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International Economics
By Robert J. Carbaugh
9th Edition
Ch 1 The International Economy
Ch 10 International Factor Movements
and Multinational Enterprises
Ch 2 Foundations of Modern
Trade Theory
Ch 11 The Balance of Payments
Ch 3 International Equilibrium
Ch 12 Foreign Exchange
Ch 4 Trade Model Extensions and
Applications
Ch 13 Exchange-Rate Determination
Ch 5 Tariffs
Ch 14 Balance-of-Payments Adjustments
Under Fixed Exchange Rates
Ch 6 Nontariff Trade Barriers
Ch 15 Exchange-Rate Adjustments
and the Balance of Payments
Ch 7 Trade Regulations and
Industrial Policies
Ch 16 Exchange-Rate Systems
Ch 8 Trade Policies
for the Developing Nations
Ch 17 Macroeconomic Policy
in an Open Economy
Ch 9 Regional Trading Arrangements
Ch18 International Banking:
Reserves, Debt and Risk
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 1:
The International Economy
Economic interdependence
Elements of interdependence
 Trade: goods, services, raw materials,
energy
 Finance: foreign debt, foreign investment,
exchange rates
 Business: multinational corporations, global
production
4
Economic interdependence
Forces driving globalization
 Technological change:
 Production
 Communication & information
 Transport
 Liberalization of trade & investment:
 Tariff, non-tariff barrier reductions
 Liberalized financial transactions
 International financial markets
5
Economic interdependence
Waves of Globalization
 1st wave: 1870-1914
 Falling tariff barriers
 improved transportation
 2nd wave: 1945-1980
 Agreements to lower barriers again
 Rich country trade specialization
 Poor nations left behind
 3rd wave: 1980-present
 Growth of emerging markets
 international capital movements regain importance
6
Economic interdependence
Exports of goods and services as percent of
Gross Domestic Product, 2001
Country
Netherlands
Norway
South Korea
Canada
Germany
France
United Kingdom
Mexico
United States
Japan
Exports (% of GDP)
Imports (% of GDP)
68%
48
46
45
35
29
28
28
11
11
62%
30
41
39
34
27
30
30
14
10
7
Economic interdependence
Leading trading partners of the United States,
2000
Country
Canada
Mexico
Japan
Germany
France
Italy
Netherlands
Belgium/Luxembourg
Venezuela
Australia
Value of US
exports ($ bill.)
$202.4
125.2
98.4
45.2
30.6
16.4
28.9
17.9
9.0
17.9
Value of US
imports ($ bill.)
$250.1
147.9
165.3
74.3
40.6
31.0
15.0
12.8
19.2
9.7
8
Economic interdependence
Interdependence: Impact
 Overall standard of living is higher
 Access to raw materials & energy not available
at home
 Access to goods & components made less
expensively elsewhere
 Access to financing and investment not
available at home
 International competition encourages efficiency
9
Economic interdependence
Interdependence: Impact (cont’d)
 Other impacts - good & bad
 Curtails inflationary pressures at home
 Limits domestic wage increases
 Makes economy vulnerable to external
disturbances
 Limits impact of domestic fiscal policy on
economy
10
Comparative advantage
Comparative advantage means:
 If the relative cost of making two items is
different in two countries, each can gain by
specializing in the one it makes most cheaply each has a comparative advantage in that
product
 Even countries that make nothing cheaply can
benefit from specialization
11
Economic interdependence
Common fallacies of international trade
 "Trade is zero-sum" - trade can bring
benefits to both partners
 "Imports bad, exports good" - if you buy
nothing from other countries, they have no
income to buy from you
 "Tariffs and quotas save jobs" - cutting
imports makes it harder to export, so other
jobs are lost
12
Comparative advantage
Competitiveness & trade
 Main objective of any nation is to generate
high and rising standard of living
 No nation can efficiently make everything itself
 International trade allows countries to focus on
producing what they make efficiently
 Inefficient sectors will be squeezed out
 Sectors open to competition become more
efficient and productive
13
Economic interdependence: globalization
Ups and downs of globalization
 Advantages
 Productivity increases faster when countries produce
according to comparative advantage
 Global competition and cheap imports keep prices low
and inflation at bay
 An open economy encourages technological
development and innovation with ideas from abroad
 Jobs in export industries pay more than those in
import-competing industries
 Free movement of capital gives the US access to
foreign investment and keeps interest rates low
14
Economic interdependence: globalization
Ups and downs of globalization
 Disadvantages
 Millions of US jobs lost to imports or production abroad;
those displaced find lower-paying jobs
 Millions of other Americans fear getting laid off
 Workers face pressure for wage concessions under
threat of having the jobs move abroad
 Service and white-collar jobs are joining blue-collar ones
in being vulnerable to moving overseas
 US workers can lose their competitiveness when firms
build state-of-the-art factories in low-wage countries,
making them as productive as plants in the US
15
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 2:
Foundations of Modern Trade
Theory
Foundations of trade theory
Historical development of trade theory
 Mercantilism
 Regulation to ensure a positive trade balance
 Critics: possible only for short term; assumes static
world economy
 Absolute advantage (Adam Smith)
 Countries benefit from exporting what they make
cheaper than anyone else
 But: nations without absolute advantage do not gain
from trade
 Comparative advantage (David Ricardo)
 Nations can gain from specialization, even if they lack
an absolute advantage
17
Comparative advantage
Absolute & Comparative Advantage
Absolute advantage: each nation is more efficient in
producing one good
Output per labor hour
Nation
Wine
Cloth
United States
United Kingdom
5 bottles 20 yards
15 bottles 10 yards
Comparative advantage: the US has an absolute
advantage in both goods
Output per labor hour
Nation
Wine
Cloth
United States
United Kingdom
40 bottles 40 yards
20 bottles 10 yards
18
Comparative advantage
Ricardo’s Comparative Advantage in
money prices
Nation
Labor
Wage
US
1 hr
UK
1 hr
UK
1 hr
(at $1.6 = £1)
$20/hr
£5/hr
$8
Cloth (yards)
Quant. Price
40
10
10
$0.50
£0.50
$0.80
Wine (bottles)
Quant. Price
40
20
20
$0.50
£0.25
$0.40
19
Comparative advantage
Production possibilities schedule
 Generalizes theory to include all factors,
not just labor
 Shows combinations of products that can
be made if all factors are used efficiently
 Slope, or marginal rate of transformation,
shows the opportunity cost of making more
of one good (how much of one good must
be given up to make more of another)
20
Comparative advantage
Marginal Rate of Transformation
21
Comparative advantage
Production possibilities schedules:
constant opportunity costs
22
Comparative advantage
Supply schedules: constant opportunity
costs
23
Comparative advantage
Trading under constant opportunity
costs
24
Comparative advantage
Production gains from specialization:
constant opportunity costs
Before
Specialization
After
Specialization
Net Gain
(Loss)
Autos Wheat
Autos Wheat
Autos Wheat
US
Canada
40
40
40
80
120
0
0
160
80
-40
-40
80
World
80
120
120
160
40
40
25
Comparative advantage
Consumption gains from trade: constant
opportunity costs
Before
Trade
After
Trade
Net Gain
(Loss)
Autos Wheat
Autos Wheat
Autos Wheat
US
Canada
40
40
40
80
60
60
60
100
20
20
20
20
World
80
120
120
160
40
40
26
Comparative advantage
Complete specialization under constant
opportunity costs
27
Comparative advantage
Changing comparative advantage
28
Comparative advantage
Trade restrictions and gains from trade
29
Increasing opportunity costs
Production possibilities schedule under
increasing costs
30
Increasing opportunity costs
Supply schedule under increasing costs
31
Increasing opportunity costs
Trading under increasing costs: US
32
Increasing opportunity costs
Trading under increasing costs: Canada
33
Increasing opportunity costs
Production gains from specialization:
increasing opportunity costs
Before
Specialization
After
Specialization
Net Gain
(Loss)
Autos Wheat
Autos Wheat
Autos Wheat
US
Canada
5
17
18
6
12
13
14
13
7
-4
-4
7
World
22
24
25
26
3
3
34
Increasing opportunity costs
Consumption gains from trade: increasing
opportunity costs
Before
Trade
After
Trade
Net Gain
(Loss)
Autos Wheat
Autos Wheat
Autos Wheat
US
Canada
5
17
18
6
5
20
21
6
0
3
3
0
World
22
24
25
27
3
3
35
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 3:
International Equilibrium
Bringing demand into the model
Indifference curves
 Final pattern of trade depends not just on
supply, but also on demand - which is
determined by income & individual tastes
 Tastes can be shown graphically with
indifference curves, which show the various
combinations of two goods that give a
consumer the same total level of
satisfaction
37
Bringing demand into the model
A consumer’s indifference map
38
Bringing demand into the model
Indifference curves (cont’d)
 Indifference curves have a negative slope
 Keeping satisfaction constant means giving up
some of one good for more of another
 Indifference curves are convex
 As the consumer gets more of one good, she is
less willing to give up what is left of the other
 The rate of substituting one good for another is
shown by the slope of the curve, the marginal
rate of substitution
39
Bringing demand into the model
Indifference curves (cont’d)
 “Higher” indifference curves (those farther
from the origin) represent greater levels of
satisfaction
 Individual preferences cannot really be
added up into a “community indifference
curve” but it is useful to imagine that they
can for the purposes of trade theory
40
Bringing demand into the model
Indifference curves and int’l. trade
41
Bringing demand into the model
Basis for trade, gains from trade
42
International equilibrium
Equilibrium terms-of-trade limits
43
International equilibrium
Theory of Reciprocal Demand (Mill)
 Actual trading prices depend on the
interaction of trading partners’ demands
 Final terms of trade will be closer to the
domestic price ratio of the nation with
stronger demand for the imported good
 Applies to nations of equal economic size,
which will share gains nearly equally
 Small nations trading with large ones can
receive the bulk of the gains from trade
44
International equilibrium
Offer curves: supply and demand
45
International equilibrium
Offer curves: supply and demand
46
International equilibrium
Equilibrium terms of trade
47
International equilibrium
Changing equilibrium terms of trade
48
Impact of trade
Immiserizing growth
49
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 4:
Trade Model Extensions and
Applications
Why relative price differentials?
