the interwar era

than at any other time before the 1970s.

Yet subsequent studies have shown that a closer look at the interwar experience

reveals the opposite lesson: The interwar experience shows the futility of trying to keep exchange rates fixed in the face of severe shocks and the necessity of turning to flexible rates to cushion some of the international shocks.

There is now general agreement that the working of the interwar gold standard

contributed to the global spread of the Depression and made it more severe. In the late

1920s and early 1930s, the United States and France accumulated well over half the

world’s gold reserves, but they did not allow their domestic money supplies to increase.

Instead, other countries, such as Britain, had to tighten their monetary policies to limit

gold outflows. The pressure toward worldwide deflationary policies helped turn a

recession into a nearly global depression. Then when Britain left the gold standard in

1931, the U.S. government responded by raising interest rates by 2 percentage points,

to deter conversions of dollars into gold. With inappropriate contractionary monetary

policy and widespread bank failures in the United States, the Depression deepened. As

political pressure intensified to pursue other goals, like reducing domestic unemploy-

ment, central banks eventually gave up their defense of fixed rates. The gold standard

ended, but not before much damage had been done.

Studies have also shown that, even during the unstable interwar era, speculation

tended to be stabilizing—it was domestic monetary and fiscal policy that was destabi-

lizing. This revisionist conclusion began to emerge from studies of Britain’s fluctuat-

ing rates between 1919 and 1925. Both Leland Yeager and S. C. Tsiang found that the

pound sterling fluctuated in ways that are easily explained by the effects of differential

inflation on the trade balance. Relative to the exchange-rate movements that would

be predicted by the purchasing power parity theory of the equilibrium exchange rate

(see Chapter 19), the actual movements stayed close to the long-run trend. The cases

in which Figure 20.7 shows rapid drops in currency values were cases in which the

runaway expansion of the national money supply made this inevitable under any

exchange-rate regime. This was true of France up until 1926; it was even more true,

of course, of the German hyperinflation.

Closer looks at the currency instability of the early 1930s suggest a similar conclu-

sion. The pound sterling, the yen, and other currencies dropped rapidly in 1931–1932

due to the gaping disequilibrium built into the fixed-exchange-rate system by the

Depression (and, for Japan, by the invasion of Manchuria). Once fixed rates were

abandoned, flexible rates merely reflected, rather than worsened, the varying health

of national economies.

The Bretton Woods Era, 1944–1971 (Adjustable Pegged Rates) Meeting at the Bretton Woods resort in New Hampshire in 1944, the monetary leaders

of the Allied powers had an opportunity to design a better system. Everyone agreed

that the system needed reform. The United States dominated the Bretton Woods

486 Part Three Understanding Foreign Exchange

pug21774_ch20_464-501.indd 486pug21774_ch20_464-501.indd 486 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

Global Governance The International Monetary Fund

Chapter 20 Government Policies toward the Foreign Exchange Market 487

At the 1944 Bretton Woods conference, the gov- ernments of the 45 countries fashioned the Articles of Agreement for a new global monetary institu- tion, the International Monetary Fund (IMF). The IMF began operating in 1946, and its membership has grown to 188 countries in 2014.

The IMF is owned by its member country governments. On joining the IMF, each member country contributes resources, called the country’s quota . One-quarter of these contributed resources are assets generally recognized as official interna- tional reserves, and the other three-quarters are its own currency. The size of the quota is roughly related to the country’s economic size, and the size of the quota determines the country’s voting rights. The United States has about 17 percent of the voting rights, so the U.S. government has a veto power over certain decisions that require an 85 percent majority, especially amendments to the Articles of Agreement. Periodically the sizes of the quotas are increased to expand the IMF’s financial resources. The IMF also can borrow from some of its members, and it receives voluntary contributions from some.

The IMF has several interlocking purposes. It promotes international monetary coopera- tion and the expansion of international trade among its members. It seeks to maintain orderly foreign exchange arrangements and to avoid com- petitive exchange-rate depreciations. It seeks to establish unrestricted convertibility of currencies for current account payments. And the IMF can make temporary loans to its members to provide time for them to correct international payments imbalances. Here we will look at the IMF’s activities outside of its role as a lender to governments. A box in the next chapter examines IMF lending in depth.

ORDERLY FOREIGN EXCHANGE ARRANGEMENTS The IMF’s priorities and key activities have changed over time, as the international financial system has evolved. Initially, the IMF monitored the Bretton Woods system of fixed exchange rates, and it had

to approve if a country wanted to make a large devaluation or revaluation of the fixed rate for its currency. The IMF judged if the change was neces- sary and if it was of suitable magnitude to correct the fundamental disequilibrium.

With the demise of the Bretton Woods sys- tem of fixed exchange rates in the early 1970s, and the shift to the current “nonsystem” in which each country can set its own exchange- rate policies, the IMF had to search for a new way to pursue the objective of orderly exchange arrangements. The IMF has enunciated principles, including avoiding excessive exchange-rate volatil- ity, refraining from manipulating exchange rates to prevent adjustment of the balance of payments or to gain unfair trade advantages, and avoiding ongoing exchange-rate misalignment that results from continual large official interventions in the foreign exchange market in one direction over a long period of time. To encourage compliance with these principles, the IMF conducts surveil- lance to monitor and to examine each member country’s exchange-rate policies and its macroeco- nomic policies. However, the power of the IMF is limited. It can advise and recommend, but it can- not force a country to change its policies. There is no formal dispute system. Noncompliance could result in the IMF refusing to lend to a country, but many countries do not need to borrow and expect never to need to borrow from the IMF.

CURRENT ACCOUNT CONVERTIBILITY In the aftermath of World War II, most countries had exchange controls on nearly all foreign transactions, so that international trade was inhibited. The IMF prodded countries to free up restrictions on foreign exchange transactions related to international trade and other current account transactions. By the early 1960s most industrialized countries had removed restric- tions and achieved current account convertibility . A number of developing countries still have restrictions on current transactions, but the global trend is toward liberalization.

—Continued on next page

pug21774_ch20_464-501.indd 487pug21774_ch20_464-501.indd 487 27/11/14 6:41 pm27/11/14 6:41 pm

Final PDF to printer

OTHER ACTIVITIES Over time the IMF has taken on other activities. First, concerns about insufficient growth of the world’s international reserve assets in the 1960s led the IMF to create Special Drawing Rights, described earlier in the chapter. The IMF made allocations that totaled 21 billion SDRs to its members in 1970–1972 and 1979–1981, and then allocations of another 183 billion SDRs in 2009. Even with the large 2009 allocations, the SDR is still only about 2 percent of the world’s official international reserves (as shown in Figure 20.2).

Second, as a part of its role to promote inter- national monetary cooperation, the IMF collects and publishes a broad range of national economic and financial data, presented in ways that make comparisons across countries easier. It also reports on and analyzes global economic trends and out- look, as well as global economic policy issues. Third, the IMF provides technical assistance and training in macroeconomic and financial sector policies, especially to government officials from low-income countries, as well as, in the 1990s, to officials from countries that were in transition from communism.

conference, just as it dominated the world economy and the world’s gold reserves

at the time. America wanted something like fixed exchange rates. Indeed, all leaders

sought to get close to the virtuous fixed-exchange-rate case sketched in Figure 20.4. If

only there were enough reserves to tide countries over temporary disequilibriums, and

if only countries followed policies that made all disequilibriums temporary, we could

capture those welfare gains from successful stabilization.

Two expert economists, John Maynard Keynes of Britain and Harry Dexter White

of the United States, came up with workable plans to give the world a new central bank

that would allow deficit countries enough reserves to ride out their temporary deficits.

The grand design was fully fixed exchange rates defended by government interven-

tion, with international reserves sufficient to permit defense by deficit countries.

Keynes’s plan also called for explicit automatic pressures on national governments

running both surpluses and deficits to change their macroeconomic policies to serve

the goal of balanced international payments.

In the end, however, the United States, Britain, and other governments could not

accept the grand design. The Americans balked at putting billions of dollars at the

disposal of other governments and at having to inflate the American economy just

because it had a balance-of-payments surplus (as was then expected). Seeing the lim-

its to what the Americans were prepared to give raised the fears of Britain and others

about how they could adjust to their likely balance-of-payments deficits. In exchange,

they insisted on the right to resort to devaluations and exchange controls when deficits

threatened to persist.

The resulting compromise was what we have come to call the Bretton Woods system. Its central feature was the adjustable peg, which called for a fixed exchange rate and temporary financing out of international reserves unless a country’s balance

of payments was seen to be in “fundamental disequilibrium.” A country in that condi-

tion might then change its “fixed” exchange rate to a new official par value that looked

sustainable. The International Monetary Fund (IMF) was created as the global institution that promotes international monetary stability and lends reserves to member

488 Part Three Understanding Foreign Exchange

pug21774_ch20_464-501.indd 488pug21774_ch20_464-501.indd 488 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

countries to finance temporary deficits. (The box “The International Monetary Fund”

provides more information on the IMF and its activities.) The IMF is something

like the global central bank that Keynes and White tried to design. Its resources and

prerogatives, however, were more limited than Keynes and White envisioned. Also

limited was the international community’s ability to bend nations’ macroeconomic

policies to keep their international payments in line.

After the immediate postwar exchange-rate adjustments, which were completed by

about 1950, the Bretton Woods system looked remarkably successful for almost two

decades. Countries grew rapidly and unemployment stayed low. Most exchange rates

stayed fixed for long time periods, as shown in Figure 20.8 .

The strong economic growth probably contributed more to the look of success for monetary institutions than they contributed to the strong growth. The good growth climate was consistent with flexible exchange rates, too, to judge from the Canadian experi-

ence of managed floating during 1950–1962. As shown in Figure 20.8, the U.S. dollar–

Canadian dollar exchange rate showed rather little movement. By itself this does

not prove that the Canadian experience was one in which flexible rates worked well.

However, detailed studies of Canada’s floating rate have borne out this inference.

Statistical analysis suggests that, if the exchange rate on the Canadian dollar had any

effect on financial movements, this effect was in the stabilizing direction; that is, a

lower value of the Canadian dollar tended to cause greater net capital inflows into

Canada, as though investors expected the Canadian dollar to rise more when it was at

FIGURE 20.8 Selected

Exchange Rates,

1950–1975

(Monthly)

Sources: For 1950–1956, Board

of Governors of the

Federal Reserve

System, Banking and Monetary Statistics, 1941–1970 (Washington, D.C.,

1976); for 1957–1975,

International Monetary

Fund, International Financial Statistics.

Index of the exchange value of this currency, in U.S.$ (January 1970 � 100)

100

110

120

130

140

150

160

170

180

Ja n

1 9 5 0

Ja n

1 9 5 5

Ja n

1 9 6 0

Ja n

1 9 6 5

Ja n

1 9 7 0

Ja n

1 9 7 5

French franc

Canadian dollar

Italian lira

West German mark (DM)

Japanese yen

Swiss franc

British pound

Chapter 20 Government Policies toward the Foreign Exchange Market 489

pug21774_ch20_464-501.indd 489pug21774_ch20_464-501.indd 489 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

low levels. Other studies have confirmed that fluctuations in the exchange value of the

Canadian dollar were no greater than we would have predicted by following move-

ments in the relative U.S. and Canadian prices of traded goods. In this stable economic

environment, the floating rate of the Canadian dollar was well behaved and almost as

stable as the fixed rates of other currencies.

The One-Way Speculative Gamble The postwar experience with adjustable pegged rates recorded only rare changes in

exchange rates among major currencies up to 1971, as Figure 20.8 suggests. Yet the

adjustable-peg system revealed a new pattern in private speculation, one that caused

a great deal of official consternation. As the world economy grew, so did the volume

of internationally mobile private funds. The new system of pegged but adjustable

exchange rates spurred private speculators to attack currencies that were “in trouble.”

The adjustable-peg system then gave private speculators a one-way speculative gamble. It was always clear from the context whether a currency was in danger of being devalued or revalued. In the case of a devaluation-suspect currency, such as the

pound sterling in the mid-1960s, the astute private speculator knew that the currency

could not rise significantly in value. She thus had little to lose by selling the currency

in the spot (or forward) market. If the currency did not drop in value, she had lost noth-

ing but a slight gap between the domestic interest rate and the foreign interest rate (or

between the forward rate and the spot rate), but if she was right and the currency was

devalued, it might be devalued by a large percentage over a single weekend, bringing

her a handsome return. In this situation, private speculators would gang up on a cur-

rency that was moving into a crisis phase.

This pattern of speculation under the adjustable-peg system meant serious difficul-

ties for any government or central bank that was trying to cure a payments disequi-

librium without adjusting the peg. A classic illustration of these difficulties was the

attempt of Harold Wilson’s Labor government to keep the pound worth $2.80 between

1964 and November 1967. When Wilson took office, he found that Britain’s trade and

payments balances were even worse than previous official figures had admitted. His

government used numerous devices to make the pound worth $2.80: tighter exchange

controls; higher interest rates; selective tax hikes; promises to cut government spend-

ing; and massive loans from the IMF, the United States, and other governments.

Speculators who, in increasing number, doubted Britain’s ability to shore up the pound

were castigated by the chancellor of the Exchequer as “gnomes of Zurich.” Yet, in the

end, all of the belt-tightening and all of the support loans worked no better than had

the attempt to make the pound worth $4.86656 from 1925 to 1931. On November 18,

1967, Britain devalued the pound by 14.3 percent, to $2.40. The gnomes had won

handsomely. Those who had, for instance, been selling sterling forward at prices like

$2.67 just before the devaluation were able to buy the same sterling at about $2.40,

pocketing the 27 cents difference. The British government and its taxpayers lost a

similar difference, by paying close to $2.80 to buy sterling that they had to concede

was worth only $2.40 after November 18.

The existence of the one-way speculative gamble seems to make the adjustable

peg of the Bretton Woods system look less sustainable than either purely fixed rates

or purely flexible rates. If speculators believe that the government is willing to turn

490 Part Three Understanding Foreign Exchange

pug21774_ch20_464-501.indd 490pug21774_ch20_464-501.indd 490 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

the entire economy inside out to defend the exchange rate, then they will not attack

the exchange rate. Britain could have made speculators believe in $2.80 in the mid-

1960s if it had shown its determination to slash the money supply and contract British

incomes and jobs until $2.80 was truly an equilibrium rate. But as the speculators

realized, few postwar governments are prepared to pay such national costs in the name

of truly fixed exchange rates. Alternatively, the speculators might have been more cau-

tious in betting against sterling if the exchange rate had been a floating equilibrium

rate. With the float, speculators face a two-way gamble. Because the current spot

exchange rate is an equilibrium rate and not an artificial official disequilibrium rate,

the actual exchange rate in the future could turn out to be higher or lower than the

current spot rate or the rate that speculators expect in the future.

Although the speculative attacks on an adjustable-pegged rate are certainly unsettling

to officials, it is not clear that they should be called destabilizing. If the official defense of a currency is primarily just a way to postpone an inevitable devaluation and not a way

to raise the equilibrium value of the currency, then it could be said that the speculative

attack is stabilizing in the sense that it hastens the transition to a new equilibrium rate.

Whether it performs this stabilizing function is uncertain, however. Officials may be

induced to overreact to the speculative attack and to overdevalue the pegged rate.

The Dollar Crisis The postwar growth of the international economy led to a crisis involving the key cur-

rency of the system, the U.S. dollar. Under the Bretton Woods system, other countries

effectively pegged their currencies to the U.S. dollar. The dollar became the major

reserve currency, and the U.S. government was committed to exchanging the dollars

held as reserves by other countries’ monetary authorities for gold at an official price

of $35 per ounce. (The system is sometimes described as a gold-exchange standard. ) As the European and Japanese economies recovered from the war, and as their

firms gained in competitive ability relative to that of U.S. firms, the U.S. payments

position shifted into large official settlements balance deficits. In part, those deficits

represented the fact that the monetary authorities of other countries wanted to run

surpluses to increase their international reserves as international transactions generally

grew rapidly. After a time, however, the deficits became a source of official concern in

Europe and Japan. More and more dollars ended up in official hands. Something like

this had happened in 1914, when other countries accumulated growing official reserves

of sterling. In the postwar setting, however, few governments felt that they could be as

relaxed about the gold backing of the U.S. dollar as the rest of the world had felt about

the link between gold and Britain’s pound before 1914. U.S. gold reserves dwindled

as France led the march to Fort Knox (actually, the basement of the New York Federal

Reserve Bank), demanding gold for dollar claims. It became questionable whether the

U.S. dollar was worth as much gold as the official gold price implied.

In this situation, the United States had the option of shrinking the U.S. economy

until foreign central banks were constrained to supply gold to the United States to

pay for U.S. exports. Other alternatives were tight exchange controls and devaluing

the dollar in terms of gold. Exchange controls were tried to a limited extent (in the

form of the Interest Equalization Tax on lending abroad, the “Voluntary” Foreign

Credit Restraint Program, and the like), but these controls ran counter to the official

Chapter 20 Government Policies toward the Foreign Exchange Market 491

pug21774_ch20_464-501.indd 491pug21774_ch20_464-501.indd 491 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

U.S. stance of encouraging free mobility of capital between countries. Devaluation of

the dollar in terms of gold would have marked up the dollar value of U.S. gold reserves

but also would have brought politically distasteful windfall gains to the Soviet Union

and South Africa (the two major gold producers).

Faced with these choices under the existing international rules, the United States

opted for changing the rules. On March 17, 1968, a seven-country meeting hastily

called by the United States announced the “two-tier” gold price system. The private

price of gold in London, Zurich, and other markets was now free to fluctuate in

response to supply and demand. The official price for transactions among the seven

agreeing governments would still be $35 an ounce. Nonetheless, the U.S. overall pay-

ments deficits continued and had to be financed by increasing sales of U.S. foreign

exchange reserves. Eventually, the United States would have to adjust, by restraining

its economy, imposing exchange controls, or changing the international monetary

rules. Again, the United States chose to change the rules.

In August 1971, President Nixon suspended convertibility of dollars into gold,

effectively severing the official gold–dollar price link. He also imposed a 10 percent

temporary additional tariff on all imports coming into the United States, to remain

in place until other countries agreed to revalue their currencies against the dollar (so

that the dollar was similarly devalued). Most major currencies then floated against the

dollar until December 1971, when the Smithsonian Agreement attempted to patch the

system back together. Under this agreement the DM was revalued by about 17 percent,

the yen by about 13 percent, and other currencies by smaller percentages, overall cre-

ating an effective devaluation of the dollar of close to 10 percent, and the United States

removed its import surcharge. The official dollar price of gold also was raised to $38

per ounce, but this was symbolic because the suspension continued. The agreement

failed to save the system. By March 1973, most major currencies shifted to floating

against the dollar. After effectively ending in 1971, the pegged-exchange-rate regime

known as the Bretton Woods system was officially abandoned in 1973.

The Current System: Limited Anarchy The current system is sometimes described as a managed floating regime. Since the early 1970s, a growing number of countries, including many major industrial-

ized countries, have floating or relatively flexible exchange rates, but government

authorities often attempt to have an impact through intervention or some other form of

management of the floating or flexible exchange rates.

A noteworthy feature of the experience since 1973 is the extent of official resistance

to floating. Some of this resistance is seen in the management of the float. For instance,

at various times since 1973, the government of Japan has tried to hold down the dollar

value of the yen, apparently to prevent a loss in the international price competitive-

ness of Japanese products. In the process, the Japanese central bank has bought huge

numbers of dollars (which subsequently declined in yen value, anyway, as the yen did

appreciate against the dollar). Another part of the resistance is seen in the substantial

number of countries that continue to peg their currencies to the dollar or to other

currencies.

The European Union has been a center of resistance to floating exchange rates, at

least for the cross-rates among the EU currencies. The governments of the European

492 Part Three Understanding Foreign Exchange

pug21774_ch20_464-501.indd 492pug21774_ch20_464-501.indd 492 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

Economic Community (the forerunner of the European Union) strove to prevent

movements in exchange rates among their currencies, first setting up the “snake”

within the “tunnel” in December 1971. They agreed on maximum ranges of movement

of the most appreciated versus the most depreciated member currency (the tunnel) and

on maximum bands within which pairwise exchange rates could oscillate (the snake).

This scheme was short-lived. Britain, Italy, and France soon allowed their currencies

to drop well below the tunnel, leaving only a fixed set of exchange rates between the

West German mark and the currencies of the Benelux countries. The governments

of the European Community then developed a successor scheme, the Exchange Rate

Mechanism (ERM) of the European Monetary System, in 1979. In the early 1990s, the

governments of the European Union established a process for moving toward perma-

nently fixed exchange rates and a single currency. At the beginning of 1999, the new

common currency, the euro, came into existence, and in 2002 it replaced the national

currencies of 12 of the then 15 EU countries.

The official desire for fixed or managed exchange rates has remained strong, but

fixed or steady rates have been hard to maintain. Once the Bretton Woods system

broke down, the U.S. government switched to advocacy of floating rates. It often

(e.g., in the early 1970s, 1980–1984, and 1995–2014) has followed a policy of

“benign neglect” toward the exchange-rate value of the dollar, with almost no offi-

cial exchange-market intervention by U.S. monetary authorities during these long

periods of time. At other times, especially in the late 1980s, the U.S. government

has been active in managing the dollar float. After the dollar soared in value during

1981–1985, the U.S. government participated in two major international accords to

manage exchange rates through coordinated intervention. The first accord, the Plaza

Agreement of September 1985, was intended to promote a decline in the exchange-

rate value of the dollar, and the dollar did fall. The second accord, the Louvre

Agreement of February 1987, was intended to stabilize the exchange-rate value of the

dollar against other major currencies. Formal coordination faded by the early 1990s,

and as we have seen, exchange rates between the dollar and other major currencies

still oscillate widely at times.

The series of exchange-rate crises in the 1990s and early 2000s shows how difficult

it is to defend pegged rates or heavily managed floating rates in the face of large flows

of private funds. When speculators believe they have spotted attempts by officials to

maintain unrealistic exchange rates, they have a one-way speculative gamble that can

overwhelm the defenses of the monetary authorities.

The first major crisis of the 1990s centered on the European Union. In the early

1990s, all EU countries but Greece had joined the ERM system of pegged rates

among these currencies. (In addition, several European countries, including Sweden

and Finland, also pegged to this system, although they were not formally part of it.)

Following the shock of German reunification and the subsequent tight monetary pol-

icy followed by Germany, a major speculative attack hit the ERM in 1992 and 1993.

Governments mounted defenses that included massive intervention, high short-term

interest rates, and tightening of capital controls. Nonetheless, Britain and Italy sur-

rendered and dropped out of the ERM in 1992, and Sweden and Finland ceased their

peg to it. Several other currencies that remained in the system were devalued in 1992

and 1993. In addition, the bands for most currencies that remained in the system were

Chapter 20 Government Policies toward the Foreign Exchange Market 493

pug21774_ch20_464-501.indd 493pug21774_ch20_464-501.indd 493 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

widened in 1993 to 15 percent on each side of the central rate (from 2.25 percent) to

deter speculation by permitting more room for the pegged rate to fluctuate.

During 1994–2002, a series of exchange crises hit developing countries, result-

ing in dramatic devaluations of pegged exchange rates or depreciations following

abandonment of pegged or heavily managed rates. Here we provide a summary. We

examine these crises in depth in the next chapter.

As discussed earlier in this chapter, after using a large part of its official reserve

holdings to defend the peso exchange rate, the Mexican government had to abandon

its heavily managed rate in late 1994. The CFA franc, a currency used by 13 African

countries, was devalued by 50 percent in 1994, after it had been pegged at the same rate

to the French franc for 45 years. In 1996, the Venezuelan government abandoned its

pegged rate, and the bolivar declined by 42 percent in one day. In May 1997, the Czech

government, after spending about 30 percent of its international reserves to defend the

pegged rate it had maintained for 6 years, shifted to a floating exchange rate, and the

koruna declined by about 10 percent during the first few days of the float.

In 1997, the Asian crisis hit. In July the Thai government gave up its pegged

exchange rate for the Thai baht. By the end of the year the baht’s value had fallen by

45 percent against the U.S. dollar. Then the Malaysian government floated its cur-

rency, and the ringgit fell by 35 percent. Soon Indonesia switched to a float, and the

rupiah fell by 47 percent. In November the Korean government gave up its defense of

the won, whose value then fell by 48 percent.

In 1998, the Russian government shifted to a floating rate and the ruble declined by

60 percent in value against the dollar in about a month and a half. From April 1998 to

January 1999, the Brazilian government used about half of its official reserves defend-

ing the pegged value of the real. Capital outflows and other speculative pressures

increased, and Brazil shifted to a floating rate in January 1999. In two and a half weeks

the real declined by 39 percent. In early 2001 the Turkish government abandoned the

pegged exchange rate for the lira, and its value fell by almost half during the year. In

early 2002 the Argentinean government shifted to a floating exchange rate for its peso.

The value of the peso plummeted, and Argentina’s economy imploded.

After all of these schemes and crises, what is the current international monetary

system? Perhaps it is best to describe it as a nonsystem—countries can choose almost

any exchange-rate policies they want and change them whenever they want. The

policies of various countries in mid-2013 are shown in Figure 20.9 .

Column 1 in Figure 20.9 shows 17 countries that use some other country’s currency

as their own. (We examine this “dollarization” as an extreme form of a fixed exchange

rate in Chapter 25.) Columns 2 and 3 show the 17 EU countries that use the euro as their

currency, and the 24 countries whose currencies are pegged to the euro. Among these

24 countries are the EU members that participate in the continuation of the Exchange

Rate Mechanism and the African countries that use the CFA franc. (At the beginning of

2014, Latvia joined the euro area, so it shifted from column 3 to column 2.)

Column 4 shows 43 countries that peg their currencies to the U.S. dollar. Column 5

shows 6 countries that peg to some other single currency, usually the currency of a larger

neighboring country. Column 6 shows 12 countries that peg to a basket of currencies.

The 17 countries shown in column 7 use a crawling pegged exchange rate in which the

pegged value is changed frequently.

494 Part Three Understanding Foreign Exchange

pug21774_ch20_464-501.indd 494pug21774_ch20_464-501.indd 494 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

FI G

U R

E 2

0 .9

x c h a n g e -R

a te

A rr

a n g e m

e n ts

, M

a y 1

, 2 0 1 3

1 C

la ss

if ic

a ti

o n o

f e a c h c

o u n tr

y i

s b a se

d o

n t

h e c

o u n tr

y ’s

a c tu

a l

(d e f

a c to

) p o li

c y , a s

d e te

rm in

e d b

y t

h e I

n te

rn a ti

o n a l

M o n e ta

ry F

u n d . F

o r

so m

e c

o u n tr

ie s

th e c

la ss

if ic

a ti

o n d

if fe

rs f

ro m

th e c

o u n tr

y ’s

o ff

ic ia

l (d

e j

u re

) st

a te

d p

o li

c y .

2 T h e se

c o u n tr

ie s

a re

o ft

e n c

a ll

e d “

d o ll

a ri

z e d .”

A ll

b u t A

n d o rr

a , K

o so

v o , M

o n a c o , M

o n te

n e g ro

, a n d S

a n M

a ri

n o (

e u ro

); K

ir ib

a ti

, N

a u ru

, a n d T

u v a lu

( A

u st

ra li

a n d

o ll

a r)

; a n d

L ie

c h te

n st

e in

( S

w is

s fr

a n c )

u se

t h e U

.S . d o ll

a r

a s

th e ir

c u rr

e n c y .

3 L a tv

ia j

o in

e d t

h e e

u ro

a re

a o

n J

a n u a ry

1 , 2 0 1 4 .

4 O

n e -s

id e d a

rr a n g e m

e n t,

t h e S

w is

s N

a ti

o n a l

B a n k d

o e s

n o t

a ll

o w

t h e e

x c h a n g e r

a te

v a lu

e t

o f

a ll

b e lo

w 1

.2 S

w is

s fr

a n c s

p e r

e u ro

S o u rc

e: I

n te

rn a ti

o n a l

M o n e ta

ry F

u n d , A

n n u a l

R ep

o rt

o n E

xc h a n ge

A rr

a n ge

m en

ts a

n d E

xc h a n ge

R es

tr ic

ti o n s,

2 0 1 3 .

C u

rr e

n cy

P e

g g

e d

T o

(1 )

(2 )

(3 )

(4 )

(5 )

(6 )

(7 )

(8 )

(9 )

U se

F o

re ig

C u

rr e n

(n o

s e p

a ra

lo ca

l c u

rr e n

cy )2

E u

ro A

re a

(u se

e u

ro a

s cu

rr e n

cy )3

E u

ro 3

U .S

. D

o ll

a r

O th

e r

C u

rr e

n cy

C u

rr e

n cy

a sk

e t

C ra

w li

n g

e g

M a

n a

g e

d F

lo a

t Fr

e e

F lo

a t

A n d o rr

a Ec

u ad

o r

El S

al va

d o r

K ir ib

at i

K o so

vo Li

ec h te

n st

ei n

M ar

sh al

l I sl

an d s

M ic

ro n es

ia M

o n ac

o M

o n te

n eg

ro N

au ru

Pa la

u Pa

n am

a Sa

n M

ar in

o T im

o r-

Le st

e Tu

va lu

Zi m

b ab

w e

A u st

ri a

B el

g iu

m C

yp ru

s Es

to n ia

Fi n la

n d

Fr an

ce G

er m

an y

G re

ec e

Ir el

an d

It al

y Lu

xe m

b o u rg

M al

ta N

et h er

la n d s

Po rt

u g al

Sl o va

k R ep

u b lic

Sl o ve

n ia

Sp ai

ER M

D en

m ar

La tv

Li th

u an

ia C

FA F

ra n c

Zo n e

B en

B u rk

in a

Fa so

am er

o o n

en tr

al A

fr ic

an R

ep .

h ad

o n g o ,

R ep

. o f

o te

d ’Iv

o ir e

u at

o ri al

G u in

G ab

o n

u in

ea -B

is sa

M al

N ig

Se n eg

To g o

O th

B o sn

ia a

n d

H er

ze g o vi

n a

B u lg

ar ia

ap e

V er

d e

o m

o ro

M ac

ed o n ia

Sã

o T

o m

é &

Pr in

ci p e

it ze

rl an

d 4

A n

g o

la A

n ti g

u a

B ar

b u

d a

A ru

b a

A ze

rb ai

ja n

B ah

am as

B ah

ra in

B an

g la

d es

h B

ar b

ad o s

B el

iz e

B o

liv ia

C am

b o d

ia C

o n

g o

, D

em .

ep . o

f C

o st

a R ic

a C

u ra

ça o a

n d

S in

M aa

rt en

D jib

o u

ti D

o m

in ic

a Er

it re

a G

eo rg

ia G

re n

ad a

G u

ya n

a H

o n

g K

o n

g Ir aq

Jo rd

an La

o P

D R

Le b

an o n

M al

d iv

es O

m an

Q at

ar St

. K

it ts

& N

ev is

St .

Lu ci

a St

. V

in ce

n t

& t

h e

re n

ad in

es Sa

u d

i A ra

b ia

So u

th S

u d

an Su

d an

Su ri n

am e

Ta jik

is ta

n Tr

in id

ad &

b ag

o Tu

rk m

en is

ta n

U kr

ai n

e U

n it ed

A ra

ir at

es V en

ez u

el a

V ie

tn am

Ye m

B h

u ta

(In d

ia n

r u

p ee

) B

ru n

ei D

ar u

ss al

(S in

g ap

o re

o lla

r) Le

so th

(S .

A fr

ic an

r an

d )

N am

ib ia

. A

fr ic

an r

an d

) N

ep al

(In

d ia

n r

u p

ee )

Sw az

ila n

(S .

A fr

ic an

r an

d )

A lg

er ia

Fi ji

Ir an

K u

w ai

t Li

b ya

M o

ro cc

o M

ya n

m ar

Sa m

o a

So lo

m o

la n

d s

Sy ri a

To n

g a

V an

u at

A rg

en ti n

a B

o ts

w an

a C

h in

a C

ro at

ia D

o m

in ic

ep u

b lic

Eg yp

t Et

h io

p ia

H ai

ti H

o n

d u

ra s

In d

o n

es ia

Ja m

ai ca

K az

ak h

st an

N ic

ar ag

u a

R w

an d

a Si

n g

ap o

re Tu

n is

ia U

zb ek

is ta

A fg

h an

is ta

n A

lb an

ia A

rm en

ia B

el ar

u s

B ra

zi l

B u

ru n

d i

C o

lo m

b ia

G am

b ia

G h

an a

G u

at em

al a

G u

in ea

H u

n g

ar y

Ic el

an d

In d

ia K

en ya

K o

re a,

S o

u th

K yr

g yz

R ep

u b

lic Li

b er

ia M

ad ag

as ca

r M

al aw

i M

al ay

si a

M au

ri ta

n ia

M au

ri ti u

M o

ld o

va M

o n

g o

lia M

o za

m b

iq u

e N

ew Z

ea la

n d

N ig

er ia

Pa ki

st an

Pa p

u a

N ew

u in

ea Pa

ra g

u ay

Pe ru

Ph ili

p p

in es

R o

m an

ia R

u ss

ia Se

rb ia

Se yc

h el

le s

Si er

ra L

eo n

e So

u th

A fr

ic a

Sr i L

an ka

Ta n

za n

ia Th

ai la

n d

Tu rk

ey U

g an

d a

U ru

g u

ay Za

m b

A u

st ra

lia C

an ad

a C

h ile

C ze

ch R

ep u

b lic

Is ra

el Ja

p an

M ex

ic o

N o

rw ay

Po la

n d

So m

al ia

Sw ed

en U

n it ed

K in

g d

o m

U n

it ed

S ta

te s

495

pug21774_ch20_464-501.indd 495pug21774_ch20_464-501.indd 495 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

Moving to the other end of the spectrum, column 9 shows 13 countries whose

exchange rates are floating and mainly determined by market supply and demand.

Included here are a number of industrialized countries. Column 8 shows that

46 countries have floating rates that are rather heavily managed. The monetary

authorities of these countries influence the exchange rates through active intervention

without committing to announced exchange-rate targets. The number of countries with

floating exchange rates has grown during the past decades. In 1991, only 36 countries

had floating exchange rates. By 2013 this number had risen to 59 countries (combin-

ing columns 8 and 9).

In summary, under the current system each country chooses its own exchange-rate

policy. Two major blocs of currencies exist: currencies pegged to the U.S. dollar and

currencies pegged to the euro. The exchange rates among the U.S. dollar, the euro,

and such other major currencies as the Japanese yen, British pound, and Canadian

dollar are floating rates, with some (usually small) amount of official management.

Economists are still debating the merits and demerits of this “nonsystem,” as well

as the strengths and weaknesses of the policy choices made by individual countries.

Critics of floating rates start at the obvious point: Floating exchange rates have fluctu-

ated “a lot,” “more than anyone expected.” But pegged exchange rates have sometimes

been difficult to maintain, so they are prone to currency crises.

Summary The two major aspects of government policy toward the foreign exchange market are the degree of exchange-rate flexibility and restrictions (if any) on use of the market.

Foreign exchange restrictions are called exchange controls. Policies toward the exchange rate itself cover a spectrum. The polar case of com-

plete flexibility is a clean float, with the exchange rate determined solely by nonoffi- cial (or private) supply and demand. Governments often do not allow a clean float, but

rather take actions (such as official intervention ) to manage (or dirty ) the float. The other kind of exchange-rate policy is a fixed, or pegged, exchange rate.

The government must decide what to fix to. The alternatives include a commodity

like gold, a single other currency, and a basket of other currencies. The government

also must decide the width of a band around the central fixed rate. The exchange rate

has some flexibility around this par value, but the flexibility is limited by the size of

the band. Although a permanently fixed rate is a polar case, it is nearly impossible

for a government to commit never to change the fixed rate. If the exchange rate is not

permanently fixed, then the government must also decide when to change the fixed

rate. If the answer is seldom, the approach is called an adjustable peg; if often, it is called a crawling peg.

If the government chooses a fixed exchange rate, it must also decide how to defend

the rate if private supply and demand pressures tend to push the actual rate outside

the allowable band. One or more of four ways can be used to defend the fixed rate:

1. Use official intervention in the foreign exchange market, in which the monetary

authority buys and sells currencies to alter the supply and demand situation.

2. Impose exchange controls to restrict or control some or all aspects of supply and

demand.

496 Part Three Understanding Foreign Exchange

pug21774_ch20_464-501.indd 496pug21774_ch20_464-501.indd 496 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

3. Alter domestic interest rates to influence short-term capital flows.

4. Adjust the macroeconomy to alter nonofficial supply and demand.

The government may also exercise a fifth option—to surrender by changing the fixed

rate (revaluation or devaluation) or by shifting to a floating exchange rate.

Government intervention in the foreign exchange market is closely related to offi-

cial reserves transactions and the official settlements balance of the country’s balance

of payments. If the government attempts to prevent the exchange-rate value of its cur-

rency from declining, it must buy domestic currency and sell foreign currency in the

foreign exchange market. The government can use its official reserve holdings as a

source of foreign currency to sell in the intervention or it can borrow. This provides the

financing for the country to run an official settlements balance deficit. If instead the

government attempts to prevent the exchange-rate value of its currency from rising,

it must sell domestic currency and buy foreign currency. The government can use the

foreign currency that it buys to increase its official reserve holdings (or to repay past

borrowings). The country’s official settlements balance is in surplus.

Official intervention in the foreign exchange market also changes the country’s

money supply because the monetary authority is adding or removing domestic money

as it carries out the intervention. The authority can use sterilization of the interven- tion to reverse the effect on the domestic money supply by taking some other action

to remove or add the domestic money back to the economy.

Defense of the fixed rate using only intervention can work and make economic

sense if the imbalances in the official settlements balance are temporary. This

approach assumes that private speculators cannot perform the same stabilizing func-

tion and that officials correctly foresee the sustainable long-run value for the exchange

rate. If these assumptions do not hold, the case for financing deficits and surpluses

with a fixed exchange rate is weakened.

Defense using exchange control creates deadweight loss similar to that of an

import quota, and it probably has high administrative costs. Efforts to evade exchange

controls, including bribery of government officials and the development of an illegal

parallel market, reduce the actual effectiveness of the controls. The success or failure of different exchange-rate regimes has depended histori-

cally on the severity of the shocks with which those systems have had to cope. The

fixed-rate gold standard seemed successful before 1914, largely because the world economy itself was more stable than in the period that followed. Many countries were

able to keep their exchange rates fixed because they were lucky enough to be running

surpluses at established exchange rates without having to generate those surpluses

using contractionary macroeconomic policies. The main deficit-running country,

Britain, could control international reserve flows in the short run by controlling credit

in London, but it was never called upon to defend sterling against sustained attack.

During the stable prewar era, even floating-exchange-rate regimes showed stability

(with two brief possible exceptions).

The interwar economy was chaotic enough to put any currency regime to a severe

test. Fixed rates broke down, and governments that believed in fixed rates were forced

into flexible exchange rates. Studies of the interwar period show that the workings

of the gold standard contributed to the depth of the Great Depression. Studies also

Chapter 20 Government Policies toward the Foreign Exchange Market 497

pug21774_ch20_464-501.indd 497pug21774_ch20_464-501.indd 497 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

Key Terms Exchange control Capital controls

Clean float

Official intervention

Managed float

Dirty float

Special drawing right

(SDR)

Pegged exchange rate Adjustable peg

Crawling peg

Reserve currency

Sterilization

Sterilized intervention

Parallel market

Gold standard

Bretton Woods system

International Monetary

Fund (IMF)

One-way speculative

gamble

show that speculation tended to be stabilizing. The large currency fluctuations were

caused by the lingering economic effects of the first world war and by the instability

of domestic monetary and fiscal policies in a number of countries.

Postwar experience showed some difficulties with the Bretton Woods system of adjustable pegged exchange rates set up in 1944. Under this system, private speculators

were given a strong incentive to attack reserve-losing currencies and force large deval-

uations. The role of the dollar as a reserve currency also became increasingly strained

in the Bretton Woods era. Under Bretton Woods, foreign central banks acquired large

holdings of dollars through official intervention, when the United States shifted to run-

ning official settlements balance deficits. At first, these were welcomed as additions to

official reserve holdings in these foreign countries, but the dollars became unwanted

as the reserves grew too large. Foreign central banks’ conversions of dollars into gold

decreased U.S. official gold holdings, further reducing foreign officials’ confidence in

the dollar. The United States had to adjust its balance-of-payments position or change

the rules. The United States opted for new rules, divorcing the private gold market

from the official gold price in 1968, suspending gold convertibility and forcing a

devaluation of the dollar in 1971, and shifting to general floating in 1973.

The current exchange-rate system permits each country to choose its own exchange-

rate policy. Two major blocs exist, one of currencies pegged to the U.S. dollar and the

other of the euro and currencies pegged to it. The euro is the successor to previous

schemes, including the Exchange Rate Mechanism of the European Monetary System,

as the countries that are members of the EU seek a zone of exchange-rate stability for

transactions within the union.

The dollar bloc and the euro bloc float against each other, and the currencies of a

number of industrialized countries—Australia, Canada, Japan, New Zealand, Sweden,

and the United Kingdom—float independently. For countries with flexible exchange

rates, most governments are skeptical of purely market-driven exchange rates, and

they practice some degree of management of the floating rate.

Many developing countries have a pegged exchange rate of some sort, but the trend is

toward greater flexibility and floating. A series of exchange-rate crises in the 1990s and early

2000s, including the Mexican peso in 1994, the Asian crisis (Thai baht, Malaysian ringgit,

Indonesian rupiah, and South Korea won) in 1997, the Russian ruble in 1998, the Brazilian

real in 1999, the Turkish lira in 2001, and the Argentinean peso in 2002, show the difficulty of

defending a pegged rate against speculative flows of short-term capital when the speculators

have a one-way speculative gamble against a currency that they believe is misvalued.

498 Part Three Understanding Foreign Exchange

pug21774_ch20_464-501.indd 498pug21774_ch20_464-501.indd 498 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

Suggested Reading

Information on each country’s policies toward the foreign exchange market can be found

in the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions. Edison et al. (2004) and Schindler (2009) examine capital controls.

For broad surveys of international currency experience during the past century, see

McKinnon (1993 and 1996) and Giovannini (1989). The prewar gold standard is analyzed

in more depth in Bloomfield (1959), Lindert (1969), and Bordo and Schwartz (1984).

Meissner (2005) offers a statistical examination of the timing of countries’ adoptions of

the gold standard. Irwin (2012) links the gold standard to rising protectionism during the

Great Depression.

A masterly survey of the interwar experience is Eichengreen (1992). Pioneering

studies of the stability of fluctuating exchange rates in the interwar period are Yeager

(1958), Tsiang (1959), and Aliber (1962).

For more detail on the Bretton Woods era, see Bordo and Eichengreen (1992). The

dollar crisis under the Bretton Woods system was predicted and diagnosed in Robert

Triffin’s classic work (1960) and by Jacques Rueff (translation, 1972). Eichengreen

(2007) considers how experiences under the Bretton Woods system illuminate current

international monetary issues. Eichengreen (2011) discusses the history and the future of

the U.S. dollar in the international monetary system.

Reinhart and Rogoff (2004) reassess exchange-rate policies since 1949. Calvo and Reinhart

(2002) document the heavy management of floating exchange rates since 1973. Agénor

(2004) examines the experiences of countries that exit from fixed-exchange-rate policies.

Questions and Problems

1. What is the difference between a clean float and a managed float?

2. What is the difference between an adjustable peg and a crawling peg?

3. For a country that is attempting to maintain a fixed exchange rate, what is the differ-

ence between a temporary disequilibrium and a fundamental disequilibrium? Contrast

the implications of each type of disequilibrium for official intervention in the foreign

exchange market to defend the fixed exchange rate.

4. “The emergence of expectations that a country in the near future will impose

exchange controls will probably result in upward pressure on the exchange-rate value

of the country’s currency.” Do you agree or disagree? Why?

5. A government has just imposed a total set of exchange controls to prevent the

exchange-rate value of its currency from declining. What effects and further develop-

ments do you predict?

6. The Pugelovian government is attempting to peg the exchange-rate value of its currency

(the pnut) at a rate of three pnuts per U.S. dollar (plus or minus 2 percent). Unfortunately,

private market supply and demand are putting downward pressure on the pnut’s exchange-

rate value. In fact, it appears that, under current market conditions, the exchange rate would

be about 3.5 pnuts per dollar if the government did not defend the pegged rate.

a. How could the Pugelovian government use official intervention in the foreign exchange market to defend the pegged exchange rate?

b. How could the Pugelovian government use exchange controls to defend the pegged exchange rate?

c. How could the Pugelovian government use domestic interest rates to defend the pegged exchange rate?

✦

Chapter 20 Government Policies toward the Foreign Exchange Market 499

pug21774_ch20_464-501.indd 499pug21774_ch20_464-501.indd 499 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

7. The Moroccan monetary authority is using a heavily managed float to keep the dirham

at U.S.$0.12 per dirham. Under current foreign exchange market conditions, nonof-

ficial supply and demand would clear at U.S.$0.15 per dirham.

a. Using official intervention, what does the Moroccan monetary authority have to do to keep the exchange rate at U.S.$0.12 per dirham?

b. If the monetary authority believes that this is a temporary disequilibrium, what does the authority expect to happen soon?

c. If private investors and speculators believe that this is a fundamental disequilib- rium, what actions are they likely to take?

8. The Danish central bank is committed to maintaining a fixed exchange rate of 7.46

Danish krone per euro, with a band of 2.25 percent on each side of this central rate.

Under current conditions in the foreign exchange market, nonofficial supply and de-

mand would intersect at a rate of about 7.1 krone per euro. The Danish central bank

has sufficient international reserve assets and uses official intervention to defend the

fixed rate.

a. Draw a demand and supply graph of the foreign exchange market showing the central rate (7.46 krone per euro) and the positions of the nonofficial supply and

demand curves.

b. As a result of the official intervention, what will be the change in Denmark’s hold- ings of international reserves? In your explanation, refer to your graph.

c. If the Danish central bank does not sterilize its intervention, will the Danish money supply tend to increase, stay the same, or decrease? Why?

9. Under the gold standard the fixed price of gold was $20.67 per ounce in the United

States. The fixed price of gold was £4.2474 per ounce in Britain.

a. What is the “fixed” exchange rate (dollars per pound) implied by these fixed gold prices? b. How would you arbitrage if the exchange rate quoted in the foreign exchange mar-

ket were $4.00 per pound? (Under the gold standard, you could buy or sell gold

with each central bank at the fixed price of gold in each country.)

c. What pressure is placed on the exchange rate by this arbitrage?

10. Consider the international currency experience for the period of the gold standard

before 1914.

a. What type of exchange-rate system was the gold standard and how did it operate? b. What country was central to the system? What was the role of this country in the

success of the currency system?

c. What was the nature of economic shocks during this period? d. What is the evidence on speculation and speculative pressures on exchange rates

during this period?

11. What are the key features of the international currency experience in the period

between the two world wars? What lessons did policymakers learn from this experi-

ence? Why are these lessons now questioned and debated?

12. Consider the international currency experience for the Bretton Woods era from 1944

to the early 1970s.

a. What type of exchange-rate system was the Bretton Woods system? How did it operate?

✦

500 Part Three Understanding Foreign Exchange

pug21774_ch20_464-501.indd 500pug21774_ch20_464-501.indd 500 14/11/14 4:25 pm14/11/14 4:25 pm

Final PDF to printer

b. What country was central to the system? What was the role of this country in the success of the currency system?

c. What is the evidence on speculation and speculative pressures on exchange rates during this period?

13. Why did the Bretton Woods system of fixed exchange rates collapse?

14. The current exchange-rate regime is sometimes described as a system of managed

floating exchange rates, but with some blocs of currencies that are tied together.

a. What are the two major blocs of currencies that are tied together? b. What are the major currencies that float against each other? c. Given the discussion in this chapter and the previous Chapters 17–19, how

would you characterize the movements of exchange rates between the U.S.

dollar and the other major currencies since the shift to managed floating in the

early 1970s?

✦

Chapter 20 Government Policies toward the Foreign Exchange Market 501

pug21774_ch20_464-501.indd 501pug21774_ch20_464-501.indd 501 12/12/14 2:41 PM12/12/14 2:41 PM

Final PDF to printer

502

Chapter Twenty-One

International Lending and Financial Crises International financial capital flows have grown rapidly in the past several decades.

The lenders (or investors) give the borrowers money to be used now in exchange

for IOUs or ownership shares entitling them to interest and dividends later.

International flows of financial claims are conventionally divided into different

categories by type of lender or investor (private versus official), maturity (long-term

versus short-term), existence of management control (direct versus portfolio), and

type of borrower (private or government). For the first three distinctions, here are

the key categories:

A. Private lending and investing

1. Long-term

a. Direct investment (lending to, or purchasing shares in, a foreign enterprise largely owned and controlled by the investor)

b. Loans (to a foreign borrower, maturity more than one year, mostly by banks) c. Portfolio investment (purchasing stock or bonds with maturity of more than

one year, issued by a foreign government or a foreign enterprise not con-

trolled by the investor)

2. Short-term (lending to a foreign borrower, or purchasing bonds issued by a

foreign government or a foreign enterprise not controlled by the investor, matur-

ing in a year or less)

B. Official lending and investing (by a government or a multilateral institution like the

International Monetary Fund or the World Bank, mostly lending, both long-term

and short-term)

In this chapter we take a close look at the causes and effects of bank lending and

portfolio investment. (Foreign direct investment and the role of management control

received their own separate analysis in Chapter 15.)

International lending and investing have been revolutionized. From before World

War II to the early 1980s, the main lender was the United States, joined in the 1970s

by the newly rich oil exporters. Since the early 1980s, the United States has been the

world’s largest net borrower, and the oil exporters also were net borrowers during

1983–1995. The dominant net lenders since 1980 have been Japan and Germany. With

the rise of crude oil prices since the late 1990s, the oil exporting countries once again

pug21774_ch21_502-538.indd 502pug21774_ch21_502-538.indd 502 27/11/14 7:04 pm27/11/14 7:04 pm

Final PDF to printer

Chapter 21 International Lending and Financial Crises 503

have become large lenders. The major type of lending has been private loans and port-

folio investments, a shift from the official loans from governments and foreign direct

investment that were dominant from the late 1940s to the early 1970s.

International lending can bring major benefits of two types. First, it represents

intertemporal trade, in which the lender gives up resources today in order to get more

in the future, and the borrower gets resources today but must be willing to pay back

more in the future. Second, it allows lenders and investors to diversify their invest-

ments more broadly. The ability to add foreign financial assets to investment portfolios

can lower the riskiness of the entire portfolio of investments through greater diversi-

fication. The chapter begins with an analysis of some of the benefits of international

lending and borrowing. We focus on the benefits of intertemporal trade that takes

advantage of different rates of return in different countries.

International lending is not always well behaved. International lending to devel-

oping countries swings between surges of lending and crises of confidence. During

the financial crises, lending shrinks and lenders scramble to get repaid. The middle

sections of the chapter examine the series of major crises that hit developing countries

during 1982–2002. After describing the crises, we explore why these financial crises

occur, how we try to resolve them, and what we might be able to do to make them

less frequent.

Industrialized countries also experience financial crises. The final section of the

chapter discusses the global financial and economic crisis that began in 2007 and inten-

sified in 2008, noting similarities between crises in developing countries and what set

off and spread the global crisis. A box toward the end of the chapter surveys the causes

of the euro crisis that began in 2010.

GAINS AND LOSSES FROM WELL-BEHAVED INTERNATIONAL LENDING

If the world is stable and predictable, and if borrowers fully honor their commitments

to repay, then international lending can be efficient from a world point of view, bring-

ing gains to some that outweigh losses to others. In such a world, the welfare effects

of international lending are parallel to the welfare effects of opening trade or those of

allowing free labor migration.

Figure 21.1 shows the normal effects of allowing free international lending and bor-

rowing. We divide the world into two large countries: “Japan,” having abundant finan-

cial wealth and less attractive domestic investment opportunities, and an “America”

in the image of Argentina, Brazil, Canada, and the United States, having less wealth

relative to its abundant opportunities for profitable investment (for instance, in its new

technologies or its open areas rich in natural resources). The length of the horizon-

tal axis in Figure 21.1 shows total world wealth, equal to Japan’s wealth ( W J ) plus

America’s wealth ( W A ). This wealth is used to finance capital investments. The verti-

cal axes indicate rates of return earned on capital investments. (We often refer to an

equilibrium rate of the return as the interest rate, although it may also incorporate

the return to equity investment.) Capital investment opportunities in Japan are shown

as the marginal-product-of-capital curve MPK Japan

, which begins at the left vertical

pug21774_ch21_502-538.indd 503pug21774_ch21_502-538.indd 503 14/11/14 4:00 pm14/11/14 4:00 pm

Final PDF to printer

504 Part Three Understanding Foreign Exchange

From no international lending ( RS ) to free lending ( T ): Japan gains ( a 1 b 1 c ) 5 27 America gains ( d 1 e 1 f ) 5 27 World gains ( a through f ) 5 54

If Japan imposes a 2 percent per year tax on lending abroad (from T to UV ): Japan gains ( e 2 b ) 5 9 America loses ( d 1 e ) 5 15 World loses ( b 1 d ) 5 6

If America imposes a 2 percent per year tax on borrowing abroad (from T to UV ): Japan loses ( b 1 c ) 5 15 America gains ( c 2 d ) 5 9 World loses ( b 1 d ) 5 6

KA 5 Capital in AmericaKJ 5 Capital in Japan

WJ 5 Japan’s wealth

World capital 5 World wealth

Percent per year (for rates of return, and MPK)

MPKAmerica

Percent per year

4,200 10,0006,0004,800

MPKJapan

T U

d b

g h

FIGURE 21.1 Gains and

Losses from

Well-Behaved

International

Lending

axis and ranks possible investments in Japan according to the returns the investments

produce. Investment opportunities in America are shown as the marginal-product-of-

capital curve MPK America

, which begins at the right vertical axis and ranks investments

in the opposite direction, from right to left.

We begin with a situation in which international financial transactions are prohib-

ited. In this situation each country must use its financial wealth to finance its own

stock of real capital. If all Japanese wealth ( W J ) is used domestically, Japan’s lenders

must accept a low rate of return because the return on domestic capital investments

follows the declining MPK Japan

curve. Competition thus forces lenders in Japan to

accept the low rate of return of 2 percent per year at point R . Meanwhile, in America, the scarcity of funds prevents any capital formation to the left of point S since W

A is

all the wealth that America has. Competition for borrowing the W A of national

wealth bids the American rate of interest on lending up to 8 percent at point S . We can also use this figure to show the value of total production in each country and

pug21774_ch21_502-538.indd 504pug21774_ch21_502-538.indd 504 14/11/14 4:00 pm14/11/14 4:00 pm

Final PDF to printer

Chapter 21 International Lending and Financial Crises 505

in the world, assuming that some capital is used in all production. If we add up the

product of each unit of capital (the MPK), we get the total production by all capital,

equal to the area under the MPK curve. With no international financial flows, the

world’s product equals the shaded area in Figure 21.1. Japan’s product is the shaded

area to the left of the vertical line through point R , and America’s is the shaded area to the right.

Now imagine that there are no barriers to international finance. Wealthholders in

Japan and borrowers in America have a strong incentive to get together. Why should

one group lend at only 2 percent and the other borrow at 8 percent if, as we assume

here, the riskiness or creditworthiness of the different borrowings is the same?

Lenders in Japan should do part of their lending in America. Over time, their lending

to America will allow more capital formation in America, with less capital formation

in Japan. The international lending leads to a different equilibrium, one in which the

worldwide rate of return is somewhere between 2 percent and 8 percent. Let’s say that

it ends up at 5 percent, at point T . In this situation the wealth of Japan exceeds its stock of domestic real assets by the same amount ( W

J 2 K

J ) that America has to borrow to

finance its extra real assets ( K A 2 W

A ).

With international financial freedom, world product is maximized. It equals

everything under either the marginal product curve or all the shaded area plus area

RST . This is a clear gain of area RST (or areas a through f ) over the situation in which international lending was prohibited. The reason for this gain is that freedom

allows individual wealthholders the chance to seek the highest return anywhere

in the world.

The world’s gains from international lending are split between the two countries.

Japan’s national income comes from two places:

• Its domestic production, which equals the area under its MPK Japan

curve down to

point T (the product of the 4,200 of its wealth that it invests at home), • Plus foreign source income on its investments in America, which equals area

a 1 b 1 c 1 g 1 h (the 5 percent return on the 1,800 that Japan has invested in America).

Japan gains area a 1 b 1 c in national income through its foreign investment. America’s national income is the difference between two flows:

• Its domestic production, which equals the area under its MPK America

curve down to

point T (the product of the total 6,800 that is invested in America), • Minus what it has to pay Japan for what it has borrowed from Japan, a payment

equal to area a 1 b 1 c 1 g 1 h (5 percent on the 1,800 that America has borrowed from Japan).

America also gains from its international borrowing, a gain of area d 1 e 1 f . Within each country there are gainers and losers from the new freedom.

Japanese lenders gain from lending at 5 percent instead of at 2 percent. That harms

Japanese borrowers, though, because competition from foreign borrowers forces

them to pay the same higher rate on their borrowings. In America borrowers have

gained from being able to borrow at 5 percent instead of 8 percent. Yet American

lenders will be nostalgic for the old days of financial isolation, when borrowers

pug21774_ch21_502-538.indd 505pug21774_ch21_502-538.indd 505 14/11/14 4:00 pm14/11/14 4:00 pm

Final PDF to printer

506 Part Three Understanding Foreign Exchange

still had to pay them 8 percent. In addition, the smaller capital stock in Japan low-

ers the productivity and earnings of other resources (like labor and land) in Japan,

whereas the larger capital stock in America raises the productivity and earnings of

other resources in America.

TAXES ON INTERNATIONAL LENDING

We have compared free international lending with no international lending and have

found the orthodox result: Freedom raises world product and national incomes.

Another standard result also carries over from trade analysis: the nationally optimal tax. If a country looms large enough to have power over the world market rate of return, it can exploit this market power to its own advantage, at the expense of

other countries and the world as a whole.

In Figure 21.1, Japan can be said to have market power. By restricting its foreign

lending, it could force America’s borrowers to pay higher interest rates (moving north-

east from point T toward point S ). Let us say that Japan exploits this power by impos- ing a tax of 2 percent per year on the value of assets held abroad by residents of Japan.

This will bid up the rate that America’s borrowers have to pay and bid down the rate

that domestic lenders can get after taxes. Equilibrium will be restored when the gap

between the foreign and the domestic rates is just the 2 percent tax. This is shown by

the gap UV in Figure 21.1. Japan’s government collects total tax revenues (area e 1 c ) equal to the tax rate times the 1,200 of international assets that Japan continues to have

after the adjustment to the tax. Japan has made a net gain on its taxation of foreign

lending. It has forced America to pay 6 percent instead of 5 percent on all continuing

debt. With a 2 percent tax, the markup, area e , is large enough to outweigh Japan’s loss of some previously profitable lending abroad (triangle b ). Setting such a tax at just the right level (which might or might not be the one shown here) gives Japan a nationally

optimal tax on foreign lending.

Two can play at that game. Figure 21.1 shows that America also has market power:

by restricting its borrowing, it could force Japan’s lenders to accept lower rates of

return (moving southeast from point T toward point R ). What if it is America (instead of Japan) that imposes the 2 percent tax on the same international assets? Then all the

results will work out the same as for the tax by Japan—except that the American gov-

ernment pockets the tax revenue (area c 1 e ). America, in this case, gains income (area c minus area d ) at the expense of Japan and the world as a whole. (If both countries impose taxes on the same international lending, the amount of international lending

shrinks. At most, one country can gain compared to its position with free lending, and

it is rather likely that both countries lose.)

INTERNATIONAL LENDING TO DEVELOPING COUNTRIES

International lending and borrowing are often well behaved and provide the sort of

mutual benefits that we have discussed. Both lender and borrower usually benefit from

the gains from intertemporal trade, as countries with net savings get higher returns and

countries that are net borrowers pay lower costs. Additional gains arise as international

pug21774_ch21_502-538.indd 506pug21774_ch21_502-538.indd 506 14/11/14 4:00 pm14/11/14 4:00 pm

Final PDF to printer

Chapter 21 International Lending and Financial Crises 507

financial investments are used to lower risk through portfolio diversification. Conflicts

sometimes arise over tax policies, but these are manageable.

However, sometimes things go terribly wrong. There are periodic financial crises—

international lending is sometimes not well behaved. For most of the rest of this

chapter, we focus on the crises in developing countries since the early 1980s, in which

lending from industrialized countries to these developing countries led to financial

breakdowns rather than mutual benefits.

In a developing-country financial crisis, the borrowing country experiences dif-

ficulties in servicing its debts, and it often defaults —that is, fails to make payments as specified in the debt agreements. Lenders cut back or stop new lending, as the bor-

rower is viewed as too risky. This section presents a brief history of capital flows to

developing countries and the nature of developing-country financial crises. Subsequent

sections look at why crises occur, how they are resolved, and suggestions for ways to

reduce the frequency of crises.

The Surge in International Lending, 1974–1982 Before World War I there was a large amount of international lending, with Britain as

the main creditor and the growing newly settled countries (the United States, Canada,

Argentina, and Australia) as the main borrowers. To a large extent this international

lending fit the well-behaved model of Figure 21.1, as lending sought out high returns

(although defaults were also common). 1 During the 1920s, a large number of foreign

governments issued foreign bonds, especially in New York, as the United States

became a major creditor country. But in the 1930s, the Depression led to massive

defaults by developing countries, which frightened away lenders through the 1960s.

Lending to developing countries remained very low for four decades.

The oil shocks of the 1970s led to a surge in private international lending to

developing countries. Between 1970 and 1980, developing-country debt outstanding

increased more than seven-fold, with debt rising from 14.0 percent of the countries’

national product in 1970 to 26.1 percent in 1980.

The oil shocks quadrupled and then tripled the world price of oil, and these shocks

caused recessions and high inflation in the industrialized countries. How did the

shocks also revive the lending? Four forces combined to create the surge. First, the

rich oil-exporting nations had a high short-run propensity to save out of their extra

income. While their savings were piling up, they tended to invest them in liquid form,

especially in bonds and bank deposits in the United States and other established finan-

cial centers. The major international private banks thereby gained large amounts of

new funds to be lent to other borrowers. The banks had the problem of “recycling”

or reinvesting the “petrodollars.” But where to lend?

Second, there was widespread pessimism about the profitability of capital forma-

tion in industrialized countries. Real interest rates in many countries were unusually

low. One promising area was investment in energy-saving equipment, but the devel-

opment of these projects took time. For a while the banks’ expanded ability to lend

1 The United States was the borrower in one of the default episodes. Britain lent substantial amounts to finance canals and cotton growing in the United States during 1826–1837. A depression began in 1837, and eight states had defaulted on their debts by 1843.

pug21774_ch21_502-538.indd 507pug21774_ch21_502-538.indd 507 14/11/14 4:00 pm14/11/14 4:00 pm

Final PDF to printer

508 Part Three Understanding Foreign Exchange

was not absorbed by borrowers in the industrial countries, which encouraged banks to

look elsewhere. Attention began to shift to developing countries, which had long been

forced to offer higher rates of interest and dividends to attract even small amounts of

private capital.

Third, in developing countries, the 1970s was an era of peak resistance to foreign

direct investment (FDI), in which the foreign investor, usually a multinational firm

based in an industrialized country, keeps controlling ownership of foreign affiliated

enterprises. Banks might have lent to multinational firms for additional FDI, but

developing countries were generally hostile to FDI. Populist ideological currents and

valid fears about political intrigues by multinational firms brought FDI down from

25 percent of net financial flows to developing countries in 1960 to 11 percent by

1980. To gain access to the higher returns offered in developing countries, banks had

to lend outright to governments and companies in these countries.