Factor endowment theory (Heckscher-Ohlin)
 Comparative advantage is explained
entirely by different national supply
conditions, especially resource
endowments
 Nations export products that use inputs
which are relatively abundant (cheap) at
home, and import products which need
inputs which are relatively scarce
(expensive) at home
51
Why relative price differentials?
Factor endowment theory: assumptions
 Nations all have the same tastes and
preferences (same indifference curves)
 They use factor inputs which are of uniform
quality
 They all use the same technology
52
Factor endowment model
Comparative advantage according to factor
endowment theory
Autarky equilibrium
53
Factor endowment model
Comparative advantage according to factor
endowment theory
Post-trade equilibrium
54
Factor endowment model
Factor endowment theory: implications
 Factor price equalization
 The shift within each nation towards use of cheaper
factors, and away from expensive ones, leads to more
equal factor prices (if factors are mobile)
 Distribution of income
 Trade changes domestic distribution of income as
demand for different factors changes
 Tests of factor endowment theory
 Emphasize the importance of varieties of different
factors (such as human capital) and accounting for
changes in resource endowment; other explanations
are also important
55
Distribution of income
Does trade worsen inequality?
 Trade theory suggests that countries with
abundant skilled labor will import goods which are
made with unskilled labor
 Equilibrium wage ratios for skilled/unskilled labor
are affected by trade and technology change,
immigration, and education & training
 Evidence suggests that trade contributes
relatively little to wage inequality, compared to
technological change and other factors; better
education and training are potential solutions
56
Bringing theory closer to reality
Economies of scale & specialization
 Economies of scale provide incentives for
specialization, since per unit costs go down
as production increases
 Trade provides a larger potential market for
products, making higher production levels
possible
57
Economies of scale
Economies of scale as basis for trade
58
Economies of scale
Trade & specialization under decreasing costs
59
Bringing theory closer to reality
Other extensions of the theory
 Overlapping demands
 Intra-industry trade
 Product cycles
 Dynamic comparative advantage industrial policy
60
Bringing theory closer to reality
Trade & the environment
 Environmental regulation can lead to a policy
tradeoff
 Increased costs can reduce comparative advantage of
regulated industry
 Public receives health and environmental benefits
 Concern that polluting industries would move to
poor countries with less regulation
 But studies indicate that environmental rules have a
small role in investment location decisions
 Polluter-pays principle: incentive to find ways to
reduce pollution at least cost
61
Trade & the environment
Trade effects of pollution-control
regulations
62
Transportation costs
Free trade under increasing costs
No transportation costs
63
Transportation costs
Free trade under increasing costs
Transportation costs of $2000 per auto
64
Bringing theory closer to reality
Specific factor theory
 Looks at the income distribution effects of
trade in the short run, when some factor
inputs are not mobile among sectors
 Indicates that workers may be better or
worse off, depending on preferences
 Predicts that owners of factors used in
export industries gain from trade, while
owners of factors used in import-competing
industries will lose from trade
65
Bringing theory closer to reality
Relative prices and the specific factor model
66
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 5:
Tariffs
Tariffs
Why restrict trade?
 Benefits of free trade come in the long
term, and are usually spread widely across
society
 Costs of free trade are felt rapidly and are
usually concentrated in specific sectors of
the economy
68
Tariffs
Defining tariffs
 A tariff is a tax (duty) levied on products as
they move between nations
 Import tariff - levied on imports
 Export tariff - levied on exported goods as they
leave the country
 Protective tariff - designed to insulate domestic
producers from competition
 Revenue tariff - intended to raise funds for the
government budget (no longer important in
industrial countries)
69
Tariffs
Types of tariff
 Specific tariff
 Fixed monetary fee per unit of the product
 Ad valorem tariff
 Levied as a percentage of the value of the
product
 Compound tariff
 A combination of the above, often levied on
finished goods whose components are also
subject to tariff if imported separately
70
Tariffs
Effective rate of protection
 The impact of a tariff is often different from
its stated amount
 The effective tariff rate measures the total
increase in domestic production that the
tariff makes possible, compared to free
trade
 Domestic producers may use imported inputs
or intermediate goods subject to various tariffs,
which affects the calculation
71
Tariffs
Effective rate of protection (cont’d)
 When tariff rates are low on raw materials
and components, but high on finished
goods, the effective tariff rate on finished
goods is actually much higher than it
appears from the nominal rate
 This is referred to as tariff escalation
72
Tariffs
Avoiding and postponing tariffs (US)
 Production sharing and special treatment
for foreign assembly using domestic
components
 Bonded warehouses
 Foreign trade zones
73
Tariffs
Tariff welfare effects
 Consumer surplus
 The difference between the price buyers would
be willing to pay and what they actually pay
 Producer surplus
 The revenue producers receive above the
minimum amount required to induce them to
produce a good
74
Tariffs
Consumer and producer surplus
75
Welfare effects of tariffs
Tariff trade and welfare effects
76
Welfare effects of tariffs
Tariff trade and welfare effects
77
Tariff effects
Who pays for import restrictions?