Fourth, “herding” behavior meant that the lending to developing countries acquired

a momentum of its own once it began to increase. Major banks aggressively sought

lending opportunities, each showing eagerness to lend before competing banks did.

Much of the lending went to poorly planned projects in mismanaged economies. But

everyone was doing it.

The Debt Crisis of 1982 In August 1982, Mexico declared that it was unable to service its large foreign debt.

Dozens of other developing countries followed with announcements that they also

could not repay their previous loans. Several factors explain why the crunch came

in 1982. Interest rates had increased sharply in the United States, as the U.S. Federal

Reserve shifted to a much tighter monetary policy to reduce U.S. inflation. The United

States and other industrialized countries sank into a severe recession. Developing

countries’ exports declined and commodity prices plummeted, while real interest rates

remained high. The debtors’ ability to repay fell dramatically.

At first the responses of the bank creditors depended on how much each bank had

lent. Smaller banks (those holding small shares of all loans) headed for the exits and

eliminated their exposure by selling off their loans or getting repaid. The larger banks

could not extricate themselves without triggering a larger crisis, and they hoped that

the problems were temporary. They rescheduled loan payments to establish repay-

ment obligations in the future, and they loaned smaller amounts of new money to

assist the debtors to grow so that repayment would be possible. Figure 21.2 provides

information on financial flows to developing countries. Bank loans, which were most

of the private long-term lending to developing countries in the early 1980s, declined

from 1981 to 1985. As shown in Figure 21.3 , the long-term foreign debt of develop-

ing countries nearly doubled between 1980 and 1985, the ratio of debt to national

product rose from 26 percent in 1980 to 38 percent in 1985, and the share of export

revenues that was committed to service the debt increased to 28 percent. As large

banks reassessed the prospects for developing country debtors, they concluded that

it was imprudent to lend more. The net flows of bank loans to developing countries

remained low until 1995.

As the debt crisis wore on through the 1980s, it became clear that the debtor

countries were suffering low economic growth and lack of access to international

pug21774_ch21_502-538.indd 508pug21774_ch21_502-538.indd 508 14/11/14 4:00 pm14/11/14 4:00 pm

Final PDF to printer

Chapter 21 International Lending and Financial Crises 509

Source: World Bank, International Debt Statistics.

FIGURE 21.2 Net Financial Flows to Developing Countries, 1981–2012 (Billions of U.S. Dollars)

Source and Type 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

Net long-term 78 75 56 47 43 42 44 52 50 57 71 99 158 160 180 210 Official loans 23 24 23 22 20 21 22 19 21 23 23 20 23 13 24 -1 Private debt 42 40 24 16 12 12 13 16 6 10 11 28 43 39 48 74 Bank and other loans 41 35 23 17 9 11 13 14 4 9 4 20 11 11 25 27

Bonds 1 5 1 -1 3 1 0 2 2 1 8 8 32 28 23 46 Portfolio equity (stocks) 0 0 0 0 0 0 0 0 2 3 6 9 30 26 14 23

Foreign direct investment 13 11 10 9 11 9 10 17 21 21 31 43 62 82 94 113

Net short-term 19 8 -15 -7 2 2 10 8 6 24 20 33 37 12 56 29 Total net financial flows 97 83 41 40 45 44 55 60 56 81 91 132 194 171 235 238

Source and Type 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Net long-term 266 232 203 182 171 151 196 299 432 629 916 812 619 847 934 1,032 Official loans 7 19 15 5 12 -5 -12 -5 -5 -16 8 26 62 67 31 41 Private debt 83 60 25 21 -2 0 37 72 77 167 240 203 66 145 245 281 Bank and other loans 41 34 -10 -7 -18 -13 17 36 35 137 165 195 16 30 124 102

Bonds 43 26 35 28 16 13 20 36 42 30 76 8 50 116 121 179

Portfolio equity (stocks) 26 2 10 14 6 6 26 37 66 102 109 -41 111 123 3 98

Foreign direct investment 149 151 153 143 155 151 146 196 293 376 559 623 380 512 655 612 Net short-term 23 -48 -22 -10 17 4 40 67 85 78 138 3 47 256 175 103 Total net financial flows 289 184 181 172 188 155 236 366 517 707 1,055 815 666 1,103 1,109 1,135

finance, but that this cost was not leading to repayments that would end the cri-

sis. In response, U.S. Treasury officials crafted the Brady Plan (named after U.S.

Treasury Secretary Nicholas Brady). Beginning in 1989, each debtor country

could reach a deal in which its bank debt would be partially reduced, with most

of the remaining loans repackaged as “Brady bonds.” By 1994, most of the bank

debt had been reduced and converted into bonds. The debt crisis that began in

1982 was effectively over.

The Resurgence of Capital Flows in the 1990s Beginning in about 1990, lending to and investing in developing countries began

to increase again. Four forces converged to drive this new lending. First, the size

and scope of the Brady Plan led investors to believe that the previous crisis was

pug21774_ch21_502-538.indd 509pug21774_ch21_502-538.indd 509 14/11/14 4:00 pm14/11/14 4:00 pm

Final PDF to printer

510 Part Three Understanding Foreign Exchange

being resolved. As each debtor country agreed to a Brady deal, it was usually able

to receive new private lending almost immediately. Second, low U.S. interest rates

again led lenders to seek out higher returns through foreign investments. Third, the

developing countries were becoming more attractive places to lend as governments

reformed their policies. Governments were opening up opportunities for financing

profitable new investments as they deregulated industries, privatized state-owned

firms, and encouraged production for export with outward-oriented trade policies.

Fourth, individual investors, as well as the rapidly growing mutual funds and pen-

sion funds, were looking for new forms of portfolio investments that could raise

returns and add risk diversification. Developing countries became the emerging

markets for this portfolio investment.

Figure 21.2 shows the rapidly growing flows of investments into developing coun-

tries, as total net financial inflows increased from 1986 to 1997. The majority of this

money went to a small number of developing countries viewed as the major emerg-

ing markets—Mexico, Brazil, and Argentina in Latin America and China, Indonesia,

Malaysia, South Korea, and Thailand in Asia. The types of investments were different

from those that drove the lending surge in the late 1970s. Foreign portfolio investors’

net purchases of stocks and bonds rose from almost nothing in 1990 to about 30 percent

of the total net financial flows in the mid-1990s. Bank lending was less important, but

even bank lending increased substantially from 1994 to 1997.

The Mexican Crisis, 1994–1995 A series of crises punctured the generally strong flows of international lending to

developing countries since 1990. The first of these struck Mexico in late 1994.

Mexico received large capital inflows in the early 1990s, as investors sought

high returns and were impressed with Mexico’s economic reforms and its entry

into the North American Free Trade Area. But strains also arose. The real

exchange-rate value of the peso increased because the government permitted only

a slow nominal peso depreciation, while the Mexican inflation rate was higher

than that of the United States, its main trading partner. The current account

FIGURE 21.3 Developing Countries’ External Debt Outstanding, 197022012 (Billions of U.S. Dollars, Unless Otherwise Indicated)

Type of Debt 1970 1980 1985 1990 1995 2000 2005 2012

Long-term debt 61 386 679 987 1,375 1,635 1,794 3,406 Public and publicly guaranteed 45 323 599 932 1,174 1,184 1,229 1,766 Private nonguaranteed 15 63 80 55 199 450 565 1,641 Loans from the IMF 1 11 36 33 50 61 63 146 Short-term debt 9 112 118 174 319 269 481 1,278 Total debt 70 510 833 1,194 1,744 1,966 2,338 4,830 Debt/GNP ratio (percentage) 14.0 26.1 38.3 39.9 40.0 37.0 27.2 22.1 Debt service-exports of goods and services ratio (percentage) 16.2 20.6 27.8 21.9 19.3 21.1 13.8 9.8

Source: World Bank, International Debt Statistics.

pug21774_ch21_502-538.indd 510pug21774_ch21_502-538.indd 510 14/11/14 4:00 pm14/11/14 4:00 pm

Final PDF to printer

Chapter 21 International Lending and Financial Crises 511

deficit increased to 6 percent of Mexico’s GDP in 1993, although this was readily

financed by the capital inflows. Mexico’s banking system was rather weak, with

inadequate bank supervision and regulation by the government. With the capital

inflows adding funds to the Mexican banking system, bank lending grew rapidly,

as did defaults on these loans. The year 1994 was an election year with some tur-

moil, including an uprising in the Chiapas region and two political assassinations.

The peso came under some downward pressure. The government used sterilized

intervention to defend its exchange-rate value, so its holdings of official interna-

tional reserves fell.

Mexico’s fiscal policy was reasonable, with a modest government budget deficit.

Still, the fiscal authorities made the change that became the center of the crisis, by

altering the form of the government debt. Beginning in early 1994, the government

replaced peso-denominated government debt with short-term dollar-indexed govern-

ment debt called tesobonos . By the end of 1994, there were about $28 billion of tesobonos outstanding, most maturing in the first half of 1995.

The crisis was touched off by a large flight of capital, mostly by Mexican resi-

dents who feared a currency devaluation and converted out of pesos. In December

the currency was allowed to depreciate, but Mexican holdings of official reserves

had declined to about $6 billion. The financial crisis arose as investors refused to

purchase new tesobonos to pay off those coming due because it appeared that the government did not have the ability to make good on its dollar obligations. Each

investor wanted to be paid off in dollars—a rush to the exit—but what was rational

for each investor individually was not necessarily rational for all of them collec-

tively. The Mexican government might not be able to repay all of them within a short

time period. As investors reassessed their investments in emerging markets, they

pulled back on investments not only in Mexico but also in many other developing

countries (the “tequila effect”).

The U.S. government became worried about the political and economic effects of

financial crisis in Mexico, and it arranged a large rescue package that permitted the

Mexican government to borrow up to $50 billion, mostly from the U.S. government

and the International Monetary Fund (IMF). 2 The Mexican government did borrow

about $27 billion, using the money to pay off the tesobonos as they matured and to replenish its official reserve holdings. The currency depreciation and the financial

turmoil caused rapid and painful adjustments in Mexico. The Mexican economy

went into a severe recession, and the current account deficit disappeared as imports

decreased and exports increased.

As the rescue took hold, the pure contagion that led investors to retreat from nearly

all lending to developing countries calmed after the first quarter of 1995. The adverse

tequila effect lingered for a smaller number of countries, as investors continued to pull

out of Argentina, Brazil, and, to lesser extents, Venezuela and the Philippines. Still,

much of the Mexican financial crisis of 1994–1995 was resolved quickly. As shown

in Figure 21.2, overall capital flows to developing countries continued to increase in

1995 and 1996.

2 For information on IMF loans to countries with balance of payments problems, see the box “Short of Reserves? Call 1-800-IMF-LOAN.”

pug21774_ch21_502-538.indd 511pug21774_ch21_502-538.indd 511 14/11/14 4:00 pm14/11/14 4:00 pm

Final PDF to printer

512 Part Three Understanding Foreign Exchange

The Asian Crisis, 1997 In the early and mid-1990s, foreign investors looked favorably on the rapidly growing

developing countries of Southeast and East Asia. In these countries macroeconomic

policies were solid. The governments had fiscal budgets with surpluses or small

deficits; steady monetary policies kept inflation low, and trade policies were outward-

oriented. Most of the foreign debt was owed by private firms, not by the governments.

A closer look showed a few problems. In Thailand and South Korea, much of the

foreign borrowing was by banks and other financial institutions. Government regulation

and supervision were weak. The banks took on significant exchange-rate risk by borrow-

ing dollars and yen and lending in local currencies. And the lending boom led to loans to

riskier local borrowers and rising defaults on loans. In Indonesia, much of the foreign bor-

rowing was by private nonfinancial firms, which took on the exchange-rate risk directly.

The external balance of the countries also showed some problems. The real exchange-

rate values of these countries’ currencies seemed to be somewhat overvalued, and the

growth of exports slowed beginning in 1996. With the exception of Thailand, the current

account deficits were not large. Thailand’s current account deficit rose to 8 percent of

GDP in 1996. Still, the strong capital inflows provided financing for the deficits.

Crisis struck first in Thailand. Beginning in 1996, the expectation of declining

exports led to large declines in Thai stock prices and real estate prices. The exchange-

rate value of the Thai baht came under downward pressure. By mid-1997, the pres-

sures had become intense. Banks and other local firms that had borrowed dollars and

yen without hedging rushed to sell baht to acquire foreign currency assets. The Thai

government could not maintain its defense, and the baht was allowed to depreciate

beginning in July 1997.

Throughout the rest of 1997 the crisis spread to a number of other Asian countries,

especially to Indonesia and South Korea, and also to Malaysia and the Philippines, as

foreign investors lost confidence in local bank borrowers and the local stock markets,

and as local borrowers scrambled to sell local currency to establish hedges against

exchange-rate risk. Figure 21.4 shows the declines of 40 percent or more in the

exchange-rate values of the currencies of Thailand, Indonesia, Korea, Malaysia, and

the Philippines during the second half of 1997. (The figure also shows that the value

of the Singapore dollar was affected much less, and the value of the Hong Kong dollar,

fixed to the U.S. dollar through its currency board, not at all.)

In response, the IMF organized large rescue packages, with commitments to lend

up to $17 billion to Thailand ($13 billion actually borrowed), up to $42 billion to

Indonesia ($11 billion borrowed), and up to $58 billion to South Korea ($27 billion

borrowed). As in Mexico, these large rescue packages and policy changes did

contain the crises, though not without costs. The currency depreciations and the

recessions did lead to improvements in the current account balance, largely through

decreases in imports. However, these countries also went into severe recessions.

The Russian Crisis, 1998 Russia weathered the Asian crisis in 1997 reasonably well, but its underlying fundamental

position was remarkably weak. It had a large fiscal budget deficit, and government

borrowing led to rapid increases in government debt to both domestic and foreign

pug21774_ch21_502-538.indd 512pug21774_ch21_502-538.indd 512 14/11/14 4:00 pm14/11/14 4:00 pm

Final PDF to printer

Chapter 21 International Lending and Financial Crises 513

—Continued on next page

Global Governance Short of Reserves? Call 1-800-IMF-LOAN

As we noted in the box “The International Monetary Fund” in the previous chapter, one of the IMF’s major activities is lending to its mem- bers when appropriate to give them time to correct payments imbalances. These loans can be large and they can be controversial.

The IMF makes loans under a number of dif- ferent programs, and maximum amounts of loans from the various programs are in proportion to a country’s quota contribution to the IMF. Standard loans to assist a country to address its balance of payment problems are called stand-by arrange- ments , and the IMF also makes longer (extended fund) loans. These loans are made at market- based interest rates, with larger loans incurring a higher rate. Standard loans normally are to be repaid within five years.

With programs first offered in the mid-1970s, the IMF also makes loans at very low (con- cessional) interest rates to low-income coun- tries. Facilities under the Poverty Reduction and Growth Trust make loans to assist countries with protracted or urgent balance of payments prob- lems. The loans are to be repaid within 10 years. These low-rate loan programs seem to be a form of “mission creep,” as they shift the IMF to a role as a development organization.

The accompanying figure shows IMF lending since 1970. Up to the early 1980s both industrialized countries and developing countries borrowed from the IMF. From 1980 to 2010 most IMF loans went to developing countries at market-based rates. The low-rate lending to poor developing coun- tries is not large in total, with less than $10 billion outstanding. From 1987 to 2008 no industrialized country borrowed from the IMF. Then, Iceland borrowed in 2008, Greece borrowed in 2010, and Ireland and Portugal borrowed in 2011, as each of these countries experienced a crisis.

Let’s focus on the major part of IMF lend- ing, loans with market-based interest rates to countries with large payments deficits, coun- tries whose official reserves are declining to low levels. The loans provide additional official reserve assets to the country. The country can use these

additional reserves to buy time for the country to make orderly macroeconomic adjustments to reduce the deficit, without resorting to exchange controls or trade restrictions. Ideally, the adjust- ment can occur without excessive costs or disrup- tions to the country or to other countries.

The IMF only makes loans that it expects to be repaid. The IMF requires a borrowing country to agree to how it intends to correct its payments imbalance. That is, the IMF imposes conditionality — the IMF makes a loan only if the borrowing country commits to and enacts changes in its policies with quantified performance criteria. The policies should promise to achieve external balance within a reason- able time. The IMF disburses some loans in pieces over time. It withholds pieces if the performance criteria are not met. The policy changes that are usu- ally included in an IMF adjustment program are not surprising. They include fiscal and monetary restraint, liberalization of restrictions on domestic markets and on international trade, and deregulation.

What is the record for these IMF loans? Do they work? One answer is repayment. Prior to the mid-1980s, nearly all loans had been repaid on time. However, from 1985 to 1992, rising amounts, reaching $4.8 billion, were not repaid on time. These overdue payments then declined and were about $2 billion during 2008–2013.

Do the loans assist payments adjustment? Evaluation of the effects of the loans and the conditions attached to them is difficult—what would have happened without them? Nonetheless, the programs accompanying IMF loans typically appear to result in increases in a country’s exports, decreases in imports, and reduction in the payments deficits, but these changes are often temporary.

The conditions that a government is required to meet for a loan are often not popular domesti- cally. The policy changes are usually contractionary, for instance, reductions in the rate of new lending by banks in the country. Indeed, the conditions are often resisted, and half or more of the lending pro- grams break down because the conditions are not met by the country’s government, as happened in Russia in 1998 and Argentina in 2001.

pug21774_ch21_502-538.indd 513pug21774_ch21_502-538.indd 513 27/11/14 7:04 pm27/11/14 7:04 pm

Final PDF to printer

514 Part Three Understanding Foreign Exchange

In the programs for the Asian crisis countries, the use of conditions seemed to get out of hand. The agreement with Indonesia had 140 conditions, and the agreement with the Philippines over 100. Some of these conditions required changes in basic economic structures and institutions, includ- ing changes in labor rules and business governance. Critics saw these structural conditions as unneces- sary to address the external imbalances. In 2002 the IMF adopted guidelines to focus its conditionality on measures crucial to the needed macroeconomic adjustment, with fewer conditions that are easier to monitor for compliance. The fund hopes that this change will elicit more support for its require- ments from the governments (and the people) of the borrowing countries.

Finally, you can see that the accompanying figure shows interesting recent developments. The

amount of outstanding market-based IMF loans decreased dramatically from $107 billion at the end of 2003 to $16 billion in early 2008. Countries like Indonesia, Brazil, and Argentina were able to pay back their loans early, and there were no new major financial crises from 2002 through early 2008.

IMF lending expanded rapidly with the wors- ening of the global financial and economic crisis in 2008. During 2008–2010 the IMF reached agreements for market-rate lending arrange- ments for 28 countries. By mid-2014 IMF loans outstanding had reached a total of $125 billion. While the IMF seemed in danger of becoming irrelevant in early 2008 because it was lending so little, it has regained its importance in global governance with a host of new lending programs to countries in trouble, both small industrialized countries and developing countries.

IMF Loans Outstanding, 1970–2013 (Billions of U.S. Dollars)

1 9 7 0

1 9 7 5

1 9 8 0

1 9 8 5

1 9 9 0

1 9 9 5

2 0 0 0

2 0 0 5

100

120

2 0 1 0

Industrialized countries

Developing countries Low rate

Developing countries Market-based rate

Source: International Monetary Fund, International Financial Statistics.

pug21774_ch21_502-538.indd 514pug21774_ch21_502-538.indd 514 14/11/14 4:00 pm14/11/14 4:00 pm

Final PDF to printer

Chapter 21 International Lending and Financial Crises 515

lenders. In mid-1998, lenders balked at buying still more Russian government debt. In

July 1998, the IMF organized a lending package under which the Russian government

could borrow up to $23 billion, and the IMF made the first loan of $5 billion. However,

the Russian government failed to enact policy changes included as conditions for the

loan. The exchange-rate value of the ruble came under severe pressure as capital flight

by wealthy Russians led to large sales of rubles for foreign currencies. With substantial

debt service due on government debt during the second half of 1998, investor confidence

declined, with selling pressure driving down Russian stock and bond prices.

In August 1998, the Russian government announced drastic measures. The govern-

ment unilaterally “restructured” its ruble-denominated debt, effectively wiping out

most of the creditors’ value. It placed a 90-day moratorium on payments of many

foreign currency obligations of banks and other private firms, a move designed to

protect Russian banks. And it allowed the ruble to depreciate by shifting to a floating

exchange rate. Russia requested the next installment of its loan from the IMF, but the

IMF refused because the government had not met the conditions for fiscal reforms.

Foreign lenders were in shock. They had expected that Russia was too important

to fail and that the IMF rescue package would provide Russia with the funds to repay

them. They reassessed the risk of investments in all emerging markets and rapidly

sought to reduce their investments. The selloff caused stock and bond prices to plum-

met, with a general flight to high-quality investments like U.S. government bonds.

FIGURE 21.4 Exchange Rates, Asian Countries, 1994–2014

Source: International Monetary Fund, International Financial Statistics .

U .S

. d

o ll a rs

p e r

u n

it o

f th

e c

u rr

e n

cy (i

n d

e x

n u

m b

e r,

J u

n e 1

9 9 7 5

1 0 0 )

100

120

January 1994

January 1997

January 2000

January 2003

January 2006

January 2009

January 2012

Hong Kong dollar

Singapore dollar

Korean won

Thai baht

Philippines peso

Indonesian rupiah

Malaysian ringgit

pug21774_ch21_502-538.indd 515pug21774_ch21_502-538.indd 515 14/11/14 4:00 pm14/11/14 4:00 pm

Final PDF to printer

516 Part Three Understanding Foreign Exchange

The reversal of international bank lending and stock and bond investing in 1998 led

to a decline in net long-term financial flows to developing countries (see Figure 21.2).

Argentina’s Crisis, 2001–2002 In the late 1980s, Argentina’s economy was a mess, with hyperinflation of over

2,000 percent per year and a currency whose exchange value was in free fall. In a few

years in the early 1990s everything changed, as it fixed its peso to the U.S. dollar using a

currency board, reduced its inflation rate to almost zero, and grew rapidly up to 1998. It

also strengthened its banking system and established sound regulation and supervision.

Foreign investors saw all this and they liked it—foreign capital flowed into Argentina.

Beginning in 1997 the peso experienced a real appreciation, first because the dollar

strengthened against other currencies and then because Brazil’s currency depreciated

by a large amount in 1999. The international price competitiveness of Argentina’s

products declined and its current account deficit increased. Its fiscal situation had been

a weak point all along, and the fiscal deficit increased as the economy went through

years of recession beginning in 1998. Much of the government debt was denominated

in foreign currencies and owed to foreign lenders and bondholders.

In late 2000 Argentina reached agreement for a package of official loans of up to

$40 billion, with $14 billion committed by the IMF. However, things did not improve,

and the fiscal deficit remained a problem. Private capital inflows dried up. Rising inter-

est rates in Argentina made the recession worse. In September 2001 the IMF made an

unusually large disbursement of $6 billion to Argentina, but it was to be the last. The

IMF refused to make additional loans because the government had not met the condi-

tions set by the Fund for improvements in government policies.

The Argentinean people began to fear for the continuation of the fixed exchange

rate and the soundness of the banking system. In response to depositor runs on

banks, the government closed the banks in November. When the banks reopened in

December, withdrawals were severely limited. Angry protest spawned looting and

rioting, with 23 deaths. The country’s president resigned, and Argentina then had four

new presidents in two weeks.

In early 2002 the government surrendered the fixed exchange rate, and the peso

lost about 75 percent of its value in the first six months of the year. The government

defaulted on about $140 billion of its debt, much of it owed to foreigners. In addition,

the peso depreciation caused huge losses in the banks because of some mismatch of

dollar liabilities and dollar assets, and especially because of the terms under which

the government mandated the conversion of dollar assets and liabilities into pesos.

A number of banks closed, and the banking system was nearly nonfunctional. During

2002 real GDP declined by 11 percent, a huge recession after the economy had already

endured several previous years of recession.

At first it appeared that Argentina’s collapse would have few effects on other

developing countries because it had been widely expected. But after a few months

Argentina’s problems did spread to its neighbors, especially Uruguay. Uruguay

relied on Argentina for tourism and banking business. The tourism dried up, and

Argentinean withdrawals from their Uruguayan accounts increased. After its holdings

of official reserves plummeted defending Uruguay’s crawling pegged exchange rate,

the Uruguay government floated its currency in June; within two weeks, the currency

pug21774_ch21_502-538.indd 516pug21774_ch21_502-538.indd 516 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

Chapter 21 International Lending and Financial Crises 517

had fallen by half. In August Uruguay received an IMF rescue package and used it

to stabilize its financial situation. Still, it suffered a severe recession, with real GDP

declining by over 10 percent during the year.

FINANCIAL CRISES: WHAT CAN AND DOES GO WRONG

International lending to developing countries brings benefits, but, as we just saw

in the history of the past several decades, it also brings recurrent financial crises.

How can we understand the frequency and scope of these crises? We gain major

insights by focusing on five major forces that can, and do, lead to financial crises:

1. Waves of overlending and overborrowing.

2. Exogenous international shocks.

3. Exchange-rate risk.

4. Fickle international short-term lending.

5. Global contagion.

Waves of Overlending and Overborrowing Our model of well-behaved lending, shown in Figure 21.1, assumes that lenders only lend

(and that borrowers only borrow) for investment projects that generate the returns in the

future that can be used to service the debt. This is not always true. In the late 1970s and

again in the mid-1990s, lenders seemed to lend excessive amounts to some countries.

The classic explanation of overlending/overborrowing is that it results from exces-

sively expansionary government policies in the borrowing country. These policies

lead to government borrowing to finance growing budget deficits, and the government

may also guarantee loans to private borrowers in order to finance the growing current

account deficits. Lending to national governments, like the Mexican government in

the late 1970s and early 1980s or the Argentinean government in the 1990s, seems to

be low risk, but it’s not. When the government realizes that it has borrowed too much,

it has an incentive to default, and a financial crisis arises. (The box “The Special Case

of Sovereign Debt” examines government defaults in more depth.)

The Asian crisis (and to a lesser extent the Mexican crisis of 1994–1995) presented a

new form of overlending and overborrowing: too much lending to private borrowers rather

than to national governments. In the 1990s, lending to banks in Asian countries seemed to

be low risk because the countries’ governments provided guarantees that creditors would

be repaid. Large capital inflows lead to easy domestic credit. In a domestic lending boom,

some of the lending is for current consumption, so that it is not invested to generate future

returns. 3 Other lending goes to investments that are of low quality—projects that offer low

returns or are too risky (too likely to fail to produce returns). More generally, the capital

inflows and lending boom tend to inflate stock and real estate prices. For a while the

capital inflows appear to be earning high returns, until the price bubble bursts.

3 Borrowing for current consumption can be sensible if it is part of a strategy to smooth the country’s consumption over time. It makes sense if the country’s income will be higher in the future, so that part of the higher future income can be used to repay the loan. But borrowing for current consumption is also risky because it is not adding to future income potential.

pug21774_ch21_502-538.indd 517pug21774_ch21_502-538.indd 517 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

518 Part Three Understanding Foreign Exchange

Extension The Special Case of Sovereign Debt

Most long-term debt of developing countries is sovereign debt —debt of the government of the country or debt of private borrowers that is guar- anteed by the country’s government. According to the information in Figure 20.3, sovereign debt was 94 percent of total long-term debt in 1990, and this was still 52 percent in 2012, notwith- standing the rising importance of investments in the securities of private companies.

Sovereign borrowers are different. They cannot be legally forced to repay if they do not wish to do so. Creditors cannot sue them in court or seize their assets. Granted, there have been times in the past when creditors could force repayments: Britain and France were able to take over Egyptian tax col- lections in the latter half of the 19th century after Egypt failed to repay English and French creditors, and creditors were backed by gunboats when they demanded repayment from Venezuela at the beginning of the 20th century. But the gunboat days are over. If Malaysia defaults on its debts, the United States and other lending countries cannot send gunboats to Malaysia. Nor can they send thugs to beat up the Malaysian finance minister.

If sovereign debtors cannot be forced to repay, why should they ever repay? The usual answer—that the debtor will repay on time to protect its own future creditworthiness— surprisingly turns out to be false, at least by itself. If fresh loans keep growing fast enough, the debtor country can afford to repay an ever- growing debt service. But this is no solution if the debtor never actually repays the full amount. When lenders tire of “repaying themselves” and cut their new lending, the debtor then defaults.

The answer to why sovereign debtors repay requires that they have something more to lose than just access to future loans. In domestic lend- ing, collateral works well as the something more to lose. National laws allow the creditor to take over assets of the nonrepaying debtor, but only in amounts tied to the value defaulted.

Aside from creditworthiness, what might the sovereign debtor lose when it defaults? There are ways to create seizable international collateral, even though they are not perfect counterparts

to the collateral recognized by domestic law. If a debtor country has actual investments in the banks and enterprises of the creditor country, it should worry that these could be seized in retali- ation, as when the United States froze Iranian assets in response to the Teheran hostage crisis in 1979–1981 and several countries froze Iraqi assets after Iraq invaded Kuwait in 1990. In practice, however, the international collateral mechanism is not finely tuned. The value of such assets is not necessarily close to the size of the possible default by the debtor country, and it may be legally dif- ficult for the creditors to seize them.

There are two other sources of loss to the debtor country from default. First, the country can experi- ence macroeconomic costs. We have seen that defaults linked to financial crises disrupt the domes- tic financial system and the domestic economy. The economy usually goes into a severe recession, exacting a large cost on the country. In addition, the debtor country may lose some ability to export and import if it loses access to trade financing or if new barriers are erected to its trade by the credi- tor countries. Second, the country can experience a general loss of reputation that results in a loss of other benefits. For instance, multinational firms may see the default as a sign of increased country risk. If multinationals fail to invest or they pull out of the country, it loses the spillover benefits from the technology, management practices, worker training, and marketing skills that the multinational firms bring to the country.

These extra losses create a true benefit–cost problem for the sovereign debtor considering default. And the answer to this benefit–cost problem indicates the limits to prudent lend- ing to the sovereign borrower. The key forces are summarized in the accompanying graph. To simplify, let’s examine the case in which the sov- ereign borrower owes full payment of all debt and interest at the end of the period, equal to the stock of debt ( D ) plus the interest due on this debt ( iD ). The debtor is considering full default, so that the straight line (1 1 i ) D shows the ben- efits of not repaying. The debtor’s cost ( C ) of not repaying also depends on the stock of debt, but

pug21774_ch21_502-538.indd 518pug21774_ch21_502-538.indd 518 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

Chapter 21 International Lending and Financial Crises 519

only to some extent. There is a fixed cost ( C 0 ) to

any nonrepayment, regardless of the amount of debt. The fixed cost could be in the form of reduced creditworthiness, macroeconomic costs, or some loss of general reputation. Beyond C

0 ,

the cost of not repaying probably rises with the amount of debt not honored, but not as fast as the stock of debt itself. Loss of access to future loans, asset seizures, macroeconomic costs, and more serious loss of general reputation are prob- ably larger if the default is larger, but these losses are limited. A bigger default does not bring a much bigger penalty.

The fact that the cost of not repaying rises more slowly with extra debt than does the benefit of default means that the sovereign debtor repays debt faithfully as long as the debt is not too large. However, beyond some threshold amount of debt ( D

limit ), the willingness to repay disappears. Well-

behaved lending occurs to the left of the limit because the cost of nonrepayment exceeds the amount of debt service that could be avoided.

Actual default can occur for any of several reasons. First, the borrower may amass debt larger

than D limit

. This is overlending and overborrowing, discussed in the text. We gain a subtle insight from the analysis here. Sovereign debtors may decide that it is not wise to repay even if they are able to repay. Second, a rise in the real rate of interest raises the benefit of not repaying. This is an upward rotation of the benefit line (1 1 i ) D in the graph. If the sovereign debt just equaled D

limit before the

increase in the interest rate, then it is now above the new D

limit for the higher interest rate. The coun-

try has the incentive to default. This is an example of how exogenous shocks (discussed in the text) apply to the special case of sovereign debt.

Should lenders make new loans if the sovereign debtor announces that it “cannot” repay with- out new loans to cover its current debt service? The graph suggests a negative answer. The debt- or’s announcement suggests that the stock of debt is already over the safe limit ( D . D

limit ).

Extending more loans to cover current inter- est payments moves us farther to the right ( D rises). The gap between the debtor’s benefits and the costs of not repaying grows wider. Unless something else changes, default will occur.

Stock of debt (D)0

Benefits and costs of not repaying this period

Dlimit

Debt service due this period 5 benefit from not repaying 5 (1 1 i )D

Cost of not repaying (C ) 5 assets that could be seized, denial of benefits of future credit, macroeconomic costs, general loss of reputation, etc.

If D is in this range, debtor will repay

If D is above Dlimit, debtor will not repay

pug21774_ch21_502-538.indd 519pug21774_ch21_502-538.indd 519 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

520 Part Three Understanding Foreign Exchange

Once foreign lenders realize that too much has been lent and borrowed, each has

the incentive to stop lending and to try to get repaid as quickly as possible (before

available money runs out). All cannot be repaid quickly, and a financial crisis erupts.

The excessive lending/borrowing that can lead to a financial crisis is sometimes called

a debt overhang —the amount by which the debt obligations exceed the present value of the payments that will be made to service the debt.

Exogenous International Shocks When exogenous international shocks hit a country’s economy, international lenders

and the borrower must reassess the borrower’s ability to meet its obligations to ser-

vice its debt. For instance, a decline in export earnings, perhaps due to a decline in

the world price of the country’s key export commodity, makes it more difficult for the

country to service its debt and thus more likely to default.

The experiences of the early 1980s and mid-1990s indicate that a change in U.S.

real interest rates is a major exogenous shock. New funding flows to developing coun-

tries decrease, as fewer projects meet this higher required return. In addition, projects

previously funded may not be profitable enough, leading to difficulties in servicing

bank loans and to decreases in the market prices of stocks and bonds in the develop-

ing countries. Foreign investors can sour on their investments and try to sell them off

before values decline further. The abrupt shift in flows can result in a crisis if the bor-

rowers cannot adjust quickly enough.

Exchange-Rate Risk Sometimes the form of the debts can help us understand financial crises. In the

Mexican and Asian crises, private borrowers took on large liabilities denominated in

foreign currency while acquiring assets valued in local currency. The borrowers took

on these positions exposed to exchange-rate risk because they expected (hoped?) that

the government would continue to defend the fixed or heavily managed exchange-rate

value of the foreign currency. A major part of this uncovered foreign borrowing was

the “carry trade,” in which financial institutions borrow dollars or yen at a low interest

rate, exchange the money to local currency, and lend in the borrowing country at a

higher interest rate. This is very profitable as long as the exchange value of the local

currency is steady (so that local currency can be exchanged back to dollars or yen at

the same rate in the future, to repay the foreign borrowing).

When the likelihood of devaluation or depreciation becomes noticeable, the bor-

rowers attempt to hedge their exposed positions by selling local currency, but this

puts additional pressure on the government defense of the fixed exchange rate. If the

government gives up the fixed rate, borrowers suffer losses to the extent that their

positions are still unhedged. The losses make it more difficult for them to service their

foreign debts. Foreign lenders then may reduce new lending and try to be repaid more

quickly, leading to a financial crisis.

Fickle International Short-Term Lending Another form of debt can help us understand financial crises. Short-term debt—debt

that is due to be paid off soon—can cause a major problem because foreign lenders

can refuse to refinance it. The inability of the Mexican government to refinance the

pug21774_ch21_502-538.indd 520pug21774_ch21_502-538.indd 520 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

Chapter 21 International Lending and Financial Crises 521

large amount of short-term tesobonos that were coming due was a major contributor to the Mexican crisis of 1994–1995. In the Asian crisis, the large amount of short-term

borrowing by banks that was coming due created a policy dilemma for the countries’

governments. The governments could raise interest rates to attract continued foreign

financing, but this would weaken local borrowers and hurt the banks’ loan returns.

Instead, the governments could guarantee or take over the banks’ foreign borrowings,

based on the need to prevent the local banks from failing. But the governments them-

selves did not have sufficient foreign exchange to pay off the debts, so they risked

setting off a financial crisis on their own if foreign lenders demanded repayment.

Short-term debt is risky to the borrowing country because international lenders can

readily shift from one equilibrium to another, based on their opinion of the country’s

prospects. In one equilibrium, the lenders refinance or roll over the short-term debt,

and this can continue into the future. But a rapid shift to another equilibrium in which

lenders demand repayment is also possible. If the borrowing country cannot come up

with the payoff quickly, a financial crisis occurs.

Global Contagion The four forces already discussed—overlending/overborrowing, exogenous shocks,

exchange-rate risk, and short-term borrowing—provide major insights into why a

financial crisis could hit a country. But the financial crises since 1980 were more

than this. When a crisis hits one country, it often spreads and affects many other

countries. It appears that international contagion is at work. Some contagion is the result of close trade links between the affected countries; thus, a crisis downturn in

one country, like Argentina, has spillover effects in another country, like Uruguay.

Contagion can be an overreaction by foreign lenders as they engage in a scramble

for the exits. Herding behavior can occur. Borrowers often do not provide full infor-

mation to lenders. The high costs of obtaining accurate information on their own can

lead some lenders to imitate other lenders who may have better information about the

borrowers, or to fear that other borrowing countries are likely to have problems similar

to those of the crisis country, even if there is no evidence that this is true.

Contagion can also be based on new recognition of real problems in other countries

that are similar to those in the country with the initial crisis. The financial crisis in

one country can serve as a “wake-up call” that other countries really do have similar

problems. The crisis in Mexico led to a more severe tequila effect in countries that had

problems similar to those of Mexico—currencies that had experienced real apprecia-

tions, weak banking systems and domestic lending booms, and relatively low holdings

of official international reserves. In Asia the crisis in Thailand led to a recognition that

Indonesia and South Korea had similar problems, including a weak banking sector,

declining quality of domestic capital formation, a slowdown in export growth, and

fixed exchange rates that may not be defensible for very long.

Analysis suggests that different forms of contagion are probably important and

occur together in many crises. The initial reaction to a crisis in one country is often

pure contagion, as international lenders pull back from nearly all investments in devel-

oping countries. Lenders then examine the other countries more closely. International

lenders resume lending to those countries that do not seem to have problems. But

the financial crisis spreads to those countries that seem to have similar problems.

pug21774_ch21_502-538.indd 521pug21774_ch21_502-538.indd 521 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

522 Part Three Understanding Foreign Exchange

Although the spread of the crisis has a basis in the recognition of actual problems,

it is still a kind of contagion effect. Without the crisis in the first country, the other

countries probably would have avoided their own crises.

RESOLVING FINANCIAL CRISES

A financial crisis in a developing country has serious negative consequences for the bor-

rowing country and its economy. As new lending to the country dries up, the economy

goes into recession. Also, a financial crisis in one country can threaten the economies of

other countries and the broader global financial system, through contagion effects that

reduce capital flows to other borrowers and can send some into their own crises. The two

major types of international efforts to resolve financial crises have been rescue packages

and debt restructuring. Let’s look at each of these, how they work, and the questions that

arise about these efforts.

Rescue Packages When a financial crisis hits a country, that country’s government usually seeks a

rescue package of loan commitments to assist it in getting through the crisis. As indicated in the discussion of the history of lending to developing countries, the sizes

of these rescue packages have been large since the mid-1990s, for example, $17 billion

for Thailand and $58 billion for South Korea. The lenders generally included the IMF,

the World Bank, and some national governments.

A rescue package can have several purposes. First, the loans in the rescue package

compensate for the lack of private lending during the crisis. The money allows the coun-

try to meet its needs for foreign exchange, to provide some financing for new domestic

investments, and to cushion the decline in aggregate demand and domestic production.

Second, the package can restore investor confidence by replenishing official reserve hold-

ings and by signaling official international support for the country and its government.

This can stem the capital outflow, even if it does not immediately restart new private

foreign lending to the country. Third, the IMF and the other official lenders in the rescue

package hope that the package will limit contagion effects that could spread the crisis to

other countries. As the leader in most of these efforts, the IMF is organizing an interna-

tional safety net, in a way similar to national efforts (like deposit insurance and discount

lending) to prevent problems at one bank from spreading to other banks in the national

financial system. Fourth, the IMF imposes conditions as part of its lending, to require the

government of the crisis country to make policy changes that should speed the end of the

financial crisis. These policy reforms usually include tighter monetary policy and tighter

fiscal policy, and they may include other structural reforms like liberalizing restrictions on

international trade or improving regulation of the banking system (an issue that we will

take up in the next section of the chapter).

One major question about these rescue packages is how effective they actually

are. The rescue package for Mexico in 1995 seemed to be very successful in help-

ing Mexico to resolve its financial crisis. The packages for the Asian countries in

1997 were at best moderately successful. The economies went into surprisingly deep

recessions, and the exchange-rate values of the countries’ currencies declined greatly

before stabilizing. Russia was a nontest—Russia did not abide by the IMF conditions,

pug21774_ch21_502-538.indd 522pug21774_ch21_502-538.indd 522 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

Chapter 21 International Lending and Financial Crises 523

so the package never took hold. The package for Argentina did not succeed in head-

ing off a crisis, but it also was withdrawn before the crisis because the Argentinean

government did not meet the IMF’s conditions.

The other major question about the rescue packages is whether they actually increase

the likelihood of financial crises because they encourage overlending and overborrow-

ing. A large rescue package provides a bailout for lenders and borrowers when a crisis

hits. But if lenders and borrowers expect to be bailed out, then they should worry less

about the risk of a financial crisis. This leads them to lend and borrow more than is

prudent—an example of moral hazard, in which insurance leads the insured to be less careful because the insurance offers compensation if bad things happen. Given the costs

that the borrowers incur when a crisis hits, it seems that the moral hazard for them is

probably not too large. Borrowers still lose a lot even with a rescue package.

The rescue package can create moral hazard for lenders. In the Mexican crisis of

1994–1995, the rescue package was used to pay off foreign investors, including full

payment to the holders of the tesobonos. The lack of large losses to rescued creditors in the Mexican crisis probably encouraged too much international lending during

1996–1997 because the lenders worried too little about the risks of the lending.

In the Asian crisis, lenders to banks in the crisis countries were generally repaid in

full, using money from the rescue packages. Still, the scope for moral hazard had its

limits. Foreign investors in private bonds and stocks suffered large losses as the market

prices of these securities declined, and foreign banks suffered large losses on loans to

private nonfinancial borrowers.

The failure of the rescue package for Russia led to large losses for all foreign

creditors. Many of these lenders were specifically relying on a rescue to limit their

downside risk (moral hazard in action), so they received quite a surprise. Some of the

caution in lending to developing countries in the years after the Russian crisis was

probably the result of a reappraisal of the risks of this lending. This message was

reinforced when Argentina defaulted in 2002 without any bailout appearing. Moral

hazard in lending to developing countries has declined because lenders realize that

rescue packages may not provide a bailout.

Debt Restructuring Debt restructuring refers to two types of changes in the terms of debt:

• Debt rescheduling changes when payments are due, by pushing the repayments schedule further into the future. The amount of debt is effectively the same, but the

borrower has a longer time to pay it off.

• Debt reduction lowers the amount of debt.

When a financial crisis hits a country because the country has more debt than it

is willing or able to service, resolution of the crisis often requires debt restructuring.

By stretching out payments or reducing debt, the borrowing country gains a better

chance of meeting a more manageable stream of current and future payments for

debt service. A key issue is the process of reaching a restructuring agreement among

creditors and borrowers. There is a free-rider problem here. Each individual creditor

has the incentive to hold out, hoping that others restructure their lending agreements,

but not altering its own. Then the free rider can be repaid faster or fully, while other

pug21774_ch21_502-538.indd 523pug21774_ch21_502-538.indd 523 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

524 Part Three Understanding Foreign Exchange

creditors that agreed to restructuring must wait longer or get less. But if free riding

prevents a restructuring deal, then all creditors will probably lose, as the crisis is

not resolved.

The debt crisis of 1982 dragged on through the 1980s partly because there was

no framework for overcoming the coordination problem among the hundreds of

banks that had lent to the crisis countries. In addition to the free-rider problem, legal

clauses in many syndicated loan agreements limited debt restructuring. As we saw

earlier, the Brady Plan of 1989 finally established a process for debt restructuring. It

offered a menu of choices to the creditor banks, as well as coercion when necessary,

to overcome the free-rider problem. In a typical Brady deal, each bank was offered a

choice between partial debt reduction and continuance of its loan agreements along

with required new lending to the crisis country. The debt reduction occurred when the

bank exchanged its bank loans for a smaller amount of new bonds that were backed

by collateral (usually U.S. government bonds). The borrowing country was able to

establish the collateral by borrowing part of the value from the IMF and World Bank.

(As usual, the IMF also imposed conditions for policy changes by the country along

with its loan.) Brady deals succeeded in reducing the debt of 18 crisis countries by

$65 billion, about one-third of their total debt. As the Brady deals resolved the linger-

ing crisis, international lending to these countries resumed.

During the crises of the 1990s, restructuring of bank debt was smoother. The lim-

ited number of debtors and creditors eased the negotiations. The key issue that arose

in the 1990s was the difficulty of restructuring bonds.

Most sovereign bonds issued internationally before 2003 could not in principle

be restructured without the consent of all holders of the bond. There are often

hundreds or thousands of bondholders, so negotiations can be complicated, and

a few holdouts can try to prevent an agreement that the debtor country and most

bondholders find acceptable. (In addition, any bondholder can sue to force imme-

diate full repayment if the issuer defaults.) It is certainly possible to restructure

such international bonds fairly smoothly, as the examples of Ecuador, Pakistan,

and Uruguay show. But it can also be slow and acrimonious, as the examples of

Russia and Argentina indicate.

Some international bonds include collective action clauses, which

• Provide that a qualified majority (often 75 percent) can bind all bondholders to the

terms of a restructuring agreement.

• Require that all payments and recoveries from the issuer be shared evenly among

the bondholders.

• Mandate that there can be no legal action against the issuer unless a minimum

portion (often 25 percent) of bondholders agree to the suit.

Traditionally, bonds issued under New York State law did not include collective

action clauses. In 2003, a path-breaking issue under New York law by Mexico did

include a collective action clause, and it is now typical for bonds to include such

clauses. As bonds with collective action clauses become the norm, the process of

bond restructuring will be streamlined, to the benefit of both the issuers that run into

problems and most bondholders, who are likely to receive better partial repayments.

pug21774_ch21_502-538.indd 524pug21774_ch21_502-538.indd 524 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

Chapter 21 International Lending and Financial Crises 525

REDUCING THE FREQUENCY OF FINANCIAL CRISES

Financial crises in developing countries impose large costs through sudden declines

in access to lending and the macroeconomic costs of recessions and slow economic

growth that usually accompany the crises. Financial crises also create large losses for

international lenders though defaults, debt rescheduling, debt reduction, and declines

in the market prices of bonds, stocks, and loans that are traded on secondary markets.

While we have ways for trying to resolve crises once they occur, it would also be

great to find ways to prevent financial crises from occurring, or at least to reduce their

frequency.

There have been many proposals for improving the “international financial archi-

tecture.” Four reforms enjoy widespread support and have been adopted by many

countries. First, developing countries should pursue sound macroeconomic policies

to avoid creating conditions in which overborrowing or a loss of confidence in the

government’s capability could lead to a crisis. Second, countries should improve the

data that they report publicly to provide sufficient details on total debt and its com-

ponents, as well as on holdings of international reserves, and they should report these

data promptly. The belief is that with better data lenders will make more informed

decisions on lending and investing, making overlending less likely and reducing the

risk of pure contagion against emerging markets debt. While providing more informa-

tion is not controversial, it has its limits. Developing-country governments have the

incentive to provide misleading or incomplete data at exactly the times when lenders

most need accurate information. Third, developing-country governments should avoid

short-term borrowing denominated in foreign currencies to avoid crises that begin

when foreign lenders abruptly demand repayment. In the next part of this section we

look more closely at a fourth reform that enjoys widespread support—better regula-

tion and supervision of banks in developing countries.

Other proposals for reform are more controversial, and in some cases serious

competing proposals suggest moving in opposite directions. One proposal is that

developing countries should end efforts to fix or heavily manage the exchange-rate

values of their currencies. Among other possible benefits, the shift to more flexible

exchange rates makes the existence of exchange-rate risk palpable, so private borrow-

ers are less likely to build up large unhedged liabilities in foreign currencies. But a

competing proposal is that developing countries should move to nearly permanently

fixed exchange rates, with greater use of currency boards and dollarization. Such

arrangements may discipline government macroeconomic policies to be more sound.

In another set of competing proposals, one is that the IMF should expand its scope of

activities, including being ready to offer large rescue packages if a number of large

countries need assistance simultaneously. Backers of this proposal want the IMF to

be able to quell panics and contagion more effectively by acting more like a global

lender of last resort. The other is that the IMF should be abolished, or at least that its

rescue activities be severely limited, because it creates substantial moral hazard with

its lending. By encouraging overlending, it makes crises more likely. The IMF has

recently greatly increased the total amount that it can lend, so the proponents of the

expanding IMF are winning.

pug21774_ch21_502-538.indd 525pug21774_ch21_502-538.indd 525 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

526 Part Three Understanding Foreign Exchange

After we discuss proposals for better bank regulation, which is not controversial, we conclude the discussion of financial crises in developing countries with a look at a

proposal that is controversial: expanding the use of capital controls to limit borrowing.

Bank Regulation and Supervision Banks are considered to have a special role in an economy. They are at the center

of the payments system that facilitates transactions in the economy. They acquire

deposits from customers based on trust that the banks can pay back the deposits in the

future, but if this trust is broken, depositors create a run on the bank as they all try to

get their money out quickly.

In developing countries banks are often especially important because bank lending

is also the major source of financing for local businesses. Stock and bond markets are

often underdeveloped, but government regulation and supervision of banks in develop-

ing countries has often been weak. With weak regulation, banks engage in more risky

activities. Banks make loans based on relationships—“crony capitalism” loans to bank

directors, managers, friends of directors and managers, politically important people,

and their businesses. Banks take on large exposures to exchange-rate risk by borrowing

foreign currencies to fund local-currency loans. Banks operate with little equity capital,

so they are more likely to take risks and require government rescues. In addition, the

government often exerts direct influence on lending decisions, to favor some borrowers

based on the government’s strategy for economic development.

Thus, with weak supervision and an explicit or implicit guarantee that the govern-

ment will rescue banks in trouble, banks have incentives to borrow too much internation-

ally (and lenders are comfortable lending so much), and banks are more willing to take

the risk of unhedged foreign-currency liabilities. A financial crisis becomes more likely.

There is a clear need for better government regulation and supervision of local banks

in the borrowing countries. Regulators should require banks to use better accounting

and disclose more information publicly, to use risk assessment and risk management to

reduce risk exposures, to recognize bad loans and make provision for them, and to have

more equity capital. The regulators should be willing to identify weak banks, to insist on

changes in practices and management at these banks, and to close them if they are insol-

vent. In addition, the government probably should permit more foreign banks to operate

locally because these foreign banks may bring better management and better techniques

for controlling risks. Furthermore, a country’s government should get the sequencing of

its reforms right. To reduce the risk of a crisis, the country should solidify its regulation

of banks and other financial institutions before it liberalizes its financial account and provides them with easy access to foreign-currency exposures.

In the abstract, the proposal for better bank regulation and supervision in develop-

ing countries is not controversial. The challenge is in the implementation. There is

likely to be political resistance—from the banks, from the borrowers favored by crony

capitalism, and from the government officials who lose some power to direct bank

lending. Even if such political resistance can be overcome, there is also a shortage of

people with the expertise to regulate banks effectively. Bank regulation and supervision

meet world standards in some countries like Brazil, and supervision will continue to

improve in developing countries more generally, but the improvement is likely to be a

slow process.

pug21774_ch21_502-538.indd 526pug21774_ch21_502-538.indd 526 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

Chapter 21 International Lending and Financial Crises 527

Capital Controls A controversial proposal for reducing the frequency of financial crises is to increase

developing countries’ use of controls or impediments to capital inflows. 4 Such con-

trols could take any of several forms, including an outright limit or prohibition, a tax

that must be paid to the government equal to some portion of the borrowing, or a

requirement that some portion of the borrowing be placed in a deposit with the coun-

try’s central bank. (If this deposit does not earn interest, then it is effectively a tax on

the borrowing.) There are three ways in which such controls can reduce the risk of

financial crisis. First, the controls can prevent large inflows that could result in over-

lending and overborrowing. Second, the controls can be used to discourage short-term

borrowing. Third, the controls can reduce the country’s exposure to contagion by

limiting the amount that foreign lenders could pull out of the country.

Chile is usually offered as the example of a country that used controls on capi-

tal inflows successfully during the 1990s. The Chilean government required that a

percentage of the value of new lending and investments into the country be placed

in an interest-free deposit with the central bank for one year. And the government

required that foreign investors keep their investments in Chile for at least one year.

These requirements seem to have had their major effect by altering the mix of

borrowing—less short-term debt. More recently, some developing countries have

imposed or reimposed capital controls as financial inflows grew rapidly after the

global crisis. For example, Brazil had ended its tax on capital inflows in late 2008 but

reimposed a 2 percent tax on portfolio inflows in October 2009 and raised the rate a

year later to 6 percent for foreign investments in Brazilian bonds.

What are the overall benefits and costs of controls on capital inflows? A major cost

of the controls is the loss of the gains from international borrowing, to the extent that

they discourage capital inflows. While they can provide benefits by reducing the risk

of a financial crisis, they are a second-best policy. It would be better if the govern-

ment of the borrowing country could identify the specific problems that might lead

to a crisis and address these directly (recall the specificity rule from Chapter 10).

For instance, if overborrowing or too much short-term foreign-currency borrowing

occurs because of the excessive risks taken by local banks, the direct policy response

is to improve bank regulation and supervision. If bank regulation cannot be improved

immediately, then capital controls can be a second-best policy response. However,

the capital controls are likely to lose their effectiveness over time, as investors and

borrowers find ways to circumvent them. They probably only buy time for the govern-

ment to adopt the direct policy improvement like better bank regulation. Furthermore,

governments can also make mistakes with controls on capital inflows. For instance,

4 Another possible use of capital controls is to limit capital outflows during a financial crisis. Malaysia adopted such controls as a temporary measure in 1998. The goal is to prevent continued capital flight and remove the pressures that it places on local financial institutions, local capital markets, and the exchange-rate value of the country’s currency. Government fiscal and monetary policy can then be directed to addressing the internal imbalance of recession, with less fear that the shift to expansionary policies will worsen the financial crisis. Such controls are often only effective for a short time, as pressures build and investors find ways around the controls. The major cost of such controls is that they are likely to scare off new capital inflows in the future, even after the controls are removed, so that the country loses the gains from international borrowing.

pug21774_ch21_502-538.indd 527pug21774_ch21_502-538.indd 527 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

528 Part Three Understanding Foreign Exchange

South Korea removed controls on short-term bank borrowing while continuing to

restrict longer-term capital inflows like foreign purchases of stocks and foreign direct

investments. Korean banks then borrowed on a massive scale, and this became a key

part of the Korean crisis of late 1997.

GLOBAL FINANCIAL AND ECONOMIC CRISIS

This time may seem different, but all too often a deeper look shows it is not.

Carmen M. Reinhart and Kenneth S. Rogoff, This Time

Is Different: Eight Centuries of Financial Folly (2009)

Following the Argentinean crisis of 2001–2002, no new financial crisis occurred in

developing countries in the next years. Instead, world production and real incomes grew

at a healthy annual rate of about 4 to 5 percent during 2004–2007. But conditions in

financial markets were building toward the worst global financial and economic crisis

since the Great Depression of the 1930s. This crisis arose not in the developing coun-

tries but rather in the industrialized countries. We conclude our examination of financial

crises by describing how the global crisis happened and discerning the similarities with

the developing-country crises we have already discussed in this chapter.

How the Crisis Happened The story begins in the United States. With strong U.S. economic growth and low infla-

tion, U.S. monetary policy was expansionary. Interest rates were moderate and there was

little pricing of risk. Total U.S. debt outstanding, both bank loans and bonds, rose from

280 percent of U.S. GDP in 2002 to 340 percent of GDP in 2007. Banks increasingly

pooled loans into asset-backed securities that could be sold to investors around the world,

and these asset-backed securities were often structured into slices (called tranches), so

that the top slices appeared to have very little risk. U.S. housing prices took off, rising by

about 13 percent per year from 2002 to their peak in April 2006. The United States was

in a credit boom, and one manifestation was a bubble in housing prices.

In 2007 the first signs of trouble appeared. More sub-prime mortgages, those made to

high-risk borrowers, were going into default. Losses on securities backed by these mort-

gages began to mount. In August we got a clear sign that something was amiss, when

the French bank BNP Paribas halted redemptions for three of its mutual funds because

it was unable to value the sub-prime U.S. mortgage assets held by the funds. This shock

was a wake-up call in the financial sector. Banks and other investors quickly wondered

whether other financial institutions were impaired because they also held dodgy assets.

Banks became reluctant to lend to each other—each wanted to build its own liquidity

rather than risk that loans to other banks might not be repaid. Investors became wary

about the issuers of asset-backed commercial paper, a kind of short-term debt security,

and that market froze as new issues plummeted. More generally, banks tightened stan-

dards on new loans. U.S. stock prices reached a peak in October. In December a reces-

sion began in the United States, though at first it was mild. Losses on mortgage-backed

financial securities totaled about $500 billion by early 2008.

In this first phase of the crisis, the key issue seemed to be limited access to fund-

ing for banks and other financial institutions. The credit boom had shifted to a credit

pug21774_ch21_502-538.indd 528pug21774_ch21_502-538.indd 528 27/11/14 7:04 pm27/11/14 7:04 pm

Final PDF to printer

Chapter 21 International Lending and Financial Crises 529

crunch. The U.S. Federal Reserve and other central banks reacted as they usually do,

using monetary policy to try to stabilize the financial sector and the economy. The

Fed began to cut its interest rate target in increments beginning in August 2007, but

banks and investors continued to be reluctant to lend and invest. So, in December, the

Fed decided that it had to do more, and it introduced two unusual programs to provide

additional liquidity. First, it began to auction funds to banks using the Term Auction

Facility, to overcome banks’ reluctance to borrow from the Fed using traditional

discount loans. Second, the Fed began foreign central bank liquidity swaps with the

European Central Bank and the Swiss central bank. The foreign central banks could

use the swaps to obtain dollars, which they could then lend to their own banks, which

were having trouble obtaining dollars through normal interbank borrowing. (The box

“Central Bank Liquidity Swaps” in Chapter 24 discusses these swaps.)

While these central bank actions had some positive effects, conditions in financial

markets remained unsettled. In March 2008 the investment bank Bear Stearns lost

access to short-term funding and averted failure only when the New York Federal

Reserve Bank arranged for J.P. Morgan Chase to purchase it.

Everything changed on September 15, when the investment bank Lehman Brothers

failed. This shock pitched the world into the second, and much worse, phase of

the global crisis. Things happened rapidly. Reserve Primary Fund, a money market

fund, had invested in large amounts of debt issued by Lehman. On the next day,

September 16, when many depositors tried to remove their funds, Reserve Primary

had to “break the buck,” paying depositors at less than the $1 promised par value.

Scared depositors then pulled cash from other money market funds, and this had

follow-on contractionary effects as these funds liquidated their investments. The com-

mercial paper market, a big source of short-term funding, froze. Also on September 16,

the insurance company AIG, which had issued very large amounts of credit default

swaps without sufficient assets on hand to back them, was rescued from failure by an

$85 billion loan from the Fed.

With the Lehman failure, financial institutions were much more unwilling to lend to

each other. The freezing of financial markets and of lending deepened the U.S. reces-

sion, and the recession quickly became global. During the six months spanning late

2008 and early 2009, world real GDP declined at an annual rate of about 6 percent.

Central banks made valiant efforts to address the financial and economic implosion.

From mid-September to November 2008 the Fed more than doubled the size of its

assets. The Fed purchased massive amounts of financial assets to provide support for

specific financial markets (including commercial paper and asset-backed securities)

and for specific financial institutions (including not only AIG but also primary dealers

and money market funds). The Fed also greatly expanded the liquidity swaps with for-

eign central banks. Then, starting in late 2008, as its holdings of other assets started to

decline, the Fed purchased massive amounts of mortgage-related securities to provide

support to the depressed housing sector in the United States. From April 2006 to April

2009, U.S. housing prices fell at an average annual rate of about 12 percent, and new

construction plummeted.

Financial markets began to recover in early 2009, and by late 2009 most were

operating reasonably. U.S. stock prices hit a low in March 2009 and then rose by over

50 percent in the next year. The U.S. recession ended in June 2009, but the recovery

pug21774_ch21_502-538.indd 529pug21774_ch21_502-538.indd 529 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

530 Part Three Understanding Foreign Exchange

of the goods and services economy was much slower than the recovery of the financial

markets. (Many developing countries, including China, recovered more quickly, and

the growth of world real GDP was above 4 percent in 2010.)

Causes and Amplifiers The global financial and economic crisis came out of the United States and Europe, and

its effects were huge and worldwide. In previous sections of this chapter we examined key

contributors to developing-country financial crises. Let’s explore how our observations

about developing-country crises help us to understand the global crisis that began in 2007.

The origin of the global crisis was centered in overlending and overborrowing. U.S. financial institutions, businesses, and households took on large amounts of new debt in

the years leading up to 2007, and similar borrowing booms occurred during these years

in quite a number of other countries, including Iceland, Ireland, Spain, Bulgaria, and

New Zealand. (The box “National Crises, Contagion, and Resolution” examines the

euro crisis that began in 2010.) Behind these big rises in debt were massive amounts of

saving in other countries, especially Asian countries, including the dollars amassed by

China in its foreign exchange market intervention to keep the yuan undervalued. The

“global savings glut” was the source of funding for the overlending, channeled through

large capital inflows that directly financed the large current account deficits of the

United States and other countries. The savings glut put downward pressure on interest

rates generally. The search for higher yields led to excessive investments in risky assets,

so that the risk premiums built into interest rates on these assets fell to tiny levels. Cheap

funding, especially for risky uses, was an important incentive for the overborrowing.

Another driver of overlending, especially in the United States, was the increasing

ability of banks to package loans to households and businesses into asset-backed secu-

rities. These securities could be structured to perform the near-magic of turning risky

loans, such as sub-prime mortgages, into apparently low-risk bonds that could readily

be sold to investors around the world. For example, German savings banks bought

large amounts of complex U.S. mortgage-backed securities.

In the United States, a number of European countries, South Africa, and New

Zealand, lending booms led to bubbles in real estate prices and other asset prices. The

overlending and overborrowing fed on itself, for instance, as higher house prices created

the collateral for yet more loans, including home equity loans in the United States.

The overlending and overborrowing built a massive pile of combustibles, and

shocks provided the fire sparks. The shock that began the first phase of the global crisis was the announcement by BNP Paribas in August 2007 that it could not value many of

the sub-prime mortgage-backed assets held by several of its mutual funds. While we

had seen rising losses on these types of securities, the announcement focused attention

on how bad it had gotten. Then, in September 2008, the failure of Lehman Brothers

provided the shock that started the second, much worse phase of the crisis.