 Domestic consumers face increased costs
 Low income consumers are especially hurt by
tariffs on low-cost imports
 Overall net loss for the economy
(deadweight loss)
 Export industries face higher costs for inputs
 Cost of living increases
 Other nations may retaliate, further
restricting trade
78
Reasons for tariffs
Arguments for trade restrictions
 Job protection
 Protect against cheap foreign labor
 Fairness in trade - level playing field
 Protect domestic standard of living
 Equalization of production costs
 Infant-industry protection
 Political and social reasons
79
Reasons for tariffs
Politics of protectionism
 “Supply” of protectionism (trade policy)
depends on:
 the cost to society of restricting trade
 the political importance of the importcompeting industries
 Magnitude of the adjustment costs from free
trade
 Public sympathy for those sectors hurt by free
trade
80
Reasons for tariffs
Politics of protectionism
 “Demand” for protectionism depends on:
 The amount of the import-competing industry’s
comparative disadvantage
 The level of import penetration
 The level of concentration in the affected sector
 The degree of export dependence in the sector
81
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 6:
Nontariff Trade Barriers
Types of non-tariff barriers
Import quotas
 Quotas are a restriction on the quantity of a
good that may be imported in any one
period (usually below free-trade levels)
 Global quotas restrict the total quantity of
an import, regardless of origin
 Selective quotas restrict the quantity of a
good coming from a particular country
83
Types of non-tariff barriers
Import quota: trade & welfare effects
84
Types of non-tariff barriers
Effects of a quota on sugar imports
85
Types of non-tariff barriers
Comparing tariffs and quotas
86
Types of non-tariff barriers
Tariff-rate quota
 The tariff-rate quota is a two-tiered tariff
 A specified number of goods (up to the quota
limit) may be imported at one (lower) tariff rate,
while imports in excess of the quota face a
higher tariff rate
87
Types of non-tariff barriers
Tariff-rate quota: trade & welfare effects
88
Types of non-tariff barriers
Orderly marketing agreements
 Market sharing pact signed by trading
partners
 Intended to protect less efficient domestic
producers
 Usually involve voluntary export restraints,
or export quotas
 Recent trade negotiations have restricted
the use of these agreements
89
Types of non-tariff barriers
Effects of a voluntary export quota
90
Types of non-tariff barriers
Domestic content requirements
 Rules that require a certain percentage of a
product’s total value to be produced
domestically
 Often has the effect of forcing lower-priced
imports to include higher-cost domestic
components or be assembled in a highercost domestic market
91
Types of non-tariff barriers
Domestic content: trade & welfare effects
92
Types of non-tariff barriers
Subsidies
 Domestic subsidy
 Payments made to import-competing
producers to raise the price they receive above
the market price
 Export subsidy
 Payments and incentives offered to export
producers intended to raise the volume of
exports
93
Types of non-tariff barriers
Subsidies: trade & welfare effects
94
Types of non-tariff barriers
Subsidies: trade & welfare effects
95
Types of non-tariff barriers
Dumping
 The practice of selling a product at a lower
price in export markets than at home (or
exporting at prices below production cost)
 Sporadic dumping - to clear unwanted
inventories or cope with excess capacity
 Predatory dumping - to undermine foreign
competitors
 Persistent dumping - reaping greater profits by
engaging in price discrimination
96
Types of non-tariff barriers
Other NTBs
 Government procurement policies
 Social regulations (health, environmental
and safety rules can also restrict trade)
 Sea transport and freight restrictions
97
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 7:
Trade Regulations and
Industrial Policies
Trade regulation
The US and international trade
 Smoot-Hawley Tariff Act (1930)
 High point of US protectionism
 Reciprocal Trade Agreements Act (1934)
 Introduced “most favored nation” (MFN) clause
(now called “normal trade relations”)
 General Agreement on Tariffs and Trade
[GATT] (1947)
 World Trade Organization (1995)
99
Trade regulation
GATT - Postwar trade liberalization
 Founded on the principle of nondiscrimination, including:
 "Normal Trade Relations" treatment
 National treatment of imported goods
 Included trade dispute resolution
mechanisms
 Committed signatories to use tariffs rather
than quotas
100
Trade regulation
GATT - Postwar trade liberalization (2)
 Started regular negotiations to reduce
tariffs and NTBs
 Exceptions allowed nations to sidestep the
rules when they felt threatened, without
abandoning the entire process
101
Trade regulation
GATT negotiations
 Early bilateral agreements
 Kennedy Round (1964-67) - first multilateral negotiations; focus on tariff cuts
 Tokyo Round (1973-79) - focus on lowering
non-tariff barriers
 Uruguay Round (1986-93) - covered new
issue areas (intellectual property, services,
agriculture), included developing nations
102
Trade regulation
GATT becomes WTO
 GATT agreement became World Trade
Organization in January 1995
 WTO members must adhere to all agreements
negotiated under GATT (not pick and choose)
 Covers trade in goods, services, intellectual
property and investment
 WTO strengthens GATT's dispute-settlement
mechanisms
103
Trade regulation
Controversy over WTO
 Worries about infringement on national
sovereignty
 Concern about trade liberalization
undermining environmental protection
 WTO became a target for broader
opposition to "globalization"
104
Trade regulation
US trade remedy laws
 Escape clause
 Countervailing duties
 Anti-dumping duties
 Unfair trade practices (Section 301)
 Protection of intellectual property
 Trade adjustment assistance
105
Trade regulation
Effects of dumping, subsidies, and remedies
106
Trade regulation
Effects of dumping, subsidies, and remedies
107
Industrial policy
US “industrial policy”
 Broad policies to foster economic growth
 Aid to targeted sectors
 Agriculture, ship-building, energy, technology,
manufacturing (autos, for example), etc.
 Tariff protection of declining sectors
 Export promotion and financing
 Export-Import Bank
 Commodity Credit Corporation
 Knowledge based growth policy
108
Industrial policy
Japan’s industrial policy
 Trade protection and subsidies (especially
early on)
 Assistance to targeted sectors
 Shipbuilding, steel, autos, machine tools, hightechnology
 Ministry of International Trade and Industry
(MITI) to target aid to promising sectors
 It is unclear how much of Japan’s success
can be attributed to government assistance
109
Industrial policy
Strategic trade policy
 Response to competition in sectors with
imperfect competition - small number of
producers, each large enough to affect
market price
 Subsidies can give the advantage to
domestic manufacturers over foreign ones
 Critics argue that it is too difficult to
determine where assistance makes
economic sense
110
Industrial policy
Welfare effects of strategic trade policy
111
Trade regulation
Economic sanctions
 Trade sanctions
 Financial sanctions
 Success of sanctions depends on:
 Number of nations imposing sanctions
 Nature of ties between target and imposing
nations
 Extent of political opposition in target nation
 Cultural factors in target nation
112
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 8:
Trade Policies for the
Developing Nations
Developing nations and trade
Developing nations’ trade
 Very dependent on the developed industrial
countries as export markets and source of
imports
 Exports are heavily weighted toward primary
products (agricultural goods, raw materials, fuels)
and labor-intensive manufactures
 Share of manufactured exports is increasing, but
mainly in a small number of newly industrialized
nations (such as South Korea, Hong Kong)
114
Developing nations and trade
Developing nations: dependence on
primary products (2000)
Country
Nigeria
Saudi Arabia
Venezuela
Burundi
Mauritania
Zambia
Ethiopia
Chad
Major export
product
As % of
total exports
Oil
Oil
Oil
Coffee
Iron ore
Copper
Coffee
Cotton
96
86
86
79
56
56
54
40
115
Developing nations and trade
Developing nations’ concerns
 Question whether gains from trade with industrial
countries have been fairly distributed
 Face problems of unstable export markets
 Concentration on one or a few primary-product exports
combined with inelastic supply and demand conditions
 Argue that they face worsening terms of trade as
relative value of primary products has fallen
compared to manufactured goods they import
 Face limited market access for exports because
of protectionism
 Especially for agricultural and labor-intensive goods
116
Developing nations and trade
Export price instability for a developing nation
117
Developing nations and trade
Remedies for developing nation problems
 Stabilizing commodity prices - international
commodity agreements
 Production and export controls
 Buffer stocks
 Multilateral contracts
 Generalized system of preferences (GSP)
 But experience with commodity agreements
has been mixed, at best, and application of
the GSP is spotty
118
Developing nations and trade
Production and export controls
119
Developing nations and trade
Buffer stocks: price ceiling and price support
120
Developing nations and trade
Cartels
 Attempt to restrict competition among producers
and support higher prices for their product
 Face obstacles:






Incentive to cheat
Number of sellers
Cost and demand differences
Potential competition
Economic downturns
Substitute goods
121
Developing nations and trade
Growth strategies
 Import substitution
 Trade barriers protect emerging domestic
industries
 Popular in 1950s and 1960s
 Export-led growth
 Focus on export of manufactures as engine of
growth
 Became more common starting in 1970s
122
Growth strategies
Import substitution: pros
 Risk of establishing home import-replacing
industry is low because home market
already exists
 Easier for developing nations to protect
their own markets than to force industrial
nations to open theirs
 Gives foreign firms an incentive to locate
production in developing country, providing
jobs
123
Growth strategies
Import substitution: cons
 Trade restrictions shelter home industry
from competition, giving no incentive for
efficiency
 Small size of most developing country
markets makes it difficult to benefit from
economies of scale
 Protection of import-competing industries
draws resources away from all other
sectors, including potential exporters
124
Growth strategies
Export-led growth: pros
 Encourages industries in which developing
countries are likely to have a comparative
advantage - such as labor-intensive
manufactures
 Export markets allow domestic producers to
utilize economies of scale
 Low level of trade restrictions forces
domestic firms to remain competitive
125
Growth strategies
Export-led growth: cons
 Main disadvantage to export-led growth is
that it depends on the ability and
willingness of industrial nations to absorb
large quantities of manufactures from