After each shock, precarious short-term lending took over. In what came to be known as the “shadow banking system,” financial institutions other than regular banks

had grown in importance. The “shadow banks” included investment banks that became

more active in lending and investing their own funds, mutual funds, hedge funds, and

structured investment vehicles that regular banks increasingly used to move some

of their financial activities “off the balance sheet.” While regular banks can obtain

pug21774_ch21_502-538.indd 530pug21774_ch21_502-538.indd 530 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

Chapter 21 International Lending and Financial Crises 531

funding from the deposits of households and businesses, shadow banks mostly rely on

short-term funding from banks and other financial institutions and from debt markets.

After each shock, one form of contagion hit the financial system. Potential lenders and investors feared that other financial institutions had the same kinds of problems

and losses that Paribas and Lehman had. Potential lenders and investors became much

less willing to refinance or roll over short-term debt coming due. With such herding

and scrambling for the exits, financial markets shifted rapidly from the previous high-

confidence equilibrium of easy short-term lending to a low-confidence equilibrium

of a near stop in short-term lending. For example, the market for commercial paper

imploded. For the shadow banking system, this near stop is the equivalent of a run on

the banks. The shadow banks that could not maintain funding for their assets had to

sell the assets. Massive selling drove down asset prices, increasing the losses at these

financial institutions and reinforcing the unwillingness to lend to them.

Because European financial institutions that had invested in U.S. mortgage-backed

securities suffered losses, the seizing up of short-term lending easily crossed national

boundaries. Other forms of contagion also contributed. Most important was inter-

national trade. When financial markets and lending froze in late 2008 following the

Lehman failure, the United States and a number of other countries headed into deeper

recessions. With production and incomes declining in these countries, they imported

less. (We examined the collapse of international trade in the box “The Trade Mini-

Collapse of 2009” in Chapter 2.) Declining imports meant declining exports for other

countries, and their recessions deepened. Even countries, such as China, whose finan-

cial systems were resilient were still adversely affected by the loss of exports.5

Regulation and supervision of financial institutions are supposed to help us guard against such a cataclysm. In many ways regulation of regular banks in the United

States (and in other industrialized countries) is competent and effective. However,

financial innovations had opened and exploited holes in the regulatory system.

Shadow banks performed many of the functions of regular banks but avoided much

of the regulation. Regular banks were able to move some of their activities to lighter

or no regulation by moving them off the balance sheet. Financial institutions had

used their political power to lighten the regulation of financial derivatives, including

the credit default swaps that almost brought down AIG. More generally, regulation

became more difficult as the expansion of dealing among financial institutions created

pervasive interconnections that greatly increase risks to the entire financial system.

Through overlending and overborrowing, shocks, the near stop to short-term bor-

rowing, contagion, and gaps in financial regulation, we can see many parallels between

developing-country financial crises and the global financial crisis that began in 2007. It

would be good if we could learn from past crises. While we cannot hope to eliminate

the possibility of future crises in industrialized countries, we can try to reduce the

likelihood of another one being so destructive. Private players—financial institutions,

investors, lenders, and borrowers—should use their historical memory to recognize

the huge risks built by overlending and overborrowing. Government leaders should

champion the design of better regulation and supervision of financial institutions.

5The case for using capital controls gets support from experience during the global crisis. Developing countries, including China and India, that had broad capital controls generally were less affected by the global crisis—they suffered less of a decline in real economic growth.

pug21774_ch21_502-538.indd 531pug21774_ch21_502-538.indd 531 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

532 Part Three Understanding Foreign Exchange

Euro Crisis National Crises, Contagion, and Resolution

The global financial crisis that began in 2007 and intensified in 2008 affected the euro area and the rest of Europe. A recession began in the euro area during the first quarter of 2008. The recession was rather severe, but it ended by mid- 2009, and the euro area began to grow again. The euro area appeared to be weathering the global crisis fairly well. There were indicators sug- gesting problems in some of the countries of the euro area, including the large current account deficits and large net foreign debts noted in the box “International Indicators Lead the Crisis” in Chapter 16. Still, most observers expected the euro area to recover at a good speed from the global crisis because the crisis was centered in the United States, not Europe.

Yet, in the next few years, crises would hit a series of euro countries and then threaten the euro itself. In October 2009, the newly elected government of Greece announced that the previ- ous government had been misreporting govern- ment finances. The 2009 government budget deficit that was forecast to be less than 6 percent of Greek GDP would actually be more than 10 percent. Even before this, a housing price bubble had burst in Ireland, with house prices peaking in September 2007 and a rapid decline beginning in October 2008. In September 2008, to shore up confidence in a banking system that was expe- riencing rising bad loans, the Irish government guaranteed all deposits and debts of six major Irish banks.

How did large government budget deficits in one small euro-area country and a burst housing bubble in another lead the entire euro area into crisis? Shambaugh (2012) views the euro crisis as three interlocking crises that fed on each other. The figure below summarizes this view, with each arrow showing a major way in which intensifica- tion of one crisis tends to make the other crisis more likely or worse.

Because of the global crisis and recession, all euro countries in 2009 had weak macro- economic performance. Greece was the first to enter a full crisis, through a sovereign debt crisis. For a number of years the Greek govern- ment had been underreporting its government budget deficits, but the truth came out in 2009, and the deficit for that year turned out to be almost 16 percent of GDP. Outstanding Greek government debt had increased from about 100 percent of GDP in 2005 to about 130 percent of GDP in 2009. With recognition of increased default risk, the prices of Greek government bonds decreased and the interest rates (yields) on the bonds increased. The Greek government by early 2010 was entering into a sovereign debt crisis, in which it could not pay such high interest rates on new borrowing. In May 2010 it received a bailout package of €110 billion from the European Union and the IMF. (Greece also received a second bailout pro- gram in 2012 that added €130 billion, bringing the total to more than the size of Greece’s GDP.)

Sovereign Debt Crisis

Lending Decreases

Bad Loans Rise as Borrowers Default

Banking Crisis

Gov ern

me nt

Bai l-O

uts

Pressure to Reduce DeficitDecreased Tax

Revenues Bon

d P rice

Fall , De

fau lt

Macroeconomic Crisis

Source: Adapted from Shambaugh (2012).

pug21774_ch21_502-538.indd 532pug21774_ch21_502-538.indd 532 02/12/14 6:10 pm02/12/14 6:10 pm

Final PDF to printer

Chapter 21 International Lending and Financial Crises 533

Even with the bailout, the crisis worsened for Greece. Greek banks held Greek government bonds as assets, and losses as the prices of these bonds decreased threatened a banking crisis. When the banking crisis came with the Greek government’s default on its privately held bonds in March 2012, the Greek government had to borrow to inject funds to bail out the banks. The sovereign debt crisis and the banking crisis inter- acted and reinforced each other.

The sovereign debt crisis, and the strict condi- tions that came with the bailout loans, forced the Greek government to change policies to reduce the fiscal deficit, by reducing government spend- ing and raising taxes. But these fiscal changes (“austerity”) reduced national demand and pro- duction, pushing Greece toward a macroeconomic crisis. Real GDP fell for six years (2007–2013), including annual declines of 7 percent in 2011 and 2012. Real GDP was 24 percent lower in 2013 that it had been in 2007 and unemploy- ment was 27 percent. As production, spending, and income declined, government tax revenues decreased, making it harder to decrease the defi- cit to address the debt crisis. The sovereign debt crisis and the macroeconomic crisis reinforced each other.

The weakened Greek banks decreased their lending to private businesses and households, making the macroeconomic crisis worse. And, with declining sales and income because of the macroeconomic crisis, Greek businesses and households increasingly could not service their existing bank loans, further weakening the banks. By 2013 Greece was in depression, and its outstanding government debt was 175 percent of its GDP.

Ireland’s crisis began differently, as a banking crisis. Irish banks had lent massively to private borrowers. When Ireland’s housing price bubble burst, loans for housing and property went bad, and the Irish banks headed into crisis. The Irish government had to make good on its guarantee of bank liabilities. The Irish government went

from a balanced budget in 2007 to a deficit of 30 percent of GDP in 2010, with outstanding gov- ernment debt rising from a modest 25 percent of GDP to 91 percent. As investors perceived ris- ing default risk, the prices of Irish government bonds fell and interest rate increased. The Irish government was forced to seek a bailout from the EU and the IMF, with the €85 billion program starting in November 2010. The Irish government reduced government spending and increased taxes. Fortunately, Ireland’s macroeconomic cri- sis was not as severe as that of Greece, but its unemployment still averaged close to 15 percent during 2011 and 2012.

Portugal was the third European country to go into crisis, and it received a bailout program of €78 billion from the EU and IMF in 2011. The beginning of Portugal’s crisis was a blend of the crises of Greece and Ireland, with excessive debt for both the government and private households, businesses, and excessive lending by Portuguese banks. Portugal’s government budget deficit was 10 percent of GDP in 2009 and 2010, and its outstanding government debt increased from a reasonable 68 percent of GDP in 2007 to 129 percent in 2013. Its unemployment rate rose to 10 percent in 2013.

The crises in these three small countries then spread. Some of the spread was through inter- national trade and international financial links, but contagion was more important. Investors and lenders focused next on Spain, where a housing price bubble had burst in late 2007. Spain had a large fiscal deficit starting in 2009, but at the end of 2010 its outstanding government debt was only 62 percent of its GDP. Still, the finan- cial market became skittish. Between April and November 2011, Spanish government bond prices fell and interest rates jumped. Italy had had out- standing government debt of over 100 percent of its GDP since before the euro was born, but its government deficit was not especially large. With the contagion spreading, Italian govern- ment bond prices fell and interest rates jumped

—Continued on next page

pug21774_ch21_502-538.indd 533pug21774_ch21_502-538.indd 533 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

534 Part Three Understanding Foreign Exchange

during June–November 2011. Spain and Italy are not small countries, and it would have been impossible to provide them with bailouts of the same relative size as those to Greece, Ireland, and Portugal. Spain did receive a smaller assistance loan from the EU, eventually drawing a little over €40 billion to rescue its banks.

In July 2011 EU officials began to discuss that Greece would have to default on and restructure its privately held government debt. Fears that Greece would decide to (or be forced to) exit from the euro rose. The continued existence of the euro was in question.

In December 2011 and February 2012 the European Central Bank (ECB) provided huge longer term loans (called long-term refinanc- ing operations) to a large number of European banks, and government bond markets calmed for a little while. Then market interest rates on Spanish and Italian government bonds spiked again during March to July 2012. Again, fears of Greek exit or even the collapse of the euro system intensified. Authorities reacted with two major changes that finally ended the worst of the crisis. In June 2012 euro-area leaders

announced the first step toward an areawide banking union, with the ECB becoming the regulator of the area’s large banks. More impor- tant, in July Mario Draghi, president of the ECB, announced forcefully that the ECB will do “whatever it takes to preserve the euro,” adding, “And believe me, it will be enough.” In September the ECB provided details of a pro- gram (Outright Monetary Transactions) under which the ECB would prevent distortions in financial markets by buying government bonds.

Draghi’s statement and the new ECB program shifted bond markets from a low-confidence crisis equilibrium to a higher confidence, more stable equilibrium. The broad euro crisis of 2010–2012 effectively ended, and by 2014 market interest rates on government bonds for all countries except Greece had fallen back to reasonable levels (even Greece’s rates were much lower than they had been at the peak of the crisis). Still, as of 2014 there was still some risk of renewed crisis. Outstanding government debt is still high—more than 100 percent of GDP in Greece, Ireland, and Portugal. And, macroeconomic performance remains weak (disastrous in Greece).

Summary Well-behaved international lending (or international capital flows) yields the same kinds of welfare results as international trade in products. International lending

increases total world product and brings net gains to both the lending and the borrowing

countries, although there are some groups who lose well-being in each country. The

lending-country government or the borrowing-country government can impose taxes

on international lending. If either country has market power (that is, if it is able to affect

the world interest rate), it can try to improve its well-being by imposing a nationally optimal tax on international lending. But if the other country retaliates with its own tax, both countries can end up worse off.

The history of international lending to developing countries shows surges of

lending and recurrent financial crises. The dramatic increase of lending in the 1970s

as banks recycled petrodollars led to the debt crisis beginning in 1982. This crisis

stretched throughout the 1980s, with low capital flows to developing countries.

The Brady Plan of 1989 led to the resolution of the crisis through debt reductions

and the conversion of much bank debt to Brady bonds. Capital flows to developing

pug21774_ch21_502-538.indd 534pug21774_ch21_502-538.indd 534 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

Chapter 21 International Lending and Financial Crises 535

countries increased dramatically during the 1990s, with more in the form of portfolio

investments in bonds and stocks. However, we also saw a series of financial crises,

including Mexico in 1994–1995, several Asian countries in 1997, Russia in 1998,

and Argentina in 2001–2002.

We can identify five major forces that can lead to or deepen financial crises in

developing countries. First, overlending and overborrowing can occur, as a result of

government borrowing to finance expansionary government policies, excessive bor-

rowing by banks, or the herding behavior of lenders seeking what seem to be high

returns. For sovereign debt owed by borrowing governments, lending can turn out to

be excessive even if the government has the ability to repay because the benefits of

default exceed the costs. Second, exogenous shocks like increases in foreign (espe-

cially U.S.) interest rates can shift flows away from developing country borrowers

and make repaying their debts more difficult. Third, borrowers, especially banks,

can take on too many unhedged foreign currency liabilities, which then become

very expensive to pay off if the local currency depreciates unexpectedly. Fourth, the

borrowing country can borrow too much using short-term loans and bonds. The bor-

rower can experience difficulties if foreign investors refuse to refinance or roll over

the debt. And finally, contagion can spread the crisis from the initial crisis country to other countries. These other countries may be vulnerable because of problems

with their policies or economic performance, but it is the contagion from the initial

crisis country that leads foreign lenders to fear a crisis and pull back from lending

to these other countries. Financial crises have elements of self-fulfilling panics, in

which investors fear defaults, so they stop lending and demand quick repayment.

If many lenders try to do this at once, the borrower cannot repay, and default and

crisis occur.

The two major types of international efforts to resolve financial crises in

developing countries are rescue packages and debt restructuring. A rescue package provides temporary financial assistance, can help to restore for- eign investor confidence, and can try to limit contagion. In the crises since

1994, these packages have been large. A key question is whether the pack-

ages create substantial moral hazard, in which lenders believe that they can lend with little risk because a rescue will bail them out. Debt restructuring attempts to make debt service more manageable for the borrowing country. Debt

rescheduling stretches out the repayments further into the future, and debt reduction

lowers the amount of debt. Restructuring can be difficult because each individual

creditor has the incentive to free ride, hoping others will restructure while the free-

rider receives full repayment on time. The Brady Plan set up a process of successful

restructuring of bank debt from the 1980s’ crisis. International bonds can be more

difficult to restructure, but it is becoming common for such bonds to include collec-

tive action clauses that streamline the restructuring process.

There are a range of proposals for reforms of the “international financial archi-

tecture” to reduce the frequency of financial crises in developing countries. Some

are radical and unlikely, and others are controversial. Several are widely supported:

Governments should have sound macroeconomic policies, they should provide better

data for lenders and investors to use in their decision-making, they should minimize

short-term debt, and they should improve their regulation and supervision of their

pug21774_ch21_502-538.indd 535pug21774_ch21_502-538.indd 535 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

536 Part Three Understanding Foreign Exchange

banks. One controversial proposal is that developing-country governments should

make greater use of controls on capital inflows. While this could limit overborrowing,

short-term borrowing, and exposure to contagion, it could also reduce the benefits to

be gained from international borrowing.

The global financial and economic crisis that began in 2007 and the euro crisis that

began in 2010 show that major financial crises also originate in industrialized countries.

For the global crisis, sub-prime mortgages that helped drive a housing price bubble in

the United States were part of the tinder of overlending and overborrowing. The shock

of the failure of Lehman Brothers in 2008 intensified the crisis. Contagion about similar

problems at other financial institutions led investors and lenders to pull back from buy-

ing short-term assets. Financial institutions that relied on this short-term funding had

to sell off their own assets and reduce their lending. As financial markets and lending

froze, the world entered a severe recession. Actions by the U.S. Federal Reserve and

other central banks may well have averted another depression like that of the 1930s.

Key Terms Nationally optimal tax Conditionality

Contagion

Rescue package

Moral hazard

Debt restructuring

Suggested Reading

Obstfeld and Taylor (2004) provide a broad discussion of international capital

movements. Agénor (2003) examines the benefits and costs of international financial

openness. Henry (2007) surveys research on the effects of opening domestic stock

markets to purchases by foreigners. Obstfeld (2012) views issues about international

financial lending and investment flows through the lens of the current account balance.

Rodrik and Subramanian (2009) offer skepticism about the effects of financial openness

on developing countries.

Roubini and Setser (2004), Eichengreen (2002), Rogoff (1999), and Goldstein (1998)

discuss developing-country financial crises and proposals for reform. Kindleberger and

Aliber (2011) and Reinhart and Rogoff (2009) explore the history of centuries of crises.

Panizza et al. (2009) survey the economics of sovereign default. Shambaugh (2012) and

Pisani-Ferry (2014) provide overviews of the euro crisis.

Bird (2001) and Joyce (2004) survey evidence on the adoption and effects of IMF loan

programs. Eichengreen and Mody (2004) analyze the inclusion of collective action clauses

in international bonds. Ostry et al. (2011) examine the use of controls on capital inflows.

Questions and Problems

1. “It is best for a country never to borrow from foreign lenders.” Do you agree or

disagree? Why?

2. “Because a national government cannot go bankrupt, it is safe to lend to a foreign gov-

ernment.” Do you agree or disagree? Why?

3. Why was there so much private lending to developing countries from 1974 to 1982,

although there had been so little from 1930 to 1974?

4. What triggered the debt crisis in 1982?

✦

pug21774_ch21_502-538.indd 536pug21774_ch21_502-538.indd 536 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

Chapter 21 International Lending and Financial Crises 537

5. Consider Figure 21.1. What is the size of each of the following? (Each answer should

be a number.)

a. World product without international lending. b. World product with free international lending. c. World product with Japan’s tax of 2 percent on its foreign lending.

What does the difference between your answers to parts a and b tell us? What does the difference between your answers to parts b and c tell us?

6. Consider Figure 21.1. In comparison with free international lending, what happens if

each country imposes a 2 percent tax on the international lending (so that there is a

total of 4 percent of tax)? What is the net gain, or loss, for each country?

7. How could each of the following cause or contribute to a financial crisis in a

developing country?

a. A large amount of short-term debt denominated in dollars. b. A financial crisis in another developing country in the region.

8. Consider the graph in the box “The Special Case of Sovereign Debt.”

a. Show graphically the effect of an increase in the interest rate ( i ). If the coun- try’s government would not default before this change, could this change lead to

default?

b. Show graphically the effect of an increase in the cost of defaulting. If the coun- try’s government would not default before this change, could this change lead to

default?

9. How could each of the following reforms reduce the frequency of financial crises?

a. Quick release of detailed, accurate information on the debt and official reserves of most developing countries.

b. Use by more developing countries of controls to limit capital inflows.

10. “The global financial and economic crisis would have been resolved more quickly and

with less cost if the IMF had provided rescue packages to the countries at the center

of the crisis.” Do you agree or disagree? Why?

11. An African country has a policy of fixing the exchange rate value of its currency to

the U.S. dollar. Banks in the country have a business model in which the banks pay

competitive interest rates to attract U.S. dollar deposits, and the banks then use these

funds to make higher-interest loans denominated in the local currency. How likely

would an unexpected devaluation of the local currency be to lead to banking crisis?

Why?

12. The “Optimal Deadbeat” Problem: The World Bank is considering a stream of loans to

the Puglian government to help it develop its nationalized oil fields and refineries. This

is the only set of loans that the World Bank would ever give Puglia. If Puglia defaults,

it receives no further funds from this set of loans from the World Bank. Whether the

Puglian government repays the loan or defaults has no other impact on Puglia. The

table on the next page shows the stream of loans to Puglia, the principal repayments

and interest payments for the loans, and the increase in oil-export profits from the proj-

ects financed by the loans. Would it ever be in Puglia’s interest to default on the loans?

If not, why not? If so, why and when?

✦

pug21774_ch21_502-538.indd 537pug21774_ch21_502-538.indd 537 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

538 Part Three Understanding Foreign Exchange

Loan Effects ($ millions)

Stock of World Bank Accumulated Interest Payments Profits on Loans and Borrowings on Borrowings Extra Oil Year Repayments at End of Year (at 8 percent) Export Sales

1 $200 (loan) $200 0 0 2 100 (loan) 300 16 30 3 50 (loan) 350 24 45 4 0 350 28 60 5 50 (repayment) 300 28 60 6 50 (repayment) 250 24 60 7 50 (repayment) 200 20 60 8 50 (repayment) 150 16 60 9 50 (repayment) 100 12 60 10 50 (repayment) 50 8 60 11 50 (repayment) 0 4 60

pug21774_ch21_502-538.indd 538pug21774_ch21_502-538.indd 538 14/11/14 4:01 pm14/11/14 4:01 pm

Final PDF to printer

539

Chapter Twenty-Two

How Does the Open Macroeconomy Work? The analysis of Chapters 17–21 brought us part of the way toward a judgment of what

kinds of policies toward foreign exchange would best serve a nation’s needs. Chapters 19

and 20, in particular, spelled out some of the implications of different policies for

the performance of the foreign exchange market, in terms of the efficiency—or

inefficiency—of the market itself.

Our focus now shifts to the other kind of performance issue previewed when the

basic policy choices were laid out at the start of Chapter 20. We address the challenge

of macroeconomic performance—the behavior of a country’s output, jobs, and prices in the face of changing world conditions. This chapter develops a general framework

for analyzing the performance of a national economy that is open to international

transactions. It provides a picture of how the open macroeconomy works. This frame-

work will then be used in the next two chapters to examine macroeconomic perfor-

mance in settings of fixed exchange rates and floating exchange rates.

There are many ways in which the national economy and the world economy

interact. This chapter and the next two establish valuable conclusions about mac-

roeconomic performance and policies. Based on these conclusions, Chapter 25 can

provide a series of lessons about where the international macroeconomic system is

headed and how well different exchange rate institutions work.

THE PERFORMANCE OF A NATIONAL ECONOMY

Each of us is comfortable judging our own performance in various activities. Did I

perform in a sport up to the level at which I am capable? How did I perform on an

examination relative to my own capabilities in the subject and relative to how others

in the class performed? Judgments about performance also drive most macroeconomic

analysis. How well is a country’s economy performing? Is it performing up to its

potential—for instance, its capabilities for producing goods and services? How close

is it to achieving broad objectives that most people would agree are desirable, such as

stability in average product prices (no inflation), low unemployment, and the mainte-

nance of a reasonable balance of payments with the rest of the world?

pug21774_ch22_539-564.indd 539pug21774_ch22_539-564.indd 539 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

540 Part Four Macro Policies for Open Economies

We judge a country’s macroeconomic performance against a number of broad

objectives or goals. We can usefully divide these broad goals into two categories. The

first category involves two objectives oriented to the domestic economy. One objec-

tive is keeping actual domestic production up to the economy’s capabilities so that

(1) the country achieves full employment of its labor and other resources and (2) the economy’s production grows over time. Another domestic objective is achieving price stability (or, at least, a low or acceptable rate of product price inflation). These domes- tically oriented goals taken together define the goal of achieving internal balance.

The other category involves objectives related to the country’s international economic

activities. This is the problem of external balance, which is usually defined as the achievement of a reasonable and sustainable balance of payments with the rest of the

world. Specifying a precise goal here is not so simple. Most broadly, the goal may be to

achieve balance in the country’s overall balance of payments. For instance, the goal may

be to achieve a balance of approximately zero in the country’s official settlements bal-

ance, at least over a number of years, so that the country is not losing official reserves or

building up unwanted official reserves. This implies that the sum of the current account

and the financial account (excluding official reserves transactions) should be approxi-

mately zero. If it is substantially different from zero for a long enough time, then we

have the disequilibrium in the country’s balance of payments (and exchange rate) that

we discussed in Chapter 20. If the disequilibrium in the country’s balance of payments

becomes severe enough, it can lead to the kind of crises that we examined in Chapter 21.

For some purposes we focus on a somewhat narrower reading of external balance,

one that focuses on the country’s current account (or balance on goods and services

trade). The goal here need not be a zero balance. Rather, it is a position that is sus-

tainable in that the value for the current account balance can readily be financed by

international capital flows (or official reserves transactions). Some rich industrialized

countries probably achieve external balance by running a current account surplus

because this allows the country to use some of its national saving to act as a net

investor in the rest of the world (capital outflows or financial account deficit). Other

countries that are in the process of developing their economies can achieve external

balance while running a current account deficit. The deficit may include imports of

machinery that directly are part of the development effort. The deficit can be financed

by borrowing from the rest of the world (capital inflows or financial account surplus).

As long as the surpluses and deficits on current account are not too large, the positions

are sustainable over time. Each can become too large, however, and can become an

external imbalance.

A FRAMEWORK FOR MACROECONOMIC ANALYSIS

To analyze the performance of an economy, we need a picture of how the economy

functions. Such a picture is not without controversy—macroeconomists do not fully

agree on the correct way to analyze the macroeconomy. One of the main difficulties

has been to form a satisfactory framework for predicting both changes in domestic

production and changes in the price level. We will use a synthesis that attempts to

combine the strongest features from several different schools of thought. Our analysis

pug21774_ch22_539-564.indd 540pug21774_ch22_539-564.indd 540 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

Chapter 22 How Does the Open Macroeconomy Work? 541

of the behavior of the economy in the short run (say, a time period of one year or less)

is relatively Keynesian in that the price level is not immediately responsive to aggregate

demand and supply conditions in the economy. The price level is sticky or sluggish in

the short run. Our view of the economy in the longer run is more classical. As we move

beyond the short run, the price level does respond to demand and supply conditions.

Furthermore, the amount of price inflation that the economy experiences eventually

depends mainly on the growth rate of the country’s money supply. In addition, the

economy tends toward full employment in the long run. We have already developed

some of the key features and implications of this long-run analysis in the discussion of

the monetary approach in Chapter 19. Here and in the next two chapters we focus more

on the economy in the shorter run. We want to develop a picture of how the economy

works in the short run that is pragmatic and useful, even if it is not perfect.

The next three major sections of this chapter focus on the determinants of real

GDP (representing both domestic product and national income) and the relationships

between international trade and national income. Then the next major section adds the

market for money and the country’s overall balance of payments, resulting in a broad

and flexible model of the open economy in the short run. To enhance the framework,

the final two sections of the chapter take up issues related to product prices. These

final sections explore the determinants of changes in the country’s product price level

(or its inflation rate) over time and the effects of international price competitiveness

on a country’s international trade.

DOMESTIC PRODUCTION DEPENDS ON AGGREGATE DEMAND

A major performance goal for an economy is to achieve production of goods and ser-

vices that is close to the economy’s potential. The economy’s potential for producing

is determined by the supply-side capabilities of the economy. Supply-side capabili-

ties include both the factor resources (labor, capital, land, and natural resources) that

the economy has available—the factor endowments from Chapters 4, 5, and 7—and

intangible influences such as technology, resource quality, climate, and motivation.

The intangibles determine the productivity of the resources.

The value of production of goods and services is the economy’s real GDP ( Y ). Because production activity creates income (in the form of wages, profits and other

returns to capital, and rents to landowners), real GDP is nearly the same thing as real

national income.

In the short run (and within the economy’s supply-side capabilities), domestic

production is determined by aggregate demand (AD) for the country’s products.

Essentially, if someone demands a product, some business (or other organization) will

try to produce it. Aggregate demand can be split into four components that represent

different sources of demand: household consumption of goods and services ( C ); domestic investment ( I

d ) in new real assets like machinery, buildings, software, hous-

ing, and inventories; government spending on goods and services ( G ); and net exports of goods and services ( X – M ). Net exports capture two aspects of aggregate demand:

• Foreign demand for our exports ( X ) is an additional source of demand for our products.

pug21774_ch22_539-564.indd 541pug21774_ch22_539-564.indd 541 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

542 Part Four Macro Policies for Open Economies

• Our demand for imports ( M ) must be subtracted because these imports are already included in the other kinds of spending but actually represent demand for the prod-

ucts of other countries.

Equilibrium occurs when domestic production ( Y, our GDP) equals desired demand for domestically produced goods and services:

Y 5 AD 5 C 1 I d 1 G 1 ( X 2 M ) (22.1)

The level of actual domestic production (relative to the economy’s potential for

producing) tends to be closely related to the economy’s labor unemployment rate.

Increases of actual GDP (relative to potential) tend to decrease the unemployment

rate, while decreases tend to increase the unemployment rate.

In order to focus on international trade issues, we can add up the national spending

components into national expenditures ( E ) on goods and services:

E 5 C 1 I d 1 G (22.2)

From basic macroeconomic analysis, we know something about the determinants of

each of these components.

Household consumption expenditures are positively related to disposable income,

and disposable income is (approximately) the difference between total income ( Y ) and taxes ( T ) paid to the government. Many taxes are based directly on income or are related indirectly to income because they are based on spending (for instance, sales or

value-added taxes). Rather than carry around all of this detail, we will summarize the

major determinant of consumption as income:

C 5 C ( Y ) (22.3)

remembering that the relationship incorporates taxes that have to be paid out of income

before consumer spending is done. There are other influences on consumption, includ-

ing interest rates that set the cost of borrowing to finance the purchase of items like

automobiles, as well as household wealth and consumer sentiment about the future.

To keep the analysis simple, we do not formally build these other influences into the

framework. Instead, we can treat major changes in these other influences as shocks that

occasionally disturb the economy.

Real domestic investment spending is negatively related to the level of interest rates

( i ) in the economy:

I d 5 I

d ( i ) (22.4)

Higher interest rates increase the cost of financing the capital assets, thus reducing the

amount of real investment undertaken. There are a number of other influences on real

investment spending, including business sentiment about the future, current capacity

utilization, and the emergence of new technologies that require capital investments in

order to bring the technologies into use. Again, we can picture these other influences

as a source of shocks to the economy.

We treat government spending on goods and services as a political decision.

Decisions about government spending are a major part of a country’s fiscal policy; the other part of fiscal policy is decisions about taxation.

pug21774_ch22_539-564.indd 542pug21774_ch22_539-564.indd 542 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

Chapter 22 How Does the Open Macroeconomy Work? 543

TRADE DEPENDS ON INCOME

According to a host of empirical estimates for many countries, the volume of a

nation’s imports depends positively on the level of real national income or production:

M 5 M ( Y ) (22.5)

This positive relationship seems to have two explanations. One is that imports are often

used as inputs into the production of the goods and services that constitute domestic

product. The other explanation is that imports respond to the total real expenditure,

or “absorption” ( E ), in our economy. The more we spend on all goods and services, the more we tend to spend on the part of them that we buy from abroad. Although

a nation’s expenditures on goods and services are not the same thing as its national

income from producing goods and services, the close statistical correlation between

income and expenditure allows us to gloss over this distinction. We can estimate the

amount by which our imports increase when our income goes up by one dollar. This

amount is called the marginal propensity to import ( m ). It is also possible that the volume of our exports depends on our national income.

If domestic national income is raised by a surge in domestic aggregate demand, there

is a good chance that the increase in national income will be accompanied by a drop

in export volumes, as domestic buyers bid away resources that otherwise would have

been used to produce exports. Although such a negative dependence of export volumes

on national-income-as-determined-by-domestic-demand is plausible, the evidence for

it is somewhat sparse. We will assume that export volumes are independent of this

country’s national income. 1

Exports nonetheless do depend on income—the income of foreign countries. If for- eign income is higher, then foreigners tend to buy more of all kinds of things, includ-

ing more of our exports. The amount by which their imports (our exports) increase if

foreign income increases is the foreign marginal propensity to import.

EQUILIBRIUM GDP AND SPENDING MULTIPLIERS

With these pieces of the framework we can gain some major insights into macro-

economic performance in an open economy. To gain these insights we make a few

assumptions that are useful now (but will be relaxed in later analysis). We assume that

all price and pricelike variables are constant. In relation to our discussion so far, this

means that the interest rate (in addition to the average product price level) is constant.

Equilibrium GDP The condition for equilibrium real GDP is that it must equal desired aggregate

demand, which in turn equals desired national expenditure plus net exports. Holding

interest rates constant, our desired national expenditure depends on national income,

1Another way that export volumes can vary with our national income is through the supply side. A supply-side expansion of the economy permits production to increase, and some of this extra production may be available to increase exports.

pug21774_ch22_539-564.indd 543pug21774_ch22_539-564.indd 543 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

544 Part Four Macro Policies for Open Economies

as does our volume of imports. These relationships indicate that the value of aggregate

demand itself depends on national income. The equilibrium condition is

Y 5 AD( Y ) 5 E ( Y ) 1 X 2 M ( Y ) (22.6)

Although our exports depend on foreign income, we initially ignore this (or assume

that foreign income is constant).

Figure 22.1A illustrates the equilibrium level of domestic production and income,

showing the matching between domestic product and aggregate demand at point A . At levels of domestic production below 100, the aggregate demand would exceed the level

of production, as shown by the fact that the AD line is above the 45-degree line to the

FIGURE 22.1 Equilibrium

Domestic

Production in

an Open

Economy

Shown in Two

Equivalent

Ways

Panel A shows that we can use the fact that aggregate demand (AD) depends on domestic product

and income (Y ) to find the equilibrium in which domestic product equals desired aggregate demand. Panel B shows that we can find the same equilibrium domestic product by

looking for the equality between net exports ( X 2 M ) and the difference between national saving and desired domestic real investment ( S 2 I

d ).

100

0 100

E 5 110

X 5 152M 5 225

A. As a Matching of Domestic Product with the Aggregate Demand at Point A

AD(Y) 5 E(Y) 1 X 2 M(Y) Slope 5 1 2 s 2 m 5 0.5

Domestic product

s 5 DS/DY 5 Marginal propensity to save (here 5 0.2) m 5 DM/DY 5 Marginal propensity to import (here 5 0.3)

Y 0

210

100

(Slope 5 2m 5 20.3)

S 2 Id (slope 5 s 5 0.2)

B X 2 M 5 If

45°

Aggregate demand AD

B. As an Equilibrium between Saving, Domestic Investment, and Net Exports

Saving, investment, and net exports

pug21774_ch22_539-564.indd 544pug21774_ch22_539-564.indd 544 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

Chapter 22 How Does the Open Macroeconomy Work? 545

left of A. At any such lower levels of production, the combination of home and foreign demand for what this nation is producing would be so great as to deplete the inven-

tories of goods held by firms, and the firms would respond by raising production and

creating more jobs and incomes, moving the economy up toward A. Similarly, levels of production above 100 would yield insufficient demand, accumulating inventories, and

cutbacks in production and jobs until the economy returned to equilibrium at point A. Figure 22.1A does not demonstrate how the nation’s foreign trade and investment

relate to the process of achieving the equilibrium domestic production. To underline

the role of the foreign sector, it is convenient to convert the equilibrium condition into

a different form. National saving ( S ) equals the difference between national income ( Y ) and national expenditures on noninvestment items ( C and G ). Subtracting ( C 1 G ) from both sides of Equation 22.6 brings about an equilibrium between national saving,

domestic investment, and net exports:

Y 5 E 1 X 2 M (Y 2 C 2 G ) 5 (E 2 C 2 G ) 1 (X 2 M )

S 5 I d 1 ( X 2 M ) (22.7)

Recall from Chapter 16 that net exports are (approximately) equal to the country’s

current account balance, which in turn equals its net foreign investment ( I f ). If we

replace ( X 2 M ) with I f , we see that this equilibrium condition is the same as saying

that a country’s desired national saving must match its desired domestic investment

in new real assets plus its desired net foreign investment.

Figure 22.1B shows this saving–investment equilibrium in a way that highlights net

exports (or the current account balance, approximately). As drawn here, Figure 22.1B

shows a country having a current account deficit with more imports than exports of

goods and services. For the equilibrium at point B , the country’s domestic saving is less than its domestic investment, so the extra domestic investment must be financed

by borrowing from foreigners (or selling off previously acquired foreign assets,

including the country’s official reserve assets). This could serve as a schematic view

of the situation of the United States since 1982 because the United States has had a

deficit in its current account balance financed by net capital inflows since then. In

contrast, Japan has usually had its version of point B lying above the horizontal axis, representing a net export surplus and positive net foreign investment.

The Spending Multiplier in a Small Open Economy When national spending rises in an economy in which actual production initially is

below the economy’s supply-side potential, this extra spending sets off a multiplier

process of expansion of domestic production and income, whether or not the country

is involved in international trade. Yet the way in which the country is involved in trade

does affect the size of the spending multiplier. Suppose that the government raises its

purchases of domestically produced goods and services by 10 units and holds them at

this higher level. The extra 10 means an extra 10 income for whoever produces and

sells the extra goods and services to the government. The extent to which this initial

income gain gets transmitted into further domestic income gains depends on how the

pug21774_ch22_539-564.indd 545pug21774_ch22_539-564.indd 545 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

546 Part Four Macro Policies for Open Economies

first gainers allocate their extra income. Let us assume, as we already have in Figure

22.1, that with each extra dollar of income, people within this nation

• save 20 cents (part of which is “saved” by the government as taxes on their extra

income),

• spend 30 cents on imports of foreign goods and services, and

• spend 50 cents on domestically produced goods and services.

In other words, the marginal propensity to save ( s, including the marginal tax rate) is 0.2; the marginal propensity to import ( m ) is 0.3; and the marginal propensity to consume domestic product (1 2 s 2 m ) is 0.5.

The first round of generating extra income produces an extra 2 units in saving, an

extra 3 in imports, and an extra 5 in spending on domestic goods and services. Of

these, only the 5 in domestic spending is returned to the national economy as a further

demand stimulus. Both the 2 saved and the 3 spent on imports represent “leakages”

from the domestic expenditure stream. Whatever their indirect effects, they do not

directly create new demand or income in the national economy. (Here, we specifically

rule out one indirect effect by assuming that this country is small and thus has no

discernible impact on production or income in the rest of the world. If the country is

small, then there is no indirect effect on foreign demand for our exports.) In the second

round of income and expenditures, only 5 will be passed on and divided up into fur-

ther domestic spending (2.5), saving (1), and imports (1.5). And for each succeeding

round, as for these first two, the share of extra income that becomes further domestic

expenditures is (1 2 s 2 m ) or (1 2 0.2 2 0.3) 5 0.5. The overall effects of this process are summarized in the spending multiplier. The

spending multiplier for a small open economy is 2

DY ___ DG

5 1 ______

(s 1 m) (22.8)

In our example, the rise in government spending by 10 ultimately leads to twice as

great an expansion of domestic production (an increase of 20) because the spending

multiplier equals 1/(0.2 1 0.3) 5 2. The value of this multiplier is the same, of course,

whether the initial extra spending is made by the government or results from a surge in

consumption, a rise in private investment spending, or a rise in exports. Note also that

the value of the multiplier is smaller in a small open economy than the multiplier in a

closed economy. Had m been zero, the multiplier would have been l/ s 5 5. We can also see the spending multiplier at work using either panel of Figure 22.1.

In panel A, the increase in government spending of 10 shifts the AD line straight up by

10. Because of the slope of the AD line, the new intersection with the 45-degree line

shows that domestic product increases to 120. In panel B, the increase in government

spending of 10 is a decrease of government saving (the difference between tax revenue and government spending) by 10. The S 2 I

d line shifts straight down by 10. Again,

2The multiplier formula can be derived from the fact that the change in production and income equals the initial rise in government spending plus the extra demand for the country’s product stimulated by the rise in income itself:

DY 5 DG 1 (1 2 s 2 m) • DY

so that

DY • (1 2 1 1 s 1 m) 5 DG

pug21774_ch22_539-564.indd 546pug21774_ch22_539-564.indd 546 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

Chapter 22 How Does the Open Macroeconomy Work? 547

because of the slopes of the lines, the intersection of the new S 2 I d line with the

(unchanged) X 2 M line indicates that domestic product increases to 120. The spending multiplier of 2 works its effects not only on the rise in production but

also on the rise in imports. Imports rose by 3 in the first round of expenditures, and they

rise by twice as much, 6 (5 0.3 3 20), over all rounds of new expenditures. With exports

constant for this small country, the country’s trade balance thus deteriorates by 6.

Foreign Spillovers and Foreign-Income Repercussions We have described the propensity to import as a leakage, without considering what

follow-on effects these imports can have. If the country is a small country, then any

follow-on effects are very small, and we can ignore them. If, instead, the country is a

large country, one whose domestic product and international trade are relatively large

in the world economy, then these follow-on effects can be important, in two ways.

First, changes in production and income of a large country have spillover effects on

production and incomes in foreign countries. When a large country’s extra spending

leads to extra imports, the extra foreign exports noticeably raise foreign product and

incomes. Second, the changes in foreign incomes alter foreign purchases of the first

country’s exports. If foreign incomes rise, foreign imports also rise, and the extra

demand for its exports raises the country’s product and income further.

Consider first foreign spillovers. The United States is a large country in the world

economy, as is the euro area, the set of countries that use the euro as their currency. The

United States accounts for about 19 percent of world production (measured using com-

mon international prices—measurement using purchasing power parity, as discussed

in Chapter 19), and it accounts for about 13 percent of world imports. The euro area

is also large, as it has about 13 percent of world production and 14 percent of world

imports. Researchers at the International Monetary Fund examined what happens in

other countries and areas of the world when national product in each of these two

large countries increases by 1 percent, using data on actual national production during

1970–2005. Their results are summarized in Figure 22.2 , with changes measured in

percentages so that the values can be compared easily across countries and areas.

Here are some basic patterns. First, the United States and the euro area are each

large enough to have noticeable effects on production and income in other countries.

For instance, an increase of 1 percent in the domestic product of either the United

States or the euro area would lead to an increase of 0.2 percent in the real GDP of other

industrialized countries. Second, the importance of close trading ties is also evident. The United States has a relatively large effect on Canada, and the European Union has

a relatively large effect on Africa.

Now consider that the effects kicked off by the rise in domestic product in a

large country can feed back to affect it further. Figure 22.3 illustrates this process of

foreign-income repercussions. An initial rise in our government purchases of goods and services, on the left, creates extra income in our national economy. Some

fraction ( s ) of the extra income will be saved, some will be spent on domestic prod- uct, and some will be spent on imports. The fraction ( m ) spent on imports will create an equal amount of demand for foreign production, as well as income for foreign sell-

ers (the foreign spillovers discussed above). The foreign countries, in turn, will save a

fraction of this additional income ( s f ), spend some in their own countries, and import

a fraction ( m f ) from us. We then divide that extra export income into saving, domestic

pug21774_ch22_539-564.indd 547pug21774_ch22_539-564.indd 547 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

548 Part Four Macro Policies for Open Economies

FIGURE 22.2 Foreign Spillovers of Changes in Domestic Product and Income

On Real Domestic Product In

The Effect of a 1 Percent Increase of Real Domestic Other Other Latin Developing Product In Canada Industrialized Mexico America Asia Africa

United States 0.5% 0.2% 0.4% 0.2% 0.1% 0.1% Euro area 0.0 0.2 0.0 0.1 0.1 0.3

Each number gives the percent rise in the domestic product of the country or area whose column is named along the top that is caused by a 1 percent rise in the real domestic product of the country or area whose row is named on the left of the table.

Source: International Monetary Fund, World Economic Outlook , April 2007, Chapter 4.

FIGURE 22.3 Foreign Trade

and Income

Repercussions

Starting from

a Rise in Our

Spending Our spending up (e.g., G up)

Our exports (X ) up

Our production (Y ) up

Our imports (M ) up

Foreign production (Yf) and spending up

Depends on sf

Depends on s

Depends on m

Depends on mf

purchases, and imports, and the cycle continues. Each round passes along a smaller

stimulus until the multiplier process comes to rest with a finite overall expansion.

The process of foreign-income repercussions has implications for the size of the

spending multiplier. For a large country, the foreign-income repercussions increase the

size of the spending multiplier. The more our country’s imports affect foreign incomes, and the more the foreign countries have a propensity to import from our country, the more our true spending multiplier exceeds the simple formula 1/(s 1 m) .

The existence of foreign spillovers and foreign-income repercussions helps

account for the parallelism in business cycles that has been observed among the

major industrial economies. Since early in the 20th century, when America has

sneezed, Canada, Europe, Japan, and many other countries have caught cold. Such a

tendency was already evident in the business cycles in Europe and the United States

in the mid-19th century, though the correlation between the European cycles and

the U.S. cycles was far from perfect. The Great Depression of the 1930s also rever-

berated back and forth among countries, as each country’s slump caused a cut in

imports (helped by beggar-thy-neighbor import barriers that were partly a response

to the slump itself ) and thereby cut foreign exports and incomes. Correspondingly,

the outbreak of the Korean War brought economic boom to West Germany, Italy, and

pug21774_ch22_539-564.indd 548pug21774_ch22_539-564.indd 548 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

Chapter 22 How Does the Open Macroeconomy Work? 549

Japan, as surging U.S. war spending raised their exports and incomes, leading to a

further partial increase in their purchases from the United States.

The same interdependence of incomes persists today. The locomotive theory posits that growth in one or more large economies can raise growth in other smaller countries

that trade with these large countries. Growth in these large economies raises their imports,

tending to pull the rest of the world along, with repercussions reinforcing the higher

growth of all countries. The United States and the euro area are often considered to be

key locomotives (a view supported by the estimates shown in Figure 22.2), and Japan

also is large enough to contribute. Unfortunately, as we see with the global financial and

economic crisis that began in 2007, the locomotives sometimes go in reverse, dragging

the world into a global recession.

We also recognize one rising player. With its rapid growth of production and imports,

China increasingly is playing the role of locomotive, especially to countries, such as

Brazil, Malaysia, and even Japan, that export raw materials or components that China

uses as inputs in its rapidly growing manufacturing industries.

A MORE COMPLETE FRAMEWORK: THREE MARKETS

The discussion of spending multipliers provides insights into macroeconomic perfor-

mance, but it is too limited to be useful as a full framework for our analysis. We need to

be able to picture three major components of the macroeconomy at the same time, add-

ing the supply and demand for money and the country’s overall balance of payments. In

the process of developing this more complete framework, we can also drop the assump-

tion that interest rates are constant. In fact, we will focus on the level of interest rates in

the country as a second variable of major interest in addition to the country’s real GDP.

Figure 22.4 sketches the basic approach, which is often called the Mundell-Fleming

model, after its developers, Nobel Prize winner Robert Mundell and Marcus Fleming

FIGURE 22.4 An Overview of

the Macromodel

of an Open

Economy

Fiscal policy, business mood, foreign trade shifts, etc.

International lending shifts, foreign trade shifts, devaluations, etc.

Monetary policy, shifts in money demand, etc.

Exogenous forces

Our domestic product market

Foreign exchange market (balance of payments)

Our money market

(domestic product)

(home country interest rate)

Markets Endogenous variables (determined by the system)

In addition to the linkages shown here, pressure in the foreign exchange market (or imbalance in the

country’s balance of payments) can feed back into and affect the country through the domestic product

market or the money market. The ways in which this occurs depend on whether the country has a fixed

or a floating exchange rate. These issues are taken up in the next two chapters.

pug21774_ch22_539-564.indd 549pug21774_ch22_539-564.indd 549 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

550 Part Four Macro Policies for Open Economies

of the International Monetary Fund. The three markets that give us a broader picture of

the country’s economy are shown in the center. The first two, the goods and services

market and the market for money, directly determine two key variables of interest, the

country’s real GDP and its interest rate ( Y and i ). At the same time, these two variables have a major impact on the country’s balance of payments and thus on the foreign

exchange market. All three of the markets can be affected by different kinds of outside

(exogenous) forces, shown on the left side of the figure. These outside forces represent

shocks or disturbances that create pressures for macroeconomic changes. 3

The Domestic Product Market The aggregate demand for what our country produces depends not only on income

( Y ). It also depends on the interest rate ( i ) because a higher real interest rate discour- ages spending. We can picture these relationships in a graph as an IS curve. (IS stands

for investment–saving.) The IS curve shows all combinations of domestic product levels and interest rates for which the domestic product market is in equilibrium. As in

the previous section of this chapter, we can think of this equilibrium as following from

the condition Y 5 C 1 I d 1 G 1 ( X 2 M ), or we can think of it as following from the

condition that national saving equals the sum of domestic investment and net exports.

If we use the latter, the domestic product market is in equilibrium when

1 2 1

S ( Y ) 5 I d ( i ) 1 X 2 M ( Y ) (22.9)

Here the signs above the equation indicate the direction of each influence in parentheses

on the value of the variable it affects. 4

To see why the IS curve slopes downward, let’s start with one equilibrium point on

it and then ask where other equilibriums would lie. Let us start at point A in Figure 22.5 , where domestic product equals 100 and the interest rate is 0.07 (7 percent a year).

3This model of the open macroeconomy is not perfect, but it does allow us to examine the interrelationships among a large number of important macrovariables, and to examine the dynamics of national adjustments to achieve external balance. Here are some of the things that it does not do well. First, changes in the price level or the inflation rate are not modeled explicitly. Instead we infer that there are upward pressures on the price level or inflation rate when aggregate demand tries to push the economy beyond its supply-side potential. Second, the supply side of the economy is not modeled, so the approach cannot easily analyze supply-side shocks or long-run economic growth. Third, international capital flows are modeled as responsive to the difference in interest rates. However, a large effect cannot be sustained beyond the short run, once international investors have adjusted their portfolios. Fourth, expectations are not modeled explicitly, but instead they are brought in as exogenous forces.

Appendix G presents an approach that can address some of the issues raised in the first two points. This approach examines aggregate demand, aggregate supply, and price adjustment over time. We also briefly discuss, later in this chapter, how to add analysis of inflation to the Mundell-Fleming model. Furthermore, at several places in the analysis of this chapter and the next two, we will remind ourselves of how the third point about international capital flows should affect our interpretation of some of the results obtained using the Mundell-Fleming model. 4Additional influences of Y and i are possible. S may be a positive function of i, for instance, if higher interest rates reduce borrowing (that is, reduce negative saving) by households. I

d may be a positive

function of Y, for instance, if high current production levels make the need for new investment to expand capacity more urgent. These additions would somewhat change the slope of the IS curve, but the picture would not be different in its essentials.

pug21774_ch22_539-564.indd 550pug21774_ch22_539-564.indd 550 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

Chapter 22 How Does the Open Macroeconomy Work? 551

FIGURE 22.5 The IS Curve:

Equilibriums in

the Domestic

Product Market

The IS curve shows all possible combinations of the interest rate ( i ) and real GDP ( Y ) that are consistent with equilibrium in the goods and services sector of the national economy, given the state

of other fundamental influences. If any of these other fundamental influences changes,

then the entire IS curve shifts. Here are some changes in fundamental influences (usually

called exogenous shocks) that shift the IS curve to the right (or up):

• Expansionary fiscal policy (an increase in government spending or a tax cut).

• An exogenous increase in household consumption (for instance, due to improved consumer

expectations about the future of the economy or an increase in wealth).

• An exogenous increase in domestic real investment (for instance, due to improved business

expectations about the future of the economy).

• An exogenous increase in exports (for instance, due to rising foreign income, a shift in

the tastes of foreign consumers toward the country’s products, or an improvement in the

international price competitiveness of the country’s products).

• An exogenous decrease in imports (for instance, due to a shift in the tastes of local consumers

away from imported products or an improvement in the international price competitiveness of

the country’s products).

To see what exogenous shocks can cause the IS curve to shift to the left (or down), reverse

all of these.

.09

.07

.05

Interest rate = i

Area of deficient aggregate demand: Id 1 (X 2 M) , S

Area of excess aggregate demand: Id 1 (X 2 M) . S

Domestic product 5 Y (national income)

100 120800

We somehow know that this combination brings an equilibrium in the domestic

product market. That is, given other basic economic conditions, having Y 5 100 and i 5 0.07 makes domestic investment plus net exports, I

d 1 ( X 2 M ), match national

saving, S. What would happen to the equilibrium in the product market if the inter- est rate is lower, say, only 0.05? The lower interest rate induces the nation to invest

in more domestic real capital. The higher level of aggregate demand (because I d is

larger) results in a higher level of domestic product. (In fact, because of the spending

multiplier, the increase in domestic product is larger than the increase in real domestic

investment resulting directly from the lower interest rate.) According to the IS curve,

the higher level of domestic product matching aggregate demand for that low interest

rate is Y 5 120, as represented at point B. Similarly, if point A is one equilibrium, then others with higher interest rates must lie at lower production levels, as at point C.

pug21774_ch22_539-564.indd 551pug21774_ch22_539-564.indd 551 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

552 Part Four Macro Policies for Open Economies

So the IS curve slopes downward. The higher the interest rate, the lower the level of

domestic product that is consistent with it. Points that are not on the IS curve find the

domestic product market out of equilibrium.

Changes in any influence other than interest rates that can directly affect aggregate

demand cause a shift in the IS curve. These are the exogenous forces or shocks noted

in Figure 22.4. For instance, an increase in government spending, or an improvement

in consumer sentiment that leads people to increase their consumption spending,

increases aggregate demand and shifts the IS curve to the right.

The Money Market The next market in which macroeconomic forces interact is that for the money of the

nation. As usual, there is a balancing of supply and demand.

The supply side of the market for units of a nation’s money is, roughly, the conven-

tional “money supply.” Monetary policy, the set of central-bank rules, regulations, and actions that determine the availability of bank deposits and currency in circula-

tion, is the top influence on the money supply.

Our view of the demand for money is an extension of the money demand discussed

in Chapter 19. There we posited that the (nominal) demand for money depends on the

value of (nominal) GDP, which equals the price level P times Y (real GDP). Money is held to carry out transactions, and the value of transactions should be correlated

with the value of income or production. The larger the domestic product during a time

period such as a year, the greater the amount of money balances that firms and house-

holds will want to keep on hand to carry out their (larger) spending.

In addition to the benefits of money in facilitating transactions, there is an opportunity

cost to holding money. The opportunity cost is the interest that the holder of money could

earn if his wealth were instead invested in other financial assets such as bonds. Some

forms of money (currency and coin, traveler’s checks, zero-interest checking accounts)

earn no interest. Others (interest-paying checking accounts) earn some interest, but the

interest rate earned is generally relatively low. Interest forgone is an opportunity cost

of holding money. This cost leads us to attempt to economize on our money holdings,

and we attempt to economize more as the interest rate available on other financial assets

rises. A higher interest rate tempts people to hold interest-earning bonds rather than

money. That is, a higher interest rate reduces the amount of money demanded.

The demand for (nominal) money ( L ) is positively related to nominal GDP and negatively related to the level of interest rates available on other financial assets:

1 2

L 5 L ( PY , i ) (22.10)

The equilibrium between money supply M s and money demand is then

1 2

M s 5 L ( PY , i ) (22.11)

where the plus and minus signs again serve to remind us of the direction of influence

of PY and i. The money market equilibrium can be pictured as the “LM curve” of Figure 22.6 .

The LM curve shows all combinations of production levels and interest rates for

pug21774_ch22_539-564.indd 552pug21774_ch22_539-564.indd 552 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

Chapter 22 How Does the Open Macroeconomy Work? 553

The LM curve shows all possible combinations of the interest rate ( i ) and real GDP ( Y ) that are consistent with equilibrium in the money sector of the national economy, given the state of other

fundamental influences. If any of these other fundamental influences changes, then the entire LM

curve shifts. Here are some changes in fundamental influences (exogenous shocks) that shift the

LM curve down (or to the right):

• Expansionary monetary policy (increase in the money supply).

• Decrease in the country’s average price level (for instance, due to a sudden decline in

oil prices).

• Exogenous decrease in money demand (for instance, due to the introduction of credit cards that

allow people to buy things without using money directly).

To see what exogenous shocks can cause the LM curve to shift up (or to the left), reverse

all of these.

0.09

0.07

0.05

Interest rate 5 i

Area of excess supply of money: L , Ms

Area of excess demand for money: L . Ms

Domestic product 5 Y100 120800

FIGURE 22.6 The LM Curve:

Equilibriums

in the Money

Market

which the money market is in equilibrium, given the money supply (set by policy), the

price level ( P ), and the money demand function (representing how people decide their money holdings). LM stands for liquidity–money, where money demand is viewed as

demand for the most highly liquid financial assets in the economy.

To see why the LM curve slopes upward, begin with the equilibrium at point A and think of where the other equilibriums would lie. If the interest rate is higher, say, at

0.09, people would hold less money in order to earn the higher interest rate by holding

bonds instead. To have the money market in equilibrium at that higher interest rate,

people would have to have some other reason to hold the same amount of money sup-

ply as at point A. They would be willing to hold the same amount of money only if the level of domestic product and income is higher, raising their transactions demand for

holding money. That happens to just the right extent at point F , another equilibrium. In contrast, going in the other direction, we can ask how people would be content

to hold the same money supply as at point A if the interest they gave up by holding money were suddenly lower than at point A. By itself, the lower interest rate on bonds would mean a greater demand for money because money is convenient. People would

be willing to refrain from holding extra money only if some other change reduced

the demand. One such change is lower domestic product, meaning lower transactions

pug21774_ch22_539-564.indd 553pug21774_ch22_539-564.indd 553 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

554 Part Four Macro Policies for Open Economies

demand for money. Point G is a point at which the lower interest rate and lower pro- duction leave the demand for money the same as at point A.

Changes in any of the influences on money supply and money demand other than

the interest rate and domestic product represent exogenous forces that shift the entire

LM curve. Consider an increase in the nominal money supply ( M s ) by the central bank. If the price level ( P ) is sticky in the short run (so there is no immediate effect on the country’s price level or inflation rate), then the increase in the money supply tends to

reduce interest rates (or, equivalently, the increased money supply can support a higher

level of domestic product and transactions). The LM curve shifts down (or to the right).

So far, we have two markets whose equilibriums depend on how domestic product

( Y ) and interest rates ( i ) interact in each market. For any given set of basic economic conditions (fiscal policy, the business mood, consumer sentiment, foreign demand for

the country’s exports, monetary policy, and so forth), these two markets simultane-

ously determine the level of domestic product and the level of the interest rate in the

economy. The intersection of the IS and LM curves shows the levels of Y and i that represent equilibrium in both the market for goods and services and the market for

money. For instance, if the IS curve from Figure 22.5 is added to Figure 22.6, the

intersection is at point A. The short-run equilibrium level of real GDP ( Y ) is 100, and the equilibrium interest rate is 0.07 (7 percent).

The Foreign Exchange Market (or Balance of Payments) The third market is the one where the availability of foreign currency is balanced

against the demand for it. This market can be called either the foreign exchange market, if we want to keep the exchange rate in mind, or the balance of payments, if we are using the country’s official settlements balance ( B ) to reflect the net private or nonofficial trading between our currency and foreign currency. To picture this third

market, it is easier to think through the balance-of-payments approach.

The country’s official settlements balance is the sum of the country’s current

account balance (CA) and its financial account balance (FA, which does not include

official reserves transactions). The influences on B can be divided into trade flow effects and financial flow effects. How do our key variables—real product or income

( Y ) and the country’s interest rate ( i )—affect the country’s balance of payments? Previous discussion has shown two major effects. First, the balance on goods and

services trade (or the current account) depends negatively on our domestic product,

through the demand for imports. Second, international capital flows depend on inter-

est rates (both at home and abroad). A higher interest rate in our country will attract a

capital inflow, provided that the higher domestic interest rate is not immediately offset

by higher foreign interest rates.

The easy intuition that a higher interest rate in our economy will attract investment

from abroad and give us a capital inflow is valid, but only in the short run (say, for a

year or less after the interest rate rises). Over the longer run, this effect stops and is

even reversed for at least two reasons:

1. A higher interest rate attracts a lot of capital inflow from abroad at first, as investors

adjust the shares of their wealth held in assets from our country. Soon, though, the

inflow will dwindle because portfolios have already been adjusted.

pug21774_ch22_539-564.indd 554pug21774_ch22_539-564.indd 554 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

Chapter 22 How Does the Open Macroeconomy Work? 555

2. If a higher interest rate in our country succeeds in attracting funds from abroad and

raising B in the short run, it may have the opposite effect later on for the simple reason that bonds mature and loans must be repaid. We cannot talk of using higher

interest rates to attract capital (lending) to this country now without reflecting on

the fact that those higher interest rates will have to be paid out in the future, along

with repayments of the borrowed principal. 5

For these reasons, the notion that a higher interest rate in our country can “improve”

the balance of payments is valid only in the short run. We can use the short-run

reasoning if the issue before us is the effect on B now. We will often use this short- run focus, but only with the warning that in the long run a higher interest rate has an

ambiguous effect on the overall balance of payments.

We can express the dependence of the balance of payments (or the foreign exchange

market) on production and interest rates with an equation. The official settlements bal-

ance, B , equals the current account balance, CA (which is approximately equal to net exports, X 2 M ), plus the financial account balance, FA:

2 1

B 5 CA( Y ) 1 FA( i ) (22.12)

Raising our domestic product lowers the current account surplus (or raises the deficit)

because it gives us more demand for imports of foreign goods and services. Raising

our interest rate, on the other hand, attracts an inflow of capital from abroad, raising

our financial account surplus (or reducing the deficit).

To link the balance of payments with i and Y , we can also use the FE curve of Figure 22.7 . For a given set of other basic economic conditions that can influence

the country’s balance of payments, the FE curve shows the set of all interest-and- production combinations in our country that result in a zero value for the country’s

official settlements balance.

The FE curve, like the LM curve, slopes upward. To see why, begin again with

an equilibrium at point A. Let’s say that this is the same point A as in the previous two figures, although it need not be. If point A finds our international payments in overall balance, how could they still be in balance if the interest rate is higher, say,

at 11 percent? That higher interest rate attracts a greater inflow of capital, bringing

5The balance-of-payments cost of attracting the extra capital from abroad could be even greater than the interest rate alone might suggest. To see how, let us suppose that the home country (a) is a net debtor country and (b) is large enough to be able to raise its own interest rate even though it is part of a larger world capital market. Let us imagine Canada is in this position.

Suppose that a rise in Canada’s interest rate from 9 percent to 12 percent succeeds in raising foreign investments into Canada from $500 billion to $600 billion. What interest will Canada pay out each year on the extra $100 billion of borrowing (a temporarily higher B)? The annual interest bill on the new $100 billion itself comes to $12 billion a year. But, in addition, to continue to hold the original investments of $500 billion within the country—that is, to “roll over” these bonds and loans as they come up for renewal or repayment—Canadian borrowers have to pay an extra $15 billion [5 $500 billion 3 (.12 2 .09)]. After the original bonds and loans have been rolled over, the total extra interest outflow each year will be the $12 billion plus the extra $15 billion, or payments of $27 billion just to hold on to an extra $100 billion in borrowings. That’s an incremental interest cost of 27 percent, not just 12 percent. This is an expensive way to attract international “hot money.”

pug21774_ch22_539-564.indd 555pug21774_ch22_539-564.indd 555 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

556 Part Four Macro Policies for Open Economies

The FE curve shows all possible combinations of the interest rate ( i ) and real GDP ( Y ) that are consistent with an official settlements balance of zero for the country, given the state of other

fundamental influences. If any of these other fundamental influences changes, then the entire FE

curve shifts. Here are some changes in fundamental influences (exogenous shocks) that shift the FE

curve to the right (or down):

• An exogenous increase in exports (for instance, due to rising foreign income, a shift in

the tastes of foreign consumers toward the country’s products, or an improvement in the

international price competitiveness of the country’s products).

• An exogenous decrease in imports (for instance, due to a shift in the tastes of local consumers

away from imported products or an improvement in the international price competitiveness of

the country’s products).

• Exogenous changes that result in an increase in capital inflows or a decrease in capital

outflows (for instance, a decrease in the foreign interest rate, an increase in the expected rate of

appreciation of the country’s currency, or a decrease in the perceived riskiness of investing in

this country’s financial assets).