developing countries
 In other words, it is sensitive to economic
cycles and protectionist pressures in the
export markets
126
Growth strategies
Economic performance of developing nations
by trade orientation, 1963-92 (World Bank, 1987; OECD, 1998)
127
Growth strategies
Growth strategies: case studies
 Brazil - import substitution in computers
 Policy backfired, and was abandoned by 1991
 East Asian newly industrialized countries - exportled growth




Generally very successful, until 1997 crisis
High rates of investment and building human capital
Problems overlooked: pollution, income distribution
Vulnerable to protectionist reactions elsewhere
128
Growth strategies
Growth strategies: case studies
 China - transformation from extreme importsubstitution to focus on exports
 Dramatic change in China’s role in the world economy has
accompanied rapid growth in its domestic economy
 Heavy state role in economy (legacy of central planning) raises
issues of fairness
 Political issues, lack of enforcement of some agreements
(intellectual property) complicate economic relations
 Accession to the WTO will mean adherence to global trade rules and coping with the dislocations that will involve
129
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 9:
Regional Trading Arrangements
Regional trade agreements
Types of regional trade arrangements
 Free trade areas (NAFTA, for example)
 Customs unions (Benelux)
 Common markets (EU)
 Economic/monetary union
131
Regional trade agreements
Effects of regional trade agreements
 Static effects
 Trade creation effect (consumption effect,
production effect)
 Trade diversion effect
 Dynamic effects
 Economies of scale
 Greater competition
 Investment stimulus
132
Regional trade agreements
Static effects of a customs union
133
Regional trade agreements: case studies
The European Union
 Created by the Treaty of Rome (1957)
 Policy aims included:




Abolition of tariffs, quotas and other restrictions
Common external tariff
Free movement of capital, labor and business
Common policies on transport, agriculture, and
competition and business conduct
 Coordination of monetary and fiscal policies
134
Regional trade agreements: case studies
The European Union (cont’d)
 Lowering of barriers caused within-region
trade to grow much more quickly than
overall world trade in the 1960s
 Steps to remove remaining barriers (198592) further increased integration
 Maastricht Summit (1991) began process of
economic and monetary union (EMU)
 EMU came into full effect in 2002 with the
introduction of a common currency, the euro
135
Regional trade agreements: case studies
EU Economic & Monetary Union
 Member nations which met economic criteria by
1999 replaced their national currencies with the
euro in 2002
 New European Central Bank created to control
monetary and exchange rate policy
 “Convergence criteria” required for membership:




Price stability
Low long-term interest rates
Stable exchange rates
Sound public finances
136
Regional trade agreements: case studies
Other key EU policies
 Common agricultural policy (CAP)
 Support payments to farmers
 Variable import levies
 Export subsidies
 Government procurement policies
 All EU businesses can bid for larger contracts
in any nation
137
Regional trade agreements: case studies
CAP: variable levies and export subsidies
138
Regional trade agreements: case studies
Opening up government procurement
139
Regional trade agreements: case studies
European Union enlargement
 The EU is negotiating with 12 applicant nations,
mostly transition economies in eastern Europe,
for EU membership by 2004
 Candidate members had to demonstrate their
fitness by achieving:
 Stability of institutions, and guaranteed democracy, rule
of law, human rights and protection of minorities
 A functioning market economy which is ready to
compete in the EU market
 Adherence to the EU’s aims of political, economic and
monetary union
140
Regional trade agreements: case studies
Costs & benefits of EMU
 Europe does not meet all the requirements
of a theoretical “optimal currency area”
 Advantages of EMU - real but small:




Lower transaction costs
Price comparisons easier
Exchange rate risk eliminated
Stimulates competition
141
Regional trade agreements: case studies
Costs & benefits of EMU (cont'd)
 Disadvantages of EMU:
 Loss of monetary policy and the exchange
rates as economic adjustment tools
 Use of fiscal policy for adjustment is also
constrained
 Adjustment to shocks therefore depends on
wage flexibility and labor mobility, which are
both low in Europe
142
Regional trade agreements: case studies
North American Free Trade Agmt. (1994)
 Gradual and comprehensive elimination of
trade barriers among US, Mexico and
Canada over 15 years:





Full, phased elimination of import tariffs
Elimination of most NTBs
Protection of intellectual property rights
Dispute settlement procedures
Side agreements on environmental protection
and labor law
143
Regional trade agreements: case studies
NAFTA's benefits
 Mexico stood to gain the most, with access to
large industrial markets and new inward
investment flows
 Canada maintained its preferences in the US
market and hoped for future access to South
American markets
 US stood to gain from access to the Mexican
market and cheap labor and parts, access to
reliable oil supplies, and less immigration
pressure; but the benefits were modest
144
Regional trade agreements: case studies
Concerns about NAFTA
 Main US losers from NAFTA would be importprotected industries competing with Mexican
producers, and unskilled workers
 US industrial workers also worried about lower
pay scale in Mexico and plant relocations
 Concerns Mexico would not enforce
environmental protection measures
 Side agreements on environment and labor law
were concluded to address those concerns
145
Regional trade agreements: case studies
NAFTA’s impact so far
 Trilateral trade increased significantly
 Some US jobs were lost to Mexico, but the
numbers were small compared to job creation
that came with US growth
 Changes in investment flows were small (in
relation to total US foreign investment)
 Closer political ties were built among the three
nations, and they refrained from building new
trade barriers even during recession
146
Regional trade agreements: case studies
Special case: economies in transition
 Nations of eastern Europe and the former
Soviet Union have been making a transition
from a non-market (planned) economy to a
market economy since the early 1990s - which
has been very disruptive
 These nations’ planned economies required
them to be largely isolated from world trade instead, set up their own trading bloc, the
Council for Mutual Economic Assistance
(CMEA) with only limited trade with the West
147
Regional trade agreements: case studies
Economies in transition (cont’d)
 Even after the collapse of the central
planning system, the nations remained
tied together because of historical trade
links inside CMEA and their common
legacy as non-market economies
 There is an ongoing debate over the best
pace for economic reform (including
trade and financial liberalization) - “shock
therapy” vs. gradualism
148
Regional trade agreements: case studies
Economies in transition (cont’d)
 Barriers to trade with the West used to make
strategies such as countertrade, co-production
agreements, joint R&D agreements, and
contract manufacturing agreements very
common
 Gradual elimination of barriers to foreign
business in most transition countries has
allowed foreign firms to operate in the region
more normally in recent years
149
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 10:
International Factor Movements
and Multinational Enterprises
Factor movements & multinational enterprises
Factor movements
 International movement of factors of
production (capital, labor) is a substitute for
international trade in goods
 International capital flows (investment) can
substitute for trade in capital-intensive
goods
 Labor mobility can substitute for trade in
labor-intensive goods
151
Factor movements & multinational enterprises
Multinational enterprises
 Various business operations in numerous
host countries
 Headquarters often far from operations
 Stock ownership and management are
usually multi-national
 Frequently employ vertical integration,
horizontal integration, conglomerate
structure
152
Multinational enterprises
Foreign direct investment
 A foreign or multinational firm can buy a
controlling interest in a local firm
 Buy or build new plants or equipment
overseas
 Shift funds abroad to expand a subsidiary
 Reinvest the earnings of a foreign
subsidiary
153
Multinational enterprises
Reasons for foreign direct investment
 Demand factors
 Serve different local markets
 Respond to market competition
 Cost factors




Access to key raw materials
Labor costs
Transportation costs
Government policies
154
Foreign direct investment
Choice between export and FDI
155
Foreign direct investment
Choice between licensing and FDI
156
Multinational enterprises
International joint ventures
 Two companies can operate a venture in a
third country
 A foreign firm can work with a local
company
 A foreign firm can form a venture with a unit
of the local government
157
Multinational enterprises
Reasons for international JVs
 Cost sharing - R&D, capital expenditures
(in mining and oil, for example)
 Avoiding restrictions on foreign ownership
of local firms (ensuring local participation)
 Forestalling pressure for protectionism
 Problems: divided control means success
of JV depends on ability of firms to work
together
158
Multinational enterprises
Effects of an international JV
159
Multinational enterprises
Controversy over multinationals
 Employment
 Host country may not gain many jobs, foreign
managers often brought in; source country
worries about losing jobs
 Technology transfer
 MNEs are reluctant to share technology with
host nations; source country worries about
giving away advantage
160
Multinational enterprises
Controversy over multinationals (Cont’d)
 National sovereignty
 Host country worries about power of MNE to
influence affairs; source country worries about
ability to regulate MNE activities elsewhere
 Balance of payments
 MNE investments and profits (internal
transfers) have impacts on the payments status
of both source and host nations
161
Multinational enterprises
Controversy over multinationals (Cont’d)
 Taxation
 Source countries may have difficulty taxing
MNE income stemming from foreign operations
 Tax rate differences may discourage
investment at home
 Transfer pricing
 Both host and source governments worry that
MNEs may illegally manipulate prices paid
between subsidiaries to avoid taxes
162
Multinational enterprises
Transfer pricing illustrated
Germany
Ireland
United States
(tax rate 48%)
(tax rate 4%)
(tax rate 34%)
Computer
produced by
parent firm for
$2000. Sold to
Irish subsidiary
for $2000.
Irish subsidiary
resells the same
computer to US
subsidiary for
$2500, earning
$500 profit.
US subsidiary sells
computer at cost,
for $2500. No profit
is earned.
German tax paid:
$0.
Irish tax paid:
$20.
US tax paid: $0.
Irish subsidiary
then lends money
to US subsidiary
for expansion
163
International factor movements
Migration
 Tends to equalize wage rates between countries
 Shifts distribution of income between capital and
labor
 Other concerns:




Fiscal drain from immigration
Brain drain from developing countries
Impact of illegal migration
Wider gulf between skilled and unskilled workers
164
International factor movements
Effects of labor migration
United States
Mexico
165
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 11:
The Balance of Payments
The Balance of Payments
Balance of Payments
 A record of international transactions between
residents of one country and the rest of the
world
 International transactions include exchanges
of goods, services or assets
 “Residents” means businesses, individuals
and government agencies, including citizens
temporarily living abroad but excluding local
subsidiaries of foreign corporations
167
The Balance of Payments
Double-entry accounting in the BOP
 All transactions are either debit or credit
transactions
 Credit transactions result in receipt of payment
from abroad






Merchandise exports
Transportation and travel receipts
Income received from investments abroad
Gifts received from foreign residents
Aid received from foreign governments
Local investments by overseas residents
168
The Balance of Payments
Double-entry accounting (cont’d)
 Debit transactions lead to payments to foreigners






Merchandise imports
Transportation and travel expenditures
Income paid on investments of foreigners
Gifts to foreign residents
Aid given by home government
Overseas investments by home country residents
 Each credit transaction has a balancing debit
transaction, and vice versa, so the overall
balance of payments is always in balance
169
Structure of the Balance of Payments
Current account
 Goods and services balance
 Merchandise trade balance
 Services balance
 Investment income (net)
 Unilateral transfers
 Private transfer payments
 Governmental transfers
170
Structure of the Balance of Payments
Capital and financial account
 All purchases or sales of assets, including:




Direct investment
Securities (debt)
Bank claims and liabilities
Official settlements transactions
171
Current account
Current account surplus and deficit
 Current account and capital & financial account
balance each other; when one is in surplus the
other must be in deficit
 Current account surplus means exports of
goods and services, investment income and
transfers exceed imports and outflows
 Current account deficit means imports of goods
and services, and outflows are greater than
exports and inflows; must be financed by
borrowing (capital account inflows)
172
Balance of Payments
US Balance of Payments, 2001 ($ bill.)
Current account
Merchandise trade
exports
$720.8
imports
-1,147.4
Net
Services
Travel & transport recpts. 13.4
other services, net
65.4
All services, net
Balance on goods & services
-426.6
78.8
-347.8
Cont’d.
173
Balance of Payments
US Balance of Payments, 2001 ($ bill.)
Current account (cont’d)
Income receipts & payments
investment income, net
-13.7
employee compensation
-5.4
All income, net
-19.1
Unilateral transfers, net
-50.5
Balance on current account
$-417.4
174
Balance of Payments
US Balance of Payments, 2001 ($ bill.)
Capital & financial account
Capital account transactions, net
0.7
Financial account transactions, net 455.8
Statistical discrepancy
-39.1
Balance on capital &
financial account
$417.4
175
Balance of Payments
US Balance of Payments 1970-2001
176
Balance of Payments
Current account deficit a problem?
 Current account deficit has little to do with
foreign trade practices or competitiveness
 Determined mostly by domestic macroeconomic conditions that cause demand to
exceed supply and increase imports (paid for
with borrowing)
 Whether a current account deficit is good or
bad depends on whether the borrowed funds
are used to pay for consumption or investment
177
Balance of Payments
Balance of international indebtedness
 Summarizes one nation’s overall quantity of
assets and liabilities against the rest of the world
 Shows whether the nation is a net debtor or a net
creditor
 Indicates sensitive items, such as short term debt
held by foreigners which could be liquidated
quickly, straining finances
178
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 12:
Foreign Exchange
Foreign exchange
Foreign exchange market
 Largest and most liquid market in the world
 No central market - key markets in several
cities around the world
 Participating banks and brokers are in
constant contact via phone and computer
 Three general types of transaction
 Between banks and their customers
 Domestic interbank market conducted through brokers
 Trading with overseas banks
180
Foreign exchange
Types of FX transactions
 Spot transactions - executed nearly
immediately
 Forward transactions - agreement to buy or
sell a currency at a date in the future, at a
rate agreed in advance
 Currency swaps - agreement to trade one
currency for another now, and to trade
currencies back again later, both at prices
agreed at the beginning
181
Foreign exchange
Foreign exchange quotations
 Exchange rate is the price of one currency
in terms of another
 One country’s currency has depreciated
when more of it is needed to buy a unit of a
foreign currency (is worth less relative to
the other currency)
 A currency has appreciated when less of it
is needed to buy a foreign currency (is
worth more relative to the other currency)
182
Foreign exchange
Foreign exchange quotations
 Cross exchange rate between two
currencies is calculated from their
exchange rates with a third, benchmark
currency - frequently the US dollar
183
Foreign exchange markets
Forward markets, futures & options
 Forward contracts obligate buyer to buy or
sell a certain amount of foreign currency at
a future date
 Usually made between banks and firms who
expect to receive or make payments in foreign
currency; the amount of currency and the date
are set by the agreement
184
Foreign exchange markets
Forward markets, futures & options
 Futures, traded on special exchanges, are
contracts to trade given amounts of
currencies at a specified date
 Only a small number of major currencies can
be so traded, and only in fixed lots with fixed
trade dates
185
Foreign exchange markets
Forward markets, futures & options
 Options provide the holder with the right
(but not the obligation) to buy or sell foreign
currencies at an agreed rate within a period
of time, in return for a fee paid to the seller
of the option
 Options to buy are called call options, and
those to sell are called put options
 Options are frequently used to reduce risk from
exchange rate changes
186
Foreign exchange markets
Exchange rate determination
187
Foreign exchange
Impact of an appreciating US dollar
 Pros
 Lower prices on
foreign goods
 Keeps inflation
down
 Foreign travel is
cheaper
 Cons
 Exporters’ products
become more
expensive abroad
 Imports-competing
firms face price
competition
 Travel more
expensive for
foreign tourists
188
Foreign exchange
Impact of a depreciating US dollar
 Pros
 Exporters can sell
abroad more easily
 Less competition for
US firms from
imports
 Foreign tourism is
encouraged
 Cons
 Higher prices on
imports
 Upward pressure
on inflation
 Travel abroad more
expensive
189
Foreign exchange markets
Arbitrage and hedging
 Exchange arbitrage involves taking
advantage of exchange rate differences in
different markets to make a profit
 Helps equalize exchange rates globally
 Interest arbitrage involves taking advantage
of differences in international interest rates
to get a higher return
 Subject to exchange rate risk
190
Foreign exchange markets
Arbitrage and hedging
 Hedging involves making use of forward
contracts or options to minimize exchange
rate risk in international transactions
 Firms which expect to need to make or receive
payments in the future can use forward
contracts or options to “lock in” rates and avoid
the disruptive effects of sudden exchange rate
swings
191
Foreign exchange markets
Speculation
 Speculation differs from arbitrage, in that it
involves the purchase or sale of a currency
in the expectation that its value will change
in the future
192
Foreign exchange markets
Speculation
 Speculation can either reduce or increase
volatility in foreign exchange rates
 If speculators expect a current trend in rates to
change, then their purchase or sale moderates
the price movements
 If they expect a current trend in rates to
continue, their transactions can accelerate the
rise or fall of the target currency
193
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 13:
Exchange-Rate Determination
Exchange rates
Factors influencing exchange rates
 Market fundamentals





Bilateral trade balances
Real income
Real interest rates
Inflation rates
Consumer preferences for domestic or foreign
products
 Productivity changes affecting production costs
 Profitability and riskiness of investments
195
Exchange rates
Factors influencing exchange rates
 Market fundamentals (cont’d)
 Product availability
 Monetary policy and fiscal policy
 Government trade policy
 Market expectations
 News about future market fundamentals
 Speculative opinion about future exchange
rates
196
Exchange rates
When are these factors important?
 Short run (days)
 Dominated by financial transfers responding to:
 Differences in real interest rates
 Shifting expectations of future exchange rates
 Medium run (months)
 Primarily influenced by economic cycles
197
Exchange rates
When are these factors important?