To see what exogenous shocks can cause the FE curve to shift to the left (or up), reverse

all of these.

0.11

0.07

0.03

Interest rate 5 i

Area of official settlements balance surplus: B . 0

Area of official settlements balance deficit: B , 0

Domestic product 5 Y100 120800

IS LM

FIGURE 22.7 The FE Curve:

Balance-of-

Payment

Equilibriums

an official-settlements-balance surplus unless something else also changes. With

the higher interest rate, B could still be zero (no surplus, no deficit) if domestic product and income are higher. Higher product and income induce us to spend more

on everything, including imports. The extra imports shift the balance of payments

toward a deficit. In just the right amounts, extra production and a higher interest

rate could cancel each other’s effect on the balance of payments, leaving B 5 0. That happens at point H. Correspondingly, some combinations of lower interest rates and lower production levels could also keep our payments in overall balance,

as at point J. How does the slope of the FE curve compare to the slope of the LM curve? As

drawn in Figure 22.7, the FE curve is steeper. This is not the only possibility, though.

pug21774_ch22_539-564.indd 556pug21774_ch22_539-564.indd 556 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

Chapter 22 How Does the Open Macroeconomy Work? 557

It depends on how responsive money demand and the balance of payments are to

changes in the interest rate and domestic product. If, for instance, capital flows are

very sensitive to interest rates, then the FE curve is relatively flat, flatter than the LM

curve. The FE curve is relatively flat because only a small increase in the interest

rate is needed to draw in enough capital to offset the decline in the current account

if domestic product is higher. (Point H would be lower, with an interest rate that is not much above 0.07.) If capital flows are extremely sensitive to interest rates, then

we have the case of perfect capital mobility, and the FE curve is essentially completely flat (a horizontal line).

What happens when some other condition or variable that affects the country’s

balance of payments changes? These are the exogenous forces of Figure 22.4. When

one of these changes occurs, it shifts the FE curve ( just as a change in an exogenous

condition relevant to the IS curve or the LM curve causes a shift in that curve). For

instance, an increase in foreign income increases demand for our exports, improving

our balance of payments and shifting the FE curve to the right. Or an increase in for-

eign interest rates causes a capital outflow from our country, deteriorating our balance

of payments and shifting the FE curve to the left.

Three Markets Together Bringing the three markets together, we get a determination of the level of domes-

tic product ( Y ), the interest rate ( i ), and the overall balance of payments ( B ). The economy will gravitate toward a simultaneous equilibrium in the domestic product

market (on the IS curve) and the money market (on the LM curve). With Y and i thus determined, we also know the state of the balance of payments ( B ).

• The official settlements balance is in surplus if the IS–LM intersection is to the left

of (or above) the FE curve.

• The official settlements balance is zero if the IS–LM intersection is on the FE curve

(for example, point A in Figure 22.7). • The official settlements balance is in deficit if the IS–LM intersection is to the right

of (or below) the FE curve.

This section has given the same reasoning about three markets in three alternative

forms: the causal-arrow sketch of Figure 22.4; the listing of Equations 22.9, 22.11,

and 22.12; and the use of IS–LM–FE diagrams (Figures 22.5 through 22.7). The way

that we use this framework—especially the way that we use the FE curve—depends

on the type of exchange-rate policy that the country has adopted. As we will exam-

ine in the next chapter, if a country adopts a fixed exchange rate, then any divergence

between the IS–LM intersection and the FE curve shows that official intervention

is needed to defend the fixed rate. The official settlements balance is not zero—

official intervention to defend the fixed rate results in official reserves transactions.

As we will examine in Chapter 24, if the country adopts a clean float, then the offi-

cial settlements balance must be zero, and somehow a triple intersection between

the IS, LM, and FE curves must occur. In different ways, to be explored in each

chapter, these situations create pressures for adjustments that affect the country’s

macroeconomic performance.

pug21774_ch22_539-564.indd 557pug21774_ch22_539-564.indd 557 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

558 Part Four Macro Policies for Open Economies

THE PRICE LEVEL DOES CHANGE

In developing the framework so far, we have generally ignored the product price level

( P ). We assumed that the price level is a constant for the short run, given by previous history. While this may be reasonable for most short-run analysis, it is clearly not

appropriate generally. The price level does change over time for three basic reasons. 6

First, most countries have some amount of ongoing inflation. This amount can be

anticipated and built into inflation expectations. Generally, ongoing positive inflation

requires sufficient ongoing growth of the country’s nominal money supply. The role of

ongoing inflation was prominent in Chapter 19, especially in discussing the monetary

approach.

Second, strong or weak aggregate demand can put pressure on the country’s

price level. If the price level is somewhat sluggish, then this effect will not be felt in

the immediate short run, but it will have an impact as the economy moves beyond

the initial short run. The strength of aggregate demand must be evaluated against the

economy’s supply-side capabilities for producing goods and services. If aggregate

demand is very strong, then actual production strains against the economy’s supply

capabilities. The economy will “overheat” and there will be upward pressure on the

price level. (In a setting in which there is ongoing inflation, this really means that the

price level will rise more than it otherwise would have, anyway. The inflation rate

will increase.) If aggregate demand is weak, then product markets will be weak, creat-

ing downward pressure on the price level because of the “discipline” effect of weak

demand. (Again, in a setting of ongoing inflation, this really means that the inflation

rate will be lower than it otherwise would have been—the price level may still be ris-

ing, but it will rise more slowly.)

Third, shocks occasionally can cause large changes in the price level even in the

short run. One example is an oil price shock. As oil prices rose dramatically during

2004–2008, inflation rates increased in the United States, the euro area, and most other

oil-importing countries, although the effects were not as large as those during the two

oil price shocks in the 1970s.

Another source of a price shock is a large, abrupt change in the exchange-rate value

of a country’s currency. As we will discuss in the next chapter, a large devaluation

or depreciation is likely to cause a large increase in the domestic-currency price of

imported products. The general price level tends to increase quickly because of both

the direct effects of higher import prices and the indirect effects on costs and other

prices in the country.

For subsequent analysis using our framework, the effect of strong or weak aggregate

demand on the price level is of major interest. As we move beyond the initial short run,

we do expect adjustment in the country’s product price level. This can have an impact

on the country’s international price competitiveness, as discussed in the next section.

If international price competitiveness is affected, then the country’s current account

balance changes. In addition, although we will not focus on this effect in subsequent

analysis, a change in the price level changes money demand (through the PY term).

6Appendix G presents a formal framework for analyzing the adjustment of the price level over time.

pug21774_ch22_539-564.indd 558pug21774_ch22_539-564.indd 558 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

Chapter 22 How Does the Open Macroeconomy Work? 559

If the nation’s money supply is not changing in line with the change in money demand,

then the LM curve will shift over time. 7

TRADE ALSO DEPENDS ON PRICE COMPETITIVENESS

As previously discussed, a country’s exports, imports, and net exports depend on

production and incomes in this country and the rest of the world. Standard microeco-

nomics indicates that demand for exports and imports each should also be affected by

the prices of these products. Quantity demanded depends on both income and relative

prices.

Our demand for imports depends not only on our income but also on the price of

imports relative to the price ( P ) of domestic products that are substitutes for these imports. What is this relative price? Consider that an imported product (say, a bottle

of French wine) is initially priced in foreign currency (say, 10 euros). Once imported

into the United States, its foreign-currency price P f is converted into dollars using the

going (nominal) exchange rate (say, $1.40 per euro). The domestic-currency price of

the import is then equal to P f • e ($14.00 for the bottle), where the (nominal) exchange

rate ( e ) is stated in units of domestic currency per unit of foreign currency. Our deci- sion about whether to buy this import depends partly on its dollar price relative to the

price of a comparable domestic product (say, a bottle of California wine). The price

ratio is ( P f • e )/ P. This ratio may look familiar—it is essentially the real exchange rate

introduced in Chapter 19 (but here the expression is measuring the real-exchange-rate

value of the foreign currency).

Thus, by expanding our previous Equation 22.5, we see that the demand for imports

has two major determinants:

1 2

M 5 M ( Y , P f • e / P ) (22.13)

The volume of imports tends to be higher if our production and income are higher, but

lower if imports are relatively expensive (meaning P f • e / P is high).

Foreign demand for our exports depends not only on foreign income but also on

the price of our products exported into the foreign market relative to the prices of their

comparable local products ( P f ). Our export product (say, a personal computer) is ini-

tially priced in our currency (say, $1,500). This can be converted into a foreign currency

(say, yen) at the going (nominal) exchange rate (say, e 5 $0.01 per yen). The foreign- currency price of our export is then equal to P / e. (Here $1,500/.01 5 150,000 yen.) The foreign decision about whether to buy their domestic product (say, an NEC

7If the aggregate demand pressure continues for a sufficient period of time, it can also affect the ongoing rate of inflation. For instance, the United States went into the 1990–1991 recession with an ongoing inflation rate of about 4.5 percent. The weak aggregate demand that caused the recession (and slowed the subsequent recovery) reduced the actual inflation rate to less than 3 percent. In addition, the ongoing inflation rate expected to continue into the future (even when the economy had fully recovered from the recession) was reduced to about 3 percent, according to most estimates. (The expected ongoing inflation rate fell to 2.5 percent by the early 2000s, largely because technical changes lowered the measured inflation rate.)

pug21774_ch22_539-564.indd 559pug21774_ch22_539-564.indd 559 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

560 Part Four Macro Policies for Open Economies

computer) or our exported product is based partly on the relative price, which equals

P f /( P / e ), or ( P

f • e )/ P. The higher this ratio, the less attractive is their domestic

product, and the more attractive is our exported product.

Thus, the demand for our exports has two major determinants:

1 1

X 5 X ( Y f , P

f • e / P ) (22.14)

The volume of our exports tends to be higher if foreign production and income are

higher or if foreign substitute products are relatively expensive.

Thus, in addition to the income effects, net exports ( X 2 M ) tend to be higher if the price competitiveness of our products is higher, both because the volume of exports

tends to be larger and because the volume of imports tends to be smaller. Our general

indicator of international price competitiveness is the ratio ( P f • e )/ P . 8 Our interna-

tional price competitiveness improves if the foreign-currency price of foreign substi-

tute products ( P f ) is higher, the domestic-currency price of our products ( P ) is lower,

or the nominal exchange-rate value of our currency is lower ( e is higher). Over time, our price competitiveness improves if the foreign inflation rate is higher, our inflation

rate is lower, or our currency appreciates less (or depreciates more).

A change in international price competitiveness can be incorporated into our

IS–LM–FE framework. It is one of the other economic conditions (or exogenous

forces) that can cause shifts in the curves. A change in international price competitive-

ness shifts two curves: the FE curve and the IS curve. To see this, consider an improve-

ment in a country’s international price competitiveness, perhaps because the country

has had low product price inflation or because the country’s currency has depreciated

or devalued. The improved price competitiveness increases exports and decreases

imports. The increase in net exports increases aggregate demand, so the IS curve shifts

to the right. The current account improves, so the FE curve also shifts to the right.

Summary The performance of a country’s macroeconomy has both internal and external dimen- sions. We evaluate the country’s internal balance against goals oriented toward the

domestic economy. Internal balance focuses on achieving domestic production that matches the country’s supply capabilities so that resources are fully employed, while

also achieving price-level stability or an acceptably low rate of inflation. We evaluate

8While this ratio (essentially, the real exchange rate) is a useful broad indicator of a country’s international price competitiveness, it is not perfect. For any particular product, the relative price is affected by several influences not usually captured in the ratio. First, transport costs and government barriers to imports can alter the price ratio by increasing the price of the imported product. Second, exporters may use strategic pricing so that the local-currency price of the imported product is not just the domestic-currency price in the home market converted at the going exchange rate. This reflects international price discrimination. It is particularly interesting here because exporters may resist passing through the full effect of any exchange-rate change into foreign-currency prices for their products. This is called incomplete pass-through or pricing to market. When the yen appreciated sharply from 1985 to 1987, Japanese firms did raise the dollar prices of the products that they exported to the United States, but by far less than the amount of the exchange-rate change. They did this, presumably, to minimize their loss of export sales. From the point of view of the U.S. economy, this means that the volume of imports did not fall as much as might have been expected following the large dollar depreciation.

pug21774_ch22_539-564.indd 560pug21774_ch22_539-564.indd 560 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

Chapter 22 How Does the Open Macroeconomy Work? 561

external balance against goals related to the country’s international transactions.

External balance focuses on achieving an overall balance of payments that is sustainable over time.

A key aspect of how an open macroeconomy works is the relationship between

domestic production and international trade in goods and services. International trade

in goods and services is one component of total aggregate demand, which determines

domestic product and income in the short run. In addition, domestic production and

income have an impact on international trade, especially through the demand for

imports.

These relationships influence how shifts in aggregate demand affect our domestic

production. Holding interest rates (as well as the product price level and exchange

rates) constant, we generally expect that an increase in some component of aggregate

demand (like government spending) has a larger effect on domestic production—a

phenomenon summarized in the spending multiplier. In a closed economy, the size of

the multiplier is 1/ s , where s is the marginal propensity to save (including any govern- ment saving “forced” through the marginal tax rate). For the open macroeconomy, a

rise in domestic product and income increases imports. The size of the spending multiplier for a small open economy is 1/( s 1 m ), where m is the marginal propensity to import. The larger the country’s propensity to import, the smaller is the spending multiplier. The leakage into imports, like the leakage into saving,

dampens the effects of the initial extra spending on the ultimate change in domestic

product and income.

If the country is not small, then changes in its demand for imports have notice-

able effects on other countries, with several specific implications. First, any boom or

slump in one country’s aggregate demand can spill over to other countries. Second,

the changes in production and income in the other countries can then feed back into

the first country— foreign-income repercussions. These foreign-income reper- cussions make the true spending multiplier larger than the simple formula 1/( s 1 m ). Swings in the business cycle (recession or expansion) are not only internationally

contagious but also self-reinforcing, a conjecture easily supported by the experience

of the 1930s and the global crisis that began in 2007. The locomotive theory posits

that growth in the world’s large economies (the United States, the euro area, Japan,

and increasingly China) can spur growth in the entire world.

A more complete framework for analyzing a country’s macroeconomy in the short

run requires that we are able to picture not only domestic product, income, and aggre-

gate demand but also supply and demand for money and the country’s overall balance

of payments. The IS–LM–FE approach, also called the Mundell-Fleming model,

provides this framework.

The IS curve shows all combinations of interest rate and domestic product that are equilibriums in the national market for goods and services. Because lower

interest rates encourage borrowing and spending, the IS curve slopes downward. The

LM curve shows all combinations of interest rate and domestic product that are equi- libriums between money supply and money demand. For money demand to remain

equal to a given, unchanged money supply, the increase in money demand that accom-

panies a higher domestic product must be offset by a higher interest rate that reduces

money demand, so that the LM curve slopes upward.

pug21774_ch22_539-564.indd 561pug21774_ch22_539-564.indd 561 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

562 Part Four Macro Policies for Open Economies

The FE curve shows all combinations of interest rate and domestic product that result in a zero balance in the country’s overall international payments (its official

settlements balance). The FE curve also generally slopes upward. An increase in

domestic product and income increases demand for imports so that the country’s

current account and overall payments balance deteriorate. This can be offset (at least

in the short run) by a higher interest rate that draws in foreign financial capital (or

reduces capital outflows) so that the financial account (excluding official reserves

transactions) improves.

The intersection of the IS and LM curves indicates the short-run equilibrium values

for domestic product ( Y ) and the interest rate ( i ) for the country. The position of this IS–LM intersection relative to the FE curve indicates whether the official settlements

balance is positive, zero, or negative.

Although we often assume that the country’s product price level is constant in the

short run, over time the price level changes. Most countries have some amount of

ongoing inflation that is expected to continue. The monetary approach presented in

Chapter 19 emphasizes that ongoing inflation is related to continuing growth of the

money supply. In addition, the strength of aggregate demand relative to the economy’s

supply capabilities can affect the price level or inflation rate. If aggregate demand is

too strong, the economy overheats and the price level or inflation rate rises. If aggre-

gate demand is weak, the discipline effect of weak market demand tends to lower the

price level or inflation rate. Furthermore, price shocks can cause large changes in the

price level or inflation rate even in the short run.

International price competitiveness is another key determinant of a country’s inter-

national trade in goods and services, in addition to the effects of national income on

the country’s imports and foreign income on the country’s exports. If the price of

foreign products relative to the price of our country’s products is higher, our demand

for imports tends to be lower and foreign demand for our exports tends to be higher.

The real exchange rate is a useful general indicator of this relative price and thus

of the country’s international price competitiveness. A change in international price

competitiveness shifts both the IS curve and the FE curve because the current account

balance changes. For instance, if competitiveness improves, then exports increase and

imports decline. The increase in aggregate demand shifts the IS curve to the right, and

the improvement in the country’s payments position shifts the FE curve to the right.

Key Terms Internal balance External balance

Fiscal policy

Marginal propensity

to import

Spending multiplier for a

small open economy

Foreign-income

repercussions

IS curve

Monetary policy

LM curve

FE curve

Perfect capital

mobility

pug21774_ch22_539-564.indd 562pug21774_ch22_539-564.indd 562 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

Chapter 22 How Does the Open Macroeconomy Work? 563

Suggested Reading

Bosworth (1993, Chapter 2) discusses the concepts of internal and external balance

and develops the IS–LM–FE model. Hervé et al. (2011) and Dalsgaard et al. (2001)

present empirical estimates of the domestic and foreign effects of policy changes

using dynamic macroeconomic models that incorporate trade and other linkages

among countries. Chapter 4 of the International Monetary Fund’s April 2007 World Economic Outlook examines foreign spillovers of production and incomes and the correlation of business cycles across countries. Campa and Goldberg (2005) provide

a statistical analysis of incomplete exchange-rate pass-through for industrialized

countries.

Questions and Problems

1. According to Figure 22.2, on which country other than Canada does the United States

have the largest impact? Why do you think that this is so?

2. “A recession in the United States is likely to raise the growth of real GDP in Europe.”

Do you agree or disagree? Why?

3. An economy has a marginal propensity to save of 0.2 and a marginal propensity to

import of 0.1. An increase of $1 billion in government spending now occurs. (Hint: Assume that the economy is initially producing at a level that is below its supply-side

capabilities.)

a. According to the spending multiplier for a small open economy, by how much will domestic product and income increase?

b. If instead this were a closed economy with a marginal propensity to save of 0.2, by how much would domestic product and income increase if government spending

increased by $1 billion? Explain the economics of why this answer is different from

the answer to part a. 4. A country has a marginal propensity to save of 0.15 and a marginal propensity to import

of 0.4. Real domestic spending now decreases by $2 billion.

a. According to the spending multiplier (for a small open economy), by how much will domestic product and income change?

b. What is the change in the country’s imports? c. If this country is large, what effect will this have on foreign product and income?

Explain.

d. Will the change in foreign product and income tend to counteract or reinforce the change in the first country’s domestic product and income? Explain.

5. How does the intersection of the IS and LM curves relate to the concept of internal

balance?

6. How does the FE curve relate to the concept of external balance?

7. Explain the effect of each of the following on the LM curve:

a. The country’s central bank decreases the money supply. b. The country’s interest rate increases.

8. Explain the effect of each of the following on the IS curve:

a. Government spending decreases. b. Foreign demand for the country’s exports increases. c. The country’s interest rate increases.

✦

pug21774_ch22_539-564.indd 563pug21774_ch22_539-564.indd 563 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

564 Part Four Macro Policies for Open Economies

9. Explain the effect of each of the following on the FE curve:

a. Foreign demand for the country’s exports increases. b. The foreign interest rate increases. c. The country’s interest rate increases.

10. Explain the impact of each of the following on our country’s exports and imports:

a. Our domestic product and income increase. b. Foreign domestic product and income decrease. c. Our price level increases by 5 percent, with no change in the (nominal) exchange-

rate value of our currency and no change in the foreign price level.

d. Our price level increases by 5 percent, the foreign price level increases by 10 percent, and there is no change in the (nominal) exchange-rate value of our

currency.

11. According to the Board of Governors of the Federal Reserve System, the real effective

exchange rate of the U.S. dollar (relative to the rest of the world) went from 110 in

late 2002 to 100 in late 2003. Looked at the other way, the real exchange rate of the

rest of the world relative to the dollar went from 91 in late 2002 to 100 in late 2003.

Did the international price competitiveness of U.S. products improve or worsen from

late 2002 to late 2003? Other fundamental things equal, what was the effect (if any)

on the U.S. IS curve? On the U.S. FE curve?

12. Consider a small open-economy country, with s 5 0.25 and m 5 0.15. This coun- try’s economy is otherwise standard, but it has one unusual feature. When real GDP

increases, the expanded sales to domestic buyers reduce the pursuit of export sales by

domestic firms. That is, the export equation is X 5 X(Y), and the “marginal propensity to export” (z) is 20.1, so that each $1 increase in real GDP causes a $0.10 decrease in exports.

Is the size of the spending multiplier for this small open economy larger, the same,

or smaller (than the spending multiplier for a country that is the same except that it

does not have this unusual export behavior)? What is the mathematical expression for

the spending multiplier for this country with the unusual export behavior?

✦

pug21774_ch22_539-564.indd 564pug21774_ch22_539-564.indd 564 29/11/14 4:51 pm29/11/14 4:51 pm

Final PDF to printer

565

Chapter Twenty-Three

Internal and External Balance with Fixed Exchange Rates Fixed exchange rates can reduce the variability of currency values if governments are

willing and able to defend the rates. This chapter examines the macroeconomics of a

country whose government has chosen a fixed exchange rate.

Many major countries of the world have instead chosen floating rates (albeit with

modest amounts of government management). Why study fixed rates? There are three

important reasons. First, within the current system a substantial number of countries

do fix their exchange rates. As shown in Chapter 20, there are two major blocs of

currencies with fixed exchange rates. A large number of developing countries that fix

their currencies to the U.S. dollar form the dollar bloc. The euro bloc includes the 18

European Union countries that use the euro, other EU countries that fix their curren-

cies to the euro through the Exchange Rate Mechanism, and a number of countries

outside the EU that fix their currencies to the euro. In addition, a number of other

countries fix their moneys to currencies other than the dollar or the euro or to a basket

of currencies. Second, in the current system a number of countries have floating rates

in name, but the rates are so heavily managed by the governments that they are closer

to being fixed rates in many respects. Third, there are continuing discussions about

returning to a system of fixed rates among the world’s major currencies. Proposals

range from target zones, which would be a kind of crawling peg with wide bands, to a

return to the gold standard. Before we can assess the desirability or feasibility of such

proposals, we need to understand how a fixed exchange rate affects both the behavior

of a country’s economy and the use of government policies to influence the economy’s

performance.

The analysis of the chapter shows that defense of a fixed exchange rate through

official intervention in the foreign exchange market dramatically affects the country’s

monetary policy. The intervention can change the country’s money supply, setting off

effects that tend to reduce the payments imbalance. But this process limits the coun-

try’s ability to pursue an independent monetary policy. Defending the fixed rate also

has an impact on fiscal policy, which actually becomes more powerful if international

financial capital is highly mobile. In addition, intervention to defend the fixed rate

pug21774_ch23_565-602.indd 565pug21774_ch23_565-602.indd 565 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

566 Part Four Macro Policies for Open Economies

affects how the country’s economy responds to shocks, both shocks that come from

within the country and shocks that are international in origin.

Fixed rates challenge government policymakers who are attempting to guide

the country to both external balance (balance in the country’s overall international

payments) and internal balance (actual production equal to the economy’s supply

potential, or a high level of employment—“full employment”—without upward

pressure on the country’s inflation rate). Internal and external balance are often

hard to reconcile in the short and medium runs. A government that pursues external

balance alone, tidying up its balance of payments while letting inflation or unem-

ployment get out of hand at home, may be thrown out of office. On the other hand,

controlling domestic production alone, with fiscal or monetary policies, may widen

a deficit or surplus in the balance of payments, jeopardizing the promise to keep the

exchange rate fixed.

One possible solution is a subtle mixture of policies, with monetary policy assigned

to reducing international payments imbalances and fiscal policy assigned to stabiliz-

ing domestic production (GDP). Another possible “solution” is surrender—to change

the fixed rate by devaluing, revaluing, or shifting to a floating rate. The chapter looks

at both ideas and concludes by considering the conditions that influence whether a

change in the fixed rate will be successful in improving the country’s internal and

external macroeconomic performance.

FROM THE BALANCE OF PAYMENTS TO THE MONEY SUPPLY

Once a country’s government has decided to have a fixed exchange rate, the govern-

ment must defend that rate. As previously discussed, the first line of defense is official

intervention—the monetary authority (central bank) buys or sells foreign currency

in the foreign exchange market as necessary to steady the rate within the allowable

band around the central value chosen for the fixed rate. Several implications follow

from official intervention. First, the holdings of official reserves change as the central

bank buys or sells foreign currency. Second, the country’s money supply may change

as the central bank sells or buys domestic currency as the other half of its official

intervention.

Our goal in this and the next three sections of the chapter is to show how these

effects occur and what implications they have for the country’s macroeconomy. Let’s

begin with the assets and liabilities of the central bank that will be the core of our

story. Here is a simplified balance sheet that shows these items:

Central Bank

Selected Assets Selected Liabilities

Domestic assets (D) Monetary base (MB) Debt securities Currency Loans to banks Deposits from banks International reserve assets (R) Foreign-currency assets

pug21774_ch23_565-602.indd 566pug21774_ch23_565-602.indd 566 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

FIGURE 23.1 Key Balance-

Sheet Items,

the Fed and the

ECB, December

31, 2013

(Billions of U.S.

Dollars)

Source: Federal Reserve Board of

Governors, annual

report, 2013;

European Central

Bank, annual report,

2013.

Federal Reserve European Central Bank (Consolidated System) (Consolidated System)

Key Assets

Securities (denominated in domestic currency) 3,952 852 Loans to banks (domestic currency) 0 1,037 Foreign-currency- denominated assets 24 361

Key Liabilities

Currency (paper notes and coins) 1,198 1,318 Deposits from banks (domestic currency) 2,249 652

Chapter 23 Internal and External Balance with Fixed Exchange Rates 567

The differences in the holding of the key domestic assets reflects the difference in operating procedures. The Fed conducts its domestic monetary policy using open market operations, in which the Fed buys and sells U.S. government securities, so it holds a lot of these assets.

The ECB conducts its domestic monetary policy mostly by making loans (in euros) to banks and other financial institutions . These are two alternative ways of regulating the two key liability items, which together form the monetary base. In addition, the sizes of securities holdings

by the Fed and deposits from banks at the Fed are much larger than under normal conditions

because of “quantitative easing” by the Fed. The ECB has conducted a milder form of quantitative

easing, which has increased the sizes of its holdings of securities and its loans to banks.

The difference in holdings of foreign-currency assets mainly reflects history. The U.S. government seldom intervenes in the foreign exchange market, so the Fed has little need to hold

international reserve assets. The ECB inherited its official reserve assets from the national central

banks of the euro area. Historically, these national banks actively intervened, so they needed to hold

substantial international reserves.

Figure 23.1 shows the magnitude of these items for the Federal Reserve, the U.S. central

bank, and the European Central Bank (ECB), the central bank for the euro area.

The two key types of assets are domestic assets ( D ) and international reserve assets ( R ), especially the central bank’s holdings of foreign currency and foreign- currency-denominated securities. The domestic assets are not international reserves

because they are denominated in domestic currency. Two major types of domestic assets

held by the central bank are (1) bonds and similar debt securities and (2) loans that the

central bank has made to (regular) domestic banks or other domestic financial institutions.

On the other side of the balance sheet, the liabilities of interest to our story are

(1) the domestic currency (paper money and coins) issued by the central bank and

(2) the deposits that the country’s (regular) domestic banks (or other domestic finan-

cial institutions) have placed with the central bank. The deposits from regular banks

may be required by regulations of the central bank. In addition, the central bank often

uses the deposits from banks in the process of settling payments between domestic

banks (for instance, in the process of clearing checks drawn on one bank but payable

to another). The total of these two central-bank liabilities, currency and deposits from

banks, is called the monetary base (MB).

pug21774_ch23_565-602.indd 567pug21774_ch23_565-602.indd 567 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

568 Part Four Macro Policies for Open Economies

The country’s money supply consists (mainly) of currency held by the public and various types of deposits (like checking accounts) that the public has at regular banks.

The country’s central bank has the ability to influence the total amount of these bank

deposits from the public because banks are required to hold, or wish to hold, certain

assets as bank reserves to “back up” these deposit liabilities. We presume that the

types of assets that count as bank reserves are a bank’s holdings of currency “in its

vault” and the bank’s holdings of deposits at the central bank. The amount of reserves

that a bank is required to hold is typically some fraction of the deposits that the bank

owes to its customers—a system called fractional reserve banking. 1

In this setting the central bank controls the country’s money supply by controlling

its own balance sheet and by setting the reserve requirements that (regular) banks must

meet. To see this, consider what happens if the central bank allows its liabilities (the

monetary base) to increase. This will expand the money supply. If the increase is in

the form of an increase in currency that is held by the public, then the money supply

increases directly. If the increase is in the form of central bank liabilities that count as

bank reserves (either currency in bank vaults or deposits from banks), then banks can

increase the value of their deposit liabilities, and they can increase deposits by a multiple

amount of the value of the increase in bank reserves. With fractional reserve banking,

each dollar of extra bank reserves can back up several dollars of deposits (where several is the reciprocal of the reserve requirement fraction). The multiple expansion of the

money supply with fractional reserve banking is called the money multiplier process. 2

With this background on the country’s central bank and its control of the country’s

money supply, let’s return to the effects of official intervention used to defend the

fixed exchange rate. If the country has an official settlements balance surplus, so that the exchange-rate value of the country’s currency is experiencing upward pressure, the central bank must intervene to buy foreign currency and sell domestic currency . On its balance sheet this is

• an increase in official international reserve holdings (R↑) and • an increase in its liabilities (MB↑ as the domestic currency is added to the economy).

1As you can see, the standard terminology seems intended to confuse us. Bank shows up in two ways. The country’s central bank is the official monetary authority that controls monetary policy and (usually) is the authority that undertakes official intervention in the foreign exchange market. Regular banks, often just called banks, conduct regular banking business (making loans, taking deposits, transacting in foreign exchange) with regular customers (for instance, individuals, businesses, and government units) and among themselves (for instance, interbank loans and interbank foreign exchange trading). Reserves is an even more dangerous term. A central bank (or the country’s relevant monetary authority if it is not exactly a central bank) holds official international reserve assets. Regular banks hold bank reserves as assets, usually in proportion to their deposit liabilities. Part of these bank reserves is usually in the form of deposits that these regular banks have at the central bank. (Just to add to the soup, there is another type of reserve in bank accounting—liability items such as reserves for bad loans—but these are not part of our main story.) 2This description of the central bank and the way in which it controls the country’s money supply is appropriate for the United States (the Federal Reserve, or “Fed”) and for many other countries. Still, some countries use different procedures (for instance, implementing monetary policy through limits on the expansion of loans by banks to their customers). Analysis of such countries would need to be modified somewhat to match their procedures, but the major conclusions to be reached in the sections below generally still apply.

pug21774_ch23_565-602.indd 568pug21774_ch23_565-602.indd 568 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

Chapter 23 Internal and External Balance with Fixed Exchange Rates 569

The increase in liabilities can be in the form of an increase in actual currency outstand-

ing (if the central bank delivers the domestic currency as currency itself ). More likely,

and more efficiently in terms of the process, the central bank delivers the domestic

“currency” to a regular bank (the bank with whom it is transacting in the foreign

exchange market) by increasing the deposits that the bank has at the central bank. In

either case, the country’s money supply will increase . If, as is likely, the reserves held by banks increase (because their deposits at the central bank increase or their holdings

of vault cash increase), then the money supply can increase by a multiple of the size

of the central bank intervention in the foreign exchange market.

If instead the country’s official settlements balance is in deficit and the exchange- rate value of the country’s currency is under downward pressure, the central bank must intervene to sell foreign currency and buy domestic currency. On its balance sheet this is

• a decrease in official international reserve holdings (R↓) and • a decrease in its liabilities (MB↓ as the domestic currency is removed from the

economy).

The central bank probably collects the domestic “currency” by decreasing the deposits

that the regular bank involved in the foreign exchange transaction has at the central

bank. Then the reserves held by banks decline (because their deposits at the central bank

decrease), and the money supply must decrease by a multiple of the size of the central bank intervention in the foreign exchange market (the money multiplier in reverse).

The conclusion here is that official intervention alters the central bank’s assets and

liabilities in ways that change not only the country’s holdings of official international

reserve assets but also the country’s money supply, unless the central bank does something

else to attempt to resist the change in the money supply. Indeed, under fractional reserve

banking, the change in the money supply will be a multiple of the size of the intervention.

FROM THE MONEY SUPPLY BACK TO THE BALANCE OF PAYMENTS

If official intervention changes the country’s money supply, what are the implications

for the country’s balance of payments and for the country’s macroeconomic perfor-

mance in general? The change in the money supply sets off several effects that tend to

reduce the payments imbalance.

Consider first the case in which the country begins with a surplus in its overall

balance of payments. The surplus requires official intervention in which the central

bank buys foreign currency and sells domestic currency. The domestic money sup-

ply increases “automatically” as the central bank increases its liabilities when it sells

domestic currency. Figure 23.2 summarizes the effects of the increase in the money

supply on the balance of payments.

As the central bank increases bank reserves, banks are more liquid and want to

expand their business. They seek to make more loans. In the process, their competition

to lend more is likely to bid down interest rates.

pug21774_ch23_565-602.indd 569pug21774_ch23_565-602.indd 569 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

For a decrease in the money supply, reverse the direction of all changes.

With an increase in the money supply, banks are more willing to lend

Interest rate drops

Overall payments balance “worsens”

Real spending, production, and income rise

Current account balance “worsens”

Capital flows out

Price level increases

(in the short run)

(beyond the short run)

FIGURE 23.2 Expanding the Money Supply Worsens the Balance of Payments with Fixed Rates

570 Part Four Macro Policies for Open Economies

The lowering of interest rates in the economy, at least in the short run, has several

effects on the balance of payments. One is through the country’s financial account.

The decline in interest rates causes some holders of financial assets denominated in

the domestic currency to seek higher returns abroad. The international capital outflow

causes the financial account to “deteriorate” (become less positive or more negative). 3

This effect on the financial account can occur quickly, but it may not last long. Once

portfolios are adjusted, any ongoing capital flows are likely to be smaller. In fact, the

outflows could reverse when bonds mature or loans come due. (In addition, the extra

foreign investment is likely to set up a stream of income payments that the country

receives in the future.)

Another effect is on the current account because of changes in real income, in the

price level, or in both. The decrease in domestic interest rates encourages interest-

sensitive spending—for instance, through more borrowing to support additional new

real investment projects. The expansion in spending results in an increase in real

domestic product and income (assuming that there is some availability of resources

to expand production in the economy). The rise in income increases imports of goods

and services and “worsens” the current account balance. (A smaller surplus or a larger

deficit results.) In addition, the extra spending can put upward pressure on the price

level in the economy, especially if the expansion of aggregate demand pushes against

the supply capabilities of the economy. If prices and costs in the economy rise, then

the country’s international price competitiveness deteriorates, and the country’s current

account worsens. Which of these two effects actually occurs depends on the start-

ing point for the economy and the time frame involved. If the economy begins with

unemployed resources, then the effect through real income is likely to be larger. If the

3We are assuming that the change in the domestic interest rate lowers the interest differential because foreign interest rates have not changed or have not changed as much. In addition, we are assuming that expectations of future spot exchange rates have not changed. For instance, international investors believe that the fixed rate will be maintained, so the expected future spot rate remains about equal to the current spot rate.

pug21774_ch23_565-602.indd 570pug21774_ch23_565-602.indd 570 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

FIGURE 23.3 Payments

Adjustments

for a Surplus

Country with

Fixed Rates

If the country begins at point A with a payment surplus, intervention to defend the fixed exchange rate results in an

increase in the money supply. The LM curve shifts down or

to the right, and the surplus falls toward zero as the IS–LM

intersection shifts toward point E .

0.07

0.06

Interest rate 5 i

Domestic product 5 Y100 110

LM0

Chapter 23 Internal and External Balance with Fixed Exchange Rates 571

economy starts close to full employment, then the effect through the price level is likely

to be more important, at least beyond the short-run period when prices are sticky.

Thus, official intervention by a country that initially has a balance-of-payments

surplus can increase the money supply, and this increase in the money supply sets off

adjustments in the economy that tend to reduce the size of the surplus. Key features

of the adjustment can be pictured using an IS–LM–FE diagram. Suppose that the

economy is initially at point A in Figure 23.3 , the intersection of the initial IS and LM

0 curves. This point is to the left of the FE curve, showing that the country has a

surplus in its official settlements balance. Official intervention to defend the fixed rate

increases the money supply, shifting the LM curve down or to the right. As the LM

curve shifts down, the equilibrium interest rate decreases and domestic product and

income increase. The intersection of the IS curve and the new LM curve is moving

closer to the FE curve. If the price level does not change, then full adjustment has

occurred (probably over several years) when the LM curve has shifted down to the

triple intersection at point E . The equilibrium interest rate has fallen from 7 percent to 6 percent, domestic product has risen from 100 to 110, and the official settlements

balance is zero (because the economy is on the FE curve). 4

If the country instead begins with a deficit in its official settlements balance and

downward pressure on the exchange-rate value of its currency, then all of these effects

work in the reverse direction. The domestic money supply decreases and domestic

interest rates increase, at least in the short run. The rise in interest rates draws a

capital inflow, improving the financial account. The rise in interest rates also lowers

4If the price level also increases, then both the FE and IS curves will shift to the left as the country loses international price competitiveness. The LM curve will shift by less, and the triple intersection will occur with a somewhat lower real domestic product.

pug21774_ch23_565-602.indd 571pug21774_ch23_565-602.indd 571 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

572 Part Four Macro Policies for Open Economies

aggregate demand and real domestic product, reducing imports and improving the

current account. The weak aggregate demand also puts downward pressure on the

economy’s price level, at least beyond the short-run period in which prices are sticky.

This increases the country’s international price competitiveness and improves its cur-

rent account. The overall balance of payments improves—the deficit declines toward

zero. The country’s IS–LM intersection is initially to the right of the FE curve. The

LM curve then shifts up or to the left, and eventually a triple intersection is achieved.

The thrust of the analysis is clear. If an external imbalance exists, intervention to

defend the fixed rate changes the domestic money supply. The money supply change

causes adjustments that move the country back toward external balance. So what is the

problem? Possible problems are of two types.

First, the process is based on changes in the country’s holdings of international

reserve assets. For a country that begins with a payments surplus, the monetary

authority will acquire official international reserve assets. For a deficit, the authority

will lose official reserves. Officials may view either change as undesirable. However,

this may not really be a problem if the authority accepts that the money supply must change (and the LM curve must shift). The central bank can simply use its domestic operations to speed up the adjustment. For instance, the country can use open market

operations in which it buys or sells government securities.

In the surplus situation, the country could expand the money supply more quickly,

and lower interest rates more quickly, by buying domestic government securities. This

open market operation adds to both the domestic assets (D↑) and the liabilities (MB↑) of the central bank. By changing monetary conditions more quickly, external balance

is achieved more quickly. Official reserve assets ( R ) increase by less because some of the increase in the domestic money supply is the result of the increase in domestic

assets ( D ) held by the central bank. In the deficit situation, the country could contract the money supply by selling

domestic government bonds in an open market operation. Bank reserves decrease, the

money supply contracts, and interest rates rise more quickly. The payments deficit

shrinks more quickly, and external balance is achieved more quickly. Official interna-

tional reserves do not decrease as much; instead, part of the money supply decrease is

the result of a decrease in domestic assets held by the central bank.

A second possible problem with the adjustment toward external balance is that it

may not be consistent with internal balance. In the surplus situation, the increase in the

money supply can put upward pressure on the country’s price level, and this pressure

toward a positive (or higher) rate of inflation may be viewed as undesirable—a shift

toward internal imbalance. In the deficit situation, the decrease in the money supply

can result in a recession (declining real production), with rising unemployment.

STERILIZATION

Rather than allowing automatic adjustments to proceed (or speeding them up), the

monetary authority instead may want to resist the change in the country’s money supply. One reason for resistance is that the money supply change would tend to

create an internal imbalance, as just described. Another is that the authority may

pug21774_ch23_565-602.indd 572pug21774_ch23_565-602.indd 572 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

Chapter 23 Internal and External Balance with Fixed Exchange Rates 573

believe that the international imbalance is temporary and will soon reverse. This is the

case of temporary disequilibrium discussed in Chapter 20.

The central bank can keep the external surplus or deficit from having an impact on

the domestic money supply by taking an offsetting domestic action. Sterilization is taking an action to reverse the effect of official intervention on the domestic

money supply. If the central bank is intervening to defend the fixed rate in a situ-

ation of payments surplus by selling its national currency in exchange for foreign

currency, the money supply tends to increase (R↑ and MB↑). This can be sterilized if the central bank, for instance, undertakes an open market operation in which

the central bank sells domestic government bonds. While the intervention in cur-

rency markets tends to expand the money supply, the open market operation tends

to reduce it by reducing both the domestic assets held by the central bank and the

central bank liabilities that serve as the base for the domestic money supply ( D ↓ and MB↓). The effects on the monetary base and the money supply of the combination

of intervention and sterilization tend to cancel out (MB↑ 5 MB↓). The net effects of the sterilized intervention are to alter the composition of the central bank’s assets

(in this case, R ↑and D ↓). In the case of a deficit, the central bank can sterilize the official intervention (buying

the nation’s currency) by buying domestic government bonds with that same currency

in an open market operation. In this case, the intervention reduces official reserve

holdings ( R ↓) and the central bank’s liabilities (MB↓). The sterilization increases the central bank’s holding of domestic securities ( D ↑) and increases its liabilities (MB↑). The effects on the monetary base and the money supply tend to cancel out, and the net

effects are on the central bank’s assets ( R ↓ and D ↑). Because a sterilized intervention does not change the money supply, the LM curve

does not change. In Figure 23.3 the economy’s equilibrium remains at point A . There is no adjustment toward external balance. Often this is a wait-and-see or a wait-and-hope

strategy. Perhaps something else will shift the FE curve toward point A , or some other source of change will shift the IS–LM intersection toward the FE curve. If nothing else

moves the economy toward external balance, there are limits to the ability of the mon-

etary authority to use sterilized intervention to continue to run a payments imbalance.

In the case of the payments surplus, the limit may be (1) the unwillingness of the

central bank to continue to increase its holdings of official reserve assets or

(2) the complaints by other countries about the country’s ongoing surplus. China was

in the middle of this scenario during 2005–2014. Previously, Taiwan saw this process

play out in the 1980s, when its interventions resulted in official reserve holdings that

grew rapidly to a value equal to about three-quarters of the value of its annual national

income. Pressure by the U.S. government then induced Taiwan to allow its currency to

appreciate quickly during 1986–1987.

In the case of a payments deficit, the limit is the inability of the central bank to

obtain foreign currency to sell in the official intervention. The country’s official

reserve assets may dwindle toward zero (and it cannot borrow more foreign currencies

because of its precarious international position). This limit can be dramatic—if inter-

national investors and speculators believe that the central bank is low in its holdings of

official reserves, a currency crisis based on the one-way speculative gamble discussed

in Chapters 20 and 21 can develop.

pug21774_ch23_565-602.indd 573pug21774_ch23_565-602.indd 573 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

Starting from point E with an overall payments balance of zero, the country attempts to implement an expansionary policy. The

LM curve shifts down or to the right, but at point H the payment balance is in deficit. Intervention to defend the fixed exchange

rate decreases the money supply, and the LM curve shifts

back up, eventually returning the country to point E .

0.06

Interest rate 5 i

Domestic product 5 Y 110

LM'LM

FIGURE 23.4 Expansionary

Monetary Policy

with Fixed

Rates

574 Part Four Macro Policies for Open Economies

MONETARY POLICY WITH FIXED EXCHANGE RATES

The discussion of the preceding two sections has a major implication— fixed exchange rates greatly constrain a country’s ability to pursue an independent monetary policy . To a large degree the country’s monetary policy must be consistent with maintaining

the value of the fixed rate. Payments imbalances place pressure for changes in the

money supply driven by the intervention to defend the fixed rate. Sterilization can

be used to resist these money supply changes, but there are limits to how long the

country’s central bank can use sterilization, especially if the central bank’s holdings

of official reserves are declining because of a payments deficit.

Even if the country begins with a payments balance, its ability to pursue an indepen-

dent monetary policy is greatly constrained. To see this, consider a country that initially

has an official settlements balance of zero. While the country has achieved external bal-

ance, the country may believe that it has not achieved internal balance. Specifically, it

has a high unemployment rate and wants to expand its domestic product. To pursue this

goal with monetary policy, it attempts to implement an expansionary monetary policy.

For a time this policy may increase real product. But the country’s official settle-

ments balance will go into deficit through the process shown in Figure 23.2. Both the

current account and financial account will deteriorate. The country then must intervene

to defend its fixed rate, selling foreign currency and buying domestic currency. This

reduces the domestic money supply, effectively forcing the country to abandon its

expansionary policy. Even if the central bank resists this for a while using sterilization,

it cannot continue to sterilize indefinitely. Eventually, the country must allow its money

supply to shrink (or pursue some other adjustment like an exchange-rate change).

This process can be seen in Figure 23.4 , where the country is initially at point E , a triple intersection. The increase in the money supply shifts the LM curve down or to

pug21774_ch23_565-602.indd 574pug21774_ch23_565-602.indd 574 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

For contractionary fiscal policy, reverse the direction of all changes.

Government spending rises or tax rates fall

Interest rate rises

Overall payments balance may “improve” at first, but worsens eventually

Real spending, production, and income rise

Current account balance worsens

Capital flows in

Price level increases

(in the short run)

(beyond the short run)

FIGURE 23.5 How

Expansionary

Fiscal Policy

Affects the

Balance of

Payments with

Fixed Rates

Chapter 23 Internal and External Balance with Fixed Exchange Rates 575

the right. The IS–LM intersection at point H indicates that real domestic product has increased, but the new intersection is to the right of the FE curve, indicating a pay-

ments deficit. As the country intervenes to defend the fixed exchange rate, the money

supply shrinks and the LM curve shifts back. If nothing else changes, the LM curve

shifts back to the original triple intersection.

In this example, in contrast to the analysis in the earlier sections, we are starting

from payments balance and conducting the analysis as “from the money supply to

the balance of payments” and then “from the balance of payments back to the money

supply.” In the process we conclude that the ability to change the money supply is

limited, and eventually stops, because of the feedback from the balance of payments

and the need to defend the fixed rate.

FISCAL POLICY WITH FIXED EXCHANGE RATES

Fiscal policy is implemented by changing government spending and taxes. A change in

fiscal policy affects the balance of payments through both the current account and the

financial account. Let’s examine the case of an expansionary fiscal policy, say, a rise in

government purchases of goods and services. This case is summarized in Figure 23.5 .

(Contractionary fiscal policy is analyzed in the same way, with all of the changes

occurring in the opposite direction.)

The extra government spending means a bigger government budget deficit (or a

reduced budget surplus). We’ll tell the story using a budget deficit. To finance the

larger budget deficit, the government is borrowing more and driving up interest rates.

The higher interest rates should attract a capital inflow, “improving” the country’s

financial account.

The extra government spending also increases aggregate demand and real domestic

product (assuming that some resources are available to expand production). 5 The extra

spending spills over into extra import demand, “worsening” our current account balance.

pug21774_ch23_565-602.indd 575pug21774_ch23_565-602.indd 575 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

576 Part Four Macro Policies for Open Economies

In addition, the extra aggregate demand may put upward pressure on the price level

once we pass beyond the short-run period in which the price level is sticky. If the price

level increases, then the country loses international price competitiveness, another

reason that the current account deteriorates.

The effect on the country’s overall balance of payments depends on the magni-

tudes of these changes. Given the worsening of the current account, we can examine

the effect on overall balance as a question of how responsive international financial

capital flows are to interest rate changes.

• If international capital flows are very responsive to interest rate changes (high

capital mobility), then the capital inflows will be large, and the official settlements

balance will go into surplus.

• If the capital flows are unresponsive (low capital mobility), then the financial

account will improve only a little, and the overall balance will go into deficit.

The effect on the overall balance is probably also affected by timing—the capital

inflows may be large at first, but they probably will dwindle as international portfolios

are adjusted to the new economic conditions.

Figure 23.6 shows the effects of a fiscal expansion with fixed exchange rates in the

short run assuming that the price level is steady. For both cases we begin with a triple

intersection at point E . The shift to an expansionary fiscal policy shifts the IS curve to the right, to IS'. The new intersection with the LM curve is at point K, with a higher interest rate and a higher level of real domestic product. 6

The two cases shown in Figure 23.6 differ in how responsive international capital

flows are to changes in the interest rate. The left graph shows the case of high capi-

tal mobility so that the FE curve is relatively flat. The right graph shows the case

of low capital mobility so that the FE curve is relatively steep. If capital flows are

responsive, as in Figure 23.6A, then the new intersection point K lies to the left of the FE curve and the overall payments balance goes into surplus. If they are unre-

sponsive (Figure 23.6B), then point K lies to the right of FE and the overall balance goes into deficit. 7

The discussion so far has offered conclusions about the effects of a fiscal policy

change on the domestic economy and on external balance. It might seem that we can

stop here, but we should not. If the official settlements balance shifts into surplus or

deficit, then official intervention is needed to defend the fixed exchange rate, and the

country’s money supply will change (although this effect might be postponed if the

5In the short run real GDP increases even if there is partial crowding out, as interest-sensitive domestic spending decreases somewhat when interest rates increase. 6Another way to see the pressure for a higher interest rate is to use the direct logic of the IS–LM analysis. The increase in real income and spending increases the transaction demand for money, but there is no increase in the money supply (assuming, at least initially, that the central bank does not permit any increase because of an unwillingness to shift its monetary policy). The extra money demand must be choked off by an increase in interest rates. (All of this represents a movement along the LM curve from E to K.) 7The slope of the FE curve does not matter much in analyzing monetary policy because there is no ambiguity in the direction of effects on the overall balance for an attempted shift in monetary policy such as that analyzed in Figure 23.4.

pug21774_ch23_565-602.indd 576pug21774_ch23_565-602.indd 576 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

Expansionary fiscal policy shifts the IS curve to the right and the IS–LM intersection shifts from E to K . The effects of fiscal policy depend on how strongly international capital flows respond to the interest rate increase. In panel A, the

overall payments balance goes into surplus. ( K is to the left of FE.) In panel B, the overall payments balance goes into deficit. ( K is to the right of FE.) In either case the payments imbalance leads to a change in the money supply (assuming that the central bank does not or cannot “sterilize” it). In panel A, intervention to defend the fixed rate increases the

money supply, shifting the LM curve down, and the economy shifts toward a new full equilibrium at point E'. In panel B, intervention to defend the fixed rate decreases the money supply, shifting the LM curve up, and the economy shifts

toward a new full equilibrium at point E".

0.08 0.07 0.06

0.09 0.08

0.06

Interest rate 5 i

Domestic product 5 Y

110

A. Responsive International Capital Flows

130140

LM'

IS'

E'E

Interest rate 5 i

110

B. Unresponsive International Capital Flows

120 130

LM''

IS'

K E''

FIGURE 23.6 Expansionary Fiscal Policy with Fixed Exchange Rates

Chapter 23 Internal and External Balance with Fixed Exchange Rates 577

8If the price level also increases, the FE curve shifts to the left and the IS curve shifts back somewhat to the left. Real domestic product does not increase by as much in this case and in the one discussed in the next paragraph.

intervention is sterilized). If the intervention is not sterilized, then interest rates and

domestic product will be affected further as the money supply changes. The direction

of this effect depends on whether the overall balance shifts into surplus or deficit.

If capital is highly mobile, then overall payments go into surplus, and the central

bank must intervene by selling domestic currency and buying foreign currency. With

no sterilization, the domestic money supply expands, reducing interest rates and

supporting a further expansion in domestic product. In Figure 23.6A, the increase

in the money supply shifts the LM curve down or to the right. It will eventually

shift to the dashed LM', where a new triple intersection is achieved at point E '. In this case, fiscal policy becomes more powerful in increasing real GDP because the

monetary authority expands the money supply as it intervenes to defend the fixed

exchange rate. 8

If capital mobility instead is low, then the overall payments deficit requires official

intervention in which domestic currency is purchased and foreign currency is sold. If

the intervention is not sterilized, then the domestic money supply decreases, raising

pug21774_ch23_565-602.indd 577pug21774_ch23_565-602.indd 577 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

578 Part Four Macro Policies for Open Economies

interest rates and reversing some of the increase in real domestic product. In Figure

23.6B the decrease in the money supply shifts the LM curve up or to the left, eventu-

ally to the dashed LM". In this case, expansionary fiscal policy loses some of its power

to increase real GDP.

PERFECT CAPITAL MOBILITY

The case of perfect capital mobility is an extreme case of how international financial

flows can alter the effectiveness of monetary and fiscal policies under fixed rates.

Perfect capital mobility means that a practically unlimited amount of international capital flows in response to the slightest change in one country’s interest rates.

Perfect capital mobility may be a good basis to analyze countries whose capital

markets are open to international activity and whose political and economic situa-

tions are considered stable (so that no perceptions of political and economic risks

limit capital inflows). Indeed, the success of a system of fixed exchange rates makes

perfect capital mobility more likely. If investors are convinced that exchange rates will

remain fixed, they will be more willing to move back and forth between currencies in

response to small differences in interest rates.

For a small country (one that is too small to influence global financial markets by

itself ), perfect capital mobility implies that the country’s interest rate must be equal to

the interest rate in the larger global capital market. When exchange rates were fixed,

this gave substance to the Canadian complaint that “Canadian interest rates are made

in Washington.”

If international capital flows are highly sensitive to slight, temporary interest rate

changes, then they practically dictate the country’s money supply, even in the short run.

Why? Consider what happens if an incipient reduction of the money supply begins to

increase the country’s interest rates. The slightly higher interest rates draw a large capital

inflow. Intervention to defend the fixed exchange rate requires selling domestic currency,

thus expanding the money supply. Furthermore, sterilization is nearly impossible under

such circumstances because of how large the capital inflows could be. Conversely, a

nearly unlimited outflow of capital could occur if the country expanded its money sup-

ply and lowered interest rates slightly. The capital outflow forces the money supply

back down to its original level to eliminate the slight drop in interest rates. The balance

of payments rules the money supply. Perfect capital mobility with fixed exchange rates robs monetary policy of its ability to influence interest rates or the domestic economy .

For fiscal policy, perfect capital mobility actually means enhanced impacts on the

domestic economy in the short run. Expansionary fiscal policies do not raise interest

rates because the extra government borrowing is met by an influx of lending from

abroad. Thus, the government borrowing does not crowd out private domestic bor-

rowers with higher interest rates, allowing fiscal policy its full spending multiplier

effects on the economy. In other words, with perfect capital mobility and interest

rates set outside the country, fiscal expansion cannot be guilty of crowding out private

real investment from lending markets. This extra potency of fiscal policy under fixed

exchange rates and perfect capital mobility may be a poor substitute for the loss of

monetary control because government handling of spending and taxes is often crude

pug21774_ch23_565-602.indd 578pug21774_ch23_565-602.indd 578 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

Chapter 23 Internal and External Balance with Fixed Exchange Rates 579

FIGURE 23.7 With Perfect

Capital

Mobility,

Monetary

Policy Is

Impotent but

Fiscal Policy

Is Strong

0.06

Interest rate 5 i

Domestic product 5 Y 1601100

E LM and FE

IS'IS

and subject to the vagaries of politics. Yet this is apparently a fact of life for small coun-

tries under truly fixed exchange rates and open capital markets (no capital controls). 9

Figure 23.7 shows the effect of perfect capital mobility on the IS–LM–FE picture.

The FE curve is flat because the tiniest change in interest rates would trigger a poten-

tially infinite international flow of capital. If the global interest rate is 6 percent, then

any point above the flat FE, corresponding to a domestic interest rate greater than

6 percent, results in a massive capital inflow and payments surplus. Any point below

results in a massive capital outflow and payments deficit.

With perfect capital mobility the LM curve is also effectively flat and the same

as FE. Any flood of international capital swamps any other influence on the nation’s

money supply. The money supply must be whatever is necessary to keep the domestic

interest rate at 6 percent. Only the interest rate of 6 percent, dictated by financial con-

ditions in the world as a whole, is consistent with equilibrium in the country’s market

for money. Under the conditions shown in Figure 23.7, the country has no independent

monetary policy. The monetary authorities cannot change the domestic interest rate or

control the money supply.

By contrast, fiscal policy takes on great power under these conditions. Raising

government spending or cutting tax rates causes the usual rightward shift of the IS

curve to IS'. As soon as the extra government deficit raises the home country’s interest

rate even slightly, there is a rush of capital inflow, as international investors seek the

slightly higher interest rate in this country. The inflow raises the money supply until

the interest rate is bid back down to 6 percent. So a rightward shift of the IS curve has

a large effect on domestic product and no effect on the interest rate. 10

9With perfect capital mobility, as with the other cases discussed in this chapter, we must remember that any attracted capital must be paid for later with reflows of interest and principal back to the foreign creditors. 10In fact, fiscal policy’s impact on domestic product fits the spending multiplier formula of Chapter 22. For example, suppose that the country in Figure 23.7 had a marginal propensity to save of 0.2 and a marginal propensity to import of 0.3. This would make the multiplier equal to 2, according to Chapter 22. In this case, the rightward shift of DY = 50 from point E to point E' in Figure 23.7 could be achieved by DG = 25.

pug21774_ch23_565-602.indd 579pug21774_ch23_565-602.indd 579 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

580 Part Four Macro Policies for Open Economies

The case of perfect capital mobility shows clearly that monetary policy is subordi-

nated to the defense of the fixed exchange rate and that fiscal policy can be powerful

with fixed exchange rates. For the rest of this chapter we now return to the case of mod-

erate capital mobility and an upward-sloping FE curve. Perfect capital mobility can be

considered the limiting case (flat) of the general case (upward-sloping) that we examine.

SHOCKS TO THE ECONOMY

From time to time a country’s economy is hit by major shocks—both shocks that

represent changes in basic conditions in the domestic economy and those that arise

externally in the international economy. What are the effects of these exogenous forces

on an economy that has a fixed exchange rate? To provide a simple base for our analy-

sis, we will usually examine cases in which the country has achieved external balance

(a triple intersection in the IS–LM–FE graph) just before the shock hits the economy.

Internal Shocks One type of internal shock arises in the market for money. A domestic monetary shock alters the equilibrium relationship between money supply and money demand because (1) the money supply changes or (2) the way in which people decide on their

money holdings changes. The latter can arise, for instance, from financial innova-

tions like money market mutual funds, the spread of credit cards, or automated teller

machines (ATMs). A domestic monetary shock causes a shift in the LM curve. Its

effect on domestic interest rates and domestic product is quite limited with fixed rates.

As we saw in our analysis of the attempt to run an independent monetary policy, a shift

in the LM curve tends to reverse itself as the central bank must intervene to defend the

fixed rate. A major effect of a monetary shock instead can be on the country’s holdings

of official reserve assets, if intervention is the basis for the money supply change that

shifts the LM curve back toward its initial position.

Another type of domestic shock arises from exogenous changes in domestic spend-

ing on goods and services. A domestic spending shock alters domestic real expen- diture ( E ) through an exogenous force that alters one of its components (consumption, real domestic investment, or government spending). A change in fiscal policy is one

such shock. Another would be a change in the business mood or consumer sentiment,

resulting in a change in real investment or consumption spending. The discussion of

fiscal policy provides an example of the analysis of this type of shock. In addition, it

is important to remember that effects on foreign countries will be transmitted through

changes in our imports, and that this can have repercussions back to our economy if

the induced changes in the foreign economies alter their imports from us.

International Capital-Flow Shocks One type of external shock arises from unexpected changes in the country’s financial

account. An international capital-flow shock is the unpredictable shifting of internationally mobile funds in response to such events as a change in the foreign

interest rate, rumors about political changes, or new restrictions (capital controls) on

pug21774_ch23_565-602.indd 580pug21774_ch23_565-602.indd 580 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

Chapter 23 Internal and External Balance with Fixed Exchange Rates 581

international asset holdings. Let’s examine an international capital-flow shock in the

form of a shift by international investors and speculators to a belief that the country’s

government is considering devaluing its currency in the near future. Although this is

not necessary to the analysis, we begin with a country that has an external balance.

(In this case the shift in belief is not related to a payments imbalance today—rather, it

may be related to doubts about the political leadership of the country, or to a belief that

the country may try to use devaluation to boost international price competitiveness in

order to increase net exports and lower domestic unemployment.)

The shift in belief leads to a capital outflow as international investors attempt to

reposition their portfolios away from assets denominated in this country’s currency

before the devaluation occurs. This type of capital outflow is a form of “capital flight,” in which investors flee a country because of doubts about government policies. If the

country begins with an external balance, then the overall balance shifts into deficit as

the financial account deteriorates. There is downward pressure on the exchange-rate

value of the country’s currency, and the central bank must intervene to defend the

fixed rate. The central bank buys domestic currency and sells foreign currency. If the

intervention is not sterilized, then the domestic money supply shrinks. Interest rates

increase and real domestic product decreases.

The increase in interest rates here becomes part of the defense of the fixed exchange

rate. If the interest differential shifts in favor of this country, then international inves-

tors are more willing to keep investments in this country’s financial assets (or are less

interested in fleeing) even if there is some risk of devaluation. (Recall our discussions

of uncovered financial investments in Chapters 18 and 19.) In fact, countries faced

with a capital-outflow shock often immediately shift policy to raise short-term inter-

est rates dramatically, for instance, from annual rates of less than 10 percent to annual

rates of over 100 percent. This is an example of using monetary policy actively to reestablish external balance, rather than waiting for the slower effects of intervention

on the domestic money supply to move the country toward external balance.

The effects of this shock are pictured in Figure 23.8 . The economy begins at point E . The international capital-flow shock causes the FE curve to shift up or to the left. Once

the FE curve has shifted, the official settlements balance is in deficit at point E . The central bank must intervene to defend the fixed rate. The central bank may attempt

to keep the economy at point E by sterilizing the intervention. The central bank may hope that the disequilibrium in the overall balance is temporary, perhaps because the

fears of the international investors will subside and the FE curve will shift back to the

right in the near future.

However, if the monetary authority cannot or does not sterilize the intervention,

then the LM curve will begin to shift up or to the left. If the new FE curve remains

where it is, the LM curve must shift to LM', with a new triple intersection at point T . External balance has been reestablished at point T . Real domestic product has declined. The country now has an internal imbalance, in the form of low aggregate demand

and higher unemployment, assuming that the country did not begin with the opposite

imbalance of excessively strong aggregate demand. Under fixed exchange rates, exter- nal capital-flow shocks can have powerful impacts on internal balance through the changes in the money supply driven by official intervention to defend the fixed rate .

pug21774_ch23_565-602.indd 581pug21774_ch23_565-602.indd 581 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

A shift of international capital flows away from the country

causes the FE curve to shift up or to the left, and the overall

payments balance goes into deficit. Intervention to defend the

fixed rate shifts the LM curve up or to the left. The economy

shifts toward a new full equilibrium at point T .

0.07 0.06

Interest rate 5 i

Domestic product 5 Y

100 110

LM'

T E

FE'

FIGURE 23.8 An Adverse

International

Capital-Flow

Shock

582 Part Four Macro Policies for Open Economies

International Trade Shocks A second type of external shock arises from exogenous changes in the country’s

current account. An international trade shock is a shift in a country’s exports or imports that arises from causes other than changes in the real income of the country.