 Long run (years)
 Dominated by movements of goods, services,
investment, which are influenced by:






Inflation rates
Investment profitability
Consumer tastes
Real income
Productivity
Trade policy
 How these factors interact to affect exchange
rates depends on the relative importance of trade
and financial relations between the countries
198
Exchange rates
Exchange rate components
199
Factors influencing exchange rates
Real income differentials
 A country with faster economic growth than
the rest of the world will have a depreciating
currency (other things being equal)
 Imports rise faster than exports, so demand for
foreign currency rises faster than its supply
 Real income changes can also reflect other
processes, which might lead to rising
exports
200
Factors influencing exchange rates
Impact of real income differentials
201
Factors influencing exchange rates
Real interest rates
 Short term real interest rate differences
influence international capital movements
 Real interest rate is nominal minus inflation
 Low short term rates lead to less demand
for the currency and depreciation
 High rates lead to greater demand for the
currency and appreciation
202
Factors influencing exchange rates
Impact of interest rate differentials
203
Factors influencing exchange rates
Purchasing power parity
 Law of one price: In theory, a good should cost
the same in all countries (aside from tariffs or
transportation costs)
 As a result, exchange rates should end up
making prices equal across countries
 By this theory, if two countries have different
inflation rates, exchange rates will move in the
opposite direction to keep prices the same
 The theory may be more useful for predicting
long-term trends than short-run fluctuations
204
Factors influencing exchange rates
Impact of inflation rate differentials
205
Factors influencing exchange rates
Market expectations
 As with stock markets, foreign exchange
markets react quickly to news or even
rumors that point to future changes
affecting rates
 Future expectations can be self-fulfilling;
speculative bubbles can start without any
real information but can become self
sustaining - for a while
206
Alternative approaches to exchange rates
Monetary approach
 Focus on exchange rates as the result of
supply and demand for money at home and
abroad
 Demand depends on real income, prices,
interest rates
 Supply is controlled by central banks
 Exchange rates seen as returning domestic
money supply to equilibrium after a change
207
Alternative approaches to exchange rates
Asset-markets approach
 Investors (firms and individuals) balance
their portfolios among domestic money,
stocks and bonds and foreign stocks and
bonds
 Short run exchange rate changes are
caused by shifts in the kind and location of
financial assets investors want to hold
 Investors shift between assets based on
market expectations for expected returns
208
Exchange rate markets
Short, long run equilibrium: overshooting
209
Exchange rate markets
Forecasting exchange rates
 Judgmental forecasts
 Subjective forecasts based on economic,
political and other data for a country
 Technical analysis
 Uses historical exchange rate trends to project
short-run future movements
 Fundamental analysis
 Includes macroeconomic and policy
information in a predictive model
210
Alternative approaches to exchange rates
Equilibrium in asset-markets approach
211
Alternative approaches to exchange rates
Asset-markets approach: shift in demand
212
Alternative approaches to exchange rates
Asset-markets approach: shift in supply
213
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 14:
Balance-of-Payments
Adjustments Under Fixed
Exchange Rates
Balance of payments adjustments
Balance of payments adjustments
 If part of the balance of payments is in
deficit or surplus for a period of time,
mechanisms are needed to restore
equilibrium
 Adjustment mechanisms can be:
 Automatic - economic processes
 Discretionary - government policies
215
Balance of payments adjustments
Automatic adjustment under fixed
exchange rates
 Key variables




Prices
Interest rates
Income
Money
216
Balance of payments adjustments
Schools of thought on adjustment
 Classical approach (1800s - early 1900s)
 Centered on gold standard
 Emphasized role of prices and interest rates
 Keynesian approach (1930s onward)
 Emphasized income changes affecting
adjustment
 Monetarist approach (1960s-, Chicago school)
 Focus on role of money in changes and
adjustment
217
Balance of payments adjustments
Price adjustment - background
 Under the gold standard, each nation’s
currency was backed by gold and had a
fixed price in terms of gold
 Imports and exports were paid for in gold
 A nation’s money supply (total amount of
gold and gold-backed currency) was
directly tied to balance of payments whether gold was flowing in or out overall
218
Balance of payments adjustments
Price adjustment - background (cont’d)
 Balance of payments surplus would expand
money supply; deficit would shrink money
supply
 By the classical quantity theory of money,
increases in the money supply led directly
to an increase in overall prices (and a
shrinking money supply caused overall
prices to fall)
219
Balance of payments adjustments
Price adjustment of the BOP
 Deficit nations
 Would be losing gold, therefore shrinking their money
supply and causing prices to fall
 Lower prices would make their exports more
competitive and lessen demand for imports, restoring
equilibrium
 Surplus nations
 Would be gaining gold, increasing money supply and
price level
 Higher prices would cut exports and encourage imports
until the surplus was eliminated
220
Balance of payments adjustments
Problems with price adjustment theory
 Gold flows are not directly linked to
domestic money supply
 Nations are often not at full employment
 If economy is not at capacity, less likely that
prices will rise as money supply does
 Prices and wages are often not able to fall
in the short run
 Falling money supply will cut output and
employment rather than prices
221
Balance of payments adjustments
Interest rate adjustment
 Inflows of gold expand the money supply,
causing short-term interest rates to fall;
outflows cause rates to rise
 Investors in surplus nations would send
gold abroad in search of higher rates;
deficit nations would receive gold from
abroad for investment, restoring equilibrium
222
Balance of payments adjustments
Interest rate adjustment
223
Balance of payments adjustments
Income adjustment
 Surplus nations will experience rising national
income, leading to an increased demand for
imports - partially offsetting the surplus
 Deficit nations will experience falling income,
leading to a drop in demand for imports - partially
offsetting the deficit
 Foreign repercussions effect - one country’s
deficit is another’s surplus, so that while income
is declining in one country, its exports will
increase to the country with rising income
224
Balance of payments adjustments
Income adjustment applied
225
Balance of payments adjustments
Disadvantages of automatic mechanisms
 Require governments not to intervene
 Automatic systems seem desirable when
they are believed to lead to full
employment; when nations face
unemployment and shrinking output,
automatic mechanisms seem inadequate
226
Balance of payments adjustments
Monetary adjustment - background
 BOP disequilibrium represents an imbalance
between the supply and demand for money
 Demand for money is:
 Directly related to income and prices
 Inversely related to interest rates
 Supply of money has two components:
 Domestic component - credit created by national
government
 International component - foreign exchange reserves
227
Balance of payments adjustments
Monetary adjustment
 Payments deficits are the result of an
excess supply of money at home
 Excess supply of money encourages imports,
which results in foreign exchange reserves
flowing overseas and reducing the money
supply
228
Balance of payments adjustments
Monetary adjustment
 Excess demand for money leads to a
payments surplus
 Excess demand is reflected in higher interest
rates and less spending on imports,
encouraging a flow of foreign exchange into
the country
229
Balance of payments adjustments
Monetary adjustment - implications
 Theory focuses on domestic monetary
policy as key to balance of payments
 Other policies designed to affect the
balance of payments - tariffs, quotas,
devaluation of the currency - are
ineffective in the long run according to the
theory
230
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 15:
Exchange-Rate Adjustments
and the Balance of Payments
Exchange rate adjustments
Exchange-rate adjustment and the BOP
 Automatic mechanisms may restore
balance-of-payments equilibrium, but at the
cost of recession or inflation
 As an alternative, governments allow
exchange rates to change
 Floating exchange rates, determined by
markets
 Devaluing or revaluing fixed exchange rates
232
Exchange rate adjustments
Exchange rate effects on costs & prices
 Impact of appreciation or depreciation on costs
depends on the proportion of inputs priced in
foreign vs. domestic currency
 As foreign-currency denominated costs rise as a
proportion of total costs, exchange rate changes have
less effect on the foreign currency price and more
effect on the domestic price
 If foreign-currency costs are a small part of total costs,
exchange rate changes have more impact on foreign
currency price of the product and less on domestic
price
233
Exchange rate adjustments
Exchange rate effects on costs & prices
 Generally, currency appreciation increases
the costs of exports in foreign currency
terms, which hurts total exports (while
depreciation encourages exports)
 Effect on prices is modified by the ability and
willingness of sellers to change their prices
234
Exchange rate adjustments
Requirements for successful devaluation
 When can devaluation correct a payments deficit?