For instance, demand for a country’s exports can change for many reasons. Export

shocks seem to be largest for countries specializing in exporting a narrow range

of products, especially primary commodities for which demand is sensitive to the

business cycle in importing countries. Instability has strongly affected exporters of

metals, such as Chile (copper), Malaysia (tin), and, to a lesser extent, Canada. Import

shocks can occur if our consumers unexpectedly alter their purchases between import

products and domestically produced substitutes, for instance, because of changing per-

ceptions of the relative quality of the products. Trade shocks can also occur because

of shifts in the prices or availability of domestic and foreign products. An important

example of this type of shock is a shock to the price of a major import, such as oil for

most industrialized countries. 11

11The analysis of an increase in the price of a major import is a bit complicated. Examples of such price shocks for crucial imports are the oil shocks of 1973–1974 and 1979–1980, the smaller one of 1990, and the more drawn-out oil price increase that peaked in 2008. The shock raises the price of imports of this product and may lower the quantity of imports. The analysis is similar to that about to be discussed in the text if the foreign price shock initially raises the total value of imports and lowers national purchasing power (with the higher price acting as a “tax” on the economy imposed by the exporters). These conditions hold if imports of the product take a large share of our national spending and our demand for the product is price-inelastic (at least in the short run). An additional twist is that an oil price shock can quickly increase the price level (P) so that the LM curve also shifts up or to the left as a result of the shock.

pug21774_ch23_565-602.indd 582pug21774_ch23_565-602.indd 582 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

A shift of international trade away from the country’s products causes the FE and IS curves to shift to the left, and the overall

payments balance goes into deficit. Intervention to defend the

fixed rate shifts the LM curve up or to the left. The economy

shifts toward a new full equilibrium at point W .

0.06 0.05

Interest rate 5 i

Domestic product 5 Y

100 110

LM'

FE' FE

IS'

FIGURE 23.9 An Adverse

International

Trade Shock

Chapter 23 Internal and External Balance with Fixed Exchange Rates 583

An international trade shock alters the country’s current account. Thus, it directly

affects both the country’s overall balance of payments and aggregate demand for the

country’s domestic production. For instance, a shift of foreign demand away from our

exports, or a shift of our demand toward imports (and away from our own products),

leads to a worsening of the current account and the overall balance (assuming that there

is little effect on international capital flows). It also reduces aggregate demand, lower-

ing real domestic product. 12 In addition, the country’s central bank must intervene to

defend the fixed rate by buying domestic currency and selling foreign currency. If the

intervention is not sterilized, then the domestic money supply contracts, leading to a

further decline in aggregate demand. External balance can be reestablished through these

changes, but the internal imbalance of low aggregate demand and high unemployment

will be increased.

Figure 23.9 shows the effects of this shock. Beginning at point E , the adverse international trade shock shifts the FE curve to the left and the IS curve to the left

as well. At the new IS–LM intersection (point V ), real domestic product declines (as does the domestic interest rate). With point V to the right of the new FE' curve, the country’s overall payments are in deficit. Intervention to defend the fixed rate reduces

the domestic money supply (assuming that it is not sterilized). The LM curve begins to

12We are assuming that the current account actually does deteriorate even though the reduction in our real income will offset some of the initial decline by lowering the country’s demand for imports through the domestic-income effect on imports. In Figure 23.9 this assumption ensures that point V is to the right of the new FE curve even if the FE curve is steeper than the LM curve.

pug21774_ch23_565-602.indd 583pug21774_ch23_565-602.indd 583 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

In some situations a policy to change aggregate demand can serve both internal and

external goals, but in some cases (marked “??” here) it cannot. To deal with high

unemployment and a payments surplus, policymakers should expand aggregate

demand (upper-left case). To deal with inflation and a payment deficit, they should

cut aggregate demand (lower-right case). But with the other two combinations of

imbalances, there is no clear prescription for aggregate-demand policy.

State of the domestic economy

High unemployment Rapid inflation

State of balance of payments

Surplus

Deficit

Expansionary policy

?? Contractionary

policy

FIGURE 23.10 Policies for

Internal and

External

Balance

584 Part Four Macro Policies for Open Economies

13As shown, the interest rate returns to 0.06. This is not the only possibility—the interest rate could be higher or lower, depending on the magnitudes of the curve shifts and the slopes of the curves.

shift up or to the left. External balance is reestablished at point W when the LM curve shifts to the dashed LM'. However, real domestic product has declined even more. 13

Thus, as with international capital-flow shocks, international trade shocks can have a powerful effect on the internal balance of a country with a fixed exchange rate . The intervention needed to defend the fixed rate tends to magnify the effect of the shock

on domestic production.

IMBALANCES AND POLICY RESPONSES

A country wants to achieve both internal balance and external balance. Yet its actual

performance is often short of these goals. In many situations it has imbalances in both

its internal and external situations as a result of shocks that hit the economy, or previ-

ous government policies that resulted in poor economic performance.

Internal and External Imbalances Figure 23.10 catalogs the four possible cases in which the country has both internal

and external imbalances. With fixed exchange rates, a country’s policymakers could

get lucky and face the straightforward problems represented by the upper-left and

lower-right cells.

The government of a country experiencing high unemployment and a payments

surplus can use expansionary policies to address both problems. Most obviously, an

expansion of the domestic money supply can increase aggregate demand and lower

unemployment, while also reducing the payments surplus (as summarized previously

pug21774_ch23_565-602.indd 584pug21774_ch23_565-602.indd 584 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

Chapter 23 Internal and External Balance with Fixed Exchange Rates 585

in Figure 23.2). This shift occurs automatically if the country intervenes to defend the

fixed exchange rate and does not sterilize, but the country can also speed it up by using

active monetary policy to expand the money supply more quickly.

The government of a country experiencing an inflation rate that is viewed as being

too high and a payments deficit can use contractionary policies to address both. Again,

an obvious choice is a contraction of the money supply (or, perhaps more realistically,

a reduction of the growth rate of the money supply).

Even in these cases the exact policy solution may be tricky because balance in one

dimension may be achieved while part of the other imbalance remains. Nonetheless,

the initial direction of the desirable policy change that reduces (if not eliminates) both

imbalances is clear.

What about the other two cells in Figure 23.10? In broad terms the correct policy

response is not clear. The dilemma of having to choose which goal to pursue has been

felt most acutely by countries in the lower-left cell, where low aggregate demand has

resulted in high unemployment, but the balance of payments is in deficit. This was the

near tragedy of Britain after it rejoined the gold standard in 1925 at its prewar gold parity,

with the high value for the pound making British products uncompetitive in international

trade. This was the problem facing the United States in the early 1960s. France faced a

similar problem in the early 1990s, as discussed in the box “A Tale of Three Countries.”

In these cases, reducing unemployment called for raising aggregate demand with

expansionary policies. However, this would worsen the trade balance and tend to

worsen the overall balance. The dilemma was not well solved in any of the cases.

Britain was driven off the gold standard in 1931. The United States reduced its unem-

ployment rate with a series of fiscal policy changes (the tax cut of 1964, domestic

“Great Society” spending programs, and Vietnam War spending), but the payments

imbalance led toward the breakup of the Bretton Woods fixed-rate system. Through

the mid-1990s, France continued to suffer from high unemployment.

The opposite dilemma faces governments worried about a rising or high inflation

rate while the country is running a payments surplus (the upper-right cell of Figure

23.10). Saudi Arabia and several other Middle East oil-exporting countries that peg

their currencies to the U.S. dollar found themselves in this situation in 2007–2008.

Each had a surplus driven by tremendous growth of export revenues as oil prices rose

dramatically. The rising revenues were fueling income growth that was overheat-

ing the domestic economy. Each country wanted to shift to contractionary monetary

policy to fight the rising inflation. Instead, if each remained committed to defend the

fixed exchange rate, it had to allow domestic monetary expansion as the government

intervened to purchase dollars and sell its domestic currency.

The government of a country in one of the two dilemma cells has three basic

choices:

1. It can abandon the goal of external balance, which eventually means that the

country will abandon its fixed exchange rate.

2. It can abandon the goal of internal balance, at least in the short run, and set its

policies (especially its monetary policy and money supply) to achieve external bal-

ance. This is sometimes called the “rules of the game” in a fixed-rate system such

as the gold standard. Defending the fixed rate is the highest goal.

pug21774_ch23_565-602.indd 585pug21774_ch23_565-602.indd 585 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

Case Study A Tale of Three Countries

In 1992, unemployment in France was high and rising. Inflation was almost nothing. The French government seemed to respond by tightening up on money and raising interest rates.

Madness? Not really, but an example of the policy dilemma that can arise with fixed exchange rates. France was a member of the Exchange Rate Mechanism (ERM) of the European Monetary System. Membership committed the French gov- ernment to keep the exchange rates between the French franc and the currencies of the other member countries within small bands around the central rates chosen for the fix.

To understand France we actually need to start with Germany, the largest member of the ERM. The Berlin Wall fell in 1989, and German unification proceeded rapidly over the next year, politically, financially, and economically. German government policy toward unification included support for the eastern part in the form of transfers, subsidies, and other government expenditures on such things as public infra- structure investments. This expansionary fiscal policy increased aggregate demand. Domestic production expanded rapidly in 1990 and 1991, and unemployment fell, but the economy began to overheat as demand exceeded production capabilities, so that the inflation rate increased. German policymakers, especially those at the Bundesbank (Germany’s central bank), loathe inflation. History matters—the hyperinflation of the 1920s in Germany is considered to be the eco- nomic disaster of the past century for Germany.

In response to the rise in inflation, the German monetary authorities tightened up on mon- etary policy, after a spurt in money growth in 1990–1991 resulting from monetary unification. Interest rates rose. This monetary tightening slowed the economy during 1992–1993.

We can capture the main elements of the German story in an IS–LM picture. Germany began at point A. The fiscal expansion shifted IS

1 to IS

2 , and the increased growth rate of the

money supply shifted LM 1 to LM

2 . At the new

equilibrium point B, real domestic product was higher, but the economy was trying to push past its supply capabilities. In response to the internal imbalance of rising inflation, the Bundesbank reduced money growth, shifting LM

2 to LM

3 .

Interest rates rose and domestic product declined as the economy moved toward point C .

In this way the German government adopted policies that focused almost completely on inter- nal political and economic problems. (In fact, although we could add the FE curve to Germany’s picture, we have instead omitted it to emphasize this internal focus of German policy.) Meanwhile, back in France . . .

In 1990, the French economy was already weak and weakening. The unemployment rate was 9 percent and rising. For internal reasons the French government probably wanted to shift to an expansionary policy. But it had an external problem. Rising interest rates in Germany could set off a capital outflow that would threaten the fixed exchange rate between the franc and the DM. France had to respond to this incipient external imbalance by tightening up on money and raising French interest rates. Unfortunately, for political reasons, fiscal policy could not turn expansionary. The assignment rule could not be used. Instead, the higher interest rates made the French econ- omy worse. The growth rate of real French GDP declined from 1989 through 1993, and real GDP actually fell in 1993. The French unemployment rate rose from 1990 through 1994.

In France’s picture, France began at point F , with aggregate demand already weak and unem- ployment high. The rise in Germany’s interest rate shifted France’s FE curve up or to the left (FE

1 to FE

2 ).

To avoid capital outflows and a payments deficit, the French monetary authorities responded by tight- ening money, shifting LM

1 to LM

2 . As the economy

moved toward point H, demand and production weakened and the unemployment rate rose.

However, this was not always enough. International investors and speculators doubted the resolve of the French (and most other non-German members of the ERM) to stick to fixed exchange rates. Major speculative attacks occurred in September 1992, November 1992, and July 1993. In these the FE curve for France shifted sharply up or to the left. The French government responded with massive official intervention, buying francs and selling DM, and with high short-term interest rates to discourage the speculative outflows. Total intervention by all ERM members in September 1992 was over

pug21774_ch23_565-602.indd 586pug21774_ch23_565-602.indd 586 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

$100 billion, with capital losses of about $5 billion to the central banks that bought currencies of the countries (Britain, Italy, Spain, and Portugal) that then devalued or depreciated anyway. Total intervention in July 1993 was also more than $100 billion, with the French central bank alone sell- ing more than $50 billion of DM in defense of the franc. Official reserve holdings of the French central bank declined close to zero, but the French govern- ment was “successful.” The franc was not devalued.

The third largest economy in the European Union is Britain. Britain’s journey through these years was different. Britain was not a member of the ERM until joining in 1990, when it committed to a pound–DM rate of about 0.35. The next two years were not good for Britain. To defend the fixed rate, the growth rate of the British money supply had to be kept low (although at the same time British interest rates could decline, starting from a high level). A severe recession with two years of decline in real GDP hit, and the unemploy- ment rate rose to about 10 percent. While Britain’s and France’s stories are broadly similar during these years, Britain’s recession was worse.

In 1992, Britain’s story diverged. As a result of the speculative attack on non-DM currencies in September 1992, Britain left the ERM. The British government spent close to half of its official reserves defending the pound before surrendering. Britain shifted to a floating exchange rate, and the pound depreciated by over 10 percent against the DM. This improved British price competitiveness.

In addition, the British government could allow its money supply to grow more quickly. Interest rates fell sharply in 1993 and real GDP began to grow. Britain’s unemployment rate plateaued in 1993 and declined in 1994 (while the unemployment rate was still rising in both France and Germany). After declining in 1993, the inflation rate increased a lit- tle in Britain in 1994, but not even close to enough to reverse the gain in price competitiveness from the currency depreciation. Britain’s depreciation of 1992 seems to have been successful.

Let’s pick up Britain’s picture as Britain left the ERM in 1992. (Its picture for 1990–1992 is similar to that of France.) The initial situation, just before the departure, is at point J . With the depreciation of the pound, the improvement in price competitiveness shifts FE

1 right to FE

2 and

moves IS 1 right to IS

2 . The money expansion shifts

LM 1 right as well to LM

2 . The British economy

shifts toward point K , with higher real domestic production and a lower interest rate.

Tales have lessons. The lesson of this tale is that countries can be forced to choose between fixed exchange rates and control over their internal balance. When large countries choose internal bal- ance, the choice gets tougher for smaller countries. Germany ran its policies mainly to satisfy internal objectives (like the United States in the 1960s). This created problems for other ERM members— conflicts for them between internal and external balance. Both France and Britain faced a dilemma: high unemployment and a tendency toward

LM3 LM1 LM1

LM1

LM2 FE1

FE1 FE2

FE2

LM2 LM2

A B

IS2IS1 IS1 IS2IS1

Germany, 1990–1993 France, 1990–1993 Britain, 1992–1993

—Continued on next page

pug21774_ch23_565-602.indd 587pug21774_ch23_565-602.indd 587 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

payments deficits. For a while, both responded with tight money that tried to achieve external balance but made the internal imbalance (high unemployment) worse.

All of this did not completely convince inter- national investors and speculators. With the speculative attack of September 1992, the paths diverged. France defended the fixed rate, at fur- ther cost to internal balance.

Britain surrendered, withdrawing from the ERM. This allowed Britain to address its internal imbal- ance. Expansionary policy and the competitiveness gained from the pound’s depreciation rekindled economic growth. The unemployment rate declined.

The speculative attack in July 1993 led to a semi-surrender even by France and other ERM

members. They widened the allowable bands around the central rates from plus or minus 2.25 percent to plus or minus 15 percent. This widen- ing of the band forestalled any further specu- lative attacks. But, during the next years, the franc–DM rate seldom was more than 3 percent from its central value. France continued to direct its policies to keeping the franc exchange rate steady against the DM, and France’s unemploy- ment rate remained high.

DISCUSSION QUESTION Explain whether or not the story could have turned out better if (a) Germany would have raised taxes in 1990 or (b) France would have reduced taxes in 1991.

1988 1989 1990 1991 1992 1993 1994

Growth Rate of Real GDP (%)

Germany 3.7 4.2 5.5 4.3 1.8 –1.2 2.7 France 4.2 3.9 2.4 0.6 1.2 –1.3 2.8 Britain 4.5 2.2 0.6 –2.1 –0.5 2.1 4.3

Unemployment Rate (%)

Germany 8.7 8.9 7.2 5.5 5.8 7.3 8.2 France 10.0 9.4 9.0 9.4 10.3 11.7 12.3 Britain 8.4 6.3 5.8 8.0 9.8 10.3 9.4

Inflation Rate (%)

Germany 1.3 2.8 2.7 3.5 4.0 4.2 3.0 France 2.7 3.5 3.4 3.2 2.4 2.1 1.7 Britain 4.9 7.8 9.5 5.9 3.7 1.6 2.4

Short-Term Interest Rate (%)

Germany 4.0 6.6 7.9 8.8 9.4 7.5 5.3 France 7.5 9.1 9.9 9.5 10.4 8.8 5.7 Britain 9.7 13.6 14.6 11.8 9.4 5.5 4.8

Money Supply Growth Rate (%)

Germany 7.5 4.6 8.4 9.4 6.7 8.1 7.8 France 4.1 8.1 3.8 –4.7 –0.2 1.4 2.8 Britain 7.6 5.7 2.6 3.0 2.5 5.6 7.3

Exchange Rate

Franc/DM 3.4 3.4 3.4 3.4 3.4 3.4 3.4 Pound/DM 0.32 0.32 0.35 0.34 0.36 0.40 0.40

Source: Growth rate of real GDP, unemployment rate, (CPI) inflation rate, and money supply growth rate (M1 for France, M3 for Germany, and M0 for Britain) from Economic Intelligence Unit, Country Report, various issues for these three countries. Short-term (money market) interest rates and exchange rates from International Monetary Fund, International Financial Statistics Yearbook, 1998.

pug21774_ch23_565-602.indd 588pug21774_ch23_565-602.indd 588 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

Chapter 23 Internal and External Balance with Fixed Exchange Rates 589

3. The government can try to find more policy tools or more creative ways to use the

tools that it already has.

Giving up is unpopular, and the natural tendency is to search for more tools and

creative solutions.

A candidate for addressing the dilemma of high unemployment and payments

deficit is enhancement of the economy’s supply capabilities. Why not come up

with policies that create more national income by improving our productivity?

Productivity improvements would enhance our ability to compete in international

trade, thereby shifting demand to our products, expanding production and employ-

ment, and improving our current account balance. It sounds too good to be true. And

it probably is. Policymakers usually have no fast, low-cost way of improving the

economy’s supply capabilities. That comes through sources of growth, such as the

advance of human skills and technology, that respond sluggishly, if at all, to govern-

ment manipulation.

A Short-Run Solution: Monetary–Fiscal Mix There is a way to buy time and serve both internal and external goals using conven-

tional demand-side policies while staying on fixed exchange rates. Looking more

closely at the basic policy dilemma, Robert Mundell and J. Marcus Fleming noticed

that monetary and fiscal policies have different relative impacts on internal and exter-

nal balance. This difference can be the basis for a creative solution.

The key difference between the impacts of fiscal and monetary policies is that

easier monetary policy tends to lower interest rates and easier fiscal policy tends to

raise them, as noted in Figures 23.2 and 23.5. An expansion of aggregate demand and

domestic product can be achieved with different mixes of fiscal policy and monetary

policy, and the mix matters for the resulting level of the interest rate, at least in the

short run. Expansion of domestic product can result in a low interest rate if it is driven

mainly by expansionary monetary policy. Expansion can result in a high interest rate

if it is driven mainly by expansionary fiscal policy. Because interest rates affect the

country’s payments balance, the interest rate is important. If the interest rate is lower,

the payments balance deteriorates. If, instead, the interest rate is pushed high enough

(for instance, by using very expansionary fiscal policy coupled with somewhat con-

tractionary monetary policy), the payments balance improves (as long as capital flows

are responsive to interest rate changes).

More generally, monetary and fiscal policies can be mixed so as to achieve any combination of domestic product and overall payments balance in the short run. Figure 23.11 illustrates the opportunities for solving one of the four policy challenges posed

in Figure 23.10, namely, the case of excessive unemployment and payments deficits,

starting at point Z . The goal is to raise the economy to full employment, which can be achieved at the level of domestic product Y

full . Shifting only one policy would not work,

as we have seen, but shifting both can work. In this case, it is best to shift to tighter

(contractionary) monetary policy to attract foreign capital with higher interest rates and

to easier (expansionary) fiscal policy in pursuit of full employment. In the right amounts,

the monetary tightening and fiscal easing can bring us exactly to full employment and

payments balance. In Figure 23.11, this is achieved by shifting IS to IS' and LM to LM'.

pug21774_ch23_565-602.indd 589pug21774_ch23_565-602.indd 589 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

At the starting point Z , domestic product Y 0 is below the full

employment level Y full

and the balance of payments is in deficit.

To reach full employment and payments balance at point E , combine the right amounts of tight monetary policy

and easy fiscal policy.

0.07

0.04

Interest rate 5 i

Domestic product 5 Y

LM'

E FE

IS'

Yfull

FIGURE 23.11 How Monetary

and Fiscal

Policy Could

Combine to

Cure Both

Unemployment

and a Balance-

of-Payments

Deficit

590 Part Four Macro Policies for Open Economies

A similar recipe can be used to get from any starting point to internal balance and

payments balance. The principle is clear: As long as there are as many different poli-

cies as target variables, as in the present case of two policies and two targets, there is

a solution.

Furthermore, the pattern of policy prescriptions reveals a useful guideline for

assigning policy tasks to fiscal and monetary policy. This is Robert Mundell’s

assignment rule: Assign to fiscal policy the task of stabilizing the domestic economy only, and assign to monetary policy the task of stabilizing the balance of payments only.

We can see from Figure 23.12 that such marching orders would guide the two arms of

policy toward internal balance and payments balance. Studying the different cases in

Figure 23.12, you will find that the assignment rule generally steers each policy in the

right direction. There are exceptions, as Figure 23.12 notes, but even in these cases it is

likely that following the assignment rule does nothing worse than make the economy

follow a less direct route to the goal of internal and external balance.

The assignment rule is handy. It allows each arm of policy to concentrate on a

single task, relieving the need for perfect coordination between fiscal and monetary

officials. It also directs each arm to work on the target it tends to care about more

because the balance of payments (and exchange-rate stability) has traditionally been

of more concern to central bankers than to politicians who make fiscal decisions.

The rule might or might not work in practice. We have already mentioned problems

with the interest rate effect on capital flows that is supposed to guarantee the existence

of a solution. Furthermore, if either branch of policy lags in getting signals from the

economy and responding to them, the result could be unstable oscillations that are even

worse than having no policy at all. Or monetary policy may be run largely to accom-

modate the country’s fiscal policy (and the need of the government to fund its deficit

pug21774_ch23_565-602.indd 590pug21774_ch23_565-602.indd 590 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

These recipes conform to the assignment rule: Assign monetary policy the task of balancing

the country’s international payments, and assign fiscal policy the task of bringing the domestic

economy to full employment without excessive inflation. There are exceptional cases, however,

when the assignment rule fails to follow the most direct route to the goal. In the diagram the

assignment rule is wrong for monetary policy at points like B and G , and it is wrong for fiscal policy at points like D and I .

State of the Domestic Economy

High unemployment Rapid inflation

State of the Balance of Payments

Surplus

Deficit

Easier monetary policy, easier fiscal policy

Tighter monetary policy, easier fiscal policy

Easier monetary policy, tighter fiscal policy

Tighter monetary policy, tighter fiscal policy

Interest rate 5 i

Domestic product 5 Y

IS'

Yfull

LM'

Z I

FIGURE 23.12 Monetary–

Fiscal Recipes

for Internal

and External

Balance

Chapter 23 Internal and External Balance with Fixed Exchange Rates 591

14Another possible problem might seem to be the case of perfect capital mobility because the country has no control of its money supply. This is not a problem. In fact, the case of perfect capital mobility effectively forces the government to follow the assignment rule. Monetary policy must allow the money supply to be whatever is necessary to achieve external balance on the FE curve. Fiscal policy can then be directed toward achieving internal balance, addressing any problems of domestic unemployment or inflation pressures.

spending), in which case independent policies are not really possible. In addition, the

mix influences both the composition of domestic spending and the level of foreign debt.

A policy of high interest rates, such as that used in Figure 23.11, reduces domestic real

investment. This can harm the growth of the economy’s supply capabilities by reducing

the growth of the capital stock. It also builds up foreign debt, which must be serviced

in the future, reducing the amount of national income that the country keeps for itself. 14

SURRENDER: CHANGING THE EXCHANGE RATE

If an imbalance in a country’s overall balance of payments is large enough or lasts

for long enough (a “fundamental disequilibrium”), the country’s government may

pug21774_ch23_565-602.indd 591pug21774_ch23_565-602.indd 591 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

592 Part Four Macro Policies for Open Economies

be unwilling to change domestic policies by enough to eliminate the imbalance. The

country’s government instead may conclude that surrendering the fixed rate is the best

choice available. If the payments balance is in deficit, a devaluation may be used; if

it’s in surplus, revaluation may occur.

The government may hope that the exchange-rate change can adjust the external

imbalance without excessive disruption to the domestic economy. Nonetheless, the

exchange-rate change will affect aggregate demand, domestic production, unemploy-

ment, and inflation. In some situations these domestic changes represent a departure

from internal balance. The internal effects of the exchange-rate change may then need

to be offset by other policy changes, creating a rationale for a policy mix that includes

the exchange-rate change and one or both of a fiscal policy change and a monetary

policy change.

In other situations the internal effects of an exchange-rate change can themselves

be desirable. Interestingly, these are precisely the dilemma cases of Figure 23.10.

Consider a country that has a fixed exchange rate, a payments deficit, and a rather

high unemployment rate (the lower-left cell in Figure 23.10). This country’s govern-

ment is not willing to allow an “automatic” adjustment to external balance through

a decline in the money supply because this would raise interest rates, lower demand

and production, and increase unemployment further. Instead, the government has

been sterilizing its intervention. It is also not capable of following the assignment

rule, perhaps because domestic politics precludes adopting the right policy mix.

What happens if this country devalues (or shifts to a floating exchange rate and

allows its currency to depreciate)? What effects does this exchange-rate surrender

have on external and internal balance?

The devaluation should improve international price competitiveness (as long as

any changes in the domestic price level or the foreign price level do not offset the

exchange-rate change).

• Exports tend to increase as firms from this country can lower the foreign-currency

prices of their products (and as higher profits draw resources into producing for

export).

• Imports tend to decrease as the domestic-currency prices of imported products

rise (and as higher profits in producing domestic products that can now com-

pete more successfully with imports draw resources into producing these import

substitutes).

Thus, the current account tends to improve. The effects on the financial account are

less clear-cut. The financial account may also improve. If some financial capital was

fleeing the country in fear of the impending devaluation, then this flight could stop or

even reverse once the devaluation was done. Overall, we expect an improvement in the

payments balance (a decrease in the deficit).

If exports increase and imports decrease, then these changes increase aggregate

demand and domestic production, reducing domestic unemployment. However,

import prices in local currency increase, and this increase puts some upward pressure

on the average price level or inflation rate in the country. The extra demand could also

put upward pressure on the price level, but this effect may be small if the economy

begins with high unemployment.

pug21774_ch23_565-602.indd 592pug21774_ch23_565-602.indd 592 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

In response to the payments deficit at point B , the country’s government devalues its currency. The devaluation improves its

international price competitiveness, so it shifts the FE and IS

curves to the right. If the devaluation is of the correct size, it can

shift the economy toward a new full equilibrium at point E .

0.06

0.04

Interest rate 5 i

Domestic product 5 Y

90 110

FE'

IS'

FIGURE 23.13 Devaluation of

the Country’s

Currency

Chapter 23 Internal and External Balance with Fixed Exchange Rates 593

Figure 23.13 shows these effects in the IS–LM–FE diagram, assuming that the

domestic price level is steady. The country begins at point B with a payments deficit. The (low) level of domestic production at B results in rather high unemployment. The devaluation improves the current account (and may improve the financial account),

shifting the FE curve down or to the right. The increase in net exports as a result of

the change in price competitiveness shifts the IS curve to the right. The figure shows

that a devaluation (of the correct size) can shift the economy to a triple intersection

(external balance) with a higher domestic product (and lower unemployment). The

new equilibrium at point E may not exactly be internal balance (full employment), but it is a move in the correct direction. 15

This sounds good—another possible answer to the dilemma of deficit and unem-

ployment. In some cases it seems to work well. (See the discussion of Britain in

the box “A Tale of Three Countries.”) The comparable analysis, with all the signs

reversed, indicates that a revaluation (or appreciation after the government allows

the country’s currency to float) can be an appropriate policy response to surplus and

inflation (the upper-right cell in Figure 23.10) because it can lower a surplus while

reducing inflation pressure in the economy by decreasing demand and lowering the

local-currency price of imports.

This analysis posits clear, direct effects of a devaluation on aggregate demand and

external balance. However, there are a number of ways in which things can turn out

differently. Consider first aggregate demand. Recall our discussion in Chapter 21 of the

15If the price level also rises as a result of the devaluation, the FE and IS curves do not shift as much, and the LM curve shifts up or to the left. This reduces the effect on the payments balance and on domestic product. In fact, if the price level rises by enough, there is no gain in competitiveness and the benefits of devaluation on external and internal balance are lost.

pug21774_ch23_565-602.indd 593pug21774_ch23_565-602.indd 593 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

594 Part Four Macro Policies for Open Economies

role of currency mismatches as a risk factor for financial crises in developing countries.

If many domestic firms have substantial net liabilities denominated in foreign currency

(because they have borrowed or issued debt securities denominated in, for instance, U.S.

dollars or euros), then the devaluation causes losses for these firms. The adverse balance-

sheet effects force them to cut back on capital spending and other business activities. If

this reduction is severe enough, the IS curve shifts to the left instead of to the right.

Consider next external balance. There are times that a devaluation fails to reduce the

external imbalance. One possible reason for failure is taken up in the next section—the

value of the current account may not actually increase because of low responsiveness

of export and import volumes to the exchange-rate change. Another possible reason for

failure is that the government pursues fiscal or monetary policies that themselves are

driving to expand the payments deficit, and these are so strong that they overwhelm

the benefits of the devaluation. For instance, expansionary monetary policy can expand

income and import demand, as well as increase the price level through extra inflation

so that the improved price competitiveness is lost. A third possible reason is that capital

flows react in the “wrong” direction. For instance, a devaluation could lead to fears

among international investors that the devaluation will not be successful in reducing the

deficit (perhaps for one of the first two reasons). They then expect that another devalu-

ation will be needed soon. Rising capital outflows (capital flight) could deteriorate the

financial account and make the payments deficit bigger.

A key to external balance is how other government policies are used with the

devaluation. If other government policies (especially monetary policy) can limit any

increase in the country’s price level or inflation rate, then the devaluation probably

will improve the current account balance. International investors, seeing this, are less

likely to fear that another devaluation will be needed. If the current account improves

and the financial account does not deteriorate, then the devaluation will be successful

in reducing the payments deficit.

HOW WELL DOES THE TRADE BALANCE RESPOND TO CHANGES IN THE EXCHANGE RATE?

According to the discussion in the preceding section, a change in the nominal exchange

rate should alter net exports, at least as long as it alters international price competi-

tiveness. The conclusion is straightforward for effects on the volumes (or quantities) of exports and imports, although we can still wonder about the speed or magnitude of the

changes. However, the effect on the value of the trade balance is not so obvious because both prices and volumes are changing. Yet the effect on the value of net exports is what matters for the country’s balance of payments and for its FE curve.

The value of the country’s trade or current account balance, measured in foreign

currency (here pounds) is

CA (our current

account balance,

measured in £/year) = P£ x • X 2 P£

m • M

pug21774_ch23_565-602.indd 594pug21774_ch23_565-602.indd 594 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

Chapter 23 Internal and External Balance with Fixed Exchange Rates 595

where P£ x and P£

m are the pound prices of the country’s exports and imports and X and

M are the quantities. Now consider the likely direction of changes in the trade prices and quantities when the country’s currency (here the dollar) drops in value:

£ Price Quantity £ Price Quantity of Exports of Exports of Imports of Imports Effects of a

devaluation 5 No change • No change 2 No change • No change of the dollar or down or up or down or down

A dollar devaluation is likely to lower the pound price of exports (if it has any net effect

on this price). This is because U.S. exporters are to some extent willing to lower pound

prices while still receiving the same (or even higher) dollar prices because pounds are

now worth more. If there is any effect of this price change on export quantities, the

change is upward, as foreign buyers take advantage of any lower pound prices of U.S.

exports to buy more from the United States. It is already clear that the net effect of

devaluation on export value is of uncertain sign because pound prices probably drop

and quantities exported probably rise. On the import side, any changes in either pound

price or quantity are likely to be downward. The devaluation is likely to make dollar prices of imports look higher, causing a drop in import quantities as buyers shift toward

U.S. substitutes for imports. If this drop in demand has any effect on the pound price of imports, that effect is likely to be negative. The sterling value of imports thus clearly

drops, but if this value is to be subtracted from an export value that could rise or fall, it

is still not clear whether the value of the net trade balance rises or falls. We need to know

more about the underlying price elasticities of demand and supply in both the export and

the import markets.

How the Response Could Be Unstable A drop in the value of the dollar actually could worsen the trade balance. It would clearly

do so in the case of perfectly inelastic demand curves for exports and imports. Suppose that buyers’ habits are rigidly fixed so that they will not change the quantities they buy

from any nation’s suppliers despite changes in price. Examples might be the dependence

of a non-tobacco-producing country on tobacco imports, or a similar addiction to tea or

coffee, or to petroleum for fuels. In such cases of perfectly inelastic demand, devaluation

of the country’s currency backfires completely. Given the perfect inelasticity of import

demand, no signals are sent to foreign suppliers by devaluing the dollar. Buyers go on

buying the same amount of imports at the same pound price, paying a higher dollar price

without cutting back their imports. No change in the foreign exchange value of imports

results. On the export side, the devaluation leads suppliers to end up with the same

competitive dollar price as before, but this price equals fewer pounds. U.S. exporters get

fewer pounds for each bushel of wheat they export, yet foreigners do not respond to the

lower price by buying any more wheat than they would otherwise.

In the case of perfectly inelastic demand curves for exports and imports, the

changes in the current account are as follows:

CA £ 5 P£ x • X 2 P£

m • M

Down 5 (Down • No change) 2 (No change • No change)

pug21774_ch23_565-602.indd 595pug21774_ch23_565-602.indd 595 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

FIGURE 23.14 Devaluation

Affects the

Trade Balance

A. How Devaluation Could Worsen the Trade Balance

Exchange Rate P £ x • X 2 P £

m • M 5 CA£

Before dollar devaluation: $1.60/£ 1.00 • 80 2 1.00 • 120 5 240 After dollar devaluation: $2.00/£ 0.80 • 80 2 1.00 • 120 5 256

The key to this case: Demand curves are inelastic, so the volumes of exports and imports do not

change. Devaluing our currency just lowers the value of foreign exchange we earn on exports,

worsening the trade deficit.

B. The Small-Country Case

Exchange Rate P £ x • X 2 P £

m • M 5 CA£

Before dollar devaluation: $1.60/£ 1.00 • 80 2 1.00 • 120 5 240 After dollar devaluation: $2.00/£ 1.00 • 105 2 1.00 • 100 5 15

The small-country case illustrates the ability of high demand elasticities to guarantee that

devaluation improves the trade balance. The essence of the small-country case is that foreign

curves are infinitely elastic, so the world ( £ ) prices are not affected by our country’s actions. On the export side, the infinite elasticity of foreign demand means that our own supply elasticity

dictates what happens to the volume of exports ( X ). We probably export more, raising our earnings of foreign exchange. On the import side, the infinite elasticity of foreign supply means that our

demand elasticity dictates what happens to volume ( M ). We probably import less, cutting our demand for foreign exchange.

Appendix H generalizes from such special cases, showing how larger demand elasticities raise

the ability of devaluation to improve the trade balance.

596 Part Four Macro Policies for Open Economies

A numerical illustration of this case is given in Figure 23.14A . There, devaluing the

dollar merely lowers the value of foreign exchange the United States earns on exports,

from 80 (5 1.00 3 80) to 64 (5 0.80 3 80), worsening the trade balance. It might seem that this perverse, or unstable, result hinges on something special

about the export market. This is not the case, however. It only looks as though the

change is confined to the export side because we are looking at the equation expressed

in sterling. If we had looked at the CA equation in dollar prices, the deterioration

would still appear:

CA $ 5 P$ x • X 2 P$

m • M

Down 5 (No change • No change) 2 (Up • No change)

Why the Response Is Probably Stable In all likelihood, however, a drop in the value of the home currency improves the cur-

rent account balance, especially in the long run. The reason, basically, is that export

and import demand elasticities end up being sufficiently high, and, as Appendix H

proves, this is enough to ensure the stable response.

One quick way to see why the case of perfectly inelastic demand does not prevail

is to note its strange implications. It implies, first, that we make it harder for ourselves

to buy foreign goods with each unit of exports (i.e., P£ x / P £

m drops), yet this impoverish-

ing effect fails to get us to cut our spending on imports. The result looks even stranger

pug21774_ch23_565-602.indd 596pug21774_ch23_565-602.indd 596 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

Chapter 23 Internal and External Balance with Fixed Exchange Rates 597

upside down. It implies that a country could succeed in cutting its trade deficit and

at the same time buy imports more cheaply (in terms of the export good) by cleverly

revaluing its currency (for example, raising the value of the dollar from $1.60/£ to $1.00/£). If that were a common occurrence, governments would have discovered it

long ago, and they would have solved their trade deficits by happily raising the values

of their currencies.

Over the long run, price elasticities tend to be higher, and each nation tends to

face elastic curves from the outside world, both the foreign demand curve for its

exports and the foreign supply curve for its imports. In the extreme small-country case, the home country faces infinitely elastic foreign curves. Foreign-currency (£) prices are fixed, and the current account balance is affected by a drop in our cur-

rency as follows:

CA £ 5 (P£ x • X ) 2 ( P£

m • M )

Up 5 ( No change • Up ) 2 ( No change • Down )

We know that, if the real volume of exports ( X ) changes, it will rise because the same pound price of exports means more dollars per unit for sellers. They will respond to

the new incentive with extra production and export sales. Similarly, we know that

any change in the real volume of imports ( M ) will be a drop because the same pound price for imports leaves the dollar-country consumers with a higher dollar price. In

the small-country case, both sides of the current account move in the right direction:

Export revenues rise and import payments decline. Figure 23.14B provides a numeri-

cal illustration that underlines the contrast with the pessimistic case of Figure 23.14A.

The crucial role of elasticities, illustrated in the two halves of Figure 23.14, also

emerges from the technical formulas of Appendix H.

Timing: The J Curve The fact that the elasticities of response to a given change (here, the devaluation

or depreciation of the dollar) usually rise over time brings a second key result:

Devaluation is more likely to improve the trade balance after a sufficient span of time has elapsed . The current account balance may dip for several months after a devalu- ation or depreciation of the home currency. The changes in prices are likely to occur

faster than any changes in trade quantities. The changes in trade quantities at first are

small because it takes time for buyers to respond to the price changes by altering their

behavior. Contracts previously concluded must expire or be renegotiated, and alter-

native sources of products must be identified and evaluated. Eventually the quantity

responses become larger, as buyers do switch to lower-priced products. As quantity

effects become larger, the current account balance improves.

Figure 23.15 gives a schematic diagram of what economists think is a typical

response of the current account balance to a drop in the exchange-rate value of a

country’s currency. The typical pattern is called a J curve because of its shape over the first couple of years of response to devaluation. The value of the country’s cur-

rent account at first deteriorates, but then begins to improve. After a moderate time

period, perhaps about 18 months, the value of the current account returns to where it

started, and thereafter it moves above its initial value. This analysis indicates that it

may take some time for a large devaluation or depreciation of the country’s currency

pug21774_ch23_565-602.indd 597pug21774_ch23_565-602.indd 597 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

FIGURE 23.15 The J Curve:

How the Trade

Balance

Probably

Responds to a

Drop in the

Value of a

Country’s

Currency

Net change in trade balance

Time elapsed after devaluation

18 months

598 Part Four Macro Policies for Open Economies

to have a positive impact on the country’s current account. The shift in the FE curve

is more complicated than in the previous section. In the short run the FE curve could

(perversely) shift to the left unless a capital inflow (perhaps based on the anticipation

of the eventual beneficial effects of the devaluation) stabilizes the curve. Eventually

the FE curve should shift to the right, but perhaps not until a year or more after the

devaluation.

Summary If a country has a fixed exchange rate, it must defend the fixed rate chosen. The first part of this chapter examined four major implications of having a fixed exchange rate

and defending it using official intervention.

The first implication is that intervention to defend the fixed rate alters monetary

conditions in the country. Faced with an external imbalance in the country’s overall

international payments, the central bank defends the fixed rate by buying or selling

domestic currency in the foreign exchange market. The intervention changes the

central bank’s liabilities that serve as the monetary base for the domestic money supply. The change in the domestic money supply then results in macroeconomic adjustments that tend to reduce the external imbalance. The domestic interest rate

changes, altering international capital flows, at least in the short run. The change in

real domestic product and income alters demand for imports. In addition, a change in

the domestic price level can alter both exports and imports by changing the country’s

international price competitiveness.

The central bank can attempt to resist this monetary process through sterilization, which prevents the domestic money supply from changing. But there are limits to how

long the central bank can use sterilized intervention to defend the fixed exchange rate.

If the external imbalance continues, then the country’s holdings of official reserves

continue to change because the central bank is also selling or buying foreign currency

as the other half of the intervention. Eventually the change in official reserve holdings

forces the central bank to make some adjustment. For instance, if the central bank is

selling foreign currency in its intervention, then eventually the central bank runs low

on its holdings of official reserves.

pug21774_ch23_565-602.indd 598pug21774_ch23_565-602.indd 598 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

Chapter 23 Internal and External Balance with Fixed Exchange Rates 599

The second implication is that a fixed exchange rate and its defense constrain a

country’s ability to pursue an independent monetary policy. If the country begins with

an external deficit, the defense of the fixed rate eventually forces the country to con-

tract its money supply. If the country begins with an external surplus, the defense of

the fixed rate eventually forces the country to expand its money supply. If the country

begins with an external balance, then any change in monetary policy and the money

supply would create an external imbalance, and the intervention to defend the fixed

rate would tend to reverse the monetary change.

The third implication is that the effects of fiscal policy are also altered by a fixed

exchange rate. A change in fiscal policy causes the country’s current and financial

accounts to change in opposite directions in the short run, so the effect on the overall

payments balance depends on how large the two changes are. If international finan-

cial capital flows are not that responsive to interest rate changes, then the resulting

external imbalance following a fiscal policy change leads to intervention that changes

monetary conditions in the other direction, reducing the effect of the fiscal policy

change on domestic product. If international capital flows are sufficiently responsive,

the resulting external imbalance leads to intervention that changes monetary condi-

tions in the same direction, enhancing the effect of fiscal policy on real product. In

the extreme case of perfect capital mobility, the fiscal change can have the full spending multiplier effect because the domestic interest rate remains unchanged and

equal to the foreign interest rate. (However, with perfect capital mobility and a fixed

exchange rate, the country has no independent monetary policy.) The fourth implication is that defending a fixed exchange rate without sterilization

alters how different exogenous shocks affect the country’s macroeconomy in the short

run. The effects of domestic monetary shocks are greatly reduced. The effects of domestic spending shocks on domestic product depend on how responsive international financial capital flows are to changes in the interest rate. If international

capital is highly mobile, a domestic spending shock has more effect.

International capital-flow shocks can have major effects on the domestic economy because they require intervention to defend the fixed rate as the shock hits.

For instance, a shift to capital outflow leads to intervention that results in a lower

domestic money supply. Domestic interest rates tend to increase, and domestic prod-

uct and income tend to decline.

International trade shocks affect the economy directly by changing aggregate demand. In addition, the resulting intervention to defend the fixed exchange rate

causes a monetary change that generally reinforces the change in demand, resulting in

a larger change in domestic product and income.

The second part of the chapter examined broad policy issues for countries that have

fixed exchange rates. A country wants to achieve both internal and external balance.

Yet stabilizing an open macroeconomy with a fixed exchange rate is not easy. If a

country has only one policy for influencing aggregate demand (for instance, monetary

policy that changes the money supply), it would have to be very lucky for the level of

aggregate demand that is best for the domestic economy to turn out to be the one that

keeps external payments in balance.

There is a way out of the dilemma if the country can use two policies (monetary

and fiscal policies). Expansionary monetary and fiscal policies have opposite effects

pug21774_ch23_565-602.indd 599pug21774_ch23_565-602.indd 599 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

Key Terms Domestic assets International reserve

assets

Monetary base

Money supply

Sterilization

Perfect capital

mobility

Domestic monetary

shock

Domestic spending

shock

International capital-flow

shock

International trade

shock

Assignment rule

J curve

600 Part Four Macro Policies for Open Economies

on domestic interest rates. The difference can be used to influence international capital

flows in the short run. Monetary policy has a comparative advantage in affecting the

external balance, whereas fiscal policy has a comparative advantage in affecting the

domestic economy. We can thus devise a monetary–fiscal mix to deal with any pairing

of imbalances in the external accounts and the domestic economy.

In fact, policymakers can follow a simple assignment rule with fair chances of at least approaching the desired combination of internal and external balance. When

policies are adjusted smoothly and take quick effect, internal and external balance

can be reached by assigning the internal task to fiscal policy and the external task to

monetary policy.

Faced with a large or continuing external imbalance, a country’s government may

decide to react by surrendering—by changing the exchange rate: devaluing, revalu-

ing, or shifting to a floating exchange rate that immediately depreciates or appreci-

ates. A change in the exchange rate can reduce the external imbalance by altering

the country’s international price competitiveness. Changes in exports and imports

alter the current account balance. The exchange-rate change also has an impact on

internal balance. The export and import changes alter aggregate demand, and the

change in the domestic prices of imported goods can alter the country’s general

price level or inflation rate.

However, it is not certain that the exchange-rate change actually does reduce the

external imbalance. The effect on the value of the current account balance depends on changes in both the volumes (quantities) and the prices of exports and imports.

Consider a devaluation. Measured in foreign currency, the price of exportable prod-

ucts tends to decrease, the quantity of exports tends to increase, and the price and

quantity of imports tend to decrease. The value of exports can increase or decrease.

If the value of exports decreases, the current account balance improves only if the

decline in the value of imports is larger. A general condition that ensures that the

current account balance improves is that the price elasticities of demand for exports

and imports be sufficiently high so that the changes in the volumes of exports and

imports are large enough. In practice, the price effects, especially the decrease in the

foreign-currency price of exports, often occur quickly, while the volume effects occur

more slowly but eventually become sufficiently large. The current account balance

thus deteriorates at first, but after a period of months it tends to improve, tracing out

a pattern called the J curve.

pug21774_ch23_565-602.indd 600pug21774_ch23_565-602.indd 600 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

Chapter 23 Internal and External Balance with Fixed Exchange Rates 601

Suggested Reading

A technical treatment of the economics of fixed exchange rates is presented in

Rivera-Batiz and Rivera-Batiz (1994, Chapter 14). Some of Robert Mundell’s pioneering

articles on internal and external balance and the implications of international capital

mobility are reprinted in Mundell (1968, Chapters 16 and 18). The same path-breaking

analysis was simultaneously developed by Fleming (1962). Chapter 3 of the International

Monetary Fund’s April 2007 World Economic Outlook examines the role of exchange-rate changes in reducing large current account deficits and surpluses.

Questions and Problems

1. “A country with a deficit in its overall international payments runs the risk of increas-

ing inflation if it defends its fixed exchange rate by (unsterilized) official intervention

in the foreign exchange market.” Do you agree or disagree? Why?

2. A country with a fixed exchange rate has achieved external balance. Government

spending then increases in an effort to reduce unemployment. What is the effect of this

policy change on the country’s official settlements balance? If the central bank uses

unsterilized intervention to defend the fixed rate, will intervention tend to reduce the

expansionary effect of the fiscal policy?

3. What does perfect capital mobility mean for the effectiveness of monetary and fiscal

policies under fixed exchange rates?

4. What is the assignment rule? What are its possible advantages and drawbacks?

5. “According to the logic of the J-curve analysis, a country that revalues its currency

should have an improvement in the value of its current account balance in the months

immediately after the revaluation.” Do you agree or disagree? Why?

6. The Pugelovian central bank intervenes in the foreign exchange market by selling

U.S.$10 billion to prevent the Pugelovian currency (the pnut) from depreciating.

a. What impact does this have on the Pugelovian holdings of official international reserves?

b. What effect will this have on the Pugelovian money supply if the central bank does not sterilize? Explain.

c. What effect will this have on the Pugelovian money supply if the central bank does sterilize (using an open market operation in Pugelovian government bonds)?

Explain.

7. A country initially has achieved both external balance and internal balance.

International financial capital is highly but not perfectly mobile, so the country’s

FE curve is upward sloping and flatter than the LM curve. The country has a fixed

exchange rate and defends it using official intervention. The country does not sterilize.

As a result of the election of a new government, foreign investors become bullish on

the country. International financial capital inflows increase dramatically and remain

higher for a number of years.

a. What shift occurs in the FE curve because of the increased capital inflows? b. What intervention is necessary to defend the fixed exchange rate? c. As a result of the intervention, how does the country adjust back to external

balance? Illustrate this using an IS–LM–FE graph. What is the effect of all of this

on the country’s internal balance?

✦

pug21774_ch23_565-602.indd 601pug21774_ch23_565-602.indd 601 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

602 Part Four Macro Policies for Open Economies

8. A country initially has achieved both external balance and internal balance. The

country prohibits international financial capital inflows and outflows, so its financial

account (excluding official reserves transactions) is always zero because of these

capital controls. The country has a fixed exchange rate and defends it using official

intervention. The country does not sterilize. An exogenous shock now occurs—

foreign demand for the country’s exports increases.

a. What is the slope of the country’s FE curve? b. What shifts occur in the IS, LM, or FE curves because of the increase in foreign

demand for the country’s exports?

c. What intervention is necessary to defend the fixed exchange rate? d. As a result of the intervention, how does the country adjust back to external

balance? Illustrate this using an IS–LM–FE graph. What is the effect of all of this

on the country’s internal balance?

9. A country’s government is committed to maintaining the fixed-exchange-rate value

of its currency through central bank intervention in the foreign exchange market. The

country’s government also believes that its holdings of international reserve assets are

barely adequate, and it would like to keep its holdings close to the current level. The

country’s international capital flows are relatively unresponsive to changes in interest

rates. The country currently has an official settlements balance deficit. What, if any-

thing, can the central bank do in this situation? For your answer, draw an IS–LM–FE

graph and use it in your explanation.

10. A country has a fixed exchange rate. Initially, the country has a surplus in its overall

international payments, as well as excessive aggregate demand that is putting upward

pressure on the country’s price level because the current level of real GDP (Y 0 ) is greater

than the “full-employment” level of real GDP (Y full

). The country’s international capital

flows are noticeably responsive to changes in interest rates (the country’s FE curve is up-

ward sloping and flatter than its LM curve). Evaluate the ability of each of the following

policies (separately, not in combination) to address the initial macroeconomic situation.

In each answer, use an IS–LM–FE graph as part of the explanation.

a. Sterilized intervention to defend the fixed exchange rate. b. A change in the fixed-rate value of the country’s currency.

11. What is the mixture of monetary and fiscal policies that can cure each of the following

imbalances?

a. Rising inflation and overall payments deficit (e.g., point H in Figure 23.12). b. Rising inflation and overall payments surplus (e.g., point F in Figure 23.12). c. Insufficient aggregate demand and overall payments surplus (e.g., point C in

Figure 23.12).

12. The Pugelovian government has just devalued the Pugelovian currency by 10 percent.

For each of the following, will this devaluation improve the Pugelovian current

account deficit? Explain each.

a. People are very fixed in their habits. Both Pugelovian importers and foreign buyers of Pugelovian exports buy the same physical volumes no matter what.

b. Pugelovian firms keep the Pugelovian pnut prices of Pugelovian exports constant, and foreign firms keep the foreign-currency prices of exports to Pugelovia constant.

✦

pug21774_ch23_565-602.indd 602pug21774_ch23_565-602.indd 602 29/11/14 7:53 pm29/11/14 7:53 pm

Final PDF to printer

603

Chapter Twenty-Four

Floating Exchange Rates and Internal Balance One way to reconcile the goals of external balance and internal balance is to let the

exchange rate take care of external balance and to direct macroeconomic policy

toward the problem of internal balance. If the exchange rate is allowed to float cleanly,

without government intervention, then the exchange rate changes to achieve external

balance. If there are no transactions in official reserves, then the official settlements

balance must be zero, and the exchange rate must change to whatever value is needed

to achieve this external balance. Changes in the exchange rate are the “automatic”

mechanism for adjusting to achieve external balance.

Even if a floating exchange rate is used to achieve external balance, this still

leaves the problem of achieving internal balance. How does use of floating exchange

rates affect the behavior of the economy and the effectiveness of monetary and fiscal

policies that might be directed to achieving internal balance? The purpose of this

chapter is to examine the macroeconomics of floating exchange rates. It first exam-

ines how monetary policy and fiscal policy work in an economy that has a floating

exchange rate. Then it explores the impacts of various shocks on such an economy.

The shocks are the same types that we examined in the previous chapter, so we

can see how the choice of fixed or flexible exchange rates alters how the economy

responds to different shocks.

In our analysis of floating exchange rates, we use the same basic model of the

open macroeconomy that we developed in Chapter 22 and applied to fixed rates in

Chapter 23. The key difference from the previous chapter is that the exchange rate is

now a variable determined endogenously by the macroeconomic system rather than

a rate set (and defended) by the government. With a floating rate, the exchange rate

brings the foreign exchange market (or the overall balance of payments) into equilib-

rium by affecting people’s choices about whether to buy goods and services abroad or

at home and whether to invest in this country’s financial assets or another country’s

financial assets. The impact on demand for goods and services then has a feedback

effect on the country’s domestic product.

pug21774_ch24_603-627.indd 603pug21774_ch24_603-627.indd 603 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

604 Part Four Macro Policies for Open Economies

The analysis of how a country with a floating exchange rate responds to a policy

change or another type of economic shock can usefully proceed through three steps:

1. At the initial value of the exchange rate, what are the effects of the shock on the

country’s economy? In particular, does the shock push the official settlements balance

away from a zero value?

2. If there is a tendency away from zero for the official settlements balance, what

change in the exchange-rate value of the country’s currency (appreciation or depre-

ciation) is needed to move back to a zero balance?

3. What are the additional effects on the country’s macroeconomy of this change in

the exchange rate?

The additional effects indicate the “special” ways in which floating rates alter the

behavior of the economy ( just as the additional effects resulting from intervention to

defend the fixed rate indicated the “special” ways in which fixed rates alter the behav-

ior of the economy). The additional effects show how floating rates alter the effective-

ness of government policies. They also suggest how floating rates alter the country’s

ability to keep internal balance in a changing world.

MONETARY POLICY WITH FLOATING EXCHANGE RATES

With floating or flexible exchange rates, monetary policy exerts a strong influence

over domestic product and income. To see how, let us consider the case of a deliber-

ate expansion of the domestic money supply. Such a change is implemented by using

a domestic tool of monetary policy. For instance, the country’s monetary authority

might use open market operations to buy domestic securities. As the monetary author-

ity pays for its securities purchase, it issues new liabilities that expand the country’s

monetary base and money supply.

An expansion of the money supply increases banks’ willingness to lend, and inter-

est rates decrease. Borrowing and spending rise. As we saw in Chapter 23, the drop

in interest rates tends to worsen the overall balance of payments in the short run. The

financial account tends to worsen as capital flows out of the country, and the current

account worsens as imports rise. The demand for foreign currency is now greater than

the supply. In the fixed-rate analysis of the previous chapter, the government had to

intervene to defend the fixed rate against the pressure resulting from this payments

deficit. With floating exchange rates, the pressure results in a depreciation of the

exchange-rate value of the country’s currency, as summarized in Figure 24.1 .

Depreciation of our currency increases the international price competitiveness

of the products produced by our country’s firms (assuming that the nominal depre-

ciation is larger than any increase in domestic prices and costs in the short run—a

form of overshooting like that discussed in Chapter 19). The improvement in our

firms’ ability to compete with foreign firms is likely to improve our current account

balance, as export volumes increase and import volumes decline. (Improvement

in the current account balance occurs only after the initial stage of the J-curve

has played itself out. This assumes that the stability conditions of Chapter 23 and

Appendix H eventually hold. In this chapter we focus on situations in which the

response is stable.)

pug21774_ch24_603-627.indd 604pug21774_ch24_603-627.indd 604 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

Chapter 24 Floating Exchange Rates and Internal Balance 605

FIGURE 24.1 Effects of Expanding the Money Supply with Floating Exchange Rates

For a decrease in the money supply, reverse the direction of all changes.

Interest rate drops

Our currency depreciates

Real spending, production, and income rise

Current account balance “worsens”

Current account balance improves

Real product and income rise more

Capital flows out

(in the short run)

Price level increases

(beyond the short run)

Money supply increases; banks are more willing to lend

The improvement in the current account balance lowers the overall payments deficit,

reducing and eventually eliminating pressure for further depreciation of the exchange-rate

value of our currency. External balance is restored through the exchange-rate change.

The new competitive edge for the country’s firms raises aggregate demand for what

the country produces. Such extra demand due to the depreciation augments the direct

domestic effects of the increase in the money supply. Due to the extra demand, real

domestic product and income may rise even more. However, the depreciation may also

enhance the effects of monetary policy on the price level and inflation rate as well.

The depreciation results in higher domestic prices for imported products, and the extra

demand can create general upward pressure on prices.

Thus, under floating exchange rates, monetary policy is powerful in its effects on inter-

nal balance. The induced change in the exchange rate reinforces the standard domestic

effects of monetary policy. Monetary policy gains power under floating exchange rates,

whereas, as we saw in the previous chapter, it loses power under fixed exchange rates.

This general conclusion holds whatever the degree of capital mobility. Whatever the

degree, expanding the money supply causes a depreciation, and this further expands

aggregate demand. Consider, for instance, perfect capital mobility. Capital flows

respond to both interest rates and the expected change in the exchange rate into the

future. Perfect capital mobility implies that uncovered interest parity always holds

because nearly unlimited flows of international financial capital occur if there is any

deviation from this parity. 1 The overshooting discussed in Chapter 19 is a form of per-

fect capital mobility. There we saw that, if a monetary expansion reduced the domes-

tic interest rate, the exchange-rate value of the country’s currency would depreciate

immediately by a large amount. The overshooting results in a large improvement in the

country’s international price competitiveness in the short and medium runs.

1For the fixed-rate analysis of Chapter 23, perfect capital mobility also implied uncovered interest parity, but the expected change in the exchange rate was assumed to be approximately zero if investors expected the fixed rate to hold into the future. With no change is expected in the fixed rate, uncovered interest parity means that the domestic interest rate is equal to the foreign interest rate.

pug21774_ch24_603-627.indd 605pug21774_ch24_603-627.indd 605 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

606 Part Four Macro Policies for Open Economies

2Dalsgaard, André, and Richardson (2001).

Change in the Country’s Real GDP after Two Years

Holding the Exchange Allowing the Floating Rate Steady Exchange Rate to Depreciate

United States 0.5% 0.8% Japan 0.7 0.9 Euro area 0.6 0.9

Thus, the induced depreciation of the country’s currency increases the effect of the

monetary expansion by about 50 percent on average.

We can see the effects of monetary policy in the IS–LM–FE picture used in the

previous two chapters. Consider a country that begins with external balance—a triple

intersection shown as point E 0 in Figure 24.2 . The country’s central bank now uses a

domestic change (such as an open market purchase of domestic securities) to expand

the domestic money supply, and the LM curve shifts down to LM'. Even if the

exchange-rate value of the domestic currency is unchanged, the direct domestic effects

of this policy change reduce the domestic interest rate from 6 percent to 5 percent and

Starting from point E 0 with an overall payments balance of zero, the

country implements an expansionary policy. The LM curve shifts

down or to the right, but at point T 1 the payments balance tends

toward deficit. The country’s currency depreciates, and the FE and

IS curves shift to the right, reestablishing external balance at E 1 .

0.06 0.055 0.05

Interest rate 5 i

Domestic product 5 Y

110

LM'

IS1

120125

FE1E0

FIGURE 24.2 Expansionary

Monetary Policy

with Floating

Exchange Rates

How large are the follow-on effects from the currency depreciation? Simulations

using a computer model of the global economy developed by the Organization for

Economic Cooperation and Development (OECD) provide some answers. 2 Consider a

monetary expansion in a country that reduces interest rates by 1 percentage point (e.g.,

from 6 percent to 5 percent), with monetary policy unchanged in the rest of the world.

Here is what the OECD model shows for each of the three largest countries/currencies:

pug21774_ch24_603-627.indd 606pug21774_ch24_603-627.indd 606 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

Chapter 24 Floating Exchange Rates and Internal Balance 607

For contractionary fiscal policy, reverse the direction of all changes.

Interest rate rises

Capital flows in

(in the short run) Our currency may appreciate at first, but it probably depreciates eventually

Spending and income may rise less at first, but eventually probably rise more

Government spending rises or tax rates fall

Real spending, production, and income rise

Current account balance worsens

Price level increases

(beyond the short run)

FIGURE 24.3 Effects of Expansionary Fiscal Policy with Floating Exchange Rates

increase real domestic product from 110 to 120. In addition, the country’s balance of

payments tends to go into deficit. (The intersection of LM' and the original IS curve

at point T 1 is to the right of the initial FE curve.) The country’s currency depreciates

in the foreign exchange market. As the country’s price competitiveness improves,

exports increase and imports decrease. The current account balance improves, so the

FE curve shifts to the right and the IS curve shifts to the right. If the floating exchange

rate adjusts to maintain external balance (a zero balance in the country’s official settle-

ments balance), then the economy will be at a triple intersection of all three curves after

the exchange rate has adjusted. The new triple intersection is point E 1 . Because of the

depreciation, real GDP increases even more, to 125. Monetary policy is powerful in affecting real GDP in the short run under floating exchange rates. 3

FISCAL POLICY WITH FLOATING EXCHANGE RATES

How fiscal policy works with floating exchange rates is a little more complicated.

Fiscal policy can affect exchange rates in either direction, as shown in Figure 24.3 .

The left side of the figure shows the same effects of expansionary policy as we saw

in Chapter 23. The fiscal expansion bids up domestic interest rates as the government

borrows more. Higher domestic interest rates tend to attract capital from abroad, at

least temporarily. Meanwhile, aggregate spending, product, and income are raised by

higher government spending and/or lower tax rates. This raises imports and worsens

the current account balance. So there are two opposing tendencies for the country’s

3The monetary expansion and the induced depreciation are also likely to increase the domestic price level through inflation, especially beyond the short run. If the domestic price level increases, then the LM curve shifts back up (or does not shift down by as much in the first place). The higher domestic price level reverses some of the gain in international price competitiveness, so the FE and IS curves also shift back (or do not shift by as much in the first place). The increase in real GDP is not as large. Indeed, in the long run, the currency depreciation will be exactly offset by the higher price level if money is neutral in the long run and purchasing power parity holds.

pug21774_ch24_603-627.indd 607pug21774_ch24_603-627.indd 607 12/5/14 5:39 PM12/5/14 5:39 PM

Final PDF to printer

608 Part Four Macro Policies for Open Economies

overall balance of payments and thus for the exchange-rate value of the country’s

currency. The interest rate rise tends to draw a capital inflow that strengthens the

country’s currency, but the rise in aggregate demand and imports weakens it. Which

tendency will prevail? There is no firm answer. If capital is mobile internationally,

then the capital inflow effect at first is probably large enough to appreciate the coun-

try’s currency. Eventually the aggregate-demand effect is probably stronger and longer

lasting, so eventually the currency depreciates. 4

The “feedback” effects on the domestic economy depend on which way the

exchange rate changes. If the country’s currency at first appreciates, then the country

loses price competitiveness. The country’s exports decline and its imports increase.