 Elasticity approach
 Emphasizes price effects; devaluation works best when
demand is elastic
 Absorption approach
 Focus on income effects; domestic spending must fall,
too
 Monetary approach
 Focus on change in purchasing power of money and
effect on domestic spending
235
Devaluation as adjustment tool
Elasticity approach
 Impact of currency devaluation depends on
price elasticity of domestic demand for
imports and of foreign demand for exports
 The less either foreign or domestic demand
responds to price changes, the less effect a
devaluation will have on the payments
imbalance
236
Devaluation as adjustment tool
Elasticity approach
 Marshall-Lerner condition:
 Devaluation will improve the trade balance if
domestic demand elasticity for imports plus
foreign demand elasticity for exports is greater
than 1
 Devaluation will worsen the trade balance if the
sum of the two elasticities is less than 1
 If the sum is equal to 1, devaluation will have
no effect
237
Devaluation as adjustment tool
Devaluation and time horizon
 The J-curve effect: in short run, devaluation
worsens trade balance, but with time the
balance improves (3-5 years)
 Recognition lags; decision lags; delivery lags;
replacement lags; production lags
 Currency pass-through: effect of
devaluation depends on how quickly
producers pass on higher or lower costs to
their customers
238
Devaluation as adjustment tool
Absorption approach
 Emphasizes impact of devaluation on
spending behavior of domestic economy
 Balance of trade is the difference between
total domestic output and domestic
absorption
 Positive balance means output exceeds
domestic spending
 Negative balance means spending exceeds
total production
239
Devaluation as adjustment tool
Absorption approach (cont’d)
 Devaluation will only improve the trade
balance if output rises relative to domestic
absorption
 If an economy is operating below capacity, a
devaluation will shift resources into export
production and encourage spending on import
substitutes
 If an economy is operating at full employment,
production cannot rise; trade balance can only
be cut by slowing the domestic economy
240
Devaluation as adjustment tool
Monetary approach
 Elasticity and absorption approaches apply
only to the trade balance; monetary
approach includes capital account
 Devaluation may induce a temporary
improvement in the balance of payments
 Devaluation increases the domestic price level,
increasing demand for money and drawing
foreign capital flows (because of higher interest
rates that result)
241
Devaluation as adjustment tool
Monetary approach (cont’d)
 In the long run, the inflow of money
increases domestic spending, increasing
imports and returning the economy to the
starting point
 Devaluation affects real economy only
temporarily; only long run effect is to raise
the domestic price level
242
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 16:
Exchange-Rate Systems
Exchange rate systems
Exchange rate practices
 Floating rate - market determined
 Float independently
 Float in unison with a group of other countries
 Adjust according to a formula
 Fixed (“pegged”) rate
 Peg to a single major currency
 Peg to a basket of currencies
 Peg to gold (obsolete)
244
Exchange rate system alternatives
Exchange rate arrangements of
IMF members, 2001
Exchange Arrangement
Exchange arrangements with no
separate legal tender
Currency board arrangements
Conventional pegged (fixed) exchange rates
Number
of Countries
39
8
31
Pegged rates within horizontal bands
6
Crawling pegged exchange rates
4
Exchange rates within crawling bands
5
Managed floating exchange rates
33
Independently floating exchange rates
47
245
Exchange rate system alternatives
Fixed exchange rates
 Fixed exchange rates are normally used by small
developing nations to peg to a key currency
 For international settlement purposes
 To stabilize import/export prices with the main trading
partner
 To reduce inflationary expectations
 Pegs can be established
 To a single currency
 To a trade-weighted basked of currencies
 To the special drawing right (SDR), a basket
established by the IMF
246
Exchange rate system alternatives
Key currencies: Share of national currencies in
total identified official holdings of foreign exchange, 2000
Key currency
All
countries
Industrial
countries
Developing
countries
US dollar
Japanese yen
Pound sterling
Swiss franc
Euro
Other
68.2%
5.3
3.9
0.7
12.7
9.2
73.3%
6.5
2.0
0.2
10.2
7.8
64.3%
4.4
5.2
1.1
14.6
10.4
247
Exchange rate system alternatives
Fixed exchange rate system
 Establish a par value against one or more
key currencies
 Create a stabilization fund to defend this
fixed rate
 Government must be ready to make good on
all demands to convert to/from foreign currency
 At some point, because of basic economic
changes, the fixed rate can become
impossible to defend and must be changed
248
Exchange rate system alternatives
Exchange rate stabilization under fixed rates
249
Exchange rate system alternatives
Exchange rate stabilization under fixed rates
250
Exchange rate system alternatives
Devaluation and revaluation
 Devaluation is intended to lower the value
of a currency relative to other currencies,
correcting a balance of payments deficit
 Revaluation is intended to raise the
currency’s value relative to other
currencies, correcting a surplus
251
Exchange rate system alternatives
Devaluation and revaluation
 Legally, the changes are made in the par
value of the home currency in terms of the
reference currency
 Economically, the effect is to change the
value of the currency relative to the main
trading partners - who may retaliate by
changing their own fixed rates
252
Devaluation and revaluation
Devaluation/revaluation: legal and economic impact
253
Devaluation and revaluation
Devaluation/revaluation: legal and economic impact
254
Stabilizing developing country currencies
Currency boards vs. dollarization
 A currency board is a monetary authority
empowered to issue domestic currency which can
be converted at a fixed exchange rate
 The rate is usually set in law, and the board must
have foreign exchange reserves large enough to
cover the domestic currency in circulation
 Put another way, the domestic money supply is
limited by the amount of foreign reserves on hand
 Currency boards do not make loans or finance
government deficits
255
Stabilizing developing country currencies
Currency boards vs. dollarization (cont’d)
 Currency boards have become popular as a
solution for countries which have not been able to
control inflation or hold to a fixed exchange rate
 The boards guarantee stability, and political
independence (sometimes more than central
banks, which they sometimes replace)
 But the boards also leave no flexibility in
monetary policy to respond to changing
circumstances and require large foreign
exchange reserves; experience has been mixed
256
Stabilizing developing country currencies
Currency boards vs. dollarization (cont’d)
 Dollarization: residents of a country use the US
dollar with or instead of their local currency
 Unofficial dollarization: residents hold assets and bank
accounts denominated in dollars
 Official dollarization: US dollar replaces local currency
 Countries use dollarization to reduce risks for
investors and avoid problems with domestic
inflation and devaluations
257
Stabilizing developing country currencies
Currency boards vs. dollarization (cont’d)
 Dollarization implies acceptance of monetary
policy set in the US by the Federal Reserve
 Less subject to domestic politics
 Cannot respond to local problems, or run deficits
 US Federal Reserve would not be a lender of last
resort, however
 By holding dollars rather than US government
bonds, the country gives an interest-free loan to
the US
258
Exchange rate system alternatives
Floating exchange rates
 Currency prices established daily by an
unrestricted market
 Large foreign exchange reserves are not
needed to defend a fixed rate
 Rates respond to economic shifts;
payments imbalances are corrected by rate
changes
 Gives greater freedom to domestic
economic policy
259
Exchange rate system alternatives
Floating exchange rates (cont’d)
 Works only if there is enough trade in a
currency to make a viable market
 Greater freedom for domestic policy may
mean poor economic policy has fewer
immediate consequences
 Market rates may move erratically
260
Exchange rate system alternatives
Bretton Woods and after
 Postwar economic system negotiated at Bretton
Woods (1944) included adjustable pegged rates
 In practice, countries were reluctant to adjust their
exchange rates, causing stresses that ended the
system by 1973
 In 1973, the adjustable peg system was replaced
with a “managed float” system, which used
government intervention in exchange markets to
stay close to a target exchange rate
261
Exchange rate system alternatives
Adjustable pegged rates
262
Exchange rate system alternatives
Managed floating exchange rates
263
Exchange rate system alternatives
Exchange rate stabilization and monetary policy
264
Exchange rate system alternatives
Crawling peg
 Establishing a fixed exchange rate is
difficult in an economy with high inflation
 A number of nations use a crawling peg,
under which the fixed rate is frequently
adjusted to account for inflation or other
factors
 Frequent changes keep pegged rates from
becoming unrealistic, and unannounced
changes keep speculators at bay
265
Exchange rate system alternatives
Exchange controls
 Some nations (most, until the 1950s) use controls
over foreign exchange to control the balance of
payments
 At the extreme, the government can have a
monopoly over buying and selling foreign
exchange, capturing export income and limiting
import expenditures
 Multiple exchange rates are also used, with
different rates set for more or less desired
transactions (discouraging imports, for example)
266
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 17:
Macroeconomic Policy in an
Open Economy
Open economy macro policy
Policy in an open economy
 Countries which are open to the world economy
cannot make domestic economic policy choices
without considering the impact on trade and
payments and their international relationships
 Nor can open economies entirely insulate
themselves from other countries’ policy choices
 As a result, nations make efforts to coordinate
their international economic policies
 Economic policies are also subject to domestic
and foreign institutional constraints
268
Open economy macro policy
Economic objectives
 Internal balance
 Fully employed economy
 Little or no inflation
 External balance
 Current account is close enough to balance
that foreign debts can be repaid (deficit) or that
other nations can repay their debts (surplus)
269
Open economy macro policy
Policy instruments
 Expenditure-changing policies: alter aggregate
demand for goods
 Fiscal policy (government taxes and spending)
 Monetary policy (money supply)
 Expenditure-switching policies: shift demand
to/from imports or domestic goods
 Devaluation or revaluation (fixed rates)
 Exchange market intervention (managed float)
 Direct controls
 Tariffs, quotas, subsidies, capital controls
270
Open economy macro policy
Economic objectives and macro policy
271
Open economy macro policy
Exchange rate policies & overall balance
 If a nation was experiencing recession and
a BOP deficit, a currency devaluation would
encourage exports and help boost domestic
production
 If it were experiencing inflation and a BOP
surplus, a revaluation would cut back on
exports and cool domestic spending
272
Open economy macro policy
Exchange rate & overall balance (cont’d)
 Such policy moves are not made in a
vacuum; one country’s devaluation
effectively means a revaluation for its main
trading partners
 If done without international consultation,
these policy shifts might invite retaliation
(as occurred during the Great Depression)
273
Open economy macro policy
Fiscal & monetary policy: internal effects
 Fiscal and monetary policy are generally used to
achieve internal balance, but their effectiveness
depends on the external sector
 Under a fixed exchange rate system, fiscal policy
is more successful in promoting internal balance
than is monetary policy
 Under a floating rate system, monetary policy is
more effective than fiscal policy at achieving
internal balance
274
Open economy macro policy
Fiscal policy: short run internal effects
Under fixed exchange rates
Aggregate
demand
rises
Increase in
government
spending
Money
demand and
interest
rates
increase
Output and
employment rise
Net
capital
inflows
Central bank
sells
currency and
money
supply rises
Output and
employment rise
further
Assumes high degree of capital mobility
For contractionary fiscal policy, reverse all changes
275
Open economy macro policy
Fiscal policy: short run internal effects
Under floating exchange rates
Aggregate
demand
rises
Increase in
government
spending
Money
demand and
interest
rates
increase
Imports rise
and trade
account
worsens
Output and
employment
rise
Net
capital
inflows
Decrease in
aggregate
demand, output,
employment
Currency
appreciation
Assumes high degree of capital mobility
For contractionary fiscal policy, reverse all changes
276
Open economy macro policy
Monetary policy: short run internal effects
Under floating exchange rates
Money
supply
increases
Aggregate
demand
rises
Output and
employment rise
Interest
rate
falls
Net
capital
outflows
Currency
depreciates
Exports
rise and
trade
account
improves
Output and
employment rise
further
Assumes high degree of capital mobility
For contractionary monetary policy, reverse all changes
277
Open economy macro policy
Monetary policy: short run internal effects
Under fixed exchange rates
Money
supply
increases
Aggregate
demand
rises
Interest
rate
falls
Net
capital
outflows
Output and
employment rise
Central
bank
purchases
currency
Money
supply
decreases
Output and
employment fall
Assumes high degree of capital mobility
For contractionary monetary policy, reverse all changes
278
Open economy macro policy
Fiscal & monetary policy: external effects
 Since floating rates foster BOP equilibrium, focus
is on fixed rates
 In short run, monetary policy has a clear effect on
BOP
 Expansion worsens BOP balance
 Contraction improves BOP balance
 Short run effects of fiscal policy are not certain they depend on capital mobility
279
Open economy macro policy
Monetary policy: short run external effects
Under fixed exchange rates
Aggregate
demand
rises
Money
supply
increases
Trade
account
worsens
Interest
rates
fall
Overall BOP
worsens
Net capital
outflows
Capital
account
worsens
Assumes high degree of capital mobility
For contractionary fiscal policy, reverse all changes
280
Open economy macro policy
Fiscal policy: short run external effects
Under fixed exchange rates
Aggregate
demand
rises
Trade
account
worsens
Increase in
government
spending
Overall BOP
may
improve
Money
demand
rises
Interest
rates
rise
Net
capital
inflows
For contractionary fiscal policy, reverse all changes
281
Open economy macro policy
Policy agreement and policy conflict
 Monetary policy
 If a nation has unemployment with a BOP surplus, or
inflation with a BOP deficit, an increase/decrease in the
money supply will restore both internal and external
balances
 But if a nation has unemployment with a BOP deficit, or
inflation with a BOP surplus, a policy aimed at solving
one problem will worsen the other
 Fiscal policy - effects are unclear under those
circumstances
282
Open economy macro policy
Policy agreement and conflict (cont’d)
 In such cases where policy aims do conflict, some
combination of fiscal and monetary policy
measures will be necessary
 Some imbalances are even more intractable,
such as the case where a nation experiences
both inflation and unemployment along with a
BOP imbalance, and require a wider range of
policy instruments
283
Open economy macro policy
International policy coordination
 Domestic economic policy moves can spill
over to affect other countries
 Major industrial nations have worked to
coordinate economic policy so that external
balances are maintained without sacrificing
domestic objectives
284
Open economy macro policy
International policy coordination
 Annual Group of Seven (G-7) economic
summits
 Regular meetings of central bank heads at
the Bank for International Settlements
 Major international policy agreements, such
as the Smithsonian Agreement (1971); Bonn
Summit (1978); Plaza Accord (1985);
Louvre Accord (1987)
285
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 18:
International Banking:
Reserves, Debt and Risk
International reserves
Nature of international reserves
 Reserves of foreign currency and other
suitable assets are used to finance payments
imbalances
 Reserves allow a nation to take more time to
correct BOP disequilibrium (but may also
delay needed action)
 Demand for reserves depends on the
monetary value of international transactions
and the size of payments imbalances
287
International reserves
Demand for international reserves
 Main factor in demand for reserves is the
nature of the adjustment mechanisms to
correct BOP imbalances
 Exchange rate flexibility is a crucial element
of the adjustment process
 Key use for reserves is to intervene in currency
markets to defend an exchange rate
 The more a nation is willing to let its currency
float, the less it will need sizable reserves
288
International reserves
Demand for international reserves
 Other factors affecting demand for
reserves:
 Automatic adjustment mechanisms that
respond to payments imbalances
 Economic policies used to correct payments
imbalances
 International coordination of economic policies
 Level of world prices and income
289
International reserves
Demand for reserves and exchange rate flexibility
290
International reserves
Supply of international reserves
 International reserves may be owned by nations
or may be borrowed if reserves on hand prove
insufficient
 Owned reserves:
 Reserve currencies (US dollar, Japanese yen, etc,)
 Gold - once central, now rarely used
 Special drawing rights
 Borrowed reserves can come from the IMF and
other official arrangements, or can be borrowed
from major commercial banks
291
International reserves
Gold as a reserve asset
 Gold was originally used as currency, but it began
to be replaced by paper money and bank
deposits
 Post-World War I inflation prompted many nations
to return to a gold standard, where all currency in
circulation was backed by gold
 Gold standard collapsed during the Great
Depression, to be replaced by a gold exchange
standard after World War II
292
International reserves
Gold as a reserve asset (cont’d)
 The US dollar was set to be convertible to gold at
a fixed rate, and the dollar became a key reserve
asset
 Stresses from persistent US payments deficits
brought an end to the gold exchange standard by
1973, and in 1975 gold was removed as an
international reserve asset
293
International reserves
Special Drawing Rights (SDRs)
 Because a gold standard limits the amount of
currency available to the supplies of gold on
hand, the IMF created the SDR to increase
international liquidity
 SDRs represent rights to draw foreign currencies
from the IMF to use for settlement purposes; they
are allocated to IMF members proportionally
 SDRs are pegged to a basket of key international
currencies, and are useful because they are not
tied to any one currency
294
International reserves
Facilities for borrowing reserves
 IMF drawings - members may purchase foreign
currency with their own currency, with limits and
sometimes conditions
 General Arrangements to Borrow - major
industrial nations agreed to make further reserves
available to the IMF if needed
 Swap arrangements - major industrial nations
agree to swap currencies with each other; can be
done more quickly and less visibly than Fund
drawings
295
International reserves
Facilities for borrowing reserves (cont’d)
 Special financing facilities - to compensate mostly
developing countries which face hardships which
are transient or beyond their control:
Compensatory Financing Facility, Oil Facility,
Buffer Stock Facility
 Commercial bank lending
296
International lending
International lending risk
 Credit risk - potential for financial default
 Country risk - whether government policies
will help or hinder the servicing of the loan
 Currency risk - whether devaluations or
exchange controls will interfere with the
repayment of the loan
297
International lending
International debt problems
 Many developing nations borrowed heavily
on easier terms in the 1970s because
major banks were flush with deposits from
oil producing states
 In the 1980s, rising interest rates caused
payments on the variable rate international
loans to increase, and the ability of many of
these major debtor nations to service their
loans came into question
298
International lending
International debt problems (cont’d)
 Most loans were denominated in dollars,
meaning that these nations had to run
current account surpluses to earn foreign
exchange with which to make loan
payments - just as the industrial nations
went into a recession
 Measures used to gauge debt burden:
debt-to-export ratio; debt service/export
ratio
299
International lending
Options for debt-service problems
 Nations can stop making payments - but
there are severe consequences
 Service debt at any cost - but may be
politically impossible
 Reschedule the debt - stretch out
repayment schedule (but pay more overall)
 Obtain emergency loans from the IMF - but
conditionality may be hard to stomach
300
International lending
Reducing bank exposure to developingcountry debt
 Loan sales in secondary market
 Debt buybacks or debt-for-debt swaps
 Debt-for-equity swaps
 Debt reduction and forgiveness
301
International lending
Eurocurrency markets
 Deposits in dollars and other major
currencies in banks outside the US
 Main advantage over US deposits is
interest rate differential
 Eurocurrency market facilitates financing of
trade and investment, but there are
concerns that some of the banks in this
market do not face the same regulations as
do large banks in the industrial nations
302