The decline in the country’s current account reduces the expansionary effects of the

fiscal change on the country’s domestic product. That is, the expansionary effect is

reduced by “international crowding out”—the appreciation of the country’s currency

and the resulting decline in the current account. If the country’s currency instead (or

eventually) depreciates, the enhanced price competitiveness and resulting increase in

the current account give a further trade-based stimulus to domestic production.

The effects of fiscal expansion can be pictured using an IS–LM–FE graph. Figure 24.4

shows the two cases possible. In both cases the economy begins at the triple intersection

E 0 . The fiscal expansion directly shifts the IS curve to IS', increasing the domestic interest

rate from 6 percent to 8 percent and boosting domestic product from 110 to 130.

The two cases differ by whether the country’s overall payments balance tends to

go into surplus or deficit. The left graph in Figure 24.4 shows the case of a tendency

to surplus because the capital inflow effect is larger. In this graph the incipient pay-

ments surplus is shown by the IS'–LM intersection to the left of the initial FE curve.

The country’s currency appreciates, the current account balance worsens, and the FE

and IS curves shift to the left. The new triple intersection is at point E 2 . Because of the

currency appreciation, domestic product declines somewhat from 130 to 125 (or does

not rise as much from its initial value of 110). International crowding out reduces the

expansionary thrust of the fiscal change. 5

The right graph in Figure 24.4 shows the case of a tendency to deficit because the

aggregate-demand effect is larger—the IS'–LM intersection is to the right of the initial

FE curve. The country’s currency depreciates, the current account balance improves,

and the FE and IS curves shift to the right. The new triple intersection is at point E 3 .

Because of the currency depreciation, domestic product rises to 140 rather than 130.

The large U.S. fiscal expansion implemented in the early 1980s illustrates the

nature and timing of the effects of a change in fiscal policy under floating exchange

rates. The box “Why Are U.S. Trade Deficits So Big?” discusses the U.S. experience.

4The extreme case of perfect capital mobility is also consistent with this pattern. The initial interest rate increase leads to an immediate appreciation of the domestic currency. The exchange rate overshoots, so that the currency is expected subsequently to depreciate slowly. Uncovered interest rate parity is reestablished because the interest differential in favor of the country is offset by the expected depreciation. 5If the fiscal expansion causes the price level to increase, then the LM curve also shifts up, and both the FE and IS curves shift to the left somewhat (or do not shift as much to the right) as a result of some loss of international price competitiveness due to the higher domestic prices. For either of the two cases discussed here in the text, these additional shifts reduce the amount by which real domestic product increases from its initial value of 110.

pug21774_ch24_603-627.indd 608pug21774_ch24_603-627.indd 608 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

Chapter 24 Floating Exchange Rates and Internal Balance 609

Expansionary fiscal policy shifts the IS curve to the right, and the IS–LM intersection shifts from E 0 to T

2 or T

3 initially.

The effects of fiscal policy depend on how strongly international capital flows respond to the interest rate increase. In

panel A, the overall payments balance tends toward surplus. ( T 2 is to the left of FE.) In panel B, the overall payments

balance tends toward deficit. ( T 3 is to the right of FE.) In either case the payments imbalance leads to a change in the

exchange rate. In panel A, the country’s currency appreciates, and the FE and IS curves shift to

the left, reestablishing external balance at E 2 . In panel B, the country’s currency depreciates, and the FE and IS curves

shift to the right, reestablishing external balance at E 3 . Here we assume that the LM curve does not move because the

central bank can keep the money supply steady if it doesn’t need to defend a fixed exchange rate.

0.08 0.075

Interest rate 5 i

Domestic product 5 Y

110

IS'

125130

E0 E0

0.06

FE2

FE3

IS2

IS3

E2 E3

A. Responsive International Capital Flows

0.09 0.08

Interest rate 5 i

110

IS'

130140

0.06

B. Unresponsive International Capital Flows

FIGURE 24.4 Expansionary Fiscal Policy with Floating Exchange Rates

SHOCKS TO THE ECONOMY

Major shocks occasionally strike a country’s economy. What are the effects of these exog-

enous changes on a country that has a floating exchange rate? We will look at the same

shocks that we examined in the previous chapter for a country with a fixed exchange rate so

that we can contrast the results.

Internal Shocks Domestic monetary shocks affect the equilibrium relationship between money supply and money demand, causing a shift in the LM curve. A change in the country’s

monetary policy is an example of such a shock. As we saw in the analysis of expan-

sionary monetary policy, domestic monetary shocks have powerful effects on an econ-

omy with a floating exchange rate. If the monetary shock tends to expand the economy,

then the exchange-rate value of the country’s currency tends to depreciate, further

increasing domestic product (or putting additional upward pressure on the country’s

price level or inflation rate). If the monetary shock tends to contract the economy, then

the country’s currency tends to appreciate, further decreasing domestic product.

Domestic spending shocks alter domestic expenditure, causing a shift in the IS curve. A change in fiscal policy is an example. As we saw for fiscal policy, the

effect of this kind of shock on the exchange rate depends on which changes more:

international capital flows or the country’s current account.

pug21774_ch24_603-627.indd 609pug21774_ch24_603-627.indd 609 12/5/14 5:40 PM12/5/14 5:40 PM

Final PDF to printer

610 Part Four Macro Policies for Open Economies

Case Study Why Are U.S. Trade Deficits So Big?

The United States has had a trade deficit every year since 1980. Why does the United States have this trade deficit? Why did it become very large in the mid-1980s and again starting in the late 1990s?

The United States has a floating exchange rate, so one place to look for an explanation is in changes in the real exchange-rate value of the U.S. dollar (recall our discussion of the real exchange rate in Chapter 19). The top graph in the accompanying figure shows the value of the real effective exchange-rate value of the dollar, as an indicator of the international price com- petitiveness of U.S. products, and the value of the U.S. trade balance (measured as a percentage of U.S. GDP, to make the size more comparable over time). It is clear that we may have a pretty good explanation here, if we allow for the lag of one to two years (recall the J curve from Chapter 23). That is, the dollar begins a large real appreciation in 1980 and the trade balance begins to deterio- rate in 1982. The value of the dollar peaks in 1985 and begins a real depreciation that returns the real value in 1988 back to what it was in 1980. The trade balance begins to improve in 1987. The next big swing begins when the dollar starts another real appreciation in 1995. The trade bal- ance deteriorates beginning in 1997. Then the dollar begins a real depreciation in 2002. This time the lag is somewhat longer—the trade bal- ance begins to improve in 2006.

So an explanation of the large U.S. trade def- icits is the change in international price competi- tiveness caused by exchange-rate swings. When the dollar experiences a real appreciation, the loss of price competitiveness hurts U.S. exports and encourages U.S. imports, so the trade bal- ance deteriorates. The problem with this expla- nation is that it is not very deep. With a floating rate, the exchange-rate value of the U.S. dollar is an endogenous variable. We should probe fur- ther to find out what is behind the broad swings in the exchange rate and the trade balance.

One place to look is in the relationships between national saving and investment that we introduced in Chapter 16 and used again in

Chapter 22. The bottom graph in the accompany- ing figure shows two aspects of national saving, private saving by households and businesses and government saving, which is the government budget surplus or deficit. If the government runs a surplus, then it is collecting more in tax revenues than it is spending, so the difference is a form of saving. If the government runs a deficit, then it is dissaving. The graph also shows domestic private investment and the trade balance again.

In the 1980s the closest relationship is between the government budget and the trade balance. In 1981 the Reagan administration obtained a major tax cut while government expenditures continued to grow. The government budget deficit increased to about 7.7 percent of GDP in late 1982 and remained at about 6 percent of GDP until 1987. In the graph the increase in the government budget deficit is shown as a decline in government saving in the early 1980s, with the line then remaining at about 26 percent for several years. Essentially, both the government budget deficit and the trade deficit increased in the first half of the 1980s and declined in the late 1980s. They came to be called the twin deficits.

Our model provides some insights into this relationship. Expansionary fiscal policy shifted the IS curve to the right, increasing both U.S. interest rates and U.S. national income. The rise in income alone tended to increase the trade deficit. The relatively high U.S. interest rates also drew large capital inflows and the real exchange-rate value of the dollar increased (as we saw in the top graph). In 1985 the capital inflows declined, so the large trade deficit became an important driver of the exchange-rate value of the dollar. The dollar began to depreciate in early 1985.

The explanation for the rise of the trade deficit in the second half of the 1990s is different. The government budget is not the explanation because the deficit began to decline in 1992. Instead, the explanation of the rising U.S. trade deficit in the late 1990s is the boom in real domes- tic investment. In the 1980s both private saving and private investment declined as shares of GDP.

pug21774_ch24_603-627.indd 610pug21774_ch24_603-627.indd 610 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

Chapter 24 Floating Exchange Rates and Internal Balance 611

Source: Federal Reserve Board of Governors for the real effective exchange rate; U.S. government national income and product accounts for the other variables.

P e rc

e n

t o

f G

D P

P e rc

e n

t o

f G

D P

R e a l e

ffe ctive

e xch

a n

g e -ra

te va

lu e o

f th e d

o lla

r (First q

u a rte

r 1 9 8 0 5

1 0 0 )

215

210

Trade balance

Government saving

Domestic private investment

Private saving

1980-I 1985-I 1990-I 1995-I 2000-I 2005-I 2010-I 27

1980-I 1985-I 1990-I 1995-I 2000-I 2005-I 2010-I

100

110

120

130

140

150

Trade balance (left axis scale)

Real exchange rate (right axis scale)

In the 1990s private saving continued to decline, but private domestic investment rose strongly, from 15 percent of GDP to about 20 percent. Businesses perceived major opportunities for prof- itable capital investments in the United States. So did financial investors, with a booming stock mar- ket drawing in large amounts of foreign capital. In terms of our macromodel, the story is much the

same, though the driver is different (real domestic investment in the 1990s, fiscal policy in the 1980s). The increase in real domestic investment shifts the IS curve to the right. The trade balance deterio- rates because of strong growth in U.S. GDP. The capital inflows appreciate the dollar, so the trade balance also deteriorates because of declining price competitiveness.

—Continued on next page

pug21774_ch24_603-627.indd 611pug21774_ch24_603-627.indd 611 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

612 Part Four Macro Policies for Open Economies

The stock market and real investment booms ended in 2000. As shown in the bottom graph, the decline in government saving (the rapid increase in the government budget deficit) again became the key driver of the growing trade deficit dur- ing 2000–2004. Then, with the onset of the global financial and economic crisis, the govern- ment budget deficit increased; private saving increased as households and businesses strove to reduce their debts; and domestic real investment,

including new residential construction, collapsed. From late 2009 the overall effects of these changes on the trade balance was actually rather small.

DISCUSSION QUESTION In mid-2014 you expected that, during the next several years, private saving would decrease and the government budget deficit would continue to decline. What was your forecast for the trade balance?

International Capital-Flow Shocks International capital-flow shocks occur because of changes in investors’ percep- tions of economic and political conditions in various countries. For instance, an adverse

shock to international capital flows, leading to a capital outflow from our country, can

occur because foreign interest rates increase, investors shift to expecting more deprecia-

tion of our currency in the future, or investors fear negative changes in our country’s

politics or policies.

The capital outflow puts downward pressure on the exchange-rate value of the

country’s currency, and the currency depreciates. The depreciation improves the inter-

national price competitiveness of the country’s products. Its exports increase and its

imports decrease, improving the country’s current account. The extra demand tends to

increase its domestic product.

The effects of this shock are pictured in Figure 24.5 . The economy begins at point

E 0 , a triple intersection. The adverse international capital-flow shock causes the FE

curve to shift to the left to FE'. The country’s overall payments balance tends to go into

deficit, as the intersection of the (initially unchanged) IS–LM curves at E 0 is below FE'.

The country’s currency depreciates, shifting the FE and IS curves to the right. A new

triple intersection occurs at point E 4 , with domestic product and the interest rate higher.

Thus, under floating exchange rates, external capital-flow shocks can have effects

on internal balance by altering the exchange rate and the country’s international price

competitiveness. Interestingly, an adverse shock tends to expand the domestic economy

by depreciating the country’s currency. We probably should add several cautions about

this result. First, the reason for the capital-flow shift is important. If capital is flowing

out because of political or economic problems in the country, then these problems may

cause the economy to contract even though the exchange-rate depreciation is pushing

in the other direction. Second, the capital outflow may disrupt domestic financial mar-

kets in ways that go beyond our basic analysis. Any disruptions in domestic financial

markets may harm the broader domestic economy, also tending to contract it. We saw

in Chapter 21 that a country often has domestic problems, large capital outflows, a

depreciating currency, financial disruption, and a severe recession during a financial

crisis. Thus, it is risky to conclude, on the basis of the simpler IS–LM–FE analysis, that

an adverse capital-flow shock is simply good for the country’s economy.

pug21774_ch24_603-627.indd 612pug21774_ch24_603-627.indd 612 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

Chapter 24 Floating Exchange Rates and Internal Balance 613

International Trade Shocks International trade shocks cause the value of the country’s current account balance to change. For instance, an adverse shock to international trade flows

might occur because of a decline in foreign demand for our exports, an increase in

our taste for imported products, or an increase in the price of an important import

such as oil.

An adverse international trade shock reduces both the current account and the

country’s domestic product and income. 6 As the current account worsens, the overall

payments balance tends to go into deficit and the country’s currency depreciates. The

improvement in price competitiveness leads to an increase in the country’s exports and

a decline in imports. The current account improves and domestic product and income

rise. If all of this happens with no change in international capital flows, then the cur-

rency must depreciate enough to completely reverse the deterioration in the current

account, putting the overall payments balance back to zero.

Figure 24.6 shows the effects of this adverse international trade shock. The shock

causes the FE and IS curves to shift to the left. The intersection of IS' with LM at T 5

is below the new FE'. The country’s currency depreciates, resulting in shifts back to

the right in the FE and IS curves. If nothing else changes (such as international capital

A shift of international capital flows away from the country

causes the FE curve to shift up or to the left, and the overall

payments balance tends toward deficit. The country’s currency

depreciates, and the FE and IS curves shift to the right,

reestablishing external balance at E 4 . Here again we assume

that the LM curve does not shift because the central bank

can keep the money supply steady.

0.07 0.06

Interest rate 5 i

Domestic product 5 Y110

E4 FE

IS4

120

FE' FE4

FIGURE 24.5 An Adverse

International

Capital-Flow

Shock

6We presume that the current account does actually decline. The shock itself worsens the current account. The decline in national income lowers demand for imports, but we assume that this is not enough to reverse the deterioration of the current account. In Figure 24.6, this assumption ensures that the new IS’–LM intersection at T

5 is to the left of the new FE’, even if the FE

curve is steeper than the LM curve.

pug21774_ch24_603-627.indd 613pug21774_ch24_603-627.indd 613 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

614 Part Four Macro Policies for Open Economies

A shift of international trade away from the country’s products

causes the FE and IS curves to shift to the left, and the overall

payments balance tends toward deficit. The country’s currency

depreciates, and the FE and IS curves shift back to the right.

Here, to simplify the diagram, we imagine the case in

which external balance is reestablished at E 0 .

0.06 0.05

Interest rate 5 i

Domestic product 5 Y100

110

FE'

IS'

FIGURE 24.6 An Adverse

International

Trade Shock

flows or the domestic price level), then the curves shift back to their original positions,

and the new triple intersection is back to E 0 . 7

With floating exchange rates, the effects of international trade shocks on internal balance are mitigated by the effects of the resulting change in the exchange rate. An adverse trade shock tends to depreciate the country’s currency, and this reverses some

of the effects of the shock. By reversing all of the directions of change, we would also

conclude that a positive trade shock appreciates the country’s currency, reversing both

the improvement in the country’s current account balance and the increase in demand

for the country’s domestic product.

INTERNAL IMBALANCE AND POLICY RESPONSES

Shocks to the economy alter both the international performance of the country’s

economy and its domestic performance. With floating exchange rates a change in

the exchange rate takes care of achieving external balance following a shock. If the

country’s overall payments tend to go into deficit, then the country’s currency depreci-

ates, reversing the tendency toward deficit. If the country’s overall payments tend to

surplus, then appreciation reverses the tendency to surplus.

A floating exchange rate does not ensure that the country achieves internal balance, but

changes in the floating rate do affect the country’s internal balance. A depreciation tends

to expand the country’s economy. If the country begins with excessive unemployment

7The depreciation of the currency may put some upward pressure on the country’s price level by increasing the domestic-currency price of imported products. If the overall domestic price level increases, then the LM curve shifts up somewhat, and the new triple intersection will still result in some decline in domestic product. Nonetheless, the decline is less than what would occur without the currency depreciation.

pug21774_ch24_603-627.indd 614pug21774_ch24_603-627.indd 614 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

Chapter 24 Floating Exchange Rates and Internal Balance 615

before the exchange-rate change, then the expansionary thrust of the depreciation is

welcome, as it reduces the internal imbalance. If the country instead begins with internal

balance or with an inflation rate that is rising or too high, then the expansionary thrust of

the depreciation will create or add to the internal inflationary imbalance.

An appreciation tends to contract the country’s economy. If the economy begins

with inflationary pressure, then this may be welcome. But if the economy is already

in or tending toward a recession with excessive unemployment, then the exchange-rate

change adds to the internal imbalance.

Government monetary or fiscal policy can be used to address any internal imbal-

ances that do arise. If excessive unemployment is the internal imbalance, then expan-

sionary monetary or fiscal policy can be used.8 The size of the change in policy needed

to address the imbalance depends on the change in the exchange rate that will occur.

Monetary policy is powerful with floating exchange rates, so a relatively small change

may be enough to reestablish internal balance. The power of fiscal policy is more

variable and may be difficult to predict if it is difficult to predict the appreciation or

depreciation of the exchange rate following the fiscal change.

INTERNATIONAL MACROECONOMIC POLICY COORDINATION

The dollar may be our currency but it’s your problem.

U.S. Treasury Secretary John Connally, speaking to a group of Europeans ( as quoted in Paul A. Volcker and Toyoo Gyohten, Changing Fortunes: The World’s Money and the Threat to American Leadership, New York: Times Books, 1992, p. 81 )

The policies adopted by one country have effects on other countries. With floating

exchange rates these spillover effects happen in several ways, including foreign

income repercussions as changes in incomes alter demands for imports, and changes

in international price competitiveness as floating exchange rates change.

One danger is that a policy change that benefits the country making it can harm

other countries. For instance, a shift to expansionary monetary policy causes the cur-

rencies of other countries to appreciate. This can appear to be a beggar-thy-neighbor

policy in that the first country benefits from increased growth, but the exchange-rate

appreciation can harm the price competitiveness and trade of other countries.

Another danger is that each country acting individually may fail to make a policy change

whose benefits mostly go to other countries. If a number of countries could coordinate so

that they all made this policy change, all would reap substantial benefits. For example, fol-

lowing the nearly global stock market crash of October 1987, the global financial system

needed additional liquidity to counteract the decline in banking and financial activity. If

any one central bank added liquidity, the rest of the global system would benefit, probably

more than the individual country would. Each individual central bank might be slow to

act, or reluctant to add liquidity aggressively, on its own. Fortunately, several central banks

coordinated their actions to inject liquidity, and the financial markets stabilized.

8As the U.S. government attempted to address the recession resulting from the global financial and economic crisis, it confronted the vexing problem that monetary policy had already lowered domestic interest rates to about zero. The box “Liquidity Trap!” discusses how the U.S. Fed responded.

pug21774_ch24_603-627.indd 615pug21774_ch24_603-627.indd 615 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

616 Part Four Macro Policies for Open Economies

Global Crisis Liquidity Trap!

Conventional monetary policy has a limit. It can- not reduce nominal interest rates below zero. Even interest rates that are as close to zero as they can go may not be enough to encourage borrowing and spending that will move the economy to its potential—that is, move real GDP to a level that results in “full employment” of the economy’s resources. This problem, known as the liquidity trap, was experienced and analyzed during the Great Depression of the 1930s but then was almost forgotten for half a century. It seemed to be a curiosity because none of the world’s major economies seemed to get any- where close to it. It reappeared in discussions of Japan’s lost decade in the 1990s, and it became disturbingly relevant for the United States and other countries with the global financial and economic crisis that began in 2007. Here’s what happened in the United States.

In August 2007, with the onset of the first phase of the global crisis, financial institutions became less willing to lend to each other and to other borrowers. Households and businesses began to cut their spending. In our picture, the IS curve was shifting to the left. Beginning in August 2007, the U.S. Federal Reserve responded with conventional monetary policy, cutting its target for the Fed funds interest rate in steps from its starting value of 5.25 percent. The Fed was shifting the LM curve down to fight the shrinking IS curve. The Fed had some suc- cess for a while, as the recession was mild. By September 2008, the Fed funds target was down to 2 percent.

On September 15, Lehman Brothers failed and the crisis became intense. The Fed cut its Fed fund target in several more steps to 0–0.25 percent in mid-December. This is essentially as low as it can go. The economy was by then in a severe reces- sion, but the United States was out of regular expansionary monetary policy. The graph shows the economy in this liquidity trap. Once interest rates in the economy, especially the short-term

interest rates that are most directly influenced by conventional monetary policy, are close to zero, the LM curve becomes horizontal, as shown. If the IS curve shifts far enough to the left, to IS

in the graph, the intersection is at point E L in the

liquidity trap. U.S. real GDP at Y L was well below

the economy’s potential Y full

. What can government policymakers do?

Conventional monetary policy cannot shift the LM curve any lower in the area of its intersection with the IS

L curve. Fiscal policy is still available,

and the U.S. government adopted a large fiscal stimulus in February 2009 to try to shift the IS curve to the right. However, this stimulus did not have that much effect, for several reasons. Other spending influences remained weak and were tending to push the IS curve to the left. Also, the actual fiscal stimulus occurred slowly, as various spending and tax-cut programs took time to implement. The fiscal stimulus probably prevented the economy from weakening further (preventing the IS curve from shifting further to the left), but it did not shift the IS curve much to the right.

The U.S. economy remained weak, with real GDP well below potential and a high unemploy- ment rate. Because the government budget deficit had ballooned, more fiscal expansion was politically impossible. With the economy in the liquidity trap, the Fed turned to a form of unconventional monetary policy, quantita- tive easing (QE)—the central bank buying and holding massive amounts of securities—which the Bank of Japan had used with some success in the early 2000s. In the depth of the crisis, the Fed purchased large amounts of financial assets, expanding its assets from about $900 billion in September 2008 to almost $2.3 tril- lion in December. These purchases pushed large amounts of high-powered money into the bank- ing system. The banks could not use this money to make new loans, so the banks deposited the funds at the Fed and held large amounts of excess

pug21774_ch24_603-627.indd 616pug21774_ch24_603-627.indd 616 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

Chapter 24 Floating Exchange Rates and Internal Balance 617

bank reserves. As the crisis in the financial market eased in 2009, the Fed deliberately maintained its quantitative easing by keeping this high level of assets, and the Fed shifted the composition of its holdings toward mortgage-backed assets and longer-term U.S. Treasury bonds.

How can quantitative easing affect the econ- omy? One can imagine several ways. First, the Fed may be able to lower long-term interest rates by buying large amounts of long-term bonds. With lower long-term interest rates, businesses and households are encouraged to take on long-term debt to finance purchases of build- ings, machinery, and housing. Effectively, the IS curve shifts to the right. Estimates of the impact of the Fed’s quantitative easing in 2008–2009 are that U.S. real GDP was about 1 to 2 percent higher by early 2011. Second, the large quantity of excess reserves that banks were holding could encourage some of them to make more loans, but this effect seems to be small. Third, some of the huge amount of dollar liquidity can flow into the foreign exchange market, depreciating the exchange-rate value of the dollar. During 2009,

the U.S. dollar had a real depreciation of about 6 percent. This effect of the unconventional mon- etary policy is conventional—the United States gains international price competitiveness. As shown in the graph, the IS and FE curves shift to the right to IS

QE and FE

QE , and U.S. real GDP

increases to Y QE

. But other countries, includ- ing Brazil, Switzerland, and Japan, complained that the dollar depreciation resulting from U.S. quantitative easing was an appreciation of their currencies that undercut aggregate demand for their production.

U.S. recovery from the deep recession of 2007–2009 continued to be slow. In 2010 the Fed began a second round of quantitative eas- ing (QE2), buying about $600 billion of Treasury bonds during November 2010 to June 2011. In late 2012 the Fed implemented a third round (QE3), buying about $1.5 trillion of bonds by late 2014. Each subsequent QE round seemed to have smaller effects on long-term interest rates and exchange rates, and the United States continued its slow growth. The United States had not yet escaped the liquidity trap.

ISL ISQE FEL

FEQE

EL EQE

YL YQE Yfull Domestic product

Interest rate

pug21774_ch24_603-627.indd 617pug21774_ch24_603-627.indd 617 12/5/14 5:40 PM12/5/14 5:40 PM

Final PDF to printer

618 Part Four Macro Policies for Open Economies

9The box “Can Governments Manage the Float?” discusses the use of intervention to influence floating exchange rates.

Given these spillover effects and interdependencies, it seems that it should be pos-

sible to improve global macroeconomic performance through international coopera-

tion and international coordination. International policy cooperation refers to such activities as sharing of information about each country’s performance, problems, and

policies. Sharing of information occurs in many places, including high-level meetings

of national finance ministers and heads of state as well as international organizations

such as the International Monetary Fund and the Bank for International Settlements.

International cooperation of this sort is not controversial.

International macroeconomic policy coordination is more than this. It is the joint determination of several countries’ macroeconomic policies to improve joint

performance. It implies the ability of one country to influence the policies of other

countries and the willingness of a country to alter its policies to benefit other countries.

In some situations coordination could be easy. For instance, in a deep global recession

with no inflation, the advantages of mutual expansionary policies are clear. All coun-

tries can benefit if each country finds an alternative to beggar-thy-neighbor policies that

harm other countries. In other situations coordination is more controversial.

We have several examples of major coordination efforts in the past 40 years. At the

Bonn Summit of 1978, the United States agreed to implement policies to reduce U.S.

inflation while also agreeing to reduce oil imports by decontrolling domestic oil prices.

Germany agreed to increase its government spending to stimulate its economy. Japan

also agreed to continue its expansionary policies, while taking steps to slow its growth

of exports. In the Plaza Agreement of 1985, the major countries agreed to intervene

in the foreign exchange markets to lower the exchange-rate value of the U.S. dollar

(but there was no other substantial coordination of policies). In the Louvre Accord of

1987, the United States committed to reduce its fiscal deficit, while Germany and Japan

committed to expansionary policies. All committed to stabilize the exchange-rate value

of the dollar, if necessary through higher U.S. interest rates and lower interest rates in

Germany and Japan, as well as through official intervention.9 More recently, central

banks undertook coordinated actions to try to address the global financial and economic

crisis, as described in the box “Central Bank Liquidity Swaps.”

We can see possible benefits of coordination by examining the Louvre Accord.

Tightening of U.S. policies (both fiscal and monetary) would tend to slow down the

U.S. economy, and slow down the economies of other countries by reducing U.S.

demand for imports. Expansionary policies in Germany and Japan could offset the

contractionary effects of the U.S. policy shift, not only in these two countries but also

in other countries (including the United States) by expanding German and Japanese

demands for imports. If this is done on a coordinated basis, the result can be a reduc-

tion of the U.S. current account deficit, reductions in the German and Japanese current

account surpluses, and a stabilization of the exchange-rate value of the dollar, without

a global recession caused by the tightening of U.S. policies.

If the benefits of international policy coordination seem clear, why do we actually

see rather little of it? There seem to be several reasons. First, the goals of different

countries may not be compatible. For instance, the United States may want to maintain

growth while stabilizing the exchange-rate value of the dollar. Policymakers at the

pug21774_ch24_603-627.indd 618pug21774_ch24_603-627.indd 618 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

Chapter 24 Floating Exchange Rates and Internal Balance 619

Case Study Can Governments Manage the Float?

Floating exchange rates allow a country to achieve external balance while maintaining con- trol over its money supply and monetary policy. But floating exchange rates are also highly vari- able, more variable than we expected when many countries shifted to floating rates in 1973.

Governments that have chosen floating exchange rates worry about the large amount of variability, and nearly all manage the float to some extent. Some governments manage their floating rates closely. If the floating exchange rate is heavily managed, then it behaves more like a fixed exchange rate, and the analysis of the previous chapter is relevant. Other governments, including the governments of most major coun- tries that have chosen floating rates, use manage- ment selectively. Occasionally the government intervenes in the foreign exchange market.

Is selective or occasional intervention effective in influencing exchange rates? Thirty years ago the conventional wisdom was clear. If the inter- vention is not sterilized, then it can be effective. However, it is effective not because it is interven- tion but rather because it changes the money supply. Unsterilized intervention is simply another way to implement a change in the domestic money supply and monetary policy. By changing the money supply, it can have a substantial effect on the exchange rate. If the intervention is steril- ized, the conventional wisdom was that it would not be effective in changing the exchange rate, at least not much or for long. Yet interventions by the U.S., Japanese, and British monetary authori- ties, among others, are fully sterilized.

The conventional wisdom was based on studies that showed little effect of sterilized intervention. It was also based on the relatively small sizes of interventions. In a market where total daily trad- ing was hundreds of billions of dollars, interven- tions that typically were less than $1 billion seemed too small to have much impact.

More recent studies have challenged this conventional wisdom. How might sterilized intervention be effective, even though it does

not change the domestic money supply and is relatively small? The most likely way is by changing the exchange-rate expectations of international financial investors and speculators. Intervention can act as a signal from the mon- etary authorities that they are not happy with the current level or trend of the exchange rate. The authorities show that they are willing to do something (intervention) now and they signal that they may be willing to do something more in the future. For instance, the authorities may be willing to change monetary policy and interest rates in the future if the path for the exchange rate remains unacceptable. Sterilized interven- tions then can be a type of news that influences expectations. If international investors take the signal seriously, they adjust their exchange-rate expectations. Changed expectations alter inter- national capital flows, changing the exchange rate in the direction desired by the authorities. For instance, in 1985 the major governments announced in the Plaza Agreement that they were committed to reducing the exchange-rate value of the dollar. They intervened to sell dollars. International investors shifted to expecting the dollar to depreciate by more than they had previ- ously thought, and the exchange-rate value of the dollar declined rapidly.

Recent studies indicate that sterilized inter- vention can be effective. One indirect measure of effectiveness is whether the monetary authority makes a profit or a loss on its interventions over time. If the authority buys a currency and suc- ceeds in driving its value up (and sells to drive the value down), the authority makes a profit (buy low, sell high). An early study found that central banks generally incurred losses on their intervention in the 1970s. However, a study of U.S. intervention during the 1980s found that the U.S. monetary authority made a profit of over $12 billion on its dollar–DM interventions and a profit of over $4 billion on its dollar–yen interven- tions during this period. Another study concluded that interventions during the mid- and late 1980s

—Continued on next page

pug21774_ch24_603-627.indd 619pug21774_ch24_603-627.indd 619 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

620 Part Four Macro Policies for Open Economies

significantly affected exchange-rate expectations in the direction intended.

Recently, a number of monetary authorities began releasing data on their daily interven- tion activities, information that had previously been kept secret. With these data the quality of statistical studies has improved dramatically. The typical findings are as follows:

• Intervention is usually effective in the short period of two weeks or less, in reversing the di- rection of the trend of the exchange rate, or at least in reducing the speed of the trend (when the authority is leaning against the wind).

• Larger interventions are more successful.

• Coordinated intervention, in which two or more monetary authorities intervene jointly to try to influence an exchange rate, is much more powerful than an intervention by one country of the same total size.

• The effectiveness of the intervention often di- minishes after this two-week period, and often there is no discernible effect one month later.

Here is one example. After the introduction of the euro in 1999, the European Central Bank (ECB) intervened to influence the exchange-rate value of the euro on only four days, in the fall of 2000, after the euro’s exchange-rate value had declined substantially during 1999–2000. On September 22 a coordinated intervention by the ECB and the monetary authorities of the United States, Japan, Canada, and Britain bought several billions of euros. The initial impact was to increase the euro’s value by over 4 percent, though about half of the effect was lost during the remainder of the day. The intervention was successful in reversing the direction of the trend for about 5 days, and after 15 days the euro’s decline was less than what it would have been if the previous trend had sim- ply continued. Still, the euro’s decline continued, and the ECB intervened again on November 3, 6, and 9. The same effects of reversing the trend for about 5 days and smoothing the decline for about 15 days occurred. These interventions may have had some lasting impact because at about this

time the value of the euro stopped its downward trend and began to vary around a trend that was essentially flat.

Here’s another example. The Japanese gov- ernment has been quite concerned about the variability of the yen’s value. From early 1991 to 1995, the yen appreciated from 140 per dol- lar to 80. Then the yen depreciated to 146 in 1998, appreciated to about 100 in 2000, and then depreciated to about 125 by April 2001. Japan’s monetary authority bought dollars (and sold yen) on 168 days during this time period, for total purchases of over $200 billion. It sold dollars (and bought yen) on 33 days, a total of $37 billion.

Ito (2003) reckons that these interventions were highly profitable for the Japanese govern- ment. It bought dollars at an average price of 104 and sold dollars at an average price of 130. It realized capital gains of $8 billion, earned an interest differential on its holdings of the dol- lars it bought of about $31 billion, and had an unrealized capital gain at the end of the period of $29 billion. In fact, the Japanese government seemed to have an unstated target exchange rate of about 125 per dollar. Sales of dollars were at rates above 125, and purchases below.

By combining days of intervention that are close together, Fatum and Hutchison (2006) iden- tify 43 separate instances of intervention, 29 of buying dollars during 1993–1996 and 1999–2000 and 14 of selling dollars during 1991–1992 and 1997–1998. In 34 of these, Japan’s monetary authority was clearly leaning against the wind— intervening against the trend during the previous two days. Of these, 24 reversed the trend for the two days after the intervention, and in another 5 the trend rate of exchange-rate change was lowered. The major failures occurred in the first half of 1995, when continual interventions could not prevent the yen from appreciating from 100 to the then-amazing level of 80 yen per dollar. However, even when the Japanese authorities succeeded during this short two-day window, there was generally little effect on the exchange rate a month after the intervention.

pug21774_ch24_603-627.indd 620pug21774_ch24_603-627.indd 620 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

Chapter 24 Floating Exchange Rates and Internal Balance 621

European Central Bank are mandated to focus solely on preventing inflation, so they

may be unwilling to expand the money supply, lower interest rates, and expand the EU

economy. It is simply difficult for a government to adopt policies that do not suit the

economic and political conditions of its country, even if these policies would benefit

other countries. Indeed, governments may disagree about how the domestic and global

macroeconomy works. For instance, they may disagree about how much expansion is

possible before inflation begins to increase noticeably.

Second, the benefits of international policy coordination may actually be small in

many situations. Often the appropriate “coordinated” policies actually appear to be

close to the appropriate policies that would be chosen by the countries individually (as

long as blatant beggar-thy-neighbor policies such as new trade barriers are avoided).

For instance, in 1987, the United States on its own probably should have shifted to

somewhat contractionary policies and reduced its government budget deficit. In turn,

both Germany and Japan, for their own benefit, probably should have shifted to more

expansionary policies. Even in situations in which the coordinated policy actions

are essentially what each government should do on its own, there can still be value

to coordination, for two reasons. First, each government can use the commitment to

international coordination to firm up domestic support for the policy changes. Second,

the governments can use the high visibility of coordinated policy actions to try to

enhance the effects on market psychology and expectations.

Coordinated interventions with the U.S. monetary authority (which occurred on 23 days during the decade) were much more powerful than interventions only by Japan. Ito estimates that, for 1996–2001, independent intervention of $2 billion by the Japanese authority moved the yen value by 0.2 percent on average. Coordinated intervention of $1 billion by each of the two authorities moved the yen value by about 5.0 percent.

After intervening rather little during 2001 and 2002, the Japanese government engaged in massive interventions during 2003 and the first quarter of 2004 to attempt to prevent apprecia- tion of the yen. The government intervened on about 40 percent of these days and purchased a total of about $315 billion. Nonetheless, the yen did appreciate from 120 per dollar at the end of 2002 to 104 per dollar at the end of March 2004, although the appreciation might have been larger if there had been no intervention. The Japanese government then abruptly ended all intervention after March 2004, and the yen value was fairly steady for several years after the cessation.

Our beliefs about the effectiveness of steril- ized intervention by the major countries is now cautious and nuanced. If the time frame is a few days, intervention seems often to be successful. If the time frame is one month or more, it usually seems to be unsuccessful. Still, there are times, such as late 2000 for the euro, when the monetary authorities believe that the market has pushed an exchange rate far from its fundamental value. As Michael Mussa, then chief economist for the International Monetary Fund, said a few days before the September 2000 euro intervention, “Circumstances for intervention are very rare, but they do arise. One has to ask, if not now, when?”

DISCUSSION QUESTION On March 11, 2011, a devastating earthquake and tsunami hit Japan. Surprisingly, during the next week, the Japanese yen appreciated by 5 percent against the U.S. dollar. Should the Japanese central bank have intervened in the foreign exchange market? If so, how should it have intervened? If not, why not?

pug21774_ch24_603-627.indd 621pug21774_ch24_603-627.indd 621 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

622 Part Four Macro Policies for Open Economies

Global Crisis Central Bank Liquidity Swaps

Central banks have often established swap lines among themselves, so that one central bank can quickly borrow from other central banks when the borrowing bank needs foreign currency for intervention in the foreign exchange market. The global financial and economic crisis brought a new kind of swap line, the central bank liquid- ity swap, innovated in December 2007 as part of a set of coordinated policies to address the crisis.

After the global crisis began in August 2007, many financial institutions that had become reliant on short-term funding from other finan- cial institutions and from debt markets found it increasingly difficult to obtain this funding because heightened concerns about credit risk partially froze short-term lending and investing. To address the constricted short-term lending and credit markets, the U.S. Federal Reserve, the European Central Bank (ECB), the Bank of England, the Swiss National Bank, and the Bank of Canada announced on December 12 that they would inject $50 billion of funds into their bank- ing systems, in the hope that the coordinated implementation of the unusual central bank loans would magnify their impact in encourag- ing regular banks to lend more fluidly.

Included among the lending programs were central bank liquidity swap lines provided by the U.S. Fed to the ECB and the Swiss central bank. These swaps addressed a specific prob- lem. Banks outside the United States, espe- cially banks in Europe, had dollar-denominated assets, but they did not have a base of deposits in dollars. In the crisis they lost ready access to dollar funding from other financial institu- tions (interbank) and from debt issues such as commercial paper purchased by money market funds. Interest rates on interbank lending (such as LIBOR, the London Interbank Offering Rate) rose well above normal levels, and there was still reluctance to lend.

The central bank liquidity swap is essentially a loan of dollars from the U.S. Fed. How does it work?

• The Fed exchanges dollars for the other coun- try’s currency with the foreign central bank.

• The foreign central bank lends the dollars to financial institutions in its country.

• The Fed holds the foreign currency passively, as collateral.

• At the maturity of the swap, the foreign central bank pays the Fed interest, and the two banks swap back the foreign currency and dollars.

The foreign central bank gets dollars that it can use, without dipping into its holdings of official international reserves. The Fed helps address the dollar shortage in the foreign banking system without direct credit risk exposure to foreign banks because its loan is to the foreign central bank.

The swap lines did allow the ECB and the Swiss central bank to lend to reduce the severity of the dollar shortage in the next months, and the limits on the total swap amounts outstanding were raised several times. With the intensification of the crisis after the failure of Lehman Brothers in September 2008, short-term funding again froze. Foreign financial institutions again lacked dollar funding, with short-term dollar interest rates like LIBOR soaring well above normal levels. Again the Fed worked with other central banks to address the problem. In September the Fed added liquidity swap lines with the central banks of Britain, Japan, Canada, Australia, Sweden, Norway, and Denmark, and in October with New Zealand, Brazil, Mexico, Korea, and Singapore. Also in October, the Fed removed limits on swap amounts with the ECB and the central banks of Switzerland, Britain, and Japan. There was a big increase in the value of swaps drawn and outstanding in October, and by December the swaps had peaked at nearly $600 billion outstand- ing, about half drawn by the ECB. Then the swaps decreased as dollar funding pressures decreased, and the program ended in February 2010.

Central bank liquidity swaps are an innova- tive form of international coordination that were effective in addressing dysfunction in dollar funding for foreign financial institutions during the crisis. The dollar loans made by the foreign central banks provided funding directly to their

pug21774_ch24_603-627.indd 622pug21774_ch24_603-627.indd 622 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

Chapter 24 Floating Exchange Rates and Internal Balance 623

Major instances of international macroeconomic policy coordination are rare.

Coordination is more likely when countries clearly see and agree to goals and the

means to achieve these goals. In practice this means that the countries commit to doing

what they largely should have done on their own. Even in these cases, governments

often have difficulty delivering on their commitments. For instance, during the 1980s,

international commitments by the U.S. government to reduce its government budget

deficit seem to have had little impact.

Summary With a cleanly floating exchange rate, the exchange rate changes to maintain external balance. If a country is tending toward a surplus in its overall international payments,

the exchange-rate value of the country’s currency will appreciate enough to reverse the

tendency. If the country is tending toward a deficit, the currency will depreciate. The

contrast with fixed exchange rates is clear. With a clean float external balance is not an

issue, but the exchange-rate value can be quite variable or volatile.

Monetary policy is more powerful with floating exchange rates. After a shift in

monetary policy, the exchange rate is likely to change in the direction that reinforces or

magnifies the effect of the policy shift on aggregate demand, domestic product, national

income, and price level. In contrast, as we saw in Chapter 23, with fixed exchange rates

monetary policy loses power because the need to defend the fixed rate tends to reverse

the policy thrust (assuming that the intervention is not or cannot be sterilized).

The effects of floating exchange rates on fiscal policy are not clear. Consider a fis-

cal expansion. If the resulting inflow of international financial capital is the dominant

effect on external balance, then the country’s currency appreciates. The loss of interna-

tional price competitiveness leads to international crowding out, as the current account

balance deteriorates. This reduces the effectiveness of fiscal policy in altering domestic

product and income. If, instead, the initial deterioration in the current account balance

is the dominant effect on external balance, then the country’s currency depreciates.

The gain in international price competitiveness improves the current account, and this

enhances the effectiveness of fiscal policy. We also saw an ambiguity in how fixed

exchange rates affect fiscal policy. But the conclusions are the opposite. With fixed

exchange rates, fiscal policy is more effective in altering domestic product and income

if capital is highly mobile internationally; it is less effective if capital is less mobile.

dollar-short banks. For their banks that already had plentiful dollars, the program assured these banks that they would have ready access to dol- lars in the future and encouraged the banks to lend their dollars rather than hoarding them. Studies show that the dollar loans from the swap lines contributed to the reduction of abnormally high interbank interest rates. Another indication

of the success of the swap lines appeared a little later in 2010. With the euro crisis that began with Greece’s government debt problems, dollar fund- ing for foreign financial institutions again became constricted. In response, in May 2010 the Fed established new central bank liquidity swap lines with the ECB and four other central banks.

pug21774_ch24_603-627.indd 623pug21774_ch24_603-627.indd 623 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

624 Part Four Macro Policies for Open Economies

The ways in which different kinds of shocks affect the country’s economy also dif-

fer according to whether the country has a fixed or floating exchange rate. Figure 24.7

summarizes the conclusions of the analysis of this chapter and Chapter 23. This fig-

ure indicates whether a particular shock would change domestic product and income

more (be more disruptive or less stable) with fixed or with floating exchange rates.

We can reach several general conclusions. First, internal shocks, especially domestic monetary shocks, are more disruptive to an economy with a floating exchange rate and are less disruptive with a fixed exchange rate. Second, external shocks, espe-

cially international trade shocks, are more disruptive to an economy with a fixed exchange rate and are less disruptive with a floating exchange rate. Floating exchange

rates provide some insulation from foreign trade shocks.

While cleanly floating exchange rates can ensure that the country achieves external

balance, they do not ensure internal balance. In several situations the exchange-rate

change that reestablishes external balance can make an internal imbalance worse.

If a country has rising inflation and a tendency toward external deficit, the depre-

ciation of the currency can exacerbate the inflation pressures in the country. If the

country has excessive unemployment and a tendency toward surplus, the appre-

ciation of the currency can make the unemployment problem worse. To achieve

internal balance, the country’s government may need to implement domestic policy

changes (contractionary to fight inflation, expansionary to fight unemployment).

In theory, international macroeconomic policy coordination can improve global macroeconomic performance. International policy coordination means that

countries set their policies jointly. The benefits of coordination include the opportunity

to consider spillover effects on other countries that arise from interdependence and the

opportunity to avoid beggar-thy-neighbor policies that benefit one country at the expense

of others. In practice, major instances of international policy coordination are infrequent.

FIGURE 24.7 Ranking of

Exchange-Rate

Systems by

Unit Impacts

of Various

Exogenous

Shocks on

Domestic

Product and

Income

More Disruptive– Less Disruptive– Less Stable More Stable

Internal Shocks

Domestic monetary shock Floating Fixed Domestic spending shock Floating* Fixed*

External Shocks

International trade shock Fixed Floating International capital-flow shock Fixed† Floating†

Comparison is between (1) a fixed exchange rate defended by intervention with no sterilization,

so adjustment is through money supply changes, and (2) a floating exchange rate with adjustment

through exchange-rate changes. If sterilized intervention is used to defend the fixed exchange rate,

this raises the disruptiveness of internal shocks, and it lowers the disruptiveness of external shocks,

each relative to fixed rates with unsterilized intervention.

*This is the result if international capital flows are unresponsive to interest rate differences (low capital

mobility), or if the current account change eventually is the dominant pressure on the exchange rate. The

opposite result applies if the financial account change is the dominant pressure. † The effect of the shock on national income is in the opposite direction for the two cases. The sense in which

the shock is less disruptive under a floating exchange rate is that the induced exchange-rate change with

floating exchange rates shifts the FE curve back toward its original position.

pug21774_ch24_603-627.indd 624pug21774_ch24_603-627.indd 624 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

Questions and Problems

1. “Overshooting is the basis for the enhanced effectiveness of monetary policy under

floating exchange rates.” Do you agree or disagree? Why?

2. A country has a floating exchange rate. Government spending now increases in an

effort to reduce unemployment. What is the effect of this policy change on the

exchange-rate value of the country’s currency? Under what circumstances does the

exchange-rate change reduce the expansionary effect of the fiscal change?

3. “A drop in the foreign demand for our exports has a larger effect on our domestic prod-

uct and income under floating exchange rates than it would under fixed exchange rates.”

Do you agree or disagree? Why?

4. Describe the effects of a sudden decrease in the domestic demand for holding money

(a shift from wanting to hold domestic money to wanting to hold domestic bonds) on our

domestic product and income under floating exchange rates. Is the change in domestic

product and income greater or less than it would be under fixed exchange rates? ( Hint: A decrease in the demand for money is like an increase in the supply of money.)

5. A country has a rising inflation rate and a tendency for its overall payments to go into

deficit. Will the resulting exchange-rate change move the country closer to or further

from internal balance?

6. Britain has instituted a contractionary monetary policy to fight inflation. The pound is

floating.

a. If the exchange-rate value of the pound remains steady, what are the effects of tighter money on British domestic product and income? What is the effect on the British

inflation rate? Explain.

✦

Chapter 24 Floating Exchange Rates and Internal Balance 625

Suggested Reading

Genberg and Swoboda (1989) present a technical analysis of the effects of government

policies on current account balances under floating exchange rates. International

macroeconomic policy coordination is discussed in Bryant (1995) and Meyer et al.

(2002). Cline (2005) and Iley and Lewis (2007) examine the U.S. current account

deficit and the U.S. international investment position. Goldberg et al. (2011) provide an

overview of central bank liquidity swaps.

Neeley (2011) and Sarno and Taylor (2001) survey the theory of and evidence on the

use of sterilized intervention to manage floating exchange rates. Ito (2003) and Fatum

and Hutchison (2006) examine Japan’s intervention during the 1990s, and Fatum and

Hutchison (2002) look at the ECB intervention in 2000.

Neely (2001) and Mihaljek (2005) present the results of surveys of central banks

about their intervention practices. Menkhoff (2013) provides an overview of research on

intervention by monetary authorities in developing countries. Aizenman and Glick (2009)

find a high degree of sterilization of foreign exchange interventions for the Asian and

Latin American countries they examine.

Key Terms Domestic monetary shock Domestic spending

shock

International capital-flow

shock

International trade shock

International

macroeconomic policy

coordination

pug21774_ch24_603-627.indd 625pug21774_ch24_603-627.indd 625 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

626 Part Four Macro Policies for Open Economies

b. Following the shift to tighter money, what is the pressure on the exchange-rate value of the pound? Explain.

c. What are the implications of the change in the exchange-rate value of the pound for domestic product and inflation in Britain? Does the exchange-rate change tend to re-

inforce or counteract the contractionary thrust of British monetary policy? Explain.

7. In the late 1980s, the United States had a large government budget deficit and a large

current account deficit. The dollar was floating. One approach suggested to reduce

both of these deficits was a large increase in taxes.

a. If the exchange-rate value of the dollar remained steady, how would this change affect U.S. domestic product and income? How would it affect the U.S. current

account balance and the U.S. financial account balance? Explain.

b. What are the possible pressures on the exchange-rate value of the dollar as a result of this change in fiscal policy? Explain.

c. If the dollar actually depreciates, what are the implications for further changes in U.S. domestic product and the U.S. current account balance? Explain.

8. What are the effects of a sudden surge in foreign money supplies on our domestic

product and income under floating exchange rates? ( Hint: The increase in the foreign money supplies will have an impact on demand for our exports and on international

capital flows as well as on exchange rates.)

9. A country initially has achieved both external balance and internal balance.

International financial capital is highly but not perfectly mobile, so the country’s FE

curve is upward sloping and flatter than the LM curve. The country has a floating

exchange rate. As a result of the election of a new government, foreign investors

become bullish on the country. International financial capital inflows increase

dramatically and remain higher for a number of years.

a. What shift occurs in the FE curve because of the increased capital inflows? b. What change in the exchange rate occurs to reestablish external balance? c. As a result of the exchange-rate change, how does the country adjust back to exter-

nal balance? Illustrate this using an IS–LM–FE graph. What is the effect of all of

this on the country’s internal balance?

10. A country initially has achieved both external balance and internal balance. The

country prohibits international financial capital inflows and outflows, so its financial

account (excluding official reserves transactions) is always zero because of these

capital controls. The country has a floating exchange rate. An exogenous shock now

occurs—foreign demand for the country’s exports increases.

a. What shifts would occur in the IS, LM, and FE curves because of the increase in foreign demand for the country’s exports if the exchange-rate value of the coun-

try’s currency were to remain unchanged?

b. What change in the exchange-rate value of the country’s currency actually occurs? Why?

c. As a result of the exchange-rate change, how does the country adjust back to exter- nal balance? Illustrate this using an IS–LM–FE graph. How does all of this affect

the country’s internal balance?

✦

pug21774_ch24_603-627.indd 626pug21774_ch24_603-627.indd 626 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

11. Each of the following indicates a series of foreign exchange interventions by the

monetary authority of a country. For each, do you think that the authority effectively

made a profit or not?

a. The local currency is pesos. In January the authority intervenes to sell U.S. dol- lars at the rate $3.00/peso. In June it intervenes to buy dollars at $3.50/peso. In

November it intervenes to sell dollars at $3.10/peso. In June of the next year it

intervenes to buy dollars at $3.40/peso.

b. The local currency is the yen. In February the authority intervenes to sell yen at $0.60/yen. In October it intervenes to sell yen at $0.55/yen. The next year it in-

tervenes to sell yen in March at $0.51/yen. In April the exchange rate stabilizes at

$0.50/yen, and the authority ceases its intervention.

12. The exchange rates between the world’s major currencies are floating. Each major

country in the world is using its monetary policy to attempt to improve the country’s

international price competitiveness during the next few years. Is this a situation

in which international macroeconomic policy coordination could be useful? Why or

why not?

✦

Chapter 24 Floating Exchange Rates and Internal Balance 627

pug21774_ch24_603-627.indd 627pug21774_ch24_603-627.indd 627 29/11/14 8:43 pm29/11/14 8:43 pm

Final PDF to printer

628

Chapter Twenty-Five

National and Global Choices: Floating Rates and the Alternatives This chapter provides a capstone for our analysis of international economic and finan-

cial performance, by exploring the issues that surround countries’ choices of policies

toward the exchange rate.

What exchange-rate policy should a country use? Should it use a clean float in

which private supply and demand determine the exchange rate? Should it commit to

a fixed rate that it defends and attempts never to change? Should it generally use a

floating, market-driven exchange rate but manage that rate to try to modify the market

outcome some of the time? Should it use a fixed rate but be willing from time to time,

or perhaps even quite frequently, to change the pegged-rate value?

Each country must choose its policy. The analysis of Chapters 16 through 24 provides

a broad range of insights into the economics of this choice. This chapter pulls these

insights together by exploring the key issues to consider. We will see that the issues

suggest that each policy has both strengths and weaknesses, so different countries might

wisely choose different policies.

The composite of all countries’ choices results in the global exchange-rate system.

At times in the past century, countries have created a coherent global regime around

a single policy—fixing to gold during the gold standard, and the adjustable pegged

system based on the U.S. dollar that we call the Bretton Woods system. At other times

countries have made more varied choices, so characterizing the system during those

times is not so easy. For instance, the period between the two world wars did not have

a dominant policy, especially after the attempt to return to the gold standard broke

down in the early 1930s.

In the current period different countries use different exchange-rate policies. Our

analysis provides insights into their choices and into the general trend toward float-

ing exchange rates. After discussing this trend, the chapter takes a look at three paths

in the opposite direction, toward fixed exchange rates that are (nearly) permanent.

The members of the European Union are on the most far-reaching of these paths, to a

monetary union with a single European currency.

pug21774_ch25_628-654.indd 628pug21774_ch25_628-654.indd 628 12/5/14 5:41 PM12/5/14 5:41 PM

Final PDF to printer

Chapter 25 National and Global Choices: Floating Rates and the Alternatives 629

KEY ISSUES IN THE CHOICE OF EXCHANGE-RATE POLICY

A country must choose its exchange-rate policy from a menu of many alternatives.

The aspect of the policy that we examine is the extent of flexibility that is permitted

by the policy. On the one side is a policy that permits substantial flexibility, with a rate

that is floating and largely (if not completely) market-driven. The polar case here is a

cleanly floating exchange rate, but a lightly managed floating rate also fits the type.

On the other side is a policy that fixes or pegs the exchange-rate value of the country’s

currency to a major foreign currency or a basket of foreign currencies. 1 A permanently

fixed exchange rate is the polar case, but we should keep in mind that it is impossible

for a country to commit never to change its policy.

Our previous analysis suggests that five major issues can influence the country’s

choice: the effects of macroeconomic shocks; the effectiveness of government policies;

differences in macroeconomic goals, priorities, and policies; controlling inflation; and

the real effects of exchange-rate variability. Let’s look at each major issue and what it

says about the advantages and disadvantages of floating or fixing. Figure 25.1 provides

a road map that you can use as you read through this section of the chapter.

Effects of Macroeconomic Shocks A country would look favorably on an exchange-rate policy that reduces the domestic

effects of macroeconomic shocks. The performance of the country’s economy is bet-

ter if shocks are less disruptive because the economy is more stable. Our analysis of

Chapters 23 and 24 indicates that the effects of various macroeconomic shocks depend

not only on the exchange-rate policy but also on the type of shock.2

Internal shocks generally cause less trouble with a fixed rate than with a float. A domestic monetary shock is less disruptive with a fixed exchange rate because

the intervention to defend the fixed rate tends to reverse the shock and its effects.

With a floating exchange rate the resulting change in the exchange rate would actu-

ally magnify the domestic effects of the monetary shock. For example, consider what

happens if the demand for holding money increases unexpectedly, perhaps because

people become wary of using credit cards and begin to pay more often with cash. The

extra money demand increases domestic interest rates and reduces domestic product

by discouraging interest-sensitive spending. The country’s overall balance of pay-

ments tends toward surplus, as the financial account improves because of increased

capital inflows and the current account improves because of lower domestic spending

and demand for imports.

1A small number of often-vocal commentators believe that countries should return to fixing the values of their currencies to a commodity like gold. The box “What Role for Gold?” explores this possibility.

2 Most of our discussion here continues to make the assumptions that product prices are rather sticky in the short run but that they do adjust to spending and monetary pressures in the long run. The discussion of the effects of shocks focuses on the short and medium runs, when shocks can cause cyclical movements in spending, production, and unemployment. In addition, our discussion of macroeconomic effects under fixed exchange rates focuses on the case in which the government does not or cannot sterilize, so the intervention does affect the domestic money supply.

pug21774_ch25_628-654.indd 629pug21774_ch25_628-654.indd 629 29/11/14 6:10 pm29/11/14 6:10 pm

Final PDF to printer

630 Part Four Macro Policies for Open Economies

Advantage of Floating Advantage of Fixed Issue Exchange Rates Exchange Rates

Effects of macroeconomic shocks With floating rates external shocks, With fixed rates internal shocks, especially foreign trade shocks, are especially domestic monetary less disruptive. shocks, are less disruptive.

Effectiveness of government With floating rates monetary policy — policies is more effective in influencing aggregate demand.

With floating rates fiscal policy With fixed rates fiscal policy is is more effective if capital flows are more effective if capital flows not very responsive to are sufficiently responsive to interest rates. interest rates.

Differences in macroeconomic Floating rates allow goals and Fixed rates require coordination or goals and policies policies to differ across countries. consistency of goals and policies across countries.

Controlling inflation Floating rates allow each country With fixed rates countries should to choose its own acceptable have about the same inflation inflation rate. rates. This creates a discipline effect on high-inflation countries (but low-inflation countries may “import” higher inflation).

Real effects of exchange-rate Variability of floating rates is Variability of floating rates, variability desirable. It shows that the market especially between the major is working well as supply and currencies, is excessive. The rates demand shift. The rate variability may be driven at times by reflects unstable economic and bandwagons and speculative political environments. Real effects bubbles. The variability causes on international trade are not that undesirable real effects. Exchange- large because much exchange-rate rate risk lowers trade volumes. risk can be hedged. Overshooting causes excessive resource shifts into and out of trade-oriented industries.

A fixed rate is simply a form of The relative stability of fixed rates price control. The fixed-rate value is may promote higher levels of often inefficiently low or high, international transactions, causing inefficient resource especially trade. allocations.

FIGURE 25.1 Advantages of Floating Exchange Rates and Fixed Exchange Rates in Terms of Various Issues

1. With a fixed exchange rate, the country’s central bank must intervene to prevent

the country’s currency from appreciating. As the central bank sells domestic currency, the

intervention increases the domestic money supply. The extra money demand is now met

by an increased money supply, and interest rates can fall back toward their original level.

The fall in interest rates spurs a recovery of interest-sensitive spending and domestic

product.

pug21774_ch25_628-654.indd 630pug21774_ch25_628-654.indd 630 29/11/14 6:10 pm29/11/14 6:10 pm

Final PDF to printer

Case Study What Role for Gold?

Gold was at the center of the international monetary system during the gold standard. Individuals had the right to obtain or sell gold (in exchange for national currency) with the coun- try’s central bank at the fixed official gold price. Gold was also an important part of the Bretton Woods system of fixed exchange rates. The U.S. government was expected to buy or sell gold with foreign central banks (but not with individu- als) at the official U.S. dollar price of gold.

What is the role for gold now? Gold remains an official reserve asset, but currently central banks make almost no official use of gold. Gold is also held by private individuals as part of their investments. Let’s look at both the official role and private role for gold more closely.

OFFICIAL ROLE: THE ONCE AND FUTURE KING?

You shall not crucify mankind upon a cross of gold. William Jennings Bryan, U.S. presidential candidate, 1896

Most observers of the current system are com- fortable with the lack of a role for gold in official international activity. Indeed, some believe that central banks and the International Monetary Fund should sell off their current official hold- ings of gold. One reason to sell is that gold plays no active role and earns no interest. The part of national wealth (or IMF assets) held in gold could be invested more productively. Another reason is that the proceeds of gold sales could be used for assistance to the poorer countries of the world. Central banks and the IMF have made gold sales into the private market in recent decades (a pro- cess called demonetization of gold ).

A small group of people are strong advocates of a return to a real gold standard in which coun- tries tie their currencies to gold. These proponents believe that a return to a gold standard would greatly reduce national and average global rates

of inflation by creating a strong discipline effect on countries’ abilities to expand their money supplies. They also believe that a return to a gold standard would eliminate the variability of exchange rates by establishing full confidence in the system and by enforcing monetary adjust- ments to achieve external balance. By creating stability and confidence in national moneys and exchange rates, they believe, the return to a gold standard would stabilize and lower both nominal and real interest rates.

Most international economists oppose a return to the gold standard. To most, a gold standard is not nearly as stabilizing as its pro- ponents claim, except perhaps in the very long run. The supply of new gold to the world is governed not by some master regulator, but rather by mining activities. A major discovery of new minable gold deposits leads to a rapid expansion of the world gold supply. As central banks bought gold to defend the fixed gold prices, national money supplies would expand rapidly and inflation rates would increase. On the other hand, if there were no new discover- ies, and if current mines slowed output as mines were exhausted (or if major strikes or similar disruptions slowed output), national central banks would have to sell gold to defend their price (assuming that private demand continued to grow). National money supplies would shrink and countries would enter into painful defla- tions (with weak economic conditions forcing general price levels lower).

Looking at the other side of the market for gold, decreases in private demand for gold would require central banks to buy gold to defend their price, expanding money supplies. Increases in private demand would force central banks to sell gold, shrinking national money supplies.

Supply swings were evident even during the classical gold standard. Between 1873 and 1896, the British price level fell by about one-third, and it then inflated back up from 1896 to 1913. These

—Continued on next page

Chapter 25 National and Global Choices: Floating Rates and the Alternatives 631

pug21774_ch25_628-654.indd 631pug21774_ch25_628-654.indd 631 29/11/14 6:10 pm29/11/14 6:10 pm

Final PDF to printer

shifts were closely related to changes in the growth rates of world stocks of monetary gold, and these were closely related to cycles in mining driven by gold discoveries.

Between 1850 and 1873, the world gold stock grew by 2.9 percent per year, with dis- coveries leading to mining booms in California and Australia. This permitted money supplies to keep up with the growing real demand for money, so that price levels remained about steady. Between 1873 and 1896, the world gold stock grew by only 1.7 percent per year. This was not enough to keep up with continued growth in real money demand, and the gen- eral price level was forced down. Then from 1896 to 1913, new discoveries of gold led to mining booms in the Klondike (Canada) and the Transvaal (South Africa). The world gold stock rose 3.2 percent per year, faster than real money demand was growing, so the general price level increased. With such fluctuations in the growth of monetary gold, it is difficult to claim that the gold standard ensured steady expansion of the world money base (although the gold standard did limit money growth and inflation in the long run).

Because a gold standard probably would not be nearly as stable as its proponents claim, most international economists oppose a return to a gold standard. Bolstering their belief are the more typical arguments about the advantages of flex- ible or floating exchange rates, including indepen- dence in choosing priorities and using policies. In addition, the resource costs of expanding official gold reserves are themselves high. New gold must be mined. This seems to be an inefficient use of resources, to produce something that will largely sit in the vaults of central banks.

PRIVATE ROLE: A SOUND INVESTMENT? The official link between gold and currencies effectively ended in 1968, and it seems unlikely to be revived. Even though its official role has largely ended, should gold play a role in the investments of private individuals? Holding gold

pays no interest, so the return to gold comes from increases in its price. (The return earned is actually lower than the price increase suggests because of the costs of buying and selling as well as the costs of storing and safekeeping.)

The accompanying graph shows the monthly dollar price of gold since 1970. There are three lessons from this graph. First, anyone who bought gold in the early 1970s earned a high rate of return through 1980, as the dollar price increased from under $100 per ounce to over $600 per ounce. Similarly, anyone who bought in the early 2000s earned a high return, as the gold price rose from less than $300 to about $1,800 in September 2011. For each of these time periods, the gold-price increase far exceeded general price inflation or the rates of return available on most financial assets.

Second, anyone who bought and sold gold from the early 1980s to the early 2000s gener- ally was disappointed. The gold price stayed in the range of $250 to $500 per ounce. The gold price did not keep up with general price infla- tion, and it underperformed compared to the returns available on many financial assets like stocks and bonds.

Third, far from being stable, or tracking gen- eral price inflation as an “inflation hedge,” the gold price has fluctuated a lot. It soared during 1979–1980, falling back during 1980–1982, rose strongly during 1982, and so forth.

Why has the price of gold jumped around so much during the past several decades? Shifts in supply have some impact, but major pressure often comes from shifts in demand. To a large extent gold is what frightened people invest in. This part of demand increases and decreases as fears and tensions rise and subside.

Suppose you are wealthy and live in an unsta- ble region of the world. Clandestine gold own- ership can protect you from having your assets seized or heavily taxed. Or suppose you fear an explosion of inflation. Holding real assets like gold provides at least some protection against the loss of purchasing power that will afflict most

632 Part Four Macro Policies for Open Economies

pug21774_ch25_628-654.indd 632pug21774_ch25_628-654.indd 632 29/11/14 6:10 pm29/11/14 6:10 pm

Final PDF to printer

Chapter 25 National and Global Choices: Floating Rates and the Alternatives 633

2. With a floating exchange rate, the tendency toward surplus causes the domestic cur-

rency to appreciate, reducing the country’s international price competitiveness. As exports

decline and imports rise in response to the shift in price competitiveness, the effect of the

shock on the domestic economy is magnified. Domestic product tends to decline more.

The effects of a domestic spending shock , such as an unexpected change in real domestic investment spending or in consumption spending, or a sudden shift in fiscal

policy, depend on how responsive international flows of financial capital are to interest

rate changes. If capital mobility is low, then domestic spending shocks are also less

disruptive with fixed rates than with floating rates. For instance, a decline in domes-

tic spending tends to improve the country’s current account balance as the demand

for imports declines. If this is the dominant effect, the country’s overall international

paper assets. Or suppose you are worried about financial and economic instability resulting from the global crisis that began in 2007, large fiscal deficits in the United States and Europe, the effects of quantitative easing by the Fed. You (and others) buy gold to move out of paper assets, and the price of gold rises rapidly.

Thus, private investments in gold are bets about the future course of gold prices. Over the long term the price of gold has roughly kept up with the rise of general prices (though past

performance is no indicator of future performance). But for any short- or medium-term period of time, gold’s value is anybody’s guess. For a commodity that symbolizes stability, unpredictable shifts in demand and supply can and do cause large swings in gold’s real price.

DISCUSSION QUESTION Would adoption of a new gold standard by the industrialized countries result in better achieve- ment of internal balance for these countries?

Source: International Monetary Fund, International Financial Statistics.

Lo n

d o

n g

o ld

p ri

ce , m

o n

th ly

(U .S

. d

o ll a rs

p e r

fi n

e o

u n

ce )

200

400

600

800

1,000

1,200

1,400

1,600

1,800

Ja n

1 9 7 0

Ja n

1 9 7 5

Ja n

1 9 8 0

Ja n

1 9 8 5

Ja n

1 9 9 0

Ja n

1 9 9 5

Ja n

2 0 0 0

Ja n

2 0 1 0

Ja n

2 0 0 5

pug21774_ch25_628-654.indd 633pug21774_ch25_628-654.indd 633 29/11/14 6:10 pm29/11/14 6:10 pm

Final PDF to printer

634 Part Four Macro Policies for Open Economies

payments also tend toward surplus. As in the monetary example, the payments surplus

results in intervention that expands the domestic money supply if the country has a fixed

exchange rate, and this tends to expand domestic spending, stabilizing the economy to

some extent. With a floating exchange rate, the appreciation of the currency tends to

lower demand and production further. Of course, if capital mobility instead is high, then

the reverse is true—domestic spending shocks are more disruptive with fixed rates.

For external shocks , we reach opposite conclusions about stability and disruption. We can see this most clearly for international trade shocks . Suppose that foreign demand for our exports declines (or, for that matter, that our country’s demand shifts

toward imported foreign products and away from the comparable domestic products).

The decrease in demand for our products tends to put the economy into a recession.

In addition, the country’s current account balance tends to deteriorate, and this tends

to worsen the country’s overall payments balance. With a fixed exchange rate, the

central bank must intervene to defend the fixed rate by buying domestic currency. The

resulting contraction of the domestic money supply reinforces the initial contraction

of demand for our products, adding to the recession. With a floating exchange rate, the

tendency to deficit depreciates the value of our currency. The improvement in price

competitiveness boosts demand for our products, countering the recession tendency.

The effects of foreign trade shocks are important because changes in foreign trade

are a major way in which business cycles are transmitted from one country to another.

With fixed exchange rates business cycles are transmitted through foreign trade, and

the intervention to defend the fixed rate can magnify the transmission. With floating

exchange rates the transmission is muted because exchange-rate changes tend to insu-

late the economy from foreign trade shocks.

International trade shocks are particularly important for small developing coun-

tries, which are frequently affected by changes in the world prices (stated in foreign

currency) of their exportable products. Christian Broda (2004) examined the effects

of a 10 percent decrease in the price of a developing country’s exports. He confirms

that a floating exchange rate buffers the effects on the country. For a typical develop-

ing country that has a fixed exchange rate, the decline in the country’s terms of trade

causes a sharp decline of real GDP of about 2 percent in two years. For a typical

developing country with a floating exchange rate, the two-year decrease in real GDP

is only 0.2 percent. With a floating exchange rate, a quick nominal depreciation of the

country’s currency results in a 5 percent decrease in the real exchange-rate value of the

country’s currency. The country’s enhanced price competitiveness increases exports

and decreases imports, so the tendency toward declining GDP is offset.

International capital-flow shocks have domestic effects under both fixed and float- ing exchange rates, but there is a sense in which they are less disruptive under float-

ing exchange rates. With a fixed exchange rate, an adverse capital-flow shift, which

results in a capital outflow, requires intervention to defend the fixed rate by buying

domestic currency. The reduction in the domestic money supply (if the intervention is

not sterilized) has an adverse effect on the economy by raising interest rates and reduc-

ing spending. Under floating exchange rates, the currency depreciates. Any adverse

effect that the capital outflow itself might have on the country’s production is countered

by the improvement in trade that results from better international price competitiveness.

The differences in the effects of shocks on the economy can have an impact on

a country’s choice of exchange-rate policy. If the country believes that it is buffeted

pug21774_ch25_628-654.indd 634pug21774_ch25_628-654.indd 634 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

Chapter 25 National and Global Choices: Floating Rates and the Alternatives 635

mainly by internal shocks, the country favors a fixed exchange rate. If it believes that

most shocks are external, then it favors a floating exchange rate.

However, we also must add a caution to this conclusion. While its conceptual basis

is clear, its practical importance is actually debatable for several reasons. The most

important reason is that the effects of shocks under fixed exchange rates depend on

whether interventions are sterilized. The previous discussion has assumed that inter-

vention is not sterilized. If, instead, the intervention is sterilized, the domestic money

supply does not change. This reduces the stabilizing properties of fixed rates when

internal shocks hit the economy, and it reduces the disruptive effects when external

shocks hit. (Of course, continued sterilization may not be feasible if the payments

imbalance persists, but the short-run behavior is still altered.)

The Effectiveness of Government Policies Government policies’ influence on aggregate demand and domestic product is altered

by the type of exchange-rate policy chosen by the country. Monetary policy loses

its control over the money supply if the country has a fixed exchange rate because

monetary policy is constrained by the need to defend the fixed exchange rate. If the

country tries to implement an expansionary monetary policy, the payments balance

tends to go into deficit, and intervention to defend the fixed rate reduces the domestic

money supply and reverses the monetary expansion. Indeed, if the country has a pay-

ments deficit for any reason, the intervention reduces the domestic money supply. If

instead the country tries to implement a contractionary monetary policy, the payments

balance tends to go into surplus, and the intervention to defend the fixed rate increases

the domestic money supply and reverses the monetary contraction. In fact, a payments

surplus for any reason expands the domestic money supply.

The country’s monetary authority can attempt to regain some control over domestic

monetary policy by sterilizing to reverse the effect of the intervention on the money

supply, but there is a limit to how long it can continue to sterilize. Indeed, if interna-

tional capital is highly or perfectly mobile, sterilized intervention cannot work. With

perfect capital mobility, a country that is committed to defending a fixed exchange rate

loses it power to have an independent monetary policy (because its monetary policy,

such as it is, must be directed to defending the fixed exchange rate). The impossibility

for a country to maintain a fixed exchange rate, to permit free capital flows, and to

have a monetary policy directed toward domestic objectives is often called the incon- sistent trinity or trilemma.

Monetary policy gains effectiveness under floating exchange rates. The result-

ing change in the exchange rate reinforces the thrust of the policy change. A shift

to expansionary monetary policy results in a depreciation of the country’s currency.

The improvement in price competitiveness further expands demand for the country’s

products. A shift to contractionary policy appreciates the country’s currency, resulting

in a further reduction in demand for the country’s products.

The effectiveness of fiscal policy depends on how responsive international capital

flows are to interest rates. If capital is highly mobile, then fiscal policy gains effective-

ness under fixed rates. The intervention to defend the fixed rate reduces the change

in domestic interest rates, so that there is less domestic crowding out. With floating

exchange rates and highly mobile capital, fiscal policy loses effectiveness. The result-

ing exchange-rate change leads to international crowding out. If capital is not that

pug21774_ch25_628-654.indd 635pug21774_ch25_628-654.indd 635 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

636 Part Four Macro Policies for Open Economies

mobile, or if capital flows decline beyond a short-run period, the reverse is true. Fiscal

policy then loses effectiveness with a fixed exchange rate and gains effectiveness with

a floating rate.

The country’s choice of exchange-rate policy can be influenced by its impact on the

effectiveness of fiscal policy. A country whose capital markets are closely linked to the

rest of the world, so that capital is highly mobile, will view a fixed exchange rate more

favorably if it wants fiscal policy to be highly effective in the short run. A country

whose capital flows are less responsive, or one that is worried about the effectiveness

of fiscal policy beyond the short-run period when capital flows are responding, will

look more favorably on floating rates.

While the impact of fiscal policy effectiveness on the choice of exchange-rate

policy is conditional, the impact of monetary policy effectiveness is straightforward.

If a country desires to use monetary policy to address domestic objectives, then the country will favor a floating exchange rate . A floating rate frees monetary policy from the need to defend the exchange rate.

Differences in Macroeconomic Goals, Priorities, and Policies Government policymakers in each country must decide on the goals and objectives of

macroeconomic policy. Even if countries generally pursue the same set of macroeco-

nomic performance goals—including real economic growth, low unemployment, low

inflation, and external balance—the priorities that governments place on the goals can

differ, as can the specific policies adopted to achieve the goals.

For fixed exchange rates between the currencies of two or more countries to be

successful, a kind of consistency or coordination between the countries involved is

necessary. A country choosing a fixed exchange rate must follow policies that permit

successful defense of the rate, given the policies and performance of the other countries

linked by the fixed rates. If the policies diverge noticeably, large payments imbalances

are likely to develop, making the defense of the fixed rates difficult or impossible.

One example is that countries should be willing to refrain from policy changes

that lead to large international capital flows, or coordinate such changes in poli-

cies across countries. For instance, a big reduction in the taxes that one country

imposes on financial investments can lead to large international capital flows

into the country. If the other countries must intervene to defend the fixed rates as

capital flows out of their countries, their international reserve holdings decline,

threatening their ability to continue to defend the fixed rates. To maintain fixed

rates, the first country may need to temper policy changes such as this. Or the

other countries may need to adopt their own policy changes to mute the incentives

for capital flows. For instance, the other countries could also lower their taxes on

financial investments, or they could raise their interest rates. These changes would

create a kind of consistency or coordination that reduces the threat to the viability

of the fixed-rate system.

Another example is the priority that each country places on controlling inflation, or

the trade-off that each country is willing to make between inflation and unemployment.

For instance, during the years of the Bretton Woods system, Germany and Switzerland

placed the highest priority on maintaining a very low inflation rate. The United States

was less concerned with inflation and more concerned with growth and employment.

pug21774_ch25_628-654.indd 636pug21774_ch25_628-654.indd 636 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

Chapter 25 National and Global Choices: Floating Rates and the Alternatives 637

Even if there is no long-run trade-off between inflation and unemployment, such dif-

ferences in priorities can still influence policy in the short run. The United States was

willing to risk somewhat higher inflation to reduce unemployment in the short run, while

Germany and Switzerland were not. The United States ended up with a higher infla-

tion rate than Germany or Switzerland, and neither side was willing to compromise to

achieve consistency. The fixed rates could not be maintained. We examine the relation-

ship of inflation rates and exchange-rate policy in more depth in the next section.

Floating exchange rates are tolerant of diversity in countries’ goals, priorities, and policies . As long as the country is willing to let the exchange rate change according to market pressures, external balance in the country’s overall payments is maintained,

whatever the country’s policies. International policy coordination is still possible across

countries, as we discussed in the previous chapter, but it is not necessary. There is no

doubt that floating exchange rates permit a country to be more independent in its choices

of policies, but we should also be a little cautious with this proposition. Policymakers

in a country often are concerned about movements in the exchange-rate value of the

country’s currency, so their policy choices are somewhat constrained, even with float-

ing rates. For instance, in the early 1980s unemployment rates were high in a number

of the major European countries. However, they did not shift to expansionary policies

because their currencies were already weak against the dollar. In fact, they tightened up

and raised their interest rates to prevent their currencies from weakening further.

Controlling Inflation The relationship between the choice of exchange-rate policy and a country’s inflation

rate is an important issue for the country. In addition, this issue has broad meaning for

global macroeconomic performance, especially for the average rate of global inflation.

Countries that choose to fix the exchange rates among their currencies are commit-

ting to have similar inflation rates over the long run. This is the prediction of purchasing

power parity—a nominal exchange rate can be steady only if the difference in inflation

rates between the countries is about zero. The logic is based on the need to maintain

reasonable price competitiveness for the products of each country. If inflation rates are

consistently different over a substantial period of time, and exchange rates are fixed, a

low-inflation country steadily gains international price competitiveness, leading to cur-

rent account surpluses. A high-inflation country steadily loses price competitiveness,

leading to deficits. These continuing and growing surpluses and deficits are not sustain-

able, and something needs to adjust. The inflation rate in the low-inflation country can

increase, the inflation rate in the high-inflation country can decrease, or the exchange

rate can change. If inflation rates change, then the fixed rate can be maintained, but the

inflation difference instead can result in surrender of the fixed rate.

A number of implications follow from the conclusion that countries that fix their

exchange rates should have similar inflation rates. First, proponents of fixed rates

argue that fixed rates create a discipline effect on national tendencies to run high infla-

tion rates. For the fixed rate to be sustained, a country cannot have an inflation rate that is much above the inflation rate(s) of its partner(s) . In fact, a country embarking on a serious effort to reduce its high inflation rate may deliberately choose to fix its

currency to the currency of another country that has a lower inflation rate. The high-

inflation country is using the discipline effect as part of its anti-inflation program.

pug21774_ch25_628-654.indd 637pug21774_ch25_628-654.indd 637 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

638 Part Four Macro Policies for Open Economies

The high-inflation country hopes that the peg to the other country’s currency can

establish the credibility of its anti-inflation program. If it can gain credibility, it has a

greater chance of success because people will lower their estimate of how much infla-

tion will occur in the future. If inflation expectations are lowered, then it is easier to

lower actual inflation and keep it low. Argentina used this strategy successfully in the

early 1990s. In 1989, prices in Argentina rose by about 3,000 percent; in 1990, they

climbed by about 2,300 percent. Argentina began an anti-inflation program and, in

1991, fixed the value of the peso to the U.S. dollar. The discipline of this peg helped

reduce the growth rate of the money supply and the inflation rate in Argentina. By

1994, Argentinean inflation had dropped to about 4 percent, nearly the same as that in

the United States, and it remained close to zero through the rest of the 1990s.

Second, a fixed-rate system in which most countries participate may also impose

price discipline to lower the average global rate of price inflation. The fixed-rate system puts more pressure on governments whose countries have international deficits

than on governments that have surpluses:

• Deficit countries face an obvious limit on their ability to sustain deficits; they soon

run out of reserves and creditworthiness. Even if they attempt to sterilize their inter-

ventions, they must tighten up on their money supplies fairly quickly if they are

to maintain the fixed rate. This forces them to contract, which lowers their money

growth and inflation rate.

• Surplus countries, in contrast, face only more distant and manageable inconveniences

from perennial surpluses. As long as they are willing to accumulate additional official

reserves, they should be able to use sterilized intervention for an extended period.

Thus, the deficit countries tend to lower their money growth, while the surplus coun-

tries tend not to raise theirs. Overall there is less money growth in the world and a lower average inflation rate.

With the price discipline of fixed exchange rates, there is a greater chance that

countries have similar inflation and that the average inflation rate may be somewhat

lower than the average that each country would choose on its own. If the system has

a leading country, such as the United States in Bretton Woods, then countries tend to

have to match the inflation rate of this lead country. For countries that would have had

a higher inflation rate, the system is imposing a discipline effect. But other countries

might prefer an even lower inflation rate.

This observation leads to the third implication. With fixed exchange rates, a country

that prefers to have a lower inflation rate than that of other countries, especially the

lead country in the system, will have difficulty maintaining this low inflation rate. It

will tend to “import inflation” from the other countries. Germany complained of this

pressure in the 1960s as the inflation rate in the United States rose.

In contrast to all of this, floating exchange rates simply permit countries to have dif- ferent inflation rates . According to purchasing power parity, high-inflation countries tend to have depreciating currencies and low-inflation countries tend to have appreci-

ating currencies. The nominal exchange-rate changes maintain reasonable price com-

petitiveness for both types of countries in the long run. Proponents of floating rates

generally view this as a virtue. Different countries’ policymakers may have different

beliefs as to what an acceptable inflation rate is. These beliefs may be the result of

historic events, such as the hyperinflation of the 1920s in Germany, which has resulted

pug21774_ch25_628-654.indd 638pug21774_ch25_628-654.indd 638 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

Chapter 25 National and Global Choices: Floating Rates and the Alternatives 639

in a strong German preference for very low inflation. Or they may be the result of a

series of decisions about acceptable trade-offs of a little more inflation in order to

reduce unemployment. This was the situation of the United States in the 1970s, and

it resulted in rather high inflation. Or the government may choose to “finance” its

large budget deficit by printing money (rather than by borrowing through the issue of

government bonds). The rapid money growth leads to high rates of inflation. This has

been the case in some developing countries.

Opponents of floating exchange rates suggest that the ability of each country to

choose its own policies toward inflation results in more inflation worldwide. The

exchange rate does not impose any discipline on money growth and inflation. Instead,

with floating exchange rates a country can be caught in a vicious circle in which

(1) high inflation leads to currency depreciation and (2) the depreciation increases the

domestic currency prices of imports, so the high inflation rate is reinforced. Continuing

high inflation requires further depreciation and so forth. Domestic money growth

simply accommodates this dynamic.

The world experience in the first decade after the shift to general floating in 1973

seemed to be consistent with the concerns of these opponents of floating rates. Average

world inflation in the 1970s was substantially higher than it had been in the 1950s or

1960s. The seeds for some of this higher inflation had been sown, especially in the

United States, beginning in the fixed-rate 1960s. In addition, the two oil shocks of the

1970s presumably would have resulted in higher average inflation even if exchange

rates had remained fixed. Nonetheless, some of the higher inflation was probably the

result of the removal of the discipline of fixed rates.

The world experience since the early 1980s indicates that the tendency toward higher

inflation with floating rates actually may not be a serious problem. The inflation rates in

many of the major countries whose currencies have generally been floating—including

Japan, the United States, and Britain—fell noticeably and remain low. Since the early

1990s, inflation rates in most developing countries have also been low. The experience

since the early 1980s indicates that what really matters in controlling national inflation rates is the discipline and resolve of the national monetary authorities.

Real Effects of Exchange-Rate Variability A major concern about floating exchange rates is that they are highly variable. Some

variability presumably is not controversial, including exchange-rate movements

that offset inflation rate differentials and exchange-rate movements that promote an

orderly adjustment to shocks. However, the substantial variability of exchange rates

within fairly short time periods like months or a few years is more controversial. What

are the possible effects of exchange-rate variability that might concern us?

If the variability simply creates unexpected gains and losses for short-term financial

investors who deliberately take positions exposed to exchange-rate risk, we prob-

ably would not be much concerned. However, we would be concerned if heightened

exchange-rate risk discourages such international activities as trade in goods and

services or foreign direct investment. Exchange-rate variability then would have real effects , by altering activities in the part of the economy that produces goods and services.

Consider international trade in goods and services. Does exchange-rate variability

create risk that leads to lower volumes of trade? First, simple short-run variability may

have little direct impact on trade activities. Anyone engaged in international trade has

pug21774_ch25_628-654.indd 639pug21774_ch25_628-654.indd 639 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

640 Part Four Macro Policies for Open Economies

a range of foreign exchange contracts, including forward foreign exchange, currency

futures, and currency options, that can be used to hedge exposures to exchange-rate risk

in the short run, for many (but not all) currencies in the world. These contracts usually

can be obtained with low transaction costs. Second, exchange-rate variability beyond

the short run can affect the real investments that must be made to support export-

oriented production. If exchange-rate variability raises the riskiness of these real

investments, they tend to be lower if firms are risk-averse. This form of exchange-

rate risk is more difficult to hedge because (1) longer maturities of many contracts

do not exist or are rather expensive to buy and (2) the specific amounts of payments

that might need to be hedged several years in the future are themselves often highly

uncertain.

Economists have studied the overall effect of increased exchange-rate risk on the

volumes of international trade activities. Early studies typically found almost no effect

of exchange-rate variability on trade volumes. More recently, Klein and Shambaugh

(2010, Chapter 9) use the gravity model of trade to show that countries with a fixed

exchange rate between their currencies trade more with each other and that greater

exchange-rate variability has a small negative effect on trade.

Overshooting raises another concern about the real effects of the variability of

floating exchange rates. When exchange rates overshoot, they send signals about

changes in international price competitiveness that seem, to some observers, to be

far too strong. Big swings in price competitiveness create incentives for large shifts

in real resources. If overshooting leads to a large appreciation of the country’s cur-

rency (for instance, the U.S. dollar in the early 1980s), this creates the incentive for

production resources to move out of export-oriented and import-competing industries,

as the country loses a large amount of price competitiveness. New capital investment

in these industries is strongly discouraged and some existing facilities are shut down.

However, as the overshooting then reverses itself, these resource movements appear to

have been excessive. Resources then must move back into these industries.

Relative price adjustments are an important and necessary part of the market

system. They signal the need for resource reallocations. The concern here is not with

relative price changes in general. The concern is with the possibility that the dynamics

of floating exchange rates sometimes send false price signals or signals that are too

strong, resulting in excessive resource reallocations.

This discussion of exchange-rate variability and the real effects of this variability

leads into a broader debate. Proponents and defenders of floating exchange rates agree

that variability has been high and that some real effects occur. But they believe that

this is what markets should do. Exchange rates as prices send signals about the relative

values of currencies. These signals represent the summary of information about the

currencies that is available at that time. As economic and political conditions change,

the prices and signals should change. The variability of exchange rates represents the

ongoing market-based quest for economic efficiency.

The proponents of floating rates believe that the supporters of fixed rates delude

themselves by claiming that the lack of variability of fixed rates is a virtue. A fixed

exchange rate is simply a form of price control . Price controls are generally inefficient because the price is often too high or too low. That is, with a fixed rate the country’s

currency is often overvalued or undervalued by government fiat.

pug21774_ch25_628-654.indd 640pug21774_ch25_628-654.indd 640 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

Chapter 25 National and Global Choices: Floating Rates and the Alternatives 641

Furthermore, a fixed rate is sometimes changed, often suddenly and by a large

amount, when the peg is adjusted through a devaluation or a revaluation. This sudden change can be highly disruptive, and it often occurs in a crisis atmosphere brought on by large capital flows as speculators believe that they have a one-way speculative

gamble on the direction of the exchange-rate change. In addition, with the comfort of a

fixed exchange rate, financial institutions and others in the country that borrow foreign

currencies can ignore or underestimate their exposure to exchange-rate risk. They do

not hedge their currency risk exposure. When a devaluation occurs, their losses can

contribute to a deep financial crisis for the country.

Detractors and opponents of floating exchange rates believe that floating exchange

rates are excessively variable and that this variability has real effects that are inefficient. Some of these detractors view the variability of floating rates as excessive because the

exchange rates themselves are sometimes inefficient, as they are affected by speculative

bandwagons and bubbles that do not reflect the underlying economic fundamentals. Other

detractors, while conceding that floating exchange rates are reasonably efficient prices

from the point of view of their function within the international financial system, believe that floating exchange rates do not serve the broader economy well. Variability and over- shooting may have a logic in international finance, but they nonetheless cause undesirable

real effects like discouragement of international trade and excessive resource shifts.

To these opponents, with floating exchange rates the market often undervalues or

overvalues a country’s currency, at least in relation to the signals that should be sent

to the goods-and-services part of the economy. Exchange rates should make transac-

tions between countries as smooth and easy as possible. To the opponents of floating

rates, exchange rates, like money, serve their transactions functions best when their

values are stable .

NATIONAL CHOICES

We have just examined five major issues that can affect a country’s choice of its

exchange-rate policy. Each country must make its own decision, and that decision

depends on the balancing of a number of factors, including the economic issues

explored here as well as political concerns. While each country will have its own

important issues because of its own economic and political situation, we can none-

theless discern in our set of five issues several factors that are likely to be of major

importance for most countries.

There are several strong arguments in favor of a country adopting a floating exchange

rate. First, a floating exchange rate provides more effective use of two important tools

for adjusting toward internal and external balances. Exchange-rate changes can promote

adjustment to external balance, and monetary policy can be directed toward achieving

internal balance because it does not need to be directed toward defending the exchange

rate. Second, a floating exchange rate permits a country to pursue goals, priorities, and

policies that meet its own domestic preferences and needs, with less concern about how

these will put pressure on the exchange rate. Third, the country does not need to defend a

fixed rate against speculative attacks, a task that is increasingly difficult as large amounts

of internationally mobile capital can be shifted quickly from country to country.

pug21774_ch25_628-654.indd 641pug21774_ch25_628-654.indd 641 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

642 Part Four Macro Policies for Open Economies

The strongest argument against a country adopting a floating exchange rate is that

floating rates have been disturbingly variable since 1973. This variability increases

exchange-rate risk, and this risk does seem to have some effect in discouraging

international activities such as trade in goods and services. In addition, overshoot-

ing of floating exchange rates may have promoted too much adjustment into or out

of trade-oriented production from time to time. A major advantage of fixed rates is

the substantial reduction in variability and exchange-rate risk if the fixed rate can be

defended and the peg is not adjusted too often.

In Chapter 20 we presented countries’ current choices of exchange-rate policy. We

saw that a growing number of countries use some form of floating-rate policy. The

world has been shifting toward floating exchange rates. The advantages of indepen-

dence in crafting and using policies to attain domestic objectives make the choice of a

floating exchange rate increasingly attractive. Put the other way, an increasing number

of governments are unwilling to subordinate money supply, interest rates, and other

policies to defending a fixed exchange rate.

The governments of these countries generally do not adopt the polar case of a clean

float. Rather, they use some form of management of the float. While they like the

advantages of adopting a floating exchange rate, they are also worried about the vari-

ability of floating rates. Through management of the float, the government attempts

to moderate wide swings without becoming chained to an officially announced fixed

rate that would give speculators a clear one-way bet at times.

There are still questions about the management of the float. A government can

make mistakes, or act out of political motives, so that the government is attempting to

resist exchange-rate trends that are justified by the economic fundamentals. There are

also questions about how effective the management can be, at least for the exchange-

rate values of the major currencies. Intervention often seems to have little impact on

the floating rate, and even with management the floating rates are often substantially

variable. Still, overall, for many countries, a managed floating exchange rate seems to be a reasonable compromise choice . It gains much of the policy independence while offering governments some ability to reduce exchange-rate variability.

While the global trend is toward floating, a number of countries continue to maintain

fixed exchange rates. For most of these countries, the compelling argument is that float-

ing exchange rates are too variable. A number of these countries are smaller countries

that fix to the currency of a major trading partner (or to a basket of currencies of major

trading partners). For these countries reducing exchange-rate risk to promote smooth

trade and avoiding overshooting that would disrupt their trade-oriented industries seem

to be the major objectives in choosing an exchange-rate policy. These countries are

willing to sacrifice some economic policy autonomy to obtain exchange-rate stability.

However, a fixed exchange rate that is adjustable—a soft peg that provides sub- stantial leeway for the country’s monetary authority to change or abandon the fixed

value—sometimes invites attack through a one-way speculative gamble if the country

is reasonably open to international capital flows. Such a speculative attack can all

but force the monetary authority to surrender, as in Mexico in late 1994; Thailand,

Indonesia, and South Korea in 1997; Brazil in early 1999; and Turkey in 2001. In

response, some countries have adopted or are considering arrangements that create

more permanent fixes (often called hard pegs ).

pug21774_ch25_628-654.indd 642pug21774_ch25_628-654.indd 642 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

Chapter 25 National and Global Choices: Floating Rates and the Alternatives 643

EXTREME FIXES

The general trend in national exchange-rate policies is toward greater flexibility. But

some countries have moved in the opposite direction—to exchange rates that are not

only fixed but also rather difficult or nearly impossible to change. In this section we

examine currency boards and “dollarization,” two “extreme” forms of fixed rates that

can be adopted by a single country. In the final section of the chapter we examine what

may be the ultimate form of fixed rates—a monetary union among several countries

that agree to a single, unionwide currency.

Currency Board A currency board attempts to establish a fixed exchange rate that is long-lived by mandating that the board, acting as the country’s monetary authority, should focus

almost exclusively on maintaining the fixed rate. A currency board holds only foreign-

currency assets (official reserve assets). The board issues domestic-currency liabilities

only in exchange for foreign-currency assets that it acquires. Because the board owns

no domestic-currency assets, it has no ability to sterilize. This arrangement increases

the credibility of a country’s commitment to maintaining the fixed exchange rate by

automatically linking the domestic money supply to the defense of the fixed rate. For

instance, if increased private selling is putting downward pressure on the exchange-

rate value of the country’s currency, the currency board defends the fixed rate by

buying domestic currency and selling foreign currency. As the board buys domestic

currency, the domestic money supply decreases. This money supply decrease sets in

motion the adjustments discussed at length in Chapter 23, and the currency board has

no power to resist. With no domestic assets, the currency board cannot sterilize the

intervention—the domestic money supply must decrease.

Several very small countries have had currency boards since before 1970, and Hong

Kong established one in 1983 to defend the value of its dollar. During the 1990s,

four transition countries—Estonia, Lithuania, Bulgaria, and Bosnia/Herzegovina—

established currency boards. Argentina set up a currency board in 1991, but it aban-

doned the board amid the turmoil of its 2002 financial crisis.

The experience of Argentina shows the advantages and disadvantages of a currency

board. Argentina’s government established a currency board to signal its commitment

to stop the country’s hyperinflation, by imposing strict discipline to limit the growth of

Argentina’s money supply. As we saw earlier in the chapter, this effort was successful

in its early years. With inflation quickly reduced, interest rates decreased and economic

growth increased. After almost no growth of its real GDP during the 1980s, Argentina’s

annual real growth averaged nearly 4 percent during 1992–1998.

However, the Argentinean economy was vulnerable to adverse external shocks. The

fallout from the Mexican peso crisis caused a recession during 1995. In this period

of foreign financial turmoil, international investors pulled back from investments in

Argentina, its money supply shrank, and its interest rates increased. In addition, con-

cerns about whether Argentina would maintain its fixed rate led to speculative out-

flows that further decreased Argentina’s money supply. In the mid-1990s Argentina

did stick with its currency board and the fixed dollar–peso exchange rate, but probably

at the cost of a deeper recession.

pug21774_ch25_628-654.indd 643pug21774_ch25_628-654.indd 643 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

644 Part Four Macro Policies for Open Economies

Argentina experienced the same pressures in the late 1990s because of the series

of crises in Asia, Russia, and Brazil. As we saw in Chapter 21, this time the outcome

was bad. A recession began in 1998 and persisted. Other shortcomings of its govern-

ment policies, including a lack of fiscal discipline, overregulation, and corruption,

interacted with the recession. After rather desperate attempts to shore up the currency

board arrangement by preventing people from using their bank accounts, the govern-

ment gave up and shifted to a floating exchange rate. Argentina by then was in the

middle of a severe financial and economic crisis.

The currency board arrangement worked well in Argentina for a number of years,

and it has worked well for the other countries that have currency boards. But a currency

board does not force a country to follow sensible fiscal and regulatory policies, and it

leaves the country more exposed to adverse foreign shocks. In addition, Argentina’s

experience shows another potential drawback of a currency board, the difficulty of

finding an exit strategy that does not add disruption to the country’s economy.

“Dollarization” So much of barbarism, however, still remains in the transactions of most civilized

nations, that almost all independent countries choose to assert their nationality by having,

to their own inconvenience and that of their neighbors, a peculiar currency of their own.

John Stuart Mill, 1870

A currency board establishes a strongly fixed exchange rate, but it is still at risk of a

speculative attack. It is a hard peg, but perhaps still not hard enough because the country’s

government could decide to shift to some other exchange-rate policy for its currency.

A more extreme form of fixed exchange rate is for the country’s government to abol-

ish its own currency and use the currency of some other country. Because the other cur-

rency is often the U.S. dollar, this arrangement is called dollarization. This is a harder peg, but even this is not permanent. The government still cannot credibly commit never

to change the exchange rate. That is, the government can still “de-dollarize” and reintro-

duce local currency, as Liberia did in the early 1980s. Panama, Micronesia, the Marshall

Islands, Timor-Leste, and Palau use the U.S. dollar as their official local currency, and

several other very small countries use the currency of a large neighboring country as

their own currency. In September 2000 Ecuador dollarized in an effort to turn around its

struggling economy. At the beginning of 2001 El Salvador dollarized in a smooth transi-

tion from the fixed rate between the colón and the dollar that it had maintained for many

years. In 2009 Zimbabwe dollarized to escape from hyperinflation.

In comparison with a well-maintained fixed exchange rate with the dollar, what

are the advantages and disadvantages of full dollarization? The major advantage

for a country like El Salvador is removing the exchange-rate risk that its govern- ment might devalue or depreciate the local currency in the future. This eliminates

the risk of a speculative attack on the currency. 3 It also eliminates the risk premium

(to compensate lenders for this exchange-rate risk) that is built into local-currency

3 An international crisis is still possible, as the experience of Panama shows. Foreign investors can run for the exits if they fear either default on government debt that is rising quickly because of large fiscal deficits or losses because of weaknesses in the local financial system.

pug21774_ch25_628-654.indd 644pug21774_ch25_628-654.indd 644 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

Chapter 25 National and Global Choices: Floating Rates and the Alternatives 645

interest rates. For El Salvador, interest rates fell by about 5 percentage points as

the country dollarized. Another advantage is the elimination of the transaction costs of currency exchanges between the local currency and the dollar. The major disadvantage of full dollarization is the loss of interest income on the country’s holdings of international reserve assets that are used in the process of full dollar- ization. The government must replace all local currency with dollars. To do this the

government uses its official holdings of U.S. government bonds to obtain dollars.

In El Salvador’s case, the loss of interest income is equal to about 0.6 percent of

its GDP. That is, with dollarization the seigniorage profit from issuing currency in El Salvador goes to the U.S. government (the issuer of dollar bills) rather than to El

Salvador’s government (the issuer of colones). 4

With full dollarization, El Salvador completely cedes its monetary policy to

the United States. The U.S. Fed will make its monetary policy decisions based on

economic conditions in the United States, with almost no concern for economic

conditions in El Salvador. This sounds like a major drawback, but El Salvador was

already fully committed to defending the fixed exchange rate, so it had already almost

completely given up its own monetary policy, anyway.

The dollarization of Ecuador is a more aggressive use of this policy because

Ecuador shifted from a flexible exchange-rate value for the sucre. In the two years

prior to dollarization, Ecuador had defaulted on its foreign debt and its currency had

lost 73 percent of its dollar value. Dollarization was shock treatment for an economy

that had serious problems. This treatment was fairly successful. Inflation fell from

96 percent in 2000 to 13 percent in 2004. Real GDP grew by an annual average of

4.5 percent during 2001–2004. Still, international trade was one problem in the transi-

tion. With an inflation rate higher than that of the United States during the first several

years after dollarization, Ecuador lost international price competitiveness. Its non-oil

exports were hurt, and its imports increased.

THE INTERNATIONAL FIX—MONETARY UNION

Since the breakup of the Bretton Woods fixed-rate system, the countries of the European

Union have attempted to establish and maintain fixed exchange rates among their curren-

cies. In 1979, they established the European Monetary System, and a subset of the coun-

tries established fixed exchange rates among their currencies through the Exchange Rate Mechanism (ERM). The Maastricht Treaty, approved in 1993, committed the countries to a monetary union and a single currency, the euro. In a monetary union, exchange rates are permanently fixed and a single monetary authority conducts a single,

unionwide monetary policy. 5 Eleven EU countries established the monetary union in

4 El Salvador’s government could attempt to negotiate an agreement with the U.S. government to gain a share of the forgone interest, but the U.S. government has not appeared to be receptive to encouraging dollarization by sharing seigniorage profits with other countries.

5 Other monetary unions are the CFA franc zone and the East Caribbean Currency Union among eight Caribbean island countries. The CFA franc zone has two groups, the eight members of the West African Economic and Monetary Union and the six members of the Central African Economic and Monetary Community.

pug21774_ch25_628-654.indd 645pug21774_ch25_628-654.indd 645 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

646 Part Four Macro Policies for Open Economies

1999, with seven more countries joining during 2001–2014. This final section of the

chapter examines the economics of monetary union as the ultimate fixed exchange-rate

arrangement, by looking at the experience of the EU during the past several decades.

Exchange Rate Mechanism In 1979, Germany, France, Italy, the Netherlands, Belgium, Denmark, Ireland, and

Luxembourg began to fix the exchange rates among their currencies as participants

in the Exchange Rate Mechanism. Spain joined the ERM in 1989, Britain in 1990,

Portugal in 1992, Austria in 1994, Finland in 1996, and Greece in 1998.

The ERM was an adjustable-peg system. There were 11 realignments during the

first nine years, 1979–1987, with a tendency for the Belgian, Danish, French, and

Italian currencies to devalue. Then from 1987 through 1992, there were no realign-

ments. In fact, the discipline effect on national inflation rates seemed to work quite

well. Germany was generally regarded as the lead country in the system due to its

economic size and the prestige of its central bank. Germany maintained a low infla-

tion rate, and the other ERM countries were disciplined by the fixed exchange rates to

lower their inflation rates toward the German level.

By mid-1992, the ERM seemed to be working very well. As part of “Europe 1992,”

the general effort to dismantle barriers to permit free movements of goods, services,

and capital within the EU, most countries had removed capital controls by 1990. The

EU countries had completed the drafting of the Maastricht Treaty, which contained the

plans for monetary union, and they were in the process of approving it.

The ERM exchange rates came under serious pressure beginning in September 1992.

Several things contributed to the severity of the pressure. International investors became

worried that the exchange-rate values of several currencies in the ERM were not appro-

priate. For instance, the Italian lira appeared to be overvalued, given that the Italian infla-

tion rate had remained above that of the other ERM members. In addition, international

investors became worried by policy tensions among the ERM members. German policy-

makers were placing full emphasis on reducing and controlling German inflation, while

policymakers in several other countries, including France and Britain, probably preferred

to shift the emphasis to reducing unemployment. Furthermore, in a general vote in 1992,

Denmark rejected the Maastricht Treaty, and the upcoming French vote was expected

to be close. These votes raised doubts about eventual monetary union, and they raised

doubts about the countries’ current commitments to fixed exchange rates. Finally, the

removal of capital controls meant that international investors and speculators could move

large amounts of financial capital quickly from one country and currency to another.

Official defense of the fixed rates was difficult in the face of these large speculative flows.

As international investors and speculators shifted to expecting devaluations against

the DM by a number of ERM countries, large amounts of capital flowed and the central

banks mounted massive defenses. Italy and Britain surrendered and left the system. As

speculative attacks continued in late 2002 and early 2003, the Spanish, Portuguese,

and Irish currencies were devalued. Another large speculative attack occurred in July

1993. The ERM widened the allowable band for exchange-rate movements around the

central fixed rates, but there was no realignment. With the exception of devaluations

of the Spanish and Portuguese currencies in 1995, exchange rates among the ERM

currencies were calm after 1993. Italy rejoined in 1996.

pug21774_ch25_628-654.indd 646pug21774_ch25_628-654.indd 646 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

Chapter 25 National and Global Choices: Floating Rates and the Alternatives 647

The ERM illustrates many of the points made in the first half of the chapter about

the strengths and weaknesses of fixed exchange rates. The ERM exchange rates

were generally steadier than floating rates were during this period, although occa-

sional realignments disturbed the stability. The fixed rates applied pressure on other

ERM countries to reduce their inflation rates toward the German level. Differences

in goals between Germany and several other ERM countries in the early 1990s led

to strains in the system, and these other countries could not use monetary policy to

address their internal imbalances. The removal of capital controls made the defense

of the fixed rates through official intervention more difficult in 1992 and 1993. In

fact, several countries temporarily reimposed or tightened their capital controls

as part of their defense efforts. These controls helped in the defense of the fixed

exchange rates, but they ran counter to the broad efforts to create a single EU market.

European Monetary Union In 1991, the EU countries completed the draft of the Maastricht Treaty (named for

the Dutch town where it was negotiated) to set a process for establishing a monetary

union and a single, unionwide currency. After several close national votes, including

a defeat in Denmark that was later reversed, all EU countries approved the treaty, and

it became effective in November 1993.

The Maastricht Treaty specified the procedure for the establishment of the

European Monetary Union. To participate in the monetary union, a country had to meet five criteria:

• The country’s inflation rate must be no higher than 1.5 percentage points above

the average inflation rate of the three EU countries with the lowest inflation rates.

• Its exchange rates must be maintained within the ERM bands with no realignments

during the preceding two years.

• Its long-term interest rate on government bonds must be no higher than 2 percent-

age points above the average of the comparable interest rates in the three lowest-

inflation countries.

• The country’s government budget deficit must be no larger than 3 percent of the

value of its GDP.

• The gross government debt must be no larger than 60 percent of its GDP (or the

country must show satisfactory progress to achieving these two fiscal requirements

in the near future).

The criteria were intended to measure whether the country’s performance had con-

verged toward that of the best-performing EU countries so that the country was ready

to enter the monetary union.

In May 1998, a summit of EU leaders decided which countries met the five criteria

and would be members of the new euro area. With some liberal use of the “satisfactory

progress” exception for the government debt criterion, 11 countries were deemed to

meet the criteria and chose to join the monetary union. Britain, Denmark, and Sweden

could have qualified but chose not to join the union. Greece did not then qualify but

was able to join two years later. The 12 countries that joined the EU in 2004 and

2007 are eligible to join the monetary union and adopt the euro if they meet the five

pug21774_ch25_628-654.indd 647pug21774_ch25_628-654.indd 647 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

648 Part Four Macro Policies for Open Economies

criteria. Slovenia joined in 2007, Cyprus and Malta in 2008, Slovakia in 2009, Estonia

in 2011, and Latvia in 2014.

The European Central Bank (ECB) was established in 1998 as the center of the European System of Central Banks, a federal structure that also includes the national

central banks as operating arms. On January 1, 1999, the monetary union began and

the ECB assumed responsibility for monetary policy in the euro area.

Modeled after the Bundesbank (the German central bank), the ECB is designed to

be independent from direct political influence and is mandated to conduct unionwide

monetary policy to achieve price stability. It has defined price stability as a consumer

price inflation rate of less than but close to 2 percent per year. Its decisions about

changes in monetary policy are made by its governing council, composed of the heads

of the member national central banks and the six members of the executive committee.

While the council is not overtly political, there is room for national economic interests

to sway unionwide policy decisions.

As the ECB began its operations, there were concerns about how effectively it

would function. As shown in Figure 25.2 , the exchange-rate value of the euro declined

from its introduction in 1999 to late 2000. Among the factors that probably contrib-

uted to the euro’s weakness were confusing and poorly worded statements by ECB

officials. The early operating issues were then largely resolved.

What can the EU countries achieve with monetary union and what did they give up

or risk? The European Monetary Union provides examples of many of the issues that

we discussed in the first half of the chapter. 6

The gains from monetary union are based on the elimination of all exchange-

rate concerns. The shift to a common currency is a permanent fix and more. It ends

exchange-rate variability and risk. It ends one-way speculation about changes in pegged

exchange rates. It eliminates all foreign exchange transaction costs. Monetary union is

6 This discussion is also largely an application of the analysis of an optimum currency area —the size of the geographic area that shows the best economic performance with fixed exchange rates (or one currency) within the area and floating exchange rates with currencies outside the area.

FIGURE 25.2 Nominal

Exchange-

Rate Value of

the Euro,

1999–2014

Source: International Monetary Fund,

International Financial Statistics.

0.60

0.70

0.80

0.90

1.00

1.10

1.20

1.30

1.40

1.50

1.60

Ja n

1 9 9 9

Ja n

2 0 0 1

Ja n

2 0 0 3

Ja n

2 0 0 5

Ja n

2 0 0 7

Ja n

2 0 0 9

Ja n

2 0 1 1

Ja n

2 0 1 3

U .S

. d

o ll a rs

p e r

e u

pug21774_ch25_628-654.indd 648pug21774_ch25_628-654.indd 648 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

Chapter 25 National and Global Choices: Floating Rates and the Alternatives 649

part of the broad drive to European integration and single European markets. Estimates

of the increase in international trade of products within the euro area range from 10 to

15 percent. In addition, the elimination of transaction costs and exchange-rate risks has

led to greater integration of European financial markets, especially markets for govern-

ment and corporate bonds, with the potential for greater gains from intertemporal trade

(international lending and borrowing).

The risks and possible losses from the European Monetary Union are the result of

economic shocks that affect different member countries in different ways. Economic

conditions sometimes vary across the countries. Especially, weak demand causes reces-

sions or slow growth in some countries. For example, Germany’s domestic product grew

by less than 1 percent per year during 2000–2005. Demand in other countries grows too

quickly, causing inflation pressures. For example, Ireland’s domestic product grew by

over 6 percent per year during the early 2000s, and it experienced rapidly rising wages

and a housing price bubble. With monetary union, each country has given up both the

ability to run an independent monetary policy that could respond to domestic imbal-

ances and the ability to use exchange-rate changes as an adjustment tool.

In the absence of national monetary policy and national exchange rates, there are

three mechanisms that can reduce national imbalances within the monetary union—

cross-national resource movements, national price-level adjustments, and fiscal poli-

cies. We have seen a major test of these mechanisms during the euro crisis that began

in 2010 and its aftermath. Chapter 1 and the box “National Crises, Contagion, and

Resolution” in Chapter 21 provide overviews of the euro crisis.

One way to adjust national imbalances is for workers to move from areas of weak

demand to areas of strong demand. If labor mobility is high, adjustments to internal

imbalances can be speeded by people moving from places where unemployment is

high to places where demand for labor is strong. Regional migration is an important

way that different regions in the United States adjust to local shocks. Most studies

conclude that labor mobility across EU countries (and even within these countries) is

relatively low and is likely to remain low. Less than 3 percent of EU citizens live in

an EU country other than the one in which they were born. Even mobility between

regions within countries is small. Adjustment also could occur with capital moving to

seek out and employ underutilized resources like unemployed labor. But, given rigidi-

ties in labor markets and labor practices, capital may not move in this way—in fact,

capital may instead flee from problem areas to those that are booming.

A second way to adjust is through changes in cross-national price competitiveness

(changes in national real exchange rates). Countries with high unemployment can boost

aggregate demand by using improved price competitiveness to increase national exports

and to decrease national imports. However, for the euro crisis, we saw the limits to this kind

of adjustment. As shown in the box “International Indicators Lead the Crisis” in Chapter

16, by 2008 Greece, Portugal, and Spain had developed large current account deficits. Here

we see a drawback of monetary union, the inability to devalue in the face of fundamental

disequilibrium. Instead of being able to adjust the country’s nominal exchange rate to

build international price competitiveness, Greece, Portugal, and Spain each had to pursue

an “internal devaluation.” Each tried to reduce wages and other costs relative to other EU

countries, such as Germany, a process that proved to be difficult and painful.

With cross-national resource movements unlikely to be helpful, and with “internal

devaluation” to build international price competitiveness being slow, the remaining

pug21774_ch25_628-654.indd 649pug21774_ch25_628-654.indd 649 12/5/14 5:42 PM12/5/14 5:42 PM

Final PDF to printer

650 Part Four Macro Policies for Open Economies

adjustment mechanism is fiscal policy, at the union level or at the national level. For

the euro area (and for the broader European Union), there is almost no unionwide

fiscal policy. The EU fiscal budget in total is only about 1 percent of EU GDP. There

are almost no “automatic stabilizers” across countries. That is, higher tax revenues

from the growing countries are not “automatically” shifted to the recession countries

through lower taxes and larger expenditures in the recession countries. And there is no

active unionwide fiscal policy to help the recession countries.

That leaves each country’s national fiscal policy as a government tool to improve

the country’s domestic performance, but in a monetary union national fiscal policy

is a two-edged sword. National fiscal policy can be used to move the country toward

internal balance, and it will be powerful if capital flows are very elastic, as they are

likely to be in a well-functioning monetary union. However, national fiscal policy

can also become a source of instability, a source of negative shocks for the country

and possibly for the monetary union. A country’s government will feel less pressure

to keep its fiscal deficit under control if it believes that the union’s central bank or

the governments of other countries in the union will come to its rescue if the deficit

becomes unmanageable.

As part of the process of moving toward monetary union, the German government

insisted on the Stability and Growth Pact, which mandates that national government budget deficits should be no more than 3 percent of GDP, with temporary exceptions

for unusual external shocks or severe national recessions. Countries that violate the

rule were to be subject to monetary sanctions. Such a rule can reduce the risk that

excessive fiscal deficits become a source of instability. The rule also limits the use of

national fiscal policy to address internal balance, and it can at times turn national fiscal

policy into a destabilizer. For instance, if the government budget deficit begins close

to 3 percent and a mild national recession hits, the government may be compelled to

raise taxes or cut government expenditures to prevent the deficit from rising above

3 percent. These fiscal changes would make the recession worse.

With slow growth in several euro-area countries, including Germany and France, in

the early 2000s, the fiscal situations in these countries deteriorated. The budget defi-

cits of Germany and France moved above 3 percent of their GDP and stayed there for

several years. It made no sense for them to aggressively raise taxes or cut spending,

which would have made their economies even weaker. The EU decided not to impose

fines (although strictly the pact called for fines), and it became clear that the pact was

largely unenforceable. In early 2005 the EU countries revised the pact to recognize a

much broader set of exceptions.

The dual roles of national fiscal policy were at the center of the euro crisis, beginning

with Greece in 2010. After joining the euro area in 2001, Greece looked fairly success-

ful, with annual real GDP growth that averaged about 4 percent to 2007, but its growth

was based too much on fiscal deficit spending and foreign borrowing. Although the data

were misreported for years by the Greek government, we now know that Greece had

never met the 3 percent deficit limit. With the recession caused by the global financial

and economic crisis, Greece’s fiscal deficit and debt rose to high levels. By April 2010

the Greek government effectively lost access to regular borrowing—the interest rate at

which the Greek government could issue new government bonds rose to prohibitively

high levels. Either the Greek government had to instantly slash government spending

and enact a massive tax increase or it needed an official rescue. In May 2010 the Greek

pug21774_ch25_628-654.indd 650pug21774_ch25_628-654.indd 650 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

Chapter 25 National and Global Choices: Floating Rates and the Alternatives 651

government received a large official rescue loan program to provide funds to cover the

ongoing Greek government deficit.

The crisis spread to other countries. Several other countries had precarious fiscal

deficits. Ireland’s government took on huge debts when it rescued the country’s banks.

Ireland received a large bailout program in November 2010. In May 2011 Portugal had

to be rescued with another large bailout program. By mid-2011, investors were also

increasingly concerned about the government deficits and debts of Spain and Italy,

and interest rates on their bonds jumped. In March 2012, with Greek government debt

equal to more than 150 percent of its GDP, Greece required a second bailout program,

and Greece’s government defaulted on most of its privately held debt.

Greece, Portugal, and Ireland went into severe national recessions. In addition to

structural reforms (liberalizing regulation of labor markets and product markets) that

may eventually improve national economic performance, the terms of the bailout

programs included reductions in government expenditures and increases in taxes to

reduce the fiscal deficit. Such austerity forced national fiscal policies to make the

recessions worse.

The bailouts were actually a form of unionwide fiscal policy compelled by the

national crises. Although some of the funding for the rescue loans came from the

International Monetary Fund, most of the funding came from other euro-area countries.

In 2010, the countries created the temporary European Financial Stability Facility, and in

2012 they replaced it with the European Stability Mechanism, with a permanent lending

capacity of €500 billion. (This may sound like a lot, but it probably would not have been

large enough to rescue a country like Spain or Italy.)

Again led by Germany, the euro area has also attempted to establish a fiscal com-

pact that tightens up the limits on national fiscal deficits and debt. New rules and a new

treaty require, with some exceptions, that each country achieve a near-zero structural

fiscal balance in the medium term and have in place a program steadily to reduce a

structural fiscal deficit that is initially too large.7 If a country is not in compliance,

the European Commission, the EU’s executive body, can recommend financial sanc-

tions, which are imposed automatically unless the European Council, an EU body of

national ministers, specifically rejects the recommendation. In addition, each country

must incorporate the structural balance rules into its core national laws.

The member countries of the euro area have a strong political commitment to EMU

and the single currency. The euro crisis calmed in 2012, and the euro survived. Still

the tension remains between national fiscal policy as a tool for stabilizing the macro-

economy of a euro-area country and national fiscal policy as a source of instability for

the country and for the monetary union.

More broadly, the problems in the euro area make it even less likely that countries

in another part of the world will establish their own monetary union. As we have noted

in this chapter, the major trend in the world outside of the European Union is toward

floating exchange rates with their promise of some degree of national independence

in economic policies.

7The structural fiscal deficit (also called the cyclically adjusted fiscal deficit) is the estimated size of the fiscal deficit if the country’s economy were operating at its potential (what we called “full employment” real GDP in Chapter 23). It ignores the part of the fiscal deficit that is driven by automatic stabilizers. For example, total tax revenues collected automatically decline as GDP and income decline in a recession, and expenditures on assistance to unemployed workers automatically increase.

pug21774_ch25_628-654.indd 651pug21774_ch25_628-654.indd 651 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

652 Part Four Macro Policies for Open Economies

Summary A major decision for a country’s government is its choice of exchange-rate policy. This chapter has examined the extent of rate flexibility that a country’s policy allows. We dis-

cussed what five major issues say about the advantages and disadvantages of choosing a

floating rate or a fixed rate. You may want to review Figure 25.1 for a summary of this

discussion.

For each issue there are usually ways in which the issue favors a floating rate and

other ways in which the issue favors a fixed rate. Because countries differ in their

economic situations, policymaking institutions, economic histories, and political inter-

ests, different countries can view the balance of advantages and disadvantages differ-

ently, leading to different policy choices. Indeed, as economic and political conditions

change over time, the policy chosen by a country can change.

In a country’s choice between a more flexible rate and a more fixed-rate policy, sev-

eral points are typically prominent. Strong arguments in favor of a floating exchange

rate include the country’s ability to use independent monetary policy and exchange-rate

changes to adjust internal and external imbalances; the country’s ability, more generally, to

pursue goals and policies that meet its own domestic needs; and the difficulty of defending

fixed rates against speculative attacks, given the large and growing amounts of financial

capital that can move quickly between countries. The strongest argument in favor of a

fixed exchange rate is that floating rates have been too variable, and this excessive vari-

ability disrupts and discourages international trade and other international transactions.

In recent decades, countries have shifted toward choosing more flexible exchange

rates. Countries generally attempt to manage the float in order to moderate the

variability of the floating rate, although the effectiveness of this management, at least

for the major currencies, is questionable.

Still, a number of countries continue to have fixed exchange rates. However, soft

pegs (fixed rates that are easily adjustable) can be difficult to sustain because they

seem at times to encourage speculative attacks. Some countries use forms of hard

pegs (fixed rates that are more nearly permanent). A currency board is a monetary authority that holds only international reserve assets, so sterilization is not possible.

With a currency board, the country’s money supply is automatically linked to the

intervention to defend the fixed exchange rate. Dollarization involves completely replacing the local currency with a foreign currency (for instance, the U.S. dollar).

Monetary conditions in the country are almost completely controlled by the foreign

central bank (for instance, the U.S. Federal Reserve).

The most ambitious fixed-rate effort is occurring in the European Union, where

18 EU countries are members of the European Monetary Union, established in 1999 and based on the Maastricht Treaty of 1993. In a monetary union, exchange rates are permanently fixed and a single monetary authority conducts a unionwide mon-

etary policy. For the European Monetary Union, the countries use a single currency, the

euro, and the European Central Bank (ECB) conducts unionwide monetary policy. The European Monetary Union is the successor to the fixed exchange rates of the

Exchange Rate Mechanism (ERM) of the European Monetary System, established in 1979. Under the ERM, the fixed exchange rates were generally less variable than

comparable floating exchange rates, although the fixed ERM rates were occasionally

adjusted in realignments. Inflation rates in other ERM countries declined toward the

pug21774_ch25_628-654.indd 652pug21774_ch25_628-654.indd 652 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

Chapter 25 National and Global Choices: Floating Rates and the Alternatives 653

low German inflation rate. However, following the removal of capital controls by

some ERM countries, differences in macroeconomic goals between Germany and

some other ERM countries led to speculative attacks in 1992 and 1993. After 1993,

the ERM exchange rates were generally steady.

The European Monetary Union can be used to indicate the major advantages and

disadvantages of a monetary union. The gains flow largely from reduced transactions

costs and reduced exchange-rate risk. For the European Monetary Union, with its shift

to a single currency, these gains are substantial.

The major source of disadvantages is that economic shocks can affect member coun-

tries differently, with some countries in recession and others growing quickly. When

this occurs, the countries will need ways to adjust their internal imbalances, but each

country no longer has national monetary policy or national exchange-rate policy. Fiscal

policy at the union level could be useful, by providing automatic stabilizers as well as

active fiscal policy changes. If unionwide fiscal policy is not sufficient, each nation

may need to use national fiscal policy actively. In addition, labor mobility can assist in

adjusting imbalances, as people move from areas of high unemployment to areas of low

unemployment. The European Monetary Union faces its major challenges in this broad

area of shocks, national imbalances, and policy and adjustment responses. The member

countries are different and experience different internal imbalances, there is almost no

fiscal policy at the union level, national fiscal policies are limited, and labor mobility is

low. The euro crisis that began with Greece in 2010 shows some of the challenges that

face the euro-area countries as a monetary union.

Key Terms Price discipline Currency board

Dollarization

Exchange Rate

Mechanism (ERM)

Monetary union

European Monetary Union

European Central Bank

(ECB)

The classic article favoring floating exchange rates is Friedman (1953). Fischer (2001)

explores the unsustainability of soft pegs. Shambaugh (2004) provides a technical

analysis of the relevance of the inconsistent trinity to recent national experiences with

fixed and floating exchange rates. Klein and Shambaugh (2010) and Ghosh et al. (2010)

analyze the differences between countries that have fixed exchange rates and those that

have floating exchange rates. Goldstein (2002) surveys other options and presents the

case in favor of managed floating.

Wolf et al. (2008) look at currency boards. Mundell (1961), McKinnon (1963), and

Tower and Willett (1976) examine fixed rates within optimum currency areas. De Grauwe

(2009), Lane (2006), and Wyplosz (2006) provide an overview and analysis of the

European Monetary Union. De Haan et al. (2005) examine the ECB’s monetary policy.

Jagelka (2013) uses the gravity model (described in Chapter 6) to estimate the trade

effects of euro adoption by Slovenia, Slovakia, Malta, and Cyprus. Pisani-Ferry (2014)

provides an overview of the euro crisis.

Suggested Reading

pug21774_ch25_628-654.indd 653pug21774_ch25_628-654.indd 653 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

654 Part Four Macro Policies for Open Economies

Questions and Problems

1. “Countries whose currencies are linked to each other through fixed exchange rates

usually should pursue very different monetary and fiscal policies.” Do you agree or

disagree? Why?

2. “If most countries adhered to a system of fixed exchange rates, global inflation would

be lower.” Do you agree or disagree? Why?

3. A country is worried that business cycles in other countries tend to disrupt its own

economy. It would like some “insulation” from foreign business cycles. Why would

this country favor having a floating exchange rate?

4. “If a country’s government decides to have a flexible exchange rate, then it should

have a clean float.” Do you agree or disagree? Why?

5. A country now has a floating exchange rate. Its government would like to fix the

exchange-rate value of its currency to another currency. You have been hired as an

advisor to the country’s government. Suggest three major criteria for deciding what

other country’s currency to fix to. Why is each important?

6. The variability of floating exchange rates since 1973 has been higher than most

economists expected.

a. Why are some economists not concerned about this? b. Why are other economists quite worried about this?

7. A new government has been elected in a country that now has a high inflation rate and

a floating exchange rate. The new government is committed to reducing the country’s

inflation rate.

a. If the government continues to use a floating exchange rate, what will the govern- ment need to do to reduce the high inflation rate?

b. As part of its effort to reduce the country’s inflation rate, why might the country’s government consider a change to using a currency board and a fixed exchange rate

with one of the major currencies of the world?

8. What is a currency board? Is having a fixed exchange rate with a currency board that

defends the fixed rate better for a country than having a fixed exchange rate and a

standard central bank that defends the fixed rate?

9. What is dollarization? Is dollarization better for a country than having a fixed ex-

change rate and a standard central bank that defends the fixed rate?

10. According to the Maastricht Treaty, what are the five convergence criteria for an EU

country to be allowed to join the European Monetary Union? What logic do you see

for having each as a requirement? Which of the five criteria seem to be more or less

important as a basis for excluding a country from the monetary union?

11. The time is 2015. After the end of the worst of the euro crisis in 2012, the European

Monetary Union and the euro have worked reasonably well. Britain has remained

outside. You are attempting to convince a British friend that Britain should join the

monetary union as soon as possible. What are your two strongest arguments?

12. Consider the same scenario in the previous question. Your British friend is trying to con-

vince you that Britain should stay out of the monetary union. What are her two strongest

arguments?

✦

pug21774_ch25_628-654.indd 654pug21774_ch25_628-654.indd 654 29/11/14 6:11 pm29/11/14 6:11 pm

Final PDF to printer

655

Appendix A

The Web and the Library: International Numbers and Other Information The Internet and the World Wide Web have fundamentally changed how we do inter-

national research. If you want to explore international trade competition, a recent

financial crisis, a trade dispute between the United States and the European Union,

the policy of the Korean government toward exchange rates, or almost any other topic

in international economics, useful information is available. You can find a lot of it by

putting the topic name into a good search engine. You usually will get links to several

useful Web sites. (You will probably also get links to a number of less useful sites, and

sometimes even links to sites whose information is not reliable. One aspect of good

Web research is identifying the best sites and validating the information you obtain.)

Of course, some sources of information are available only in hard copy, so access to a

good library is also important for many research projects.

This appendix presents some of the best sources of international data and informa-

tion. Figure A.1 shows a number of useful Web sites, ranging from those maintained

by official international organizations to those maintained by individual experts.

The rest of the appendix presents information sources that can be found in hard

copies in libraries. Many of the sources that are shown below are now available on the

Web—check the Web site of the issuing organization or use a good search engine. To

assist you if you are trying to locate these in hard copy, the first parts of their typical

Library of Congress call numbers are in parentheses.

For many research projects, you want to take a close look at the international eco-

nomic dealings of a single country. One useful source is usually that country’s statisti-

cal yearbook. Here are some examples:

• U.S. Bureau of the Census, Statistical Abstract of the United States (HA37.U4) . • Statistics Canada, Canada Year Book (HA744.581) . • Great Britain, Central Statistical Office, Annual Abstract of Statistics (HA1122.A33) . • Japan, Statistical Bureau, Japan Statistical Yearbook (HA1832.J36) . • Australian Bureau of Statistics, Year Book Australia (HA3001.B5) .

pug21774_appA_655-658.indd 655pug21774_appA_655-658.indd 655 12/10/14 7:38 AM12/10/14 7:38 AM

Final PDF to printer

656 Appendix A

Creator/Description Address

Official International Organizations

World Trade Organization www.wto.org International Monetary Fund www.imf.org World Bank www.worldbank.org Organization for Economic Cooperation www.oecd.org

and Development Bank for International Settlements: www.bis.org

Information on foreign exchange markets, international banking, and national central banks, including links to many central bank sites

United Nations: National statistics http://unstats.un.org/unsd United Nations Conference www.unctad.org

on Trade and Development: National (click on Statistics) statistics, including extensive data on foreign direct investment

International Trade

International Trade Centre: Data on trade www.intracen.org/itc/market- by product and country info-tools/trade-statistics

U.S. Trade Representative: www.ustr.gov Information on foreign barriers to U.S. exports and other trade policy issues

International Trade Administration, U.S. http://trade.gov/enforcement Department of Commerce: Information on U.S. dumping and subsidy cases

U.S. International Trade Commission: www.usitc.gov Information on dumping and subsidy cases and on other trade policy issues

U.S. Export.gov: Information http://export.gov on foreign markets for U.S. exports

Canadian International Trade Tribunal: www.citt.gc.ca/ Information on dumping and subsidy actions by the Canadian government

Canadian Trade Commissioner Service: www.tradecommissioner.gc.ca Information on foreign markets for Canadian exports

European Commission, Trade: http://ec.europa.eu/trade Information on EU trade policy and foreign barriers to EU exports

Global Trade Watch: Alternative views www.citizen.org/trade on trade policy and globalization issues, presented by Ralph Nader’s group Public Citizen

FIGURE A.1 Useful Web

Sites

pug21774_appA_655-658.indd 656pug21774_appA_655-658.indd 656 12/10/14 7:38 AM12/10/14 7:38 AM

Final PDF to printer

The Web and the Library: International Numbers and Other Information 657

Creator/Description Address

Exchange Rates and International Finance

OANDA, the Internet arm of Olsen & www.oanda.com Associates, LLC: Exchange-rate data and news

Pacific Exchange Rate Service http://fx.sauder.ubc.ca (University of British Columbia): Exchange-rate data and information

Ministry of Finance, Japan: Information www.mof.go.jp/english/international_policy/ on foreign exchange intervention by the reference/feio/index.htm Japanese government

National, Regional, and International Data

U.S. federal government: Access to a www.fedstats.gov wide range of data and information

St. Louis Federal Reserve Bank: Data http://research.stlouisfed.org/fred2 on United States and other countries

U.S. Bureau of Economic Analysis: www.bea.gov/International U.S. balance of payments data

European Union http://europa.eu/index_en.htm Statistics Canada www.statcan.gc.ca/start-debut-eng.html

Central Banks

U.S. Federal Reserve System www.federalreserve.gov European Central Bank www.ecb.europa.eu/home/html/

index.en.html Bank of Japan www.boj.or.jp/en

Other Useful Sites

Resources for Economists on the www.rfe.org Internet: Links to a broad range of sites with economics information

WebEc International Economics: Many www.helsinki.fi/WebEc/framef.html useful links

Michigan State University: Links to many http://globaledge.msu.edu/reference-desk useful sites and a glossary

University of Auckland, Offstats: Data www.offstats.auckland.ac.nz and links to sites with data

Nationmaster: Comparative national www.nationmaster.com data and tools for displaying the data

Peterson Institute for International www.iie.com Economics: Information on its publications, including some available online

World Economic Forum: Reports www.weforum.org and discussions of global issues

Abyz News Links: Links to the Web sites www.abyznewslinks.com of newspapers from around the world

FIGURE A.1 continued

pug21774_appA_655-658.indd 657pug21774_appA_655-658.indd 657 12/10/14 7:38 AM12/10/14 7:38 AM

Final PDF to printer

658 Appendix A

You may find statistical yearbooks for other countries in the Library of Congress’s

HA_ range.

If you want to compare countries in the same region, you can get numbers for all

the countries in the region from such compilations as the following:

• United Nations, Economic Commission for Latin America and the Caribbean,

Statistical Yearbook for Latin America and the Caribbean (HA751.A58) . • United Nations, African Statistical Yearbook (HA1955.U5) . • European Bank for Reconstruction and Development, Transition Report (HC331.E2) .

For analysis of global issues for developing countries, see the World Bank’s annual

World Development Report (HC59.7.W659). At http://data.worldbank.org, the World Bank provides access to World Development Indicators and other sets of data. For

most of the main economic aggregates, you can also see the International Monetary

Fund’s International Financial Statistics (HG3881.I626), which covers more than just international finance. The United Nations Development Project produces its annual

Human Development Report (HD72.H85), which focuses on measures of living condi- tions, education, and male–female differences in achievements.

Some global volumes cover specific aspects of international economics that are

evident from their titles:

• United Nations, International Trade Statistics Yearbook (HF91.U47) . • United Nations, National Accounts Statistics (HC79.I5.N388). • International Monetary Fund, Balance of Payments Statistics (HG3882.B34) . • United Nations Conference on Trade and Development, World Investment Report

(HG4538.W67) .

• Organisation for Economic Cooperation and Development, International Direct Investment Statistics Yearbook (HG4583.I58) .

• International Monetary Fund, Direction of Trade Statistics (HF1016.I652) . • International Monetary Fund, Annual Report on Exchange Arrangements and

Exchange Restrictions (HG3834.I61A3) . • World Bank, International Debt Statistics, formerly Global Development Finance

(HJ8899.W672).

• United Nations Environment Programme, Year Book (HC79.E5 U55).

• International Organization for Migration, World Migration Report (JV6006.W67).

Multilateral organizations produce other useful periodic reports, including the

World Trade Organization, Annual Report (HF1371.A56); the International Monetary Fund, World Economic Outlook (HG230.3.O4); and the Bank for International Settlements, Annual Report (HG1997.I6A3).

Here is one more useful resource: Alan V. Dearforff, Terms of Trade: A Glossary of International Economics (HF1373.D43), provides definitions, graphs, and explanations.

pug21774_appA_655-658.indd 658pug21774_appA_655-658.indd 658 12/10/14 7:38 AM12/10/14 7:38 AM

Final PDF to printer

659

Appendix B

Deriving Production- Possibility Curves The shape of the production- possibility curve used so much in the theory of interna-

tional trade depends on the factor supplies of the country and on the technology for

combining these factors to produce outputs. The usual device for portraying the state

of technology is the production function, which expresses the output of any one commodity as a function of its inputs.

Geometrically, the production function for each commodity can be shown in two

dimensions by plotting the various combinations of two factors needed to produce

given amounts of the commodity in question. Figure B.1 shows several production isoquants, each showing the different combinations of land and labor that could yield a given level of output. The smooth isoquants of Figure B.1A portray a case in

which land and labor are partial substitutes for one another in cloth. Starting from a

point like W, it would be possible to keep the same cloth output per year (i.e., stay on the isoquant T–T ) with less labor if we used enough more land, as at V. By contrast, in Figure B.1B, the production function has a special form (sometimes called the

Leontief production function) in which land and labor are not substitutes at all. Thus,

starting from point W, we cannot give up any labor inputs without falling to a lower output isoquant, regardless of how much extra land is added. Thus the isoquant moves

vertically up from point W to points like Z demanding the same labor inputs. Some industries are thought to resemble this special case, though the factors of production

are usually partial substitutes for one another, as in Figure B.1A.

What combination of resources should be used to produce a specific amount of

output of a product? If the factors are partial substitutes, then the lowest- cost combina-

tion of resources to use depends on the factors’ prices. The relative prices of the two

factors are summarized in factor- price slopes like that of isocost lines S–S and S'–S' in Figure B.1A, which are parallel. This slope shows the ratio of the wage rate for labor

to the rental rate for land—the number of acres of land use that can be traded for each

hour of labor in the marketplace. For given factor prices, isocost lines farther from the

origin indicate higher total costs.

To minimize the cost of producing a specific level of output, a firm would seek the

lowest isocost line, the one that is just tangent to the isoquant for that output level. For

instance, if factor prices are shown by the slope of line S–S, then the least- cost way of

pug21774_appB_659-663.indd 659pug21774_appB_659-663.indd 659 12/8/14 7:10 PM12/8/14 7:10 PM

Final PDF to printer

Land use (acre-years)

Labor (person-hours per year)

A. Production Function for Cloth

T S

Land

Labor

T Z

W T

Cloth

Wheat T9

T S

B. Production Functions with Fixed Factor Proportions

FIGURE B.1 Production: Isoquants and Expansion Paths

660 Appendix B

producing the output level for isoquant T–T is to use the combination of labor hours and land acres shown by point W. If land then becomes cheaper relative to labor, the factor- price slope would be steeper than S–S. Firms should substitute the lower- priced land for labor, and production would shift to a point like V.

How would the use of labor and land increase if the industry wanted to expand

output, assuming that factor prices are constant? In Figure B.1A, we have shown

the often- imagined case in which any expansion of output would be achieved along the

expansion path R, a straight line from the origin as long as the factor- price ratio is still the slope S–S. In Figure B.1B the factor proportions would always be fixed, on the more labor- intensive expansion path (X ) for cloth and the more land- intensive expan- sion path (Y ) for wheat, regardless of the relative prices of land and labor.

To know the most efficient combinations a nation can produce, we must now com-

bine the technological possibilities represented by the production- function isoquants

with the nation’s total supplies of land and labor. A handy device for doing this is the

Edgeworth–Bowley box diagram, in which the dimensions of the box represent the amounts of land and labor in a country, which we call Britain. These factor supplies

are assumed to be homogeneous in character and fixed in amount.

Figure B.2 shows an Edgeworth–Bowley box for production functions with fixed

factor proportions and constant returns to scale (so that a proportionate increase in all

inputs used to produce a product results in an increase in the product’s output by the

same proportion). The production function for cloth is drawn with its origin in the

lower- left corner of the box at O, and with its isoquants, T–T, T'–T', and so on, moving out and up to the right. Its expansion path is OX. If all the labor in Britain (OR ) were used to make cloth, only RX of land would be required, and O'X of land would be left unemployed. At X, the marginal physical product of land would be zero.

The production function for wheat is drawn reversed and upside down, with its origin

at O' and extending downward and to the left. Its expansion path is O'Y. At Y, all the

pug21774_appB_659-663.indd 660pug21774_appB_659-663.indd 660 12/8/14 7:10 PM12/8/14 7:10 PM

Final PDF to printer

Labor used in wheat

O Labor used in cloth

La n

d u

se d

i n

c lo

La n

d u

se d

i n

w h

e a t

G Y H R

T J

Cloth

Wheat

FIGURE B.2 Edgeworth–

Bowley Box

Diagram with

Fixed Factor

Proportions

Wheat (units per year)

Cloth (units per year) O X

FIGURE B.3 Production-

Possibility

Curve

Derived from

Edgeworth–

Bowley Box

Diagram with

Fixed Factor

Proportions

Deriving Production-Possibility Curves 661

land and YR of labor would be employed, but OY of labor would be unemployed. OX and O'Y intersect at W, which is the only production point in the box diagram where there can be full employment and positive prices for both factors. At any other point on

either expansion path, say, F on OX, land and labor will be able to produce at J on the expansion path for wheat; OG of labor will be engaged in cloth, and HR in wheat. RK of land will be employed in cloth, and O'K in wheat. But GH of labor will be unemployed.

The curve OWO', as in Figure B.2, is in effect a production- possibility curve, showing the various combinations of wheat and cloth that can be produced in Britain,

given the factor endowments of the country. The only point providing full employ-

ment of the two factors and positive factor prices is W. OWO' does not look like a production- possibility curve because it is given in terms of physical units of land and

labor, rather than physical units of production. If we remap the OWO' curve in Figure B.2 from factor space into commodity space in terms of units of wheat and cloth and

turn it right side up, it is a production- possibility curve, kinked at W, as in Figure B.3.

pug21774_appB_659-663.indd 661pug21774_appB_659-663.indd 661 12/8/14 7:10 PM12/8/14 7:10 PM

Final PDF to printer

Labor

O Labor

La n

Cloth

Wheat Wheat

ClothO

A. Constant Opportunity Costs: Identical Fixed Factor Proportions

B. Production-Possibility Curve Derived from B.4A

FIGURE B.4 Production-Possibility Curve with Identical Factor Proportions

662 Appendix B

If cloth and wheat were produced with fixed factor coefficients, and these were

identical, the two expansion paths would coincide, as in Figure B.4A. In this case,

if production also involves constant returns to scale for both products, then the

production- possibility curve becomes a straight line, as in Figure B.4B. Because land

and labor are always used in the same combination, they might well be regarded as

a single factor. This is equivalent to Ricardo’s labor theory of value and its resultant

straight- line production- possibility curve. A similar straight- line production-possibility

curve would be produced for any economy in which the production functions are con-

stant returns to scale and identical factor- intensity for the two commodities.

When there is the possibility of substitution between factors in the production of a

commodity, there is no unique expansion path. Instead, a separate expansion path can

be drawn for any given set of factor prices. To determine the production-possibility

curve, we can draw in the isoquants for both commodities and trace out a locus of

points of tangency between them. This locus represents the efficiency path, or the maxi-

mum combinations of production of the two goods that can be produced with the exist-

ing factor supplies. It is shown in Figure B.5A. To see why it is an efficient path, suppose

that production were to take place at W, away from the efficiency locus. W is on cloth isoquant 7 and on wheat isoquant 5. But there is a point T, also on cloth isoquant 7, that is on a higher isoquant (6) of wheat. It would therefore be possible to produce

more wheat without giving up any cloth. There is also point T' on wheat isoquant 5 that is on cloth isoquant 8. It would be equally possible to produce more cloth and

the same amount of wheat. Any point off the locus of tangencies of isoquants of the

two production functions is therefore inefficient, insofar as it would be possible to get

more output of one commodity without losing any of the other, by moving to the locus.

When the Edgeworth–Bowley box is used for picturing production, it shows not

only the efficient combinations of outputs but also factor combinations and factor

pug21774_appB_659-663.indd 662pug21774_appB_659-663.indd 662 12/8/14 7:10 PM12/8/14 7:10 PM

Final PDF to printer

Labor

O Labor

La n

Cloth

Wheat Wheat

ClothO

A. Maximum Efficiency Locus under Variable Factor Proportions

B. Production-Possibility Curve Derived from B.5A

T 9 T

7 8

FIGURE B.5 Production-Possibility Curve with Variable Factor Proportions

Deriving Production-Possibility Curves 663

prices. If production is at T, the factor proportions in cloth are represented by the slope of the dashed line OT, and the factor proportions in wheat by the dashed line O'T. The relative price of land and labor with these outputs is represented by the slope of the

line tangent to the isoquants at T. If the production function for each product shown in Figure B.5A is constant returns

to scale, then the bowed shape of the efficiency locus translates into the bowed- out

production- possibility curve in Figure B.5B. One way to see the basis for this is first

to recognize that production along the diagonal of this Edgeworth–Bowley box would

result in a straight- line “ production- capability” curve. (The logic is essentially the same

as that sketched for the case of identical constant- returns- to- scale production functions.)

Because moving off the diagonal to produce instead on the efficiency locus increases

output for all points except the corners of the box, the actual production- possibility

curve lies outside of this straight line connecting the end points (where the country is

completely specialized in producing only one product, corresponding to the corners of

the Edgeworth–Bowley box). The resulting production- possibility curve is bowed out.

pug21774_appB_659-663.indd 663pug21774_appB_659-663.indd 663 12/8/14 7:10 PM12/8/14 7:10 PM

Final PDF to printer

664

Appendix C

Offer Curves In Chapter 2 we demonstrated how to use supply and demand curves to determine the

equilibrium international price with free trade. Another geometric device that serves a

similar function is the offer curve, which shows how the export and import quanti- ties a nation chooses will vary with the international price ratio. This appendix gives

the geometric derivation of the offer curve. Appendix D shows how it can be used in

discussing optimal tariff policy.

A region or nation’s offer curve is equivalent to both its supply curve for exports

and its demand curve for imports. (For examples of the latter two curves, see the center

panel of Figure 2.3.) It graphs trade offers as a function of the international price ratio.

And it can be derived from the same production-possibility curves and community

indifference curves used extensively in Chapter 4.

Figure C.1 shows the derivation, starting from the usual production and consump-

tion trade-offs. For each international price ratio, the behavior of the United States

produces a quantity of exports willingly offered in exchange for imports at that

price ratio. At 2 W/C , the United States does not want to trade at all, as shown at S

0 . At 1 W/C , the United States would find cloth cheaper, and wheat more valuable,

than without trade. It would be willing to export 40 billion wheat units and import

40 billion cloth units, by efficiently producing at S 1 and consuming at C

1 . A price of

1/2 W/C would again induce the United States to offer 40 billion of wheat exports, but this time in exchange for 80 billion of cloth imports. Each offer of exports for imports

is pictured as a trade triangle with corners at the production and consumption points

for the price ratio.

Each of these offers is plotted on the lower half of Figure C.1 (as points O , O 1 , and O

2 ),

where the axes are the exports and imports to be exchanged, and the slope of any

ray from the origin is a price ratio. The resulting curve O US

is the U.S. offer curve.

A similar derivation produces the rest of the world’s offer curve, O RW

. Only at the

equilibrium price of 1 W/C , at point O 1 , will the United States and the rest of the world

be able to agree on how much to trade.

There is another way to derive the same offer curve for a country. We can use

trade indifference curves , which show the levels of well-being attained by a country for different amounts of imports received and exports paid. Imports add to national

well-being by expanding consumption while exports detract from well-being because

they are not available for local consumption. A trade indifference curve pictures the

trade-off that the country would be willing to make while remaining at the same level

pug21774_appC_664-666.indd 664pug21774_appC_664-666.indd 664 12/8/14 7:13 PM12/8/14 7:13 PM

Final PDF to printer

Offer Curves 665

Cloth (billions of units per year)

Wheat (billions of units per year)

87.5 80

50 47.5

10O 20 40 60 90

I3 C1

Price 5 1 W/C

Price 5 2 W/C

Price 5 1/2 W/C

United States

Cloth (imports into the United States,

exports from the rest of the world)

Wheat (exports from the United States, imports into the rest of the world)

40 80

Price 5 2 W/C

Price 5 1 W/C

O2 I3 I2

OUS

ORW

FIGURE C.1 Deriving the

Offer Curve

of overall well-being. The bottom half of Figure C.1 shows two U.S. trade indiffer-

ence curves: I 2 and I

3 . 1 These two trade indifference curves correspond to the levels

of U.S. well-being shown by community indifference curves I 2 and I

3 in the top half

of the figure. The trade indifference curves have the upward slope and rather peculiar

1The trade indifference curves for the country can be derived from its production-possibility curve and community indifference curves.

pug21774_appC_664-666.indd 665pug21774_appC_664-666.indd 665 12/8/14 7:13 PM12/8/14 7:13 PM

Final PDF to printer

666 Appendix C

shape for the United States (and I 3 is better than I

2 ) because more cloth imports are the

desirable item, while more exports are undesirable.

We can find a point on the U.S. offer curve by determining the highest trade indif-

ference curve that can be reached if the price ratio is 1 W/C . The highest trade indif- ference curve, and therefore the highest level of well-being that the United States can

reach at this price ratio, is the tangency with trade indifference curve I 2 at point O

1 .

Thus, O 1 is a point on the U.S. offer curve. For the price ratio of 1/2 W/C , the tangency

is with I 3 , so O

2 is another point on the U.S. offer curve.

Offer curves can be used to analyze what happens when something fundamental

changes. For instance, the implications for the United States of a shift in the offer

curve of the rest of the world are straightforward. If it shifts out, the two offer curves’

intersection shifts from point O 1 to a point like O

2 . The extra supply of cloth exports

from the rest of the world decreases the relative price of cloth. (The price line becomes

flatter.) This represents an improvement in the U.S. terms of trade, and the United

States is better off, reaching an indifference curve like I 3 instead of I

2 .

Growth of production capabilities in the United States usually shifts the U.S. offer

curve. We can use offer curves to show how the international price ratio is affected

by this growth. For instance, if the growth increases the willingness to trade (as dis-

cussed in Chapter 7), then the U.S. offer curve shifts out (or up), and the relative price

of cloth increases in moving to the new equilibrium intersection. The U.S. terms of

trade decline. 2

Holding the country’s production capabilities steady, and assuming that the foreign

offer curve is also steady, is there anything that a country can do to improve its well-

being by moving its own offer curve? Not if the nation consists of large numbers of

private individuals competing against each other in production and consumption with

no government intervention. Such private competition merely puts us on the offer

curve in the first place and does not shift the curve. Yet if the nation acted as a single

decision-making unit, there is the glimmering of a chance to squeeze more advan-

tage out of trade in Figure C.1. Starting at the free-trade equilibrium O 1 , the United

States might be able to come up with a way to move a short distance to the southwest

along the foreign offer curve O RW

, reaching somewhat higher indifference curves than

at O 1 . How could this be done? Through an optimal tariff of the sort discussed in

Appendix D, where the offer curves reappear.

2We cannot use the original trade indifference curves to analyze the effects of this growth on U.S. well- being because the growth in the U.S. production capabilities means that the United States has a new set of trade indifference curves. Chapter 7 shows how changes in well-being can be examined using production-possibilities curves and community indifference curves once the change in the equilibrium price ratio is determined.

pug21774_appC_664-666.indd 666pug21774_appC_664-666.indd 666 12/8/14 7:13 PM12/8/14 7:13 PM

Final PDF to printer

667

Appendix D

The Nationally Optimal Tariff

DERIVING THE OPTIMAL TARIFF

In the latter part of Chapter 8 we presented the nationally optimal tariff for a country

that can affect the foreign-supply price of its imports without incurring retaliation by

the foreign country. This appendix derives the formula for the nationally optimal tariff

using both the demand–supply framework of Chapter 8 and the offer-curve framework

of Appendix C. An analogous formula is derived for the optimal export duty, both for

a nation and for an international cartel.

As we saw in the demand–supply framework, a small increase in an import tariff

brings an area of gain and an area of loss to the nation. Figure D.1 compares these

two areas for a tiny increase in the tariff above its initial amount per unit, which is

the fraction t times the initial price P paid to foreign exporters. The extra gains come from being able to lower the foreign price on continuing imports, gaining the level of

imports M times the foreign price drop dP/dt . The extra losses come from losing the extra imports ( dM/dt ) that were worth tP more per unit to consumers than the price ( P ) at which foreigners were willing to sell them to us.

The optimal tariff rate is that which just makes the extra losses and extra gains

from changing the tariff equal each other. That is, the optimal tariff rate t* as a share of world price is the one for which

Extra gains 2 Extra losses 5 M dP ___ dt

2 t*P dM ___ dt

5 0

so that

t* 5 dP/dt _____ dM/dt

M __ P

Since the foreign supply elasticity is defined as

s m 5 dM/dt _____

dP/dt · P __

along the foreign supply curve, the formula for the optimal tariff is simply t* 5 1 /s m ,

as stated in Chapter 8. If the world price is fixed beyond our control, so that s m 5 `,

pug21774_appD_667-672.indd 667pug21774_appD_667-672.indd 667 12/8/14 9:20 PM12/8/14 9:20 PM

Final PDF to printer

668 Appendix D

1Figure D.1 makes it easy to show that the nationally optimal tariff is lower than the tariff rate that would maximize the government’s tariff revenue, even when the foreign supply curve slopes upward. The optimal tariff in Figure D.1 is one that equates the “extra gains” area with the “extra losses” area. But at this tariff rate a slight increase in the tariff still brings a net increase in government tariff revenue. By raising the tariff rate slightly, the government collects more duty on the remaining imports, M, while losing the “extra losses” area on the discouraged imports. However, its gain in revenue on M is not just the “extra gains” area already introduced, but this plus the thin unlabeled rectangle above the tP gap, which takes the form of a higher price to consumers importing M. A slight increase in the tariff would still raise revenue even when it brings no further net welfare gains to the nation. It follows that the revenue-maximizing tariff rate is higher than the optimal tariff rate. Thus a country would be charging too high a rate if it tried to find its nationally optimal tariff rate by finding out what rate seemed to maximize tariff revenues.

Quantity of imports

Price

Extra gains 5 M

Extra losses 5 tP dM___ dt

dP__ dt

Foreign supply of imports

Demand for imports

dM___ dt

FIGURE D.1 The Gains and

Losses from a

Slight Increase

in the Tariff, in a

Demand–Supply

Framework

then the optimal tariff rate is zero. The more inelastic the foreign supply, the higher

the optimal tariff rate. 1

OPTIMAL EXPORT TAXES

We can derive the optimal rate of export duty in the same way. Just replace all terms refer- ring to imports with terms referring to exports and redraw Figure D.1 so that the extra gain

at the expense of foreign buyers of our exports comes at the top of the tariff gap instead of

at the bottom. It turns out, symmetrically, that the optimal export duty equals the absolute

value of 1/ d x , or the reciprocal of the foreign demand elasticity for our exports.

The formula for the optimal export duty can also be used as the optimal rate of

markup of an international cartel. Since both the international cartel maximizing joint

profits from exports and the single nation optimally taxing its exports are monopo-

listic profit maximizers, it stands to reason that the formula linking optimal markup

to foreign demand elasticity should hold in both cases. So the optimal markup for an

pug21774_appD_667-672.indd 668pug21774_appD_667-672.indd 668 12/8/14 9:20 PM12/8/14 9:20 PM

Final PDF to printer

The Nationally Optimal Tariff 669

international exporting cartel is t* 5 |1 /d c |, or the absolute value of the reciprocal of

the world demand elasticity for the cartel’s exports.

We can extend the formula to show how the optimal export markup for cartel mem-

bers depends on the other elasticities and the market share discussed in Chapter 14’s

treatment of cartels like OPEC. We can link the elasticity of demand for the cartel’s

exports to world demand for the product, the supply of perfect substitutes from other

countries, and the cartel’s share of the world market by beginning with a simple identity:

Cartel exports 5 World exports 2 Other countries’ exports

X c 5 X 2 X

Differentiating with respect to the cartel price yields

c ___ dP

5 dX ___ dP

2 dX

0 ___

This can be reexpressed in ways that arrive at an identity involving elasticities:

c /dP ______

X 5 dX/dP ______

X 2

dX 0 /dP ______

c ___ dP

P __ X

c __ X

5 dX ___ dP

P __ X

2 dX

0 ___

dP P __

X 0

0 __

The cartel’s share of the world market is defined as c 5 X c /X 5 1 2 ( X

0 /X ). The

elasticity of demand for the cartel’s exports is defined as d c 5 ( dX

c / dP )( P/X

c ); the elas-

ticity of world export demand for the product is d 5 ( dX / dP )( P/X ); and the elasticity of noncartel countries’ competing export supply of the product is s

0 5 ( dX

0 /dP )( P/X

0 ).

Substituting these definitions into the equation above yields

d c · c 5 d 2 s

0 (1 2 c)

so that

d c 5

d 2 s 0 (1 2 c)

____________ c

Now since the optimal markup rate is t * 5 |1/ d c |, this optimal cartel markup rate is

t* 5 c ____________ |d 2 s

0 (1 2 c)|

The optimal markup as a share of the (markup-including) price paid by buying coun-

tries is greater, the greater the cartel’s market share ( c ), the lower the absolute value of the world demand elasticity for exports of the product ( d ), or the lower the elasticity of noncartel countries’ export supply ( s

0 ).

THE OPTIMAL TARIFF AGAIN WITH OFFER CURVES

The nationally optimal tariff on imports (or exports) can also be portrayed using

the offer-curve framework of Appendix C, though this framework is less convenient

for showing the formula for the optimal tariff. A trade-taxing country can use the

pug21774_appD_667-672.indd 669pug21774_appD_667-672.indd 669 12/8/14 9:20 PM12/8/14 9:20 PM

Final PDF to printer

670 Appendix D

tariff to move its own offer curve until it reaches the point on the foreign offer curve

that maximizes the country’s well-being. Figure D.2 shows this optimal tariff for

a wheat-exporting country. Our country, the wheat exporter, has pushed its offer

curve to the right by making the price of imported cloth in units of wheat higher

within the country than the price received by our foreign cloth suppliers. At point

T domestic consumers must pay for cloth at the domestic price ratio SR/RT , giving up SR in wheat for RT in cloth. The foreign suppliers receive only OR in wheat for their RT of cloth. The government has intervened to collect tariff revenue at the tariff rate SO/OR .

Figure D.2 shows that this particular tariff rate happens to be optimal because at

point T the foreign offer curve is tangent to I 0 , the best indifference curve we can

reach through trade. The optimal tariff is positive because the foreign offer curve is

not infinitely elastic. If it were infinitely elastic, in the form of a fixed world price line

coming out of the origin, our optimal tariff would be zero because no other tariff can

Our cloth imports

Our wheat exports

O U

Our offer curve: With no tariff

With optimal tariff

Foreign offer curve

R T

At point T , foreign sellers are paid only OR of our wheat for OU of their cloth. But domestic buyers have to pay the OR plus the tariff revenue of OS in extra wheat to get that OU of cloth. While that is bad for our cloth consumers in their role as cloth consumers, our nation gets to the better trade indifference curve I

0 , helped by the fact

that foreign suppliers pay some of the tariff, in effect, when they are forced to accept

a lower world price (the slope OT ) than the price reflected by the slope OW , which they would receive for cloth with no tariffs.

FIGURE D.2 An Optimal

Tariff, Portrayed

with Offer

Curves

pug21774_appD_667-672.indd 670pug21774_appD_667-672.indd 670 12/8/14 9:20 PM12/8/14 9:20 PM

Final PDF to printer

The Nationally Optimal Tariff 671

put us on as high an indifference curve as we can reach on our free-trade, no-tariff

offer curve. The same principle emerges here as in the demand–supply framework:

The more elastic the foreign trading curve, the lower is our optimal tariff.

Deriving the formula for the optimal tariff rate is more complicated with offer

curves than with demand and supply curves. The elasticity of the foreign offer curve

is conventionally defined differently from a foreign supply curve, and defined in a

way that is hard to identify in the offer-curve diagram itself. Any country’s offer-curve

elasticity is conventionally defined as the ratio of the percent response of its import

demand to a percent change in the relative price of its imports:

Offer-curve elasticity (E OC

) 5 2(% change in M)

_________________ [% change in (X/M)]

Since the change in the price ratio X/M is not easy to spot on an offer-curve diagram like Figure D.2, let’s convert this definition into a more usable equivalent:

E OC

5 2(% change in M )

______________________________ (% change in X ) 2 (% change in M )

5 21

__________________

(% change in X )

______________ (% change in M)

2 1

5 1 ___________________

1 2 ( slope −X ___ −M ) (M/X)

This last expression can be translated into a relationship among line segments in

Figure D.2. We now take the foreigners’ point of view since it is their offer curve we

are trying to interpret. The foreigners export cloth and import wheat. Thus the slope

showing how a change in cloth exports relates to a change in their wheat imports at

point T is the ratio RT/SR , and the ratio ( M/X ) is OR/RT . Therefore the elasticity of their offer curve becomes

E OC

5 1 __________

1 − RT ___ SR

OR ___ RT

1 _______

1 − OR ___ SR

SR ________ SR − OR

5 SR ___ SO

(Some authors derive an equivalent ratio on the cloth axis: E OC

5 UO/VO .) We can now see the close link between the optimal tariff rate at point T and the

elasticity of the foreign offer curve:

t* 5 SO ___ OR

5 SO ________ SR 2 SO

5 1 _______ SR ___ SO

2 1

t* 5 1 _______ E

OC 2 1

This expression seems to differ slightly from the formula relating to the foreign

supply elasticity for our imports, derived above. But the difference is only definitional.

The elasticity of the foreign offer curve is defined as the elasticity of the foreigners’

wheat imports with respect to the world price of wheat, not the elasticity of their cloth

exports (supply of our cloth imports) with respect to the world price of cloth. Since

pug21774_appD_667-672.indd 671pug21774_appD_667-672.indd 671 12/8/14 9:20 PM12/8/14 9:20 PM

Final PDF to printer

672 Appendix D

the ratio of the foreigners’ cloth exports to their wheat imports is just the world price

of wheat, the foreign offer-curve elasticity [(Percent change in wheat)/(Percent change

in cloth/wheat)] is equal to one plus their elasticity of supply of our import, cloth. So

the above expression is equivalent to the reciprocal of the foreigners’ supply elasticity

of our import good, as in the demand–supply framework. 2

2One word of caution in interpreting the optimal tariff formula relating to the foreign offer curve: The tariff rate can equal the formula 1/(E

OC – 1) for any tariff rate, not just the optimal one. To know that

the rate is optimal, as at point T, you must also know that the foreign offer curve is tangent to our trade indifference curve.

pug21774_appD_667-672.indd 672pug21774_appD_667-672.indd 672 12/8/14 9:20 PM12/8/14 9:20 PM

Final PDF to printer

673

Appendix E

Accounting for International Payments In Chapter 16 we examined the uses and meanings of a country’s balance of

payments, which records all flows of economic value between a country’s residents

and the residents of the rest of the world. We noted that the balance of payments is

based on double-entry bookkeeping . Each transaction between a resident of our coun- try and a resident of the rest of the world includes two items:

• A credit item (measured with a positive sign) is what we give up in the transac- tion, so that it creates a reason for a payment by the foreigner into the country—a

monetary claim on the foreigner.

• A debit item (measured with a negative sign) is what we receive in the transaction, so that it creates a reason for a payment by our country to a foreigner—a monetary

claim owed to a foreigner.

The assumption of double-entry bookkeeping is that each transaction is an exchange

of value for equal value. (For something that is given away, this equality is not true,

but in this case we create an artificial item to maintain the system.)

This appendix shows how accounting for the balance of payments works, by

examining five illustrative transactions between the United States and the rest of

the world during a short period of time. For each transaction, we will post the items

to relevant parts of the balance of payments, and then we will create a simplified

balance of payments for the United States for this time period using these five

transactions.

FIVE TRANSACTIONS

First, suppose that Northern Illinois Gas, a U.S. utility company, buys $34 million in

natural gas from a Canadian firm. It does not pay in cash immediately, but instead

issues a promissory note saying that it will pay the bill (plus interest that will accrue

over time) one year later. For the U.S. balance of payments, two accounting entries are

made for the transaction that occurs now:

pug21774_appE_673-676.indd 673pug21774_appE_673-676.indd 673 12/8/14 7:23 PM12/8/14 7:23 PM

Final PDF to printer

674 Appendix E

Credit (1) Debit (2)

($ million) ($ million) Import of goods (natural gas) $34 Change in foreign loans to the U.S. (promissory note) $34

The debit entry probably seems easier and more natural than the credit entry in this

case. It is clear that importing natural gas is an inflow of something valuable for

which the United States must pay. But why should the promissory note be recorded

as a credit item? Because the Canadian seller of the gas has received something valu-

able in exchange, the right to be paid in the future. Effectively, the Canadian seller is

providing the funds to Northern Illinois now (in exchange for the promissory note),

so that Northern Illinois can use those funds now to “pay for” the natural gas that it

is importing.

Consider a second international transaction, in which Brazilian soccer fans spend

$6 million as tourists in the United States during a soccer tournament, and they pay

for their hotels, meals, and transportation by using the deposits that they have at a New

York bank. The two flows are entered in the U.S. accounts as

Credit (1) Debit (2)

($ million) ($ million) Exports of services (travel) $6 Change in foreign investments in the U.S. (reduction in U.S. bank obligations to foreign residents) $6

Again, one entry fits intuition more easily than the other. It is easy to see that sales

of tourist services to Brazilians are a U.S. export, for which the United States must

be paid. If this is a credit item, then the other item must be a debit item. Reducing a

liability to foreigners is something of value that the United States must pay for now.

Effectively, the New York bank is providing the funds to the Brazilian tourists so that

they can use these funds to pay for their expenditures.

For our third transaction, suppose that the U.S. Treasury pays $25 million in inter-

est on its past borrowing from Swiss investors, paying with checks on a New York

bank. The two accounting entries are

Credit (1) Debit (2)

($ million) ($ million) Income paid to foreigners (interest payment) $25 Change in foreign investments in the U.S. (increase in U.S. bank obligations to foreign residents) $25

The payment of interest is payment of income to foreign residents, so this is a debit. The

means of payment is a credit. The private New York bank on which the U.S. government

wrote the checks now has a new liability to residents of Switzerland. The bank uses the

pug21774_appE_673-676.indd 674pug21774_appE_673-676.indd 674 12/8/14 7:23 PM12/8/14 7:23 PM

Final PDF to printer

Accounting for International Payments 675

borrowing from foreigners to cancel an equal checking-account obligation to the U.S.

government, which has less claim on the private bank now that it has written the checks.

In our fourth transaction the U.S. monetary authority in its official role becomes

concerned that the exchange rate value of the dollar may appreciate against the

Japanese yen. It decides to purchase yen-denominated bank deposits from a major

Tokyo bank and pay by transferring $15 million of its New York bank deposits to this

Tokyo bank. For this transaction, here are the entries for the U.S. balance of payments:

Credit (1) Debit (2)

($ million) ($ million) Change in U.S. official holdings of foreign assets (increase in yen financial assets) $15 Change in foreign investments in the U.S. (increase in U.S. bank obligations to a foreign resident) $15

Here we have a purely financial exchange. Effectively, the U.S. monetary authority

is transferring part of its dollar bank deposits to a foreigner (the Tokyo bank) to get

the funds that it uses to pay for the yen deposits. (There are two things to note about

the accounting. First, the increase in U.S. holdings of foreign assets is measured as a

negative item. This is simply based on the choice of how the credit, or positive, and

debit, or negative, items are defined. Second, the yen value of the Tokyo bank deposits

is converted into its dollar equivalent because all values must be measured in the same

currency.)

So far we can see that every transaction has two equal sides. If we add up all the

credits as pluses and all the debits as minuses, the net result is zero. Let’s turn to a case

that might look like a violation of this accounting balance.

The fifth transaction involves giving something away. Suppose that the U.S. gov-

ernment simply gives $8 million in foreign aid to the government of Egypt in the form

of wheat from U.S. government stockpiles. The correct way to record the credit and

debit items is:

Credit (1) Debit (2)

($ million) ($ million) Exports of goods (wheat) $8 Unilateral transfer (aid to Egypt) $8

The $8 million credit is easy because this is just the export of a good, for which

the United States ordinarily would be paid. The accountants get around the fact the

United States is not paid by inventing a debit item for the unilateral transfer (gift) to

Egypt. We can imagine that the United States receives $8 million of goodwill—or

gratitude—from Egypt. That goodwill is something received, a debit, for which the

United States pays in wheat. In this way, even a one-way flow is transformed by

accounting fiction into a two-way flow, preserving the all-in zero balance of double-

entry bookkeeping.

pug21774_appE_673-676.indd 675pug21774_appE_673-676.indd 675 12/8/14 7:23 PM12/8/14 7:23 PM

Final PDF to printer

676 Appendix E

Current Account

Exports of goods and services 16 1 8 5 114 Imports of goods and services 234 Income paid to foreigners 225 Unilateral transfers, net 28 Current account balance 253

Financial Account (excluding official international reserves)

Changes in foreign loans to the U.S. and other investments 134 2 6 1 25 115 5 168 Financial account balance 168

Official International Reserves

Changes in U.S. official holdings of foreign assets 215 Changes in official international reserves, net 215

Other important balances Goods and services balance 220 Overall balance 115

FIGURE E.1 U.S. Balance

of Payments,

Based on Five

Hypothetical

Transactions

($ millions)

PUTTING THE ACCOUNTS TOGETHER

To arrange the credit and debit items from the separate transactions into a useful sum-

mary set of accounts, group them according to the major types of flows. Figure E.1

does this for our set of five transactions. For the five transactions, the United States

has a current account deficit of $53 million, but this is more than offset by a (private

or nonofficial) financial account surplus of $68 million. Thus, the United States has

an overall payments (or official settlements balance) surplus of $15 million, and the

United States has increased its holdings of official reserve assets by this amount.

pug21774_appE_673-676.indd 676pug21774_appE_673-676.indd 676 12/8/14 7:23 PM12/8/14 7:23 PM

Final PDF to printer

677

Appendix F

Many Parities at Once In Chapter 18 we introduced two parity conditions relating interest rates in different

countries and exchange rates. In Chapter 19 we introduced another parity condition,

purchasing power parity, that linked the prices of goods in different countries through

exchange rates. These parity conditions are all based on people’s ability to arbitrage

between countries. As long as there are different ways of starting with one asset or

product and ending up with another asset or product, the prices at which the assets or

products can be exchanged will be closely related.

These parity conditions reveal relationships between foreign exchange markets

and such macroeconomic phenomena as inflation and real interest rates. To see the

relationships, let’s think about the fact that investors can move between currencies

and products. To simplify here, let us think about uniform products that can be bought

or sold in either country. In addition to holding currencies today or in the future, you

can hold products today or in the future. Investors must worry about price trends for

products as well as price trends for currencies. Suppose, for example, you fear more

inflation in the prices of products in Britain than in America over the next 90 days.

How should your decision about where to hold your wealth relate to this fear and to

the interest rates and trends in exchange rates? If others share your fear, what will

happen to currency and commodity markets?

There are a number of links here, portrayed by Figure F.1 . The central rectangle is

just the lake diagram of Figure 18.1 revisited. Now, however, there also are ways to

buy and sell products with currencies. You can trade either currency for products today

at the dollar price P $ or the sterling price P

£ . If you start with today’s dollars, your way

of buying products depends on the relative prices shown at the bottom of Figure F.1.

You might just take, say, $10,000 and buy 10,000/ P $ in current products with it. Or

you could take a more roundabout route, using the $10,000 to buy £10,000/ e worth of sterling and then using it to buy 10,000/( eP

£ ) in products today. Do whichever is

cheaper. That is, you have an incentive to travel the cheaper of the two routes between

today’s dollars and today’s products. The availability of this choice means that the

two prices will tend to be bid into line: P $ 5 eP

£ . This is the (absolute) purchasing

power parity (PPP) condition discussed in Chapter 19. As argued in that chapter, it is a

general tendency that works reasonably well over decades, but only more roughly over

shorter periods because of trade barriers, the costs of transactions and transportation,

and the underlying differences in the goods whose prices are being compared.

pug21774_appF_677-679.indd 677pug21774_appF_677-679.indd 677 12/8/14 7:29 PM12/8/14 7:29 PM

Final PDF to printer

678 Appendix F

Moving with the arrow, multiply the value of your goods or money by the expression.

Moving against the arrow, divide by it.

Symbols: P $ , P

£ 5 today’s price level for goods (wheat, DVD movies, etc.) in terms of $, £; π

ex $ ,

π ex £ 5 the expected rate of inflation in the dollar and sterling goods’ price levels; e, f 5 the spot

and forward prices of the £ (in $/£); e ex 5 the expected future level of the spot price of the £ (not to be confused with the present forward price of it); i

US , i

UK 5 the interest rates on widely

marketed assets (e.g., treasury bills) in America and Britain. (Ignore transactions fees and ignore

futures markets in goods such as grain futures.)

Today’s pounds

Future pounds

Today’s dollars

Future dollars

Future products

Today’s products

P$ P£

(1 1 iUK) (1 1 iUS)

P$(1 1 π ex) $ P£(11 π

ex)

eex or f

FIGURE F.1 Spot and

Forward

Positions in

Currencies and

Products

A version of purchasing power parity should also hold for the future. If it doesn’t,

there may be unexploited chances for profitable arbitrage. Buying goods with dollars

in the future should look equally cheap whether we expect to buy directly at the future

dollar price or at the future pound price of goods times the dollar price of getting

each pound. These different prices will depend on how much price inflation people

expect between now and the future (say, 90 days from now). If people expect dollar

prices to go up by the fraction π ex $ and pound prices to go up by the fraction π

ex £ , then

these average expectations should be tied to what future exchange rate people expect

( e ex ). Their expectations should equate the direct and indirect dollar prices of goods shown at the top of Figure F.1, or P

$ (1 1 π

ex $ ) 5 e ex P

£ (1 1π

ex £ ). This condition can be

called expected future PPP . It is only a rough tendency, like today’s PPP, when actual changes in prices are used as measures of the expected changes π

ex $ and π

ex £ .

The tendencies toward purchasing power parity today and in our expectations about

the future provide links among expected price inflation, interest rates, and exchange

rates. Recall from Chapter 18 that the forward price of the pound, f , should equal e ex , the average expectation about the future value of the spot rate. Combining the equality

e ex 5 f with the interest parity conditions of Chapter 18 gives further results shown in Figure F.2’s summary of key parity conditions.

pug21774_appF_677-679.indd 678pug21774_appF_677-679.indd 678 12/8/14 7:29 PM12/8/14 7:29 PM

Final PDF to printer

Many Parities at Once 679

1. Purchasing power parity (PPP) today: eP £ 5 P

$ , roughly (see Chapter 19).

2. Expected future PPP: eexP £ (1 1 πex

£ ) 5 P

$ (1 1 πex

$ ), roughly, so that

eex/e 5 (1 1 πex $ )/(1 1 πex

£ ), or, approximately, Expected appreciation of

£ 5 Expected $ inflation 2 Expected £ inflation. 3. Covered interest parity: (f/e) 5 (1 1 i

US )/(1 1 i

UK ) definitely.

4. Speculators’ forward equilibrium: Forward rate measures average expected future spot rate, or eex 5 f, we think.

5. Uncovered interest parity: (eex/e) 5 (1 1 i US

)/(1 1 i UK

), we think. Combining parities 2, 3, and 5, we see that

eex/e 5 f/e 5 (1 1 i US

)/(1 1 i UK

) 5 (1 1 πex $ )/(1 1 πex

£ ),

or, approximately,

Expected appreciation of £ 5 Premium on forward £ 5 Difference between $ and £ interest rates 5 Expected difference between $ and £ inflation rates

So we expect real interest rates to be roughly equal internationally: 6. Real interest rate equilibrium: (1 1 i

US )/(1 1 πex

$ ) 5 (1 1 i

UK )/(1 1 πex

£ )

or, approximately, (i US

2 πex $ ) 5 (i

UK 2 πex

£ ).

FIGURE F.2 International

Parities

One result that emerges from all these arbitrage equilibriums is that real inter-

est rates should tend to be the same across countries. This is only a rough long-run

tendency. In fact, expected real interest rates, as best (such) expectations can be mea-

sured, can differ noticeably between countries for years at a stretch. There is nonethe-

less a tendency toward equality.

Figure F.2 shows some of the intricacy we must expect from increasingly globalized

financial and product markets. To illustrate, let us return to a question posed above:

What would happen if more inflation in Britain were expected in the near future? If

you alone have this new perception of higher British inflation, you can act on it by

moving away from sterling into dollars or products over any of the routes shown in

Figure F.1. As long as your fear is confirmed, you will gain from the eventual general

exodus from sterling. If everyone eventually agrees with your quick interpretation of

the latest news, then prices and rates must change. The nominal interest rate must rise

in Britain and the forward premium on the pound must decline, as the parity condi-

tions in Figure F.2 show.

The moral of Figures F.1 and F.2 is that interest rates, exchange rates, and expected

inflation rates are tied together. Whatever affects international differences in one is

likely to affect international differences in the other two. It should be stressed, though,

that one parity is much more reliable than the others. That one is the covered interest

parity condition.

pug21774_appF_677-679.indd 679pug21774_appF_677-679.indd 679 12/8/14 7:29 PM12/8/14 7:29 PM

Final PDF to printer

680

Appendix G

Aggregate Demand and Aggregate Supply in the Open Economy In Chapter 22 we noted that a difference between the actual level of real GDP and its

full-employment level will put pressure on the country’s product price level or infla-

tion rate. The formal IS–LM–FE model that we used in Chapters 22, 23, and 24 does

not have an explicit role for the adjustment of the country’s level of prices. This appen-

dix develops a model of a country’s macroeconomy that focuses on price adjustment

over time. The standard way to analyze price adjustment is to picture the economy as

a combination of aggregate demand and aggregate supply.

THE AGGREGATE DEMAND CURVE

A country’s aggregate demand curve shows the level of real GDP that represents a short-run equilibrium for each possible price level, given fundamental conditions in

the economy. We presume that this short-run equilibrium incorporates all adjustments

to a triple intersection in the IS–LM–FE picture for the country. That is, for a country

with a fixed exchange rate, the aggregate demand curve includes induced intervention

to defend the fixed exchange rate (as discussed in Chapter 23). If the country instead

has a floating exchange rate, the aggregate demand curve includes the induced adjust-

ment of the exchange rate value (as discussed in Chapter 24).

Figure G.1A shows an aggregate demand curve. To see how it is derived, consider that

we start at point A , where we know that aggregate demand level Y 1 corresponds to price

level P 1 . What is the effect on the level of aggregate demand if the price level changes

to P 2 ? At this higher price level, the level of aggregate demand changes for two reasons:

• First, the nominal demand for money increases (see equation 22.10 in Chapter 22).

The LM curve shifts to the left, and the level of aggregate demand tends to

decrease.

• Second, the increase in the country’s price level decreases the country’s inter-

national price competitiveness. The IS curve shifts to the left, and the level of

aggregate demand tends to decrease.

pug21774_appG_680-689.indd 680pug21774_appG_680-689.indd 680 12/8/14 7:32 PM12/8/14 7:32 PM

Final PDF to printer

Aggregate Demand and Aggregate Supply in the Open Economy 681

1The decrease in international price competitiveness also shifts the FE curve to the left. In addition, the new IS–LM intersection is not necessarily on the new FE curve. If not, then with a fixed exchange rate there will be intervention to defend the fixed rate. Or, with a floating exchange rate, the exchange rate will change. The adjustments to external balance will alter the specific slope of the AD curve, but it will still be downward-sloping. There is no general rule that says that the aggregate demand curve is necessarily steeper or flatter with a fixed or floating exchange rate, and we will ignore any differences in the slope in the remainder of this appendix.

FIGURE G.1 Aggregate

Demand and

Aggregate

Supply

Price level = P Price level = P

Domestic product = Y

A. Aggregate Demand B. Aggregate Supply

YfullY1Y2

ASLR ASSR

For both of these reasons, the level of aggregate demand falls to Y 2 at point B if the

price level increases to P 2 . 1 The aggregate demand curve AD is downward-sloping.

The AD curve shifts if there is a change in anything fundamental (other than the price level) that affects the level of aggregate demand in the economy. Examples

include exogenous changes in consumption and domestic real investment, changes in

fiscal policy, and a devaluation by a country using a fixed exchange rate.

AGGREGATE SUPPLY

Figure G.1B shows two types of aggregate supply curves. The long-run aggregate supply curve ( AS

LR ) is vertical and corresponds to the full-employment level of real

GDP. This level of real GDP, also called potential real GDP, is the output the country

can produce using the factor resources available in the country and the technologies

in use in the country. (It corresponds to production being on the country’s production

possibility curve we used in Chapters 3–5 and 7.) We presume that markets in the

country work well enough that the economy tends toward full employment in the long

run. That is, in the long run, prices fully adjust so the economy achieves full employ-

ment of its resources. The AS LR

curve shifts if there are changes in factor resource

availability or changes in technologies used in production.

pug21774_appG_680-689.indd 681pug21774_appG_680-689.indd 681 12/8/14 7:32 PM12/8/14 7:32 PM

Final PDF to printer

682 Appendix G

The short-run aggregate supply curve ( AS SR

) is upward sloping because some

prices in the economy do not adjust quickly. That is, some prices are sticky in the short

run. For instance, a dry cleaner does not continuously adjust its prices as it sees what

business arrives. Instead, the dry cleaner has a price list that it sticks to, and it typically

changes the price list infrequently. Similarly, tuition at most universities is adjusted

at most once per year. Essentially, the short-run supply curve is anchored by a set of

prices that are given for the short-run time period.

To see the slope of the short-run aggregate supply curve, consider first an extreme

case. If no prices can change in the short run, then the short-run aggregate supply curve

would be a horizontal line (up to some high level of real GDP). If instead some prices

change in the short run but others do not, then the aggregate supply curve is upward

sloping. That is, it is “in-between” the horizontal aggregate supply curve where no

prices change and the long-run aggregate supply curve where all prices are completely

flexible. We also presume that the economy in the short run can operate beyond its

long-run full-employment level of production, so part of the short-run aggregate sup-

ply curve is to the right of the long-run aggregate supply curve. Essentially, it is pos-

sible for people to work more hours than they normally want to, and for firms to run

their machines more than they normally do, but this high level of factor use cannot be

sustained for long periods of time.

The short-run aggregate supply curve shifts because the level of the sticky prices

that anchors the curve changes over time. In fact, this is the essence of the slow price

adjustment that characterizes the macroeconomics of many countries. The short-run

aggregate supply curve also shifts if there is a shock to the country’s price level, or if

there is a shift in the long-run aggregate supply curve.

THE PRICE ADJUSTMENT PROCESS: AN EXAMPLE

Before we analyze various kinds of shocks that can hit an open macroeconomy, let’s

first look at the nature of price adjustment as the economy moves beyond a short-run

period of time. Consider Figure G.2 , in which the country’s economy is at a short-run

equilibrium at point A 1 . Because A

1 is to the left of the AS

LR , the actual level of pro-

duction, Y 1 , is below the full-employment level, Y

full . The level of aggregate demand is

low, relative to the economy’s potential for producing goods and services.

With weak product markets and high levels of unemployment of labor and other

resources, there is downward pressure on product and factor prices. As the economy

moves beyond the short run, the price level falls as the short-run aggregate supply

curve falls from AS SR1

to AS SR2

. The decline in the price level from P 1 to P

2 moves the

economy down its aggregate demand curve from A 1 to A

2 . This occurs because interest

rates fall as the nominal demand for money decreases, and the country gains inter-

national price competitiveness as its price level declines. Interest-sensitive spending

increases and net exports increase, so real GDP increases, from Y 1 to Y

2 .

The process continues until the short-run aggregate supply curve has shifted down

to AS SR3

, and the price level has declined to P 3 . At this triple intersection the economy

is now in a long-run equilibrium operating at potential real GDP Y full

. However, the

process of getting to this long-run equilibrium may be slow and painful if there is

pug21774_appG_680-689.indd 682pug21774_appG_680-689.indd 682 12/8/14 7:32 PM12/8/14 7:32 PM

Final PDF to printer

Aggregate Demand and Aggregate Supply in the Open Economy 683

FIGURE G.2 The Price

Adjustment

Process

Price level = P

Domestic product = Y

Y1 Y2 Yfull

ASLR ASSR1

ASSR2

ASSR3

resistance to reductions in product prices, wages, and other resource prices. There

may be a case for speeding up the process of achieving full employment by using

expansionary government policy to shift the AD curve to the right, rather than waiting for the price adjustment.

SHOCKS AND PRICE ADJUSTMENT

The aggregate demand–aggregate supply model can be used to gain additional insights

into the effects of shocks in the open macroeconomy. We are building on what we have

already learned in Chapters 23 and 24 using the IS–LM–FE analysis. We will first

examine the same four types of shocks that we examined in those chapters, for both

a fixed exchange rate and a floating exchange rate. We will then turn to look at two

types of shocks to aggregate supply.

Internal Shocks As we saw in Chapter 23, a domestic monetary shock has no effect with a fixed exchange rate, assuming that the country’s monetary authority cannot or does not ster-

ilize. The monetary shock is neutralized by the induced adjustments in the domestic

money supply as the country’s monetary authority intervenes to defend the fixed rate.

So there is nothing for the AD – AS analysis to show. A domestic monetary shock does have an effect with a floating exchange rate.

Figure G.3 shows the effect of a shift to an expansionary monetary policy, which

shifts the AD curve to the right, from AD 1 to AD

2 . If the economy starts from a

pug21774_appG_680-689.indd 683pug21774_appG_680-689.indd 683 12/8/14 7:32 PM12/8/14 7:32 PM

Final PDF to printer

684 Appendix G

FIGURE G.3 Domestic

Monetary

Shock, Floating

Exchange Rate

Price level = P

Domestic product = Y

Y3 Y2Yfull

ASLR ASSR4

ASSR3

ASSR1

AD2

AD1

C4 C3

position of long-run equilibrium at point C 1 ( P

1 and Y

full ), the economy shifts to point

C 2 , with a higher price level P

2 and a higher real GDP Y

2 . Excessively strong aggre-

gate demand is driving the price level up, and inflation is rising. As the economy

moves beyond the initial short run, even the sticky prices begin to increase, and the

short-run aggregate supply curve shifts up from AS SR1

to AS SR3

. The price level rises

to P 3 . The higher price level takes some of the strength out of the level of aggregate

demand because the interest rate is increasing back up as the nominal demand for

money increases and because the country is losing international price competitive-

ness as the price level rises. This process continues until the aggregate supply curve

has shifted up to AS SR4

, and the economy is back to production Y full

with a higher price

level, P 4 . In the long run, expansionary monetary policy causes inflation and a higher

price level, the relationship that we focused on in Chapter 19 when we discussed the

monetary approach to exchange rate determination. In the short and medium runs,

the slow price adjustment is a key part of exchange rate overshooting that was also

discussed in Chapter 19.

A domestic spending shock causes a shift in the aggregate demand curve. The magnitude of the shift may differ depending on whether the country has a fixed or

floating exchange rate, but the general direction is the same. For instance, a shift to an

expansionary fiscal policy causes a shift to the left in the AD curve. If the economy begins at full employment, then the price-adjustment story is similar to the one that we

just looked at for monetary policy with a floating exchange rate. Actual real GDP is

temporarily above its long-run potential, the inflation rate and the price level increase,

and production falls back to Y full

pug21774_appG_680-689.indd 684pug21774_appG_680-689.indd 684 12/8/14 7:32 PM12/8/14 7:32 PM

Final PDF to printer

Aggregate Demand and Aggregate Supply in the Open Economy 685

FIGURE G.4 An International

Capital Flow

Shock: Fixed

Exchange Rate

or Floating

Exchange Rate

Price level = P

Domestic product = Y

Y4Y2 Yfull

P2 P1

ASLR ASSR5

ASSR1

ASSR3

AD4 (floating exchange rate)

AD2 (fixed exchange rate)

AD1

E5 E4

E1 E2

International Capital Flow Shock An international capital-flow shock shifts the aggregate demand curve because of

the induced effect on the money supply (fixed exchange rate) or on the exchange

rate (if it is floating). Consider an adverse shock in which investors are pulling their

financial capital out of the country. In Figure G.4 the country begins at point E 1 ,

and then the shock hits. If the country has a fixed exchange rate , the intervention to defend the fixed rate requires that the country’s monetary authority sell foreign

currency and buy domestic currency. The country’s money supply shrinks and the

aggregate demand curve shifts to the left , from AD 1 to AD

2 . The country goes into

a recession and production falls from Y full

to Y 2 . Downward price adjustment could

eventually return the economy to full employment as the economy will move down

the AD 2 curve to point E

3 . But this could be a slow process. Expansionary fiscal

policy could be used to speed the process, by shifting the aggregate demand curve

back to the right.

Consider now that the country instead has a floating exchange rate , again start- ing from point E

1 in Figure G.4. The capital outflow results in a depreciation of

the country’s currency. The depreciation improves the country’s international price

competitiveness and the aggregate demand curve shifts to the right, from AD 1 to

AD 4 . The strong aggregate demand causes the price level to increase, and the price

adjustment process is moving the economy toward point E 5 . If the economy is over-

heating, there is a case for a shift to contractionary monetary policy or contraction-

ary fiscal policy. If contractionary policy is used to shift the aggregate demand curve

pug21774_appG_680-689.indd 685pug21774_appG_680-689.indd 685 12/8/14 7:32 PM12/8/14 7:32 PM

Final PDF to printer

686 Appendix G

back to the left, it can stabilize the economy at production level Y full

and avoid the

period of inflation.

International Trade Shock With a floating exchange rate, an international trade shock has no lasting effect on

the economy, once we include the induced change in the exchange rate. As we saw

in Chapter 24, an adverse international trade shock leads to a depreciation of the

country’s currency, and the currency depreciation reverses the negative effect on real

GDP. There is nothing for the AD–AS analysis to show. With a fixed exchange rate, an adverse international trade shock reduces the

country’s net exports and the intervention to defend the fixed exchange rate leads to a

reduction in the domestic money supply. Both of these changes result in a reduction

in aggregate demand. The economy goes into a recession. Downward adjustment in

the country’s price level will return the economy to full employment over time, but the

country instead could use a shift to expansionary fiscal policy to shift the AD curve back to the right and speed the adjustment.

Shocks to Aggregate Supply Shocks to aggregate supply can affect one or both of the short-run and long-run aggre-

gate supply curves. A shock to the short-run aggregate supply curve, sometimes called

a price shock, occurs when some economic change causes a quick and substantial

change in the price level. A shock to the long-run aggregate supply curve occurs when

some economic change alters the full-employment level of real production, perhaps

because of a change in the amount of resources available or a change in the technology

used in production. Let’s examine two types of aggregate supply shocks, an oil price

shock in an oil-importing country and a large improvement in technology.

Oil price shock . In the 1970s two major oil-price shocks hit the world economy, a smaller shock occurred in 1990, and a more spread-out oil price increase occurred

in the 2000s. When an oil-price shock hits, it has several effects on the economy

of an oil-importing country. First, it causes a sudden jump upward in the country’s

price level because oil and the products produced from oil are important to and

used throughout the economy and because the short-run demand for oil is price

inelastic. Second, the higher oil prices can have long-lasting adverse effects on

the country’s supply capabilities. For instance, some capital equipment that can

be used profitably when oil prices (or energy prices more generally) are low is

uneconomic to use when oil (energy) costs are higher. Third, the jump in oil prices

tends to increase the value of imports, so the country’s trade balance deteriorates.

That is, the oil price shock also causes an international trade shock. Here we focus